Not Exactly Silicon Valley: China’s Distinct Brand of Entrepreneurship

Most observers believe that China’s remarkable economic performance over the past three decades is due primarily to large, state-owned companies. While those organizations are, indeed, key players, the country’s entrepreneurs have long been overlooked. According to the Global Entrepreneurship Monitor, nearly 25% of the adult population are entrepreneurs, twice as many as in the U.S. Working with limited resources and against intense competition, these individuals have played a major role in the country’s unprecedented growth.

China’s economic resurgence began with Deng Xiaoping’s Reform and Opening policies in 1978, when Special Economic Zones — most notably Shenzhen in southern China — were established to test capitalism. Whether the central government knew it or not, there was a surplus of entrepreneurs ready to find ways to take advantage of these new opportunities. From the perspective of a copper refinery CEO in Zhejiang province, “the Chinese people really exceeded the government’s expectations. After the Cultural Revolution, they were starting with literally zero resources at their disposal.”

During the 1980s, China’s central government supported entrepreneurship in a sustained way. In 1984, it implemented its first patent law. In 1986, it passed a law that allowed state-owned enterprises (SOEs) to go bankrupt. A year later, it repealed a law limiting private firms to seven employees. As a result, entrepreneurship, measured in terms of the number of companies officially registered, saw a jump of 93% in 1987 alone.

Two main types of entrepreneurial activity emerged in the 1980s and 1990s. The first was export–oriented, determining what other countries needed and making those goods cheaper. The second involved bringing goods already popular in developed nations to the Chinese market. While many parts of the economy have yet to open fully and domestic consumption is still on the rise, this does not mean a lack of sophistication. Moving forward, entrepreneurs will play an important role in China’s future growth.

The Entrepreneurial Ecosystem in China

Entrepreneurial ventures in emerging economies such as China operate in environmental and institutional contexts that differ markedly from those in high-income countries. According to a 2011 article by Nir Kshetri and Nikhilesh Dholakia in the Journal of International Entrepreneurship, a key determining factor in a country’s entrepreneurial environment is participation by the government, which has been fractious for entrepreneurs. China’s heavily state-biased, government-run legal system and regulatory practices put politically unconnected entrepreneurs at a distinct disadvantage compared to state-owned enterprises and government-backed private ventures. The court system, while vastly improved over the last two decades, is still inefficient and rife with corruption. In a survey of China’s court proceedings, small businesses generally lose to large ones, and private interests lose to state enterprises. To protect their business interests, entrepreneurs must divert significant effort from wealth creation to non-market factors, such as fostering relationships with local politicians.

Funding continues to be the greatest bottleneck for entrepreneurial growth.

The Chinese government recognizes the crucial role entrepreneurs play in the country’s rapid growth and tries to encourage entrepreneurial activity, in particular through increased access to funding. However, funding continues to be the greatest bottleneck for entrepreneurial growth. Writing in Time magazine in 2009, Beijing correspondent Austin Ramzy noted that China does not have a well-established system to rate credit, and banks often set standards that are too high for small businesses to meet. Furthermore, private entities may not operate banks, so commercial loans can be issued only by state-owned banks, which maintain a strong bias toward state-owned enterprises and other large, low-risk businesses. In addition, laws bar inter-company lending, preventing small businesses from obtaining loans from other businesses.

Thus, many entrepreneurs find funding is limited to two sources: equity investment or illegal “off-the-books” loans from friends or loan sharks. Both options are expensive. The government recognizes the funding barriers entrepreneurs face: Both former premier Wen Jiabao and current Premier Xi Jinping have promised to increase lending opportunities for entrepreneurs by liberalizing bank interest rates, authorizing privately run banks, and regulating private lending markets. Unfortunately, despite Beijing’s best intentions, China will see significant credit tightening as large numbers of those who received subprime government loans during the 2008 global recession begin to default. Inevitably, small businesses will feel the squeeze first.

Despite the unfavorable legal environment and significant credit constraints, China’s growing middle class provides sufficiently fertile ground in which entrepreneurs can thrive. The question for many of them is not “Should I start a company?” Rather, more often it is “What is my exit strategy?” As Ben Ng, general partner at growth-stage private equity firm SAIF, notes, IPOs were traditionally the preferred route. Large companies were sufficiently dominant in their markets and did not seek to buy smaller competitors. At the same time, Chinese entrepreneurs yearned for the prestige of an IPO and hesitated to relinquish ownership of their companies. In sectors such as technology, however, this trend is shifting toward acquisitions, increasing the feasibility of profitable exits for entrepreneurs on a shorter timeline. According to China-based VC firm ZhenFund, one-third of market exits in 2012 were M&As, which marks a significant increase from previous years.

