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U.S. Venture Capital in China

Posted on September 25, 2005

I just got back from a great bike ride. Today I was an on-bike marshall for the inaugural 2005 Hub On Wheels event held here in Boston. The idea of the event was to increase bicycle awareness by allowing people to ride an arrowed route with support through all parts of the city to get a different feel for the city and bikes. The event was a huge success. I would estimate that there were about 400 riders (Since writing this piece I have received word from the Hub On Wheels Director that there were about 700 riders in total!) and even more people who attended the festival at Franklin Park. I also rode a lot of miles and now think I could give Brad Feld a run for his money in the fitness area. Probably not… Anyhow, you are probably thinking “What does this have to do with VCs in China?” Well, not too much to tell you the truth. However, after I lead my ride group this morning, I helped direct traffic at a tricky intersection (while simultaneously fixing a flat I got from a huge drywall screw) for about 2 hours so I had a lot of time to think and think I did.

My thoughts drifted to China because of the great bicycle culture there. Then that lead me to think about the amount of VCs starting programs in China. This has become a large trend in the Valley in particular. SiliconBeat has been publishing story after story about VC firms announcing funds in China. In the past couple of weeks Accel (partnership with IDG who has been in China since the 80s), Sequoia, New Enterprise Associates and Burrill have announced China funds. VCs who have not announced funds are furiously trying to figure out what to do in China. SiliconBeat reported that DFJ lost their guy in China to Sequoia but they also said they could not confirm that so we’ll have to wait and see what surfaces there. Either way, there appears to be a massive turf war playing out and there is a reason why competition for locals with large rolodexes are in demand.

Relationships are taken to a much higher degree in China than they are here in the U.S.. The culture demands either locals or a long tenure (10+ years) of doing business in China to get things done. A lot of the top venture firms realize this and have taken steps to recruit locals to obtain better deal flow. Others, however, have just decided to go there and break into the market, a strategy that will probably end in disaster. There are other problems with investing in China that also need to be addressed.

  1. The regulatory climate is not favorable.
  2. The investing landscape looks like the U.S. during the internet bubble in the late 90s.
  3. Very little has been contributed by China in the form of advanced R&D break throughs.

New regulations being levied in China are beginning to make U.S. VC firms chances look pretty bleak. To start, there was a recent regulation passed that deals with the ownership of offshore assets by China’s residents. This regulation will significantly impact venture capital investment, M&A activity and stock exchange listings. To make things worse, this regulation and others essentially force foreign venture capitalists to rely on overseas stock market IPOs for their exits. Intellectual property law is also of concern.

The investing landscape of China today eerily resembles the beginning of the U.S. internet bubble. The companies getting funded are even quite similar. There is Yahoo’s $1 billion dollar investment into Alibaba, a six year old e-commerce company, for example. Seems like quite a hefty price tag. However, if there is one deal that seems to have caused venture capital investment in China to hit the tipping point, it would have to be the Baidu IPO which has rocketed up and up in price and been one of the NASDAQ’s most successful IPOs since 2001. It seems like there is a lot of greed and a multitude of e-commerce companies being formed and funded in spaces with low barriers to entry which makes me a bit leery.

The last thing that I think investors forget about China is that it has not contributed many R&D break throughs to the world. China’s core competency to date has been cost cutting and mass production, creating economies of scale if you will, that lead to lower prices for consumers. This has undoubtedly helped many innovations get to the mass market. However, this is not paradigm shifting innovation. This is manufacturing efficiency.

There are a lot of reasons not to invest in China but there are also the usual suspects urging investors to take the plunge. The sheer size of the population, income per capital is on the rise, phone use has dramatically increased, and a number of U.S. educated Chinese entrepreneurs are beginning to move back to China (interestingly enough, the Wall Street Journal recently reported on how many VCs are investing in local Chinese entrepreneurs and not U.S. educated Chinese returnees). However, all of these good signs are not proof that the market is currently there for VCs. It seems to me that this could be a lot of hype. This is not to say that there isn’t a lot of money to be made from the hype so I can see why some VCs are going for it. It is just a matter of who will win and who will lose. My bet is on Patrick McGovern and his IDG/Accel China Fund since he has been investing in China since the 80s.

In closing I would like to leave you with a piece of a SiliconBeat article written about a year ago describing Don Valentine’s feelings on investing in China:

…Valentine did go on the SV Bank trip to China, but the experience only confirmed his view that Sequoia should stay away from direct investments there, he said. Indeed, Valentine ragged on China all evening long. Summing up his views about the rush by others to invest China, he quoted the title of a song from 1950’s jazz singer, Billy Eckstine: “Fools rush in where angels fear to tread.” He continued: “China has no laws, no accounting system, bankruptcy banks, and according to Fortune, a stock market that is made up of a den of thieves no different from the ones on Wall Street.”

Valentine said Sequoia hasn’t invested abroad in its 30-plus year history, and it’s unlikely to begin doing so. Even investing in a Boston company is a big deal for Sequoia, he said, and most of our investments are not only west of the Mississippi, they’re west of the California border, he said. Concluding with a bang, Valentine prophesied about China: “You’re about to see a bubble burst in the next five years, or sooner, that will make our bubble look meaningless.”

Definitely some harsh words but, according to SiliconBeat, the statement above is similar to what Valentine told his colleagues about the U.S. market in 1999 when they raised a fund to invest in pre-IPO companies at the top of the bubble. In the end, Sequoia ended up with a loser of a fund to say the least. VC investing in China is going to be very interesting to watch especially considering that we are now armed with fresh insight from the U.S. e-commerce bubble. Ladies and gentlemen, buckle your seatbelts, we are in for one heck of a ride!

Off topic: I just read in PC World that Massachusetts, my home state, will be the first U.S. state in which executive branch agencies will adopt the OpenDocument standard. Pretty neat stuff.

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1 Comment so far
  1. T G Wilkinson November 1, 2006 11:29 am

    Eric,

    All true. However, you are missing the main opportunity in China- the thousands of small, entrepreneurial, truly private companies run by guys that actually know what they are doing. They are mostly copying the best low to mid range international version of whatever their product category is. This is a great stategy because most products are at the end of their developmental life cycle. I work with several medical equipment companies whose products have everything a doc needs without the useless feature overhang and related cost,complexity and reliability problems of the big brands. They are selling fast all over the world and are earning a reputation for quality and reliability.

    They have teams of very capable Product Development guys - they do not need to invent new technology - they just need to package and deliver it in the best/lowest cost form. In the future, they will add fundadmental innovation. Andd they will get from the US/Europe wherever. Right now, they do not need to.

    This is the China of the future - it is not located in Beijing or Shanghai, it is not internet related in most cases, and it definitely is not government owned or co-owned.

    You are right about the old China. Unfortunately, the VCs and real estate investors rushing in tokday only know about the old China. They get recyvled government guys who only know Chinese recyced government guys who only know the old system. They will bid up the cost of poor quality assets, get burned again and again and keep coming back for more. ( Using OPM makes this OK)

    The future is in these new, smaller real companies. But the guys that run these companies are still Chinese- they value relationships and are very suspicious of foreigners- and other Chinese -bearing offers of money and help. It takes time to vet out the good ones and even more time to build the relationships required to do business. US VCs will miss this bus for this reason. Too bad.