China tech down rounds: Down and out?

For the first time in 13 years, Apple has posted a year-on-year decline in quarterly revenue - and China is in a large part to blame. The 13% decline in the first three months of 2015 included a 26% slump in Greater China. Are these difficulties Apple's alone, or do they reflect a broader malaise in domestic smart phone demand?

The question is particularly pertinent for Xiaomi, the largest player in the Chinese market ahead of fellow homegrown brand Huawei Technologies and Apple, and a PE darling.

Founded just six years ago, the company's growth has been meteoric, fueled by numerous rounds of equity funding from VC and PE firms. The most recent of these closed at $1.1 billion in late 2014, valuing Xiaomi at $45 billion. Despite concerted efforts at diversification, 90% of the company's shipments are within mainland China. And having targeted smart phone sales of 80-100 million in March of last year, the overall total for 2015 came in at around 70 million.

With uncertainty about the start-up's ability to maintain its stellar growth, numerous industry sources claim that valuations of Xiaomi shares in the secondary market have plummeted. However, the company has not been forced to raise money at a lower valuation to meet its capital needs. Xiaomi was able to eschew equity funding for debt financing, thereby avoiding the perceived ignominy of a down round.

Many start-ups globally must face this kind of reckoning, although perhaps not with the same outcome. On the back of the technology boom, the last two years have seen a proliferation in unicorns - privately-held technology-related companies worth $1 billion or more - as investors have piled into late-stage round at ever higher valuations. A series of markdowns and down rounds in the US suggest the exuberance has faded, but China has yet to see much of the same. Is it only a matter of time?

"In China a few companies are closing down, but there aren't many down rounds," says J.P. Gan, managing partner at Qiming Venture Partners, an early investor in Xiaomi. "Chinese entrepreneurs would do almost anything to avoid a down round, whether that means delaying new rounds of funding or cutting costs. And some of them have raised a lot of money in the past, so they don't need any more for now."

Behind the numbers

The overall venture capital investment environment has cooled, with later-stage activity chiefly responsible. Law firm Cooley handled 135 disclosed VC deals totaling more than $3.1 billion of invested capital globally in the first quarter, down 15% and 12%, respectively from the last three months of 2015. Series A deals accounted for nearly half of transactions, the highest level in over a year, while median pre-money valuations increased at both the Series A and C stages, but declined for Series B and D and above.

AVCJ Research's numbers for China alone show a similar picture. Venture capital investment came to $2.3 billion in the first quarter of 2016, marginally up on the previous quarter. Transaction volume was also more or less the same. However, growth-stage deals in the computer-related, IT and media industries amounted to $2.3 billion, down from $5.2 billion in the previous quarter.

Deals are also taking longer to get done. Transaction practitioners note that ordinarily it might take about two weeks for a term sheet to be completed, but now negotiations are lasting two months or more. At the same time, more term sheets are going unsigned as investors walk away due to market uncertainty.

"The market correction will be pass through the value chain - it will start from the publicly-listed tech companies and filtering through to private round valuations. There are very few cases of down rounds or flat rounds at the growth stage right now, so early-stage companies are still enjoying high valuations," says David Wei, founding managing partner at Vision Knight Capital. "But down rounds will eventually happen across the board."

Those losing out tend to be online-to-offline (O2O) services players in segments such as car maintenance and home delivery - typically companies that are burning through cash to build market share against strong entrenched competition. Some are not even getting flat or down rounds, but simply shutting down.

Meanwhile, there is a clutch of high-quality companies - often with large strategic backers whose presence makes outside investors comfortable - that raise substantial sums at high valuations. There have been four growth rounds in excess of $1 billion for IT-related Chinese businesses since the start of the year and three of them are affiliates of leading internet players: JD.com's finance platform and Alibaba-linked Cainiao Network Technology and Ant Financial. The fourth, food-ordering platform Ele.me, got its capital from Alibaba and Ant Financial.

