China has recognised the importance of foreign funds (and accompanying foreign expertise and talent) and the recent regulatory changes related to venture capital investments in the country are a reassuring step in the right direction. There are still uncertainties regarding feasible exit mechanisms in China and the lack of convertibility of the Renminbi, although these are somewhat allayed due to the medium-term horizon of most VC firms.
The burning question about investing in China for VCs is how to control the risk. In normal circumstances VCs exercise their judgment about people and technology, and to a large extent cover their risk by recourse to a financial and legal system which operates to reasonably predictable standards and outcomes.
In China, not only is knowing and backing the right people more difficult than in more mature markets, but the financial and legal recourse is far more uncertain and difficult. It is more difficult to establish and more difficult to enforce, not the least because the key frameworks are still being refined and implemented by government.
How do the leading VCs approach this challenge?
For some, such as DCM-Doll Capital's CoFounder David Chao the answer is to "do due diligence until you are blue in the face". Speaking at ATRE2004 in Shanghai he noted that some investors tend to cut short their normal processes or to allow themselves to believe that “China is different” and therefore different and lower standards apply.
Others, such as George Hara of Defta Partners believe that China is still an insider's game, and that the commercial risk is too high within the current financial and legal framework.
Hara says that "until we learn to manage our own risk we will continue to invite Chinese entrepreneurs to come to the US". This is a significant statement because Hara is a Japanese who has had deep contact with the Chinese and Korean investment community for a long period. Defta has investments in several Chinese-led start-ups in the US. Therefore Hara himself should be an ideal candidate to consider himself an insider, yet still feels that the risk is not managable to Defta's required standard.
For those who believe that they can manage the risk, or can accept the current level of risk, the key question comes down to finding and assessing the key people. That is, firstly building a sufficient level of trust in the founding entrepreneur, and secondly understanding how that entrepreneur finds and hires the key staff that he needs to deliver. The latter point being one this is often overlooked.
In order to gain the necessary credibility to attract professional investors many Chinese firms acknowledge the current need to establish themselves overseas, while maintaining their core teams in China. For example, David Cong of meetexpo, and Nick Zhang's Ipedo have established themselves in Silicon Valley but are essentially Chinese companies who have chosen to incorporate under the US legal system in order to qualify for investment funding.
Finally, a new VC firm is tackling the whole China investment opportunity head-on. The Hina Group, led by Hong Chen, is forging a new China-based VC firm using Chen’s extensive and successful track record in founding and floating US Start-ups.
Chen believes that China "needs their own Goldman Sachs" and he intends the Hina Group to be that company (see China's Own "Goldman Sachs" - The Hina Group).
The overriding lesson, from firms with the experience and with the scars, comes back to Chao's advice to do proper global-standard due diligence and don't succumb to the "China is different" syndrome.
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