In different times, a report published on December 24 by China e-Business Research Center might easily have gone unnoticed. It revealed that more than a third of the 100 CEOs of e-commerce companies in the country said they have listing and other fundraising plans for the next three years. But in today’s post-financial crisis environment, that’s enough for China’s venture capital (VC) players investing in high tech to heave a collective sigh of relief.
Indeed, like their counterparts around the world, China’s venture capital (VC) firms have had a white-knuckle ride during the financial crisis. According to Zero2IPO Group, a research company in China, both the value and volume of investment deals in the country in 2009 were down by as much as 30% compared with 2008. As for initial public offerings (IPOs) in the country, they all but disappeared for much of the year on major markets around the world.
All this has been happening as VC companies — and the companies they invest in — work in uncharted territory, in which there’s a lot less cash chasing a lot fewer opportunities than previously, says Allan Kwan of Oak Investment Partners. A 25-year veteran of telecommunication, wireless and Internet multinationals in China before becoming a venture capitalist at the US$8.4 billion Palo Alto, California-based company in 2007, Kwan discusses with China Knowledge at Wharton the key to VC success today in the country, while offering advice for budding venture capitalists.
The following is an edited transcript of the interview.
China Knowledge at Wharton: You made a dramatic career change relatively recently, from high-tech marketing to venture capitalism. Could you discuss what you have been able to bring to the VC world?
Allan Kwan: What I am doing now is investing in VC-funded companies in the high-tech sector. In my past career, I always tried to stay at the forefront of technology — that is why I moved from Nortel to Motorola to Yahoo. These three multinational jobs, plus my entrepreneurial experience, have given me product, market and operational know-how, which I can draw on to help the portfolio companies evaluate programs and strategies, and provide other support to enable the investments to grow until they list on the stock market or merge with other companies.
Also, the years in the tech industry allowed me to establish an extensive network of professional contacts, which provide a very good human resource pool that can help these companies recruit top financial managers and leaders.
In China, we have invested in eight companies, and I am member of the board of directors for each. Most of them are companies that have been operating for a few years and are already profitable. Whether they eventually exit through a public listing or M&A, they will have an opportunity for significant growth in the next couple of years.
China Knowledge at Wharton: How does the global VC situation today compare with, say, 10 years ago?
Kwan: From 1999 to 2001, we were just entering the first peak of the emerging Internet economy, and there was a lot of capital looking for opportunities. Many investors back then cared about the business concept of investment proposals, but did not worry as much about the underlying fundamentals. Even if companies were not making money but had growth potential, they could attract VC investors.
What is different about the current environment is that first, for most companies, it is nowhere near as easy to secure financing now as it was. Investors today will scrutinize a company’s revenue model and potential for sustainable profit.
Second, the challenges in the macro environment have led to revenue contraction. So portfolio companies require more time to reach profitability and scale.
Third, there are fewer sources of funding. After last year’s financial crisis, many venture firms faced problems with their portfolio companies in one form or another. Some companies expanded too fast or maintained too high of a cost structure or burn rate. So now they need to raise money. But the contraction and restructuring of VC as a result of the financial crisis has made it very difficult for these companies to get more funding and continue operating.
Fourth, 10 years ago, there were many opportunities to go public; now the IPO market in North America has come to a halt.
Given the current financial crisis, VC has changed greatly. In 2000, the economic bubble reached a climax and then ebbed … and many marginal investment projects were launched with hot money that continued well into the middle of the decade, particularly in the tech sector. Some adjustments have had to be made. Over the next two years, the bad start-ups among these portfolio companies will be closed, and VC will enter a consolidation phase.
China Knowledge at Wharton: The opening of the alternative Growth Enterprise Market (GEM) board for small-cap firms in Shenzhen last October adds a new exit channel for investors. How will it affect VC and private equity in China?
Kwan: First, GEM is still very new. With the government’s methodical coordination and control, it can only provide a few exit opportunities for VC-backed companies in the short term. Long term, it should mirror the evolution of Nasdaq and provide a very robust channel for Chinese companies to raise capital.
Also, most VC investment in China’s high-tech sector comes from abroad. With similar offshore equity structures, these local start-ups were designed for exit on Nasdaq or the New York or Hong Kong stock exchanges. It will be difficult for them to list domestically.
If you think about listing in China, whether on GEM or the main board, you have to adhere to government policy and regulations, in terms of the percentage of foreign investment that’s allowed, profit requirements, financial reporting and so on. If you consider converting the structure from a foreign to a domestic company, you will likely encounter several hurdles, such as capital redistribution or reassignment among domestic and foreign shareholders or procedural problems.
China Knowledge at Wharton: Does this mean mergers and acquisitions will become more widely used an exit strategy in the next 18 months?
Kwan: Mergers and acquisitions will play a very important role in China because companies trying to list face the fundamental problems just mentioned.
Because of increased competition or a general slowdown in market demand, revenue for many venture-backed companies could contract, and income and profits might not reach targets. But after a merger, the new company may have the scale and more opportunity to hit those targets.
