China e-commerce: End of the line

For a brief period, it seemed the imitator might surpass the originator. Chinese group buying site Lashou filed for an IPO on NASDAQ in late 2011, barely 18 months after it was founded and a few days after longer-standing US equivalent Groupon went public. Lashou was on a roll, having raised $166 million through three rounds of funding since inception.

By the middle of 2012, the wheels had fallen off. While Groupon saw little competition early on, allowing it to build brand momentum, it is estimated that Lashou's early success spawned around 3,000 domestic clones, many of which received support from VC investors. In a climate of cut-price - or zero-margin - competition, casualties and consolidation were inevitable.

Lashou withdrew its IPO filing last June and is currently in restructuring mode, its long-term future uncertain. Others have already seen their fate sealed. According to the Chinese E-Commerce Research Center, there were less than 2,700 group buying sites in operation at the end of 2012, with 1,000 having shut up shop over the course of the year. A lot of the survivors are a shadow of what they once were - run on a shoestring as they search for new strategies.

Online uncertainty

Group buying is an extreme example of how fortunes have turned in China's e-commerce sector. Venture capital firms poured millions into start-ups that promised to be the next big thing. With the IPO market still weak, investment horizons have lengthened and companies require capital to keep going, but existing backers are often unable or unwilling to support them. If new funding is available it is unlikely to come at the same valuations as previous rounds.

"If you are not a category leader it's much harder," says Hans Tung, Beijing managing partner at Qiming Venture Partners. "People will give top tier companies a chance to see if they can withstand an industry downturn. As for smaller companies, investors focus on how to generate an exit or let firms stay afloat by not expanding."

This explains why 360Buy, one of China's largest online retailers, last week managed to raise $700 million in a Series F round of funding. The company only completed its previous round, of $400 million, in November, taking the total raised from PE backers past $1.5 billion. 360Buy needs capital because it is not yet profitable and expansion comes at a cost, but investors believe it has sufficient scale to remain a market leader and an IPO is mooted for this year.

For those lower down the e-commerce food chain, VC firms might only participate at a discount - a flat round or a down round. This applies to companies even if they have a track record of growth. Entrepreneurs are not the only ones reluctant to see their hard work go unrewarded. Existing VC backers are often loath to see new investors come in at a lower valuation; it doesn't look good to the LPs.

DFJ DragonFund China found itself in such a situation towards the end of last year with Hudong, a wiki platform it had supported through three rounds of funding over a three-year period. "They wanted to do a new round but we felt the time wasn't right," Tony Luh, founding managing partner at DFJ DragonFund, tells AVCJ. "We told management that the company was growing nicely and we would take steps to reduce the burn rate or increase the top and bottom line. Unless a company is in dire need of fresh capital it can usually wait for a while and say no to potential investors."

In the case of Hudong, this meant refining content delivery systems and restructuring the sales force. Luh didn't comment on specific job losses but anecdotal evidence suggests this is happening with gusto in other enterprises.

"The cut backs have been fairly significant," says Thomas Chou, co-chair of Morrison &Foerster's Asia-Pacific private equity practice. "There is a tendency in China to ramp up employee numbers very quickly - certainly more so than in the US - and we are now seeing companies go from 100 head count to barely 20."

Vancl, China's largest online clothing retailer and a Qiming portfolio company, has halved its workforce to 5,000 in the last year after downsizing logistics operations. The firm has been through five rounds of funding, most recently receiving $230 million in June 2011. A US IPO was scheduled for the end of that year but later abandoned due to market volatility.

"Would they like to have more money on the balance sheet? Who wouldn't? Do they need to raise money tomorrow? No. They were cash flow positive in the final quarter of 2012," says Qiming's Tung. "If they did another round, would the valuation be as high as June 2011? We let the market decide. We have a very sensible board."

Vancl opened around 20 warehouses in 2011 with a view to serving tier-two and tier-three cities but decided the move wasn't cost effective because too much inventory was building up in these disparate locations. It has now scaled back to 6-7 core warehouses, hence the job cuts.

The situation presents an interesting parallel to 360Buy, which has devoted much of the capital raised in recent rounds to building out a national logistics network. The company operates 65 warehouses and 900 delivery stations, promising delivery within 24 hours to customers in 156 cities. Alibaba has committed considerable sums to providing a similar service.

