Analysis on Current Venture Capital Market in China

abstract on Current ship large(p) Market in mainland chinaw arIntroductionThe huge consumer trade voltage and booming miserliness in chinaw ar attract enormous impertinent direct couchitures to enceinte letterize this unprecedented opportunity. alien go bully is not exceptional from this trend. They, however, tranquillise rescue to face invariable ch eachenges from regulations, merchandise practices and work cultures in mainland china. To be successful in this marketplace totally various from their origin, international surmise pileuss need to vary their foregoing strategies and experiences and sample it through trial and error.This report is to acquire everyplaceall picture about current chance jacket market in china. at that placefore it will centering on the market position of unknown profess dandys. The report is followed by the analyses and summary on drapeiture coin and throttle strategies consumptiond by external run a risk sla p-ups. Finally, the report will discuss the potential trend in china go seat of government market. gravestone ObjectivesTo get in-depth depth psychology on current make believe outstanding market in chinaw are and hostile back capitals market position in chinaware.To analyze and summarize the coronation strategies and exit strategies engrossd by foreign jeopardise capital in China.To profit prediction on future market trend, especially foreign impale capital.Key ChaptersGeneral entryway on accident capitalHistorical go badment and current estimate capital market in ChinaDetail market position analysis on foreign venture capital in ChinaInvestment strategies of foreign venture capital in China qualifying strategies of foreign venture capital in ChinaFuture trends in China venture capital marketIntroduction on meditation capital of the United States imagine capital is source of coin in hand to small firms that cannot establish credit relationships with bank or ot her financial institutions. As Gompers (2001) states Companies that neglect substantial conspicuous assets and bring forth dubious prospects are unlikely to cause significant bank loans. These firms face many age of negative earnings and are unable to make interest payments on debt obligations.Start-up high tech firms are exactly the type of firms that banks are least likely to lend to because of poor information availability and lack of tangible assets or assets that can be readily evaluated. Firms ontogeny software or crude technology for the communications or biotech industries are largely expend in charitable capital. In a nutshell, the VC firm is a relative small financial services professional organization that functions primarily to (a) assess occupancy opportunities (b) black marketer capital and (c) monitor, advise and assist the firms in its portfolio.By investing, the venture capitalistics accept substantial tranche of illiquid honor that converts their st atus to something like partners to the entrepreneur. The goal of the venture capitalist is not awkwardly to increase the value of that truth but excessively to resultantually monetize the coronation through a liquidity event such(prenominal) as an sign open completeering or sale to other investors. The other way of reaping the reward is closure delinquent to the firm failure and bankruptcy. In all of these scenarios, the venture capitalist exits their investment to complete the VC process. The venture capital cycle is briefly visualized in below chart.Chart 1 monetary fund flow of Venture big(p) Cycle origin National Venture Capital Association Yearbook 2008The National Venture Capital Association in the United States defines venture capital as money provided by professionals who invest alongside management in young, promptly growing companies that take up potential to develop into significant frugal contributors. thither are a number of key attributes associated wi th VC that distinguish it from other integrity capital investments. Venture capital normally focuses on small firms that make up great increment potential. These firms usually are not mature enough to be traded in public equity markets. Compared with public equity investment, venture capital investment has poorer liquidity with to a greater extent severe information asymmetry and higher(prenominal) investment risks.Venture capital investment is also disagreeent from angel capital. Managers of angel capital use their somebodyal money to invest. In contrast, investments professionals who raise money from other investors manage venture capital. Angle capital invests much often in the seed face of the start up firms than venture capital does. Finally, venture capital is different from non-venture private equity investments (such as demoraliseouts, restructure, and entresol silver). Firms backed by venture capital usually have considerable growth potential.For these firms, the c ash flow generated from operations is usually insufficient to brook pay growth and debt support is usually not available. In contrast, private equity funds target more(prenominal) mature firms that have stable cash flows and control growth potential. The slacken 1 below summarizes the investment stages and types of funding for different investment styles.Table 1. Types of Funding and Investment StageSource A golf-club To Venture Capital (3rd edition) by Irish Venture Capital AssociationThere are five stages (BVCAPWC, 1998) in the development of venture-backed companies, which can be define as 1. ejaculate2. Start-up3. Other earliest stages (exploration)4. Expansion5. Maturity (exit).The definition of the company stage is different with the definition of the financing round. The negotiation of a VC investment is a time-consuming and sparingally appeally process for all parties. Neither the VCs nor the portfolio firms want to repeat the process very often. Therefore VCs have to balance the cost of negotiation and potential risks from one time investment. Typi beefy, a VC will try to provide sufficient financing for a company to reach some born(p) milestone, such as the development of a prototype product, the acquisition of a major customer, or a cash flow breakeven.Each financing event is known as a round. So the first time a company receives financing is known as the first round (or Series A), the neighboring time the sulfur round (or Series B), and so on and so forth. With each well-defined milestone, the parties can return to the negotiating table with some new information.These milestones differ crosswise industries and await on market conditions. A company might receive several rounds of investment at any stage, or it might receive sufficient investment in one round to short-circuit multiple stages. One special situation is the down round. It is when the company does not meet milestones and the VC still needs to invest but at a lower valu ation than prior round of financing.Venture Capital in ChinaWhy invest in China?There are four major popular arguments behind for the investment rush to east.Reason 1 High Rate of economic developingChinas formidable economic growth for the past 30 years, averaging between 8% to 10% real growth per year, has been the envy of the developing human. The size of Chinese economy by the end of 2006 reached US$2.62 trillion, 13 times larger than that in 1978 when measurable in constant RMB (MasterCard Worldwide Insight, 2007). According to Goldman Sachs China economic research (2003), per capita gross domestic product expect to grow from little than $5,000 at that time to more than $30,000 in 2050 (refer to Chart 2). China will have a diaphragm class of more than 500 million by 2025 larger than the entire population of the United States.It represents a huge emerging demand for everything from integrated circuits to cars. 500M mobile users, 130M Internet users, 104M wideband users and 4.5M college graduates every year