The shift in exit behavior follows a rash of scandals of mismanagement and dishonest accounting practices within public Chinese companies on international stock markets, which all but obliterated investors’ appetites for young Chinese companies. Fortunately for entrepreneurs, increasingly diverse consumer needs have forced large companies to rely on the acquisitions of start-ups that are more nimble and niche-focused to maintain their competitiveness. With more exit options, entrepreneurs can viably create more companies with greater frequency.

In addition to greater exit options, entrepreneurs currently enjoy a larger pool of resources for entrepreneurial development. One example is government-mandated zones for industry-specific development, such as Beijing’s Zhongguancun, which is hailed as China’s Silicon Valley. These concentrated zones, sponsored by local governments seeking to stimulate certain sectors of their economies, offer compelling financial incentives to fledgling enterprises operating in the zones and serve as a magnet for an increasing number of incubators and angel investors.

Another example is an increase in the quality of entrepreneurial talent, through both the sustained presence of multinational joint ventures, which train local talent in the creative process and effective management, and the emergence of the more experienced entrepreneur, who has already started a company and is better-equipped to begin a successful second company or make smart investments in other start-ups. In a 2012 survey by ZhenFund, 70% of angel investors were founders themselves, and 50% reported returns of 30% or more. These well-trained industry veterans become catalysts for local innovation, accelerating the idea-generation process and reducing China’s reliance on knowledge extraction from foreign creative centers such as Silicon Valley.

The Unique Chinese Entrepreneur

As with the entrepreneurial ecosystem, the profile of the contemporary Chinese entrepreneur reflects the distinctive socio-political environment in which he or she has emerged. Chinese entrepreneurs today are generally savvier, wealthier, and more experienced than their predecessors. In addition, what sets them apart from their peers in the Chinese business sphere is not necessarily the same contrasting set of characteristics found in the West. The personal traits, motivations, and cultural influences that define these entrepreneurs are unique to this specific era in China’s development.

A few key traits separate Chinese entrepreneurs from their non-entrepreneurial counterparts. According to a 2005 study published in the American Economic Review, although their cognitive abilities are similar, entrepreneurs tend to be more mobile, wealthier, and more willing to accept risk. In addition, having entrepreneurial friends or family members tends to increase the likelihood of a Chinese person becoming an entrepreneur.

The profile of the contemporary Chinese entrepreneur reflects the distinctive socio-political environment in which he or she has emerged.

In China, where family and the government play central roles in peoples’ lives, these two factors can have a great impact on career paths. According to a national household survey in 2000, cited by Linda Yueh in her 2011 article in the Royal Society for the Arts Journal, entrepreneurs are three times less likely than their business peers to be members of the Chinese Communist Party (CCP): 6% compared to 18%. If a person’s mother is highly educated or holds a non-manual job, the likelihood of entrepreneurship increases, whereas having a CCP member as a father decreases the likelihood. Finally, Chinese entrepreneurs focus largely on personal success, defined mainly by wealth and social status. They tend to pursue opportunistic, rather than passion-driven, industries and products.

China’s career landscape is also influenced significantly by its rigid education system, which, as Ng notes, makes it difficult for recent college graduates to start their own companies. The system emphasizes rote memorization over critical thinking, as manifested in the gaokao (college entrance exam), which singularly determines students’ major and career options. Due to the restrictive learning methods and time-consuming test preparation, industry experts say China is unlikely to foster its own Mark Zuckerberg, founder of Facebook, or other successful youthful entrepreneurs in the near term.

Instead, the current generation of successful entrepreneurs largely comprises those with significant work experience and extensive extant business knowledge. At Innovation Works, the tech incubator founded by tech industry veteran Kai-fu Lee, the choices are to back serial entrepreneurs first and high-level tech executives second. According to Mickey Du, the group’s investment manager, “We look for founders with work experience — perhaps at a larger multinational or domestic tech company, where they were doing something meaningful so that they have unique insights about the specific problem that they are tackling … and know how to structure a term sheet.” Furthermore, many of these founders have overseas experience or have been exposed to international media about the industry. Chinese entrepreneurs know about cutting-edge technological developments emerging in Silicon Valley and can quickly emulate and adapt those concepts to the China market. According to Du, following Groupon’s rapid success in the U.S., a handful of group-buying sites emerged almost overnight in China.

The perception of entrepreneurship in Chinese society is also changing. Although high-performing Chinese students (and their parents) are still likely to choose careers in finance or government, the tech industry and entrepreneurship are gradually gaining prestige. Thanks to the increasing visibility of ultra-wealthy tech entrepreneurs, such as Jack Ma of Alibaba and Robin Li of Baidu, entrepreneurship is becoming an increasingly acceptable and desirable career path.

The Chinese Brand of Entrepreneurship

As a result of the dynamics of the Chinese entrepreneurial ecosystem and the unique profile of those who start businesses in China, entrepreneurship takes a different form there than in Western economies. The Chinese version has three key components. First, those who succeed have mastered “integrated innovation.” They reinvent an existing business idea to meet the demands of Chinese consumers. Du points out that Chinese entrepreneurs often start with Western-inspired products that fill local market needs but, after many iterative loops and localization, the end product differs significantly from the Western inspiration. Companies that only copy existing models are likely to fail.

