Why Companies Set-Up Wholly-Owned Subsidiaries rather than International Joint Venture Companies - Case Study Example

WHY many companies are opting to set-up wholly-owned subsidiaries rather than international Joint Venture Companies (JVCs) Introduction Before companies venture into global market, they have to undertake important decision making concerning the kind of strategies to apply. In other words, they have to enter the target market with appropriate mode of entry that may suit their interests and goals. There are various modes of entry that can be employed by multinational companies when venturing into an international market. This report discusses two of the entry modes commonly used by such organizations: wholly owned subsidiaries and joint venture companies. With regard to how the World Trade Organization has influenced the relaxation of restrictions on international ownership across many nations such as India and China, anecdotal evidence indicates that many international organizations are actually opting for a wholly owned subsidiary kind of business instead of the international joint venture companies in such countries (Drucker, 1997, 172). This report analyzes various reasons why many companies are opting for this model. The author also evaluates the merits and demerits of the JVC in relation to the wholly owned subsidiary. Overview of Full Owned Subsidiary verses the Joint Ventures Wholly Owned Foreign Subsidiary A wholly owned subsidiary is an enterprise that is owned by another company in a different country. Various forms can be used by in wholly owned subsidiaries. These include patented technology, trademark, brands and other investment. Organizations wishing to conduct business in other countries may wish to harbor complete control on their activities (Bradgate, 2003, 23). Consequently, they may decide to have a subsidiary in the foreign nation that is wholly- owned. However, many entities find the cost of operating a foreign subsidiary to be prohibitive. Among the advantages of this arrangement is that organizations and individual which rely upon service providers and suppliers will effectively control their chain of supply through their wholly owned subsidiaries. This aspect which is termed as vertical integration means that a parent company forms its own subsidiaries that act as a supply chain in the foreign countries. For instance, a company involved in the manufacture of cars may have many subsidiaries, which may include auto part firms, tire companies, and similar ones (Bradgate, 2003, 34). In particular, a wholly-owned subsidiary is an organization whose stock is fully owned by another entity. The owner of this subsidiary is identified as the parent company. Since the parent company is the owner of all the stock in a wholly owned subsidiary, it means that the parent company is the controller of most of its operations and activities. Under GAAP, most of the financial transactions in a wholly owned subsidiary are consolidated with its parent company. This translates that all activities in a wholly owned subsidiary are considered as part of the parent company for the purposes of operation and reporting. In another perspective, a subsidiary company is where another entity, which is the parent company, owns all or most of the shares in that entity. As the owner of the subsidiary, the parent organization controls the activities performed by the subsidiary. A wholly owned subsidiary is different from a merger where a corporation buys another entity and dissolves the identity and structures of the purchased company (Dobson, 2003, 56). Subsidiaries are established in many ways. A company may form a subsidiary by either establishing the company itself or simply by purchasing a controlling interest in an already existing organization. In the case when a company acquires an extant organization, it may be preferable for such a company to form a subsidiary in relation to a merger. Since a controlling interest can be acquired by the parent company in a relatively smaller investment in relation to a merger. Additionally, there is no requirement for stakeholder approval in a subsidiary as the case would be in a merger (Goode, 2004, 356). Upon purchase of a company, the parent company may determine that the name of the acquired company may merit in making it a subsidiary instead of being merged with the parent company. A subsidiary may as well make goods or services that are not similar with those produced by the parent organization. In this situation, it may not make sense to merge the operations. Firms that operate in more than one nation in most cases find it necessary to establish subsidiaries. For instance, a multination organization may establish a subsidiary in a particular nation in order to acquire a favorable tax treatment. In another spectrum, a country may require an international organization to create a subsidiary in order to operate in that country (Wests Encyclopedia of American Law, 2008, 22). Part a) Advantages of Wholly Owned Ventures Over Joint Venture Cultural and social factors have a very important impact on the mode of entry in international market. These may include cultural variation between the host country and home country. According to Piotr et al (2008), the cultural pattern may strengthen the relative significance