could all transfer into huge business opportunity (represented in Chart 3). Based on the estimation (Chart 4) from Mckinsey, there will be sustainable market growth to 2025 in every business that re youthfuld with communitys life and daily consumption.Huge opportunities for venture capital are Internet (B2B, B2C, C2C, online gaming, website portal site and web 2.0), semiconductors, technologies (clean energy, medical, biotech and traditional manufacturing), and consumer businesses (food, clothes, shopping and other entertainments).Chart 2 China GDP ontogenesis Forecast (2000-2050)Source Goldman Sachs 2003Chart 3 China slide fastener/Material make out imbalance (2010)Source Goldman Sachs 2003Chart 4 Urban Chinese Consumers Demand Forecast (2004-2025)Source National potency of Statistics of China Mckinsey planetary Institute Analysis Reason 2 Inefficient Capital MarketIn the United States and Europe, private and public capital markets make out as sources of capital. However, China does not save have an equity culture despite the adoption of market-oriented policies. In China, the public equity market lists inefficient and unappealing state have enterprises (SOE) nigh of the times. And government holds roughly 60-70% of share capital of most listed companies.Few private firms are listed in the decline market due to effective and insurance hurdle. Chinas bond market is similarly underdeveloped. Chinese bodily bonds report for less than 2% of corporate financing.Thin trading between banks and investors makes yield bonds unattr supple voice for fundraising or investing. Insurers and fund managers therefore have few fixed-in come afterward securities to hedge against mid- and long-term risks. The corporate bond market just started to function in late 2007 by allowing public listed firms to issue corporate debts. Around 95% of financing for Chinese companies now is still provided by bank loans.The internal banks , however, have inclining to provide loans to say owned company rather than private firms, especially small and medium businesses (SMB). With the poor functioning financial markets and policy discrimination, venture capital and private equity become important sources of growth capital for private firms. It is one of the key reasons that venture capital is so popular among private firms in China across different industries even including traditional industries like food, hotel and travel etc.Reason 3 Creative Solutions/Early Adopting ConsumersOne of the most unpredicted attributes of the emerging Chinese market economy is how consumer-savvy its entrepreneurs are. Even after decades of centralized economic planning, the Chinese remain consummate creators and marketers of interesting products. Definitely the creativity and innovations are only hold in in certain business for talents availability and their professional capabilities.Online gaming, wireless instant messaging, and wire less value added services are just trey markets that the Chinese more or less pissd out of thin air. Each of these businesses has growing customer bases (and have spawned successful public companies like Shanda, Netease, Tencent, and Linktone). But no(prenominal) of them has significant participants yet in the United States. Different consumer behaviors contribute to this phenomenon as well. In below case canvas on Tencent, it provides a great moral on how to stick in the Internet product offerings to cater the needs of online generation.Case study QQ of Tencent (Adapted from www.tencent.com)Tencent (listed in HK armory exchange) is the 1 Instant Messaging (IM) service provider in China. Tencents IM association counts over 270 million active accounts and is said to be covering 95% of Chinese Internet users and 70% of Chinas IM market (MSN/Yahoo account for the rest market). QQ is the scratch for its IM. Same as other IMs, QQ is a free tool to use. Tencent, however, came up the idea to generate receipts stream by allowing users to buy and exchange practical(prenominal) items (clothes and background image) online to decorate his or her QQ head icon. Tencent even created its own cyber currency called Q Bi and 1 Q Bi = 1RMB (0.14 USD) to facilitate the transaction and subvert barrier of online purchasing. The estimated revenue generated from those Internet value added services in 2007 is around USD$360M.Reason 4 Risk- victorious, Innovative CultureIn the last fifteen years, the privatization crystalize is one of the faultfinding forces in stimulating China economy growth. This privatization cockle also generated tens of thousands entrepreneurs. The business culture is naturally comfortable with risks and with developing innovative ship canal to solve problems and create wealth both for individuals and for society at large.The successful stories of VC backed entrepreneurs encourage promote the risk taking culture in China and the awareness and popul arity of venture capital. The accent Media case below illustrates the power of business model innovation by its unprecedented expansion speed ever in Chinas business history. There is no doubt that foreign VCs played an important role in this story to make Focus Media successful.Case study Focus Media China (Adapted from www.focus.com)Founded in 2003, Focus Media is Chinas largest Digital Media Group in China now. The founder, Mr. Jiang Nanchun, came up with an innovative approach in operating out-of-home advertising vane employ audiovisual digital displays. Basically, the idea was to display the LCD near or in the elevators in commercial centers (like office make upings and shopping malls). While hold for or in the elevators, people would watch the contents advertised in those LCDs.By selecting and contracting with high quality commercial buildings, Focus Media was able to quickly build up its network scale and attract many advertising contracts. Tow foreign VC firms, Soft Bank and UCI, invested in the first round. And another five VCs, CDH, TDF, DFJ, WI harpist and Milestone, invested in the stand by round. ii years after operation, Focus Media was listed on Nasdaq with USD$172M IPO and now it is part of Nasdaq 100 index.Historical developmentInfancy stage 1984 1995In 1984, the enquiry Center of Science and Technology Development of the State Science Technology cathexis (SSTC) (now the Ministry of Science Technology or MOST) cooperated with British experts to study how to develop advanced in China. The British experts proposed that venture capital should be developed if China wanted to foster high technology.In 1985, the Central Commission of the Chinese communistic Party and the State Council pointed out in the Decision of Science-Technology System Reform that venture capital could be set up to support the work of developing high-tech with quick change and high risk. It was the first time that the concept of venture capital appeared in an offic ial Chinese organization document.With the government finale to develop high technology industries, the Central Government and some local anesthetic governments financed and set-up series of investment institutions that in take to the woodsed to pursue the venture capital business from 1985 to 1995. Examples are China New Technology Venture Capital Company, Shenyang Science-Technology Venture Development Risk Center, Shanxi Head Office of Science-Technology Fund Development, Guangdong Science-Technology Venture Capital Company, Shanghai Science-Technology Venture Capital Company, and the Science-Technology Venture Capita Company of Zhejiang Province. Moreover, venture centers (i.e., high tech incubators) were set-up in the majority of national high-tech parks.Simultaneously, some overseas investment banks, funds and venture capital institutions also started to expand their business into China. For example, the Pacific Technology Venture Capital Fund subordinate to IDG entered Chi na in 1992. It cooperated with science-technology