Too Much Money Hurts China

 Sintia Radu
  31st-Jul-2018

China is being called a new Silicon Valley, striving for global domination through companies covering a wide array of technologies. In the second quarter of this year alone, its startups reportedly attracted 47 percent of all global venture capital, compared with the 35 percent that companies in the United States and Canada cumulatively raised.

For the first time, Chinese entrepreneurs took the lead in venture fundraising, proving that the nation's combination of long-term state planning – as well as specialization in areas such as robotics, new-energy vehicles and biotechnology – may be paying off.

Yet venture capitalists say there's a dark side to China's tech sector, stemming from something other industries and countries would envy: Too much money from both the government and the private sector is pouring into startups, regardless of a company's merits.

The overflow of money into China’s tech sector reflects how companies in all of the country’s industries have trouble assessing risk, a result of following government priorities, not market forces, experts say. The landscape rings eerily familiar to the internet bubble that formed in the U.S. in the 1990s, and as a result, China’s decadeslong economic boom is also fueling massive debt.

"You have like $70 (billion)-$80 billion a year going into venture (capital), but you are getting funded not just the good companies but also the bad companies," says William Bao Bean, managing director of Chinaccelerator, a Shanghai-based startup accelerator for software companies in China. That's happening, Bao Bean says, because of the pressure put on VCs to invest from shareholders and owners.

A bad company is not necessarily one that is unprofitable, experts say. Entities that are poorly conceived and put together present a much higher risk of never being successful. Such companies, although having the potential to temporarily create jobs, might ultimately hurt investors and damage consumer confidence.

Funding for even the least-promising businesses is readily available. Company founders can put in their own resources or call venture capital firms to help jump-start an effort. They also can access popular investment programs from the giant technology companies in the area, such as Alibaba – China's e-commerce platform that reported transactions worth $248 billion in 2017 – or Tencent, a social media platform worth more than Facebook. These companies, experts say, have the luxury of constantly investing in any startup that simply looks interesting because of their massive financial resources.

"At the end of the day (even if those startups don't make money), they can always fold it in," says Shaun Rein, managing director of China Market Research Group, a Shanghai-based strategic market intelligence firm, and author of a book on Chinese innovation. "It's not like in venture capital firms where you have to be a lot more thoughtful on valuation because that is your only source of revenue. (Alibaba and Tencent) approach pretty much anything that comes out and hope that 1 of the 100 investments makes money."

Public officials in China have also created investment funds for startups, a result of Beijing's priority to create well-paying jobs for China's growing middle class. Premier Li Keqiang frequently boasts of the country's "mass entrepreneurship and innovation initiative," but rarely acknowledges the failures along the way.

Money That Hurts Innovation

The relationship between money and innovation has fueled many debates. Some argue that the more financial resources a company has, the better chances it has to develop new methods and products to support its core business. Others say the role of money is overrated, and that success relies on more than seed capital. As a result, a company with too much capital removes the incentive for creative solutions and damages its long-term future.

These days, China's big tech companies appear willing to overpay for the development of new products that look good in the eyes of their shareholders, Rein says. This is bad, he adds, because new companies might need to struggle less with developing a workable business plan and simply focus on the concept they put forward.

"Tencent and Alibaba are not just throttling the market, but in many ways they are hurting innovation," Rein says. "Because right now basically people are saying, 'Let’s start a company. Let’s create something that sounds innovative, even if it’s not. Let’s not necessarily plan on research and development for five years, let’s instead create something that sounds good and then sell it to Tencent or Alibaba.'"

World map textured human brain covered with abstract connections, artificial intelligence concept

The Global AI Race

In 2017 alone, Alibaba spent $11 billion on its top 10 investments, while in the past two years it sealed 70 deals worth a combined $29 billion. Tencent invested in more than 60 companies in 2018. The two companies have become the core investors new companies need to have to ensure a smooth market penetration.

"If you are a tech startup you either have to get money from Tencent or Alibaba or you won’t be able to grow because these two companies control the tech ecosystem," Rein says. "Basically, any new idea is getting funded by one of the two and its major competitor is funded by the other one of the two."

While the Chinese technology sector seems to be driven by trends – startups tied to blockchain or artificial intelligence are currently fashionable – experts say competition on the open market has become so high in the country that young companies need more than investment capital to be successful.

"Everything to do with sales and marketing is super important, even more so than I would say in the U.S. because it's such a highly competitive market and everything moves super, super fast," says Tal Badt, director of business development at Tsinghua University's x-lab, a university-based education platform aimed at fostering creativity, innovation and entrepreneurship. "In order to survive, they have to stake a claim very early on, devote a lot of resources and be very, very aggressive toward fast expansion in all directions."

Money also ends up being used as a "weapon," experts say, with the richest companies more easily attracting talent and destabilizing competitors.

"So if one company gets more funding than the others, the others just go in and steal all the competing company's employees or they'll take out the key employees," Bao Bean says. "And most people have an impression of China (as being all about) cheap labor, but compensations at (the) senior level are similar to Silicon Valley, and at the middle level maybe slightly below."

Competition exists among investors in China's startups, as well. If "you come up with something cool, very soon there's going to be investors hanging around your doorstep because there's just so much money here and there's so few investments that investors in many ways have to beg to get in on deals," Rein says.

To compete against the wealthy tech giants – namely, AliBaba and Tencent – experts say VCs need to do a better job at selling their services and expertise. This can prove challenging, Rein adds, because many venture capitalists in China lack entrepreneurial experience: "Most of them are deal-makers," he says.

Developing competitive companies in China will require Beijing to relax strict rules it imposes on businesses, others argue. China needs to accept competition from both domestic and foreign companies, experts say.

"If you're throwing money at companies and blocking out foreign competition you are probably not going to get a first-rate company," says Robert Manning, a senior fellow at the Atlantic Council, a Washington D.C.-based foreign affairs think tank, and co-author of a report on global innovation.

Change is already slowly happening, experts say, and early stage entrepreneurs in the future may need to rely more on their own money to develop a workable business, as investors are beginning to turn more conservative.

"If you're (a) super-early stage startup, It'll be very hard for you to get funding from anyone that's kind of more institutional or (a) private investor, and that's a big concern" says Badt, of Tsinghua University. "I think almost everyone that I spoke with is looking for companies that already have some sort of test case, some user base and are at least in A round (the first major round of business financing), if not further along in terms of the corporate development.

"And this is also happening in Israel, in the U.S. and Europe, so the Chinese are taking the same approach."

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