of these values over others (227). Cultural variations are from the values, language, life and work patterns, business and management modes. If cultural variations are obvious, the wholly owned subsidiary has to spend more in adapting to the cultural distance. In the case of a wholly owned subsidiary, all the senior management of the particular entity are derived from a home country. They do have a similar background and philosophy of management, similar behavior and thinking patterns. When the senior management considers the strategic interests and objectives, they take the strategic objectives of the parent company as well as the long-term directional goals. This translates that cultural conflicts and differences in management are avoided in wholly owned subsidiary (Molero, 1999, 222). This aspect is different in a joint venture where the staff and management are derived from different nations with different cultural backgrounds. Additionally, these managers and staff may harbor different attitudes, values and operational practices. As long as these people are working together, there is a potential of conflict that may occur during the course of operations. In most cases, the stronger partner may represent an economic achievement. These cultural conflicts and variations have been occasionally felt between partners in many joint ventures. Such conflicts may be at the time of discussing the cooperation, establishing of the joint venture, co-management and eventual cooperation (Hofstede, G. 2001). In the light of China, it should be considered that a wholly owned subsidiary is regarded as a separate entity in legal perspectives. This means that a country’s laws where the wholly owned subsidiary is incorporated applies to the subsidiary and not the parent organization. In the case when a company acquires an extant organization, it may be preferable for such a company to form a subsidiary in relation to a merger. This owes to the fact that a controlling interest can be acquired by the parent company in a relatively smaller investment in relation to a merger. Additionally, there is no requirement for stakeholder approval in a subsidiary as the case would be in a merger (Redding, 1994, 34). Control right For a wholly owned subsidiary, the parent company participates in decision-making and management in accordance to the articles of association. This is because they are the controlling shareholders of this subsidiary (Dennis and Chwen, 2002, p.332). The principal leaders in a wholly owned subsidiary are selected by the parent company. This is also the case with appointment of senior staff, evaluations, punishment, and rewards for the company employees. In another spectrum, the parent company regulates the business development plan, management activities, and investment orientation. Apparently, wholly owned subsidiaries formulate and revised their own strategies of development and the recent planning under guidance of the parent company. Further, the parent company supervises all the conditions of operation and the quality of assets in order to improve benefit, profits and the security of the invested assets. Wholly owned subsidiaries are expected to report financial conditions and ensure that the accuracy and authenticity of the information concerning production, financial operations and management (Schwab, 1980, 45). Wholly-owned subsidiaries in China have a high advantage with regard to trademarks and other technologies to prevent meddling in its business and technical secrets as well as protection in the basic monopoly position. Operating a wholly owned subsidiary may be a simple assembly or a complex production of activities. The parent company has total control over these aspects. The parent company may have an overall control over the entire management and operations such as production, sales and promotion. The parent company has autonomy in disposing profits and they can effectively protect their commercial secrets and their technological innovations. Demerits However, in comparison to JVCs, wholly- owned subsidiaries have some demerits in such aspects as higher opportunity cost, operational cost, a relative higher political risk and exit disadvantages. In essence, subsidiaries that are wholly -owned harbors a higher operational risk in comparison to JVCs. This is attributed to uncertain factors in higher opportunity and operational cost since they have to establish new sales channels as well as advertising channels in effectively operating in their new environment. The political risk depends on the host country’s political stability and environment. Wholly owned subsidiaries will find it hard to exit their host country owing to their full and total investment while it is easier to end JVCs. More organizations are going the way of fully owned subsidiary in relation to other models for the reasons that have been already discussed. In fully owned subsidiary, businesses hope to obtain recognition and support for the country in which they have invested in and get to acquire higher profits. Among the major disadvantage associated with a wholly owned subsidiary is higher operational risk in comparison to JVC. This is mainly attributed to uncertainty in business operation in a foreign nation. There may also be managerial issues that may be associated with wholly