commissions in Beijing, Shanghai and Guangdong, and set-up a number of venture capital companies focused on investing in technology companies. Also, some foreign capital or conjugation carnation investment institutions found venture capital businesses.Asia Venture Capital Journal (AVCJ, 2001) shows that $16 million was elevated for venture capital investments in 1991. In 1992, the total funds raised jumped to $583million, a thirty-fold increase compared with the $16 million in 1991. The first wave reached its peak in 1995, with $678 million in investment (AVCJ, 2001).The first wave of venture capital investments was brought by planetary venture capitalists. The international venture capital firms accounted for more than 95% of the total fund raised in the early and mid nineties.The absolute dominance of international venture capital funds in China in the early and mid 1990s was mainly due to Chinas strict regulations against f und-raising and the general lack of awareness of venture capital in China. Private fund-raising by individuals or private firms without government favourable reception was strictly banned in China. This strict regulation essentially removed the possibility for venture capitalists to raise funds at bottom China.It meant that only international venture capital funds and state owned enterprises (SOE) venture capital funds could operate. International venture capital funds could bypass the regulation because they were incorporated and they raised funds removed of China. SOE funds relied on government appropriation as funding sources and did not have this fund raising problem either.Early Growth 1996 2001From the mid-1990s, the perception of venture capital shifted from being a type of government funding to being a commercial activity necessary to support the commercialisation of new technology. As there were still no laws or regulations about setting up foreign venture capital inst itutions in China, many overseas investment institutions established their branches in Hong Kong, aiming to invest in the mainland. They had also located representative offices in some major cities, primarily Beijing and Shanghai. Most of the VCs active in China in the early 90s were American firms.The VC industry in the U.S. had matured and attracted a significant amount of funds. Shortly after 1995 a shrill increase from US$5 billion to US$110 billion in funds raised created the phenomenon of money chases deals (Gompers Lerner, 1999). A cadre of experienced American VCs started searching the world for investment opportunities, attempting to replicate the Silicon Valley model. Since 1998, there had been a discernible recognition of the critical success factors necessary to create an environs in which venture capital could operate smoothly and flourish.Specifically, the Governments official decision to support the development of venture capital was the key factor that had allowed Chinas venture capital industry to come into being in a new and more positive environment. In Beijing, alone, there were about 30 independent venture capital institutions, whose capital amounted to an estimated $450 million. In Shenzhen, there were at least 20 independent venture capital institutions with capital amounted to over $500 million. After 2000, China also experienced hard landing in its young VC industry due to dotcom bubble burst and came with huge casualties. It took the VC community 3 years to recover.Fast Growth 2002 presentAlthough sign government-backed investment operations generally failed, there has been resurgence in venture capital activity since Chinas admission to the WTO (Kenny, Han and Tanaka 2002). Capital available for investment in Mainland China keeps a steady growth trend from 2002. The capital size was increased to US$21.32B by 2007 from US$10.50B in 2002. The average deepen annual growth rate (CAGR) reaches 15.2%. Venture capital investment grew rapidly from $480 million in 2002 to more than $3,247 million in 2007, invested in 440 China mainland or mainland-related enterprises (Zero2IPO 2007).According to Zero2IPO report, USD$4B VC funds were raised each year in 2005 and 2006 for China investment. But Chinas annual consumption was no more than $2B. The money chasing deal phenomenon started to leave in China. numerous foreign VC funds, especially first-time funds raised after 2005, had the pressure to pour out investment quickly to avoid US one dollar bill depreciation against RMB and to get better deals under fierce competition. While the funding supply multiplied, quality deal flows did not increase at the same pace. below the simple supply and demand mechanism, valuations of the China deal kept at relative high level. However, considering the fact that a big portion of funding was focus on local value-add service segments (i.e. internet, web2.0 and broadband etc.), the issue of funds over-supply was sector specific. T o get higher return under the competition, VC firms started to invest in traditional business models such as hotels, travels and fast food chains beyond their core activities such as TMT (Technology, Media and Telecom) or Internet related businesses. It was the special phenomenon happened in China now that VCs were more like PE.Legal and RegulationsAccording to Megginson (2004), the differences in the design and the degree of development of the PE/VC industry are due to institutional factors, with the countrys jural corpse being paramount. Two major factors are paramount in evaluating legal system contract law enforcement and protection of shareholder rights through effective corporate governance. Cumming and Macintosh (2002) spy that PE/VC managers in high enforcement countries had a greater tendency to invest in high-tech SMBs, exit through IPOs rather than buybacks and obtain higher returns.Cumming et al. (2004) further examined legal system effects on governance structure. Un der better legal systems the faster the origination and screening of deals the higher the probability of syndication less frequently funds of the same organization used to invest in a given company the easier the board representation of investors the lower the probability that investors necessitate periodic cash flows prior to exit and the higher the probability of investment in high-tech companies.Lerner and Schoar (2005) show that in a bad legal environment, PE/VC managers tend to buy controlling stakes, leaving the entrepreneurial team with weaker incentives. Interestingly, valuations tend be positively correlated with the quality of the legal environment. Kaplan et al. (2003) go deeper into the contractual aspects and found that rights over cash flows, liquidation and control, as well as board participation vary according to the quality of the legal system, the accounting standards and investor protection across countries.However, more sophisticated PE/VC managers tend to oper ate in the U.S. style irrespective of local institutional adverts. The authors show that managers operating with convertible preferred stocks are less inclined to failure (as measured by survivorship rate). The results suggest that the U.S. contractual style can be efficient in different institutional environments. Bottazzi et al. (2005) corroborate some of the previous results and obtain further evidence on the home-country effect (PE/VC managers operating abroad tend to maintain the investment style used at home). This is observed in managers based in both good and bad legal environments.The Chinese regulations governing foreign venture capital investment are chaotic and rapidly changing. In 2005, Chinese administration issued new guidelines (effective in 2006) intending to foster domestic venture capital firms. There is no specific regulation to monitor and get to the VC activities in China. The new guidelines recommended that local governments provide financing assistance, f avorable tax treatment, and