After two years of struggling to raise money, Chinese start-ups are seeing interest from venture capitalists pick up again, as the boom in the US crosses over the pacific. 

“The capital winter is over, competition for deals is fierce,” said Ming Liao of Prospect Avenue Capital. “You need to bring something to the table more than just cash to get into deals now.”

The number of venture deals in China rose 56 per cent in the first quarter from a year earlier, the fourth consecutive quarter of rising activity, as start-ups pulled in Rmb354bn ($55bn) in investment, according to data provider ITjuzi.

Buoyant public markets and a flood of foreign money have helped. Tencent, the most active investor, cashed in some gains as its listed investment portfolio tripled in value last year. VC firms such as GGV Capital, Qiming Venture Partners and Matrix Partners China raised large new funds.

In some ways investing in China and the US is similar; both markets are large enough to foster the creation of large tech groups and Chinese investors say start-up valuations now compare with their American peers. 

But investing in China also has its own quirks. Each new idea often sprouts a slew of copycats, and even competitive forays from the country’s tech giants. Differing culture and government regulation add to the challenges.

Cultural differences extend to the type of business models that work. Unlike in the US, which has seen sky-high valuations for companies selling software-as-a-service (SAAS) to large enterprises, this sector has yet to develop in China. Shaun Lim of Hopu Investments said it can be a struggle for software companies to sign up subscription customers. 

“People here don’t attach as much value to intangible services. They are more willing to pay for something they can see and touch,” he said. Lim said one enterprise AI software company he backed increased its sales by embedding its software applications into the servers it sold. 

Other factors that have hindered SAAS adoption include a history of free pirated software and cheap labour to handle some of the functions that software can automate.

Chart on China start-up investments over the past six years

Consumer tech has historically drawn most VC funding and produced the largest returns, leading the hot sectors of the day into booms and busts. While copycatting ideas occurs everywhere, it can be of a different magnitude in China.

During China’s infamous “war of a thousand Groupons” in the early 2010s, research firms say 1,880 start-ups copied Groupon’s group-buying business model. The ride-hailing wave fostered 214 competitors, at least 20 companies pushed into bike sharing, and 208 have launched businesses that rent out portable power banks for recharging electronic devices.

With such fierce competition, investors say execution and hard work can overcome not being the first mover in a new field.

For Jixun Foo of GGV Capital it was faith in founder Yang Lei that helped him get behind Hellobike’s push into the bike-sharing space when a rainbow of orange, yellow and blue share-bikes were already clogging the streets of China’s largest cities.

“I was convinced that [Yang] could run this in a more operationally efficient way,” Foo said. “First mover gives you a lead . . .[but] how efficient are you running relative to your peers? That edge will definitely show over time.” Five years later, Hellobike reported almost $1bn in sales last year with narrowing losses. Many of its competitors have failed.

In the equally competitive space of portable power banks, Wanlin Liu who focuses on tech investments for Carlyle in China, decided to invest when a winner emerged from the first wave of start-ups that got into the business. Even then, as she weighed an investment in Energy Monster, she worried about China’s Big Tech companies pushing in.

“You really have to understand all the top players and any potential competition from the larger tech giants, before we can make the call,” she said. Energy Monster has held its lead even after the $240bn delivery company Meituan entered. “It’s all about execution,” said Liu.

To help assess which teams have what it takes, Nathan Zhong of M31 Capital sometimes makes unannounced visits to the offices of start-ups at night before he invests. On one recent outing, he found the office of a data analytics start-up empty. 

“Their product iterations were not very fast — the CEO’s determination to keep fighting was weakening,” he said. “Getting off work early represented that.” M31 decided not to invest. 

Patrick Zhong leading one of M31 Capital’s weekly Monday meetings
Patrick Zhong, at M31 Capital’s weekly meetings, says unorthodox evening visits are a way of judging the suitability of potential investment targets © Ryan McMorrow

The unorthodox evening visits are part of what M31’s founder Patrick Zhong calls “feeling the temperature” of potential investment targets. “Everyone in China is smart; if you’re asleep at the wheel, your competition will catch up quickly.” 

Government policy can also be a source of uncertainty. In January, China’s central bank proudly declared that it had stomped out every single peer-to-peer online lender in the country — from a peak of 6,000 — wrapping up a campaign that wiped out a wave of VC bets.

“You always have to be aware of: ‘Is this company on the right side of China’s longer term government policy?’” said Gary Rieschel, who founded Qiming Venture Partners 15 years ago. “China’s entrepreneurs have to deal with a great deal of ambiguity,” he added. 

VCs say there are smaller differences throughout the investing process. Start-ups often engage financial advisers or FA, as they are called colloquially, to reach out to investors. Candid CEO references can be hard to find. And investing in a fledgling company that may someday need a new leader may not end well. Getting senior executives to “replace the trust that they had in that original founder,” is very difficult in China, Rieschel said. “It’s a low trust environment.”

Even though SAAS businesses have yet to take off in China, M31 Capital’s Zhong believes software is the future and finds it valuable to review trends under way in the US. In a recent weekly meeting, his team spent an hour studying how growth reaccelerated at database company MongoDB as its use cases expanded and examined its valuation.

“In the next 20 years China will follow the US in using software to improve enterprise efficiency,” said Zhong. “We’re not saying it will be the exact same path as the US, but it’s a reference point.”



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