Trust, but verify! Basic due diligence in China

The EU SME Centre in China (INSME Partner), a project funded by the European Union to provide business support to SMEs, highlights the importance of carrying out due diligence and presents 7 rules to keep in mind when entering the Chinese market.

European companies – big and small – are very much used to exercising due diligence, i.e. the checks performed to assess a potential business partner’s trust- and creditworthiness. More than 24 million SMEs are active in the 27 Member States and they deal with each other on a daily basis. What is more, over one quarter of all European SMEs are active internationally (importing, exporting, or both), adding international due diligence experience to their set of capabilities. Thus one might assume that European SMEs are well prepared to venture into the Chinese market; one in which cooperation with a local partner, and therefore due diligence, is essential. Unfortunately this is not so. No matter how much experience a company has in dealing with international partners – doing business in China for the first time is different from anything that came before.

Booming business and lagging legislation

In many cases legislation, standardisation and enforcement have not been keeping pace with the staggering changes the market has experienced during the last decades. The Chinese authorities are working hard to build a regulatory framework that is consistent with realities on the ground. In the meantime, local and foreign companies alike are forced to struggle with inconsistencies, duplications and lack of information – so much so that not even local companies can be sure that the standard their product complied with a few weeks ago is still valid.

Everybody needs somebody

Despite that fact, local knowledge is crucial to successful market entry in China. After all, the Chinese language in itself is an obstacle hard to overcome for many Europeans. In addition, setting up a network of importers, distributors, suppliers, service providers and government officials takes cultural knowledge and social skills that differ markedly from European conventions. Thirdly and most compellingly, a Chinese business partner is required by law for many of the essential business activities European SMEs will be required to perform while doing business in China.

Trust, but verify

This mix of an unclear regulatory framework and the need to find a trustworthy local partner makes due diligence a major concern for all foreign companies looking to penetrate the Chinese market. Checking a number of documents with the assistance of a Chinese lawyer in addition to conversations with the right people and a healthy amount of vigilance will give you a working knowledge of your potential partner’s financial, legal and operational background. Of course, carrying out regular due diligence during your on-going business cooperation is just as important as conducting preliminary due diligence.
In the recently published fifth part of a diagnostic kit for European SMEs looking to sell to or invest in China entitled “Knowing your partners in China”, the EU SME Centre proposes seven rules of due diligence that should always be on a company’s mind when considering to co-operate with a local partner in China.

The seven rules of due diligence

1.) Assess how Chinese companies treat the partner company
Local knowledge is key to successful due diligence. Therefore, try to understand what other Chinese companies think about your potential partner and how they treat them. It is harder for Chinese companies to mislead other Chinese companies and there is less incentive to do so since local co-operation tends to be longer-term and the legal framework is clearer.
2.) Do not take company introductions at face value
Personal networks and group solidarity are important in China. Therefore, be wary of contacts arranged by your potential partner. Any supplier, employee or customer engaged through the partner company may have an agenda benefitting the partner company rather than you.
3.) Always ask yourself “Is this too good to be true?”
Opportunities might abound in China and prices might be low at times, but even in China wages and other costs are rising constantly. So be cautious whenever an offer seems too good and remain vigilant at all times.
4.) Scrutinise the company operations
It is vital to make sure that your potential partner company actually exists and is able to do what they claim. Visit their premises, speak to employees, suppliers, and service providers involved.
5.) Scrutinise the company’s paperwork
There are a number of documents you can check to make sure everything is in order. Ask to see the business licence, the company stamp, any special permits and licences as well as land use and intellectual property rights certificates, and research the company at the state or provincial branches of the Administration of Industry and Commerce (AIC). Be on the lookout for mistakes in names, locations, dates, amounts given and stamps used. It is best to make use of the services of a Chinese lawyer for these checks.
6.) Speak to other stakeholders
The more independent sources you speak with the better. Check the consistency of the potential partner’s claims against the experiences of employees, competitors, suppliers, regulators, customers, industry media and even neighbours.
7.) Do not delegate
Since business subordinates and outsiders might have reason to conspire with the potential partner company, take ownership of the due diligence process yourself. Do not rely on the conclusions of third parties but try to form your own opinion based on information received from as many different sources as possible.

In conclusion, two things have to be stressed: Firstly, the vast majority of companies in China are honest and willing to develop sustainable business. Secondly, the seven rules outlined above are intended to serve as a rough guideline for preliminary due diligence only; to ensure the safety of your company’s assets a much more thorough investigation done by professionals is advisable. For specific questions on due diligence as well as in the areas of business development, commercial law, standards and human resources, feel free to contact the in-house experts at the EU SME Centre at this email address.


eusmeThe EU SME Centre (INSME Partner) is a support service provider for European small and medium-sized enterprises and business support organisations facilitating market access in China. Financed by the European Union, the Centre provides free of charge, practical information, advice and business tools to better equip SMEs to develop their business and tackle challenges faced in the Chinese market. For more information, including the report “Knowing your partners in China”, please visit the Centre’s website at www.eusmecentre.org.cn.

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