Over the past few years, a lot of capital has flowed into China and a lot of companies have accumulated [financial] resources; other companies may lack funding but have good technology or core businesses. These two types of companies could complement each other and become very strong if they are combined in a merger. They also will have an easier time meeting listing requirements.
But, of course, M&A has proven to be very difficult to execute in China, so we must bear this in mind [when weighing up] the trade-offs for a successful exit.
China Knowledge at Wharton: What do successful VC investors in China look for when choosing a project?
Kwan: China will always provide good opportunities. In the next several years, there will be more high-quality companies because they’re developing under the tutelage of VC investors and absorbing valuable lessons in market and business models.
When choosing a project, I look at the team and their respective responsibilities. There’s a saying in China, “The matter depends on the individual.” A company’s success is very closely related to the composition and structure of its team.
It usually takes at least five to 10 years from when a company is founded to when it is ready for an IPO. Can the team endure that long [period] in the face of fierce competition? When the market changes, when uncertain factors swing one way or another, the core team needs to [adapt] its management model or company structure, stay unified, move forward and implement its plan. It requires an ability to meet contingencies and have perseverance and integrity. Being able to adjust to the market during times of upheaval or financial crisis is very valuable.
Also, after a company goes public, the founders face the challenge of growing the business even more. Listing is the beginning of a new stage. It raises the requirements for financial reporting and strategic planning. Can the original team continue moving forward to enhance company performance? Can they put aside personal interests and concentrate on the success of the company as a whole? Or will some entrepreneurs opt out after the company reaches maturity and [be willing] to let more experienced managers run the company? As you get to different stages of development, you face very different, very difficult choices.
Your judgment of people needs to be accurate. That is, if a person harbors ill intentions or is unethical, his or her business may be successful at the beginning. But if it is a large-scale enterprise, the problems will eventually cost you dearly. Of course, it is impossible to know everyone’s secrets or morality. But if you have worked in the industry long enough and developed enough personal relationships, you will have a very good system of checks and balances. At the very least, you will find out about a person’s previous work experience and relationships with former partners, superiors and subordinates. It is not difficult to find this data, if you have the personal relationships to get it.
While I always pay very close attention to the entrepreneurial team, the sector that the company is in and business model are also important considerations. [I look at] whether the market will provide enough scope for the company’s development — for example, the mobile phone and high-end broadband markets in China will bring numerous opportunities — and whether the company has the right business model to capture sustainable revenue growth from the market.
Many unsuccessful investments can be seen clearly just from the numbers, but it is often more difficult to understand the people side of things. Sometimes the business model is sound, and the market opportunity is excellent, but the people fail to make the grade. Usually, each one of these factors is crucial for the success of an enterprise.
China Knowledge at Wharton: What advice would you give someone who is thinking about becoming a venture capitalist today?
Kwan: Anyone wanting to join the industry at this time must consider the decision carefully, as the industry is facing a large-scale adjustment. There are resources, but it is not easy to find a good VC fund. What counts, to a large extent, is knowledge of operations or a sector.
If you want to cultivate an understanding of the investment side of a business, part of this should come from some years of operational experience. You could join the VC world as early as possible after building that experience. You can do an internship in a specialized industry and work there for many years, or you can start at a junior level. All this depends on the opportunity offered by VC firms operating in different stages of the investment cycle. Earlier stage VCs tend to need more analysts and associates, so they offer more posts to recent MBA grads. But unlike investment banks or consulting companies, the recruiting activities of VC firms are generally more limited.
If you enter this industry, your early development – say, the first 10 years — is not easy, unless you are very specialized. Like consulting, it is only when you reach the stage of being a partner that you can really have your own views on the market.
China Knowledge at Wharton: Over the course of your career — at Motorola, Yahoo and so on — you have done a lot of mentoring. Are there any common mistakes that you see people making as they climb up the career ladder?
Kwan: Many people are impatient, and change jobs after working for two years, usually because of a higher salary. The truth is that they have not learned anything real in those wasted two years. You have to be very careful when deciding which industry to get into. Your decision should be based on your long-term perspective and goals and not on temporary trial and error. If you build a solid foundation, you will enhance your chances of success.
China Knowledge at Wharton: Having spent your early years in Taiwan, Canada and then the U.S., you have since studied and worked in China for more than 25 years. Given the rapid internationalization of the country over this time, has much changed in terms of what foreign and local entrepreneurs need to succeed there?
Kwan: When I did graduate work in China in the 1980s, a lot of importance was given to learning languages. Foreign students at that time had a competitive edge in the country because they knew the international market and had strong English skills. But the local universities have made great progress and trained many excellent students in the past 10 years. Local students have a better command of English, and they really understand local industry and the country. Unlike in the past, they are as competitive as the students returning from abroad.
Communication and local language requirements will only get tougher. Anyone wanting to get ahead in this country must be able to read and write Chinese. The barriers to entry are increasing and in any part of industry — operations, investment or consulting — you have countless contracts and related documents. Most business documents are written in Chinese and local entrepreneurs communicate mainly in Chinese. This is even more prevalent when you evaluate domestic deals or expansion opportunities in tier two or tier three cities, and raise capital on domestic stock exchanges. Today, just as the demand for experience is high, so too is the requirement for cultural awareness, language and hands-on experience.