As China’s middle class grows and urban migration increases at an unprecedented rate, venture capital funds are seeing a vast potential in its consumer base. But China is a risky investment on many levels, especially in the areas of law and regulation, and particularly intellectual property protection. At a recent Wharton Thought Leadership Series event held in San Francisco, Wharton professor of insurance and risk management Kent Smetters moderated a discussion between Ted Schlein, a partner with Kleiner, Perkins, Caufield & Byers (KPCB), and Andrew Metrick, a Wharton professor of finance who specializes in venture capital and is author of the book, Venture Capital: Finance and Innovation. Their discussion covered the ins and outs of venture capital investing in China, the VC models that are common there, and why innovation isn’t a top priority in the Chinese market. The conversation was followed by audience questions about KPCB’s approach to China and other VC-related topics. An edited version of the discussion follows.

Kent Smetters: Our first speaker tonight is Wharton’s Andrew Metrick, who will focus on developments in venture capital. Then, Ted Schlein, who joined Kleiner Perkins in 1996, will talk more specifically about China.

Andrew Metrick: Thanks, Kent. First let me talk a little bit about the industry in the U.S. Some statistics: Starting in the early 1980s, when the industry started to grow, we saw about 500 companies a year receiving venture capital funding for the first time, and that number held remarkably steady from the early 1980s through the mid‑1990s. [During the same period,] somewhere between 20-30% of the companies that received initial financing eventually went public.

Beginning in the mid‑1990s, we really saw an explosion of companies receiving first‑time financing, and towards the end of the decade, as everybody located in the [San Francisco] Bay Area will know, there were a whole lot of companies going public as well, but not nearly enough to keep pace with that old percentage. So between 1998 and 2000, roughly 2500 companies received first‑time financing per year. From 2001 through 2003, and those three years put together, we had about 80 companies that were venture‑backed go public. So we are looking at numbers that are very much in the low single digits.

This kind of change in the industry, this view of the industry as a growing asset class where there is so much competition and so much entry, has made it very difficult. These are the kinds of statistics that lead firms like Sevin Rosen to say that they are going to opt out altogether, that they think it is very, very difficult to succeed. All the evidence that we have ‑‑ and it is somewhat limited ‑‑ suggests that the very top‑tier firms, the Kleiner Perkins and Sequoias of the world, actually have not been that adversely affected by all of this “competition,” and have continued to do well; but it is the mid‑tier that has been really, really pressed.

With regards to venture capital in China, and broadly exporting the venture capital model of the United States to other countries, there are two challenges that you always hear when you talk to VCs. One is the difficulty of having exits: I can get into these companies just fine, but how can I get out of them? While we do have some Chinese and Indian companies that manage to go public on Western exchanges, it is not nearly as easy. There is an extra hurdle that you do not have if you are a Silicon Valley‑based company.

The second challenge is corporate governance and legal structure. That is a real concern. As a venture capitalist, you make your living as a professional board member. You are a minority investor in a company, and your job really is to give advice. When dealing with other countries, how can you make sure that your investment is not expropriated one way or the other — that the money that you put in is used in the way that you want it to be used, and that contracts will be enforced?

The issue is not the honesty of people across different cultures, but rather the enforceability of contracts, and the ability for a minority investor to exercise any official oversight. I hope that Ted, who is on the ground thinking about these kinds of investments, can address some of the specific challenges, and maybe tell us how he has overcome those challenges.

Ted Schlein: Thanks, Andrew. First, I’ll start with Kleiner Perkins. We’ve been doing venture for about 35 years. What we mostly invest in are early startups. We do some “speedups,” which in our definition are companies that have a million dollars in revenue the quarter after we invest in them. We also do “incubations,” which are just ideas that we want to [give] form; we find the entrepreneurs, we put it together and build it in our offices and go forth.

Our [core] areas of interest are IT and IT infrastructure, and its growth, and we have been involved in that for years. About 25% of what we do is around life sciences, and we’ve been doing that for many years, too. Something we have done very recently in life science is pandemic preparedness, and we started a completely separate fund which is targeted at investing in the areas of vaccine development and technologies to help vaccine development, as well as diagnostics. Another new area is [investment] around green technology.

But one of the other initiatives that we laid out a year ago was international expansion. That is really new for us. Honestly, 90% of our investing was about sixty square miles from our office, and a “foreign investment” would be Salt Lake City, Utah. And so, this is a big deal for us.

