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The pleasures and perils of taking a local business global.
Don Durfee, CFO Magazine
June 1, 2006
Nearly 35 years after China reestablished trade with the United States, launching a foreign subsidiary there remains difficult — especially for a smaller company. Managers must come up with a business plan, translate it into Mandarin, then submit it along with a two-inch pile of forms. That's when the real work begins, with seemingly endless revisions and negotiations with Chinese officials. From start to finish, the process can take two years.
Even then, a foreign operation needs a Chinese name before it can begin to conduct business. When The Hoffman Agency, a Silicon Valley public relations firm, reached that point, CFO Leon Hunt was told he had to come up with six possible DBAs to submit to officials in China. Hunt says he could barely come up with four that captured the mission of his company. Still, the form had to be completed, so he picked the last two names arbitrarily. "Our attorneys said not to worry," recalls Hunt. "They said we'd get our first or second choice."
The PR firm got its sixth choice. The name translated roughly as "Good Fortune Consulting Co." — an auspicious title, perhaps, but one better suited for a local tea-leaf reader than a global public relations firm. In the end, The Hoffman Agency managed to secure its first choice (which loosely translates as Hoffman Business Consulting), but not without some scrambling.
Managers at many small-to-midsize businesses can relate. Consultants say they've seen a flood of smaller companies rushing overseas over the past two years. Some of the risk-takers are lured by burgeoning consumer markets in big countries like China, India, and Russia. Some are looking to set up cheaper production facilities in emerging markets. Others are simply following clients overseas to major European cities.
Most are going sooner than they would have 10 years ago. Indeed, many small businesses are expanding internationally before they've even established a solid base of operations in their home markets. "You used to see venture-backed companies going abroad after their C or D round of funding," notes Larry Harding, founder and president of High Street Partners, a consultancy that helps companies manage their international finances. "Now they go abroad during the A round."
Many are unprepared for what awaits them. Operating in several markets across a number of time zones presents operational challenges. Tax codes may be convoluted. Quirks in local employment laws can prove baffling for inexperienced managers, landing their fledgling operations in legal hot water. Fluctuations in exchange rates can foul up even the most modest revenue forecasts. Emerging markets remain particularly risky for small companies, which can't always afford the high-powered lawyers employed by the Fortune 500.
The risk takes a toll. According to a recent study by Bain & Co., only a third of expansions overseas by U.S. retailers have returned their cost of capital. "People are naturally enticed by growth," cautions Ron Langford, managing partner at consulting firm Marakon Associates. "But they're spending less time thinking about the bottom-line implications of their decisions."
Contract First, Office Second
Bruce Ferber can attest to that. Ferber, now CFO at Herndon, Virginia-based consulting firm Digital Focus, was involved in overseas expansions with two previous employers. Neither fared particularly well.
At one, a division of General Electric called GE Capital Spacenet, managers spent millions of pesos building a satellite ground-services operation in Argentina. Customers were less than enthusiastic. Eventually, GE Capital spun off the struggling division. "'Build it and they will come' is way too risky from my perspective," says Ferber.
Instead, the Digital Focus CFO prefers a less starry-eyed approach. He advises small-business executives to sew up a contract in a foreign country before setting up a local office. Ferber stuck to that belief when management at Digital Focus began contemplating its own move overseas last year.
The planned expansion wasn't optional. Digital Focus had recorded revenue growth of 300 percent in 2003. But business at the technology consulting firm slowed dramatically the next year, with revenues up just 30 percent. Boosting sales meant opening in new markets. It wasn't hard to decide which ones. European countries are deregulating their national telecommunications companies. Such a bust-up usually means technology chaos and big IT budgets — a good combination for tech advisers like Digital Focus. With this opportunity before them, the company's managers okayed a scheme to set up an operation in London.
This time, however, Ferber was determined to match costs more closely to revenues — and London isn't cheap. "The prices in London and New York are pretty much the same," he says. "Just put a pound sign in front of the number instead of a dollar sign." Rather than committing to an expensive lease and hiring a local salesperson, the company first sent president Erin Smith to the UK to drum up business. After a sales meeting and a few phone calls, Smith landed Digital Focus's first overseas contract. The consulting firm's team worked out of client conference rooms, hotel lobbies, and local coffee shops.
