China angels: Divine intervention

Lei Jun is a classic product of the virtuous cycle in Chinese technology. Having started out as an employee at software developer Kingsoft Holdings, he became an angel investor, then an entrepreneur, and finally a venture capitalist. 

Lei spent 20 years at Kingsoft, 10 of them as CEO, and stepped down in 2007, shortly after taking the company public in Hong Kong. This signaled the start of the angel phase and a focus on three themes he thought likely to drive the next generation of internet start-ups: e-commerce, social networking and mobile. Early targets included social networking site YY, clothing retailer Vancl, and mobile browser UCWeb. YY listed in the US, while UCWeb was acquired by Alibaba Group.

Industry participants say Lei has an innate ability to spot companies with potential. He is also known for concentrating on industries he understands and working alongside entrepreneurs he knows well. "If you work with Lei Jun, you know he has strong opinions on product development and business strategy. Even if he doesn't have a majority stake, he has strong views that may differ from those of the entrepreneur," one early-stage investor says. "But I think he has changed a bit in recent years."

Growth-stage VC firms like to work with Lei, providing financing to start-ups he has seeded. But the man himself has described angel investing as merely a hobby. In 2009, he founded smart phone brand Xiaomi, which has since become one of the world's most sought-after start-ups with a valuation of $45 billion in its most recent round of funding. Lei's angel activity has been replaced by an institutional platform, Shunwei Capital Partners. The firm recently raised $1 billion for its third US dollar fund.

Six years ago, before the likes of Xiaomi broke through, there were only a handful of sophisticated angel investors in China - among them, Xu Xiaoping, Cai Wensheng and Xue Manzi, as well as Lei. But their success has helped propel the market to new heights. At one end of the spectrum, entrepreneurs, cash rich from exiting their initial ventures, are putting money back to the ecosystem; at the other, investors with no tech background are flocking into the space, drawn by the ever-rising valuations.

In an industry awash with capital, individual angel investors, angel funds operated by groups of friends and seed funds are looking for deals. Some have reached a level of maturity comparable to Shunwei and are managing third-party capital, coming up against the traditional VC firms. It is as if everyone wants to be an entrepreneur and every entrepreneur wants to become an investor. But what happens when the bull market turns?

"People who have a technology background should be more suitable candidates to be angel investors, given their wide networks and the industry experience they can bring to the start-ups," says Tuck Lye Koh, who set up Shunwei with Lei and now serves as CEO. "It's very difficult to be a good angel investor. Only few of them can become fully institutionalized and stand out in the market."

Origin of the species

The evolution of China's angel ecosystem differs from the US in that the first generation of internet entrepreneurs did not turn their companies over to professional management and focus on nurturing a new wave of start-ups. The founders of Alibaba, Tencent Holdings and Baidu (the BAT) remain at the helm of their companies, building them into even bigger behemoths.

Rather, it is the second generation - founders who worked at those first-generation companies before striking out on their own and setting up businesses in industry verticals around the BAT - that have kick-started the virtuous cycle. Using stock options or the proceeds of selling their businesses to the BAT, these entrepreneurs are now providing capital and expertise to a third generation.

Joe Wu is one of them. He was CEO of Chinese Android app marketplace 91 Wireless until the company was purchased by Baidu for $1.85 billion two years ago. Since then Wu has become an active angel investor, backing start-ups such as Hong Kong logistics service GoGoVan.

There are thousands of executives still with established internet firms that want to make angel investments on the side, while thousands more have on industry expertise to call upon but want to participate anyway. Amateur investors might only write three to four checks per year, but the more active angels are known to back 20-25 different start-ups.

More than 2,500 angel funds and incubators have formed in the last two years, many run by investors who call upon friends or traditional VC firms for capital. Shaw Wang, co-founder of Baidu, left his position in 2011 and set up Unity Ventures with few other tech professionals. Crystal Stream Capital was founded in 2013 and raised a $100 million fund from the likes of ex-Qunar CEO Chenchao Zhuang and Hillhouse Capital. It is managed by former Baidu executive Mengqiu Wang. There is also Rice Bank Capital, which was set up by several former Alibaba workmates.

