The huge consumer market potential and booming economy in China attract enormous foreign direct investments to capitalize this unprecedented opportunity. Foreign venture capital is not exceptional from this trend. They, however, still have to face constant challenges from regulations, market practices and business cultures in China. To be successful in this marketplace totally different from their origin, foreign venture capitals need to adapt their previous strategies and experiences and test it through trial and error.
This report is to get overall picture about current venture capital market in China. Then it will focus on the market position of foreign venture capitals. The report is followed by the analyses and summary on investment and exit strategies used by foreign venture capitals. Finally, the report will discuss the potential trend in China venture capital market.
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1). To get in-depth analysis on current venture capital market in China and foreign venture capital’s market position in China.
2). To analyze and summarize the investment strategies and exit strategies used by foreign venture capital in China.
3). To make prediction on future market trend, especially foreign venture capital.
1. General introduction on venture capital
2. Historical development and current venture capital market in China
3. Detail market position analysis on foreign venture capital in China
4. Investment strategies of foreign venture capital in China
5. Exit strategies of foreign venture capital in China
6. Future trends in China venture capital market
Venture capital is source of funds to small firms that cannot establish credit relationships with bank or other financial institutions. As Gompers (2001) states: Companies that lack substantial tangible assets and have uncertain prospects are unlikely to receive significant bank loans. These firms face many years of negative earnings and are unable to make interest payments on debt obligations.
Start-up high tech firms are exactly the type of firms that banks are least likely to lend to because of poor information availability and lack of tangible assets or assets that can be readily evaluated. Firms developing software or new technology for the communications or biotech industries are largely investing in human capital. In a nutshell, the VC firm is a relative small financial services professional organization that functions primarily to: (a) assess business opportunities; (b) provide capital; and (c) monitor, advise and assist the firms in its portfolio.
By investing, the venture capitalists accept substantial tranche of illiquid equity that converts their status to something like partners to the entrepreneur. The goal of the venture capitalist is not only to increase the value of that equity but also to eventually monetize the investment through a liquidity event such as an initial public offering or sale to other investors. The other way of reaping the reward is liquidation due to the firm failure and bankruptcy. In all of these scenarios, the venture capitalist exits their investment to complete the VC process. The venture capital cycle is briefly visualized in below chart.
Chart 1 Fund flow of Venture Capital Cycle
Source: National Venture Capital Association Yearbook 2008
The National Venture Capital Association in the United States defines venture capital as money provided by professionals who invest alongside management in young, rapidly growing companies that have potential to develop into significant economic contributors. There are a number of key attributes associated with VC that distinguish it from other equity capital investments. Venture capital normally focuses on small firms that have great growth potential. These firms usually are not mature enough to be traded in public equity markets. Compared with public equity investment, venture capital investment has poorer liquidity with more severe information asymmetry and higher investment risks.
Venture capital investment is also different from angel capital. Managers of angel capital use their personal money to invest. In contrast, investments professionals who raise money from other investors manage venture capital. Angle capital invests more often in the seed stage of the start up firms than venture capital does. Finally, venture capital is different from non-venture private equity investments (such as buyouts, restructure, and mezzanine funds). Firms backed by venture capital usually have considerable growth potential.
For these firms, the cash flow generated from operations is usually insufficient to support finance growth and debt financing is usually not available. In contrast, private equity funds target more mature firms that have stable cash flows and limited growth potential. The Table 1 below summarizes the investment stages and types of funding for different investment styles.
Table 1. Types of Funding and Investment Stage
Source: A Guild To Venture Capital (3rd edition) by Irish Venture Capital Association
There are five stages (BVCA&PWC, 1998) in the development of venture-backed companies, which can be defined as: 1. Seed
3. Other early stages (exploration)
5. Maturity (exit).
The definition of the company stage is different with the definition of the financing round. The negotiation of a VC investment is a time-consuming and economically costly process for all parties. Neither the VCs nor the portfolio firms want to repeat the process very often. Therefore VCs have to balance the cost of negotiation and potential risks from one time investment. Typically, a VC will try to provide sufficient financing for a company to reach some natural milestone, such as the development of a prototype product, the acquisition of a major customer, or a cash flow breakeven.
Each financing event is known as a round. So the first time a company receives financing is known as the first round (or Series A), the next time the second round (or Series B), and so on and so forth. With each well-defined milestone, the parties can return to the negotiating table with some new information.
These milestones differ across industries and depend on market conditions. A company might receive several rounds of investment at any stage, or it might receive sufficient investment in one round to bypass multiple stages. One special situation is the ‘down round’. It is when the company does not meet milestones and the VC still needs to invest but at a lower valuation than prior round of financing.
There are four major popular arguments behind for the investment rush to east.
Reason 1: High Rate of Economic Growth
China’s impressive economic growth for the past 30 years, averaging between 8% to 10% real growth per year, has been the envy of the developing world. The size of Chinese economy by the end of 2006 reached US$2.62 trillion, 13 times larger than that in 1978 when measured in constant RMB (MasterCard Worldwide Insight, 2007). According to Goldman Sachs China economic research (2003), per capita GDP expect to grow from less than $5,000 at that time to more than $30,000 in 2050 (refer to Chart 2). China will have a middle class of more than 500 million by 2025 – larger than the entire population of the United States.
It represents a huge emerging demand for everything from integrated circuits to cars. 500M mobile users, 130M Internet users, 104M broadband users and 4.5M college graduates every year could all transfer into huge business opportunity (represented in Chart 3). Based on the estimation (Chart 4) from Mckinsey, there will be sustainable market growth to 2025 in every business that related with people’s life and daily consumption.
Huge opportunities for venture capital are Internet (B2B, B2C, C2C, online gaming, website portal and web 2.0), semiconductors, technologies (clean energy, medical, biotech and traditional manufacturing), and consumer businesses (food, clothes, shopping and other entertainments).