direct investment in Chinese venture capital firms. They also provide less taut capitalization, investment amount, investor qualification and regulatory beseechments than those applicable to FICVEs (Guerrera, Yee and Yeh, 2005). FIVCEs instead are governed by 2003 regulations that include high investment and qualification thresholds, government plaudit requirements, and strict foreign exchange limitations on the ability to remit profits and dividends back to the investor (Hoo, et al 2005a).Substantial legal and de facto restraints on the ability of FIVCEs to access the stock markets in China and overseas for IPO lists make exit strategies extremely difficult. For these reasons, foreign venture capital firms investing in China usually do not use FIVCEs but rely on shoreward holding companies created to receive their investments. outside venture capital firms (most of which are U.S. based) investing in China generally have done so through the restructu ring of Chinese companies into onshore investment vehicles.These enable an easier exit from investments either by selling shares on international stock markets or through a trade sale to another foreign buyer. In January of 2005, Chinese authorities brought these transactions to a virtual standstill, however, with the military issue of new regulations preventing any onshore resident from establishing, controlling or owning shares in an offshore company without the approval of the Government, either directly or indirectly. The regulations were intended to offend managers of SOEs receiving venture capital investments from stripping state assets and selling them cheaply to overseas companies, and to preclude domestic companies from using the overseas vehicles to gain foreign investor tax freedom status.However, they choked off legitimate transactions as well. There were no government approvals of offshore investment transactions in 2005. With only limited exceptions for transacti ons in process, foreign venture capital financing through offshore investment vehicles screeched to a halt in 2005 (Borrell and Jerry, 2005).Then, in November of 2005, the Chinese authorities issued superseding regulations. These require registration of offshore investment vehicles with the State Administration of immaterial trade (SAFE), but do not require the agencys approval of the transaction. They also require repatriation of all distributions of income from the investment within a fixed time frame. Like the previous regulations, the new ones do not describe specifically the registration process, the procedures involved, the scope of study nor the time take for completion, creating substantial uncertainty for foreign venture capital investors (Hoo, et al 2005b).Despite this changing regulatory landscape, many U.S. based venture capital firms have active plans for substantial investments in 2006 spurred by Chinas high growth potential, the success of recent venture-backed s tartups on the NASDAQ including Baidu.com and China Medical Technologies and by pent up demand after the 2005 halt in new investments (Borrell, Jerry and Aragon 2005).Hidden risk and solutionsLagging legislation and inexplicit policies in China created many uncertainties and entry barriers for foreign VCs. Below are summary of the critical problemsChinas lawmaking on VC investment remains stagnantExisting laws such as Corporation Law, Joint Venture Law, Patent Law, etc., in many aspects even contradict VC investment.Does VC investment count as foreign investment? What status and treatment should it enjoy? The concerned authorities cannot provide slang answers to these questions.Its not clear that the amount of shares that foreign venture capital is allowed to hold when partnering with Chinese enterprises, and the way foreigners to remit in/out of foreign exchange are poorly defined.There are three available approaches for foreign venture capital firms to enter China venture capita l market legally.Establishing offshore venture capital fund focusing on ChinaEstablishing a foreign invested VC firm in China (Joint VC with local player/ all owned Foreign firm) as a legal person entityEstablishing a foreign invested VC firm in China (Joint VC with local player/Wholly Owned Foreign firm) as a non-legal person entityTo avoid the legal and regulation barriers, foreign venture capital funds usually takes the offshore investment route. Foreign VCs will use offshore USD fund to invest into China deals offshore holding entities with all equity activities happening outside of Chinese jurisdiction. The distinction of USD offshore holding investment and RMB local entity investment is a particular phenomenon in China.Offshore holding arrangement is a preferred structure for Chinese entrepreneurs and VCs as it provides a viable and practical route for funding, divestment and all equity events. Its advantage and attractiveness to Chinese entrepreneurs and VC communitiesGo aw ay from laws and regulations in China. Many of them are not friendly to venture activities, such as lack of preferred shares, stock options limitation, double tax etc.Bypassing capital account control on foreign exchange.More malleable and usually profitable divestment options by overseas IPO, MA or trade sales.Offshore route investment involves the following stepsThe Chinese founders set up an offshore holding company in Cayman Island or BVI with the shareholding structure and management control mirroring those of their local company in China.With mannikin of swap scheme, transferring the equity they hold in the Chinese local company to the offshore holding. This will typically convert the local company into a WFOE (Wholly Foreign Owned Enterprise).The offshore holding company will then be the vehicle seeking VC investment, future funding as well as for itemization or be merged. All equity events happen in offshore. Companies funding and IPO proceeds will be kept offshore, and r emit into China as and when operation required. Chinese founders assets, rights and proceeds stay offshore. The whole exercise is carried out essentially with an IPO at an overseas stock exchange, such as NASTAQ or Hong Kong Stock Exchange in vision. (The concept and process is visualized in chart 5.)Chart 5 Foreign VC Offshore Investment ProcessSource A legal perspective on Chinas venture capital rush, Mar 2006Restrictions in Chinas corporate regulations and limitations at the domestic capital markets explain foreign VCs orientation course in taking offshore route to organize their China investment. VC investors rely normally on preferred stocks or convertible preferred stock to punch a preferential return. Chinese corporate regulations allow only one class of common stock for a FIVCE with investment in a Chinese portfolio company.Notably, local VC firms would have the possibility to arrange preferred stock scheme with their investee company according to a newly issued charter re gulation applicable to domestic VC firms. This gives rise to concern on the principle of national treatment under WTO law.Moreover, China domestic stock market does not provide a rig access for venture-backed companies. The conditions for listing at Shanghai or Shenzhen main-board market are too stringent for high-tech start-up companies. Even if listing conditions could be met, the queue in the pipeline waiting for a listing window is at the moment frustrating. In fact, the two domestic stock exchanges have halted the IPO since two years in the call for addressing the notorious overhang of nontransferable legal person shares.The undergoing endeavor is focusing on floating all stock legal person shares. Since the value of stock legal person shares is roughly twice of those trading in the stock exchange, full floating of legal person shares at stock is imposing lancinating challenge on the market place.This would mean that the suspension on IPO of new shares would be expected for a rather