Evolution of Joint Venture Models for Entering China’s TMT Market

Tapping the cornucopia of China's TMT market without getting lost in the black box of its regulatory framework and the minutiae of its local business practices has long driven MNCs into and out of the country. Many a venture has entered the market trying to closely follow the pattern of success stories, only to find its own story less successful. For foreign businesses to yield fruit in China, it is crucial to understand that even the basic pattern evolves, and one mould does not fit all.

The PRC regulatory framework has long distinguished foreign-invested enterprises (FIEs) organised as wholly foreign-owned enterprises (WFOEs) from those organised as Sino-foreign joint ventures (JVs). The line dividing them and details of each change frequently, primarily in tandem with changes in the foreign-investment restrictions, operating permit requirements and other regulations governing FIEs. Additional layers in the framework (eg, for foreign-invested telecoms entities (FITEs)) as well as specially created corporate structures (eg, variable-interest entities (VIEs)) further complicate the mix. 

Due to particularly deep restrictions and local practices, China's TMT industry was first approached by foreign businesses mostly through JV's with local investors and other business partners. The so-called JV 1.0, exemplified by Amazon's market entry, essentially consisted of only a contract between an offshore entity (of the foreign entrant) and a local Chinese entity: the latter was mostly passive, serving as the local shareholding required by law for the JV 1.0 to obtain operating licences (eg, an ICP licence), while the foreign entrant funnelled in capital, talent and other resources, and even handled most of the operational matters.

However, the JV 1.0 tapped only limited local resources and business opportunities, and its fate was largely pinned to that of the foreign parent (which thus could hardly exit its own investment). The conduct of and relationship with the local partner was also sometimes fraught with uncertainties. Ultimately, however, even such joint ventures found that obtaining the necessary licences for operating telecoms businesses (and thus becoming FITEs) was difficult, time-consuming and all-too-often unachievable (with fewer than a hundred FITEs registered until 2018). 

The so-called JV 2.0 was in some sense a major innovation, used by the likes of Uber and LinkedIn, built on the scheme of a VIE: a fully or majority domestic entity served as the local permit-holder and nominal operating hub but was dependent on (via licensing and technical support agreements) and controlled by (via nominee shareholding, pledge agreements, etc) a WFOE. The latter was held by a JV consisting of the foreign business and one or more Chinese partners, or even other foreign partner(s) investing offshore.

Aside from being uniquely fit for TMT sectors where PRC law prohibits even a Sino-foreign JV from operating, this structure reduces the capital commitment of the foreign party (since the partners can freely capitalise the offshore JV and all such capital can be injected into the WFOE), and allows for greater independence and the splitting of local from global business operations, facilitating an exit abroad yet being potentially separable from the foreign business' IPO, financing, etc.

On the other hand, the JV 2.0 remains fundamentally foreign in the Chinese market, even more than the JV 1.0, limited in terms of local resources and business opportunities, as well as local financing and exit avenues. Moreover, VIEs long operated in a grey area of PRC regulation and, if not structured punctiliously, could put at risk a foreign business' control over its local operations and assets (particularly, the operating permits). In the last couple of years, VIEs have come under growing regulatory attention and finally even explicit regulation.

Not long ago, as a result of regulatory shifts, as well as lessons learned from the above models, a JV 3.0 was developed and, by now, it has already been successfully used for China deals such as Evernote's spin-off of Yinxiang Biji and the joint venture between Sequoia Capital and Gitlab. Taking advantage of loosening foreign-investment restrictions and an enhanced local ecosystem of investors, management talent, etc, this next-generation model brings together the foreign party, local and/or foreign investors and an ESOP platform into an onshore JV; this is capitalised variously by the foreign and local partners and endowed with IP and other resources from its foreign parent, obtains relevant operating permits, and attracts and incentivises local management. The trend has been reinforced most recently, in mid-2022, by the removal of the previous “procedural” requirement that foreign-invested companies seeking to become FITEs had to demonstrate that their principal shareholders/parent companies had a “good track record in the telecoms business”. With this change, many foreign investors seeking to invest in China’s TMT market should have a much easier and more straightforward experience.

The result is a truly local operation that can more effectively compete with the new level of domestic TMT enterprises, while still under the aegis of the foreign business and subject to market separation parameters, as well as benefitting from wider opportunities for financing, IPOs, etc. In addition, the JV 3.0 is not susceptible to the potentially growing risks associated, in some areas of the China market, with VIE structures and more generally aligns with regulatory trends. As such, aspiring FITEs as well as media ventures (subject to strict broadcasting and content regulation) and many others in various tech sectors may enjoy smoother market entries and exits via the JV 3.0 model. It is no surprise that the number of FITEs has increased dramatically in the last few years, with several hundred currently registered.

In sum, while the wealth of opportunities in China's TMT sector is overlaid with a dense tapestry of regulations, foreign companies can effectively explore the former without getting lost in the latter. In fact, if one thing has been learnt it is that following too many threads, let alone listening to the clamouring voices in the mass media, can be counterproductive.

An operating model exists for almost any business entering China's TMT market: it is best selected or developed on a case-by-case basis for each such business, based on the latest regulatory trends and local practices, in addition to the detailed circumstances of the business.