Chart 2 China GDP Growth Forecast (2000-2050)
Source: Goldman Sachs 2003
Chart 3 China Energy/Material supply imbalance (2010)
Source: Goldman Sachs 2003
Chart 4 Urban Chinese Consumers Demand Forecast (2004-2025)
Source: National Bureau of Statistics of China; Mckinsey Global Institute Analysis
Reason 2: Inefficient Capital Market
In the United States and Europe, private and public capital markets compete as sources of capital. However, China does not yet have an equity culture despite the adoption of market-oriented policies. In China, the public equity market lists inefficient and unappealing state owned enterprises (SOE) most of the times. And government holds roughly 60-70% of share capital of most listed companies.
Few private firms are listed in the stock market due to legal and policy hurdle. China’s bond market is similarly underdeveloped. Chinese corporate bonds account for less than 2% of corporate financing.
Thin trading between banks and investors makes issuing bonds unattractive for fundraising or investing. Insurers and fund managers therefore have few fixed-income securities to hedge against mid- and long-term risks. The corporate bond market just started to function in late 2007 by allowing public listed firms to issue corporate debts. Around 95% of financing for Chinese companies now is still provided by bank loans.
The domestic banks, however, have tendency to provide loans to stated owned company rather than private firms, especially small and medium businesses (SMB). With the poor functioning financial markets and policy discrimination, venture capital and private equity become important sources of growth capital for private firms. It is one of the key reasons that venture capital is so popular among private firms in China across different industries even including traditional industries like food, hotel and travel etc.
One of the most unexpected attributes of the emerging Chinese market economy is how consumer-savvy its entrepreneurs are. Even after decades of centralized economic planning, the Chinese remain consummate creators and marketers of interesting products. Definitely the creativity and innovations are only limited in certain business for talents availability and their professional capabilities.
Online gaming, wireless instant messaging, and wireless value added services are just three markets that the Chinese more or less created out of thin air. Each of these businesses has growing customer bases (and have spawned successful public companies like Shanda, Netease, Tencent, and Linktone). But none of them has significant participants yet in the United States. Different consumer behaviors contribute to this phenomenon as well. In below case study on Tencent, it provides a great example on how to innovate the Internet product offerings to cater the needs of online generation.
Case study: QQ of Tencent (Adapted from www.tencent.com)
Tencent (listed in HK stock exchange) is the #1 Instant Messaging (IM) service provider in China. Tencent’s IM community counts over 270 million active accounts and is said to be covering 95% of Chinese Internet users and 70% of China’s IM market (MSN/Yahoo account for the rest market). QQ is the brand for its IM. Same as other IMs, QQ is a free tool to use. Tencent, however, came up the idea to generate revenue stream by allowing users to buy and exchange virtual items (clothes and background image) online to decorate his or her QQ head icon. Tencent even created its own cyber currency called Q Bi and 1 Q Bi = 1RMB (0.14 USD) to facilitate the transaction and reduce barrier of online purchasing. The estimated revenue generated from those Internet value added services in 2007 is around USD$360M.
In the last fifteen years, the privatization reform is one of the critical forces in stimulating China economy growth. This privatization wave also generated tens of thousands entrepreneurs. The business culture is naturally comfortable with risks and with developing innovative ways to solve problems and create wealth both for individuals and for society at large.
The successful stories of VC backed entrepreneurs further promote the risk taking culture in China and the awareness and popularity of venture capital. The Focus Media case below illustrates the power of business model innovation by its unprecedented expansion speed ever in China’s business history. There is no doubt that foreign VCs played an important role in this story to make Focus Media successful.
Case study: Focus Media China (Adapted from www.focus.com)
Founded in 2003, Focus Media is China's largest Digital Media Group in China now. The founder, Mr. Jiang Nanchun, came up with an innovative approach in operating out-of-home advertising network using audiovisual digital displays. Basically, the idea was to display the LCD near or in the elevators in commercial centers (like office buildings and shopping malls). While waiting for or in the elevators, people would watch the contents advertised in those LCDs.
By selecting and contracting with high quality commercial buildings, Focus Media was able to quickly build up its network scale and attract many advertising contracts. Tow foreign VC firms, Soft Bank and UCI, invested in the first round. And another five VCs, CDH, TDF, DFJ, WI Harper and Milestone, invested in the second round. Two years after operation, Focus Media was listed on Nasdaq with USD$172M IPO and now it is part of Nasdaq 100 index.
Infancy stage: 1984 – 1995
In 1984, the Research Center of Science and Technology Development of the State Science & Technology Commission (SSTC) (now the Ministry of Science & Technology or MOST) cooperated with British experts to study how to develop high-tech in China. The British experts proposed that venture capital should be developed if China wanted to foster high technology.
In 1985, the Central Commission of the Chinese Communist Party and the State Council pointed out in the Decision of Science-Technology System Reform that venture capital could be set up to support the work of developing high-tech with quick change and high risk. It was the first time that the concept of venture capital appeared in an official Chinese Government document.
With the government decision to develop high technology industries, the Central Government and some local governments financed and set-up series of investment institutions that intended to pursue the venture capital business from 1985 to 1995. Examples are China New Technology Venture Capital Company, Shenyang Science-Technology Venture Development Risk Center, Shanxi Head Office of Science-Technology Fund Development, Guangdong Science-Technology Venture Capital Company, Shanghai Science-Technology Venture Capital Company, and the Science-Technology Venture Capita Company of Zhejiang Province. Moreover, venture centers (i.e., high tech incubators) were set-up in the majority of national high-tech parks.
Simultaneously, some overseas investment banks, funds and venture capital institutions also started to expand their business into China. For example, the Pacific Technology Venture Capital Fund subordinate to IDG entered China in 1992. It cooperated with science-technology commissions in Beijing, Shanghai and Guangdong, and set-up a number of venture capital companies focused on investing in technology companies. Also, some foreign capital or joint stock investment institutions established venture capital businesses.
