Wednesday, June 6, 2012

From the Bay Area to Beijing

More than three-dozen Stanford-connected venture capitalists are helping lead the way in China's fast-moving investment world — blurring the distinctions between China and the West in the process.
David Chao photo
David Chao, MBA '93
Nisa Leung photo
Nisa Leung, MBA '01
Richard Lim photo
Richard Lim, MBA '88

Hans Tung, a venture capital investor in China, knew he had no time to waste. He had received a call from an angel investor in Vancl, a 10-month-old online-only retailer of men's clothing that Tung had been tracking. The investor said that Vancl was ready to raise a new round of funding and that Tung was the first of six venture capitalists he was calling. "Whoever could move the fastest would get the deal," recalls Tung, a 1993 Stanford graduate in industrial engineering. The opportunity seemed like a gem: Beijing-based Vancl was quickly developing a trendy brand name among China's young urban consumers, and its founder previously had run an e-commerce venture that was sold to Amazon.com. Here was a chance to back an experienced operator in China's budding e-commerce market.

Within 48 hours, Tung drafted a term sheet spelling out the agreement between Vancl and his firm, Qiming Venture Partners. Three days later, on a Sunday in June 2008, a deal in principle was signed, with Qiming leading a $20 million financing that included three of Vancl's existing venture investors.

The next step was due diligence. Tung and two colleagues interviewed six of Vancl's suppliers, two of its ad agencies, and its senior management team of six. They did phone interviews with 50 randomly selected Vancl customers and hired consultants to survey online shoppers about their habits and preferences. In a single week, Tung met in four cities with six other e-commerce startups. He hired Ernst & Young to vet Vancl's books and a leading Chinese law firm to review its corporate structure. Finally, Tung asked everybody in his office to buy from Vancl's site — and wash the clothing at home to check quality.

"We did all of that in three weeks. In the U.S., it could have taken one to two months," he says. "The competition to get into these top deals is intense."

The action is fast and furious for venture capitalists in China and the entrepreneurs they back. While venture capital fundraising and investing in the United States have declined since 2007, China has been a magnet for professional investors mining opportunities in a country that not only is the world's most populous but also is experiencing extraordinary economic growth and social change. Starting in the late 1990s and especially since 2005, venture money has poured into China, which by some measures is now the world's second-largest venture market after the United States.

Lured by an economy that has grown on average 10% a year over three decades, venture capitalists are scouring for investment opportunities that provide products and serices to China's growing number of middle-class consumers and internet users or, in some cases, that serve global consumer markets from China. A series of high-profile entrepreneurial successes in recent years, such as the Alibaba Group in e-commerce or Baidu in online search, have created role models and heroes that sustain the venture capital cycle in China. And the Asian country's ever-growing supply of engineers, researchers, and technologists provides venture capitalists with a deepening pool of talent to bet on.

The activity has spawned a transpacific community in which distinctions between China and the West are blurring. Stanford alumni are at the forefront of internationally connected investors and entrepreneurs in China, most visibly in the technology and internet arenas. Researchers at the GSB's Stanford Program on Regions of Innovation and Entrepreneurship have identified about 40 Stanford-connected venture capitalists active in China. Typically, the financiers are ethnic Chinese who have been educated or have worked in the United States. These bicultural and bilingual professionals can serve as a bridge for Chinese entrepreneurs to ideas, technology, money, and people outside the country. In turn, Chinese entrepreneurs are increasingly adept at building homegrown — and large — companies while localizing ideas and business models from the West.

Investing in China isn't for the faint of heart. Among international investors, the country is notorious for weak corporate governance and opaque financial disclosure, a perception exacerbated by recent accounting scandals at Chinese companies listed on international stock markets. What's more, international investors have long had to deal with China's foreign exchange controls, government censorship, and restrictions on direct foreign investment. "You have to be very deep in the space to do well," says Nisa Leung, MBA '01, a Hong Kong– and mainland China-based partner of Qiming who does health care investments in China. "There's a whole language issue, culture issue, the ability to navigate. It takes a lot of local know-how and connections," adds Leung, who was raised in Hong Kong and previously cofounded three health care ventures in China.

