US verses China

Choosing Between American and Chinese Investors

For tech startups in the United States (U.S.) and China, they enjoy rather large and often, rapidly growing domestic markets. However, as they continue to grow into later stages, it may become necessary for them to expand internationally in order to increase their TAM (total addressable market) and raise their company profile. This entails gaining the attention of foreign venture capital (VC) investors. In gaining their attention, it gives them an additional path towards a long-run profit and lends them an edge over their domestic competitors. Additionally, getting the backing of prominent foreign VC investors can serve as a litmus test for the long-term health of any given tech industry.

American AI company Magic Leap raised from both and this was their difficulty in the Chinese market. The company believed that tapping into the Chinese market would be of great benefit to them. This proposition was well-founded, as AI and many other tech industries have undergone rapid growth in China. The first round of funding that Chinese VC giant Alibaba participated in was a Series C round worth $793.5 million USD, the largest Series C deal completed in 2016. It was also the first VC funding for the company since October 2014. The following year, Alibaba participated in a Series D round worth $502 million USD, smaller than the Series C round from the previous year. Unfortunately for Magic Leap, this was the last round of funding Alibaba would participate in. The timeline of Magic Leap would serve as a rather poor indicator for the AI industry, particularly augmented reality (AR). Even with $2.3 billion in VC funding and the backing of VC giants like Alibaba, Magic Leap was unable to deliver on its initial hype and as a result, burned through much of the funding they got with little to show for it.

Despite the multitude of benefits associated with cross-border investments for founders and investors alike, some risks exist as well. This is due to differences that exist in the VC landscape in each country due to differing political, economic, and regulatory environments each country faces. Some major examples of these differences include ownership and operation of VC funds, sources of deal flow for investors, and differing rules in the provisions of VC deals.

Market Overview

Venture Capital Flow Between the U.S. and China in 2018 (Source: Crunchbase News)

In the global VC market, the United States has long been the leader across the board. Since the end of the 20th century, however, China’s VC market has grown at an exorbitantly fast rate and its presence now rivals the U.S. In just three decades, the Chinese VC market grew into the world’s second-largest, with 29.4% of global VC going toward Chinese startups this past year. Additionally, the U.S. and China have become each other’s biggest partner in cross-border investments. Last year, venture capital flow between the two companies amounted to $22 billion USD and hundreds of deals were completed. According to Crunchbase, there were 355 deals between American investors and Chinese companies and 198 deals between Chinese investors and American companies.

In some regards, the current VC landscape looks quite similar in the two countries. Like American investors, Chinese investors desire a strong deal flow and believe that the founders and their vision are among the most important criterion for deciding whether the firm should invest in a startup or not. Additionally, some of the largest areas of investment in both countries are software (AI, IT, FinTech, IoT, Cybersecurity, etc.), hardware, biotech, pharmaceuticals, and healthcare. However, unlike the U.S., where government involvement in the VC market is quite limited, China’s government plays a significant role in its VC market and strictly regulates it. This results in some major differences between the landscapes of the VC market in each country. Here are three key factors to consider when choosing between funding by American and Chinese investors.

1) Ownership and Operation of Funds

Through the end of 2017, domestic investment accounted for 75% of all VC activity in China, with government-led guidance funds playing a huge role in the Chinese VC market (Source: VentureBeat)

Across the globe, the vast majority of VC firms and their funds tend to be privately owned and operated. The U.S. is no exception. Almost all American VC firms and their funds are privately owned and controlled. Only in rare cases do American VC firms go public like GSV Capital did in 2011. Besides that, the majority of the remaining VC firms in the U.S. and their funds remain privately owned and operated. Of course it makes sense that many firms and their funds choose to remain private, as the VC industry is all about the long-run whereas public markets worry more about short-term fluctuations, something VC firms tend not to focus on. Additionally, remaining private allows them to not share information generally considered proprietary (such as investment valuations and internal fee structures).