Asia Venture Capital Journal (AVCJ, 2001) shows that $16 million was raised for venture capital investments in 1991. In 1992, the total funds raised jumped to $583million, a thirty-fold increase compared with the $16 million in 1991. The first wave reached its peak in 1995, with $678 million in investment (AVCJ, 2001).The first wave of venture capital investments was brought by international venture capitalists. The international venture capital firms accounted for more than 95% of the total fund raised in the early and mid 1990s.
The absolute dominance of international venture capital funds in China in the early and mid 1990s was mainly due to China’s strict regulations against fund-raising and the general lack of awareness of venture capital in China. Private fund-raising by individuals or private firms without government approval was strictly prohibited in China. This strict regulation essentially removed the possibility for venture capitalists to raise funds within China.
It meant that only international venture capital funds and state owned enterprises (SOE) venture capital funds could operate. International venture capital funds could bypass the regulation because they were incorporated and they raised funds outside of China. SOE funds relied on government appropriation as funding sources and did not have this fund raising problem either.
Early Growth: 1996 – 2001
From the mid-1990s, the perception of venture capital shifted from being a type of government funding to being a commercial activity necessary to support the commercialization of new technology. As there were still no laws or regulations about setting up foreign venture capital institutions in China, many overseas investment institutions established their branches in Hong Kong, aiming to invest in the mainland. They had also located representative offices in some major cities, primarily Beijing and Shanghai. Most of the VCs active in China in the early 90s were American firms.
The VC industry in the U.S. had matured and attracted a significant amount of funds. Shortly after 1995 a sharp increase from US$5 billion to US$110 billion in funds raised created the phenomenon of money chases deals (Gompers & Lerner, 1999). A cadre of experienced American VCs started searching the world for investment opportunities, attempting to replicate the Silicon Valley model. Since 1998, there had been a discernible recognition of the critical success factors necessary to create an environment in which venture capital could operate smoothly and flourish.
Specifically, the Government’s official decision to support the development of venture capital was the key factor that had allowed China’s venture capital industry to come into being in a new and more positive environment. In Beijing, alone, there were about 30 independent venture capital institutions, whose capital amounted to an estimated $450 million. In Shenzhen, there were at least 20 independent venture capital institutions with capital amounted to over $500 million. After 2000, China also experienced hard landing in its young VC industry due to dotcom bubble burst and came with huge casualties. It took the VC community 3 years to recover.
Fast Growth: 2002 – present
Although initial government-backed investment operations generally failed, there has been resurgence in venture capital activity since China’s admission to the WTO (Kenny, Han and Tanaka 2002). Capital available for investment in Mainland China keeps a steady growth trend from 2002. The capital size was increased to US$21.32B by 2007 from US$10.50B in 2002. The average compound annual growth rate (CAGR) reaches 15.2%. Venture capital investment grew rapidly from $480 million in 2002 to more than $3,247 million in 2007, invested in 440 China mainland or mainland-related enterprises (Zero2IPO 2007).
According to Zero2IPO report, USD$4B VC funds were raised each year in 2005 and 2006 for China investment. But China’s annual consumption was no more than $2B. The money chasing deal phenomenon started to emerge in China. Many foreign VC funds, especially first-time funds raised after 2005, had the pressure to pour out investment quickly to avoid US dollar depreciation against RMB and to get better deals under fierce competition. While the funding supply multiplied, quality deal flows did not increase at the same pace.
Under the simple supply and demand mechanism, valuations of the China deal kept at relative high level. However, considering the fact that a big portion of funding was focusing on local value-add service segments (i.e. internet, web2.0 and broadband etc.), the issue of fund’s over-supply was sector specific. To get higher return under the competition, VC firms started to invest in traditional business models such as hotels, travels and fast food chains beyond their core activities such as TMT (Technology, Media and Telecom) or Internet related businesses. It was the special phenomenon happened in China now that VCs were more like PE.
According to Megginson (2004), the differences in the design and the degree of development of the PE/VC industry are due to institutional factors, with the country's legal system being paramount. Two major factors are paramount in evaluating legal system: contract law enforcement and protection of shareholder rights through effective corporate governance. Cumming and Macintosh (2002) observed that PE/VC managers in high enforcement countries had a greater tendency to invest in high-tech SMBs, exit through IPOs rather than buybacks and obtain higher returns.
Cumming et al. (2004) further examined legal system effects on governance structure. Under better legal systems: the faster the origination and screening of deals; the higher the probability of syndication; less frequently funds of the same organization used to invest in a given company; the easier the board representation of investors; the lower the probability that investors required periodic cash flows prior to exit; and the higher the probability of investment in high-tech companies.
Lerner and Schoar (2005) show that in a bad legal environment, PE/VC managers tend to buy controlling stakes, leaving the entrepreneurial team with weaker incentives. Interestingly, valuations tend be positively correlated with the quality of the legal environment. Kaplan et al. (2003) go deeper into the contractual aspects and found that rights over cash flows, liquidation and control, as well as board participation vary according to the quality of the legal system, the accounting standards and investor protection across countries.
However, more sophisticated PE/VC managers tend to operate in the U.S. style irrespective of local institutional concerns. The authors show that managers operating with convertible preferred stocks are less prone to failure (as measured by survivorship rate). The results suggest that the U.S. contractual style can be efficient in different institutional environments. Bottazzi et al. (2005) corroborate some of the previous results and obtain further evidence on the home-country effect (PE/VC managers operating abroad tend to maintain the investment style used at home). This is observed in managers based in both good and bad legal environments.
The Chinese regulations governing foreign venture capital investment are chaotic and rapidly changing. In 2005, Chinese authorities issued new guidelines (effective in 2006) intending to foster domestic venture capital firms. There is no specific regulation to monitor and stimulate the VC activities in China. The new guidelines recommended that local governments provide financing assistance, favorable tax treatment, and direct investment in Chinese venture capital firms. They also provide less stringent capitalization, investment amount, investor qualification and regulatory requirements than those applicable to FICVEs (Guerrera, Yee and Yeh, 2005). FIVCEs instead are governed by 2003 regulations that include high investment and qualification thresholds, government approval requirements, and strict foreign exchange limitations on the ability to remit profits and dividends back to the investor (Hoo, et al 2005a).
