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The Venture Capital Process in China

Andrew Y. Yan & Brandon Ho-Ping Lin, SAIF Advisors Limited


Reprint Permission from Aspatore Inc., All Rights Reserved

Summary Bullet Points

Private equity professionals looking to invest in China should:

  • Proactively source the best local deals through their network of local relationships and strategic partners -- many local entrepreneurs may not have sufficient relationships with international private equity funds
  • Make sure there is a meeting of the minds on key terms and common goals between the investor and the entrepreneur, who may not have much prior exposure to international private equity
  • Develop local knowledge and relationships to conduct a comprehensive review of the company, the opportunity and the risks
  • Understand the intricacies of local laws and regulations and restructure companies offshore if necessary to maximize exit opportunities and protective provisions
  • Focus on details in legal documentation, final due diligence and offshore restructuring to make sure the investment is properly structured and the fund's interests are protected

General Practices

We invest throughout the Asia Pacific region with investments to date in China, South Korea, the United States, Hong Kong and India. In China, for example, the venture capital process is not as well developed as it is in the United States. Many entrepreneurs have only limited contact, if any, with international private equity funds. There are also fewer international private equity fund professionals in the region compared to more developed markets.

We typically source our deals internally through our own investment professionals and their extensive contacts in the countries they cover. We also get referrals from our strategic partners in these countries. After identifying and developing a preliminary opinion on the opportunity and conducting initial due diligence, we negotiate with the entrepreneur on a non-binding term sheet that sets out the major terms of the deal, including restructuring the company offshore if necessary. This ensures a meeting of the minds on the key terms and common goals of the parties.

We then conduct detailed due diligence to understand the potential risks and rewards and we draw on local relationships and strategic partners to assist us in a comprehensive review of the business opportunity, management, company operations, customers and competitors. After investment committee approval, detailed legal documentation, final due diligence and offshore restructuring (if necessary) are completed, the investment is made.

Venture Capital Investing in China

In China, the venture capital laws are still developing. For example, preferred shares are not recognized, which makes it more difficult to build in protective provisions for minority investors, such as veto rights on certain substantive decisions. However, the Chinese government has been making significant strides in this area. For example, the government recently promulgated new regulations governing foreign-invested venture capital funds. These regulations encourage the formation of foreign-invested venture funds onshore to invest in onshore entities (as opposed to the current situation where most international private equity funds are based offshore and make investments in offshore holding companies of Chinese companies). These regulations encourage onshore funds by setting forth more concrete provisions regarding foreign exchange conversion, repatriation of profits and taxation.

Due to a less-established track record of private equity successes in China and due to barriers in terms of language, culture, local laws and regulations and process inefficiencies, there are fewer international private equity funds operating in China, which results in less competition for quality deals at attractive valuations. This is in comparison to more developed markets where there is currently a large private equity capital overhang with a lot of capital that has been committed but has yet to be deployed. In developed markets, there are also larger numbers of experienced investment professionals chasing after the same hot deals.

In addition to the few international private equity houses and corporate programs actively operating in the region, there are local venture capitalists and angel investors who are beginning to participate more actively in finding and making private equity investments. However, many of these local players may not bring as much added value to the investee as experienced international private equity funds, especially if the investee is looking to eventually list or sell themselves overseas or require assistance in resolving important business issues.

Identifying Potential Investments

We invest throughout the Asia-Pacific region, with an emphasis on China, Korea, the United States, Hong Kong and India. In countries where we do not have a local presence or active coverage, we prefer to work with local financial or strategic partners. These are usually larger deals that require a syndicate of strategic and financial investors to complete the deal. In the technology, media and telecom sectors, these larger deals can often involve large telecom service operators.

In each country, we typically start with industry studies to identify the sectors with promising growth potential in the next few years. We then try to find the sector leaders in each sector as our potential targeted companies.

We find most of our potential investment companies through professional or social contacts. Almost all of our investment professionals grew up and worked in the countries and regions they cover in addition to receiving undergraduate or graduate degrees in the U.S. or Europe and working previously for multinational companies. This combination of local background and relationships and international experience and expertise allows us to identify and source attractive proprietary deals while applying stringent international standards in evaluating them.

Many entrepreneurs in our region are either not aware of the benefits of international private equity or lack sufficient relationships to make the right contact. Therefore, it's important for venture capitalists to identify promising sectors and companies and proactively make the initial contact and explain what they can bring to the entrepreneur in terms of capital and expertise.

