Like most in the under-30 crowd, China's venture capital market is in a hurry. Since 1985, when the State Science and Technology Commission joined the Ministry of Finance to establish the country’s first venture capital firm — called China New Technology Startup Investment Company — some 2,500 private and state-run firms have sprouted up, according to Zero2IPO, a Chinese venture capital and private equity market research firm.

Since then, the industry has been crossing one milestone after another at a steady clip. It reached a new high in capital raised in 2010 and is on its way to another record in 2011. Venture funds in China, foreign and domestic, raised US$3.4 billion in the first quarter of this year, five times higher than the same period in 2009, says Zero2IPO. In comparison, fundraising in the U.S. rose to US$7 billion from US$4.9 billion over the same period, according to the National Venture Capital Association in Virginia. “Venture capital is booming in China,” notes Gary Liu, deputy director of the Lujiazui International Finance Research Center at China Europe International Business School (CEIBS) in Shanghai.

In turn, the hot venture capital market is feeding China's IPO boom. Last year, 347 companies made their debut on Chinese stock exchanges, raising US$72 billion — that was three times the number of new issuers and twice the amount raised as the previous year, according to Zero2IPO. Unlike the mixed fortunes of Chinese IPOs listed outside the country, China-listed firms have enviable price-to-earnings ratios. As of May 26, the average ratio on China's young, Nasdaq-like Chinext in Shenzhen was 141.2% — 34% higher than its average at the end of 2009, says Wharton management professor Raffi Amit. Even if that ratio settles to 25%, it will still outpace the U.S. average of 15%, he adds.

For all the froth, however, China’s venture capital industry is at a tricky turning point. In 2008, domestic venture firms in China outpaced their foreign counterparts in terms of total investments. In the first quarter of this year, however, just 4% of China’s venture funds financed early-stage investments, compared with about 35% in the U.S., according to Thomson Reuters and Dow Jones’s VentureSource, respectively. The dearth of early-stage venture financing has obvious implications for the government's plans to diversify China's economy and drive further growth. “If there is insufficient capital, this will stifle innovation, [which is] the source of productivity enhancement, new job creation, and social and economic prosperity,” says Amit. “Incentivizing early-stage investment is a profound issue that needs to be tackled in China.”

Too Early, Too Late

Venture capitalists have many reasons for preferring to invest in later-stage deals in China. To be sure, funding earlier-stage companies anywhere in the world always requires a leap of faith, but perhaps more so in China. As Zhang Zhang, a research fellow at Shenzhen Green Pine Venture Capital and an adviser at Shenzhen Venture Capital Fund of Funds, notes, early-stage companies do not have a lot of cash flow, leaving little margin for error. In addition, "their corporate governance is on a primary level,” making it difficult to monitor and manage performance, and potentially hiding unpleasant surprises.

Adding to the murkiness is the heavy local reliance, particularly among the political elite, on guanxi — or, in English, personal connections — rather than the merits of a fledgling business to attract investors. Because listing on public stock exchanges requires approval from the China Securities Regulatory Commission (CSRC), it’s often not what you know, but who you know that counts. “China's IPO system is very different from that in the U.S.,” says Liu of CEIBS. “Some VCs use their guanxi to get an 'in' with CSRC officials and pave the way for an IPO, and their investments in the IPO firm will get a huge return.”

Observers say the key reason why venture capitalists in China don’t invest in early-stage enterprises is their lack of operating experience. Even the Chinese investors with such experience are still relatively new to the whole process, according to Mart Bailey, managing partner at San Francisco-based Callaway Private Equity Partners, which invests in early- to late-stage technology firms in China. “For them, mid-to-late stage investing is more of a no-brainer. In China, they only lend up, because they don’t know how to lend down.”

Indeed, unlike in, say, the U.S., many local Chinese venture capitalists are not former entrepreneurs with operating expertise in the sectors they finance. Consequently, “they are less able to assess operating risks before investment,” says Gary Rieschel, a former senior executive at Silicon Valley tech giant Cisco and founder of Qiming Venture Partners in Shanghai.