Substantial legal and de facto restraints on the ability of FIVCEs to access the stock markets in China and overseas for IPO listings make exit strategies extremely difficult. For these reasons, foreign venture capital firms investing in China usually do not use FIVCEs but rely on offshore holding companies created to receive their investments. Foreign venture capital firms (most of which are U.S. based) investing in China generally have done so through the restructuring of Chinese companies into offshore investment vehicles.
These enable an easier exit from investments either by selling shares on international stock markets or through a trade sale to another foreign buyer. In January of 2005, Chinese authorities brought these transactions to a virtual standstill, however, with the issuance of new regulations preventing any onshore resident from establishing, controlling or owning shares in an offshore company without the approval of the Government, either directly or indirectly. The regulations were intended to stop managers of SOEs receiving venture capital investments from stripping state assets and selling them cheaply to overseas companies, and to preclude domestic companies from using the overseas vehicles to gain foreign investor tax exemption status.
However, they choked off legitimate transactions as well. There were no government approvals of offshore investment transactions in 2005. With only limited exceptions for transactions in process, foreign venture capital financing through offshore investment vehicles screeched to a halt in 2005 (Borrell and Jerry, 2005).
Then, in November of 2005, the Chinese authorities issued superseding regulations. These require registration of offshore investment vehicles with the State Administration of Foreign Exchange (SAFE), but do not require the agency’s approval of the transaction. They also require repatriation of all distributions of income from the investment within a fixed time frame. Like the previous regulations, the new ones do not describe specifically the registration process, the procedures involved, the scope of review nor the time required for completion, creating substantial uncertainty for foreign venture capital investors (Hoo, et al 2005b).
Despite this changing regulatory landscape, many U.S. based venture capital firms have active plans for substantial investments in 2006 – spurred by China’s high growth potential, the success of recent venture-backed startups on the NASDAQ including Baidu.com and China Medical Technologies – and by pent up demand after the 2005 halt in new investments (Borrell, Jerry and Aragon 2005).
Lagging legislation and inexplicit policies in China created many uncertainties and entry barriers for foreign VCs. Below are summary of the critical problems:
China's lawmaking on VC investment remains stagnant
Existing laws such as Corporation Law, Joint Venture Law, Patent Law, etc., in many aspects even contradict VC investment.
Does VC investment count as foreign investment? What status and treatment should it enjoy? The concerned authorities cannot provide clear answers to these questions.
It’s not clear that the amount of shares that foreign venture capital is allowed to hold when partnering with Chinese enterprises, and the way foreigners to remit in/out of foreign exchange are poorly defined.
There are three available approaches for foreign venture capital firms to enter China venture capital market legally.
Establishing offshore venture capital fund focusing on China
Establishing a foreign invested VC firm in China (Joint VC with local player/Wholly Owned Foreign firm) as a legal person entity
Establishing a foreign invested VC firm in China (Joint VC with local player/Wholly Owned Foreign firm) as a non-legal person entity
To avoid the legal and regulation barriers, foreign venture capital funds usually takes the offshore investment route. Foreign VCs will use offshore USD fund to invest into China deals’ offshore holding entities with all equity activities happening outside of Chinese jurisdiction. The distinction of USD offshore holding investment and RMB local entity investment is a particular phenomenon in China.
Offshore holding arrangement is a preferred structure for Chinese entrepreneurs and VCs as it provides a feasible and practical route for funding, divestment and all equity events. Its advantage and attractiveness to Chinese entrepreneurs and VC communities:
Go away from laws and regulations in China. Many of them are not friendly to venture activities, such as lack of preferred shares, stock options limitation, double tax etc.
Bypassing capital account control on foreign exchange.
More flexible and usually profitable divestment options by overseas IPO, M&A or trade sales.
Offshore route investment involves the following steps:
The Chinese founders set up an offshore holding company in Cayman Island or BVI with the shareholding structure and management control mirroring those of their local company in China.
With kind of swap scheme, transferring the equity they hold in the Chinese local company to the offshore holding. This will typically convert the local company into a WFOE (Wholly Foreign Owned Enterprise).
The offshore holding company will then be the vehicle seeking VC investment, future funding as well as for listing or be merged. All equity events happen in offshore. Companies’ funding and IPO proceeds will be kept offshore, and remit into China as and when operation required. Chinese founders’ assets, rights and proceeds stay offshore. The whole exercise is carried out essentially with an IPO at an overseas stock exchange, such as NASTAQ or Hong Kong Stock Exchange in vision. (The concept and process is visualized in chart 5.)
Chart 5 Foreign VC Offshore Investment Process
Source: A legal perspective on China’s venture capital rush, Mar 2006
Restrictions in China’s corporate regulations and limitations at the domestic capital markets explain foreign VC’s preference in taking offshore route to organize their China investment. VC investors rely normally on preferred stocks or convertible preferred stock to secure a preferential return. Chinese corporate regulations allow only one class of common stock for a FIVCE with investment in a Chinese portfolio company.
Notably, local VC firms would have the possibility to arrange preferred stock scheme with their investee company according to a newly issued charter regulation applicable to domestic VC firms. This gives rise to concern on the principle of national treatment under WTO law.
Moreover, China domestic stock market does not provide a ready access for venture-backed companies. The conditions for listing at Shanghai or Shenzhen main-board market are too stringent for high-tech start-up companies. Even if listing conditions could be met, the queue in the pipeline waiting for a listing window is at the moment frustrating. In fact, the two domestic stock exchanges have halted the IPO since two years in the call for addressing the notorious overhang of nontransferable legal person shares.
The undergoing endeavor is focusing on floating all stock legal person shares. Since the value of stock legal person shares is roughly twice of those trading in the stock exchange, full floating of legal person shares at stock is imposing acute challenge on the market place.
This would mean that the suspension on IPO of new shares would be expected for a rather extended term. By leveraging on an offshore holding structure, foreign VCs could take advantage of the corporate governance in a jurisdiction where they feel most comfortable and bypass the restrictions under Chinese corporate law. VCs could take the SPV to the international stock market for IPO in a timely and straightforward manner, without the necessity to obtain permission from Chinese government in advance.