Xiaomi was able to raise debt financing rather than do a down round because it is a large company with substantial assets and cash flow. Most start-ups have yet to turn a profit so this is not an option. Traditional banks are unlikely to lend money to them, while venture debt - providing loans to start-ups without equity dilution - is still at an early stage in China. Many are therefore resorting to "dirty term sheets."

"In a dirty term sheet, it looks like the valuation is slightly up, but the terms have a lot of conditions attached which would be triggered if the company cannot achieve certain performance criteria," says James Lu, a partner at Cooley who has seen fewer down rounds in the China than the US, but a number of dirty term sheets. "For a lot of companies and existing investors, this is worse than a down round, because all future financing will become very complicated."

First of all, if an investor is uncertain about a start-up's prospects it could split the deal into several tranches. Rather than committing $10 million up front, there will be an initial $5 million payment, followed by $2.5 million when the company turns profitable. The final $2.5 million is conditional on the achievement of certain milestones. If the targets are not hit, the investor can re-adjust the valuation of the round, perhaps turning it into a down round.

Another favored term is the full ratchet anti-dilution protection. If a start-up subsequently issues shares at a lower price than the round in which an investor participated, the investor has the option of retroactively reducing the price of the previous round to ensure parity. The rebalancing is comes about by issuing more shares to the investor in compensation, usually by converting preferred shares to common stock at a higher ratio.

Other forms of investor protection focus on liquidation events. For instance, guaranteed return clauses entitle an investor to additional shares in an IPO if the price of the public offering doesn't meet a pre-agreed premium to the price at which the investor entered. Similarly, liquidation preference rights mean certain investors can get paid before anyone else in the event of an M&A exit.

Whenever an investor gets additional shares they come at the expense of existing stockholders whose positions are diluted. In China, dilution tends to be concentrated on the founder. "If a founder made the most of the overheated valuations before, it's the time for them to pay the price. Previously, they could raise money at high valuations with only minimal share dilution. Now there is more balance. They need to dilute more to raise a little money, which is fair," Vision Knight's Wei says.

Anything but

Rather than accept these "dirty terms," which make the future valuation of their holdings difficult to calculate, founders could simply raise a clean down round. However, this process is complicated by multiple vested interests and conflicts often prevent actual implementation.

If new investors offer unattractive terms, existing backers could use their preferred right to block the financing round. On the other hand, new investors could only agree to participate in a down round if pay-to-play clauses are triggered, which means the existing backers would have to commit additional capital alongside them on a pro rata basis. Existing investors that refuse to contribute capital would see their preferred shares converted into ordinary shares or at least heavily diluted.

New investors argue that a pay-to-play is necessary because of the turnaround risk they face. The standard retort from existing investors that don't want to comply is the terms do not acknowledge the significant sums they have historically invested in the company and the early-stage risk they took.

"While the new capital infusion may be in the best interest of the company in its fight for survival, the terms may be too bitter of a pill for the existing investors to swallow, resulting in a stalemate. To make things worse, these conflicts often have to be negotiated at a time when the company is desperately short on cash and trying to meet minimal operational requirements, such as making payroll for its employees," says Thomas Chou, a partner at Morrison & Foerster.

The negative stigma attached to a down round should not be underestimated. Many Chinese founders have never experienced a difficult fundraising environment and so they see a down round as a failure. VC investors are also potentially subject to emotional bias, especially for those sitting on strong paper gains for a handful of unicorns. If they are in the process of raising a new fund, writing down valuations of existing portfolio companies could eat into overall fund performance and discourage LPs.

In this context, a preferred option might be to raise an extended round instead of a down round and save face. Capital is raised at flat valuations or at a small premium for the company. M&A is another solution, with the merger last year O2O services platforms Meituan and Dianping a case in point. Meituan was struggling to raise capital at a higher valuation than its previous round, so existing shareholders suggested that it join forces with Dianping.

The deal meant that the two companies, as the single dominant player in the market, would no longer consume so much cash fighting one another. M&A can also facilitate cost-cutting through redundancies if certain employees are performing duplicate functions. Meituan-Dianping subsequently raised a round of funding at a higher valuation than their combined worth when operating as independent entities.

