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How Not To Run a Business in China

Beijing's expatriates are up in arms. One member of their own, Olaf Kristoffer "Kro" Bauer, a young entrepreneur who helped establish the Kro's Nest chain of pizza restaurants in September 2006, is embroiled in a fight with his Chinese business partner, Yuan Jie. It is hard to separate fact from rumor, but one thing we do know: Bauer, a 26-year-old American, is no longer working at the company he says he started.

How did this happen? What lessons can we learn from Bauer's situation? Former Kro's Nest manager (and current law student) Damjan DeNoble has blogged feverishly about the situation at Through his words we can learn what to do and what not to do in China as a businessperson.

The first rule for would-be entrepreneurs in China: Make sure the ownership structure of the business is clear. Although Bauer did a masterful job building a loyal following for the pizza chain among Beijing residents, he was never the legal owner of the company. Indeed, having interviewed both Bauer and Yuan (a Beijing resident born in 1968), I can say the lack of ownership is one of the few things on which the two ex-partners agree. Brauer says he let Yuan handle legal issues, while he focused on building up the brand and operations. Yuan, on the other hand, says he started the company and hired Kro to give his restaurant a foreign face.

Neglecting the Legal Steps

Disagreements like this happen far too often to people doing business in China. They get the business vision right but miss the evolving legal and political issues. Frustrated by the Chinese bureaucracy and the high costs of setting up a wholly foreign-owned enterprise or paying tax, many foreign entrepreneurs in China skip important legal steps. This is a recipe for disaster.

That leads us to another lesson from the Kro's Nest situation. China is no longer the Wild East. Many foreigners see a thriving underground economy selling pirated Microsoft (MSFT) software and gray market Apple (AAPL) products, so they think they can get away with cutting corners. Wrong. Foreign executives absolutely cannot break the law, and Chinese ones increasingly should not. If foreigners get caught, the government will make examples of them. Take what happened in the Rio Tinto (RIO:AX) case when the Melbourne-based mining company's China head, Australian citizen Stern Hu, was thrown in jail for 10 years for accepting bribes.

Bottom line: corruption and illegal activities exist everywhere in China, but foreigners should make sure to establish corporations, pay tax, and do everything aboveboard.

Building "Trust Networks"

DeNoble also talks about the many hours he and the Kro's Nest partners spent entertaining local officials to build guanxi. Many foreigners hear about guanxi, which they define as connections, before even arriving in China. That definition is misleading. Guanxi means something more. Guanxi should be defined as building a trusted network over years, if not decades. Like most developing economies, China exists in a low-trust environment. As a result, Chinese build trust networks based usually on familial lines. The family as bedrock is changing as the one-child policy has shrunk family sizes, but looking for trusted networks is still critical. It is virtually impossible for foreigners to break into these networks unless they have spent years in China.

It is very hard for foreigners to build true guanxi. Most foreigners who say they have good guanxi are either lying or deluding themselves, especially those former U.S. government officials who sat on the opposite side of the negotiating tables with Chinese officials. Sure, they can arrange meetings, but the difference is huge between knowing people and actually having those people trust you.

Take me as an example. Since I turned 18 in the mid 90s, I have spent at least six months a year here and have lived in China full-time for the past decade. My wife is from China, and my mother is Chinese. Although I can call and arrange a meeting with just about anyone in China, few Chinese would ever truly consider me part of their guanxi network. If they do something for me, it is more because of my wife. As more Chinese study abroad and get acclimated to Western ways, undoubtedly more foreigners will be able to build true guanxi with Chinese. But it is not easy.

Happily, Bauer tells me he is staying in China and starting another food venture. A talented entrepreneur, he is optimistic and says he will do everything right from the beginning. Starting a company anywhere, in China or the U.S., is not easy. Instead of letting failure stop him, Kro is learning from his experiences. I hope I get the chance to buy something from his next venture.

Rein is the founder and managing director of the China Market Research Group, a strategic market intelligence firm focused on China. He is the author of "The End of Cheap China: Economic and Cultural Trends that Will Disrupt the World."

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