Case Study: Sina.com (Revised from Sina’s IPO filing in SEC)
Sina is the leading online media company and mobile value-added service provider in China. In order to list IPO overseas, Sina had undergone major organization restructuring to qualify. To work around state policy and to get clearance from the regulators, Sina had to set up a complicated investment structure that segregated its principal assets, the China-based operations, from the company incorporated in the Caymans Islands and headquartered in Hong Kong.
Two major rounds pre-IPO financing were obtained from foreign VCs and institutional investors: 1) $25 million round of financing on March 10, 1999. Investors included Walden International Investment Group, Goldman Sachs and other venture and private investors. 2) $60 million Series C financing round, with 7,675,661 Series C preferred shared issued at $8.32 per share in October and November 1999 to 42 investors. Sina was listed on Nasdaq on April 13, 2000, with IPO of 4 million shares at $17 per share.
Another possible approach to enter China VC market is to operate through a China domiciled VC vehicle, i.e. foreign invested venture capital enterprise (FIVCE). FIVCEs are permitted either as corporate legal persons or non-legal persons. In case of corporate legal persons, Chinese law foresees the legal forms of the Wholly Foreign Owned Enterprise (WFOE), Equity Joint Venture (EJV) or Cooperative Joint Venture (CJV) under the governing principles of the Limited Liability Company (LLC) or Joint Stock Limited Company (JSLC) according to the Company Law.
As a WFOE or an EJV is by definition a Chinese legal person, non-legal person FIVCE could only take the form of a CJV, which requires the engagement of a Chinese partner while excludes Chinese individuals acting as such partner. Under non-legal person scenario, limited partnership arrangement commonly used in VC formation elsewhere is recognized by the FIVCE Rule, where at least one general partner bears joint and several liability for the debts of the FIVCE while other limited partners would only bear the risks to the extend of their investment in the FIVCE.
By comparing the FIVCE Rules with the Local VC Rules, domestic VC firms appear to have certain regulatory advantages over their foreign rivals. For example, FIVCEs are subject to a higher registered capital requirement (up to 2.5 times of that of the local VC firms). There is a total managed asset prerequisite for the necessary investor of a FIVCE, while no corresponding condition is stipulated for a local VC firm. FIVCEs in general are subject to a lengthier and more burdensome approval and registration procedure.
Thus, foreign venture capitalist is facing higher market entry barrier. In terms of business operation, FIVCEs are mandated to invest in High – and – new Tech Companies, while local VC firms do not adhere to this restriction. FIVCEs are not allowed to incur debts for investment, while local VC firms could incur debt finance to strengthen their investment capacity. As mentioned before, local VCs firms are also granted the instruments such as convertible preferred stock or stock options that are not available for FIVCEs. Furthermore, FIVCEs are still subject to sector restrictions that are generally in place for foreign direct investment. (The concept and process is visualized in chart 6.)
Chart 6 Foreign VC onshore investment process
Source: A legal perspective on China’s venture capital rush, Mar 2006
Case study: SAIF RMB Fund
SAIF Growth (Tianjin) Fund was founded in December 2004 after it was approved by Chinese Ministry of Commerce. It is the first Sino-foreign non-legal person cooperative joint venture in Chinese venture capital history. The investors of the Fund are Softbank Asia Infrastructure Fund and Tianjin Venture Capital Co., Ltd. Softbank Asia Infrastructure Fund was founded in the year of 2001. Its main investors are Softbank Company (Japan) and Cisco System Company (US). Tianjin Venture Capital Co., Ltd came into being in December 2000. It was registered by Tianjin Venture Capital Development Center under Tianjin municipal government. The Fund entrusted SAIF Growth Investment Venture Capital Management Co., Ltd, which is a venture capital management company jointly invested by Softbank Asia Infrastructure Fund and Tianjin Venture Capital Co., Ltd to perform its daily operation.
Source: Revised from www.saiftj.com
Besides available deal size and stages, it is difficult to define the underlying differences between domestic and foreign VC firms. The investor and investee relationship is a possible area to discover the key differences in those two types of VCs. According to Zhang and Jiang (2002) supported by research from Bruton and Ahlstrom (2002), there are three key differences that are still prevalent today. Much of those differences are mainly due to shortage of talent pool and limited exposure to VC investments. Those two bottlenecks are expected to gradually improve with talent mobility and learning curve.
First, Chinese VCs are less active in their monitoring of investee management than foreign VCs. For example, foreign venture capital firms require financial reports more frequently. While almost all Foreign VCs require monthly financial reports, only two-thirds of domestic VCs required monthly reports. Foreign VCs also retain veto rights, while fewer domestic VCs obtain such rights.
Second, domestic VCs exercise weaker influence over their investee management decisions than do foreign VCs. For example, they use staged investment in the same round of financing less frequently than foreign VCs. They are less likely to make follow-on investment and cash flow rights of entrepreneur’s contingent on the venture’s performance. Domestic VCs are beginning to introduce stock option plans more generally into investee firms and often only to top management. Foreign VCs almost always introduce stock options into investee firms and for all employees.
Finally, the domestic VCs provide much less to investees in terms of value-added services. While foreign VCs usually take part in board meetings at least once per quarter (and often monthly), less than half of the domestic VCs participate so frequently. Indeed, an underlying difference between these types of firms is that the domestic firms in general do not see addressing operational issues of investees as an important part of their development, or their role as investors. Instead, they concentrate their monitoring and participation on the financial aspects of the investee firms.
Gompers and Lerner (1998), Jeng and Wells (2000), and Romain and Van Pottelsberghe (2004) have investigated the determinants of the PE/VC industry's size and found that the most significant factors are: on the demand side – (i) reduction in the capital gains tax over time; (ii) entrepreneurship activity; (iii) innovative efforts (i.e., overall R&D expenditure, stock of knowledge and patent fillings, especially when the workforce is mobile and the entrepreneurial activity exceeds a certain level); (iv) GDP growth (in countries with low market rigidity); (v) labor market rigidities (mainly the high-skilled workers, with a stronger effect over early stage investment); and (vi) interest rates (with a positive rather than negative effect).
