Angel investors rise in China

When lashou.com, a Chinese group-purchasing website, announced in April that it had raised $110 million in Series C financing, it was cause for the venture capital industry to be very afraid or very excited -- or perhaps a bit of both. Despite a corporate history stretching back barely 12 months, Lashou had managed to go through three rounds of financing, raising a total of $166 million from the likes of Milestone Capital and an affiliate of luxury goods company Richemont. Some GPs say it takes them 6-8 months to complete the due diligence for just one round. In light of this, Lashou was accused of falsifying its prices in order to exaggerate discounts just six weeks later.

Yet, the risks attached to this investment go beyond allegations of management malpractice. While Groupon, the US group-purchasing site upon which Lashou is modeled, saw little competition early on, allowing it to build brand momentum, there are around 3,000 Chinese equivalents and they all entered the market around the same time. Competition is cut-price – or zero-margin –  and much of the business is off-line as sales staff hit the road in search of deals.

A period of consolidation is inevitable and if the industry is to have a future in China and it is difficult to say whether Lashou or another provider will prevail. Yet according to Tony Luh, founding managing partner at DFJ DragonFund China, 300 group-purchasing sites have received backing from venture capital firms and angel investors. Does this demonstrate the potential of early-stage deals or are investors wading blindly into a market they don’t understand?

Back to basics

Certainly, an increasing number of venture capitalists are seeking refuge in the start-up space where they originally made their names. These tend to be companies that pioneered China technology investments in the last decade. They managed to raise larger funds on the back of strong track records and subsequently moved into growth capital. But the explosion of interest in this area, particularly from renminbi-denominated funds has prompted a re-think. Total growth capital investment reached $7.1 billion in 2010, up 21% from 2008, while pre-IPO deals rose 238% to $7.8 billion. Early-stage deals fell 61% to $1.4 billion over the same period, according to AVCJ research.

“Early-stage investing has come back in vogue in the last 6-9 months,” Richard Hsu, managing director of Intel Capital China, tells AVCJ. “For the last couple of years the market has been driven by growth-stage companies and pre-IPO. Prices are getting forced up and the market is overcrowded. Investors are looking for better value and shifting to early stage.”

Sequoia Capital is an interesting example. The firm raised $200 million in 2005 for its first China fund and AVCJ research has records of 12 investments, nine of which were in tech-focused companies. Based on transaction values for 11 of the 12 (one wasn’t disclosed), average deal size was $12.5 million. A year later Sequoia launched a $500 million growth fund. AVCJ has 10 recorded deals and the average transaction size for the nine disclosed was $67.2 million. Just one of the companies was tech-related; the others covered energy, real estate, pharmaceuticals, retail, financial services and luxury goods trading.

Sequoia’s latest growth fund, announced last year, has a wider remit – from start-ups to growth capital deals – and the firm now runs specific venture funds as well. This doesn’t necessarily indicate a retrenchment, but Sequoia has a bigger name and greater resources than many of its counterparts.

Inflated valuations

For all the comfort that scaling back on growth capital might bring, the fact remains that Lashou is just one of a number of very expensive early-stage tech investments in China. Kai-Fu Lee, chairman and CEO of Innovation Works, a Beijing-based incubator fund, remains convinced by the nascency of China’s internet story, and its altering form due to a rise in mobile usage and online spending from a very low base. Speaking at AVCJ’s China forum in May, Lee blamed pockets of overvaluation on US-based analysts failing to understand China and instinctively placing a premium on companies that appear to be versions of business models that work in North America.

But the success of Chinese tech listings on US exchanges has raised entrepreneurs’ expectations across the board. In some cases, terms sheets have already been signed when company founders call up investors with a view to renegotiating the price. Consequently, venture capital firms are pushing to close deals earlier and earlier, which may explain how Lashou managed to squeeze three rounds of funding into 12 months. “Previously deals were closing in 4-5 months,” Harry Man, a partner at Matrix Partners China, tells AVCJ. “Now people will to do it in two months and sign off before the offshore structure has been finalized.”
With some of the tech stocks that saw such successful trading debuts now languishing below their IPO prices, the bubble might be deflating. Hsu draws comparisons with Silicon Valley in 2000: as growth-stage funding became highly competitive, venture capital firms retreated to Series-A funding and the high prices followed, but ultimately the market righted itself. Other GPs warn that this will take time to filter through to the entrepreneurs.

The consensus view of the VC panel at AVCJ’s China summit was that the best strategy is to look at long-term growth prospects rather than heady forward price-to-earnings ratios. Focus on a small number of sectors – cleantech and life sciences are popular, as are certain kinds of ecommerce and mobile companies - and specialize in a particular investment phase in order to build up expertise.

