China's tech start-up sector is big on cash but short on experience

Over-incubated?

China's tech start-up sector is big on cash but short on experience

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Shao Qizhe, a 28-year-old University of Southern California graduate, didn't stop starting companies after his first failure.

Shao said his first startup suffered from basic problems during its roll-out “involving every aspect of the company, and the staff wasn't motivated.” Last March, he launched his second: A B2C e-commerce platform that only orders and sells products that consumers recommend. Whether it succeeds or not, Shao already has much in common with other Chinese entrepreneurs. 

"Entrepreneurship is not a privilege of a small number of people but the choice of many." Those inspirational words came from Chinese Prime Minister Li Keqiang last May when he visited Beijing’s Zhongguancun, a hub of technology and Internet firms in the capital often referred to as "China’s Silicon Valley".

It seemed like the timing could not have been better for the launch of an Internet startup in China. A day before the Li’s tour, the State Administration of Taxation urged local tax authorities to properly implement tax relief measures for startups, echoing the central government’s vow to unleash China's potential for technological innovation. In addition to the government’s strategic decision to embrace an Internet-service economy, both local and foreign venture capital firms are pouring money into the startup industry.

China seed and startup tech investments rose to $2 billion in 2014 from $946 million in 2013, according to Hong Kong-based AVCJ Research. In the first quarter of 2015, according to Dow Jones VentureSource, the number of deals increased to 215, up 56% from the same period last year.

Quantity may have risen, but quality remains in question: It is only when the current funding frenzy leads to real firms with real products that the growth of startups will become a boon for China’s otherwise sagging economy. As investors clamor to shower entrepreneurs with millions or billions in pursuit of trillions in profit, the main challenge facing China's early-stage startups is no longer access to funding. It's getting their business off the ground.

Dealmakers, dealbreakers

For an early-stage company to grow into a fully fledged firm, it needs to scale up, with rapid growth in revenue, market access and staff. To achieve that, every young startup requires knowledge of business development, marketing and hiring to bring its creative ideas to fruition--a business model that can generate repeat business for the company. During this entrepreneurial adolescence small firms can benefit greatly from the guidance and mentorship of venture capitalists as they deal with challenges both unique and universal.

Zhu Xiaohu, managing partner at GSR Ventures, has warned that the survival rate for start-ups is very low. In an interview with Xinmin Weekly in May, Zhu said his firm's statistics showed that from 2005 to the end of 2014, an average of only 2-3 Chinese venture-backed businesses went public in the US each year.

But the frequency of such listings picking up: In the first quarter of 2015, eight firms went public in China according to a review of global technology IPOs by PWC. While the mainland stock market rally might account for some of that, listings were already rising before share prices began soaring. A total of 31 Chinese Internet companies went public in 2014, 12 of them in the US, according to ITjuzi.com, a Chinese business information provider that focuses on Internet startups. That's almost double the number of total listings the site reported in 2013.

This doesn't necessarily reflect an improvement in funded firms' survival rate. Instead, it may be that more venture capital firms are throwing more money at more startups, producing a net gain in successes. Huxiu, a Chinese business information and exchange platform, shows that throughout 2014, more than ten new venture capital firms were launched by venture capitalists focusing on investing in early-stage tech companies.

A matter of strategy

Among the many lessons VC firms can impart is how to avoid the market risks that most startups will face but fail to consider in the competitive and constantly changing technology sector. Companies need to learn how to be deft enough to make the necessary adjustments before the window of opportunity closes as a rival startup with a similar idea reaches the market first.

“Venture capitalists have seen so many start-ups. They have a better overall sense of the entire market,” said Han Di, a 31-year-old entrepreneur from Beijing who just launched the OSO food take-out and delivery service in one of China’s fastest growing markets.

Venture capital firms can do more than steady wobbly young startups by providing them with vital knowledge. By the time a startup meets with potential investors, it generally has little more than a small team and an idea, or possibly a product prototype. For a company to scale up it must also know how to reach potential customers.

"Sometimes, even if there’s a market out there for the product that a startup is developing, the team still needs an extra hand to gain ground in the marketplace, and venture investors can help find customers," said Cher Liang, Senior Investment Manager at Fosun Kinzon Capital. "VCs can also help them hire people. Early-stage startups are often understaffed, especially for a variety of positions such as business development, marketing, and public relations."

But several entrepreneurs said that during the current start-up frenzy not many venture capital firms have the time to provide anything more than money to help boost and maintain a company’s growth.

"VCs are focusing on seeing new entrepreneurs and ferreting out the best deals," said Shao, who is currently looking to raise Series A funding for his e-commerce business. "They are too busy to take care of their portfolio companies."

Bursting bubbles

For VC firms the majority of investments lose money, and only a small fraction ever become even marginally profitable. But with so many other investors now on the hunt for China's next Baidu, Alibaba or Tencent, the only option is to throw money at anything that might have a chance at success and quickly move on to vet other opportunities.

That may be leading to a glut of both funding opportunities and startups, according to David Zhang, founding managing partner at Matrix Partners China. In an open letter to the CEOs of Matrix's portfolio companies last September titled "A Bubble Is Out There", Zhang argued that a "funding round of tens of millions of dollars or up to 100 million dollars which previously didn't occur frequently is very common now, and the time between the funding rounds is shrinking rapidly."

The threat of a bubble means that entrepreneurs should be sustainably building up their companies so that if one does burst they will still be able to weather a downturn thanks to running a viable, profitable business. It also makes the mentoring duties of VC firms that much more important. If both sides of the sector can't recalibrate their expectations, China's best source of potential innovation could suffer an overcapacity problem that is already plaguing the rest of its economy. 


Author: Xin Yuan (@yyyuanxin)

Editor: Hudson Lockett (@KangHexin)