Episode 2: 4 Modes of Entry for Manufacturing in Mexico
In this episode, Ricardo Rascon welcomes back David McQueen to build on their previous conversation. After focusing in the last episode on why expanding into Mexico might make sense for your company, Ricardo and David shift their attention today to how a company can get started with this expansion process. They discuss modes of entry to consider, factors to weigh in choosing one, and David's own experience and advice to manufacturing leaders!
There are several modes of entry for manufacturing companies to consider as they move toward expanding into Mexico: subcontracting, joint ventures & acquisitions, incorporation, and the shelter. In order to determine which mode to pursue, companies should bear in mind the five factors of risk (including technological and/or financial risk), cost (investment and operational), speed to market, production control, and feasibility and viability. David considers each mode of entry in turn and explores how it relates to the decisional factors companies should be weighing. Subcontracting, he shares, represents a low-cost and low-risk option, but raises the challenge of identifying and qualifying subcontracting partners. Joint ventures and acquisitions are a good path for companies with existing trustworthy partner relationships, but this mode of entry requires a good deal of due diligence. The incorporation process is similar in the US and Mexico, but companies can err by incorporating too hastily or by missing the purpose and subtleties of the incorporation model.
The shelter mode of entry is unique to Mexico, and it allows foreign manufacturing companies to enter the Mexican market with limited dealings with legal and regulatory issues. The company must be eligible for IMMEX and come under the shelter of an IMMEX partner, and the arrangement effectively outsources administration to the shelter company. After offering further comments on when a shelter model does and doesn't make sense to adopt, David explains his own experience leading two Canadian companies that expanded into Mexico and shares parting advice with listeners looking to take next steps in a similar expansion process.
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Announcer: Welcome to Tetakawi's Manufacturing in Mexico podcast, where we talk to internal and external experts to provide you with news, insights, and best practices about doing business in Mexico. Whether you're thinking about expanding into Mexico or are already there, this podcast will provide you with the information and advice you need to launch, operate, and thrive.
Ricardo Rascon: Hello, and welcome to another episode of the Tetakawi's Manufacturing in Mexico podcast. My name is Ricardo Rascon, and today I'm joined again by my good friend and colleague, David McQueen. Dave, how you're doing today?
David McQueen: I'm great. Thanks Ricardo.
Ricardo Rascon: Great. Glad to hear. And for those of you that joined us last time, we spoke about the reasons why expanding into Mexico might make sense for your company. On today's podcast we're going to talk about how manufacture in Mexico. If you're a manufacturer who's thinking about expanding into Mexico, there's a couple of modes of entry to consider. There's subcontracting, joint ventures and acquisitions, incorporation. And then there's a unique mode of entry known as the shelter.
Dave, for companies that are sitting there listening and saying, "Okay, I'm ready to expand into Mexico. Now I just need to figure out the how." How do they determine the best option for their company?
David McQueen: Well, I think Ricardo, most companies would consider five factors. The first is risk. And that can be technical risk or it can be financial risk. Second thing that's going to be right up on top of the list is cost. And once again, there's the cost of investment to consider, but there's also the operating cost. Most companies are also going to give some consideration to the speed to market, how quickly do they need this solution to be in place and up and running.
There's also production control. And that can be a complicated question. It depends on each company's business and their own strategy, but how much do you need to control the operation? How much need to have direct control over the production and the quality of the product that you're manufacturing? And that will vary widely. And finally, you need to think about feasibility and viability. You can want to do a solution, but maybe it's not feasible for you. Maybe it's not practical for you, or maybe it's not a viable solution for your particular operation.
Ricardo Rascon: Great. So let's go over now the four modes of entry that I mentioned earlier and talk about how they relate to these different factors that you highlighted. Let's start with subcontracting, Dave. What can you tell us about contract manufacturing in Mexico?
David McQueen: Well, first of all, it's similar to most countries. You execute a legal contract with a vendor who's going to provide you with some goods to your specifications. There are some differences in Mexico. One difference being that many of the subcontractors do not have the financial viability to support the same level of credit and investment that they do in other countries. So that can be a difference.
There's also the question of whether a subcontractor exists to support your need. It's not the same as China where state enterprises were devolved into a lot of entrepreneurial manufacturers. In Mexico things evolve with a lot of direct foreign investment. So potentially there isn't a subcontracting base to do exactly what you want in Mexico and to do it at the price you want.