owned subsidiaries. These may include inadequate organizational structure, imperfect governance structure, and inappropriate selection of personnel and so on. Most of these issues may lead to wrong decisions being made, low inefficiency, and collusion. In another spectrum, issues that are involved in related transactions or matters that are beyond the scope of the business or approval authority may result into litigations, investment failures and loss of assets (Zandpour, 1994, 56). On the other hand, the selected managers, directors, senior management and staff may be selected from the host country. This means that they may not design strategies nor consider interests of the subsidiary from the parent company’s perspective. Designing of strategies and interests that are based on the host country rather than the parent company may lead to incorrect formulation and implementation of financial methods as well as erroneous information on the consolidated financial statements. The inaccurate methods and information will subsequently cause high risk to investors plus the general company. This will also lead to these investors making decision-making mistakes, legal proceedings and other risk aspects (Zandpour, 1994, 34). Wholly owned organizations has to develop its own capacity and knowledge, develop new channels of sales, advertising channels, and effective operation under a host environment. For instance, sales representative have to find good advertisers, communicate and coordinate with them. Finding an effective advertiser would require sufficient finance and time. This is because advertisers are also producers of goods and services who just like other marketers are also interested in selling their products to users (Claude, Carole & Bruno, 2009, 5). Hence, it is necessary for the home country to go through the best effort when developing new businesses and achieve a particular level in the strategic mode of a wholly owned subsidiary. The management of a Wholly owned subsidiary have to pass through a long term process in acquiring new business knowledge and skills in their host country, resulting into a high opportunity cost. Disadvantage of exit For a wholly owned subsidiary, the parent company must bear all the costs and resources in her new venture. These cost may include, labor costs, employment, human resources, technical support investment, development of sales channels, advertising costs and so on. The switching costs involved are high. These leads to serious losses in the case when the subsidiary decides to exist the host country for particular reasons. Some of the reasons that may necessitate such an exit may include destabilization of a political situation in a host country and in the case when such a country undergoes drastic changes making the wholly owned subsidiary to be unable in maintaining their normal operations and production. In this situation, the parent company has to close down and move elsewhere where it can be able to sustain itself. The parent company may not be able to recover the investment costs fully when they exist the host country. Leaving the aspect of profit aside, the exit disadvantage is an obvious phenomenon for wholly owned subsidiary. Part B) Advantages of Joint Ventures Over Wholly Owned Subsidiaries Many benefits abound for and entity or individual in participating in joint venture. It makes good sense for and individual or entity to collaborate with another business having complimentary capabilities such s distribution channels, finance, technology and other resources. These and many others are the reasons on why joint venture is currently becoming popular as a form of business transaction. Since the parties in the joint venture are meant to compliment with one another, this form of business makes it easy for either party obtain what he or she needs in an easy and faster way, without many legal implications (Pennyslavia, Bar Institute, International, 2012, 1). Unlike in a limited or general partnership, the main reason why parties form a joint venture is to realize individual gain. In most cases, this may include a share of the objective of the whole project. Other advantages of this type of businesses include offering the parties with an opportunity in acquiring new expertise and capacity. Enable organizations to enter new geographical markets or link them to related businesses. It may also lead to access to more resources including enhanced technology (Pennyslavia, Bar Institute, International, 2012, 1). . Unlike the FOB or C.I.F contract, the venture business also makes it easy for parties in international trade to share risks. Moreover, it is flexible whereby; the ventures lifespan is limited and ends once the objectives of the partners are realized. This means that the joint venture does not aim for profit making but to acquire a specific goal by the parties. In this time of consolidation and divestiture, JV has been regarded as offering creative ways for organizations to exit from non-essential businesses. Complementing each other Complimenting each other is one of the driving forces on why companies decide to form a cross-cultural alliance. In this case, a company harbors what is needed by the other company which don’t have the same, and vice versa (Gupta and Wang, 2011). Collaborating with another entity is