Method of entry Research one of the methods of entry in Chapter 4. Discuss in depth issues related to the considerations pertaining to this method o

4.3 Active Exporting Once a firm realizes that it wants to exploit the possibilities that sales abroad can bring and decides to become involved in export activities, a number of alternatives open up. Several alternatives are possible, differing not only in the level of involvement of the exporter, but also in the strategies pursued by the exporter.6 4.3.1 Agent An agent is usually a small firm or an individual located in the im- porting country who acts as a manufacturer’s representative for the ex- porter. The agent sells the manufacturer’s products to customers in the importing country, using the terms of sale—price, delivery, discounts— determined by the exporter. An agent does do not buy product, but arranges sales directly from the principal to the customers. For this work, an agent is paid a commission, calculated as a percentage of the sale price of the product to the customer, and collected after the cus- tomer has paid the principal. An agent often has several principals and generally sells a group of complementary products rather than products that compete directly with one another. The agent will handle all of the sales functions for the exporter, from the initial prospecting for customers to the close. The agent is usually given varying support by the exporter: some exporters provide only the bare minimum of a sales brochure and a price list, while the more experienced exporters provide training on the product’s characteristics, analysis on the competitors’ products, information on the sales and service philosophy of the company, sales support in the form of samples, catalogs (translated or adapted), trade advertisingand financial support to attend trade shows, technical visits by corpo- rate engineers, participation in sales incentive programs, and so on. Agents, as a whole, like to keep control over their schedule and over their sales approach, but the exporter’s support of their efforts is crit- ical to their success and to the extent to which they expend a lot of effort selling the exporter’s product. In particular, requests for quotes and pro forma invoices should be handled quite promptly, and negotia- tions on price and delivery done diligently, so as to not delay the agent’s sales efforts; time differences sometimes exacerbate the perception of a lack of responsiveness on the part of the exporter. Sometimes, there is the suggestion that, given a set of guidelines, the agent could be trusted to reach decisions and negotiate with the cus- tomer on critical aspects of the sale: price, delivery, terms of trade (see Chapter 6), terms of sale (see Chapter 7), and collection. However, it is critical that all such negotiations be handled by the principal, with the agent acting as an intermediary between the exporter and the importer. If the agent is allowed to negotiate directly with the importer, then the agent is considered by a large number of countries’ governments as a binding agent, and the exporter is considered to have a permanent establishment in the country of import. This determination has signif- icant taxation implications; the profits realized on the sales made in that country are now considered taxable by the country of import. If there is no permanent establishment, the profits are not taxable in the country of import, although they are obviously taxable in the country of export. After the sale is concluded between the agent and the importer, all of the other aspects of the transaction, from the pro forma invoice to the actual collection of payment, from packaging to shipping the goods, are handled directly and solely by the exporter. Finally, the agent does not get paid until after the exporter has been paid by the importer. The choice of an agent should obviously be made on a large number of criteria: its ability to represent the exporter and its product accu- rately, its ability to sell, its contacts, its knowledge of the industry that the exporter wants to target, the compatibility of its objectives with those of the exporter, and so on. Moreover, the choice of an agent is a long-term commitment; although the contract is often based on one- year increments, the duration of an effective relationship between an exporter and its agents is much longer. There are several alternative routes to finding agents in foreign coun- tries; among the most commonly used methods are contacts made at trade shows, participations in trade missions, inquiries with the com- mercial attachés of the exporter’s country’s consulates, and contacts with other successful exporters. The use of an agent is generally driven by several factors, one or more of which can be enough to trigger this strategic decision

