Sourcing in China and Alibaba

Alibaba and its Scandals

One of the more recent high-profile cases to attract the scrutiny of Western investors, regulators and buyers is the news of Alibaba, the huge Chinese e-commerce and business-to-business platform, caught in a fraud scandal.

Quick background: Jack Ma, the founder of Alibaba, put together a great website linking buyers in the West to suppliers in China. As many as 65 million people use this website, thus making it a phenomenal success.

The emerging problem stems from the way Alibaba generates income. In this brave new world of ours, it seems many businesses make a lot of money by giving valuable things away for free. Look at Skype and Facebook. Sure enough, Alibaba does not charge any fees for putting the customers that use its website together with suppliers. It does not generate income by taking a percentage of the earnings of the vendors on its site. Alibaba offers that service for free. To make money, it uses a business model different from most of its western e-commerce counter-parts. Rather than charge a commission per sale, the site charges vendors for granting them a higher status: Alibaba’s sales force makes money only when they bring in such clients who pay to secure “gold status” on the website (reminiscent of “Power Sellers” status on Ebay). “Gold Status”, conveys to prospective customers that a seller has been approved by the website and should be trusted. This status was awarded to no less than 2,236 merchants who subsequently cheated their customers, thus severely hurting the Alibaba brand and leading many to question the company’s operations.

In the wake of this crisis, the top two executives at Alibaba resigned and a fund has been established to pay back defrauded customers in an effort to shore up the company’s reputation. In an industry where the commodity that you sell is trust between seller and buyer, one can understand Alibaba is concerned about its reputation. But trying to fix fraudulent deals with a fund, well intended as it might be, is like taking an aspirin for a broken leg: it takes the edge off the pain but it does not fix the underlying problem. The issue of integrity remains: can you trust the vendors on Alibaba? In fact, can you trust Alibaba? Will it happen again?

The answer lies in the business model, in how Alibaba makes money and whether their revenues are aligned with the interests of their customers. Jack Ma tried to deflect criticism by stating: “Profit maximizing is never Alibaba’s top goal … We would rather see no growth than hurt the customers. Let alone cheating …” But we have no objections to Alibaba growing or maximizing their profits. Nothing wrong with that. Profits are good, not only for shareholders of Alibaba, who after all have invested for a profit, but also for Alibaba’s customers, the buyers, who see profits as evidence that this is a sound platform that will be around for a while. Why is Alibaba suggesting they need to make a choice between integrity and profit? It must be because their business model requires them to pick one or the other. Would it not be better if Alibaba’s profits were linked to its integrity? The more happy customers, the more profits? It sounds like a good idea, but it is not the Alibaba model.

Note: McDonalds at the beginning of its history had a similar problem. Traditional franchisers made a profit by forcing franchisees to buy all raw materials from them. But this meant that their interests were not aligned: the franchisees could be losing money while McDonalds made a profit. They eventually changed the system so that they took a share of the profits, thus aligning their interests with those of the franchisees: no profits, no fees. This was one of the elements that made the company so successful in the end.

Alipay: This is the other, less well-known scandal of Alibaba. Alipay is the online payment platform of Alibaba. Potentially one of the most lucrative parts of the company, Alipay is an escrow type of payment service, which allows buyers to verify the goods before they release payment. (A useful tool, as one can imagine, especially given the propensity some vendors have to defraud their customers) Alipay claims to have 550 million registered users and provide services to over 500,000 Chinese businesses. This great business (a key asset of the Alibaba group) was transferred out of Alibaba to a company privately owned by Jack Ma for a nominal price, without apparently bothering to advise, or seek approval from, its controlling shareholders, and Softbank. Jack Ma claims that this was done for Chinese regulatory reasons, and said he did advise the board properly. Hmm, again, we seem to see profitability clashing with integrity.

What’s the lesson?

Technology allows people and businesses nowadays to connect and interact like they have never done before. In this respect, Alibaba provides a valuable service, allowing buyers in the comfort of their home offices, to connect and find suppliers thousands of miles away. But human nature does not change and buyers know to beware. The process of vetting suppliers remains essential. Nothing seems to be able to replace on-site verification by trustworthy people. Not even modern technology, which, for every elegant solution it provides, seems to spawn new defrauding techniques. Business is still, and in my opinion will always be, about people first. People on the ground, meeting other people face to face, measuring, understanding, eyeballing the goods, verifying, and feeling. And integrity, that most valuable quality, is what binds people and companies together for the long run.

Michael De Clercq
President, China Performance Group

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