In terms of risk and cost and speed to market, there's a lot of advantages of subcontracting. Obviously it's going to be fast. Obviously a lot of the risk ends up being on the shoulders of the subcontractor, particularly with respect to the operating risk in Mexico that the subcontractor's going to bear. The cost of course is higher, but the risk on the cost is less because the subcontractor takes that risk. It can be pretty quick to launch and it can be pretty easy to control, depending on what it is you're doing.
In terms of downside risks, though, you do have to face the fact that a subcontractor in Mexico, number one, doesn't need you as much as a subcontractor in China might need you to provide distribution services. So that means their pricing might be higher and they might not be as eager to get the business. Secondly, you have to consider whether that subcontractor's potentially a competitor. There's good intellectual property protection in Mexico, but that doesn't mean that you aren't teaching somebody how to do your business. So those are the downside risks you have to think about.
Ricardo Rascon: Right. And for our listeners, Dave, when is and isn't contract manufacturing in Mexico a good idea?
David McQueen: Well, certainly if you're looking at low volumes, it's probably a good option to think about. If you're looking at subproceses that are fairly straightforward, say stamped components or injection molded parts, probably a good idea to think about subcontracting if there isn't significant volumes involved. If you've got high volumes or if you need to protect your processes and your product from the potential for competition, or if you don't want to be faced with the fact that you might need to invest in equipment and inventory and credit to support your subcontractor, those are cases where subcontracting might not be attractive.
Ricardo Rascon: Great, thanks. So from my perspective, it sounds like contract manufacturing is a low cost and low risk way to manufacture in Mexico. But the challenge comes in identifying and qualifying contract manufacturing partners. So let's talk about joint ventures and acquisitions in Mexico, Dave.
David McQueen: Well, first of all, Mexico is pretty open as far as foreign investment goes. Foreign investors can own Mexican companies in almost every industry. They can own as many companies as they want. They can set up joint ventures with whatever share and whatever arrangements they like. So it's wide open in that respect.
One of the advantages of course of an acquisition or a joint venture is that you're acquiring a market, some expertise, and probably some people, and in an operation that you can use, it could be quick to launch. But the downside is finding a target. So much like subcontracting, the chance that you can find an appropriate target in Mexico might not be that great. You have to find the right fit. You have to close the deal. And that's always a problem with acquisition.
Generally speaking it's easy to do. And if you know of a target or you've been working with somebody that's a good fit, then it might be a very quick, very low-risk solution. If you have to find a target, it could take a long time. And at the end of the day, you might not manage to achieve what you're looking for.
Ricardo Rascon: And what are some common mistakes that you see when companies explore the possibility of joint ventures and acquisitions in Mexico?
David McQueen: Well, the first mistake is relying on it as a primary strategy without knowing whether you can find a target. That can leave you spending a lot of time and coming up empty handed.
Second thing is due diligence. Due diligence with smaller companies, particularly can be challenging. There may not be the necessary documents to support due diligence that you'd like to have in terms of GAAP documents and so on. Consequently, you need to do a very thorough due diligence. Your remedies are less easy to exercise. So there's risk around the due diligence.
Another part of that's important is to understand the union relationship. If you've got a company that has a particularly militant union and a difficult union relationship, that adds risk, and that might not be readily apparent from the due diligence. So those are probably the two primary strategies.
As a secondary strategy or in cases where companies have identified a target and are able to close a deal, it can be a very good strategy.
Ricardo Rascon: Right. So it sounds like joint ventures and acquisitions are a good path forward for companies that have existing relationships with partners they can trust, but there's a significant amount of due diligence that's required. So if a company's listening and saying, "Okay, maybe a joint venture acquisition isn't for me," incorporation might be the next logical mode of entry to them or forming their own subsidiary in Mexico. Can you tell us a little bit about that, Dave?
David McQueen: Yeah. Incorporating in Mexico is similar to a lot of other countries. In fact, the modes of incorporation and the types of corporations permitted are similar to those in the United States. And as we've already discussed, Mexico has no limit in most industries on foreign investment. So foreign investors can incorporate as many companies as they want. They can own 100% of those companies and so on. So it's a pretty open opportunity in terms of the business market for a corporation. It's very easy to do.
There is one difference is that Mexico tends to define the purpose of corporations a little more narrowly. So you can run into situations where you need more than one or three or four corporations to do all of the things that you want to do. That's a little different than some other countries. But at the end of the day, it's relatively inexpensive to incorporate, it's very easy. And then that's a common solution. So it's not a big impediment. You just need to be aware of that. The purpose of your activities may affect how many and the types of corporations you need to set up.