The pace of change can also be a challenge. Tim Chang, MBA '01, managing director of the Mayfield Fund, who is based in Menlo Park and co-leads its China practice while focusing mostly on U.S. tech investments, says "one of the curses of China" is that it has grown so fast there's "a get-rich-quick, land-grab mentality." That can encourage cutting corners and fighting dirty. For instance, it's not uncommon for Chinese companies to keep three sets of books — one for investors, one for tax collectors, and the real one, says the American-born Chang. It's also not uncommon for a company going public to be smeared by competitors who call up journalists and financial auditors to spread negative rumors that could delay or derail the company's stock offering. In China, "every deal, every transaction, every interaction is almost like a detective story. You've really got to dig down to the bottom for what's going on," Chang says.

Competition is often more intense than in the United States. New competitors spring up seemingly overnight, a reflection of the eagerness to grab early market share and the knack for cloning successful business models from the United States. Case in point: China has an estimated 5,000 group-buying sites similar to Groupon; the number of such sites reportedly doubled during the first half of 2011. "The velocity of change, innovation, and localization is a lot faster than in the U.S.," says Tung, a general partner and managing director of Qiming. "You're compressing 100 years of development into 30."

A further challenge is that the "underlying Chinese culture is very unforgiving to people who fail," says David Chao, MBA '93, general partner and cofounder of DCM, a Sand Hill Road venture firm with offices in Beijing and Tokyo that does early-stage investments. The typical Peking University student prefers safer employment with a large or multinational corporation to joining a startup, he notes. But that's changing. Over the last decade, China has developed more tolerance for risk and, as a result, better conditions for startups, including more entrepreneurial talent, venture capitalists, angel investors, law and accounting firms, and even universities with new-business incubators. If Silicon Valley's ecosystem for high-tech startups rates a 9 on a scale of 10, China's has gone from a 2 in 2000 to "close to a 7" today, says Chao, who is based in Silicon Valley and also does U.S. investments.

In fact, not only have foreign venture investors swarmed into the Asian country, but Chinese venture capitalists have sharply stepped up their activity. Domestic venture funds account for the lion's share of the market today. In 2011, Chinese and foreign institutions established 382 China-focused venture funds, raising $28.2 billion, more than two-and-a-half times the $11.2 billion raised in 2010, according to Zero2IPO Group, a Beijing research firm. Venture funds made about 1,500 investment deals that pumped $12.8 billion into Chinese companies, more than double the investment amount in 2010, the firm estimates. In addition, China has seen the emergence of "superangel" investors — former entrepreneurs with the wealth to invest in startups.

Since venture investors make money when they exit a company through its sale or initial public offering, the high valuations they paid fueled an IPO gold rush. In 2010 and 2011, more than 200 companies from China went public in Hong Kong, the United States, and other international stock markets, according to Zero2IPO. The U.S. IPO window slammed shut in mid-2011 as stock markets sank amid Europe's debt crisis and investor concerns mounted about the reliability of Chinese financial statements. China's internet stocks have been among the hardest hit; many are trading far below their IPO prices. For now, that has left many Chinese companies on the runway waiting to go public with stock offerings. Company valuations have dropped dramatically.

Improving Conditions
Most venture capitalists believe China's long-term investment prospects are strong, and they say they have seen a maturation among companies in which they invest. For instance, among internet companies, the first wave of startups, Chao says, were mainly web portals, which went public in 1999–2000. The second set, including firms in online search, job listings, and travel, listed on stock markets in 2004–2005. The newest crop, including social networking and e-commerce sites, went public in 2010–2011. Throughout, international venture capitalists bet heavily on entrepreneurs who returned to China from abroad, where they gained skills, knowledge, and exposure to Western business.

For instance, Singapore-born Richard Lim, MBA '88, the Palo Alto–based cofounder and managing director of GSR Ventures, a transpacific firm that has been funding Chinese startups since 2004, invested in Alan Guo, MBA '05. Guo worked for Microsoft in the United States before attending Stanford. After business school, he joined Google, where he helped launch the search giant's China office and became a strategist at Google China. In 2006, journalist Thomas Friedman gave a talk at Google's Beijing office. Afterward, Guo and a few others had lunch with Friedman and peppered him with questions about globalization. Guo says Friedman's book The World Is Flat inspired him to launch in 2007 with three others a company called LightInTheBox.com. The Beijing company sources made-to-order wedding dresses (and sells them for a fraction of U.S. retail prices) and other apparel and goods from China, and ships to more than 200 countries. Guo says the internet allowed him to go global "from day one." He credits his six years in the United States, including at Stanford and in Silicon Valley, with helping him to "dare to think of this type of business."