1. When the firm estimates that its potential sales in that market are small (perhaps no more than 5 or 10 percent of its domestic sales), with moderate or no growth potential 2. When the product is not a stock item, but a product specifically designed and made for a particular customer 3. When the product is a very expensive item, such as operating ma- chinery 4. When the company expects a short product life cycle 5. When the product does not require frequent after-sale service 6. When the exporter is unlikely to ever become one of the dominant players in the market and will remain a niche player 7. When the company is reasonably well equipped to handle export sales 8. When the company is not pursuing a top-of-the-line strategy and does not attempt to collect premium prices 9. When the company wants to keep a reasonable amount of control over its prices and delivery policies 4.3.2 Distributor Another entry strategy is to use a firm located in the importing country— or, sometimes, in a neighboring country—that buys the goods from the exporter. Such an intermediary is called a distributor, that takes ti- tle to the goods, sells them, and earns a profit on the sales it makes. What characterizes a relationship with a distributor is that there are two sets of invoices: one set of international invoices between the ex- porter and the distributor, who is also the importer of record; and a set of domestic invoices between the distributor and its customers, who see these transactions as domestic sales of a foreign product. A distrib- utor is therefore carrying inventory of the exporter’s goods, and it also often carries inventory of spare parts and provides after-sale service. A distributor will carry complementary products but also may carry products that compete directly with those of the exporter. A distributor is taking much more risk in its relationship with the exporter than does an agent, and experiences much higher costs. The distributor carries the traditional risks associated with inventory and invests a considerable sum of money in the inventory; should the goods not sell well, the distributor is saddled with the unsold or obsolete goods. In addition, it is traditional for a distributor to participate in the costs of advertising, trade show attendance, and so on. In exchangethe distributor has much more freedom in setting prices, negotiating terms with customers, and managing all matters not directly related to the exporter’s trademarks or copyrights. However, there is a large number of exporting firms that attempt to limit these freedoms, specif- ically on price, in order to maintain a standard strategy from country to country and to eliminate or reduce “parallel imports” (see Section 4.5 on page 139). A distributor should also be considered a long-term partner. Be- cause it makes a substantial investment in inventory and in the training of its employees, the distributor considers itself involved for a long pe- riod of time, and great care should be taken in finding the right partner. The choice of a distributor should be made on a large number of crite- ria: its ability to represent the exporter and its product accurately, its ability to invest in the exporter’s products, to sell them, and to provide after-sale service, as well as its employees, their contacts, its knowl- edge of the industry, the compatibility of its objectives with those of the exporter, and so on. There are several alternative routes to identifying potential distribu- tors in foreign countries; among the most commonly used methods are trade shows, trade missions, the commercial attachés of the exporter’s country’s consulates, and contacts with other successful exporters. The use of a distributor is generally driven by several factors,7 one or more of which can be enough to trigger this strategic decision: 1. When the firm estimates that the market is substantial (perhaps 20 or 25 percent of its domestic sales) or when it estimates that there is substantial growth potential 2. When the product is a stock item, and generally not tailored to the needs of a specific customer 3. When the product is a rather moderately priced item 4. When the company expects a fairly long product life cycle 5. When the product requires (frequent) after-sale service and/or main- tenance parts 6. When the company estimates it will not become much more than a minor player in the market 7. When the company prefers to handle export sales with only one customer 8. When the company is not pursuing a prestige pricing strategy with premium prices and service 9. When the company is comfortable relinquishing control of its price and delivery terms.

4.3.3 Additional Issues in the Agent-Distributorship De- cision There are two other issues to consider when determining whether an agent or a distributor would be the most appropriate partner—both issues are legal in nature. First, some countries will not allow agents at all, or will not allow agents to represent foreign manufacturers, or will mandate a physical after-sale service presence on the country’s soil, all requirements that mandate the use of a distributor. The second issue is more complicated: many governments make a substantive differentiation in the way agents and distributors are con- sidered by their judicial systems. Most often, because agents tend to be individuals or very small firms, many countries have decided to place them under the protection of labor law, the code of laws that deals with the relationships between employers and employees (see Section 5.3.1 on page 156). In many countries, notably in Europe, labor law tends to be very restrictive in terms of what an employer can and cannot impose on an employee and, in those countries in which labor law applies to agents, what an exporter can and cannot require of an agent. For exam- ple, even though the principal-agent contract may call for a termination notice of thirty days and no compensation, labor law may call for a six- month notice and six-month loss-of-income compensation, overruling the terms of the contract. There are similar restrictions on the num- ber of hours worked, the payment of taxes, the legal requirements of certifications, licenses, and so on. In contrast, distributors, because they tend to be larger and