More and more Chinese investment companies are putting their money into Western medtech companies these days. Just recently, Grail, Inc., a California-based early cancer detection company, secured a $300 million Series C funding round from several Chinese investors. While Chinese investors do not always drop as much as $300 million per project, there is no doubt that Chinese investment will continue for many years to come.
Given today’s tough fundraising environment, many Western medtech companies enthusiastically welcome such capital. However, prior to accepting Chinese money, Western medtech companies need to be careful and perform extensive due diligence to make these partnerships work. It is crucial that a Western medtech company that receives Chinese funds scrutinize what their Chinese partner intends to do with their products in China, and not just passively accept the money.
Question 1: Who is the Chinese investment company?
While there are some very accomplished Chinese venture capital funds and sophisticated Chinese investors who really understand Western values and ethics, most Chinese investors may have their own ways of doing business and do not understand Western business practices. Sometimes it is hard to even obtain any trustworthy information about the Chinese company. For example, a small Western medtech company who received $6 million from a group of Chinese investors recently contacted us. When we tried to conduct some due diligence on the Chinese investors, we could not get much information on the origin of the money. The Chinese companies that invested had very sketchy or limited publicly available background information. Without much knowledge about the Chinese investors, no one at the Western medtech company felt very comfortable accepting the money despite the obvious appeal of the $6 million.
Question 2: What are the investor’s real motivations for investing in your company?
Determining the motives of some Chinese investors can be difficult. How do you know if your Chinese partner really wants a long-term partnership, or is just trying to obtain your trade secrets to copy your products and dump you down the road? If your company has invested $50 million to develop new medtech products, and the Chinese partner invests $6 million into your company, it is possible that this $6 million is really just a shortcut to buy your R&D and copy your technology. Copying is still a rampant issue in China, and the Chinese company may eventually try to copy the products and start a competing business if they have access to your trade secrets.
Chinese investors want to gain access to top Western medical technologies, oftentimes to bring these technologies back to China to maximize sales. Typical Chinese investment deals include the Chinese company investing in the Western medtech company’s stock, in return for exclusive distribution rights in China, and sometimes manufacturing rights in China as well. If the Chinese company obtains exclusive distribution rights in China, they will buy and import the medtech products at a previously negotiated transfer price and/or pay a royalty on China sales to the Western medtech company. We have seen some deals where the transfer price or royalty stream is not well documented in the contract, or these details are vague. Also, in almost all cases, there is no information on how the Chinese investor plans to sell the Western medtech companies products in China. Be wary if these deal terms are not finalized before any funding occurs.
Western medtech companies need to establish certain parameters upfront to ensure the success of their business in China. For one, Western medtech companies need to determine a good transfer price for their products to be sold to China and discuss this with their China partner in a very detailed manner prior to signing investment contracts. Of course, the medtech company should sell its products to their Chinese partner at a transfer price above the cost to make the goods. However, determination of the ultimate transfer price requires that the Western device company have some knowledge of the competitive market and pricing in China. What reimbursements can be realized on selling your products there? Solely relying on the Chinese investors’ recommendations on transfer pricing may lead to the Western medtech company leaving money on the table. If you are accepting royalties in lieu of a transfer price, always base your percentage on the gross selling price received before your China partner deducts real or non-real expenses.
One way or the other, the Western medtech company also needs to stay on top of how the products will be registered in China, and who will take sales and marketing responsibilities. For example, if the Chinese side gets distribution rights, they will usually register the Western medtech products in their own name with the China Food and Drug Administration (CFDA), and not in the name of the Western medtech company. Normally, the Chinese partner will not allow the Western medtech company to register their product via an independent third party in the Western medtech company’s name. In this scenario, there is not much the Western medtech company can do to protect their products, since they do not own the registrations. But if for some reason the partnership fails, the Western medtech company should have the rights to buy back the registration from the China partner so they do not need to re-register from scratch.
Along these lines, the Western medtech company should always obtain a copy of all documents submitted to the CFDA for the initial product registrations, copies of the correspondence between the Chinese partner and the CFDA, and a copy of the product approvals in China. If the Western company has serious problems with their Chinese partner and wants to end the relationship, there is a chance that the CFDA will allow the Western company to transfer their registrations without the consent of the Chinese partner if the Western company has the above-mentioned documents.
Even if the Chinese company is handling the product registration, there is no reason the Western company should send them any confidential information or trade secrets regarding the manufacturing, specifications or materials of the products. Nowadays, the CFDA will never try to reverse engineer your products, so you can obtain product approval even without providing your Chinese partner with confidential information of which they can take advantage.
The Western medtech company should also understand how their Chinese partner will distribute their products in China. If the Chinese investor is already in the medtech distribution business, they should have a good idea on the selling and marketing of your products in China. Even in this scenario, it is always a good idea to carefully oversee this process. If the Chinese investor is not experienced in the medical distribution business, but sub-contracts sales and marketing to another Chinese distribution entity, you should check into whether this is the right sub-contracted distributor for your product and whether they are trustworthy and capable of maximizing your sales.
As mentioned previously, the Chinese partner may obtain the rights to manufacture your products in China in addition to the exclusive distribution rights. In this case, what is the best strategy for the technology transfer? Again, just relying on your Chinese partner to do the right thing in the manufacturing area is not a good idea. Western medtech companies need to be actively involved in the tech transfer of the manufacturing of their products in China to make sure the products are made accurately and at a high quality, especially if these products will be sold directly to Western markets. To prevent situations in which the Chinese company steals your trade secrets and copies your products, you need to closely monitor the tech transfer process as well as the on-going manufacturing. Western medtech companies should employ their own Chinese technical team (or consultants) to represent their interests during the tech transfer and manufacturing. As your own on-the-ground team works with the Chinese investors’ team, they can try and evaluate the real intent of the Chinese manufacturer and whether both parties’ interests are aligned.
While intellectual property protection in China has been improving, it still has a long way to go, and being overly cautious is a good way for Western medtech companies to protect their products and business while working with Chinese investment partners.