China and India, in particular, originally started for us as labor arbitrages: smart, inexpensive labor. At one point in time, India was a six-to-one arbitrage in labor cost. Then, the big guys moved in. IBM set up shop there and drove all the prices up, and now it is about a three to one, just to give a little perspective for you. And slowly, with the rise of the middle classes in these countries, they have become huge markets of their own.

A lot of our investing — and others’ investing — over there is really not so much about innovation, but really about market capture. How do I come up with consumer services that target these consumers? And that is what a large number of these companies are started around, consumer services.

Most of the venture capitalists in China are ex‑investment bankers. I am generalizing [based on my experience there], but most come from a finance background. A large number of the venture capitalists here in the United States come from operating backgrounds. Certainly every one at Kleiner Perkins has an operating background. I spent ten years building a software company before coming to do venture. What this has caused is a very transactional point of view over in China — what I think is kind of a scary point of view. Everything is about the IPO. And in venture, we like to think of ourselves as company building. We are here to build a company, and an IPO is an event that takes place — yes, it is a way for us to get compensated eventually — but it is not the endgame. It is actually part of the first-third game, if you will. And quite honestly, statistically, we make far more money post‑IPO, than we do prior to an IPO.

So, growing these companies is not a mentality there. It is about getting a company public. There are a couple of problems with that. There have been 39 Asian tech IPOs since 2000. Of those, 25 trade at or below their asking price, most below. That doesn’t show a whole lot of attention to the future — the building of the company. Capital markets will wake up to that eventually, and a backlash will happen. It is also indicative of something else that I see a lot of: The talent pool cannot absorb $3 billion in investments yet. There is not enough management yet. …There are a whole lot of really smart folks over there, [but] they work really inefficiently, and there is not a lot of accountability. And this is a problem.

Also, as Andrew pointed out, there is really not a body of contract law established in China. So it is a little scary to be an investor over there, because you don’t really know how things are going to end up. As a result, we have come up with an amazingly convoluted way to make investments in companies based in China. You also have the added burden of wondering, “What’s the government going to do today?” Right now, the government loves all of us. There are huge amounts of capital flowing into their country. But if they decide that for some reason they don’t like it, then they could make a change. And then what? There is that cloud out there. You worry about it — not too much, but you have to worry about it.

I’m going to end my opening remarks with the methodologies I’ve seen U.S. venture firms use to approach the Chinese market. The first one was the “Got No Soul” model. This is really how the venture guys got started in China. It was “fly in, fly out.” It’s not unlike what I have done with [a Chinese] company whose board I’m on. I live in the U.S., and the deal that I cut with them was, “I’ll come twice a year.” We agree to talk on the phone all the time and trade lots of emails and all that kind of thing. The “Got No Soul” is the practice of venture capitalism to selectively invest in a company.

The next one was the “Dragon Roll.” A U.S. venture firm would hire a bunch of inexperienced or less experienced Chinese nationals in the country but really not empower them. There would be this raw American in the middle, making the decisions without really having the on‑the‑ground experience to understand what it really means to make investment decisions.

Another one was the “Peking Duck.” The “Peking Duck” meant making an investment in another fund that’s based over there: “Let’s go ahead and invest; we’ll put $10 million in their fund because then we get to see what they’re investing in and learn.” It doesn’t really work that way. You might get to see what they invest in, but you really don’t learn. You just get a feel for what that group of people is putting its money into.

And then there is the last model, which will be the enduring model. I just call it “The Franchise.” You will find professional managers over there, professional venture capitalists, and buy into them. They will be part of your firm. You will open a fund and they will be part of your fund, and you will integrate together. Maybe you will raise a separate fund, or maybe they are just general partners that are there. But they are Chinese nationals; they are practiced venture capitalists, at least to the extent that it has been practiced over there. Or you vetted them and you believe they can be good practitioners of ventures. They are senior enough, they make the decisions over there, and you don’t try to manage them from the United States. I think that’s the only way that you’re going to have an enduring way to practice venture capital over there.

Smetters: Thanks, Ted. Let me just bottom line it: What excites you most about China? It sounds like it’s not about the source and opportunities, it’s really about the consumer base that clients are mostly interested in.

