China remains one of the largest untapped markets for many global B2B SaaS/cloud companies. Beyond the large established enterprise resource planning (ERP) solutions (e.g., Workday) and customer relationship management (CRM) offerings (e.g., Salesforce.com), there are thousands of global niche SaaS companies already in China or considering entering the market and hoping to take advantage of China's massive potential customer base, which includes 35,000+ companies with revenues north of US$ 150 million, in addition to China's 40 million small businesses.
However, despite the clear market opportunity, there are concerns from global enterprise software companies on how to stay in compliance while generating a positive ROI in China. These are increasingly reasonable concerns as more software companies continue to transform their delivery models from locally installed (on-premises) installation to "service" delivery via the cloud (SaaS). This transformation puts them into a significantly more scrutinized area of China's regulatory environment. As regulations continue to evolve, SaaS companies are struggling to understand if there are still paths to China that can be pursued with a modest investment and at the same time avoiding the arduous requirements that require a local majority partner. Fortunately, there are alternative paths companies can use to enter China. In this article we will share how SaaS companies have, and continue to, address China on their own.
As a refresher, we would like to briefly touch on the most often raised compliance issues for SaaS companies. The Commercial Internet Content Provider License ("ICP License") is the most often cited Value-added Telecom Service (VATS) License that SaaS businesses apply for in China. However, there is a lot of debate about whether an ICP License is strictly necessary for a company simply offering its own solutions over the cloud or not transacting directly through its website in China. But the risk remains that the local regulatory authorities may not have a nuanced understanding of different interpretations of the applicable rules and will default to a view that a SaaS business will require a Commercial ICP License. The main concern around the license is that it requires a at least part Chinese ownership, which is a non-starter for many foreign executives and a very difficult license to obtain in practice even if a joint venture (JV) arrangement is acceptable. SaaS companies by their nature handle lots of data, including personal data. Here China is stepping up its game with the new Data Security Law (DSL) that was passed 10 June 2021 and comes into effect 1 September 2021, and the Personal Information Protection Law (PIPL) which was passed 20 August and comes into effect 1 November 2021. Perhaps the most direct impact to international companies with operations in China is the increased sensitivity to the processing of personal data and to scrutiny on cross-border data transfers. The silver lining to these new requirements is that the rules are becoming more and more clear especially once implementing regulations come out within the next year. Companies should be aware of these changes, but we expect with this new clarity, firms will be able to comply without too much concern.
Where many companies start is not always the right place
Historically, most SaaS companies start their China journey through a cross-border approach by leveraging their existing global infrastructure and then build out a sales and marketing program on the ground independently and/or with partners. Depending on the type of solution and its technical performance requirements, this can be an effective strategy for many companies, at least in the initial stages.
However, this strategy is typically limited for several reasons:
1. The company may struggle to understand and meet the needs of its China customers from afar.
2. Larger customers and state-owned entities are often hesitant to purchase from companies without local technical and operational support.
3. The company's IT infrastructure will typically encounter performance issues due to its location outside of China's Great Firewall.
All that said, many companies eventually need to do more than provide their solution from abroad, and may need to set up a cloud in China when:
1. Their products simply do not work well enough to support their customers in China from abroad, or
2. They are providing services in China from abroad and have hit a cap on their potential, and/or
3. They are concerned that the data they are capturing is at risk of being blocked or running afoul of increasingly stringent data residency requirements in China.
In most other markets, hosting a solution locally is as simple as spinning up new AWS, Azure or Google Cloud instance. However, nothing is so simple for foreign companies in China. The closest alternative is working with a local IT partner (value-added distributor, VAD). Many foreign companies start by speaking with one these VADs which can obtain the licenses they believe necessary to operate their business in China.
While initially attractive to many SaaS companies (they often expect the VAD to take the business and run with it in China), the realities and the downsides of working with these distributors usually become quickly apparent. The downsides can include:
- A high upfront fee + revenue sharing. For companies without an existing business in China they will typically push for exclusivity to offset the risk of bringing an unproven company into China.
- The VAD making the company's business a low priority (both because SaaS is hard, and for new entrants especially, because there isn't an existing pipeline)
- The company having to still spend resources to understand and customize its cloud for the China market
- The VAD being unable to fully understand, sell, and service the company's complex SaaS solutions in the market.
