what we think

By Art Dicker and Robin Tabbers

More and more software solutions are being delivered via the cloud rather than locally installed. There is an enormous and growing market for these Software-as-a-Service (SaaS) offerings in China. Many of the most advanced global SaaS companies are American, and it is no surprise that these firms’ technology are often the leading products in China.

In addition to the large established enterprise resource planning (ERP) solutions (e.g. Workday) and customer relationship management (CRM) offerings (e.g. Salesforce.com), there will also continue to be opportunities in China for niche offerings and a growing potential customer base of SMEs.

In the below, we discuss some of the challenges foreign SaaS providers face entering the China market.

Regulatory

China divides telecommunication businesses into basic and value-added business services. Basic telecommunication businesses are essentially off limits to foreign companies but operating cloud services in China is permitted and generally requires a particular Value-Added Telecommunication Service License (“VATS License”).  

One of the different types of VATS Licenses that will often apply to a SaaS business looking to operate in China is the Internet Content Provider License (“ICP License”). We note that there is some debate in the field about whether an ICP License is strictly necessary for a company simply offering its own existing offline software solution over the cloud. But this line of thinking is not the majority view, and instead the overwhelming risk remains that the local regulatory authority will not have a nuanced understanding of different interpretations of the applicable rules.

Many regulators will default to a general understanding that a business delivering its product or allowing its customers to buy the product directly over the internet will require an ICP License.

While a joint venture where the foreign investor owns no more than 50% of the company is in theory allowed to apply for a VATS/ICP License, there are very few cases of such licenses being granted in practice. This leaves a foreign company to consider one of the following four options instead.

Possible Structures

1. Offshore

One possibility is to continue to host the service on servers located outside of China. However, the user experience is often less than ideal. First, there is latency – connection speeds from within China to any server outside of China are slowed by having to go through cross-border firewalls. Second, as personal data and data security are becoming increasingly important and increasingly regulated in China, there is always the potential for SaaS offerings that handle large amounts of data being transmitted outside of China to have access blocked inside of China. Third, as the Chinese currency, the Renminbi, is not freely convertible to foreign currency and most Chinese individuals or companies do not have the means to pay in foreign currency, a site hosting and collecting payment for services overseas will invariably not be as simple as it could be locally.

2. WFOE

Some companies may simply rely on the previous interpretation that providing pure software services only, may not require ICP and other VATS Licenses, and open a 100% owned subsidiary in China.

3. Chinese partner

The option some other companies take is to offer their SaaS solution in partnership with a local company. The foreign SaaS company and the local company that holds an ICP License essentially enter a licensing arrangement, whereby the foreign company’s technology and trademarks are licensed to the local company and technical support services are also provided.

The local company is the “Seller of Record” providing the actual services to customer and collecting payments from those customers. The software is provided over the cloud hosted locally on servers in China, and data resides in China subject to export restrictions. The local partner signs all customer contracts and collects fees, while the local partner’s brand is also used when presenting the service to customers.

If you have a relatively large existing or potential customer base in China, you will have an easier time finding a local partner to invest the time and resources you need. It can sometimes be a challenge to find a local partner sophisticated enough to support you and be able to understand, sell, and service your solutions with customers.

4. VIE

Variable Interest Entity (VIE) structures are a potential work-around for restrictions on foreign-invested companies obtaining VATS Licenses.

• A domestically-invested company is first established as an operating company to apply for and hold the ICP License.
• To still have this local company be considered part of a group of affiliated companies for accounting purposes, 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) offer the foreign company 100% effective 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. Still, the risks of the foreign company losing control over nominee shareholders, and these contracts ultimately not being enforceable in court remain present.

Considerations for SaaS companies entering China

Providing software solutions via the cloud often has tremendous benefits for collecting and analyzing customer usage data, benefits which more than justify any incremental costs of cloud hosting. But those incremental costs are higher with a larger upfront investment to operate in China. For this reason, a company looking to offer a SaaS solution in China might want to have some initial traction with local customers (i.e. by providing offline solutions or via offshore servers) in order to justify this investment.

Hosting a SaaS solution via local cloud servers subjects the data to local data protection and data security laws (e.g. obtaining necessary consents and being sensitive to compliance on cross-border data transfers). These extra compliance costs are often more than justified considering the risk reductions we referenced above i.e., that the site hosted offshore gets potentially blocked in China.

Finally, if a company works with a local partner, there is some potential for confusion or loss of quality in the customer experience, but this also must be balanced against the increase in connectivity speeds, localized payment options, and further integration into the local internet (especially social network and e-commerce) ecosystems.

There are challenges SaaS providers face in entering and operating in China, but the opportunities are clearly there for companies willing to make the investment.

Art Dicker and Robin Tabbers, together with the regulatory team of R&P China Lawyers, frequently assist international SaaS companies finding the most suitable way entering the Chinese market. Feel free to contact the authors if you are interested in exploring your opportunity in China.