It helps that the costs are low. The government is willing to waive property rental fees in order to support incubators and then it is relatively easy to back a start-up without committing too much money. No wonder some industry participants think the angel community is becoming as overpopulated as its VC counterpart. William Bao Bean, an investment partner at SOS Ventures and managing director of Chinaccelerator, notes that valuations for angel-stage companies has gone up 4x in the last 18 months, with pre-money valuations soaring from $500,000 to an average of $2 million.

"In the past there were very few early-stage investors and there was no such thing as a pre-Series A round. The average Series A investment in China was about $10 million and it was almost impossible for start-ups to raise $2-4 million before Series A. There was a hole in the market, but now it has been filled. We are seeing later-stage funds coming down to do the pre-A rounds, spraying money all over the place. That has also helped drive up valuations," Bean explains.

Demanding stakeholders

It is difficult to gauge the full extent of angel activity in China, largely due to a lack of transparency. In the US it is common for a handful to as many as 20 angels to team up and invest in a company, each one writing a relatively small check. China relies on friends' referrals and so it is not unusual to find a small number of angels concentrating their capital on a relatively narrow selection of companies and making follow-on investments. Investor mentality is also different. Whereas in Silicon Valley angels invest in business plans, in China they are backing teams. If one start-up doesn't work out, they will support the same entrepreneur on his next initiative.

As a result of these dynamics, Chinese angels tend to want a higher degree of operational influence start-ups. The line between investor and entrepreneur is blurred as they try to impose their own ideas as to what the companies are going to be. "It can be very good if the person has the right idea. But investors in the West usually don't tell entrepreneurs what to do," Bean notes.

In this context, some Chinese angel investors pursue strict economic terms that would be seen as unfair by many in Western start-up communities. They may demand 30-40% of the total equity in an angel round and insist on liquidation preferences that guarantee a certain level of return. Founders that are unfamiliar with Western norms - or are so desperate for capital they agree to almost any terms - often simply go along with it.

"However, with more angel investors entering the market, founders have a wider variety of options and they can negotiate favorable terms. If you only have one term sheet then you will accept it. But if you have five term sheets, and three of them have restricted terms and two are a bit fairer, you can pick one of the fairer ones," says Chris Evdemon, a Silicon Valley-based partner at Innovation Works, which makes early-stage investments in China.

Another characteristic of local angel funds is the absence of sustainable structures; founders receive inconsistent messages and within the funds themselves team volatility is rife. For example, one of the co-founders of Rice Bank Capital is understood to be about to leave the firm.

"Many of these angel funds are not so institutionalized. Everyone thinks it is a pretty easy game but once they get into early-stage deals they realize it's a tiring and challenging business," says one VC investor. "Once you've spent all your $100-$200 million in capital from friends and family, what are you going to do? It won't really impact the portfolio companies - if they are doing well they can raise capital from traditional VCs - but for angel funds there is uncertainty. It all depends on whether the firm wants to be a one-time fund manager or a repeat manager."

Long-term game

The line between angel and early-stage venture capital is becoming blurred as technological advances enable a greenfield idea to crystallize into a functional start-up within a condensed timeframe. This means early-stage investors are likely to participate in everything from angel and seed to Series A rounds.

"About 20 years ago, the time it took for a US start-up to reach a Series A round was actually quite long, perhaps 1-2 years after the angel round. With mobile technology, start-ups can change dramatically in the space of 2-3 weeks," says Peng Cheng, managing director at TusPark Ventures, an early-stage VC firm under Tsinghua University. "We want to position ourselves as an early-stage investor. One defining point is that we back start-ups that have completed commercial registration, so they have actual business activity."

Investors adopting institutionalized structures - funds with a formal lifespan, a clear delineation between GP and LP, and so on - also gravitate towards the early-stage where companies are more proven.