- The types of decisions needed in the early stages are complex and the company and partner need to be able to communicate effectively and coordinate resources to make decisions together on suitable China pricing models, product features and business strategy.
Regardless of the downsides, some companies do start by partnering with a VAD. In our experience, however, after a couple of years many of these companies become disillusioned and look for alternatives to re-energize their China business.
Whether new to the market and looking to go at it alone or a company that started with a partner and now wants to consider a more active approach to China, they will turn back to the same key question, what other options are out there for SaaS companies that want to control their own IT infrastructure and China strategy?
Option 1 - You may not actually be a SaaS company in China, so why not stay that way
Simply launching servers in China and running aspects of a business through the cloud does not automatically mean a company is considered "SaaS" by the Chinese regulators. This means that many SaaS companies' business and/or delivery models do not require a Commercial ICP license (and a local JV) in order to operate in China.
Other companies do – on the face of it – seem to require a Commercial ICP license. For those companies, however, there are many variables that can determine if such a license is really necessary (and is often not). Some common variables include:
- Pricing models and where payments are processed
- The type of data collected, where and how the company aggregates and processes that data
- How products are delivered (on-premises, local installation, cloud)
- The type of customers that are being targeted in China (MNC, SOEs, SMEs)
- The size of the business
The bottom line is that many companies operate in ways that do not require a Commercial ICP license. The strategies are unique to every company - competent legal and go-to-market advisors can help companies work through alternatives. For some companies these strategies can be a permanent solution. For others, they act as a delaying mechanism until the company has validated its opportunity and is ready to consider a more significant investment in China.
Option 2 - Some companies ARE SaaS companies and should have a license, but...
Many B2B SaaS companies take the direct route into China (whether independently or with the help of services providers). They made an upfront investment, created a WFOE, put boots on the ground, filed an ICP registration, set up their services on local cloud providers or on their own servers, and then started to serve China customers. These companies in 2021 may not be technically in compliance and need to look at their options. However, it's important to understand that many of these regulations have only been introduced over the last 4 years, so many of these companies are still developing their paths to compliance.
These companies may have some exposure but thus far we haven't seen the government pursuing companies that are technically out of compliance but are not doing anything illegal and are not touching sensitive data. While this could change, in practice we continue to see many new companies following the same path. China, like all countries, is looking to attract good companies to invest in its economy and increase its local tax base. Generally speaking, when companies get in trouble for not being fully licensed, it is more likely because a local competitor blew the whistle (because they were feeling threatened by a foreign company's success) than because the government was trying to find violators.
Option 3 - VIE
Variable Interest Entity (VIE) structures have historically been a potential work-around for restrictions on foreign-invested companies obtaining VATS Licenses although there are some indications these structures may be falling out of favor with regulators (and not just for SaaS businesses).
- A domestically-invested company is first established as an operating company to apply for and hold the ICP License.
- The foreign business must find local Chinese citizens – sometimes key local management – to act as nominees to hold these shares of the local operating company on the foreign company's behalf.
- A set of contracts between the foreign and local company (and its shareholders) ostensibly offer the foreign company 100% control over the local company.
VIE structures have been used for over 20 years, especially by many Chinese internet companies when listing on stock exchanges outside of China. While it is an option, there remains a lot of debate about the risk of the structure especially if the relationship of the parties in substance appears primarily to avoid the regulations. There are other possible issues as well, such as the risks of the foreign company losing control over nominee shareholders, as well as contracts ultimately not being enforceable in court.
Balancing Considerations for SaaS companies entering China
There are challenges for business software providers entering and operating in China, especially those built exclusively to using a SaaS model, but the opportunities are clearly there for both SaaS and non-SaaS software companies alike that are willing to make the investment.
Art Dicker, Director at R&P China Lawyers
Together with the regulatory team of R&P China Lawyers Art frequently assists international SaaS companies finding the most suitable way entering the Chinese market. Feel free to contact him if you are interested in exploring your opportunity in China.
Chris DeAngelis, Partner & General Manager at Alliance Development Group
Chris DeAngelis has lived in China since 2005 and is considered a leading expert on the China technology scene and its emerging trends. Prior to joining ADG, Chris was a VP at GE Capital where he underwrote over US$1 billion in transactions supporting U.S. and cross-border leveraged buyouts on behalf of global private equity funds.
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