A Chinese JV means big work for the board: given the likely importance of China to the company's future, the board has an important role to play in ensuring a joint venture's success. Here are the decisive pressure points.

• Author: Yoost, Dean A.
• Position: BOARD OVERSIGHT - Joint ventures

VIRTUALLY EVERY U.S. COMPANY investing in China and their board of directors confront a myriad of challenges and risks with joint ventures. Historically, joint ventures have been the optimum or, in many cases, the mandatory investment vehicles. More recently, however, direct investment is gaining popularity as valuable on-the-ground experience in China has been achieved, restrictions on foreign investments are easing, and the difficulties of negotiating, establishing and managing joint ventures have become evident.

State-owned enterprises (SOEs) have consolidated, creating national champions in many industries. These SOEs are increasingly pursuing their own investments in research and development and innovation, as well as directly investing overseas. The desire for foreign investment and the perceived need for domestic JVs have receded in many industries. Nevertheless, in many cases, joint ventures remain attractive, particularly as the costs of greenfield investments rise and valuations remain elevated for acquisitions of Chinese targets.

From the perspective of the board of directors of an investing U.S. company, joint ventures in China require a continuing risk assessment. As with all other risks, the board and its designated committees should follow management's lead in identifying, managing and mitigating risks. While the challenges of joint ventures can present a steep learning curve for the board, taking advantage of the opportunities involves the board's understanding of the unique characteristics of the risks.

It is the board's responsibility to gain sufficient insight to ensure they are in the position to provide thoughtful, meaningful counsel to management, and to exercise skepticism regarding the company's plans. This can be done by challenging the assumptions and critically assessing progress, which can be particularly difficult because China is vastly different, unfamiliar, and subject to rapid, radical change.

Most boards of global companies have, or seek, someone with relevant experience and specialized expertise in the China market given its strategic importance. This proficiency sometimes is lacking, however, requiring a recalibration of the board's approach and potentially a re-composition of its members. Current best practices suggest that the establishment of a special advisory board that counsels the board and management on joint venture matters can help in plugging deficiencies.

Partner selection and diversification

Historically joint ventures were greenfield relationships, creating a new legal entity with some form and amount of technology, capital, and local operations/facilities contributed by both parties. Increasingly, joint ventures are now formed through acquisition of a part of an existing Chinese legal entity by the U.S. investor. While acquisition of the entirety of a target may appear more expedient, it is also much more complicated and inherently more risky. The U.S. investor will also be buying into all the problems and issues of the target, in many cases with direct successor liability.

There are many good reasons to have a joint venture. Local partners who understand the market and customs, as well as having good relationships with government officials and other intermediaries, can be attractive partners and help mitigate the risks of entering into the market. Many industries have dominant and increasingly international competitors raising the barriers to entry. This may also be a good reason to form a joint venture. However, it is imperative that U.S. investing companies select partners that explicitly share their strategic and commercial goals. This does not necessarily eliminate as potential partners large, well-established Chinese companies. But it does open the door to faster growing, privately owned, and smaller companies that bring a strong commercial mindset and tangible business assets to joint ventures.

Our experience suggests that U.S. investing companies frequently spend too little time with potential partners building a shared understanding of its future business, the markets it will compete in, and how it will evolve over time. Insufficient attention is given before the formation of the joint venture to jointly developing business plans and preparing for probable changes in the market dynamics. Differences of opinion rooted in competing expectations of future performance ultimately can affect the joint venture's strategy and focus and eventually lead to its failure.

Some U.S. investors emphasize profitability, even when growth is slow, while their Chinese partners emphasize growth, even without profitability. U.S. investors often will have a longer-term view of a joint venture's financial returns, willing to reinvest profits and increase registered capital, while the Chinese partner will often be more short term and dividend focused. The result can be different priorities for investments and a lack of cooperation, both between the joint venture partners and within the mixed management team.

In any relationship the inevitable question of how to handle partner disagreements must be addressed. In our experience, the most common disagreements arise from differences of opinion on how to finance growth, often involving disagreements about reinvesting retained earnings and additional capital requirements. Since venture financing is key and a common joint venture issue subject by law to unanimous agreement of the partners, how to handle disagreements and the process to get to an agreement should be explicitly addressed in the venture's formation documents.

Also essential is the ongoing oversight and cultivating of partner relationships, as joint ventures will likely go through difficult strategic and business issues particularly in the initial years. Problems between joint venture partners will ultimately be solved between people based on a deep mutually understanding of respective aspirations for the joint...