Earlier this year, a private Chinese company located in Southern China wanted to raise $10 million to $20 million to boost its sales and marketing before its planned IPO. Projected net income was between $8 million and $9 million for 2011.
Overnight, more than 30 investors contacted the company, including boldface PE and VC names; in addition, the management team was courted by a number of individual investors and local funds. Among these investors was a European PE fund, whose partner looked desperate, complaining that his fund had not done any deal in the past two years because too many funds were chasing a limited number of quality deals.
Meanwhile, in a neighboring state, a Chinese returnee from the US was for capital to fund his startup. After a lengthy period of searching he finally landed on RMB20mm (equivalent to $3.1mm) from the local government in exchange for 50% of his company. While he was happy to move his business forward, on the other hand, he was concerned about the company’s future since the local government’s investment in his company might make it more difficult in the future to go public overseas and attract new rounds of investment. He had no choice but to accept these risks with the investment.
Such is the present reality in China. Though it is a country with considerable capital, a private company, especially in its early stage of growth, may find it very difficult to find growth capital. It is estimated there are more than 1000 PE funds, both domestic and foreign and over 2500 local VCs in China. Investment pouring into VC funds in China increases at a pace faster than both the U.S. and Europe since 2008; however, the percentage of capital went to early stage companies is below 10% compared with 35-40% in the U.S. The majority of investment funds in China look for companies that are ready to go public within 2-3 years. Additionally, the line between VC and PE is getting blurred. Most of the VCs in China, both local and foreign, have demanding top and bottom line criteria. For example, a self-claimed early stage local VC requires minimum RMB10mm ($1.6mm) profit in the year prior to funding, while another, Intel Capital China, avoids start-ups without profits. One of the reasons VCs try to stay away from early stage start-ups is that Chinese VCs do not have enough experience in helping a start-up to grow, while foreign VCs find it challenging to work in a foreign market environment and therefore are more conservative.
However, there are not many high quality, profit generating, later stage companies in China. In the past few years, we have witnessed this situation in China: a small number of start-ups growing into maturity combined with a large number of IPOs boosted by PE and VC investment has drained the pipeline of good deals. As a result, PEs are fighting harder for good deals amidst soaring IPO valuations.
The encouraging news is that, to the surprise of some, the Chinese government is filling the gap. Between 2008-2009, the National Development and Reform Commission of China seeded 20 VC funds in 20 provinces, each specializing in one specific industry such as biotech and clean energy. Local governments are expected to match the seed capital and the rest of the capital raise comes from individual investors. In addition to this initiative, some local governments, such as Jiangsu and Guangdong provinces, are aggressively, and in creative ways, offering assistance to startups. Local governments may invest capital in the start-ups in exchange for equity; other times they may subsidize the interest payments a start-up owes to lenders; and sometimes, they may lend land to start-ups at very low cost.
Increasingly, some private business owners are providing funding to start-ups. Often these business owners have amassed their wealth through manufacturing low margin products such as buttons, shoes or sunglasses. As many look to transition into something more value-added and higher return ventures, some have identified the opportunity to become angel investors or lenders. They often understand little about investing or investments and will rely on their gut feelings and how well they know the person who is going to receive their money. The drawback is that, as some entrepreneurs complain, most of these angel investors look over their shoulders constantly without adding much value to the growth of the start-up. As a result, some entrepreneurs prefer not to raise money from them unless they have no other choice.
In very rare cases, local banks may be a source of funding for start-ups. However, this is not an option for everyone since it requires a very strong relationship with someone in a bank and a good understanding of the bank’s lending criteria. But it is not unlikely. One entrepreneur in China launched a dredging company with 3 dredging boats, each costing him about $800,000. He funded them mostly through bank loans. Given his success in obtaining bank loans for his company, obtaining bank loans for other small private business owners has become his second job. When people turned to him for help, he said, “sure, tell me what you need. I can structure something for you.” Most of the time, he has succeeded.
Coco Kee is Managing Partner of Kee Global Advisors LLC, a New York-based boutique advisory firm advising companies of different stages on China-related cross-border business development, financing and M&A.