The absence of a reliable logistics network is seen as a key differentiator between China and the US. Amazon.com took nine years to achieve profitability with CEO Jeff Bezos repeating the mantra that as long as revenue kept rising costs would eventually max out because the underlying infrastructure was there. Even with rapidly increasing sales, what will it take for Chinese equivalents like 360Buy to reach this milestone if they must build their own infrastructure, not to mention deal with cutthroat domestic competition?

Too big to fail?

The question isn't so much whether a tweaked version of the US e-commerce model can work in China - the sheer market potential, with Boston Consulting Group expecting market value to reach $364 billion by 2015, a threefold increase on 2011, suggests that it can - but how quickly and at what cost? This has a direct impact on which firms VC investors decide to back and the amount of capital they are willing to commit.

"A lot of people expected a similar development path to the US where as soon as you have a certain scale you are profitable and valuable," says Ludvig Nilsson, managing director at China-focused fund-of-funds Jade Invest. "But in China you have to be a lot larger - 10 million users isn't enough."

According to Morrison &Foerster's Chou, clients have begun asking about wipeouts and pay-to-play provisions, vocabulary familiar to Silicon Valley VC players but new to China. At present, there is still more talk than action, but one option that is actively being explored is bridge financing.

Qiming has around 80 portfolio companies and Tung estimates that the number down rounds is in the "low single digits," while a few more portfolio companies have accepted bridge loans. Capital is extended to a company on the understanding that it will eventually convert to equity at a lower valuation to the previous round of funding or at a discount to the next round. This approach means the GP avoids having to do a down round - either internally or by bringing in new investors - yet puts in the capital required on terms that could turn out to be lucrative if the company continues to grow.

Obtaining debt externally, while generally challenging, is not impossible. It also tends to be structured as bridge loans in return for hugely diluted equity or warrants. Industry participants claim to have seen plenty of these deals in the market over the last year - typically offered by managers of renminbi-denominated funds or more informal capital providers - but they don't always close, presumably because the terms are so stringent.

Rocky Lee, Asia managing partner at Cadwalader, describes it as "vulture capital" because the lenders might have ulterior motives. "The suspicion is that there is already a deal in place with a third party for a set price," he says. "They will do a $2-3 million bridge loan, use the assets as collateral and lock up the management team for 1-2 years, with a view to picking up the assets on the cheap. The owners are basically taking a bet on their survival."

In some instances, prospective buyers don't bother with a stalking horse. Certain Chinese internet companies have been known to approach smaller players under the pretence that they are in acquisitive mode. They conduct due diligence on the target, extract proprietary information and submit a lowball offer that is likely to be rejected. The companies then return with headhunters and hire away the talent or use the information to set up competing operations.

"The bigger guys have a lot of tricks up their sleeve," says DFJ DragonFund'sLuh. "They do a lot of things that would be deemed illegal if they were operating in the US."

Even in transparent negotiations, it remains a buyer's market and this creates an obstacle to getting transactions done. Those who have worked on failed deals note that, even though sellers' expectations have moderated, strategic buyers still come in with valuations that are too low or seek to impose performance targets that are too high, while CEOs who run their companies more like family businesses than corporations resist selling for personal reasons.

Cadwalader's Lee adds that prospective buyers from the Japan and the US have become reluctant to engage in M&A. For the Japanese, the ongoing territorial dispute over islands in the South China Sea is a deterrent. For the Americans, there were concerns that acquisitions made close to last November's presidential election would become political footballs. Cadwalader worked on several deals where the buyers were nervous about being accused of exporting jobs to China.

Nevertheless, there have been some acquisitions and industry participants expect to see more as portfolio companies struggle to raise more capital and existing investors become increasingly desperate for an exit, perhaps because their funds have little time left to run.

Last year, DFJ DragonFund was mulling its options regarding Fastweb, a cloud-based content delivery network that required additional capital. While a fresh round of funding was considered, the company was ultimately sold in September to NASDAQ-listed 21Vianet Group, a Chinese internet data services provider that had previously expressed an interest in buying the business. Luh describes the valuation as "not what we would have liked, but acceptable."