However, this approach is not necessarily sustainable. On one hand, not all entrepreneurs welcome mergers, particularly if they are essentially being acquired. On the other, cutting costs to generate positive cash flow can be easier said than done. For example, existing investors might want a company to pursue an aggressive growth strategy ahead of an IPO or trade sale.

Over the last two years, GPs such as DCM Ventures, Banyan Capital, Shunwei Capital Partners and GGV Capital have raised sidecar vehicles, or top-up funds in order to continue investing in existing portfolio companies as they raise ever larger private rounds. These funds can also serve a purpose in a difficult investment environment. According to industry participants, in the US top-up funds have been used to provide flat rounds for portfolio companies that might otherwise have to raise down rounds if new investors come in.

This is a means of preserving paper gains, but it is no long-term solution; GPs need other investors to share the risk. Moreover, such moves arguably go against what top-up funds are meant to do, which is support winners rather than minimize the number of losers. The counterpoint is these companies might be fundamentally strong and are worth supporting until market conditions become more favorable.

"We have a top-up fund to support the companies we like and we think they can grow fast. Instead of passing these companies to someone else, we want to maintain or increase our ownership in the companies. We aren't worried there is a flat round, up round or down round. The price of the new round raised by [our existing portfolio companies] should reflect what the market is willing to pay," says Hans Tung, managing partner at GGV Capital.

The chaos to come

Down rounds are expected to escalate in the US. One industry participant notes that companies are in cash conservation mode right now, but about 60% of the current crop of unicorns will need to raise money or go public towards the end of this year or in early 2017. China may well find itself in a similar position, if the private secondary market is anything to go by. Existing shareholders and employees - and not only in Xiaomi - are said to be offering stock to family offices at huge discounts.

"The problem now is that a lot of highly-valued companies have the mentality of staying private as long as possible. But if they don't have public liquidity, they will never know what their real valuation is. Public stocks are always up and down, so in the VC world it can't be always up. We have to get used to valuation fluctuations," says Cooley's Lu. "The US is a more mature market and when there is a down round, it's probably easier for people to face up to it. In China, it might be tougher to swallow."

Others, including Qiming's Gan, suggest the scale of down rounds will be less smaller in China due to the different types of investors participating in later-stage deals. In the US, mutual funds are very active in this space and many have now pulled back. By contrast, in China the principal actors are private equity, high net worth individuals (HNWI), and A-share companies. First, HNWI demand still seems to be strong, which should prop up valuations. Second, some of the institutional players are more willing to support companies over a longer period.

All-Star Investments would fall into the latter category. An existing investor in Xiaomi and vacation rentals platform Tujia, it classifies itself as a hedge fund with late-stage private equity exposure. Richard Ji, the firm's founding partner, says he is happy to stay invested even after companies have accessed the capital markets.

"We take advantage of the price movement. So we want to invest at the reasonable valuation - ideally with significant discounts relative to the company's growth outlook - and help create value," he explains. "Unlike other PE funds, which usually make an exit in an IPO, we don't need to sell shares in a public offering. We can hold all the way after the IPO and we can invest cross-over both in private and public markets."

One often-overlooked factor during this market transition is that as start-ups stay under private ownership for longer, the input they require from investors changes. Whereas at an early stage the priority might be finding a top-class engineer, once these companies achieve a certain scale they have to address standard growth challenges: eking out operational efficiencies to save costs, entering new markets, and exploring M&A opportunities. The onus is on investors to contribute in these areas.

"When a company grows to a later-stage, they're looking for business partnerships and access to public markets. As a late-stage investor, we should bring different values compared to the early stages," Ji adds. "Our team was involved in many IPOs at Morgan Stanley and we can also help form partnerships by leveraging our investor base. Many of our LPs are industry leaders."

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• Topics
• Greater China
• Venture
• Technology
• Expansion
• TMT
• Xiaomi
• China
• Qiming Venture Partners
• All-Star Investments
• Vision Knight Capital
• GGV Capital