I wasn’t planning on writing a detailed post about cross-border financing structures for a while, although it was on my To Do List. Dan’s latest post at CLB on “fake Joint Ventures” requires a response, although I’ll save some issues for later when I have time for more.

To set the context for all this, Dan was discussing some of the recent client conversations he has had, which he recreates as follows:

Caller: I’ve got this great website and it is exactly what China wants/needs. And I’ve been working on developing it with some Chinese tech friends of mine and we are want to take it legal so we can start getting VC (venture capital) funding for it. Here’s our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.

Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing.

I’m in basic agreement with Dan’s advice. At heart, I’m quite conservative when it comes to risk. Most corporate lawyers tend to be risk avoiders. This is not the case, however, with folks in the venture capital and private equity business, and although Dan’s post discusses joint ventures, it is really about cross-border financing.

Let’s take a look at Dan’s example more closely. We have an online business in China. For the sake of argument, let’s assume that it has an e-commerce component, which means that there are limits on foreign investment. The client cannot own that company, nor can it hold a controlling interest in a JV. What to do?

The scenario outlined by Dan’s hapless client is that the foreign company will have some sort of contractual arrangement with the Chinese company, the latter being the operating entity that holds all the (government-granted) licenses. Obviously in this case, the contractual arrangement (some sort of side letter regarding equity) is pretty lame. For more sophisticated folks, there are much more elaborate structures that purport to bind the offshore investor to the Chinese operating company, supposedly minimizing risk.

What do these look like? A really nice article can be found here, which outlines most of the major structures that are used. The one we are talking about is Structure 3, which looks like this:

This is not as complicated as it looks. For the purposes of this discussion, focus on what’s going on onshore between the WFOE (the foreign company in China) and the “Domestic operating companies.” Essentially this is that contractual relationship noted above between the investor and the Chinese company. The other bit, involving the Chinese Founders, illustrates to overall attempt to minimize risk, but you can ignore that part for now.

I will save for another post the specific types of agreements executed by the investor and the Chinese founders — interesting as well. For now, I would just like to point out that despite all of this crap, we are left with the exact same situation as that described by Dan’s client: a Chinese company operating in a restricted area with a contractual obligation to a foreign company. The only real difference is that there are two types of obligations: company to company, and founder/shareholder to company.

None of this other stuff changes that fundamental problem of foreign investment limitations. This is a restricted industry, meaning that although lots of foreign companies are doing business in this area, they are not really supposed to be doing so. These fancy structures are work-arounds, because a straightforward investment is (sorry to put it bluntly) illegal.

This gets us finally to why these structures are fundamentally risky: when it all boils down to the basics, the investor does not hold equity in the domestic company and therefore has no real control of the most valuable asset, the operating licenses. You can tie up the Chinese founders in 100 different contractual knots, but unless those founders have huge assets offshore (real assets, not equity in the holding company) that you can go after in a dispute, they can always tell you to piss off and kick your ass out of the business.

I’ve seen several Chinese companies owned by proxies/nominees of foreign companies. I would disagree with Dan on one point: they don’t always end in disaster (e.g., several of them are trading on NASDAQ and doing quite well), and the foreign company can sometimes salvage things in the event of a dispute. I would put it this way: these structures, which are heavily lawyered things and therefore have the appearance of solidity, are actually fragile beasts. You get into a dispute with your Chinese partner, odds are that you are screwed. The ones that are doing well are simply lucky, and some may be running on borrowed time. When business slows down, disputes will occur, and I expect that many of these structures will be tested over the next couple of years.

What’s very interesting to note here is that Dan’s analysis is pretty much applicable to any Joint Venture, but not necessarily intended as a special case applicable to VC or PE investors. Folks in the finance biz would argue that this is no simple JV deal (look at that diagram!) and that Dan, if he is treating it like a JV deal, must simply be inexperienced.

Bullshit. Don’t ever get fooled by the gibberish spouted by the “experts” and the complex structures created by these sorts of deals. When you simplify all of this, you have the exact same risk issues as a JV, and these remain significant no matter how many intermediate companies and loan guarantees are put into place.

I kind of wrote this on the fly, and I should note that a lot of this is gross oversimplification. Many different scenarios exist that can change the outcome here, and ways to minimize risk do exist under some of those different fact patterns. Hopefully I can return to this topic soon and flesh this out better.