In terms of risk, of course, corporations put the risk on the corporation itself. So the shareholders of that corporation end up bearing the risk. And those shareholders and the officers of that corporation will have liability directly under Mexican law. So you need to be aware that you are assuming some liability directly. In terms of cost, the cost to incorporate is low, but of course, then all the investment and operating expense is yours.
In terms of speed, the corporation can be set up relatively quickly. Two to three months is typically the timeframe to get a corporation registered, to get it set up and to do the appropriate permits and so on. It takes a little longer to get certified if you're dealing with an IMMEX corporation. An IMMEX is a program that helps exporters. It allows exporting companies to avoid paying value added tax. Now, if you form an IMMEX corporation, you avoid value added tax in the sense that you can recover any value added tax you've paid from day one. But there is also an opportunity to avoid the cash flow impact of paying and recovering, at least some of the value added tax. That comes with certification and you have to be operating for a certain amount of time and pass certain hurdles in order to get that. That's the only thing that takes time. Otherwise, it's pretty easy.
There are lots of accounting firms and lawyers in Mexico who are reliable and dependable and can execute at relatively low cost, $5,000 to $10,000 can get you set up and operating in most cases.
Ricardo Rascon: And are there any mistakes that you see when companies decide to form their own entities in Mexico?
David McQueen: Well, I think the biggest mistake is that a lot of companies jump in and form a company before they really need to. There's really no impediment to doing your due diligence, even so far as leasing property. You can lease a property from your foreign corporation. You don't have to have a Mexican corporation to lease property or buy property in Mexico. So almost everything you do can be done without a corporation in Mexico. So there's no real need to set up a corporation the minute you set foot there. And we see many companies that feel that they need to do that right away. And you don't. That can cut you off from other options. It can mean you haven't examined all of your options in terms of incorporating.
And then the second thing is companies that don't understand the purpose, and we talked about that a few minutes ago, setting up the appropriate corporations that you need. For example, companies will set up a non IMMEX corporation because they understand that to issue a Mexican invoice and sell directly in Mexico, which requires you to collect value added tax and to pay it, that they need a corporation to do that. What they don't immediately realize necessarily is that, I mean, IMMEX corporation can be set up for the bulk of their production, which avoids value added tax and allows them to participate in export programs, including exporting within Mexico to other exporting companies. And then they can set a second company up that's a trading company to perform the transactions necessary to invoice in Mexico.
So those kinds of subtleties, if you rush into things, you may think your business looks a certain way, but you may not realize that there are other ways to organize it. If you've got good advisors, they're going to point that out, but those are the mistakes that we typically see.
Ricardo Rascon: Okay, great. So the first three modes of entry that we discussed, Dave, they're pretty self-explanatory. They're common modes of operating in any country, whether it's the US, Canada, Mexico. But when it comes to Mexico, there's a unique mode of entry that's known as the IMMEX shelter program. Can you describe what it is and tell us why many foreign manufacturers choose to start under a shelter?
David McQueen: Yeah. The shelter is, as you say, a unique offering in Mexico. It was put in place 30 some years ago when Mexico first launched the maquiladora program. And the whole idea behind it was to make it easy for foreign companies to enter the Mexican market and to not have to deal with a lot of the legal and regulatory requirements of being in a foreign country.
So what the core of the program is, is that it allows a foreign company to contract with a Mexican shelter company, which is dually registered with the Mexican government and identified as a shelter provider, and then use the legal umbrella of the shelter company so that they don't have to have permanent establishment. They aren't directly liable for legal or regulatory compliance, and yet they can operate as if they did have permanent establishment.
So that's the essence of it. It does have to be, as you say, an IMMEX operation. And just to further clarify what IMMEX is. IMMEX is the Mexican government program. It applies to corporations as well as shelters. And it allows an exporting company to avoid the payment of value added tax, or if they have to pay it, to recover that value added tax. It also allows them to access certain import-export programs. But the core of it is the value added tax.
Now, the unique thing about IMMEX is that you can export externally outside of Mexico, or you can export between IMMEX companies within Mexico. So a lot of business is done by IMMEX companies. The thing about the shelter is that you must be eligible for IMMEX and you must have an IMMEX company. Now, as I mentioned earlier, there is a way to have a secondary company, which would then allow you to invoice directly in Mexico to do business. So if part of your business is that way, then you can do that as well.
