Due Diligence in China: Essential questions to ask
In general terms, “Due Diligence” is an investigation of a business, individual or deal to establish facts, evaluate potential and identify risk.
Introduction/ Target Audience
Early in my China business career I was given some great advice from an old “China hand”. He told me, “before you give any money to a Chinese company, you must do your due diligence in China, then do it again!”
After spending 20 years in China myself, I would add that China is the kind of market where you even have to “do due diligence on the firm you are hiring for due diligence!” As such, this comprehensive article is designed to share best practices and common pitfalls when conducting due diligence in China.
The article will be of particular interest if you are thinking about:
- Purchasing goods from a Chinese supplier
- Hiring a China based service provider
- Investing in a Chinese business
- Representing a Chinese company overseas
- Hiring a senior executive for a position in China
For the sake of this article, when I use the term “Chinese”. I am referring to a person born and raised in Mainland China as opposed to a person of “Chinese ethnicity” who may have been born or raised outside of the Mainland.
Table of contents:
- Introduction/ Target Audience
- Due Diligence Defined
- Why is due diligence so important when doing business in China?
- When to conduct due diligence in China?
- What information is included in a due diligence report, how is it obtained, how much does it cost?
- Level One: Entry Level DIY Due Diligence
- Level Two: Investigative Due Diligence
- Level Three: Professional Due Diligence
- Corporate Assessment (CA): Stability, Assets & Reputation of a Chinese Company
- Red Flag Assessment (RFA): Risk, Scams & Fraud
- PRO TIP: How to evaluate both the company and the given transaction.
- Case Study: Incorporating Due Diligence into the Supplier Selection Process (Quality Audits vs Due Diligence)
- PRO TIPS:
- Don’t forget the pre-shipment inspection!
- Tips for Due Diligence on Logistics Firms
- Tips for Due Diligence on Sourcing Agents
- Tips for Due Diligence on Inspection Agents
- Tips for Due Diligence on Chinese lawyers
- Conclusion: Tips for Due Diligence on Due Diligence providers!
- Additional Resources
- About the Author
Due Diligence defined
In general terms, “Due Diligence” is an investigation of a business, individual or deal to establish facts, evaluate potential and identify risk.
Why is Due Diligence so important when doing business in China?
In terms of doing business in China, due diligence is the process of verifying the accuracy of the information given to you by your potential local partner. This process is particularly complicated in China because of three main factors:
- Language Barrier
Unless you are fluent in Chinese, you are most likely communicating with Chinese parties in a foreign language, most likely a 2nd or 3rd language.
Example: Discussing Numbers
Even something as simple as communicating a basic number can lead to confusion. Let’s say you asked about the value of the equipment found in a certain factory. Here are 4 common barriers:- Currency. Are we talking RMB (CNY) or USD?
- Time. Is the number based on today’s exchange rate or at the time of purchase? Is it the value on the date purchased or current value after depreciation?
- Numeric Place System: The Chinese don’t even count the same way we do. For example, we say “One Million”, they say “One Hundred Ten Thousands”! We write 1,000,000. They write 100,0000.Even professional translators mess up numbers all the time. Maybe this is where that idiom about “as hard as Chinese Arithmetic” comes from! (If you want to “geek out” on Chinese counting, check out: http://www.mandarintools.com/numbers.html )
- Pronunciation: In spoken Chinese, the numbers 4 and 10 are easy to get mixed up, even between native speakers. To help communicate better, an intricate system of hand signs had to be developed which represent the Chinese character of the number the speaker wants to state.
For fun, go ask a Chinese friend to say 444 in Chinese using their mouth and hands!
For even more fun, go ask a friend from South China to say 444 to a friend from North China!
And when native Chinese speakers state numbers in English there is a whole new set of potential problems. For example, the numbers 40 and 14 are almost indistinguishable to a Western ear when spoken in English by a native Chinese person.