Getting smaller

Another option being championed by a number of industry participants is to become even more early stage. This an area traditionally occupied by angel investors, but these are few and far between in China. According to Man, Matrix has in the past year placed less emphasis on the Series C funding, which might fetch $20 million and above, and instead targeted small Series A and B deals, typically priced at $1-$5 million and $5-$10 million, respectively. The firm is also making investments of less than $1 million, well below the threshold for most international funds in China.
“We want to be more in-depth,” Man says. “We want to find the best entrepreneurs before they start out. The hottest deals in the US involve people who are ex-employees of Facebook and Google. We are looking for experienced entrepreneurs who have been directors at places like Tencent and Alibaba Group.”

He adds that this was a strategic move – recognizing where Matrix could realize the most value – rather than a response to an excessively competitive market for larger deals.

Ideas plus capitalh

Lee has much the same objective for Innovation Works, which launched 18 months ago. The former Google vice president recalls seeing 15 people leave the company’s China operations to start their own enterprises; he concluded that he could furnish good ideas with capital and development expertise. The Innovation Works incubator identifies companies or individuals with potential and gets them started. A few go on to receive further funding – pre-Series A, Series A and maybe Series B – and venture capital firms are brought in as companies gathers momentum.
The rationale for Innovation Works’ initial investments was rooted in several trends the team identified: that smart phones and mobile internet would dominate the market; that Android would emerge as the principal system for these devices; and that Google would not win in China. Its first five investments were in an operating system, an app developer tool, an advertising platform, a PC companion platform and an Android app marketplace.

So far, 28 companies have joined the incubator and 11 received subsequent capital injections and are now ready for Series A and B funding. The goal is to have 10 firms backed to the tune of $500 million by this autumn; currently five have attracted $250 million.

Similar initiatives have already taken root in the US, with the likes of Y Combinator, TechStars, 500 Start-ups and Silicon Valley Bank. They offer varying degrees of mentoring but the basic model is as follows: A selection of start-ups each receive a small amount of money in return for a small minority stake; they then move to Silicon Valley for three months of development work, culminating in a demo day for potential third-party investors. TechStars now has a Chinese affiliate called Chinaccelerator, while 500 Start-ups and Silicon Valley Bank recently made their first forays into the country.

“The companies we invest in are still not fundable by most VCs in China. The VCs don’t have enough early-stage interest or the relevant skill sets, and even those that do have set their funds too large,” Lee says.
While US incubators are no doubt a source of inspiration, China presents a different set of challenges and opportunities. It is generally acknowledged that Chinese entrepreneurs require more mentoring than their seasoned American counterparts. At the same time, though, they are cheap to fund – Innovation Works has about 10 times the workforce of Y Combinator.
“In the US it was tough to do hardware as a start-up but in China you can do manufacturing at lower cost,” says Richard Robinson, co-founder of mobile start-up Youlu and a mentor at Chinaccelerator. “On the engineering side we are bringing in guys who can lift four to ten times their weight. They want to be with other guys like that; they want to be part of something; they want to be challenged.”

Creating this environment is not easy. In Silicon Valley, where the path from start-up to public listing is well trodden, tech professionals – talented programmers and serial entrepreneurs – are willing to take leaps of faith. In China, a less mature market, conservatism often prevails, which makes it easier for a growth capital company to recruit staff than a start-up. Here the incubators come into their own, tapping personal networks within the entrepreneur community to assemble teams that offer the technical, legal, marketing and management expertise required to carry companies forward.

Competitive advantages

Very early-stage investing seems to be, in this respect, a defendable territory.  Chinese technology giants have caught on to the advantages of the Intel Capital model, investing in start-up companies that can contribute to wider business needs. The likes of TCL, ZTE and Huawei are setting up formal investment arms, although the most high-profile is Tencent, which has established a $1.5 billion targeting third-party software developers capable of producing applications for its online services. Chinese universities are also getting involved, sponsoring entrepreneurial activities with a view to creating the kind of link that Silicon Valley has with Stanford.
Reassuringly for foreign venture capitalists, the group that isn’t participating is the one responsible for driving them out of growth capital: local renminbi funds. Even the most conservative LPs insist on a five-year-plus-two-year structure for these funds, which effectively prevents GPs from dabbling in start-ups that may take six years to go from initial private funding to initial public offering. They would also struggle to replicate early-stage investors’ ability to match make talent with ideas.
“For them to come into early stage and compete, not only would the fund lifespan have to be much longer, but they would also need new GPs – people with a different mentality,” says Man. 

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• Topics
• Venture
• Greater China
• Media
• Exits
• Dragon Capital Group
• Milestone Capital Partners
• Sequoia Capital