The cost-conscious approach helped the company turn a healthy profit in 2005. Digital Focus is using the revenues from the initial engagement to fund further operations in the UK, including, finally, the lease of an office in London. While that workplace is three times as expensive as the consultancy's space in Herndon, the London office isn't exactly the equivalent of a Park Avenue suite. "We could have gone someplace [fancy] like Covent Garden, but we wanted to reinvest our profits," explains Smith. "There are coffee stains on the rugs, but our clients like that. They say, 'At least we're not overpaying you.'"
No Net, and Loving It
For those courting clients, not overpaying is crucial, particularly in the early days of a cross-border expansion. As Marakon's Langford points out, "Companies that are the most successful with their expansions are often the ones that can be profitable early."
That's easier said than done. Setting up cross-border operations can strain a finance chief's ability to control administrative costs. CFOs accustomed to dealing with one set of books and one set of federal tax codes suddenly find themselves dealing with several general ledgers and multiple tax regimes. Differences in accounting treatments only add to the complexity.
For larger operations, the answer is simple: hire more finance staff to master local issues and support each business location. A start-up with five overseas sales offices can't afford that, however. Neither can managers at resource-strapped small-cap companies. "You want good data from your country offices," acknowledges Stu Fuhlendorf, CFO of Isilon Systems, a manufacturer of clustered storage systems. "But you don't want a huge international infrastructure, especially when you already have the burden of Sarbanes-Oxley."
To some extent, advances in technology are easing the pain. "Ten years ago, you had to have someone in every country to create and load a payroll tape," says Bob Cecil at EquaTerra Inc., an outsource and insource advisory firm. "With self service and the Internet, you don't need that anymore."
Letting someone else do the legwork is another option. Consider Isilon's arrangement. The Seattle-based company has offices in Tokyo, Seoul, London, and across continental Europe, yet it has no permanent finance staff in any of those spots. Instead, Isilon management hired High Street Partners to help it line up local accounting firms in each market. Every month, High Street collects the numbers from the firms, reviews the figures for accuracy and consistency, and then passes the data along to its client. This allows Isilon to tap into local expertise without incurring big fixed costs. "We are ramping up very quickly, and this makes it easier for us to get into new countries," says controller Pearl Chan. "And if we have to ramp down, we can do that, too."
The arrangement is helpful, given that the business-process-outsourcing industry hasn't quite caught up with the needs of smaller global companies. Large BPO specialists generally focus on more-profitable accounts, meaning large corporations. And while finance-outsourcing boutiques such as Core3, Outsource Partners International, and Savista (owned by Accenture) do offer some overseas services, they tend to stick to certain countries or industries. Savista, for example, serves small-to-midsize companies in the restaurant business.
Even with outside help, international business is undeniably harder on finance at smaller outfits. "Having overseas subsidiaries means doing more with the same resources," says Don Pratt, CFO of Ellacoya Networks Inc., which makes hardware and software to control broadband networks. "We effectively have a 24-hour workday. If you need to talk with someone at 9 or 10 at night, you just need to do it."
Of course, executives at some small companies say they welcome the challenge of going global without the reassuring infrastructure and resources of a big multinational. That appears to be true for Bruce Ferber. "As a former GE Capital finance guy, I've played in the international space before," he says. "But this time I'm working without a net. It's exhilarating."
Shortcut This Way
With or without a net, flops happen. Before venturing into China, The Hoffman Agency tried to crack the Japanese market. Taken aback by the country's high prices, CEO Lou Hoffman came up with what seemed like a bright idea: he hired a consultant to help him find a local Japanese partner who could share office space and help sell his company's PR services in Japan. "I was feeling proud for being so clever," says Hoffman. "But it was a disaster."
Hoffman's partner was a Japanese-English translation service with three employees. As it turned out, the local partner was neither interested in learning the high-tech PR business nor able to win much new business. There was a cultural problem, too: many Japanese executives are reluctant to do business with companies that aren't incorporated in Japan. "We came across as second-class citizens," recounts Hoffman. After two years without progress, Hoffman canceled the partnership and started again.
Better planning may have prevented the problem. As Michael Collins, a partner with Bain, points out, "You need to realize that the right time to start looking at expansion is long before you need it to hit your top and bottom line." Businesses don't always have that luxury, however. When Security Innovation yielded to its customers' requests that it open an office in Europe, managers at the Wilmington, Massachusetts-based software security company moved quickly, taking just three months to make the arrangements. "It wasn't enough time," concedes CEO Edward Adams.