are as- sumed to be more sophisticated, are covered in almost all countries by contract law. Contract law is much less restrictive, and courts tend to render judgments based upon the terms of the contract; the only restrictions are limited to contracts that are obviously biased or co- erced, a situation very unlikely to be observed if one of the International Chamber of Commerce model contracts or an equivalent is used. There is another distinction that is often made between an agent and a distributor that presents some potential for misunderstandings; it is often said that a distributor has risks (it invests in inventory), whereas the agent does not. While it is a useful distinction, it is incomplete. It is correct to understand that the distributor has substantial financial risks, because it invests in inventory and is faced with the possibility of unsold inventory. However, the agent often has considerable risks as well. It invests time and effort in obtaining a sale for which it will not be compensated until after the product is delivered and paid. In some cases, especially if the product is custom-made for the importer, there may be a lag of several months between the sale and the receipt of the commission check4.3.4 Marketing Subsidiary Finally, a firm may decide, rather than employ an agent or a distribu- tor (over neither of which it has much control), to create its own sales or marketing subsidiary in a foreign country. A marketing subsidiary is a foreign office staffed by employees of the exporting firm who will sell its goods in the foreign market. A subsidiary is incorporated in the foreign market, so it is the importer of record as far as the foreign gov- ernment is concerned, and the “export” takes place between two legal entities that are part of the same company, at a transfer price. Although transfer prices can sometimes create problems in the process of clear- ing Customs, the process is very smooth altogether, as the traditional concerns of payment, terms of sale, and terms of trade are eliminated. All sales made by the foreign subsidiary to its customers are domestic sales and therefore are simpler to manage. All profits earned in the importing country are taxable to the importing country’s government. The costs of a marketing subsidiary are higher, and a good portion of them are fixed: a building must be rented, an inventory built, and employees hired and trained before measurable sales can offset these expenses. This is in stark contrast with sales through an agent, which are variable-cost sales (the commission is paid only if the agent sells) or sales through a distributor, where that distributor is the one bearing the costs of establishing the business in the foreign market. These investments obviously also require a long-term commitment on the part of the exporting firm. The choice of a sales or marketing subsidiary is made when the com- pany wants to retain control over its sales in that country, usually when the company is faced with one or more of the following situations: 1. When the firm estimates that the market potential is considerable (more than 25 percent of its domestic sales) or when it estimates that there is very substantial growth potential or very substantial profits to be made 2. When the product is technology driven, with substantial intellec- tual property content 3. When the product is rather complicated to sell 4. When the company expects to be involved for the long run, with additional products to be introduced later on 5. When the product requires sophisticated after-sale service and/or maintenance parts 6. When the company expects to become one of the major players in the market 7. When the company is exacting premium prices from customers 8. When the company is uncomfortable relinquishing control of its products and prices. 4.3.5 Coordinating Direct Export Strategies There are two types of factors included in the entry decision for an ex- porter: those factors that are market-driven and those that are company- or product-driven. Consequently, some firms elect to have a policy to always follow a strategy driven by their product line and always use a sales subsidiary or a distributor or an agent. However, some firms decide on a country-by-country basis which strategy is the most appro- priate and juggle a combination of agents, distributors, and marketing subsidiaries. Each of these overall strategies has advantages and disad- vantages. When a company chooses to have the same entry strategy in all its export markets, it certainly simplifies the management of its exports and presents a unified front to its customers on all aspects of its mar- keting. In particular, if the firm uses agents or sales subsidiaries in all countries, its prices are bound to be well coordinated and its after- sale policies clearly controlled. If there are any discrepancies, they are known to the firm and can be clearly managed and understood. A firm choosing to use distributors in all of its markets can exercise the same level of control by using contracts that specify clearly which prices dis- tributors are allowed to charge—a practice that is generally legal or, at least, tolerated—and which after-sale service they must provide. How- ever, there are problems with this “fit-all” strategy, as inappropriate strategies may lead to a poor match with the market: a potentially very lucrative market may be given away to an agent, or a sales subsidiary may have to be established in a small market. Moreover, a firm may have to postpone entry into a lucrative