If there’s a market that can do no wrong right now, it’s China. Expanding at three times the rate of the United States, with economic growth of roughly 7% per annum, China is literally a market opportunity waiting to happen.
“China has something to offer that the rest of the world can’t ignore-massive growth,” says a fund-of-funds investor who is active in China. “Thus, early stage VCs see tremendous opportunity for their portfolio companies and for new investments.”
But if you’re an early stage U.S. investor, don’t give in to the siren song coming from the Far East. Picking which early stage China-based companies will be able to capitalize on domestic and international markets while executing on your own growth strategy requires substantially different skills than the ones you have honed in the United States. You may know how to navigate anti-piracy laws, protect IP and recruit the best talent in Silicon Valley, but China really is foreign territory.
By numbers alone, China’s size and growth would appear irresistible. China has 160 cities that are each home to populations in excess of 1 million, while the United States has just nine of that size. In 1990, China’s share of world exports was almost 2%, yet by 2003 that number had expanded to 6 percent. Now, China’s manufacturing sector employs close to 100 million workers, in contrast to 14 million in the United States, according to the AFL-CIO. Moreover, according to the International Monetary Fund, China accounts for 29% of world trade in bicycles, 28% in toys, 25% in footwear and 20% in ready-made garments.
On a return on investment basis, the numbers look eerily reminiscent of the dot-com boom. To wit, Baidu.com (the “Google of China”) made a spectacular Nasdaq debut in August, and it still boasts a market cap of $2.6 billion on trailing revenues of $13 million, or 108 times revenue. To put that into perspective, the real Google trades at 18 times trailing revenues.
Foreign VCs want in on the action. VCs from outside of China accounted for about 63% of the deals done in China in the first quarter and 80% of the total dollars invested in China-based startups, according to Beijing-based consulting firm Zero2IPO. Additionally, a recent survey of the Ministry of Science and Technology indicated that through the end of 2004, there were 250 venture capital organizations in China, with total funds reaching 40 billion Yuan ($4.8 billion). A growing portion of that money has come from U.S.-based LPs.
All this attention has created at least three major arguments against seed and early stage venture investment in China.
First and foremost, it’s already a crowded investment marketplace. Quality deal flow is highly competitive. Even though scores of U.S.-educated Chinese nationals-not to mention several already successful Silicon Valley Chinese entrepreneurs-are heading home to start new companies, there’s simply not enough good companies to go around. And those that are setting up new companies are generating “me-too” business models that don’t appear sustainable.
Which brings up the sad but eminently realistic fact that not all news out of China is actually good news, particularly for VCs. Though contributions from privately owned enterprises (including venture-backed startups) to China’s national gross domestic product increased from 0.57% in 1989 to 20.46% last year-indicating that the startup market is producing vibrant companies with strong growth stories-there are also signs that a new “bubble economy” is being created.
“There are more good companies to invest in these days, but there is also far more capital chasing these investments. As a result, valuations are getting bid up and returns will inevitably suffer,” says Tina Ju, a general partner with China-based venture fund TDF Capital. In fact, says Ju, the market has become so awash in cheap foreign capital that many Chinese entrepreneurs are looking first for American money before settling for Chinese-based venture capital. Why? “Because they know they can get higher valuations from the Americans, and it will take a year or two for those investors to figure out they paid too much,” says Ju.
Others are less diplomatic about the implications of too much money in China chasing too few deals. “If you thought the bloodbath was bad in the Internet, this is going to be just as bad,” says Alex Bangash, managing partner with the Rumson Group, a Princeton, N.J.-based advisory group that measures the performance of funds and their managers.
The second major argument against investing in China is that U.S.-based skills and networks do not readily apply to China. In the same way that regional investors in the United States complain about the differences in deals, style, network and infrastructure between California, New York and Kansas, China presents an order of magnitude difference.
“The real story is very disruptive for U.S. venture investors and private equity firms, because these Chinese companies are going to be the dominant companies in the world in a few years, and Sand Hill Road knows that,” says Bangash. “Yet, the U.S. guys who are investing in China through consultants or directly into funds just by simply visiting the country for a few weeks are going to get their heads handed to them.” Or as one of the wealthiest businessmen in China said about a U.S.-based investor: “He’s so nice. He’s so smart. We’re going to eat him alive.”
Horror stories are already emerging. Two American VCs who thought they had won a bidding war against over a Chinese game company found out the hard way that knowing whom to trust is just as important as knowing what to invest in. The startup turned out to be a phantom company that disappeared just as quickly as the venture capital. Big companies, too, are suffering. Microsoft China has been hamstrung with its own China-based management problems and is reported to be generating more revenue from infringement fines than from selling licenses in China.
This leads to the third argument against early investment in China: substantial additional risks beyond normal start-up risks. The China experiment in single-party capitalism is still in its early stages. Many good rules have been placed on the books, including strengthening intellectual property laws as part of China’s admission to the WTO. However, enforcement remains spotty. In fact, 90% of software in use in China is pirated, according to a Business Software Alliance/IDC study. And a recent report in the Chinese press states that approximately half of the mobile phone batteries being used in China are counterfeit.
Meanwhile, new regulatory structures can lead to very different investor expectations of risk and exit. For example, a regulatory initiative known as Document 11 was circulated in late January by the Chinese government. The rule makes it difficult for Chinese entrepreneurs to establish the complex corporate structures that allow them to list on international stock markets, making potential exits for VCs that much more difficult.
A second regulatory endeavor put a chill through a whole investment sector: Chinese online gaming companies. A horde of VCs was chasing companies in that market. Then the government adopted regulations that limit the number of hours children may play video games.
The overall risk of the environment is underlined by anecdotal evidence from Ying Wang, co-President of the Carret China Opportunity Fund based in Washington D.C. In just the past decade, Wang notes, one-third of all private and public equity funds in China lost money, one-third broke even and only one third reported making money.
If You Must Go
What’s a VC to do with money to burn and a desire to head East? Pick the right partner, someone who knows the territory, says Bangash of the Rumson Group. “This is like the vintage years 1997-98 in the U.S., when if you had to invest in Silicon Valley you had to do it with the Kleiners and Sequoias,” he says. “The same is true for China. You need the people with the good deals, the good networks and the good operational expertise who still need to co-invest with the best local Chinese VCs.”
The right partner is the key to not losing one’s shirt in China. “For LPs investing in new China funds, it’s important to pick the right fund managers who will stay with the fund long term, and who have the track record and integrity to keep the LPs’ interests at heart,” says Ju of TDF Capital. “Without the right expectations and time horizon, I would not be surprised to see some LPs wanting to exit the China market in the next five years.”
Which brings the argument against investing in China back to what early stage investors know best: their own markets. California-the destination for $9.5 billion of venture capital investments in 2004, according to Thomson Venture Economics-remains a net importer of venture capital dollars. Of the total investment figure, only half was provided by California-based funds. Says Bangash: “For deals, American VCs should definitely steer their companies to China. But for investments? No. There are plenty of good deals and plenty of good opportunities right here in the USA.”
Sean Foote is a partner at Labrador Ventures, a seed and early stage venture capital firm. He also teaches venture capital and private equity at the University of California-Berkeley’s Haas School of Business. He may be reached at firstname.lastname@example.org.