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Venture capital and private equity firms are transforming enterprises in China by exposing them to innovative practices and enabling them to tap into the global commercial and capital markets. In 2004, venture investing in China exceeded a record $1.2 billion, following a three-year downturn.1 Much of the early venture capital went to Chinese companies in sectors such as telecommunications, e-commerce and online gaming, but experienced investors recently have been diversifying into other areas including consumer business, manufacturing, pharmaceuticals and high-tech. On the surface, China’s institutional private equity and venture capital environment is similar to that of the United States and Europe. But there are important differences that investors interested in China need to understand.
To begin with, the Chinese venture capital and private equity market is young: The earliest China-focused funds were launched in the 1980s, and the concept of private capital in China is less than a generation old. In addition, investment firms based and registered in China face regulatory constraints on the organization of portfolio companies and their listing on foreign equity markets, posing serious challenges to raising capital. Listings on local stock markets require government permissions that are difficult to obtain; investor liquidity can be hampered by stringent lockup requirements. Even companies that manage to get their shares listed locally find that the Chinese stock market is not always attractive: The market has seen only modest upward movement in the last three years. This has made local sources of venture capital less appealing to entrepreneurs. Foreign-based venture funds are not always limited by the same factors and allow companies to exist on foreign equity markets. In fact, it is not unusual for venture-backed Chinese companies to move directly from first-round venture financing toward an initial public offering on the NASDAQ, Hong Kong or Singapore exchanges, something that is extremely rare in North America and Western Europe. These Chinese investments are generally in companies with good cash flows, thus positioning them to tap into foreign markets for growth capital and liquidity.
Nevertheless, venture capitalists and private equity investors operating in China face unique challenges. Elements that are taken for granted in entrepreneurial hotbeds such as Silicon Valley have yet to take hold in China. First, there is a lack of readily available information about opportunities, entrepreneurs and companies. Second, entrepreneurs know little about finance, corporate structures and governance, requiring investors to spend considerable time educating them and filling in the gaps. In light of these issues, it is incumbent on investors interested in China to prepare themselves for dealing with the differences.
Based on interviews with leading venture capital and private equity investors who have extensive experience in China, we have identified seven disciplines critical to successful investment in China. They are knowledge and appreciation of the importance of social capital networks, or guanxi; understanding of corporate governance and shareholder rights; the ability to manage intellectual property; the ability to adapt business models to local conditions; the ability to add managerial and technical value to young enterprises; knowledge of innovative legal structures; and the ability to navigate complex regulatory environments. (See “About the Research.”).
Understanding the Disciplines
Experienced venture capital and private equity firms rely on this portfolio of disciplines to nurture young enterprises into companies that can compete both domestically and internationally. The seven disciplines provide a distinctive approach to venturing that cannot be easily replicated by inexperienced foreign investors.
The first and foremost discipline venture and private equity investors need to develop is guanxi — the effective use of social capital to advance business relations. Although its role is often misunderstood in the West, guanxi is widely seen as crucial to business relationships in China, where important business interactions are rarely conducted between strangers. Guanxi relies on social capital drawn from personal contacts, which bridges critical information gaps, enabling favors based on trust or mutual benefit. Once established, it can substitute for and even override institutional or legal guarantees common in the West. It can help those with high levels of social capital to bypass queues and snip through bureaucracy. Guanxi begins with family relationships, but it is cultivated over time — influencing everything from the most mundane to the most critical Chinese relationships. People can often build on guanxi from family and close friends, but it is also highly personal, lasting only as long as the relationships of the parties involved (and subject to the uncertainties that affect the lifespan of personal relationships). Newly formed guanxi may find it hard to compete with decades-old guanxi.
Guanxi can be vital as a source of information and as a means of influencing business behavior. It can shape everything from deal sourcing to exit options. In the United States, due diligence in the deal development phase can be as simple as calling up strangers such as former employers and current or prospective customers. In China, however, one has to have guanxi to gain access to such information or rely on an international detective agency that has its own guanxi. More important than the reference check, though, is the mutual due diligence between entrepreneur and investor. This is typically conducted in the traditional Chinese manner of relationship building, with the parties spending time with each other in a variety of settings inside and outside of work. Since there is much less reliance on contracts and institutions and far greater emphasis on personal relationships, this type of due diligence is a critical part of deal making in China.