Among the supply factors – (i) allowance for pension funds to investment in the asset class (e.g., ERISA in the U.S.); (ii) growth of the private pension market (explains variability over time but not across countries); (iii) reputation of the established PE/VC organizations; (iv) quality of accounting standards; and (v) long-term against short-term interest rates. Other factors include – (i) volume of IPOs (with stronger effect over later stage investment); (ii) stock market capitalization; and (iii) government programs (with important role in both setting the regulatory framework and galvanizing investment during downturns).
China now boasts almost all the demand factors in developing its VC/PE industry. But the limitation in allowing domestic savings to invest in VC/PE forbids the fast growth of local funds. Poor accounting records and ineffective corporate governance are other risks in promoting healthy investment for VC/PE. The abundant financial resources and advanced management skills offered by foreign VCs explain why they are so popular in China. In recent years, the government starts to build favorable investment environment by offering financial incentive for domestics VC players and setting up local exit channel.
While, the foreign VCs are allowed to have more investment flexibilities to (i.e. set up local RMB fund or partnerships) to invest locally with favorable tax rate. According to the report by Cambridge-based Library House, China's venture capital market is growing at more than three times the rate of the UK, In 2006 China became the second-largest country for venture capital investment with 1.4bn, behind the US with around 14bn. There are around 400 active VC firms in China (slightly exceeded the peak in 2002). However, the total VC investment amount in 2007 is nearly 3 times (measured in RMB) compared to that of in 2002.
Chart 7 VC investment amount and No. Of VC firms
Source: Venture Capital Guiding Fund for Technology-based SMBs, Li Wenlei, 2008
In 2007, China VC market touched new highs both in deal number and the amount invested. 440 enterprises netted total USD$3,247 million VC investment (Chart 8). Foreign and domestic VC funds active in 2007 managed US$21.32B, which increased by US$2.24B against 2006 (Chart 9). Foreign VCs, domestic VCs and Joint Venture funds managed US$14.56B, US$6.00B and US$771.78M separately. They comprise 68.3%, 28.1% and 3.6% of the total capital. Foreign VCs continue to lead in Chinese VC market. They managed over two thirds of the total capital and invested more actively than domestic counterparts during 2007. The total capital managed by foreign VCs reached US$14.56B during 2007 – a 2.4 fold increase against US$5.97B during 2002 (the CAGR is 19.5%).
Chart 8 China VC market overview (2001-2007)
Chart 9 China VC investment breakdowns (2007)
Source: Zero2IPO 2007 VC Yearbook
VC activities can be broken into three main groups: investing, monitoring, and exiting. Investing begins with VCs prospecting for new opportunities and does not end until a contract has been signed. For every investment made, a VC may screen hundreds of possibilities. Out of these hundreds, perhaps a few dozen will be worthy of detailed attention, and fewer still will merit a preliminary offer. Preliminary offers are made with a term sheet, which outlines the proposed valuation, type of security, and proposed control rights for the investors.
If the term sheet is accepted by the company, the VC performs extensive due diligence by analyzing every aspect of the company. If the VC is satisfied by this due diligence, then all parties negotiate the final set of terms to be included in the formal set of contracts to be signed in the final closing. Once an investment is made, the VC begins working with the company through board meetings, recruiting, and regular advice. Together, these activities comprise the monitoring group.
In the typical venture capital investment scenario an entrepreneur or entrepreneurial team approaches a venture capitalist with a business plan describing the firm, the management team, potential competitors, and the market (Martinelli 1994). Since venture capitalists receive hundreds of business plans per annum, though most receive at least a cursory examination; the plans recommended by someone the venture capitalist knows receive the greatest attention.
If one of the venture capitalists is interested, then the entrepreneurial team is invited to present its business plan in person. Should the venture capitalist's interest continue, the entrepreneurs’ references and others who might be able to speak to the candidate's qualifications, personal and technical, are contacted. If there are technological unknowns the venture capitalist gathers information on the project’s feasibility from technical experts.
They also interview prospective customers trying to gauge their need or desire for the product. In other words, they gather as much information as possible about the investment and its growth potential. If these hurdles are surmounted, then the team is invited to present the plan to a meeting of all of the partners. Once the partners agree, a contract detailing the terms of an offer is extended to the entrepreneurs. Upon acceptance the venture capitalist invests the firm. With this investment the relationship between the entrepreneur changes as the venture capitalist now is committed to the success of the firm.
There are three major risk mitigation strategies used by venture capitalists: (1) syndication (2) staged financing and (3) using convertible securities. (Gompers, 1995)
In China, because of regulatory constraints and the state of financial market development the use of convertible securities was not feasible (Zeng, 2004). Venture capital investments are staged, and, if the firm meets preset milestones, then it receives new investments at a higher valuation. Should the firm not meet its targets or the market change at the next stage the firm's valuation can decrease? Investing in seed stages can offer great incentives of profit sharing while investing in third stages can offer the incentive of low risk returns.
Both situations are favorable depending on the individual VC. Wang and Zhou (2004) explain the many incentives for VCs to use staged financing. Investing in stages is an effective mechanism for venture capitalists to reduce agency costs and to control risks. However the negative aspect to staged financing is that VCs may under invest in a project in the early stages when the project does not look very promising, which may cause a viable project to fail and result in a loss of social welfare. Despite this downfall, staged financing makes it optimal to invest in the seed stage rather than wait until the less risky latter stages.
Usually, venture capitalists syndicate their investments with other venture capitalists, thereby spreading risk, providing multiple contacts and sources of advice for the startup firm, and a crosscheck on the investment decision (Gompers and Lerner 1999). The most common venture capital security is a convertible preferred stock or subordinated debenture that is either convertible into common stock or accompanied by warrants for the purchase of common stock.