When Andrew Teoh, who previously led corporate finance and corporate development in Alibaba, founded Ameba Capital with the former CFO of Kingsoft, he wanted to be the first institutionalized investor in start-ups. Ameba raised $25 million for its debut fund, and closed its second vehicle three months ago. Apart from renminbi fund-of-funds, the LP base includes entrepreneurs previously backed by the GP. They have sold their businesses but retain ties with Ameba and Fund II is likely to fund these entrepreneurs' next generation of start-ups.

"I am from an institutional background managing money. When I was at Alibaba I also invested in other funds. I think if you want to build a long-term brand, you have to be institutionalized," says Teoh. "Early-stage investment is very risky. For me, the larger the number of people involved in the round the better, because I can get more help from other investors."

Much like Lei Jun with Shunwei, Xu Xiaoping, who co-founded US-listed New Oriental Education, is following an institutionalized path through ZhenFund. The firm has about $230 million in assets under management: three US dollar funds and three parallel renminbi funds; Xu and Sequoia Capital were the sole LPs in the first two renminbi and dollar vehicles.

Since 2011, the vast majority of deals have involved ZhenFund rather than Xu deploying his personal capital. While he remains the largest LP, Fund III saw participation from international groups such as family offices and VC fund-of-funds Horsely Bridge Partners. Meanwhile, Tencent and Gopher Asset Management are among the investors in the third renminbi vehicle.

"We differ from incubator and accelerators in that we don't support companies in batches, so there is no routine start-up program. Furthermore, we don't provide space and our check sizes are much bigger. On average we invest between $300,000 and $1 million per deal at the seed stage, but a lot of seed funds only put in $200,000-300, 000," says Anna Fang, partner and CEO at ZhenFund. "We are more like a micro VC fund that provides a lot of portfolio services to companies, including hiring staff, marketing, and legal and financial advisory services."

In order to generate deal flow, Fang stresses the importance of cultivating a differentiated image within the start-up community. ZhenFund receives 300 emails per day from entrepreneurs that want funding for their businesses.

Innovation Works, which was set up by ex-Google China head Kaifu Lee in 2009 as an early-stage incubation and seed capital provider, has also developed its business model. A group of 10-15 founders backed by the firm have exited their ventures in the last six years and become angel investors. In order to tap into this group's networks, Innovation Works raises side funds that invest alongside these entrepreneurs. The incubation program has been discontinued.

"These angel investors' deal flows are very interesting for us. They invest in businesses they understand and we prefer to participate from the seed round. When angel investors stop there, we can continue through the Series A. It is all about co-investing but not just observing and investing in the follow-up rounds. I think angel investors like that too; they like us to put money to work alongside them," says Evdemon.

A matter of liquidity

In the past, angel investors backed start-ups all the way through to IPO, but with valuations often now so high in the Series B and C rounds, early-stage investors have more exit opportunities. There are plenty of growth-stage VC firms willing to buy their positions, although other investors are getting involved as well as moving early becomes a theme all the way along the VC value chain. Mutual funds and hedge funds are just as likely to seek out pre-IPO investments.

The liquidity events the greater the amount of capital pumped back into the angel ecosystem - and in this way the virtuous cycle is sustained. The phenomenon sounds great in theory but it only works in practice as long as the market continues to perform. Should the valuation bubble in the tech sector burst or deflate, suddenly the "amateur" investors flooding into the space will lose their appetite and start-ups will suffer. It is only then that they we will know whether the more institutional players have staying power.

"Right now valuations are very expensive and many start-ups are easily raising a lot of money," says SOS Ventures' Bean. "When the market corrects, a lot of companies will be unable to raise again and die. And valuations will go back down."

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• Topics
• Greater China
• Early-stage
• Fundraising
• Technology
• Venture
• China
• seed
• Shunwei Capital Partners
• ZhenFund
• Fundraising
• TMT
• Venture
• Innovation Works
• SOS Ventures