- Intense Competition
In China the margins are so tight, the volumes so massive and the competition so intense… I’m not going to say that Chinese salespeople lie a lot to get your business, but… I have found that many of the Chinese business people I have dealt with during my 20 years in China have a very “elastic” concept of what “the truth” encompasses.For example, when you ask a potential supplier “do you make this widget?”. Even if they have no idea what materials and technology is involved, the answer is almost always “sure, no problem, we supply those widgets”.
In hearing that response, the buyer assumes the supplier means that they have experience in this particular production category and is fully capable of handling the order from the buyer.
In reality, the supplier really means “if you pay us enough, we will find a way to get it made in China someplace sometime somehow.” The Chinese invented gun powder, built the Great Wall and have 5000 years of continuous culture (according to my Chinese father-in-law), so with enough resources and time, you could even get a space shuttle built in China! So the “we can make it” statement is really about perspective. - Limited liability
Unlike in most parts of the West, in China the legal ramifications of getting caught in a lie are minimal.
Buyer beware!
When to conduct Due Diligence in China?
The short answers are:
- before any significant amount of money is exchanged,
- before any legally binding commitment is agreed.
Note the operative word is “before”. Once you are “in bed” with a Chinese business partner, divorces are very painful.
I would also like to stress the important of conducting strategic due diligence at periodic times in the future just to ensure the commitments made at the beginning of the partnership continue to be respected.
For example, if your investment in a Chinese factory was predicated on the fact that they remain compliant with certain environment laws, it is not enough to conduct the initial due diligence and sign a contract. Sadly, in China, you would be wise to independently verify that particular item’s status on an ongoing basis, perhaps once a year or more. Luckily, due diligence is very affordable and effective. More on the typical fee structure later in the article.
What information is included in a due diligence report, how is it obtained, how much does it cost?
The answer varies depending on the service provider, but essentially there are three types of due diligence that I use on a regular basis in my dealings in China.
Here is the way I breakdown the three levels of due diligence in China.
Level One: Entry Level DIY Due Diligence
Later in this article I will give tips on how to do “DIY Due Diligence” in China. But for now, know that I consider “DIY Due Diligence” to be research that could be conducted by typical office worker, without special training and with no Chinese language skills.
For example:
Careful review of the target company’s marketing materials
Interviewing references
Online fact checking
Sadly, because many Chinese entities know their foreign partners aren’t serious about Chinese language due diligence, they stack their English language with with what they think the foreign partner wants to hear.
Level Two: Investigative Due Diligence
At the other end of the due diligence spectrum is the type of research conducted “in the field” by highly specialized investigators.
For example, let’s say your Chinese business partner promises that they are only using the “official” and “certified” sourced of raw materials as agreed in your contract. But you have a hunch that the supplier is using cheap counterfeit materials in order to pad their pockets. Counterfeit materials in your supply chain would open you up to major legal exposure back home, so you decide to bring in the investigators.
In a case like that, the investigative due diligence could include the following:
- Stakeouts: Following trucks from the factory loading dock back to the sub supplier of origin.
- Paid Intelligence: Paying off key employees at the factory to get access to internal information.
- Undercover Work: Investigators pose as job seekers, get hired and report on the view from the inside.
How much does Investigative Due Diligence cost?
As there is an element of physical risk to the investigators when conducting this type of due diligence, the fees are far more than the other types of due diligence. In my experience, two thousand USD per day is not outside the norm.
(I’m not at liberty to state on my blog post the name of the investigator I have used, but I may be able to make an introduction if you contact me directly.)
Level Three: Professional Due Diligence
In between “Investigative Due Diligence” and “DIY Due Diligence” is an affordable, yet effective due diligence service offered by specialized firms. I refer to it as “Professional Due Diligence” and it represents 95% of the due diligence being conducted in China. Here are two of the most popular types of reports offered by ABL.
Corporate Assessment (CA): Stability, Assets & Reputation of a Chinese Company
The CA report is particularly of value if you are:
- Thinking about entering into a business arrangement with a Chinese company to buy or sell goods.
