“Underground factories”: SMiEs struggling to survive
Yuan Maofeng, Liu Yang

This is a translation of a Chinese article. The original artivle can be accessed through the follwing link: http://e.lifestyle.com.cn/digitimes/szsysd/617871.shtml

The current economic environment has turned out particularly tough for “small and micro-sized companies” (SMiEs). Many of them have eventually gone bust under huge pressures, while some others have given up their business licenses to become “underground”.

Being a member of the Chinese Communist Party for decades, Zhou Chuanhua had never imagined himself running an “underground factory” when he almost turned sixties.

December 18 2011 was a day Mr. Zhou would always remember. After reviewing his factory’s accounts which were in deep losses, he made the hard decision to cancel the business license in order to escape various taxes and fees.

Seasoned Party members like Zhou Chuanhua tend to pay special attention to their social responsibilities. Anxieties over the cancellation of business license can be easily sensed on his expressions. Nevertheless, whenever Mr. Zhou is questioned about the status of his factory, he would respond with confidence that “I would be working with my conscience”.

Mr. Zhou is one of the millions of entrepreneurs struggling to maintain their businesses. They are neither “black” nor “white”, and all used to be earnest entrepreneurs running legal businesses. However, they are now always haunted by their current “gray” status.

The start-ups
“There’s no way you can survive if you want to run a legal SMiE,” sighed Mr. Zhou. The main reason why he gave up the business license is the high taxes and high rents. “When you run a formal business, many customers would ask for invoices upon their purchases of your machines, virtually eliminating all possibilities of tax evasion,” said Mr. Zhou.

Having retired a few years ago, Mr. Zhou started a factory in Chongqing producing machinery parts. However, the factory had later on gone bankrupt under persistent losses. Unwilling to submit to the failure, Mr. Zhou entered the furniture manufacturing business in Foshan [a city in Guangdong Province] with his last bit of savings worth Rmb150,000.

The new factory started to see some bright signs in early 2008, but it eventually didn’t make through the Global Financial Crisis later that year.

According to Mr. Zhou, almost half of his revenue would be submitted to pay for the 17% value-added tax and 25% corporate income tax. Moreover, the factory has to be located in a formal industrial zone, with annual rent at least costing Rmb20/sq m. Combined with other expenditures such as power charges, fire control equipments, and employee wages, monthly fixed costs are easily over Rmb30,000. “Honestly speaking, if you run business in line with all the regulations, you are left with a profit margin of merely a few percents,” said Mr. Zhou. As a result, Mr. Zhou has had net loss around Rmb20,000 each year. The falling market demand and shrinking order have only made things worse.

Compared with Mr. Zhou’s frankness about his situation, Lin Tao seems much more haunted by the status of his business. Lin Tao has been dreaming of obtaining a legal status for his factory. Anyways, this is a must if he wants to develop business with big clients.

“Underground factories”
After turning his factory into a “gray” one, Mr. Zhou has moved out of the expensive industrial park to resident buildings. Concerned with losing everything once caught by business regulators, Mr. Zhou has been playing the game of hideouts.

In three nearby blocks, Mr. Zhou rented an apartment in each. Each apartment accommodates one production line with a “factory chief” assigned. Interaction with the outside world, like utilities payments and communication with property managers, has been taken care of by the “factory chiefs” to avoid troubles.

Mr. Zhou also boasts the fact that hardly any neighbors know the existence of his “underground factories”. This is because Mr. Zhou has required each “factory” to close operation at 7pm every day.

Mr. Zhou’s experience is quite representative among SMiE owners. Worried about the tax burdens and fire control checks, Lin Tao has also chosen to register only for his company without getting a license for his factory.

Lin Tao’s factory is located between Guangzhou and Foshan. Local villagers have built production space on their housing land, with monthly rent as low as Rmb8/sq m. A number of young entrepreneurs started their businesses there.

“Underground factories” won’t lose all business just because of their illegal status. Lower tax burdens and rents have become a competitive edge for them. Personal connections have also helped them secure some orders. Moreover, some customers also prefer cash settlement without asking for invoices, which Mr. Zhou or Lin Tao is unable to provide.

The sense of insecurity doesn’t go away
Since his firm joined the group of “gray factories”, Mr. Zhou has paid more attention to details of operation as the legal status of his business was already lost. From raw materials to blueprint design, from quality checks to sales channel control, Mr. Zhou has engaged himself in each operation stage.

Worried that skilled workers would leave his factory at anytime, Mr. Zhou has also assumed the responsibility of taking care of workers’ daily life. Salaries have been raised once in a while out of Mr. Zhou’s own initiative, and he cooks for the workers at least once in a week.

Lin Tao has also had to make emotional investment on his employees. Personal relationship has become a major management tool, as his unlicensed factory isn’t allowed to formally recruit workers, but can only rely on friend recommendations.

One of the employees has worked with Lin Tao for 3 three years, the longest among all. Workers in Lin Tao’s factory more or less earn the same as their peers in big companies. Moreover, as a result of the factory’s tiny scale, workers have had chances to accumulate exposures to all production stages. The disadvantage to Lin Tao, however, is that skilled workers could leave and start their own businesses, hence adding new rivals to him.

Lin Tao has usually been haunted by the illegal status of his business. One source is customers’ concerns over product quality when they come to see his factory, which is anyways just private housing. On the other hand, he also feels embarrassed when interacting with peers running formal businesses.

Lin Tao is in the hope of getting a legal status for his factory, which is necessary if he wants to cater to big clients.

Chances given, Lin Tao would get together with other entrepreneurs similar to him, complaining of their shared difficulties. But more often than not, their conversations are centered on how to improve products and sales.

Mr. Zhou faces similar problems, although he is reputed for the quality of his products. Due to the lack of business license and tax payment certificates, clients such as government agencies or state-owned enterprises are insulated from Mr. Zhou, no matter how good his products are. Also as a result of his factory being “underground”, Mr. Zhou had to pay fees one third higher than normal for a machinery exhibition held in Beijing. After the four day exhibition, Mr. Zhou would come back to Foshan, telling his friends whether attendance to the exhibition was a good deal.

While Mr. Zhou’s business is far from his hometown of Chongqing, he has still managed to go back home each year to submit Party membership fees and take part in some Party activities. Coming to the cancellation of his business license, he still feels sad but also believes there was no alternative.