Lim also invested in RedAtoms, a developer of social networking games, founded by David Liu, MS '98, PhD '03, electrical engineering. Liu has the pedigree that venture capitalists like to bet on — technologist and serial entrepreneur with cross-cultural experience. Liu returned to his hometown of Beijing in 2009 to start RedAtoms after having started two successful tech companies in the Silicon Valley. "Innovation happens in places where there's change," he says. "When things are changing, you have opportunity."

Increasingly, venture capitalists are betting on homegrown Chinese entrepreneurs too. Today, about one-third of the entrepreneurs launching Chinese internet companies are returnees, one-third are "second generation" founders who worked at earlier internet startups, and one-third have purely local backgrounds, says DCM's Chao. Among Qiming Ventures' recent internet investments, three founders came from Chinese search leader Baidu, one from Google, one from Chinese e-commerce giant Taobao, and one from Microsoft.

Managing relationships with Chinese-born entrepreneurs can be delicate for international venture capitalists in a culture where company and founder are inextricably linked. In the United States, it's common for venture capitalists on a company's board to swap out the founder for an experienced CEO from the outside once the business matures. In China, "everybody knows you can't fire a CEO. The company is the CEO," says Mayfield Fund's Chang. In fact, says DCM's Chao, "in China, the CEO typically takes an emperor role, whereas, in the U.S., the CEO is very aware that they are the prime minister."

Building out the management team can be tricky too. The pool of experienced managers, relative to market growth and demand, is thinner than in the United States. At one point last year, Leung, the health care partner at Qiming, was working with five different recruiting firms looking for and interviewing candidates for her portfolio companies, including chief operating officer, head of research and development, and head of sales and marketing. Qualified chief financial officers are particularly scarce, especially for a company planning to go public in the United States, because that increases the need for a bicultural, bilingual executive with U.S. public accounting credentials and experience with U.S. financial disclosure regulations. Chao says it took 18 months for one of his portfolio companies, 99Bill, a provider of online payment systems, to find a CFO.

For young Chinese tech companies, venture capitalists with a U.S. connection can be a bridge to the Silicon Valley model of success. For instance, Valley venture capitalists Lim and Chang have provided important introductions and advice to Alan Yan, founder and chief executive of AdChina in Shanghai, a leading online advertising platform in China that lets companies buy targeted online advertisements while also tracking and optimizing their effectiveness. Yan, who once worked for Lucent, Philips, and eBay, founded AdChina in 2007 with two former eBay colleagues.

Yan says his venture investors provided visibility into the U.S. online advertising business. In late 2010, Chang provided key advice on strategy, product design, pricing, and partnerships when AdChina launched its mobile ad platform. Chang also introduced him to advertising teams at Google and Apple, and another venture capitalist introduced him to the former chief executive of U.S. web advertising pioneer DoubleClick. "We get money from them," Yan says of his venture investors. "But we're also getting connections to global leaders in the online advertising space. In online advertising, lots of new technologies and new models emerge in Silicon Valley first."

Similarly, at Renren, a social networking site popular among Chinese college students, the company's first venture investor, DCM's Chao, was instrumental in getting Japan's Softbank to invest $400 million in 2008. Chao, who was born and lived in Japan until age 13 and speaks Japanese, had connections to Softbank and its legendary CEO, Masayoshi Son. "David was one of the guys sitting in the room to finalize the terms with Masa. He played go-between," says Joe Chen, MBA '99, Renren's CEO, who raised $500 million in venture funding before Renren went public last year. And it was another of Chen's early venture investors, Peter Fenton, BA '94, MBA '00, then with Accel Partners, who first pointed out a young Facebook to Chen several years ago. Accel had just invested in the social networking pioneer. "I recognized instantly there was something big there," Chen says.

Liu of RedAtoms says his venture investor, Lim of GSR, has helped the company sharpen its focus. Initially, RedAtoms, founded in 2009, launched PC-based games in the United States and Japan as well as a pop music game for the iPhone and a strategy game for the iPad in China. In early 2011, the company decided to make a major strategy change, phasing out its U.S. and Japanese gaming efforts to focus solely on mobile gaming in China, where Liu figures RedAtoms has a competitive advantage. Liu says the venture capitalist helped shape the company from its earliest days and helped him "prioritize" on the mobile gaming space. "His role was to have the conversation," Liu says — and, presumably, to have it fast.