Now, the other thing about shelter companies is that because they have to perform certain tasks in order to be the legal entity. For example, if you hire someone, you don't have a legal entity in Mexico, well, you can't legally hire them. So the shelter company has to administer that part of the activity, register with the government, make sure that the taxes are paid and so on. So because shelter companies had to set these systems up, it was natural for them to expand their services so that most shelter companies can also provide complete administration in Mexico.
So effectively with a shelter provider, you really don't need any administration in Mexico. You simply have your operating unit and you've essentially outsourced your administration to the shelter provider.
Ricardo Rascon: Great. So it's essentially then a turnkey solution. They would provide me with the space, the people, the services and infrastructure that I need to make my product and control it 100%.
David McQueen: Exactly. Exactly. That's what they do.
Ricardo Rascon: Perfect. Great. So when does or doesn't a shelter make sense, Dave?
David McQueen: Well, aside from the obvious fact that you avoid permanent establishment, and if that's an important issue to you, then the shelter's obviously the way to do it. But aside from that, the part of the shelter that makes sense is that infrastructure of services. So there's two ways it can be important to you.
First of all, the shelter provider, by virtue of the fact that they're providing services to a wide range of clients, typically has an ability to reduce costs significantly. They have a critical mass that's much larger than any one company, so they can translate that into economies of scale. And that means bottom line savings.
That becomes particularly important the smaller your operation is. Now, there's obviously going to be a point at which an operation is too small to be viable, but there's also another point at which that cost savings diminishes as your operation grows. So a rule of thumb somewhere between 15 to 20 people is usually the economic minimum for a viable manufacturing operation. At the other end of the scale, somewhere between 300 and 500 people, the shelter provider is unlikely to provide much in bottom line benefits.
So first area where it makes sense is anybody between those two bounds should be thinking about a shelter on a permanent basis, because they're going to have a bottom line savings that's going to be material to them.
The other side of it is of course, the knowledge base and the boots on the ground that they have. So the other scenario is you are a larger company, but in your launch, you haven't got boots on the ground, you haven't got an infrastructure in Mexico. It makes a lot of sense to go with a shelter company to give you that transitional period and that launch assistance to get you up and going.
And most shelter companies can put a very comprehensive program together with staged withdrawals from the shelter so that you don't even need to say, well, one day I'm in the shelter and tomorrow I take control of everything. Most of them will work out a plan to say, "Well, let's get you launched. And then you're going to take over import export on this date, and then later on, you're going to take HR and then you're going to take payroll," and so on. So that's the second scenario where it may makes a lot of sense.
The only time it really doesn't make sense, I think is one, if you don't qualify. So if you can't be an IMMEX manufacturer, if you aren't manufacturing. And by the way, it has to be significant transformation of goods. Just repackaging won't qualify. So if you aren't manufacturing, you can't do it. And the other scenario is if you didn't have any export sales at all, then maybe it doesn't make a lot of sense, or at least you would want to transition out of it because it's an unnecessary complication at that point. But otherwise I think it makes sense, no matter what the size of the company, unless you're already established down there.
Ricardo Rascon: Okay, great. And you mentioned Dave that basically the sweet spot is 15 to 300 people. After that, it doesn't necessarily seem to make a ton of financial sense. But I know there are some super large companies that have 3000 employees under a shelter. Why do they choose to maintain a relationship with the shelter service provider, despite the fact that it may not be the most cost-effective way for them to operate?
David McQueen: I think two reasons. First of all, one reason is risk management. They're outsourcing a lot of risk that they don't have to bear internally. And that's got a value to it. They don't have permanent establishment. The shelter company is taking the risk and there's a value to that.
The second thing is, as a strategy, outsourcing functions helps to reduce the management load and increase management focus. So in the same way that you would subcontract certain parts of your manufacturing operations say, we don't want to manage injection molding, we're going to outsource all of that. It's not that we can't, but we don't want to do that. We don't see the return on our efforts. We're going to outsource it. You can do the same thing with your administration. And so that's the strategy. I think in a lot of cases is, look, we don't have to worry about all of this. Our plant managers can focus solely on making their operating decisions. And we often see it in companies that have both shelter and non-shelter operations in Mexico, often their shelter operations have a higher level of performance, probably because the plant manager only has to focus on operating.