Schlein: Today, we don’t see a lot of innovation. I could give you reasons why I actually don’t think you’re going to see huge amounts of innovation for at least five to seven years. You see a lot of me‑too companies. I think that’s fine; I think it’s good. Let’s look at it: You have Baidu trying to knock off Google. You have Alibaba and DangDang trying to knock off Amazon. I’m naming some of the successful companies.

In China, there are some companies that do some things that we don’t necessarily do in the United States. But it’s not around innovation. There was a company called Focus Media, which uses beautiful plasma television screens that they place in office buildings and everywhere. It’s an advertising model, and they’ll project ads through it as well as news and other things. It’s clever, and it works in that culture. It’s a great, successful company. It’s not terribly innovative — there’s no core IP, but that’s okay. It’s serving that marketplace, and people who understand that marketplace are coming up with innovative stuff.

Generally, you don’t see huge amounts of innovation coming from them. You see great process automation and a great, big marketplace. And the question is, “Can Google get the Chinese market, or will Baidu get it?” There is a good war to be had there.

So you will see some of these U.S.‑based firms trying to go after the Chinese consumer markets, and I think in a lot of cases the Chinese companies are in a better position to go after their market.

Smetters: Some companies are starting to say, “Gee, maybe China was overrated.” Warner Brothers decided to pull out; Microsoft is now even talking about it. Do you see these as one‑off events, or is there a broader trend potentially here? Was China overrated?

Schlein: Overrated? There are 1.3 billion people out there and it’s getting wealthier. My experience was that the folks I’ve worked with over in China are really smart. This is at the ministry level, as well as the entrepreneurial level. They want to have a big burgeoning marketplace. They have targeted industry segments to go and dominate. They have no false expectations. Their expectation is that within 20 years they will own the technology sector. That’s the intent. We’ll see how well they execute on it.

Certainly, they’re going after different stacks of technologies. Look at FallWay, a government sponsored company going after networking and communication infrastructure. They can do that. It doesn’t really matter if it ever makes a dime; it can be supported and driven that way. They can therefore undercut Cisco — they can go after it. And that’s deliberate. I think if somebody is going to be successful out there, they’d like it to be one of their own companies.

Metrick: Ted, I definitely share your skepticism about the Got No Seoul, Dragon Roll and Peking Duck. I am perhaps less optimistic about the fourth model that you describe, which is the Franchise model. I just want to push back a little and ask your opinion.

Historically, the most successful venture organizations have been tight organizations where the partners sit in one place. When they get too big and too diffuse, they stop working really well as an organization. There are really only a couple of counter‑examples to that. But even those have, in many cases, given up doing venture, like Apax. Are you concerned that even if you found very good people in China that this is, to use a crass term, a brand extension that puts the venerable KP brand in some danger? That you’re handing over that name to some people that aren’t from KP, and that the incentives become a little more dulled? And that, historically, those groups can get out‑competed by a China‑specific group that has all of the strongest incentives?

Schlein: Those are all the things that keep us up at night. You’re right. In the venture world, it really comes down to people. This is why I hate the concept of venture being an asset class. I think venture is a boutique industry practiced by a few people. It can be a few hundred or a few thousand people, but a relatively small piece of the population. Therefore, it’s a very people‑centric business. You have to find the right people. If you’re going to do brand extension, if you’re going to start something in another area or office, you have to make sure you have the right people to do it with.

Now, of course, do you know that for sure until you’ve been doing it with them for a while? No. Do you do your homework ahead of time? Do you do the best you can? Do you make the best judgment calls you possibly can? Yes.

I would also argue to get over the issue of being in a tight group. They need to be a tight group. They question is, do they really need to be a tight group with us in the U.S.? We have enough going here in the U.S., so it’s not as if we’re going to add a lot of value to them, other than the extent to which we can teach them something about an investing process and investing discipline. I think that will be the difference for these franchises, if you will, that make it in the long run. Anyone is going to be able to raise a fund or two, but to make it in the long run will depend on how well you borrow from both sides of the equation, and how well you share information. And, how well you don’t borrow is equally important. Where do they not allow us to influence them wrongly, and where do we shut up and say, “You do your thing”? It’s going to be hard to be successful, but I think that’s the route to success over there.

Smetters: I’m sure there are people out there who have questions.

Audience Member: Would you take on a country like Russia where there is a