Sometimes it can take more than a year to reach the comfort level necessary to close the deal in China. Guanxi can similarly help investors plan their exits. For example, many Chinese industries, including the information industries, are heavily regulated, or at least dependent on state-run companies. Guanxi can help players understand policy debates and how certain policies might impact potential investments. In the telecommunications market, fund managers have been able to use guanxi to anticipate government regulations on new telecommunication services, thereby avoiding possible losses.
Some Chinese entrepreneurs, including so-called “returnees” from Europe and the United States with prior overseas entrepreneurial experience, understand the role of private equity capital, different forms of financing and shareholder rights. However, for many Chinese entrepreneurs, the practical distinctions between types of financing are not obvious. As one venture capital fund partner noted, “Many entrepreneurs initially have no respect for institutional capital and the rights of shareholders.” One of the key roles of an equity investor is to educate entrepreneurs about the forms of capital, governance requirements and rights of shareholders.
Many Chinese entrepreneurs are reluctant to allow venture capitalists to invest in their companies. Despite the potential upside of catapulting their local business into the global market, they often balk at the management and operational changes and loss of control they will have to accept to comply with the demands of institutions. This is especially true for Chinese companies that have been bootstrapped into high profitability.
When entrepreneurs do permit a venture investment, the changes can be dramatic. In addition to the restructuring of the board of directors, the imposition of new financial controls, and the introduction of financial transparency and new rules for corporate governance, the new regimen often includes restructuring the company into a foreign company (often based in the Cayman Islands) to create a standard venture preferred-stock structure. For U.S. companies that are led by entrepreneurs, these changes can be jarring. For Chinese companies, they can be culturally transformative. Corporate governance and transparency are vital to Chinese companies that want to list on exchanges such as the NASDAQ or NYSE.
How the transformation is achieved speaks to the considerable ingenuity and impressive skill set of Chinese venture investors. Venture capitalists in China have to bridge many gaps, including language and cultural dissimilarities, the interests of institutional investors versus private entrepreneurs, the ability to add and integrate management, and the ability to instill corporate governance and transparency. Guanxi during the first stage of the deal can mitigate many conflicts. The lure of accessing international capital markets and distinguishing a venture from its competitors provides another incentive. Pei Kang, managing partner at Chengwei Ventures, notes that it took him six months to persuadea company founder to accept the establishment of a new corporate entity based in the Cayman Islands. First, he had to explain the concept of preferred stock to the entrepreneur’s lawyer. Then he had to convince the entrepreneur to replace key family members with professional managers. Such changes had to be addressed before any outside capital was committed.
Working with management is an ongoing process for investors in Chinese companies. In the United States, venture investors often have the option of replacing management; they usually have majority control of the company. This is usually not the case in China. Like it or not, Chinese management is generally the investor’s majority partner, perhaps indefinitely. As Wayne Tsou, a governor of the China Venture Capital Association, explains, “One can seldom replace the founder CEO of a Chinese company because the core managers’ loyalties usually lie with the CEO and not with the investors or the board. So picking the right entrepreneur CEO to back in the first place is of paramount importance and often determines the ultimate success of the investment.” Indeed, venture investors who have fired CEOs remain in the minority. Given this reality, Hugo Shong, vice chairman and general partner of IDG Technology Venture Investment Inc., notes that the venture investor needs to function as a coach and learn how to nurture the relationship.
The negotiations between investors and entrepreneurs don’t end with the signing of term sheets. According to Duane Kuang, director of strategic investments at Intel Capital, the relationship can become tense even when things are going well — and of course when they are going badly. When things go well, entrepreneurs often seek to increase their share of the equity. When things go poorly, they frequently want to get out as opposed to staying on to fix the problems. Whereas Western managers recognize that contracts are fixed and hence difficult to renegotiate, Chinese entrepreneurs often seek more flexibility, and contracts may have to reflect this. In China, friendship and business are often intertwined, so a failed business relationship has the extra emotional charge of a failed friendship.
