Uncovering The Hidden Costs Of Global Expansion
“Don’t assume things work like in the U.S. and don’t take anything for granted.” - Larry Harding
That clear-eyed bit of advice came from a CEO at a consumer goods company, in response to a survey we conducted on the topic of global expansion. The survey, done in partnership with CFO Research, asked senior executives at small- and mid-sized businesses about the opportunities and challenges of opening overseas offices. Nearly 90% of the respondents were already operating overseas (the rest were considering expansion), and nearly two-thirds (65%) expected to be increasing their global footprint within a year of taking the survey.
Even for this globally experienced group, nearly 74% of these finance executives surveyed agreed that maintaining control of international activities was difficult. In their responses, executives consistently trumpeted the importance of conducting thorough research before establishing an office, to understand the target country’s legal, regulatory and cultural environment. Those of us in the business of international expansion sometimes refer to this as the “know before you go” rule. Unfortunately, we’ve found that time and again U.S. companies, especially those new to the global expansion game, tend to overlook certain important factors during the due-diligence phase of expansion.
Understanding Your New Market’s Unique Requirements
Companies considering entry into a new market must understand that market’s unique requirements, from tax laws to employment contracts to local business customs. Otherwise it will be impossible to accurately estimate the true cost of establishing and operating a new entity. Nothing can replace a comprehensive cost-benefit analysis, no matter how attractive the opportunity in a new market appears from afar.
Most U.S. companies that have never expanded into another country will begin the planning process by developing a list of common domestic expenses — including employer social security contributions, corporate income taxes and office operating expenses — and then make adjustments to account for target-country tax laws, real estate costs and other factors. The problem with this approach is that it presumes other countries operate like the U.S. In fact, each country has its own set of complex and constantly changing laws that govern how business is conducted. Unfamiliarity with a target country’s business laws, customs and practices can expose unwitting businesses to significant “hidden” costs.
The Potentially High Costs of Terminations: Two Real-Life Examples
Employee termination costs vary significantly by country, a fact that is often overlooked when planning an international expansion. In France, for instance, terminating an employee will cost an employer the equivalent of 12-18 months of salary in severance if an employee has been on board for longer than his or her probationary period – and that’s assuming that the termination was undertaken in accordance with all the myriad different employment regulations. As a CFO of a manufacturing firm put it bluntly in our survey, “Understand how to fire before your hire.”
One client story in particular bears this out. An employer discovered during a routine review that an employee in France had attempted to pass off the purchase of car tires and other personal items in an expense report. The employer carried out its investigations effectively — conducting pre-dismissal meetings and other related requirements per French law — and duly terminated the employee for misconduct. One requirement, however, had escaped the employer’s attention. Because they had failed to act within two months of becoming aware AWRE -1.09% of the misconduct, it turned out that the termination was invalid under local law. Due to this oversight, the employer was ultimately forced to pay the employee an eye-watering $180,000 in damages.
The difficulties of complying with French employee-termination laws are relatively well-known, but other countries present similar risks. Take for example a German company that terminated three employees for poor performance. Aware that they presented no significant threat to client business, the employer included language in their termination letters releasing them from their non-compete clauses. The employer was unaware, however, that under German law, waiving a non-compete clause requires twelve months’ notice. As a result, each of the employee’s non-compete clauses remained in effect at the time of termination, which in turn entitled the employees to 50% of their earnings for the duration of their non-compete periods.
These examples of the high costs of dismissals overseas not only underscore the potential for fines and reputational damage after termination, but also the importance of hiring quality local employees from the start. This may require higher-than-normal local recruiting costs that businesses must take into consideration during pre-expansion planning.
Understanding Your New Market’s Culture as Well as Its Statutory Requirements
I mentioned earlier that cultural idiosyncrasies can lead to hidden costs for companies unfamiliar with the day-to-day practices of an overseas country. China, for example, is an attractive expansion target for international businesses, but its bureaucracies are notoriously opaque. Establishing a Wholly Foreign-Owned Enterprise (WFOE) legal entity in China can take six to nine months and require a home-office staff member to manage the application process almost daily. And winding down a business in China can actually take longer — and cost more — than setting up shop. Moreover, China’s regulations are constantly evolving due in part to that country’s rapidly expanding economy, so that what is legal today may not be legal tomorrow.
To take an example, China’s unique protectionist policies can pose serious difficulties for foreign investors. The country operates under the “Catalogue for the Guidance of Foreign Investment Industries,” which places industry sectors into “encouraged,” “restricted” and “prohibited” groups. Only businesses falling into the “encouraged” category may enter China using the popular WFOE entity type. Others must have majority local shareholders or operate through a Sino-foreign joint venture. This may sound easily navigable given that there is a “guidance” catalogue. However, Chinese authorities periodically revise that catalogue, upgrading or downgrading industries to align with economic policy. As a result, some of our clients — for example those in the education sector — have been subject to downgrades that have eliminated tax incentives.
Keeping pace with these kinds of regulatory changes, whether in China or any other country, requires significant resources that may go overlooked during a company’s planning process.
Factoring in Real Estate Costs
Singapore is rated as one of the most business-friendly nations in the world. But it’s also one of the most expensive. Businesses locating there should expect real estate to be at least 50 percent higher than in the U.S. or Europe. And then there’s the cost of housing allowances: in Singapore you’ll have to pay rents on a scale higher than Manhattan or central London. And Shanghai, another popular destination for expansion, is also significantly more expensive for rents in desirable locations than New York City. And if you think Europe will provide real estate relief, think again. Real estate in France and the U.K. will require a 10-20 percent premium over big-city real estate in the U.S. Provincial cities outside London and Paris, for example, have real estate costs on par with second-tier cities in the U.S.
Businesses should also be sensitive to the potentially high cost of operating in places that are unstable. Many of our clients will testify that it is these lower-profile locations, and not necessarily London or Shanghai, that often prove the most expensive. For example, due to high levels of crime in a place like Angola, a U.S. expatriate would logically expect to be housed in a guarded community, where a standard apartment may cost the employer upwards of $10,000 a month. While this is an extreme example, many of our clients discover that when sending an expat to places like South Africa, Brazil or the Philippines, they will generally pay a premium for real estate in relatively safe locations, and perhaps pay additional fees for security services.
There are countless other examples of frequently overlooked factors that can result in surprise costs for companies that expand globally. These may involve unexpected value-added tax (VAT) liabilities, translation costs and the costs of protecting intellectual property, to name just a few. Partnering with a local institution and/or retaining outside expertise can help companies navigate these waters. But any company considering overseas expansion should make sure to invest the requisite amount of time early in its discovery process to obtain a reasonably accurate sense of all the costs associated with operating in a specific target market. This time spent will justify itself by helping you properly manage expectations, and will likely help your company avoid unexpected — and potentially crippling — costs down the line.