Venture Capital in China

By David Hornik on January 5, 2008 1:17 AM Permalink

For the last several years there has been a lot of talk on Sand Hill Road about investing in China. To a certain degree there has been a lot of talk about all the BRIC countries -- Brazil, Russia, India and China. But the most excitement is clearly around China. (Interestingly, while India is a relatively close second, I have yet to hear of a single Bay Area VC exploring investment in either Brazil or Russia). Drawn by huge markets and a rapidly expanding economy, American VC's are heading to China to stake their claims. Go East young VC's. Go East.

Venture Capital investment in China has not, however, been a headlong dive. Bay Area VC's seem to be sending over exploratory parties. By way of example, David Chao from Doll Capital has been in and out of China for some time. Now a number of his partners are getting in on the act as well. Paul Koontz from Foundation Capital spent a year in China exploring the market. And perhaps the best indicator that the Chinese market is hot is Dick Kramlich's pilgrimage to China this year. Kramlich is one of the founding fathers of Sand Hill Road -- a 25 year veteran of the venture capital business. Not one to miss out on a big opportunity, Kramlich has headed over to China for 2008 to catch the wave of entrepreneurship and, perhaps, some of the Beijing olympics. Chow, Koontz and Kramlich are not the only US VC's headed to China by any stretch of the imagination. But these high profile forays into the Chinese market are excellent indicators of the level of interest in the market.

It is hard not to be intrigued by the Chinese market. With 1.3 Billion people, you don't need a huge amount of penetration to hit big numbers. One percent of the Chinese market is 13 million people. As they say, if you are "one in a million" in China, there are thirteen-hundred people just like you. What's more, the Chinese government anticipates that approximately 300 Million people will move from the countryside to urban centers in the next decade -- that's the same number as the entire population of the United States. The combination of massive aggregate numbers, rapid urban migration (and the commensurate increase in wages) and relatively low concentrations of modernized business processes, suggest a market ripe for investment. And that is precisely the conclusion many of my brethren on Sand Hill Road have drawn.

Given all that, I was anxious to check out China for myself. And right before the new year, I had the good fortune to do just that -- I accompanied a group of Stanford Business School students on a ten day study trip to China. We met with senior executives from companies like China Telecom, Alibaba, GM China and Bao Steel, as well as senior government officials and party leaders (yes, it is still a Communist country). But the most interesting discussions, to my mind, were with the leading private investors in China. (Because my meetings with these private investors took place as part of a study trip, there was no expectation that I would blog about the content of our conversations -- thus, I have decided to exclude the names of the specific investors so as not to violate any confidences they may have reasonable expected.) These investors gave a surprisingly candid view of venture capital throughout the country -- the good, the bad and the ugly.

To the mind of the Chinese investing community, the market dynamics described above well outweigh the risks of investing in the current environment. Huge markets with lots of business white space provides for numerous opportunities for economic gain. While American investors are busy debating the degree to which the US startup market is saturated, Chinese investors are having trouble keeping up with the inflow of opportunities. The opportunities in China seem unbounded, making foreign investors starry-eyed. But despite the glories of the Chinese market -- and there is no denying that the demographic trends in China are glorious -- I heard more than enough from Chinese investors to scare me away from the market.

As an initial matter, the biggest challenge that investors find in building Chinese startups is identifying great entrepreneurs. Because there has been all but no startup culture prior to a handful of years ago, there are essentially no seasoned entrepreneurs. A few native Chinese business expats are returning from abroad to take advantage of China's increasingly open economy. But those numbers are de minimis and do nothing to staff the rest of the enterprise. Meanwhile, Chinese executives have been trained to function in a business culture of bureaucracy and Party connections -- not the fast-paced, fluid environment of the startup world. The investors with whom I met lamented the lack of qualified executives and warned about the significant challenges of doing diligence on Chinese entrepreneurs.

The second challenge with entrepreneurship in China is grounded in the laws of China. The legal structures needed to support a vibrant startup economy are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system. One investor with who I met on my trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur. In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.

In many ways, venture capital in China is like the wild west. There are big opportunities, but they are not well defined and capturing their full value may well require manipulating the law to your own devices. One investor with whom I met described entrepreneurship in the United States like a zoo and entrepreneurship in China like a jungle. In the United States, he said, while there is always a lion next to you with sharp claws, driven by self-interest, there is a cage between you and the lion to keep you safe. You can count on the cage to protect you from unreasonable or illegal behavior. In China, on the other hand, there is no cage between you and the Lion -- if you don't take great pains to protect yourself from the self-interested behavior of the lion, you are going to get bitten. Case in point, one Chinese executive with whom I met on my trip described how he was able to leverage his dominant market position to force his competitors to sell at a discount. What's more, the entrepreneur described with pride that once he had bought up all of his competition, he was able to raise his prices three-fold.