As with governance, protecting intellectual property requires Chinese entrepreneurs to think differently about how intellectual property is defined and managed. Indeed, rather than viewing copying as an infringement of intellectual property rights, some see it as a way to honor past works of masters.
Typically, there are three types of intellectual property problems: individuals seeking to launch a new enterprise using the intellectual property of their current venture-backed company; employees bringing intellectual property from their prior firm to their new employer; and unscrupulous competitors counterfeiting the company’s products. To mitigate the risks, venture investors have to instill in entrepreneurs and employees the concept of intellectual property and an awareness of the company’s intellectual property rights. Occasionally these problems can result in legal disputes, though negotiated solutions are usually preferable. Investors should assess the likelihood of these risks early in the valuation of the deal.
A key success factor for many Chinese ventures is business model innovation and adaptation to local constraints and opportunities. As Duane Kuang of Intel explains it, “At 1,000 feet, an online bookseller looks just like Amazon.com. At 500 feet, you realize you have no credit cards, and you have to adapt your business model for cash on delivery. At 100 feet, you realize that everything is different.” Venture investors need to work closely with entrepreneurs to develop business models that work in the Chinese context.
Recent experience shows that business models from other settings can be successfully adapted for China. For example, Shanda, the successful gaming company that listed on the NASDAQ in May 2004, was inspired by Korean game technology but modified the games for a Chinese audience. Similarly, 51jobs.com, a venture-backed jobs Web site, has been dubbed “the Monster.com of China.” However, the company’s revenue model had to be significantly altered. In contrast to Monster.com, whose revenue base is mainly online, most of 51jobs.com’s revenue comes from offline classified print ads.
Learning to understand contextual differences is an important skill investors must learn. For example, most computer users in China don’t have access to the Internet at home — only at work or at cafés. What’s more, many Chinese consumers do not have credit cards, or they prefer not to use them for online transactions. Such distinctions necessitate different revenue and payment models. For example, Ctrip, one of China’s largest online travel sites, allows customers to book travel online but make their payments over the phone or by cash on delivery. Ctrip generates additional revenue by signing up hotels and airlines as advertisers on its Web site and receiving a booking commission.
In China, investors are finding that success does not necessarily require breakthrough technology — it can be achieved just as well by excelling at the application of technology. For example, Baidu, China’s dominant search-engine company, uses variations of Western search algorithms. Other companies are looking at how to adapt foreign anticounterfeit technologies locally. This requires both ground-level knowledge and a sense of history. One interesting venture that demonstrates the possibilities is Yaolan, which distributes baby foods and other infant-related products from the United States. The founders saw an emerging opportunity to tap into changes in Chinese parenting practices. They developed a model for selling baby formula based on the success of Tupper-ware, where women come together at Tupperware parties. Mothers are recruited to sell products to new or expectant mothers and to train them in how to use the products to feed and care for their children. In contrast to companies that sell baby products through normal channels, Yaolan generates value for customers by making mothers a vital part of the distribution system. As salespeople, Chinese mothers can order products online for resale — providing them with a flexible way to contribute to family income.
Contributing Added Value
Beyond providing financial capital, venture investors are typically expected to add value to their investments. China is no exception. Among other things, venture investors in China add value by screening and recruiting management team members; protecting intellectual property; helping companies navigate global markets in search of capital and customers; maintaining financial controls; and identifying ways to improve productivity and achieve lower costs.
Not surprisingly, attempts to add value often lead to conflicts with entrepreneurs, who view such involvement as interference in their managerial prerogatives. In China, venture investors must rely heavily on their guanxi to mediate these conflicts. In the West, venture investors can move to replace entrepreneurs who fail to meet performance objectives. In China, replacing management, while possible, is much more complicated. Employees —and to a large extent even customers — are more loyal to the CEO than to the company. Furthermore, as noted, Chinese entrepreneurs are apt to own a controlling majority of the company.
Competent and experienced new-venture managers are scarce in China. This means that expanding management capabilities by adding new people is often easier said than done. A number of investors are turning to talent from other countries to augment the local management teams of their portfolio companies. Gordon Shaw, managing director of Baring Private Equity Asia, and Pei Kang, managing partner at Chengwei Ventures, have both recruited in Taiwan, Hong Kong and other regional markets to fill manager positions. Other investors say they have been successful at recruiting returnees and hiring foreign-based consultants to obtain critical skills. Building teams requires considerable time and diplomacy to establish good guanxi among all the parties — and it is not always easy. At one company, the entrepreneurs refused to accept a CFO, which was a requirement for the IPO, because the CFO was going to be paid more than the entrepreneurs.