In China, there is more of a mixture of public vs. private ownership of funds. There are 3,500 VC firms with an estimated $4.4 trillion in funds in the pipeline for the next decade, according to a report by the Zero2IPO group. However, these firms are not the only ones making investments domestically. The Chinese government has its own set of funds amounting to $1.8 trillion USD. These government funds, colloquially known as guidance funds, are invested in a wide variety of domestic startups with the goal of developing the Chinese economy in mind. Unlike many VC funds, which can be invested in a wide range of companies across many industries, the existence of this $1.8 trillion government-run fund is specifically for Chinese companies created for internal economic development. These funds are often allocated by industry and the amount flowing into different industries varies by province. While some American investors operate funds for specific industries, none of them are operated by the American government nor are there funds designed specifically for domestic development like there are in China.

“State-controlled ‘guidance funds’ have failed to spend much of the promised money and overlapping investment strategies may result in overcapacity in some technology sectors, according to a Gavekal Drageonomics report” — Emily Feng, Financial Times

These government-backed guidance funds have received mixed reviews in terms of its effectiveness. While some argue that these funds have been crucial to the development of the domestic economy, others argue that these government funds have not lived up to expectations. According to Qinke Private Equity, there are serious issues with allocating these funds properly. Their report included three key findings regarding the allocation of funds. The first finding is that “since 2008, only 882 out of 2,065 guidance funds have made investments”. The second finding is that “73.51% of all money from guidance funds winds up in companies that are either expanding rapidly or are already mature.” The third finding is that “only 6.41% of the money is invested in seed stage companies”. The issues regarding the allocation of government-backed funds demonstrates the challenges of having heavy government involvement in the VC market. Because the Chinese government is very large and has numerous layers of bureaucracy, there are many chances for mismanagement or misallocation of VC funds. As a result of just how complicated it can be running funds through the government, it is very uncommon to see VCs or VC funds owned or operated by a national government of large countries, the U.S. included.

2) Sources of Deal Flow and Geographic Diversity of Deals and Sources

In the U.S., deal sourcing takes place all across the country, whereas in China, there’s more of a regional divide (Source: Pitchbook)

“The most fruitful sources of deal flow for me are earlier-stage funds (microfunds, accelerators, partner networks etc.) that I have worked with in the past and have built a meaningful relationship with. Over time, these funds develop an understanding of the type of deals I am looking for and the result is a symbiotic relationship where everyone wins.” — Andy Cloyd, Cultivation Capital

One of the biggest desires of every investor is to have a strong deal flow. They believe that the best way to find the right opportunities is to come across as many potential deals as possible. Without a strong deal flow, investors are likely to miss out on some potentially great deals with strong, fast-growing startups. Investors in both countries source their deals through a wide variety of individuals and institutions. The primary sources of potential deals for both countries’ investors tend to be personal connections, primarily other investors they have worked with in the past. They also get sourcing from local and regional accelerators and incubators, although this particular ecosystem is a lot bigger in the U.S. than in China.

“That’s the thing about doing business in China. It’s the Wild, Wild West, but we’re exploring new ground all the time. What was very useful to me was that I’d already gone through the red tape, the bureaucracy, the difficulty of hiring from multinationals for jobs in China. So the ability to talk to the government and understand what is happening in their world makes a huge difference.” — Nisa Leung, Qiming Venture Partners

Both Leung and Cloyd mentioned the importance of forming relationships with those you work with, as those in your professional ecosystem can serve as sources of deals later on. The more people you connect with, the stronger your deal flow will be. However, in Leung’s case, she has an additional set of people she needs to get to know very well. That would be state-owned enterprises (SOEs) as well as the Chinese government. In China, SOEs and the government serve as major deal sources for investors. According to Garry Bruton, “VCs in China have to build relationship with the government and large state-owned enterprises (SOEs), in order to find good investment opportunities instead of rely on the investigation of the proposals”. As a result, Chinese investors often need to spend a fair amount of time and effort building connections with local government officials in order to gain access to better deal flow.