purposed to add complements on resources, and capabilities that a particular company is deficient of in order for such a company to expand, and grow more efficiently. In particular, organizations that are fast growing depend on alliances in extending their operational, and technical resources, and capabilities. In the process, they will be able to boost productivity, and save time since they would not have to develop their own. This will give them the freedom to focus on innovation, and business development. Risk Pooling Risk Pooling according to Gupta and Wang is another factor that lead many companies to form a cross-cultural business alliance. According to the authors, this aspect is more particular in the situation where commitment and capital plus the risk of losing are high. This according to these authors is the reason why oil exploration companies occasionally collaborate with each other in their ventures. The strategic risks that organizations may encounter emanates from uncertainty with regard to their market and technological environments. This translates that they cannot be certain on the prospects of a given strategic move, such as development of a new product, or setting up a new factory. Use of strategic alliances in this perspective may be helpful as a strategy to streamline risks that may rise from such moves (Mowery et al, 2008, 79). Industry-wide standards The imperative for industry wide standards is another factor that compels companies to enter into cross-cultural strategic alliances. According to the authors, this was the reason why Google licensed its Android operating systems to other mobile phone manufactures such as HTC and Samsung. In essence, firms especially corporations enter into strategic alliances in order to establish industry-wide standards that should be adhered to. It will be easier for companies to establish industry standards as a group than individually. Additionally, the sharing of capabilities and resources may give the firms a competitive advantage (Besanko et al, 2013, 148). Disadvantages of Joint Ventures Over WOS Among the major disadvantages of a joint venture is that its structure does not offer liability protection to participating parties. This translates that a partners in a joint venture has an individual obligation in the overall company obligation. In the case when the joint venture’s assets do not cover the company’s obligations and debts, the business partners in the joint venture may lose their individual assets to the point when the company debts are met. In a case of a corporation, the firm may lose assets owing to the obligation of the venture (Piotr, 2008, 3). Limited Life A joint venture is only formed for a limited period. The venture is automatically ended when the purpose of which the company as formed is fulfilled. Withdrawal or death of a member may automatically terminate the joint venture. This subsequently puts the other partner in the joint venture at a disadvantage in the case when he wants to continue in the venture. In addition, automatic termination of the joint venture may also occur if particular terms that are contained in the joint venture take place. For instance, clause in the joint venture agreement may state that the company will automatically dissolve at a specified date (Redding, 1994, 150). Conflicts and Disputes A joint venture has a high potential for disputes and conflicts between the business partners. While one partner may wish to manage the company in a particular way, the other may have a totally different idea concerning the direction which the company should follow. This may be worse in the case when there are written joint venture agreement, making the company to be vulnerable to mismanagement since the business partners have no clearly defined responsibilities and roles (Schwab, 1980, 5). Partners whose interests and goals are conflicting may harm may harm the joint business as a whole when their interests and goals are not clearly relayed beforehand. When one of the partner’s fails to fulfill her responsibility or obligation to the company, the joint venture will be severely harmed. If of the member in the joint venture has a highly valuable management staff that are known for effective decision making, while the other is ineffective in decision making, this may result into wrangles and lack of cooperation between the partners, a situation which may lead to closure of the business. Why Foreign Companies in China Prefer Wholly Owned Subsidiaries When organizations decide to venture into global market, they may not be aware if their selected entry mode is the optimal. They usually make decisions and select the mode of entry on the basis of various factors. Many companies in China perspective have come to select wholly owned subsidiary when venturing into the country for business (Klaus Meyer & Saul Estrin, 1998 .9) Among such reasons is the differentiation of their products and the technical contents are extremely high. If other companies are allowed to master their technologies as in the case of the joint venture, then they are bound to lose their competitive advantages. Owing to these, they would select wholly owned subsidiary in order to evade the use or stealing of their assets, technology or intellectual property by their competitors (Selman, 2008, 23). On the