market because of a lack of resources if it adheres to a strategy of building only subsidiaries. When a firm chooses to have different entry strategies in different countries, or when it decides to sell through a series of independent dis- tributors, the coordination of prices and after-sale service is more dif- ficult to achieve, and the possibility of parallel imports (see Section 4.5 on page 139) looms. However, the most appropriate strategy is chosen for each country, and, generally, the greatest profits can be extracted from the foreign markets. For a firm, the decision to have a coordinated entry strategy is based on criteria that can be interpreted differently by different management teams. However, there is one significant issue to consider once a choice has been made: the costs of changing from one entry strategy where an exporter uses agents or distributors to a strategy based upon sales sub- sidiaries can take a significant toll on all involved parties. The agents and distributors have generally invested a considerable amount of time, The company expects a short product life cycle The product is a stock item The product is custom-made for customers The product is an expensive capital-good item The expected sales are modest The company pursues a top-of-the-line strategy The product is moderately priced The product requires after-sale service The product has substantial intellectual-property content The company expects to become a major player in the market The company anticipates a small market share Agent Distributor Subsidiary X X X X X X X X X X X X X X X X X X X Appropriate Entry Strategy Table 4.1: Criteria for Active Exporting Choices money, and talent into building a significant market for the exporter’s products, for which they are rightfully compensated according to the terms of the original contract. If they are very successful, the exporter is often tempted to recover these expenses (the commissions paid to the agents or the profit opportunities given to the distributor) by estab- lishing a sales subsidiary. This change of strategy should be avoided as much as possible, as it is traumatic for all involved parties and often results in reduced sales and profits for several years. This is because the customers’ loyalties usually lie more with the agent or the distribu- tor than with the exporter, and regaining the customers’ confidence can take considerable effort. The slighted distributor can also be strongly tempted to counterattack, in court or otherwise: some companies can suffer greatly from this change of heart in strategy if the courts are sympathetic to the plight of the local firm,8 as they often are. 4.3.6 Foreign Sales Corporation Foreign sales corporations (FSCs) were created in the United States as tax breaks for exporters. It was not a method of entry at all, but rather a way for U.S.-based corporations to lower their income tax. The only conditions were that the corporation had to export products with a 50-percent U.S. content and had to incorporate a subsidiary in one of several pre-approved foreign locations, such as the U.S. Virgin Islands, Barbados, or Jamaica. By channeling its export sales through an FSC, a corporation was eligible for a reduction in its tax rate on profits earned on export sales of fifteen percentage points, from 45 percent to 30 per- cent.9 It was essentially a tax incentive available to exporters, regard- less of the method used for export. The European Union brought a complaint to the World Trade Orga- nization (WTO) that the FSC concept was a subsidy to exports, a prac- tice that was prohibited by the agreement. The WTO ruled against the United States in August 1999. Subsequently, the U.S. Congress created the Extraterritorial Income Exclusion (ETI) Act, which offered roughly the same benefits to U.S. exporters, but under a different legislation.10 The ETI was also found to be contrary to WTO rules in 2004 under the same argument; export sales were not taxed, and therefore the ETI was considered a form of export subsidy, contrary to WTO rules. In 2005, the U.S. Congress created a new provision to counter that setback, the Domestic Production Deduction; although it is available to all compa- nies operating in the United States,11 it is designed to provide favorable tax treatments to exporters.12 The WTO had not ruled against that lat- est legislation as of June 2013. Another tax incentive to U.S. exporters is the Interest-Charge Domes- tic International Sales Corporation [IC-DISC]. It allows exporters to cre- ate a separate subsidiary to which it pays a commission on its foreign sales. The tax rate that the subsidiary pays on these commissions is 15 percent, a much-lower rate than the 35 percent that corporations pay on ordinary income.13 The WTO has not ruled on that tax strategy as well, and, actually, it looked like no foreign state had filed a complaint against this practice as of June 2013. Regardless of the WTO’s eventual rulings on these two tax incentives for exporters, the United States Congress is likely to keep on promoting the concept of a tax break for exporters. In 1984, Domestic Interna- tional Sales Corporations (DISCs) were found to be in violation of the General Agreement on Tariffs and Trade, and Congress created FSCs in their place. Similarly, after the WTO ruled FSCs to be counter to free trade, the U.S. Congress passed the ETI Act. When that was found to not conform to WTO rules, the Domestic Production Deduction and IC-DISC were created

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