Your China PPP – The Perfect Partner Profile, Part III – Self Reinforcing Deal Structures

So by now you’ve met a potential China partner who, while by no means perfect, is certainly useful. Or you will soon, now that you know a little bit more about what you’re looking for. Try not to forget that the Perfect Partner Profile is a framework with 3 parts:

1 – Figure out what you are really looking for in a partner — being as specific and detailed as possible.
2 – Create a win-win deal structure that can be executed and put into action reasonably quickly and effectively.
3 – Avoid building an operational structure that allows (or requires) your partner to screw you over the moment it becomes possible.

Today we focus on Part 3 – building a self-reinforcing deal structure that gets stronger (in a positive way) as it succeeds.

Common Mistake: The Swinging Balance of Power
Too many China deals follow this patter: the Western part agrees to inject capital, IP and know-how into the partnership and the Chinese side agrees to provide administrative support, local expertise and distribution. The western side – seeking to protect its investment – crafts a contract that includes conditions, penalties, punishments and contingent liabilities. China side receives assets, capital and IP from western counter-party – and promptly stops picking up the phone.

What just happened? The deal was structured in such a way that the Balance of Power shifted 180 degrees in favor of the Chinese side the moment the assets were transferred. Suddenly the western side found itself with a worthless partnership, poor control of its own property and a contract that probably can’t be enforced.

How can western deal-makers structure their relationship to avoid this turn of events? By creating a deal that both sides can reasonably expect to be more valuable tomorrow than it is right now.

Structuring a self-reinforcing deal:

There are 3 ways to build such a deal structure:

    1) Triggered incentives.
    You agree in advance about what the incentives will be and what will trigger them. These are default-mode rewards – barring any unusual or unforeseen event, the reward is granted once a specific requirement is met. This could be number of units sold, amount of profit accrued, length of time spent in the partnership or any other condition. This kind of incentive usually repeats and can be predicted as a normal course of business. The most common examples are sales commissions, profit shares, vesting accounts or scheduled bonuses.

    2) Conditional incentives
    Changes to the basic structure of the agreement can be made after certain conditions are met. One common example is a discount for cash payments or a bonus for meeting a deadline. Another application would be exclusivity for a certain region if certain sales targets are met. These incentives are often unique or 1-off deals.

    3) Penalties and punishments
    Some negotiators and lawyers still try to enforce compliance through use of penalty or punishment clauses in the contract document. Withholding payment or commissions to collect on ‘fines’ imposed for non-compliance sounds good in theory – but is mess to put into practice. Chinese courts rarely award damages, so once your conflict reaches the court-room you are almost guaranteed of losing – even if you win the case.

In China, options 1 and 2 sometimes work. Option 3 is ineffective, and often leads to far bigger problems than the one you were trying to solve in the first place.

The key to developing effective incentives is to figure out specifically what kind of behaviors and outcomes you wish to reward, and then developing a simple, straight-forward means of measuring it. Incentives only work when all parties expect tomorrow’s payoff to be bigger than yesterday’s. The problem here is that counter-parties often pick the wrong goals to compensate – leading to ineffective or counter-productive deal structures.

The Sales Commission Approach
A common example is the basic ‘commission on sales’ incentive scheme. Fewer deals are more straight-forward and effective, yet there is still plenty of room for misunderstanding and problems.

The first issue is that if you pay someone to sell, then that’s what he is going to do. Sell. He’s not going to manage, train, collect, design or plan. That’s fine, if all you want him to do is sell – but if you’re plan (whether written or ‘in your head’) is to have this person provide a range of services in addition to selling, you have a problem on your hands. He may have little interest in performing such ‘unpaid’ work while there are sales to be made.

The second issue is the SIZE of the commissions being paid out. Developing new markets is hard, time-consuming and risky. That’s why some clever partners try to incentivize sales reps by paying them a higher commission rate at the beginning, and a lower rate as their sales rise. This seems much fairer to the boss than to the salesmen – who perceives it has a real DROP in his pay. Partners who propose a sales arrangement had better stop and consider what they’ll do in the even of success. Every owner and sales manager SAYS he isn’t bothered by writing big commission checks – but the truth can be different. Many partners feel that big, regular commission payments can destabilize a partnership over time and encourage the non-selling partner to seek cheaper options.

Third – be careful what you wish for. If all you want is sales, then your local partner will provide you with sales. But be very clear on the return and collection policy at the beginning. A smart salesman can manufacture bogus sales that will look real enough for a few months, but will ultimately burden the company with non-collectible receivables or a warehouse full of returns.

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