Another critical area for investor involvement is the installation and maintenance of financial controls. Since the company’s capital must be treated separately from the entrepreneur’s personal finances, it’s up to venture investors to develop policies, such as forbidding the purchase of speculative real estate and cars. Good financial controls and effective receivables management can reduce the amount of outside capital a company needs, but it requires discipline. Because of their own capital constraints, Chinese customers often attempt to stretch out payments, forcing a capital squeeze that can only be addressed by more investor capital.
Venture investors in China find that they can add value at every stage of the deal — all the way to the point of liquidity, which usually occurs through either a trade sale to a strategic buyer or an IPO. Shanda, the online gaming company, offers a good example of the extensive involvement of venture investors. A number of venture investors had shunned investing in Shanda because it lacked important requirements, not the least of which was a complete business plan. But SOFTBANK Asia Infrastructure Fund was willing to look past these issues and provide funding. The fund’s partners wrote the business plan, fine-tuned the business model and strategy, recruited new managers and then coached the management team in preparation for the company’s IPO.
Financial and Legal Structuring
In the West, venture investors use two or more classes of stock to guarantee that their investment has a preferential return — especially in the cases of either liquidity events or liquidation. The most common instrument is preferred stock, which can offer antidilution rights and board of directors’ seats for certain investors, penalties for nonperfor-mance and other protections. Other shareholders usually have common shares, which typically lack preferential rights. Venture investors in the United States and Europe also use employee stock options as a powerful incentive for employees to work extra hard in hopes of gaining personal wealth. However, neither multiple classes of stock nor option-based incentive systems are permitted in China.
In response, venture investors in China have created innovative financial and legal mechanisms, including offshore corporations that own operating companies in China. By incorporating in the Cayman Islands or the British Virgin Islands, for example, the offshore companies can use both preferred and common stock, issue employee stock options and list their shares on both U.S. and Hong Kong stock exchanges. This enables the companies to access capital more freely. The offshore entity owns the Chinese operating company that is the entity operating the business in China. Recently, China’s State Administration of Foreign Exchange raised concerns about the use of offshore corporations. But in October 2005, the government eased the restrictions. This could open the door to a more vigorous period of investment.
Creating Opportunities From Regulations
Successful investing in China requires investors to master complex political and regulatory environments. The Chinese legal and regulatory landscape can change quickly, sometimes discouraging businesses that had previously been promoted. Regulations can vary at the local, provincial and national levels. Having an inside track on shifts in regulatory policies permits China venture investors to seize opportunities and maneuver around the pitfalls.
One of the most valuable skills venture investors can supply is an understanding of how to approach regulatory policies strategically. In financial services, telecommunications, media and even the consumer sector, licensing requirements can potentially be leveraged as a deterrent to competitive entry. One company that has benefited this way is Yaolan, the baby products company. According to Pei Kang of Chengwei Ventures, the government’s requirement that each product be tested for quality assurance discourages competitors unable to meet government standards from entering the market.
China’s venture capital and private equity industries are still young, but they are bringing the transformative power of global capital to shape the next generation of Chinese enterprise. Companies backed by venture investors are increasingly global: Their managers can have considerable foreign experience, and their products and services can be sold around the world. What’s more, many of the most successful companies have embraced high standards of corporate governance and transparency and have been able to sell shares on international stock exchanges.
As China becomes a center for business and technology innovation,2 global companies and venture capital funds will find new opportunities to capitalize and bring innovations to market. However, successful China investors will have to pay attention to the seven disciplines.
1. China Venture Capital Annual Report 2004: Accounting for purchasing power parity, this figure is closer to $7 billion of investment in the United States, or approximately one-third the level of venture investment in the United States. www.zero2ipo.com.cn.
2. A. Kambil, P. Lee and V. Long, “Changing China: Will China’s Technology Standards Reshape Your Industry?” July 2004, www.deloitte.com/research.