Around the same time, Suning Appliance, China's largest electronics retailer, acquired online baby products platform Redbaby for $66 million, less than the total capital pumped into the business by VC investors across five rounds of funding over seven years. Redbaby had seen its market share collapse under pressure from larger rivals and was reportedly close to folding.

Other e-commerce companies have been bought up while on the brink of bankruptcy, but Qiming's Tung is pessimistic about domestic M&A prospects for the next 12 months because likely buyers aren't particularly acquisitive, at least not yet. He sees Suning as an outlier whose online strategy isn't being replicated by other bricks-and-mortar retailers, while larger e-commerce players such as 360Buy and Vancl must go public to get balance sheet cash for M&A. Elsewhere, the focus is on mobile, online video and gaming.

"With online video, M&A means you can consolidate bandwidth and content acquisition costs. With gaming, you are pumping content into established distribution channels," says Tung. "E-commerce is all about back-end integration, which is much harder and messier. It doesn't make sense to buy your competitors so companies will just be cut loose."

Callow youths

The key point is that an atrophying e-commerce industry doesn't necessarily reflect the wider internet sector where opportunities remain. Even within e-commerce, those with a differentiated business model can prevail. The casualties tend to be copycats that have neither sufficient scale to create barriers to entry nor consumer loyalty. Customer acquisition comes at a cost and investors are no longer willing to pick up the tab.

Another characteristic of the Chinese market that comes into the equation is its youth. For most entrepreneurs, life was a series of ever escalating valuations that outstripped rising operational costs. They haven't seen a downturn before and so board meetings become uncomfortable and contentious as interested parties try to make the best of a bad lot.

"In some circumstances there is a traumatizing discussion over valuations," says Cadwalader's Lee. "Entrepreneurs are shell-shocked. The young generation of start-up enthusiasts is also shell-shocked. It used to be that if they didn't get a pay rise they would just get a new job; now they aren't getting their Chinese New Year bonuses and those who lose their jobs cannot find new ones. This is as serious as the bubble bursting in Silicon Valley in 2001."

Confronted with down rounds, flat rounds, bridge loans or mergers, the real danger is doing nothing at all in the face of deteriorating growth. It is possible for firms to go into hibernation, shedding staff and cutting costs in the hope that the market will turn a corner when all the time a sustainable future is slipping from their grasp.

"You have an everlasting sense of deniability from the founders that their companies cannot fail. You don't have sellers lining up with real expectations that they need to merge to get to the next level," says Bob Partridge, China transactions and services partner at Ernst & Young. "That is changing and it will continue to change as they become more cash strapped."

SIDEBAR: Recap options - Global norms

When additional financing cannot be raised through its existing capital structure, VC investors must recapitalize their portfolio company to facilitate the entry of new backers. How this is done impacts the liquidation preferences, valuation differentials and priorities held by the various investors, which in turn dictate exit timing and size of returns.

1) Valuation reset: Previously issued preferred stock is restructured into a new series, with the number of shares issued to each investor based on the amount paid originally, and a new round of funding is raised. Valuation differentials between rounds are therefore removed, but liquidation preferences and priorities are retained.

2) Flattening: The stock is consolidated into a single series, removing valuation differentials and priorities but retaining liquidation preferences.

3) Preference reset: Liquidation preferences of previously issued stock are reduced and a new round is raised, with no consolidation of earlier rounds.

4) Preference and valuation reset: A combination of 1 and 3, with priorities retained.

5) Wipeout: Previously issued preferred stock converts into common stock, removing liquidation preferences and priorities; retaining valuation differentials is optional.

6) Pay-to-play: The recapitalization is structured so that existing investors are incentivized to participate in the new financing. Under pay-to-play, if an investor sits, they lose liquidation preferences, priorities and valuation differentials. Non-participation penalties include conversion of preferred stock to common stock (no rights) or shadow preferred stock (board seats, blocking vote right, pre-emptive rights or anti-dilution protection might be removed).

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• Topics
• Venture
• Technology
• Greater China
• Expansion
• Early-stage
• Financing
• TMT
• China
• Venture
• Growth capital
• Qiming Venture Partners
• Draper Fisher Jurvetson
• Distress