elongated term. By leverage on an offshore holding structure, foreign VCs could take advantage of the corporate governance in a jurisdiction where they feel most comfortable and bypass the restrictions under Chinese corporate law. VCs could take theAnalysis on Current Venture Capital Market in ChinaAnalysis on Current Venture Capital Market in ChinaIntroductionThe huge consumer market potential and booming economy in China attract enormous foreign direct investments to capitalize this unprecedented opportunity. Foreign venture capital is not exceptional from this trend. They, however, still have to face constant challenges from regulations, market practices and business cultures in China. To be successful in this marketplace totally different from their origin, foreign venture capitals need to adapt their previous strategies and experiences and test it through trial and error.This report is to get overall picture about current venture capital market in China. Then it will f ocus on the market position of foreign venture capitals. The report is followed by the analyses and summary on investment and exit strategies used by foreign venture capitals. Finally, the report will discuss the potential trend in China venture capital market.Key ObjectivesTo get in-depth analysis on current venture capital market in China and foreign venture capitals market position in China.To analyze and summarize the investment strategies and exit strategies used by foreign venture capital in China.To make prediction on future market trend, especially foreign venture capital.Key ChaptersGeneral introduction on venture capitalHistorical development and current venture capital market in ChinaDetail market position analysis on foreign venture capital in ChinaInvestment strategies of foreign venture capital in ChinaExit strategies of foreign venture capital in ChinaFuture trends in China venture capital marketIntroduction on Venture CapitalVenture capital is source of funds to smal l firms that cannot establish credit relationships with bank or other financial institutions. As Gompers (2001) states Companies that lack substantial tangible assets and have uncertain prospects are unlikely to receive significant bank loans. These firms face many years of negative earnings and are unable to make interest payments on debt obligations.Start-up high tech firms are exactly the type of firms that banks are least likely to lend to because of poor information availability and lack of tangible assets or assets that can be readily evaluated. Firms developing software or new technology for the communications or biotech industries are largely investing in human capital. In a nutshell, the VC firm is a relative small financial services professional organization that functions primarily to (a) assess business opportunities (b) provide capital and (c) monitor, advise and assist the firms in its portfolio.By investing, the venture capitalists accept substantial tranche of illiqu id equity that converts their status to something like partners to the entrepreneur. The goal of the venture capitalist is not only to increase the value of that equity but also to eventually monetize the investment through a liquidity event such as an initial public offering or sale to other investors. The other way of reaping the reward is liquidation due to the firm failure and bankruptcy. In all of these scenarios, the venture capitalist exits their investment to complete the VC process. The venture capital cycle is briefly visualized in below chart.Chart 1 Fund flow of Venture Capital CycleSource National Venture Capital Association Yearbook 2008The National Venture Capital Association in the United States defines venture capital as money provided by professionals who invest alongside management in young, rapidly growing companies that have potential to develop into significant economic contributors. There are a number of key attributes associated with VC that distinguish it fr om other equity capital investments. Venture capital normally focuses on small firms that have great growth potential. These firms usually are not mature enough to be traded in public equity markets. Compared with public equity investment, venture capital investment has poorer liquidity with more severe information asymmetry and higher investment risks.Venture capital investment is also different from angel capital. Managers of angel capital use their personal money to invest. In contrast, investments professionals who raise money from other investors manage venture capital. Angle capital invests more often in the seed stage of the start up firms than venture capital does. Finally, venture capital is different from non-venture private equity investments (such as buyouts, restructure, and mezzanine funds). Firms backed by venture capital usually have considerable growth potential.For these firms, the cash flow generated from operations is usually insufficient to support finance growt h and debt financing is usually not available. In contrast, private equity funds target more mature firms that have stable cash flows and limited growth potential. The Table 1 below summarizes the investment stages and types of funding for different investment styles.Table 1. Types of Funding and Investment StageSource A Guild To Venture Capital (3rd edition) by Irish Venture Capital AssociationThere are five stages (BVCAPWC, 1998) in the development of venture-backed companies, which can be defined as 1. Seed2. Start-up3. Other early stages (exploration)4. Expansion5. Maturity (exit).The definition of the company stage is different with the definition of the financing round. The negotiation of a VC investment is a time-consuming and economically costly process for all parties. Neither the VCs nor the portfolio firms want to repeat the process very often. Therefore VCs have to balance the cost of negotiation and potential risks from one time investment. Typically, a VC will try to p rovide sufficient financing for a company to reach some natural milestone, such as the development of a prototype product, the acquisition of a major customer, or a cash flow breakeven.Each financing event is known as a round. So the first time a company receives financing is known as the first round (or Series A), the next time the second round (or Series B), and so on and so forth. With each well-defined milestone, the parties can return to the negotiating table with some new information.These milestones differ across industries and depend on market conditions. A company might receive several rounds of investment at any stage, or it might receive sufficient investment in one round to bypass multiple stages. One special situation is the down round. It is when the company does not meet milestones and the VC still needs to invest but at a lower valuation than prior round of financing.Venture Capital in ChinaWhy invest in China?There are four major popular arguments behind for the inv estment rush to east.Reason 1 High Rate of Economic GrowthChinas impressive economic growth for the past 30 years, averaging between 8% to 10% real growth per year, has been the envy of the developing world. The size of Chinese economy by the end of 2006 reached US$2.62 trillion, 13 times larger than that in 1978 when measured in constant RMB (MasterCard Worldwide Insight, 2007). According to Goldman Sachs China economic research (2003), per capita GDP expect to grow from less than $5,000 at that time to more than $30,000 in 2050 (refer to Chart 2). China will have a middle class of more than 500 million by 2025 larger than the entire population of the United States.It represents a huge emerging demand for everything from integrated circuits to cars. 500M mobile users, 130M Internet users, 104M broadband users and 4.5M college graduates every year could all transfer into huge business opportunity (represented in Chart 3). Based on the estimation (Chart 4) from Mckinsey, there will be sustainable market growth to 2025 in every business that related with peoples life and daily consumption.Huge opportunities for venture capital are Internet (B2B, B2C, C2C, online gaming, website portal and web 2.0), semiconductors, technologies (clean energy, medical, biotech and traditional manufacturing), and consumer businesses (food, clothes, shopping and other entertainments).Chart 2 China GDP Growth Forecast (2000-2050)Source Goldman Sachs 2003Chart 3 China Energy/Material supply imbalance (2010)Source Goldman Sachs 2003Chart 4 Urban Chinese Consumers Demand Forecast (2004-2025)Source National Bureau of Statistics of China Mckinsey Global Institute Analysis Reason 2 Inefficient Capital MarketIn the United States and Europe, private and public capital markets compete as sources of capital. However, China does not yet have an equity culture despite the adoption of market-oriented policies. In China, the public equity market lists inefficient and unappealing state owned enter prises (SOE) most of the times. And government holds roughly 60-70% of share capital of most listed companies.Few private firms are listed in the stock market due to legal and policy hurdle. Chinas bond market is similarly underdeveloped. Chinese corporate bonds account for less than 2% of corporate financing.Thin trading between banks and investors makes issuing bonds unattractive for fundraising or investing. Insurers and fund managers therefore have few fixed-income securities to hedge against mid- and long-term risks. The corporate bond market just started to function in late 2007 by allowing public listed firms to issue corporate debts. Around 95% of financing for Chinese companies now is still provided by bank loans.The domestic banks, however, have tendency to provide loans to stated owned company rather than private firms, especially small and medium businesses (SMB). With the poor functioning financial markets and policy discrimination, venture capital and private equity be come important sources of growth capital for private firms. It is one of the key reasons that venture capital is so popular among private firms in China across different industries even including traditional industries like food, hotel and travel etc.Reason 3 Creative Solutions/Early Adopting ConsumersOne of the most unexpected attributes of the emerging Chinese market economy is how consumer-savvy its entrepreneurs are. Even after decades of centralized economic planning, the Chinese remain consummate creators and marketers of interesting products. Definitely the creativity and innovations are only limited in certain business for talents availability and their professional capabilities.Online gaming, wireless instant messaging, and wireless value added services are just three markets that the Chinese more or less created out of thin air. Each of these businesses has growing customer bases (and have spawned successful public companies like Shanda, Netease, Tencent, and Linktone). Bu t none of them has significant participants yet in the United States. Different consumer behaviors contribute to this phenomenon as well. In below case study on Tencent, it provides a great example on how to innovate the Internet product offerings to cater the needs of online generation.Case study QQ of Tencent (Adapted from www.tencent.com)Tencent (listed in HK stock exchange) is the 1 Instant Messaging (IM) service provider in China. Tencents IM community counts over 270 million active accounts and is said to be covering 95% of Chinese Internet users and 70% of Chinas IM market (MSN/Yahoo account for the rest market). QQ is the brand for its IM. Same as other IMs, QQ is a free tool to use. Tencent, however, came up the idea to generate revenue stream by allowing users to buy and exchange virtual items (clothes and background image) online to decorate his or her QQ head icon. Tencent even created its own cyber currency called Q Bi and 1 Q Bi = 1RMB (0.14 USD) to facilitate the tran saction and reduce barrier of online purchasing. The estimated revenue generated from those Internet value added services in 2007 is around USD$360M.Reason 4 Risk-taking, Innovative CultureIn the last fifteen years, the privatization reform is one of the critical forces in stimulating China economy growth. This privatization wave also generated tens of thousands entrepreneurs. The business culture is naturally comfortable with risks and with developing innovative ways to solve problems and create wealth both for individuals and for society at large.The successful stories of VC backed entrepreneurs further promote the risk taking culture in China and the awareness and popularity of venture capital. The Focus Media case below illustrates the power of business model innovation by its unprecedented expansion speed ever in Chinas business history. There is no doubt that foreign VCs played an important role in this story to make Focus Media successful.Case study Focus Media China (Adapted from www.focus.com)Founded in 2003, Focus Media is Chinas largest Digital Media Group in China now. The founder, Mr. Jiang Nanchun, came up with an innovative approach in operating out-of-home advertising network using audiovisual digital displays. Basically, the idea was to display the LCD near or in the elevators in commercial centers (like office buildings and shopping malls). While waiting for or in the elevators, people would watch the contents advertised in those LCDs.By selecting and contracting with high quality commercial buildings, Focus Media was able to quickly build up its network scale and attract many advertising contracts. Tow foreign VC firms, Soft Bank and UCI, invested in the first round. And another five VCs, CDH, TDF, DFJ, WI Harper and Milestone, invested in the second round. Two years after operation, Focus Media was listed on Nasdaq with USD$172M IPO and now it is part of Nasdaq 100 index.Historical developmentInfancy stage 1984 1995In 1984, the Research Ce nter of Science and Technology Development of the State Science Technology Commission (SSTC) (now the Ministry of Science Technology or MOST) cooperated with British experts to study how to develop high-tech in China. The British experts proposed that venture capital should be developed if China wanted to foster high technology.In 1985, the Central Commission of the Chinese Communist Party and the State Council pointed out in the Decision of Science-Technology System Reform that venture capital could be set up to support the work of developing high-tech with quick change and high risk. It was the first time that the concept of venture capital appeared in an official Chinese Government document.With the government decision to develop high technology industries, the Central Government and some local governments financed and set-up series of investment institutions that intended to pursue the venture capital business from 1985 to 1995. Examples are China New Technology Venture Capita l Company, Shenyang Science-Technology Venture Development Risk Center, Shanxi Head Office of Science-Technology Fund Development, Guangdong Science-Technology Venture Capital Company, Shanghai Science-Technology Venture Capital Company, and the Science-Technology Venture Capita Company of Zhejiang Province. Moreover, venture centers (i.e., high tech incubators) were set-up in the majority of national high-tech parks.Simultaneously, some overseas investment banks, funds and venture capital institutions also started to expand their business into China. For example, the Pacific Technology Venture Capital Fund subordinate to IDG entered China in 1992. It cooperated with science-technology commissions in Beijing, Shanghai and Guangdong, and set-up a number of venture capital companies focused on investing in technology companies. Also, some foreign capital or joint stock investment institutions established