- Exploring a JV or investment partnership with a Chinese entity.
- Considering litigation against a Chinese company. If a company doesn’t have assets, it’s not worth the effort to fight and win only to remain uncompensated!
Visit this page to learn how the information in a
Corporate Assessment is collected in China and
download an actual sample of the report.
A Corporate Assessment Report conducted on a Chinese company can expose the following:
Red Flag Assessment (RFA):
Risk, Scams & Fraud
These kinds of due diligence reports can help you source safe, avoid scams and confirm that the terms of the deal are fair.
This report is of particular value to newer buyers in the China Sourcing industry that have following concerns:
Visit this page to learn how the information in the Red Flag Assessment is collected,
how many days are needed to complete the report and download an actual sample of the report.
PRO TIP: Because a legit company could issue unfair terms of trade in your particular deal, it is important to evaluate both the company and the given transaction.
The Corporate Assessment and Red Flag Assessment mentioned above are designed to complement each other. By engaging both the CA and the RFA, you will protect yourself from both possible pitfalls:
Danger One: A legit business issues you a bad deal.
Danger Two: A scam/fake/unlicensed business issues you what appears to be a fair deal.
Case Study: China Sourcing: Incorporating Due Diligence
into the Supplier Selection Process
When selecting a supplier in China, two questions always come up:
Does the supplier really have the ability to product the products I want to buy?
Is the company a legitimate business with good reputation and not a scam or business on the verge of bankruptcy?
The former falls under a Quality Audit while the later can be answered using Due Diligence.
I’m happy to report that both types of reports usually come in well under $500, so if you are serious about China Sourcing (and you don’t have the time or experience to verify the supplier on your own in person in China) there is no good excuse for skipping the Quality Audits and Due Diligence.
While Quality Audits and Due Diligence both fall under the category of supplier verification, they are two distinct professions which require radically different skill sets.
Quality Audits require auditors who are trained in ISO and familiar with the tricks of the trade on the production lines of Chinese factories. These auditors go out in the field to visit the factory.
A typical Simple Factory Audits (SFA) cover the following:
- Quality Systems (Do they have a suitable system, is it written down and being followed?)
- Production Line (Status & Capacity)
- Workforce (# of Staff, HR Policies, Management Style & Working Conditions)
Due Diligence on the other hand requires researchers who are skilled at desk research, data analysis and know the accounting tricks in China. They conduct interviews, collect documents & review data from the court systems, the media, business associates, banks and the local government. The target company is not even aware that they are being investigated.
A typical Due Diligence report covers the following:
- Reputation:How do customers, employees, suppliers, local government and creditors view the factory?
- Financials:Are they cash flow positive and not likely to close their doors in the middle of your order, running away with your deposit?
- Legal: Do they have any court cases, past or present?
- Confirmation of Factory Profile: Does the target business as described by the sales team or website match the information on record with the local government?
PRO TIP: Don’t forget the pre-shipment inspection!
Even if a supplier passes the initial quality audit and due diligence with flying colors, I highly recommend you or your representative return to the supplier and conducting a pre-shipment inspection (even on repeat orders) to be safe.
If you want to learn more about how quality audits, inspections and lab testing compliments due diligence, then check out this 15 minute video tutorial I recorded entitled “Affordable quality control strategies that work!”
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ABL Blog: Sr. Editor and Primary Content Creator: Michael J. Bellamy
Originally from Upstate New York, Mike moved to Asia in 1993 and is a China business advisor to both Fortune 500 companies and small businesses. Recognized as an expert on doing business in China, he has been interviewed by WSJ, CNBC, FT & Bloomberg.
A featured presenter on China issues at seminars, trade shows and corporate events across the globe.
Learn more about Mike and AsiaBridge Law at
https://www.asiabridgelaw.com/business-advisory-services/
Mike is the author of “The Essential Reference Guide to China Sourcing”
(available on Amazon).