Ricardo Rascon: Great. Thanks for explaining that. So, Dave, now that we've kind of discussed the four different modes of entry, the pros and cons and what makes sense, I'd really just like to tap into your personal experience. Before you started working with us here at Tetakawi, you were the president of two Canadian companies who expanded into Mexico. So can you kind of just walk us through your due diligence process and how you ultimately decided on which mode of entry made the most sense for your company?
David McQueen: Yeah, sure. In both cases, the path was similar, and in both cases it started with a customer that indicated a desire for us to provide our services in Mexico. And so because of that, the subcontracting option in terms of a top level product, wasn't really an option for us. And we didn't spend a lot of time on that. And in fact, to simplify things, we said, "Look, we might resource some components or some sub supply eventually, but we're going to start our search on the basis that our customer wants us to be there and we're going to produce our goods and we're going to keep the existing supply chain just to make things simple." So that's the way we approached it.
We did give some brief consideration in both situations to acquisition, did a very cursory search, nothing turned up obvious. So we shelved that as a secondary strategy. If something turned up or if a target was revealed to us somehow, we might consider that, but we very quickly moved that to the side. So that left us with direct incorporation to the shelter.
In both cases, our operations were projected in a five-year time period to not exceed 200 people. In fact, in both cases to be somewhere between 150 and 200 in Mexico, 200 heads. So they fit right in the sweet spot of the shelter operation. And in fact, I did some analysis of a both standalone operation and a shelter operation. And there were bottom line savings that were significant going with the shelter. So that decided our course of action with respect to a shelter being our preferred choice to launch our operation and in fact, to maintain our operation.
In terms of selecting shelter companies, we actually started with location search. Once we had narrowed our location, then we knew which shelter companies were operating in that area and we could do a search of shelter companies, shortlist that down. I shortlisted to three, and then I eventually shortlisted to two and finally chose my provider who happened to be Tetakawi, but that's how I got there.
Ricardo Rascon: Yeah. You chose the best, Dave. You made a good decision. So thanks for walking us through that process.
So for the people that are listening, whether it's at home or in their car, and they're saying, "Okay, well, I'm convinced I need to go to Mexico. And maybe these are the two modes of entry that I consider in." Maybe they're thinking about contract manufacturing or the shelter. What do they do next? What's the next step in their due diligence process to really accelerate their Mexico strategy forward?
David McQueen: Well, I think the first thing is to sit down and decide on your risk tolerance, what are you willing to take on and what don't you want to take on. And that's both financial and in terms of legal and regulatory risk. The second thing of course is to think about your cost from the perspective of budget. Are you prepared to invest or are you prepared to pay more for an operating solution that doesn't require you to invest? Then you get onto some things that are probably more company specific and that includes speed to market, how quick a solution do you need and why do you need it that way. That's going to help you narrow down again, certain options are just not quick, and what kind of control do you need? And when I think about the control, there's a bunch of levels of that.
I mean, one is just, what do you want to control? What does your organization feel comfortable controlling? What do they like to have in their hands, in terms of the levers that they can pull? But there's also ways to think about it in terms of technologies, how much control do you need over quality? How much control do you need over information that might be used for a competitor to set themselves up against you? And those things can influence how much control you want over production? How much do you like your processes and your work culture to be in place? If you control it, you can put that in place. If not, you're at the mercy of your subcontractor.
Then you've got, out of all of that you probably have a short list of options that are feasible for you. You want to look at the feasibility and viability. You can select a shelter, but if you can't qualify as a shelter, well, then you can't do that. And you have to look at something else. You can select an acquisition, but if you can't find one, that's not a feasible option, it's not viable.
And finally, I think the key point is, when you're entering Mexico, don't duplicate your strategy from anywhere else. Don't just, if you're working in China now, don't just take the same solution. If you've got a manufacturing operation in the United States down, don't put in place exactly the same solution. It's a chance to rethink. There's some different options in Mexico. The economy and the business environment's a little bit different in terms of who's there and what suppliers and what customers and what opportunities there are. I think it's important to rethink each of these questions and to think about your strategy in terms of a clean sheet. And then that way you'll come up with the best solution.
Ricardo Rascon: Perfect. Well, thanks again, Dave, for your time, for the explanation, and thank everyone for listening. If you enjoyed this podcast and our other one, please stay tuned for our next one where we'll talk about how to choose the right location for expanding into Mexico. Thanks again, and have a great day.
Announcer: We appreciate you joining us for this session of the Manufacturing in Mexico podcast. For more information and resources about how to succeed in Mexico, be sure to visit our website, tetakawi.com.