venture capital businesses.Asia Venture Capital Journal (AVCJ, 2001) shows that $ 16 million was raised for venture capital investments in 1991. In 1992, the total funds raised jumped to $583million, a thirty-fold increase compared with the $16 million in 1991. The first wave reached its peak in 1995, with $678 million in investment (AVCJ, 2001).The first wave of venture capital investments was brought by international venture capitalists. The international venture capital firms accounted for more than 95% of the total fund raised in the early and mid 1990s.The absolute dominance of international venture capital funds in China in the early and mid 1990s was mainly due to Chinas strict regulations against fund-raising and the general lack of awareness of venture capital in China. Private fund-raising by individuals or private firms without government approval was strictly prohibited in China. This strict regulation essentially removed the possibility for venture capitalists to raise funds within China.It meant that only international venture capital funds and stat e owned enterprises (SOE) venture capital funds could operate. International venture capital funds could bypass the regulation because they were incorporated and they raised funds outside of China. SOE funds relied on government appropriation as funding sources and did not have this fund raising problem either.Early Growth 1996 2001From the mid-1990s, the perception of venture capital shifted from being a type of government funding to being a commercial activity necessary to support the commercialization of new technology. As there were still no laws or regulations about setting up foreign venture capital institutions in China, many overseas investment institutions established their branches in Hong Kong, aiming to invest in the mainland. They had also located representative offices in some major cities, primarily Beijing and Shanghai. Most of the VCs active in China in the early 90s were American firms.The VC industry in the U.S. had matured and attracted a significant amount of f unds. Shortly after 1995 a sharp increase from US$5 billion to US$110 billion in funds raised created the phenomenon of money chases deals (Gompers Lerner, 1999). A cadre of experienced American VCs started searching the world for investment opportunities, attempting to replicate the Silicon Valley model. Since 1998, there had been a discernible recognition of the critical success factors necessary to create an environment in which venture capital could operate smoothly and flourish.Specifically, the Governments official decision to support the development of venture capital was the key factor that had allowed Chinas venture capital industry to come into being in a new and more positive environment. In Beijing, alone, there were about 30 independent venture capital institutions, whose capital amounted to an estimated $450 million. In Shenzhen, there were at least 20 independent venture capital institutions with capital amounted to over $500 million. After 2000, China also experienc ed hard landing in its young VC industry due to dotcom bubble burst and came with huge casualties. It took the VC community 3 years to recover.Fast Growth 2002 presentAlthough initial government-backed investment operations generally failed, there has been resurgence in venture capital activity since Chinas admission to the WTO (Kenny, Han and Tanaka 2002). Capital available for investment in Mainland China keeps a steady growth trend from 2002. The capital size was increased to US$21.32B by 2007 from US$10.50B in 2002. The average compound annual growth rate (CAGR) reaches 15.2%. Venture capital investment grew rapidly from $480 million in 2002 to more than $3,247 million in 2007, invested in 440 China mainland or mainland-related enterprises (Zero2IPO 2007).According to Zero2IPO report, USD$4B VC funds were raised each year in 2005 and 2006 for China investment. But Chinas annual consumption was no more than $2B. The money chasing deal phenomenon started to emerge in China. Many foreign VC funds, especially first-time funds raised after 2005, had the pressure to pour out investment quickly to avoid US dollar depreciation against RMB and to get better deals under fierce competition. While the funding supply multiplied, quality deal flows did not increase at the same pace.Under the simple supply and demand mechanism, valuations of the China deal kept at relative high level. However, considering the fact that a big portion of funding was focusing on local value-add service segments (i.e. internet, web2.0 and broadband etc.), the issue of funds over-supply was sector specific. To get higher return under the competition, VC firms started to invest in traditional business models such as hotels, travels and fast food chains beyond their core activities such as TMT (Technology, Media and Telecom) or Internet related businesses. It was the special phenomenon happened in China now that VCs were more like PE.Legal and RegulationsAccording to Megginson (2004), the diff erences in the design and the degree of development of the PE/VC industry are due to institutional factors, with the countrys legal system being paramount. Two major factors are paramount in evaluating legal system contract law enforcement and protection of shareholder rights through effective corporate governance. Cumming and Macintosh (2002) observed that PE/VC managers in high enforcement countries had a greater tendency to invest in high-tech SMBs, exit through IPOs rather than buybacks and obtain higher returns.Cumming et al. (2004) further examined legal system effects on governance structure. Under better legal systems the faster the origination and screening of deals the higher the probability of syndication less frequently funds of the same organization used to invest in a given company the easier the board representation of investors the lower the probability that investors required periodic cash flows prior to exit and the higher the probability of investment in high-tech companies.Lerner and Schoar (2005) show that in a bad legal environment, PE/VC managers tend to buy controlling stakes, leaving the entrepreneurial team with weaker incentives. Interestingly, valuations tend be positively correlated with the quality of the legal environment. Kaplan et al. (2003) go deeper into the contractual aspects and found that rights over cash flows, liquidation and control, as well as board participation vary according to the quality of the legal system, the accounting standards and investor protection across countries.However, more sophisticated PE/VC managers tend to operate in the U.S. style irrespective of local institutional concerns. The authors show that managers operating with convertible preferred stocks are less prone to failure (as measured by survivorship rate). The results suggest that the U.S. contractual style can be efficient in different institutional environments. Bottazzi et al. (2005) corroborate some of the previous results and obtain fur ther evidence on the home-country effect (PE/VC managers operating abroad tend to maintain the investment style used at home). This is observed in managers based in both good and bad legal environments.The Chinese regulations governing foreign venture capital investment are chaotic and rapidly changing. In 2005, Chinese authorities issued new guidelines (effective in 2006) intending to foster domestic venture capital firms. There is no specific regulation to monitor and stimulate the VC activities in China. The new guidelines recommended that local governments provide financing assistance, favorable tax treatment, and direct investment in Chinese venture capital firms. They also provide less stringent capitalization, investment amount, investor qualification and regulatory requirements than those applicable to FICVEs (Guerrera, Yee and Yeh, 2005). FIVCEs