Before You Set Up Shop in China...

Small-business owners looking to move into the Middle Kingdom, take note: Despite the allure of cheap labor and a staggeringly large market, successfully setting up shop in China might be one of the biggest challenges your company will ever face.

First, there's a long history of big businesses that have underperformed in China. Global champions from PepsiCo (PEP) to Microsoft (MSFT) have stumbled there. Then there's the fact that China's business environment is still more of a maze than a well-oiled machine. Registering a company is typically a 25- to 30-step process, the nation's legal system is unreliable, and government regulations are vague and often subject to bureaucratic whims. Add to that a different set of cultural norms and a level of unpredictability that far exceeds the normal volatility of entrepreneurship, and you start to get a glimpse of what you're up against.

For most multinationals, all of this is simply part of the cost of doing business in China. Big companies can afford to pour a continual stream of capital and manpower into their China operations until they finally achieve profitability. But the little guys have no such luxury. "'For small companies, things need to be done precisely and concisely,'' says Kenneth Wong, managing partner of SmithWong Associates, a Trevose (Pa.)-based consulting firm that helps businesses craft their China strategies.

That's why it's imperative for savvy small-business owners to do their homework and check it twice before charging headlong across the Pacific. Here are a few things to keep in mind as you prepare to go to China.

Industry: With China's 2001 entry into the World Trade Organization and mounting global pressure on Beijing to level the playing field for international investors, long-standing restrictions on foreign companies are now rapidly dropping to the wayside. ''It's changing every day, quite literally,'' Wong says.

While that means China is more accessible to your small business than ever before, it also means being up to speed on the latest rules and regulations is more important than ever. Policies governing a single sector can vary widely from province to province, city to city, and even within different districts of the same metropolitan area, so make sure you not only know the ins and outs of your particular industry on a national level but also double-check to make sure the same rules apply locally.

Location: Though Beijing, Shanghai, Guangzhou, and a handful of other seaboard hubs remain the destinations of choice for most foreign companies, they may not be the best locales for businesses on a budget. ''The coastal area, I'm not saying it's saturated, but it's reaching a point where the edge it offers is not so big as it used to be,'' says K. Bobby Chao, chairman of Dragon Venture, a Silicon Valley-based venture-capital, consulting, and mergers-and-acquisitions firm that bridges the U.S. and China markets.

If you're looking for good deals on real estate and salaries, it's important to remember that China has close to 100 cities with a population topping 1 million -- nearly all of which are actively trying to attract foreign investment. By choosing a city that's a bit off the beaten path you'll be privy to a host of government incentives that can translate into substantial savings. Xi'an, a city of over 4 million in China's rapidly developing West, for example, has a High-Tech Zone that offers foreign companies deeply discounted office space and tax exemptions until they've been profitable for two consecutive years.

Investment structure: Perhaps the biggest decision of all is what type of investment structure you should adopt: Joint ventures and wholly foreign-owned enterprises are the most common. A 2004 VisionAsia study showed that wholly owned enterprises were the vehicle of choice for most foreign companies, with cities like Shanghai having nearly 19,000 wholly foreign-owned enterprises and just over 8,000 joint ventures.

For small businesses, though, the cost and amount of paperwork involved could prove a heavy burden. Says Wong: "There's just too much to navigate on your own unless you really have the capital and the time to invest, and are in a position to take your lumps and bruises." Forming a joint venture with a local Chinese partner is definitely the less expensive way to go.

However, Douglas Shelly, owner of Maple Tree Business Solutions, a China-based consulting and outsourcing company, says he has seen too many cross-Pacific partnerships go sour, leaving the foreign partner with little legal recourse. In his opinion, new companies are safest taking the independent route unless it's an industry where forging local government relationships are of particular importance, such as telecommunications or financial services.

Management: Unless you're embarking on a simple outsourcing project, experts agree that you'll want to maintain a permanent China presence. That means that you need to give serious thought to who's going to run the show. "You must be willing to set your feet on the ground in China in order to do business here," says Peter Chen, owner of P.W. China Business Consultancy and a Shanghai-based executive trainer who has spent the past 15 years advising foreign enterprises on how to succeed in China. "Never, ever attempt the 'remote control' type [of management]," cautions Chen.

But dispatching members of your U.S. staff to head your China operations can be costly, especially if they require all the perks of expatriate life. Besides, many companies have floundered under Western managers with little understanding of local ways and customs.

If you're starting small, Shelly suggests a way to minimize expenses and still keep a knowledgeable foreign presence on the ground: Employ a local Chinese manager, but then hire a "part-time expat" to regularly visit the office, oversee operations, and act as a liaison with headquarters. Most major Chinese cities are home to some Western management companies or at least a population of Westerners who've established themselves in China and are willing to do this for fraction of the cost of a "full-time" expat, he says.

Intellectual-property protection: Though international pressure is mounting for China to crack down on rampant piracy, a 2004 study by the American Chamber of Commerce-China showed that member companies still cited lack of intellectual-property protection as one of their businesses' biggest obstacles. To get around the problem, some manufacturers hold back core technologies or try to "blackbox" their operations, producing component parts in multiple locations around the country and then assembling them in a single, low-tech factory. But while you should have a clear plan for how you'll minimize your potential losses, at the outset there may be no simple, surefire means to keep the lid on your IP.

If that's too big a gamble, or if you're having trouble finding a Chinese partner you can trust and don't feel comfortable going solo, Wong says you may want to consider operating out of Hong Kong or partnering with a Hong Kong-based company. Though it's more expensive than the mainland, Hong-Kong's legal system is more developed, and companies face few trade barriers with the rest of China.

Commitment: Experts agree that one of the worst mistakes a business owner can make is to approach China without conviction. While it has a lot to offer a small company, the challenges involved in establishing an operating presence there will test your resolve. "China is a real and fierce market battleground," Chen says. "Anyone entering this arena with only a half-hearted fighting preparation would be knocked out very quickly."

However, while a carefully crafted business plan is essential, you should prepare to be flexible: In China survival often hinges on an ability to constantly adjust to the unexpected. It's a lot like running your small business now, only a lot more intense.

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