Start-up firms often have negative earnings or cash flows in their early stages, and therefore the security typically does not provide for mandatory periodic payment of either interest or dividends. Its liquidation rights are senior to common stock, but sometimes junior to other creditors of the start-up firm. The convertible security contains restrictive covenants, whose violation triggers the right of the venture capitalist to redeem its investment.
In addition, venture capitalists often hold majority voting rights and representation on the board of directors. Kaplan and Stromberg observe that many venture capital contracts condition control rights on contingencies such as the attainment of performance milestones. Venture capitalists are often given preemptive rights to participate in future rounds of financing (for example, to maintain their pro rata share of the equity in their start-up venture).
In developed markets like U.S and UK, venture capitalists are not passive investors. Hellman (2002, p285-314) states that the projected success of a new venture is highly dependent on the support of the investor and that this Level of support is endogenously determined by the investor’s incentives. Because of their equity stake, they have an interest in the firm's success, which is defined in terms of a rapid increase in the firm's value.
Invariably, one or more venture capitalists lead investors join the firm's board of directors. From this position they actively monitor the firm’s progress. Besides monitoring work, they often assist and counsel the management team. Activities includes counseling on major strategic decisions, assisting in recruiting key personnel, providing contacts in the legal, investment banking, and other business service communities. Finally, the investment by a prestigious venture capital firm creates the perception that the small firm will be a success. The brand name became an important asset for convincing customers and suppliers that the startup is viable and worthy of patronage.
U.S VC investment style is the dominant form among the foreign VC firms given their early market entrance and huge investment successes. Under the off shoring investment route, foreign VCs do not need to change much their investment strategies and deal terms. Examples are their focus on quality of the management team, shareholder rights protection and market potential of the business models or products. But foreign VCs have to cope with and navigate the rapid changing regulations and business laws.
Meanwhile, they need to understand the culture and consumer market through localization or cooperation with local players. Warburg Pincus Asia’s Chang listed some of the risks for foreign venture capitalists at a round table in Japan 2005. First, there is limited protection of minority rights and a lack of management talent. Second, Chinese competitors may enjoy cheap or even free loans from government-owned banks. Third, exiting the market can be difficult. Foreign VCs even run the risk of having too much of a good thing. If too much capital floods into China, good projects will be overvalued, causing returns to decrease.
Song saw this happen in Silicon Valley during the dotcom boom. And there are two major challenges for foreign VCs to overcome as well in China VC market: appropriateness of due diligence and protection intellectual property rights. In the due diligence process, they also need to be aware of dangers and pitfalls from lacking information, accounting frauds and ethics issues in the entrepreneurs. Meanwhile extra monitoring efforts are required from VCs to guide the entrepreneurs and protect their investments. The poor protection of intellectual property rights in China poses the challenge to foreign VCs on how to protect the uniqueness of foreign VC invested business models and technology know-how.
The due diligence process typically takes significantly longer to complete in China. Foreign VCs must work through the deal process patiently and not make any commitments without the appropriate due diligence. While guanxi, or relationship, make it more efficient to do business in China if knowing the right people, it should have only a small impact though on planning due diligence. In China, accounting standards and methods and auditing, financial and other reporting practices and disclosure requirements are different and generally simpler than those in developed countries.
According to one experienced venture capitalist many Chinese companies keep three sets of accounts – one for the outsiders, one for the government tax office and one that reflects reality. Furthermore, very few Chinese entrepreneurs have experience in securing venture capital based on appraisal documents and market research. As a result, often little accurate information is available to potential investors.
This is a significant concern for investors in established businesses. In the case of many start-up technology companies, however, due diligence in China, as elsewhere, is likely to focus on the background and quality of the founders, and the quality of their ideas and their business plan. In these circumstances, lack of information about past performance, the company’s assets, etc. may not be that relevant.
Management teams in China also require significantly more oversight and hands-on mentoring. Local management teams will not necessarily know which way to grow the company in order to provide an appropriate exit strategy for investors. From a company operation standpoint, the local management will also likely require significant guidance in implementing the corporate governance, financial reporting and other processes that are so critical to successful exits in public listing. Therefore foreign VCs are required to take a more active involvement in the process than in the developed markets. Thus, the marginal cost of identifying, screening, and monitoring investment partners is higher.
Infringement of intellectual property rights in China is widespread and systemic. Notwithstanding the promulgation of a wide range of legislation to protect intellectual property rights, enforcement remains patchy and ineffective. Chinese holders of intellectual property rights suffer from this lack of protection just as much as foreign companies. Especially in the case of a start-up whose main assets may be intangible, the inability to protect intellectual property in China can be a significant concern for potential investors.
As part of the due diligence process, it is nevertheless important to confirm that relevant registrations of trademarks, patents and copyrights have been or will be made, and that other steps have been taken to ensure to the greatest extent possible that the investee company’s confidential information is protected, for example, through confidentiality agreements with employees, licensees, suppliers and distributors.
VCs are financial intermediaries with a contractual obligation to return capital to their investors. A major concern of investors in venture capital is liquidating their position in start-up firms. Therefore VCs plan their exit strategies very carefully, usually in consultation with investment bankers. However, the exit process itself requires knowledge and skills that are somewhat distinct from the earlier investment and monitoring activities.
Three exit strategies for venture investments are available: sale of the stock through an initial public offering, sale of the firm through a merger, or bankruptcy. Upon any of these liquidity events the proceeds are returned to the limited partners as either cash or marketable securities. As a rule of thumb, three or four VC investments are expected to fail at a near total loss. Another three of four neither fail nor are easily liquidated.
These are termed the "living dead" and are judged failures by the venture capitalists. For the successful funds it is the final two or three that determine the return. In these cases one or two investments provide returns of ten to over one hundred times the initial investment. It is these successes that compensate for the failures and complete the venture capital cycle.
One of the most relevant measures of venture capital investment is the internal rate of return (IRR). Measurements done by Venture Economics (1997, page 272), an often-cited research firm, indicate that during the period between 1986 and 1996 the IRR of venture capital funds has roughly paralleled the performance of the stock market. By considering the IRR one can compare venture capital funds to other investment options as well as the economy as a whole.