Even many well-known U.S. firms operating in China are risk averse because they lack experience in China's relatively young market. “They’re dipping their toe in the water,” notes Bailey. “They’re doing later-stage investing, because it’s more proven, or investing as part of syndicate with a few domestic firms they trust.”

Sweeping Up

At an industry forum held by Zero2IPO in Hangzhou in July, the buzz among venture capitalists was the need to do more early-stage investing, particularly as opportunities in later-stage investments thin out. Right now, investors are engaged in saojie, or sweeping the street. The IPO frenzy of the past two years "has exhausted available deals" and driven up valuations of those that are coming through the pipeline, lamented one Chinese venture capitalist involved in early-stage funding at the event.

Firms, such as Qiming, are a positive sign for the next stage of China’s venture financing development. Qiming has been investing in early-stage deals since it closed its first deal in 2006 with Alltech, "a pre-product, pre-revenue MRI systems company," which it expects to have ready for an IPO in 2012, says Rieschel. Another early-stage investment to happen since then is Taomee, a children's portal, which was Rieschel notes was "very early stage" when Qiming funded in it in 2009 and had its debut on Nasdaq in June.

Joining Qiming is Beijing-based GSR Ventures. Partners at GSR, which was founded in 2005, are former tech entrepreneurs who focus on early-stage investing, and provide strategic and operational guidance to the entrepreneurs they fund. In May 2010, for example, GSR and another firm raised US$5 million in first-round financing for Lashou, a Chinese Groupon-like online group buying business, whoseCEO, Wu Bo,is a serial entrepreneur.

GSR advised Lashou, which had previously set up and then sold a website business, to first focus on expanding the new company, rather than turning a profit, in order to help it gain more market share ahead of the hundreds of Chinese Groupon copycats. To continue fuelling that growth and with a view to an eventual IPO, GSR and other firms raised US$50 million of financing last December and US$110 million in April, according to CrunchBase, an online technology company database. GSR also helped recruit the company's chief financial officer, chief scientist and senior technology team.

Meanwhile, China's government has been launching various programs to encourage more early-stage financing. Between 2008 and 2009, the National Development and Reform Commission (NDRC) set up 20 venture capital funds in seven provinces, each focused on a particular technology sector, from clean energy to life sciences. The central government said it would invest RMB 50 million (US$7.7 million) in each of the funds if local governments match that amount while also raising an additional RMB 150 million from private investors.

“The program represents an important and studied attempt by the Chinese government to spur investment in technology at its riskiest phases," says Stephen M. Sammut, a venture partner at Burrill & Company in San Francisco and Wharton lecturer, who is working on an assessment of the program with the World Bank, which is due to be published later this year. "The program borrows from and expands the best practices of government venture programs in Israel, the U.K. and the U.S., and strongly positions China competitively.”

Besides the effects of government incentives, the sheer attraction of potentially big returns may lead venture capitalists in China to focus more on early-stage investments. “I expect China overall to have a much higher return profile than the U.S. over the next decade, as we see venture capitalists and entrepreneurs take advantage of the combination of government policy, wealth creation, infrastructure development and domestic consumption,” notes Qiming’s Rieschel. “We are also starting to see real technology innovation in multiple sectors, which will also drive more early-stage investment.”

Along with funds, however, a large dose of patience is also needed, since experts point out that it can take decades to develop a sophisticated innovation ecosystem, including management and leadership skills. “You can’t shortcut that time,” says Alain Harrus, a partner at San Francisco-based Crosslink Capital, which makes early-stage investments in semiconductor and alternative energy technologies in China. “A lot of companies do not have management in the 40-to-60 age range, the generation lost during the Cultural Revolution. In the next 60 years, there will be an enormous development of managers.”

That, too, will help the venture capital system mature. If they follow the Silicon Valley playbook, today’s successful Chinese entrepreneurs will become tomorrow’s venture capitalists, with both deep pockets and practical experience. After all, says Bailey of Callaway, “the next 24 Ted Turner-type billionaires will most likely come from China.”