VC in China from K@W by way of CER and FORBES, plus a Pira… Privateer Story

Back in the days of yesteryear I worked across the street from THE Sand Hill Road. There were a bunch of small, unassuming buildings that were charging more for rent per square foot than Manhattan or London's West End. Nothing memorable about the real estate. But I've always liked this internet thing and those VCs had something to with it financing some 2,500 companies per year in 1998-2000. This number has dropped considerably, but the title "Venture Capitalist" always reminds me of Sir Francis Drake; that guy was a paragon of badassedness. With 164 other guys he set off around the world with secret financing from the Queen and a few others. 3 years and 36,000 miles later he returned with 58 men, commercial contracts with the Far East, charts of the Asian archipelagos, and tons of gold, silver, cloves and cinnamon representing a 4,700 percent return to his investors. This profit in part formed the East India Company, and according to Keynes, "may be fairly considered the fountain and origin of British Foreign Investment." But enough about history; what of venture capital in China, today? (Drake info sourced from Derek Leebaert's, To Dare & To Conquer)

There's an interesting interview at Forbes of Ted Schlein, partner at Kleiner, Perkins, Caufield & Byers (KPCB), and Wharton professor Andrew Metrick on venture capital in China (h/t CER: The Editors' Journal). Mr. Schlein is the principal interviewee and he shares his insights on the major benefit and the major drawback of venture capital in China, how KPCB takes a different approach to investing in China as opposed to other developing markets, and the four strategies of venture capital in China.. Mr. Metrick rounds out the interview with some nice background data and a useful criticism of the "The Franchise," the venture strategy that KPCB is using in China.

Mr. Schlein identifies the Chinese market as the main reason for ventures in China. He does give the common spiel that the market is huge and Chinese customers are getting wealthier, but Mr. Schlein also finds that "in a lot of cases the Chinese companies are in a better position to after the [Chinese] market" than the U.S. based companies. He identifies some significant markets wars that are taking place (Baidu v. Google; Alibaba and DangDang v. Amazon), and he identifies some Chinese companies that are serving a marketplace that doesn't exist in the U.S. (Focus Media). Chinese simply know more about the Chinese marketplace and they are in a better position to exploit it.

The problem that Mr. Schlein identifies is that many of these homegrown companies are succeeding against their U.S. rivals not as innovators but as successful "me too companies." Presumably there is more money to be made on a venture when the company your funding has its own IP. Mr. Schlein attributes this not to a lack of bright students, but to Google and Microsoft's aggressiveness in recruiting the best students from the best universities in China and paying them a lot. He says that in the US the VC firms do the same thing and crawl through university's labs, but that they just haven't started doing that yet in China.

The four venture strategies that Mr. Schlein discusses are "Got No Soul," "Dragon Roll," "Peking Duck," and "The Franchise." The first three of these strategies use an approach that is unique to China & India, in which the venture firm does not exercise as much control over the company as venture firms simply would not do in the U.S.

Usually when a venture capital firm invests in a company, partners in the venture firm take some of that companies' board positions. In Got No Soul, the U.S. board member sends emails back and forth, talks on the phone, and might go to China twice a year to check on the company. Mr. Schlein has experience investing in this way, and he says that the most important part is making sure that you have a Chinese CEO that you can trust.

In Dragon Roll:

"A U.S. venture firm would hire a bunch of inexperienced or less experienced Chinese nationals in the country but not really 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."

I guess the money wasn't what it was supposed to be?

In Peking Duck, the venture firm invests in a Chinese based fund expecting to learn how to invest in China. Mr. Schlein says, "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."

The Franchise is the type of venture that Mr. Schlein's firm, KPCB, is operating in China. There's even a link to their China franchise on their webpage. Here is Mr. Schlein's description of 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."

This is similar to his observations on the China marketplace. Chinese venture capitalists are going to have a better grasp on what needs venture funding in China.

Mr. Metrick worries that The Franchise results in the creation of "too diffuse" of a venture organization which has spelled disaster in the past. Mr. Schlein counters that they're engaged in "brand extension," and unlike the diffusion that has taken place in other firms, the U.S. head office is very hands off with the Chinese office. He says you have to try and pick the best people you can find, "teach them something about an investing process and investing discipline," and hope they succeed.

Mr. Schlein notes that this is very different to their investment process in the rest of the developing world such as Croatia or Russia. KPCB keeps some of its developers and engineers in these countries, but they bring the core business and executive team to America where they can have close watch over the business.

I guess they see something in China?