Internal affairs: China VCs and relationship management

Roadstar.ai appeared to tick all the boxes. The two-year-old autonomous driving start-up’s three founders had between them spent time working on similar technologies for Google, Tesla, Apple, Nvidia, and Baidu. In China’s relatively young industry, this combination of overseas experience and an understanding of local language and culture is a prized commodity. Roadstar duly closed a Series A round of $128 million last May. It was said to be China’s largest-ever capital raise in the space.

Now, though, the company finds itself attracting publicity for all the wrong reasons as two of the co-founders publicly denounced the third. CEO Xianqiao Tong and CTO Liang Heng accused Guang Zhou of hiding the code used in car design, taking kickbacks from the fees paid to a financial adviser who worked on the Series A, and faking production data used in a report to the local government. Zhou denied the allegations, but he was still dismissed from all his posts with immediate effect.

The following day events turned again. A letter penned by Roadstar’s investors rebutted the decision to fire Zhou and said the three founders should try to resolve their differences and focus on developing the core business, Chinese media outlet Caijing reported. The episode raises questions as to how GPs should manage their relationships with portfolio company management teams, especially when businesses run into trouble.

“The relationship between Chinese GPs and their portfolio companies should not be like that between investment bankers and their clients, as those are built on a case-by-case basis. In a healthy relationship between the two parties, when the companies are doing well, GPs should leave them alone. When they are in trouble, GPs should step away in a timely manner or find ways to reduce the loss,” says Dayi Sun, a managing director at Jade Invest. “When a company is clearly too hard to turnaround, then the GPs should learn to just let go and focus on finding the next winner in the space.”

Too much, too soon

These issues are not confined to autonomous driving start-ups, but Roadstar is not the only one to be touched by scandal. Last July, JingChi.ai – which has since changed its name to WeRide.ai – was thrown into crisis as one founder, Sining Pan, accused the other, Qing Lü, of faking his signature on a document that installed Lü as legal representative and executive director of the company in place of Pan. Lü later said he won board approval to relieve Pan of his responsibilities through appropriate procedures.

What the two companies have in common is they operate in a red-hot industry and they have raised relatively large sums of money in a short space of time. Less than six months after its founding in 2016, WeRide had secured about $80 million in angel and pre-Series A funding. 

The industry consensus is that detecting and preventing problems before they happen is far more important than handling the post-crisis fall-out. Yet investors have little time to get to know the teams they are backing, while some start-ups are in such demand that due diligence processes might be curtailed. At the same time, these are young founders thrust into a high-stakes game. Roadstar and WeRide are rushing to get their technology out ahead of even more generously funded rivals such as Momenta and Pony.ai.

Once a scandal unfolds, the reputational damage can be disastrous. WeRide has since raised two tranches of Series A funding, adding the likes of artificial intelligence giant SenseTime and Renault, Nissan Motor and Mitsubishi Motors-backed Alliance Ventures to its investor roster alongside a string of financial players. The implications of Roadstar’s more recent difficulties remain to be seen.

“There is a potential worry that once a company is related to a scandal like this, new investors would not want to pile in anymore. This is especially true for renminbi investors who are more sensitive to scandals compared to US dollar investors,” says Sun. Roadstar’s backers include Shenzhen Capital Group, Wu Capital, Yunqi Partners, CMB International Capital, Vision Plus Capital, Morningside Ventures, and Legend Capital.

Industry participants identify two potential red flags GPs should watch out for when conducting due diligence on founders: a lack of people management experience and flat ownership structures. 

“If you look at the Roadstar co-founders’ backgrounds, they are very young and they don’t have much experience managing people in big organizations,” says David Yuan, a founder and managing partner at Redpoint China Ventures, adding that this was one reason why his firm looked at Roadstar but decided not to pursue an investment. While Tong, Heng and Zhou could point to big-name companies on their resumes, none had more than five years of employment history before establishing Roadstar.

The flat ownership issue is less straightforward. According to several sources, the three co-founders have equal shares of Roadstar. Tong might be CEO, but his voting rights are no different to those of Heng and Zhou, who served as CTO and chief scientist, respectively. While in a Western context this might be regarded as a robust structure that ensures alignment of interests, Chinese corporate culture tends towards the cult of personality. A paramount leader is often seen as desirable. 

“This is like a boat without a helmsman and everyone has the right to drive it to any random direction. Founding teams usually need to have a dominant leader that could decide the major strategy of the company,” says Peter Mao, a co-founder of Panda Capital.

People play 

Early-stage investment is often about backing a founder or set of founders just as much as the business idea they are pitching. Indeed, Ron Cao, a founder and managing director at Sky9 Capital, argues this dynamic is more pronounced in China than in the West.

“Management team quality is the most important factor in our investment decisions. Technology and business models come second,” he says. “Unlike in the US, where companies like Google and Yahoo could obtain success mostly driven by their technologies, Chinese companies, especially consumer-facing ones, often times rely on the ability of a strong CEO to lead its growth.”

As such, much rests on having a sound approach to discovering the top talent. It naturally leads venture capital investors to back known quantities from within their own networks, perhaps a serial entrepreneur or a junior executive from a previous portfolio company who has struck out on their own. 

Lei Jun, founder of Hong Kong-listed smart phone brand Xiaomi is a prominent example. After establishing himself in technology circles at software company Kingsoft and by founding online retailer Joyo, Lei conceived a string of start-ups around e-commerce, social networking, and mobile services. Between 2007 and 2013, he collaborated with Morningside Ventures on seven deals and with Qiming Venture Partners on four. They were the first two institutional backers of Xiaomi.

There are countless other similar but lower-profile cases. Lightspeed China was among the first investors in Pinduoduo – a social e-commerce platform that went public in the US last year – in part because James Mi, the VC firm’s founding partner, previously worked with the founder at Google. Meanwhile, Vision Plus Capital might claim to have formalized the networking process through its connection to Alibaba Group. Based in Hangzhou and co-founded by an Alibaba alumnus, the firm is well positioned to back teams once they have left the tech giant to launch new start-ups.

Another approach is simply to incubate. The VC investor helps nurture a company from the outset, which often means it plays a role in building out the team and corporate structure, as well as taking a significant ownership stake from an early stage.

This is only an option for investors that have an incubation mandate. For instance, Legend Star is an incubator owned by Legend Holdings that has invested in more than 200 projects. Sister entity Legend Capital has backed some of these start-ups in later rounds, leveraging existing knowledge and relationships within the group. Meanwhile, Sinovation Ventures was initially an incubator and early-stage investor before broadening its scope to include later rounds.

The apparent advantage of these two approaches is that the “people factor” risk is minimized because investors already know the entrepreneurs well. Nevertheless, there are limitations. In a fast-changing environment like China’s technology sector, it is difficult to stay abreast of all developments and manage professional networks accordingly. Venture capital firms should therefore take steps to institutionalize the talent identification process, to the extent this is indeed possible.

“While relying on industry networks will continue to be the go-to approach for VCs for finding right entrepreneurs, an institutionalized way of talent discovery could improve the efficiency and be one of the development directions going forward for the industry,” says Sky9’s Cao.   

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• Topics
• Greater China
• Early-stage
• Technology
• China
• Venture
• TMT
• Panda Capital
• Redpoint China Ventures
• Jade Alternative Investment Advisors
• Sky9 Capital