other hand, competitors may decide to imitate their products and these products may not be easily replaced. These may necessitate the companies to disregard the aspect of market share when planning to enter the target country. In another spectrum, some companies have scarce products in their target countries and once they enter in, they will easily accepted in the target country. In this case, there would be need of forming a joint venture but a company may decide to form its own wholly owned subsidiary. Such companies do not necessarily have to rely on local sales channels or political relations in order to progress. In general, many companies find wholly owned subsidiary to be better in China in comparison to the joint venture. They find that setting up a wholly owned subsidiary may assist the companies to retain their knowledge and technology with more ease and therefore increasing the value in their corporate brand. On the other hand, setting up a wholly owned subsidiary may help in establishing good mechanisms for the purpose of handing disputes, control of operations as well as optimizing resources in enhancing the marketing control (Zandpour, 1994, 13). For instance, tourism, financial service companies and manufacturing firms find it sound to set up wholly owned subsidiaries in Australia. Prior to selecting Australia as their host country, they first analyzed all types of factors, considering the original brand, quality, service and trademark in establishing a wholly owned subsidiary. The subsidiary has a similar service method and business model as the parent company. In a subsidiary that is wholly owned, the senior management may have similar cultural backgrounds, differences, and conflicts, which may be avoided in management. While cultural conflicts and differences have been there in JVCs, there is a higher control in wholy owned subsidiaries in relation to JVCs. Further, businesses can effectively protect their business secrets and avoid losing to their competitors or partners in whole-owned subsidiaries in comparison to JVC. In whole owned subsidiaries, businesses can put higher investment and realize higher profits in relation to JVCs. With China’s entry into the World Trade Organization and the consistently global pressure on the country to level the playing for international investors, many foreign companies are now trooping in the country as wholly owned subsidiaries. A survey conducted by vision Asia in 2004 revealed that wholly owned subsdiaries were the avenue of choice for many international companies. A city like Shangai has more than 20, 000 wholly foreign owned entities (Rowbotham, 2012, 2). Among the reasons that have been cited for this high preference of wholly owned subsidiaries in China is the staggering large market and the allure of cheap labor in the country. Foreign owned subsidiaries would therefore benefit from a large customer base as well as low cost of labor. While there is the prospect of low cost labor for foreign businesses that venture into China, other reasons for the presence of high number of foreign subsidiaries in China are the growth opportunities from the powerful Asian economy, and being positioned in one of the largest economies in the world. Again, wholly owned subsidiaries are easy to form in China, as it is not required to find a Chinese partner. Ownership of trademarks and patents are regarded as being more secure under wholly owned subsidiary because there is no Chinese partner who may wish to exert more rights or compromise the security of the intellectual property (Rowbotham, 2012, 2). Conclusion In venturing into a global market, a business will be able to participate in international business development as well as market competition in capital, technology, products, services and policies. Firms that wish to venture into global market should select the right entry mode for an international strategy. Before selecting their entry mode, such companies should firstly identify their main objectives in order to decide on the best strategy. The mode of entry will offer information concerning the consequences of entering an international market in relation to the changes in market demand. This report has analyzed two of the entry modes, wholly owned subsidiaries and international joint ventures. Different entry modes mean different rights and levels of control. By understanding various factors that may affect their performance in a foreign nation, companies should be able to select appropriate mode of entry in a particular nation. Some of these factors to be considered include international experiences, unified strategic actions, exit barriers, culture, economies of scale, profit received and control rights. In comparison to JVCs, wholly owned subsidiaries have many merits with regard to control rights, cultural differences, higher returns and protection of commercial returns. However, wholly owned subsidiaries also harbor some demerits in relation to JVC. In conclusion, many companies find wholly owned subsidiary to be better in comparison to the joint venture. They find that setting up a wholly owned subsidiary may assist the companies to retain their knowledge and technology with more ease and therefore increasing the value in their corporate brand. 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