The Chinese government’s involvement in sourcing deals has an effect on the Chinese VC market not seen in the U.S. market: significantly less geographic diversity in domestic investments. In the U.S., deals are sourced and made across the country. Investors in New England, New York, and Silicon Valley often seek out deals in each other’s territory and consequently end up with fairly geographically diverse portfolios. In China, that tends not to be the case. Bruton notes that “the structure of the Chinese government is very decentralized, meaning a lot of regulatory decisions are made by provincial governments.” So if investors would like to make deals in other provinces of the country, they need to fully know and understand the regulations imposed by each of the provincial governments. However, the laws are often quite complex and differ greatly from province to province. As a result, it tends to make more sense for domestic investors to focus on in-province startups. Because of this, American investors tend to have a more geographically diverse portfolio than their Chinese counterparts.

3) Differing Rules and Regulations Regarding VC Provisions

Term sheet for Uber’s Series C funding. In the U.S., the founders are not subject to quite as stringent provisions as their Chinese counterparts are (Source: Pitchbook)

Another thing that sets the landscape of the VC market in the two countries apart are the differences surrounding the provisions of VC deals. These provisions outline the rights investors have and the obligations founders and their companies face. In general, the provisions of VC deals in China lend significantly more leverage towards investors and founders have significantly less leeway in negotiating the provisions. In addition, the rights given to investors as well as their scope are markedly broader in China than in the U.S.

Some of the most notable differences in provisions are in liquidation preference, right of redemption obligations, and veto rights.

  • Liquidation preferences: In the United States, in the event of liquidation, preferred stockholders (investors) are limited in their right to participate in the distribution of remaining assets. In China, participation is considered an essential right of investors.
  • Right of redemption: American startups tend to be responsible for this obligation whereas founders of Chinese companies tend to be personally liable for this.
  • Veto rights: The scope of veto rights offered to investors is significantly broader in China whereas American investors’ veto power generally focus on things that directly impact them, such as revisions to their rights and interests. Chinese investors also generally get veto rights on any future financing activities of a given company. Due to the broader scope of veto rights, Chinese investors also tend to get a say in operational matters of their portfolio companies, such as budgeting, intellectual property, and appointing people to senior positions.

Zhou Min of PacGate Law Group notes these differences, recognizing that “cross-border investors inevitably encounter legal provisions that are different from what they are used to back in their home country.” Min attributes these provisional differences to two factors.

  • The very different legal environments in which each country’s VC market operates. China’s market is significantly more regulated than in the U.S. and laws on the books generally prohibit companies from bearing certain obligations, such as redemption rights. This means that founders are the only ones who can legally handle these obligations.
  • Since VC is much newer in China compared to the U.S., investors generally hold stronger positions over founders. Additionally, Chinese founders tend to be less sensitive to stricter provisions than American founders. This means American founders are more likely to resist certain provisions, especially if they requires the founders bear personal liabilities or special restrictions are placed on their rights.

As a result of the vast differences in provisions abroad, namely the narrower scope of rights for investors, Chinese investors in particular tend to express a bit of caution when doing cross-border investments. However, since part of foreign investment includes researching the landscape of the VC market in the country you plan to invest in, many Chinese investors come fully prepared to negotiate with American founders and vice versa. This is very clear given the fact that hundreds of cross-border investments took place in 2018 alone.

Conclusion

While there was a slight decline in deal count, capital investment in the U.S. VC market hit an all-time high in 2018 at $130.9 billion USD (Source: Pitchbook)

Despite the many similarities between the two markets, some significant differences in the VC landscapes exist due to the significantly differing roles the two governments play in the domestic VC market. Heavier government regulation of the VC industry seen in China has posed some challenges for investors, namely limiting investment and exit opportunities in China, particularly in later stages. It has also caused fewer opportunities in other provinces of the country for domestic investors due to significant differences in provincial regulations.

While both countries still remain the top VC markets in the world, a couple trends have worried analysts and investors alike for the last couple years, such as a decelerating Chinese economy and the U.S.-China trade war. Despite the lingering potential for a slowdown or decline, both countries remain at the forefront of the global VC market and remain each other’s biggest partner in cross-border investments. This may well continue to be the case so long as there is a steady stream of new tech startups seeking investment in both countries. Are you a startup seeking funding during Seed or Series A? Check us out here!

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