Yet another significant challenge for United States VC's seeking to invest in China is the government itself. While China appears to be making huge market-driven strides in its economy, there remains a significant wild-card in all business transactions -- the Communist government. On my trip it was repeatedly pointed out to us that government officials don't make laws, Party leaders do. The government officials are tasked with managing the bureaucracies of their localities, but the party leaders are tasked with making the decisions. The Communist Party single-handedly makes all of the rules in China. For example, by mandate of the Party, no Chinese financial institution may be majority-owned by foreign investors. Thus, the fasted growing segment of the Chinese market is off-limits to foreign investment. What is to stop the Chinese government from making similar mandates in other market segments? This lack of predictability of the fundament legal underpinnings of business in China is sufficient in and of itself to make me take pause.

I thoroughly enjoyed my visit to China. The shear scale of Beijing and Shanghai was absolutely stunning, as was the velocity of the growth in both cities. And the extraordinarily candid conversations we had with Chinese business leaders and Party officials was both surprising and invaluable. But rather than leaving China emboldened to invest in their great economy, I returned to the United States surprised that my fellow VC's could accept the risks inherent in investing in China. I could not. And I don't anticipate that changing any time soon.

some Comments
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Don Dodge said:
David, Thanks for the thoughtful review of the VC investment situation in China. I know several VCs who are excited about the opportunities in China and who have sent lots of money and people there, but I am with you, I think the risks are too high.

I spent 5 weeks in China on 4 separate trips back in 1997 / 1998. I haven't been back since. I was hoping the situation had improved since then. Sounds like it hasn't.

The prevailing attitude then was that "profit" was evil. Essentially "profit" by a foriegn company was considered stealing money from the Chinese people. Even if you could structure some kind of deal that resulted in a profit...good luck trying to take that profit back to the USA. Money made in China stayed in China. There was no reasonable way to "repatriate" profits back to the USA. Has that changed?

Back then most business deals were structured as partnerships with China based "companies". I use the term company loosely because they were all ultimately owned by a China government agency. Sometimes the company names would make you believe they were a real for profit company, but if you dug deeper you would find out they were really owned by some government agency.
The "partnerships" always boiled down to the same theme...the USA company provides the dollars and technology, while China provides the cheap labor, land, and facilities. Any resulting profit stayed in China.
Selling software in China was difficult then. There were no intellectual property laws, no copyrights, no trademarks. And even if such laws did exist...they were never enforced. Just take a look at any store in China loaded with "Gucci" watches, "Nike" shoes, or "Microsoft" software. It was all cheap knock-offs where the brand, logo, and intellectual property was stolen. Has that changed in 10 years?
It is hard enough to launch a successful startup in the USA with all the laws and protections we have here. Imagine trying to start a company in China with all the additional risks you have mentioned. It is enormously difficult and risky. And if you are extremely lucky and succeed...will you be able to keep your profits and convert them to US dollars?
I hope a lot has changed since I tried to do business in China 10 years ago. Based on your observations it sunds like they still have a long way to go.

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David,
Having both started and invested in a number of businesses myself, I am not surprised by the anecdotes you heard and can see why you were turned off by them. You certainly went one step beyond the simple fascination with China of "fly-in" Western investors.
On the other hand, the "Wild Wests" and jungles (I would say the defining characteristic of this jungle is not the lack of cages but rather than the lack of rules, compared to the zoo) is where money has been and will be made. In the U.S., many industries emerged out of chaos characterized by the same excess and sometimes fraud, and the same lack of rules and clarity. The Internet bubble of the late 1990s is one of them.
No doubt many investors will lose their shirts in China. Many mistakes have been made due to inexperience (mainly on the part of the local investors) and lack of local knowledge and networks (the foreign investors), or both (a surprising large number).
The lack of good entrepreneurs and managers is a real challenge. It is however relative: the investee's competitor has the same issue. A personal network for recruiting and vetting is important in China, as it is in the U.S. Due to a number of reasons, inexperienced entrepreneurs among them, my view is that in China the good VCs can add far more value than they can in the U.S. Unfortunately very few VCs in China have the experience and inclination to add value, particularly when the prevailing wind is "get rich quick".
The real challenge for me is finding entrepreneurs whom I can trust and who is scalable (can be trusted by his/her employees, among other things), but who can be "flexible" when dealing with the external environment. It invariably involves some compromise.
From the perspective of Western VC firms, success will come from the quality of the local China investing team and whether the local team is empowered. Fortunately it is much easier to empower the local team via the VC partnership structure than, say, via subsidiary structures of publicly listed NASDAQ companies, whose performance in China has been abysmal indeed.
Bo Shao