If he had greater advance notice, Adams probably would have boned up on Dutch employment laws. The CEO notes that he granted one new hire in Amsterdam a lifetime contract (which is what the employee had at his previous job) without understanding the contract's binding nature. "There's essentially no concept of at-will employment," explains Adams, who is now more familiar with work rules in the Netherlands. "I didn't fully grasp that. It has the potential to be a substantial liability for the company."
That's a misstep Adams won't make again. Likewise, Hoffman says the unpleasantness in Japan helped him when he began mapping out the company's China strategy. Rather than rush things, the company recruited a skilled communications executive from China's petroleum industry and brought her back to the company's Silicon Valley office for 18 months to learn the company's business. Then and only then did the agency send her back to open an office in Beijing. "A year and a half seemed like an eternity," Hoffman concedes. But he says the "disaster" in Tokyo taught him a valuable lesson. "I learned that if something looks like a shortcut, it probably isn't."
Patience has paid off. The Hoffman Agency's unit in Beijing has grown to 14 people and is now the company's fastest-growing operation.
Don Durfee is research editor at CFO.
Software Without Borders
Small businesses may be venturing abroad in large numbers, but you'd never know it by the lack of software titles available for managers at those companies. Sage Accpac ERP, for example, is a fully featured, Web-based resource-planning program, but the software is targeted at international companies with at least 100 employees. That leaves a lot of undersized companies out in the cold.
Leon Hunt ran into this problem in 2002 when he was setting up an infrastructure for The Hoffman Agency's overseas operations. Hunt, CFO at the Silicon Valley–based public relations firm, says he couldn't find any accounting or time-and-billing software packages that fit his requirements. ERP packages from the likes of SAP and Oracle were too expensive, and scaled-down packages didn't include essential features such as currency conversion. Ultimately, Hunt kept his Peachtree accounting system (from Sage Software). "We just had to do the translations manually," he laments.
Even today, the Peachtree program, which is aimed at companies with 5 to 50 employees, lacks features for conducting cross-border business, such as multiple-language capability. Paul Hamerman, vice president, enterprise applications, with Forrester Research, says good finance programs do exist for slightly bigger companies, including packages from Microsoft Dynamics NAV, Exact Software, and the Sage Accpac application. Those products offer a full range of international business functions and, surprisingly, don't cost a fortune. Hamerman estimates that the software will run a small company between $10,000 and $25,000. A caveat: the programs are mostly one-off solutions that are difficult to deploy over a wide-area or location-by-location network. Says Hamerman: "You have to transfer the data into a consolidation package, or, God forbid, Excel." — D.D.
The Tax Trap
Finance managers who think global tax planning means mastering foreign tax codes may be peering through the wrong end of the telescope. Tax experts say the biggest tax traps for U.S. businesses with international operations often lie in their own backyards. That's because the United States, unlike many countries, taxes its citizens on the money they make around the world, not just at home. Here are a few of the snares, courtesy of Uncle Sam:
Those Darned Forms. International business brings a ton of paperwork, both from the Internal Revenue Service and the states. Examples: IRS form 5471 (ownership of a foreign corporation) and U.S. Treasury form TD90.22-1 (overseas bank accounts worth more than $10,000). Failure to file these forms — or just plain getting them wrong — can trigger fines ranging from $10,000 to $100,000 and possible criminal penalties. BDO Seidman tax partner Shawn Carson says filing problems often arise when small businesses turn to local tax firms with little experience in international tax compliance.
Pay and Pay Again. When setting up the legal structure of an overseas business, companies often choose pass-through entities such as partnerships or S corporations. Done right, these setups provide a nifty shelter, with the parent company paying only U.S. tax on the foreign income. Get it wrong, though, and troubles abound. A U.S. partnership that creates a Canadian subsidiary, for instance, may well end up paying a dividend tax in the United States and a corporate tax in Canada — without the benefit of a foreign tax credit offset.
DIY Transfer Pricing. U.S. companies with multiple overseas operations often conduct sales between those businesses to help shift profits to lower tax regimes. Advisers exist to help companies set up the schemes, but the service can be expensive (full reports can cost as much as $40,000). Doing it yourself can be tricky, though. Tax experts say managers often set prices too high or too low. "I've seen some small companies do it on their own without a problem," says Carson. "But I've seen others that have run into all sorts of problems with the tax authorities." — D.D.