The agreement between Chinese search engine Baidu and American tech firm CloudFlare is a game changer for foreign companies looking to capture part of China’s market share. The unique structure of the partnership, in which Baidu uses CloudFlare’s technology and each company shares the revenue, has been called a virtual joint venture and may be an attractive solution for tech firms that have previously encountered difficulty doing business in China. The key lesson from the virtual joint venture is these agreements utilize each company’s strengths to generate revenue while avoiding unnecessary expenditures that would have occurred if either company expanded into the foreign market on its own.

Difficulties Entering China

Due to the Chinese government’s enduring practice of media censorship, use of digital firewalls and collection of sensitive personal information from Internet users, companies such as LinkedIn have had to make concessions on the treatment of privacy for Chinese users.

Part of the process of entering China for Uber was to partner with Baidu as CloudFlare did in July 2014. Although Uber operates as its own company within China, Baidu purchased a stake in the American company and is developing a feature to offer the taxi service to users of Baidu Maps. The Chinese government looks for actions such as these when an American company makes moves to enter the country.

In February 2014, LinkedIn introduced a Chinese-language version of its platform after 4 million Chinese users signed up on the English-language platform. The introduction did not come without a price, however. LinkedIn agreed to censor sensitive information from its users in China. Chinese users do not have access to the same tools of expression the platform offers to those outside of the mainland, such as extended-length posting and the ability to join groups. When faced with the same censorship hurdles, other companies such as Twitter and Google pulled out of China.

By partnering with Chinese companies, American firms can gain access to the Chinese market without the headache of having to navigate the country’s difficult legal and political environment alone. This method of entry into China is not without risk for an American business. If an American tech firm allows a Chinese company to make use of its intellectual property, the original agreement between these parties must facilitate transparency. It requires mutual assurance that neither company will steal the other’s technology for personal gain, mishandle the sensitive information of users or fabricate revenue figures as a means of hoarding profits from the venture.

A Sizable Population

These risks, however, may be well worth it to tap into China’s population of 1.3 billion. To put that number into perspective, it is four times the population of the United States and over 1.75 times the population of the entire European continent. For Uber, a population of this size has led the company to be willing to lose out on potential profits by paying taxi drivers more than their fares just for a chance to conduct business in the large market. Despite China’s two child restriction per household, the population is projected to swell to 1.45 billion by 2030, suggesting businesses that enter now gain not only from the current market, but from a market that is increasing in size.

Effects on the Financials

What distinguishes a joint venture from other types of partnerships is the level of risk each company agrees to shoulder to collaborate on a project. Both parties are faced with significant risks and wield a strong say in the direction of the project overall. This is what makes joint ventures different from outsourcing.

By entering a virtual joint venture, companies can utilize the pre-existing infrastructures built by Chinese companies to save on overhead costs incurred by starting fresh in a new country. The expertise of the Chinese company serves as a more attractive and convenient alternative to hiring a consulting firm; the success of the mutual exchange of practical know-how is measured in profits for each party.

The companies agree to share the responsibility for certain activities, such as deciding on major marketing moves; and possess control over other activities, such as maintenance of website addresses and the personal information of users. Joint ventures, also called collaborative arrangements, incur revenue as gross or net on their balance sheets depending on whether the American firm is acting as a principal or an agent in the arrangement. Companies may not use the equity method of accounting when engaging in a virtual joint venture. In this major dealing, CloudFlare’s revenue streams are not fixed and the company bears credit risk by entering into the agreement; the American company is considered a principal in its transactions and makes use of gross reporting for accounting purposes.

An agreement between the two companies in a joint venture should be formed with the awareness of potential future tax consequences if the agreement dissolves. Likewise, the initial transaction between the two entities should not cause immediate tax consequences that can otherwise be avoided. A virtual joint venture may provide an advantageous tax environment for a business, as gains from joint ventures have the potential to be recognized on a deferral basis.

Political Risk

Companies that operate in China with express permission from the Chinese government may find that Chinese companies are seeking to actively utilize the technology of foreign companies rather than invest their own dollars into developing new technology. Part of the risk of entering into a business agreement with a company located in a foreign country is the future stability of the country and the changing political environment. The damages of political risk can abruptly end a joint venture. When American businesses enter into long-term agreements with Chinese companies, the key decision-makers need to decide if China is heading toward a less restrictive environment for market exposure, or if new laws and policies may be enacted that could jeopardize the relationships forged between venture participants.

Worldwide Market Exposure

The case of CloudFlare and Baidu has implications not only pertaining to the entrance of U.S. companies into Chinese markets but also to other parts of the world with viable markets that may be difficult to enter due to unaccommodating political environments or language barriers.

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