Statistically, the 10-year holding period IRR ending in 1996 was 20.7 percent, with most of it having been generated in the last five years, over which the median was 23.7 percent. Historically, the IPO has been the source of the most lucrative exits. IPO is considered as being a very important determinant of VC. It is the strongest driver of VC according to Jeng and Wells (2000) because it reflects the potential return to VC funds.
What is the popular solution for foreign VCs?
Chart 10 Venture Exit Counts – IPOs and M&A by Year (U.S, 1991-2008 1H)
Source: NVCA & Thomson Reuters
Main foreign VC exits in China are transfer of shares, IPO, and M&A. There are currently two promising avenues for venture capitalists to exit their investments in Chinese firms. First approach is acquired by foreign multinationals or by local Chinese firms. There have been a number of successes, including Yahoo’s $1 billion purchase of 40 percent of the Chinese e-commerce firm Alibaba, the purchase of Longshine in 2005 for $30 million by the U.S. firm Amdocs, and TDK’s purchase of ATL for $100 million in 2005.
The second exit window is listing on foreign stock exchanges. For many investors and the firms they finance, the most desirable exit is an initial public offering (IPO). According to the Asian Venture Capital Journal (AVCJ, 2005), Chinese venture-backed IPOs went from US$200 million in 2000 to $3.1 billion in 2004. Meanwhile, mergers and acquisitions quadrupled, from $510 million in 2004 to more than $2 billion in 2005.
Chinese firms venture backed by foreign venture capital cannot list on Chinese stock market under current legal regulation. Overseas public listing in NASDAQ, HK and Singapore stock exchanges become popular choices. And foreign VC firms play a vital role in advising and preparing Chinese firms for overseas listing.
According to Zero2IPO China Venture Capital Report Q2 2008, 143 out of 159 start-ups that got venture capital investment in Q2 2008 revealed a total investment amount of $1.2 billion, a 28% increase compared the investment amount last quarter. Below chart measures the sentiment of venture capitalists in China VC market. The deterioration of U.S economy and bear mood of the stock markets around the world certainly impacted the local investment sentiment in China as well.
The author of this index tracker argue that although China’s venture capitalists’ confidence has been negatively impacted by slowing global economic growth, increasing inflation, tight credit, volatile stock market, and possible valuation bubbles; strong economic growth in the long term and a maturing venture capital investment system provide cause for enduring confidence.
Chart 12 China VC Confidence Index (Q2 2005 — Q2 2008)
VCs are more like private equity firms. Investment opportunity derived from not only high tech but also high growth. Not like in the mature countries, China’s high return opportunity not necessary is powered by high tech.
In order to develop the venture capital market, the government issued new version of Partnership Company law in June 1st 2007. Thanks to the revised Partnership Enterprise Law, which took effect last June, partnership enterprises need not pay enterprise income tax, which avoids the dual-tax levy. This law has removed some legal obstacles for RMB funds in China. According to the law, three aspects were substantially adjusted: (1) Enlarging the scope of partners: partnership enterprises can be established within China by legal persons, natural persons, and other organization, reflecting that legal persons can officially become partners; (2) Augmenting the coverage of limited liability partnership, i.e. adding Special Common Partnership Enterprises, which indirectly admits the legitimacy of the limited partnership incorporation form of VC funds/firms. The present law will benefit the domestic VC industry mainly in the following aspects:
First, enterprises established in the form of the limited liability partnership can legally and effectively bundle the interests together of both fund investors and management team. As general partners, managers shall bear unlimited and joint liabilities for the limited liability partnership enterprises; as limited partners, investors shall bear the liabilities to the extent of their capital contributions.
Second, the limited partnership enterprises can effectively address the issue of dual taxation for both investors and enterprises. That is, the partnership enterprise does not need to pay corporate tax, but paid by individual general partner and limited partner.
It is convinced that China will gradually establish a better and more comprehensive legal system on VC circle with the promulgations of the Partnership Enterprise Law, amended Corporate Law and Securities Law, as well as the Interim Measures on the Administration of Venture Capital Firms.
At policy and regulatory level, China is encouraging local IPO while putting constraints on offshore entity restructuring and overseas IPO. Shenzhen SME board gradually proved to be a viable exit option for VC deals in China. Faster listing process, average 82 days from filing to listing. Shenzhen Stock Exchange has aggressive listing plan with 200 IPOs for 2007. Quality deal flows are in high demand. Good P/E (average 51x) with reasonable liquidity.
Shifting from USD offshore to RMB onshore investment. It’s mainly due to the environmental changes happening in past two years. While offshore restructuring and listing become tougher, the local IPO, investment and fund formation are greatly improved. With the emerging RMB investment opportunity, there are two alternatives for existing foreign LP funds to participate: Alternative One: Direct Invest into local deals, turn them into Sino-foreign JV, seek local listing, then to remit divested RMB into USD.
Alternative Two: As a LP to initiate and set up a RMB fund to do local deal investment. No critical legal, regulatory or foreign exchange constraint for foreign investors to invest into a local deal or a local RMB fund. The repatriation of RMB divestment might subject to up to 10% withholding tax. However, this potential tax exposure might be able to be offset by higher PE in China.
The current offshore holding investment keeping fund’s formation as well as all portfolio investment and divestment offshore could not be sustaining for longer term. Eventually, the VC/PE industry in China will do local RMB fund raising; local RMB investment into local entities, and have the portfolio divested thru local IPO or M&A. So, to complete the four major activities of a VC cycle (funding, investing, value add to portfolio, and divestment) all onshore. VC investors as well as entrepreneurs should take note to watch the emerging mega shift closely, and explore RMB fund initiative seriously. A number of investors said they were preparing for independent RMB funds after the law was put into effect, including Beijing-based DT Capital and iD TechVentures Inc, formerly known as Acer Technology Ventures.
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Flow of VC funds and Investment
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