Second, Chinese entrepreneurs have a deep knowledge of life in China and can identify unmet needs of the Chinese economy. With the Great Firewall and other government interventions, Chinese markets remain relatively closed to the rest of the world. Nevertheless, Chinese citizens continue to find ways to circumvent barriers and procure ideas from abroad, creating pent-up demand for goods and services ranging from vitamins to Facebook. Successful entrepreneurs flock to fill these gaps.

Finally, Chinese entrepreneurs carefully consider the role of government intervention. To avoid unpredictable policy changes, some entrepreneurs choose to enter regulation-light sectors. Others run toward key sectors identified in China’s Five-year Plans, which outline the government’s strategic directions for the country. These entrepreneurs hope to align with China’s industrial policy, which, when publicly announced, will be less susceptible to radical changes.

China: A Land of Entrepreneurial Opportunity

Like foreign multinational corporations, Chinese entrepreneurs see tremendous opportunity in China. However, unlike foreign entrants who often cannot see beyond China’s massive 1.3 billion-strong population, these entrepreneurs experience firsthand the shortcomings within the current system and are driven to fill the gaps. Discussions with entrepreneurs and early-stage investors revealed three sectors that will likely see increased entrepreneurial activity in the near-term:

In 2012, the largest proportion of Chinese VC investment went to high tech: 45%, totaling US$4.7 billion.

High Tech: In 2012, China had the largest number of Internet users in the world at 564 million, compared to 245 million in the U.S. China is currently the world’s largest online gaming market at US$10 billion, and e-commerce volume is expected to surpass that of the U.S. in 2013. There is tremendous demand for high-tech services, but the current supply in China is deficient. According to Steve Blank, professor of entrepreneurship at UC Berkeley’s Haas School of Business, more than 30,000 websites are blocked in China, including Dropbox, Facebook, and YouTube. For this reason, many Chinese entrepreneurs and investors enter this sector. In 2012, the largest proportion of Chinese VC investment went to high tech: 45%, totaling US$4.7 billion. Favorable demographics, combined with low up-front capital investment and relatively minimal government intervention, explain the explosive growth of this sector.

Health Care: One of the key societal issues China faces is its aging population. Within the next few years, the country is expected to have more than 220 million adults over age 60, compared to 180 million today — all of whom will require medical care, facilities, and treatments. Currently, only 5% of China’s GDP is spent on health care compared to 16% in the U.S. The market capitalization of Chinese to U.S. health care companies is 1:20; the ratio of market capitalizations for health care services companies between the two countries is even greater, at 1:100. Realizing the need to improve the quality and increase the quantity of health care in China, the government deregulated the sector, thereby inviting entrepreneurs to enter and close the gaps in basic infrastructure and services. According to Hong Lu, a principal at Piper Jaffray, “we’re still at the low-hanging fruit stage, with limited risk involved but extraordinary growth potential.”

Renewable Energy: Despite the recent tumble of the Chinese solar and wind-manufacturing sectors, renewable energy remains an opportunity for growth. It was first identified as a strategic industry in the 10th Five-year Plan of 2001 and has continued to be a focus of the government as a way to satisfy the growing demand for energy and simultaneously minimize environmental impact. From 2004 to 2011, the Chinese invested approximately US$200 billion in this sector. This investment will continue as China’s 12th Five-year Plan of 2011 targets generating 11.4% of the country’s energy from non-fossil fuel sources by 2015 and 15% by 2020, up from 8% today. However, the boom and bust of China’s renewable energy sector over the past decade taught the government, investors, and entrepreneurs the negative results of too much government intervention. Entrepreneurs still see an opportunity to ride this policy trend, but have shifted focus to less-crowded verticals within the sector, such as water treatment, lighting, gas-fire generation, and environmental services.

As China enters what could be a significant economic slowdown in 2014, there are a number of indications that the role of its entrepreneurs will expand. The country’s 12th Five-year Plan, released in 2011, announced that the education, financial services, health care, and logistics sectors would be deregulated, creating competition with state-owned enterprises and space for new firms. Shanghai recently launched a new free-trade zone in Pudong, which has already been likened to the country’s economic experimentation of the 1980s. In addition, improvements in credit systems and financial transparency should increase access to funding. China has abundant resources to create new institutions that support entrepreneurship and perform the regulatory functions required for fostering new entrepreneurial activity. For the foreseeable future, there will be a growing need in China for entrepreneurs who will no doubt play a pivotal role in the country’s future economic growth.

This article was written by Annie Jonas, Stephanie Lai, Greg Root, and Russell Warriner, members of the Lauder Class of 2015.

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