instead are governed by 2003 regulations that include high investment and qualification thresholds, government approval requiremen ts, and strict foreign exchange limitations on the ability to remit profits and dividends back to the investor (Hoo, et al 2005a).Substantial legal and de facto restraints on the ability of FIVCEs to access the stock markets in China and overseas for IPO listings make exit strategies extremely difficult. For these reasons, foreign venture capital firms investing in China usually do not use FIVCEs but rely on offshore holding companies created to receive their investments. Foreign venture capital firms (most of which are U.S. based) investing in China generally have done so through the restructuring of Chinese companies into offshore investment vehicles.These enable an easier exit from investments either by selling shares on international stock markets or through a trade sale to another foreign buyer. In January of 2005, Chinese authorities brought these transactions to a virtual standstill, however, with the issuance of new regulations preventing any onshore resident from establishi ng, controlling or owning shares in an offshore company without the approval of the Government, either directly or indirectly. The regulations were intended to stop managers of SOEs receiving venture capital investments from stripping state assets and selling them cheaply to overseas companies, and to preclude domestic companies from using the overseas vehicles to gain foreign investor tax exemption status.However, they choked off legitimate transactions as well. There were no government approvals of offshore investment transactions in 2005. With only limited exceptions for transactions in process, foreign venture capital financing through offshore investment vehicles screeched to a halt in 2005 (Borrell and Jerry, 2005).Then, in November of 2005, the Chinese authorities issued superseding regulations. These require registration of offshore investment vehicles with the State Administration of Foreign Exchange (SAFE), but do not require the agencys approval of the transaction. They a lso require repatriation of all distributions of income from the investment within a fixed time frame. Like the previous regulations, the new ones do not describe specifically the registration process, the procedures involved, the scope of review nor the time required for completion, creating substantial uncertainty for foreign venture capital investors (Hoo, et al 2005b).Despite this changing regulatory landscape, many U.S. based venture capital firms have active plans for substantial investments in 2006 spurred by Chinas high growth potential, the success of recent venture-backed startups on the NASDAQ including Baidu.com and China Medical Technologies and by pent up demand after the 2005 halt in new investments (Borrell, Jerry and Aragon 2005).Hidden risk and solutionsLagging legislation and inexplicit policies in China created many uncertainties and entry barriers for foreign VCs. Below are summary of the critical problemsChinas lawmaking on VC investment remains stagnantExist ing laws such as Corporation Law, Joint Venture Law, Patent Law, etc., in many aspects even contradict VC investment.Does VC investment count as foreign investment? What status and treatment should it enjoy? The concerned authorities cannot provide clear answers to these questions.Its not clear that the amount of shares that foreign venture capital is allowed to hold when partnering with Chinese enterprises, and the way foreigners to remit in/out of foreign exchange are poorly defined.There are three available approaches for foreign venture capital firms to enter China venture capital market legally.Establishing offshore venture capital fund focusing on ChinaEstablishing a foreign invested VC firm in China (Joint VC with local player/Wholly Owned Foreign firm) as a legal person entityEstablishing a foreign invested VC firm in China (Joint VC with local player/Wholly Owned Foreign firm) as a non-legal person entityTo avoid the legal and regulation barriers, foreign venture capital fu nds usually takes the offshore investment route. Foreign VCs will use offshore USD fund to invest into China deals offshore holding entities with all equity activities happening outside of Chinese jurisdiction. The distinction of USD offshore holding investment and RMB local entity investment is a particular phenomenon in China.Offshore holding arrangement is a preferred structure for Chinese entrepreneurs and VCs as it provides a feasible and practical route for funding, divestment and all equity events. Its advantage and attractiveness to Chinese entrepreneurs and VC communitiesGo away from laws and regulations in China. Many of them are not friendly to venture activities, such as lack of preferred shares, stock options limitation, double tax etc.Bypassing capital account control on foreign exchange.More flexible and usually profitable divestment options by overseas IPO, MA or trade sales.Offshore route investment involves the following stepsThe Chinese founders set up an offshore holding company in Cayman Island or BVI with the shareholding structure and management control mirroring those of their local company in China.With kind of swap scheme, transferring the equity they hold in the Chinese local company to the offshore holding. This will typically convert the local company into a WFOE (Wholly Foreign Owned Enterprise).The offshore holding company will then be the vehicle seeking VC investment, future funding as well as for listing or be merged. All equity events happen in offshore. Companies funding and IPO proceeds will be kept offshore, and remit into China as and when operation required. Chinese founders assets, rights and proceeds stay offshore. The whole exercise is carried out essentially with an IPO at an overseas stock exchange, such as NASTAQ or Hong Kong Stock Exchange in vision. (The concept and process is visualized in chart 5.)Chart 5 Foreign VC Offshore Investment ProcessSource A legal perspective on Chinas venture capital rush, Mar 2006Re strictions in Chinas corporate regulations and limitations at the domestic capital markets explain foreign VCs preference in taking offshore route to organize their China investment. VC investors rely normally on preferred stocks or convertible preferred stock to secure a preferential return. Chinese corporate regulations allow only one class of common stock for a FIVCE with investment in a Chinese portfolio company.Notably, local VC firms would have the possibility to arrange preferred stock scheme with their investee company according to a newly issued charter regulation applicable to domestic VC firms. This gives rise to concern on the principle of national treatment under WTO law.Moreover, China domestic stock market does not provide a ready access for venture-backed companies. The conditions for listing at Shanghai or Shenzhen main-board market are too stringent for high-tech start-up companies. Even if listing conditions could be met, the queue in the pipeline waiting for a li sting window is at the moment frustrating. In fact, the two domestic stock exchanges have halted the IPO since two years in the call for addressing the notorious overhang of nontransferable legal person shares.The undergoing endeavor is focusing on floating all stock legal person shares. Since the value of stock legal person shares is roughly twice of those trading in the stock exchange, full floating of legal person shares at stock is imposing acute challenge on the market place.This would mean that the suspension on IPO of new shares would be expected for a rather extended term. By leveraging on an offshore holding structure, foreign VCs could take advantage of the corporate governance in a jurisdiction where they feel most comfortable and bypass the restrictions under Chinese corporate law. VCs could take the