In China, due to the developing nature of the hi-tech industry, there are more first-time entrepreneurs. Serial entrepreneurs are just starting to appear in China. These are often returnees (for example, Asians who went to the U.S. for graduate degrees and worked in Silicon Valley) with successful international operations under their belt. However, these returning entrepreneurs still need to prove that they can identify and capitalize on local opportunities and adjust to doing business in China.

In Korea, due to the importance of conglomerates such as Samsung in the technology sector in the past, there are more entrepreneurs with experience at established companies who are seeking funding for their new start-up companies.

Evaluating Potential Investments

We look for companies and management teams that are capitalizing on fast growing demand at home with innovative, cost-effective products and services. Broadband applications (such as online gaming and digital video/television), payment services and telecommunications equipment components are sectors where leading companies can grow quickly and profitably in their home markets.

Since we target our investments in sectors that are already profitable and growing rapidly, we look for reasonable post-money price/earnings ratios based on both historical and projected earnings. We also prefer to use earnings ratchets to make sure that the forecasted earnings provided by the company are achievable. We discount the valuation to account for any substantial risks faced by the company, such as significant ongoing litigation.

Making the Investment

In our term sheets, we demand certain management rights and focus on securing minority investor protections and other downside protections. Through these provisions, we actively participate in important company decisions at the board level and utilize our international experience and expertise to add value to the decision-making process. We prefer detailed term sheets at the beginning of the process to make sure the parties have a meeting of the minds on key terms and common goals and to make the investment process more efficient by minimizing later negotiations.

To be competitive with other local companies, the cash compensation for management is often kept low. Managements are increasingly aware of the ability of shares and options to enrich them well beyond their low cash compensation and are highly motivated to build value for their companies in order to make the shares and options valuable. This aligns their interests with ours so we encourage appropriate equity plans for employees at our portfolio companies.

As part of our investments into Chinese companies, we often restructure them offshore, whereby the company can provide employee stock option plans to incentivize management. This is another benefit that we bring to the table as an international private equity firm as compared to local players.

After restructuring Chinese investee companies offshore in many cases, we vest the board with broad management authority and provisions that require the affirmative vote or consent of our board representative for many of the company's substantive decisions. We also put restrictions on the ability of the majority shareholders to make certain decisions at the shareholders' level without our consent.

During preparations for the IPOs of portfolio companies, we become heavily involved in introducing our companies to international investment banks who can lead the process and international independent board candidates who can play a strong role in independent oversight and guidance and who can assure public investors that their interests will be protected.

Timeline/Exit

We target a three- to five-year holding period for our investments. However, we closely monitor our investments and have exited investments sooner if we believe we can derive significantly better IRR returns through an early exit. For example, one of our largest portfolio companies, which is in the Chinese online gaming sector, was able to complete its IPO on NASDAQ within fourteen months of our initial investment due to its strong growth and profitability.

Depending on the sector, many of the companies in which we invest have already reached profitability and are expecting to grow rapidly with our investment in the series A round. For these companies, the series A round is often the final round before an exit event.

IPOs are currently the preferred exit mechanism due to attractive global equity markets. However, as the economies of the region, including China, become increasingly liberalized and foreign competitors become more active in many of the sectors we invest in, we believe there will be increased trade sales to strategic investors. As more international private equity players enter the region, we also expect more sales to other financial buyers in future years.

Assessing Risk

It's imperative to understand the risks completely, using all the local contacts and relationships you can bring to bear to help you in your due diligence. But at the end of the day, we're in the business of taking calculated risks, and you have to judge whether the potential risks are worth the potential rewards. For example, before we made a substantial investment into the leading online gaming company in China, we brought together our teams from China, South Korea and Hong Kong to fully evaluate a significant lawsuit brought by its South Korean game licensor. After fully exhausting our due diligence, we believed that an amicable resolution could be reached with active mediation, and we decided to make this investment. The company was able to settle the dispute with our considerable help and has gone on to grow rapidly as the leader in the market and completed its IPO on NASDAQ in May 2004. We feel we are well positioned to evaluate these types of risks and make calculated investments.

Changes & Trends

Asia is in the process of evolving from a production center with a low-cost, well-educated workforce into a rapidly growing demand center in its own right, with the largest number of cell phone users and online gamers and the highest levels of broadband penetration. Asian companies have become adept at addressing this rising demand in a cost-effective manner. We seek to capitalize on these trends by identifying those companies that are the sector leaders in attractive industries.

We believe that many of these companies can become technology leaders. We're already seeing this trend with leading Korean companies that have established themselves as global technology leaders in areas such as cell phone design and components. By combining technology leadership with their cost advantages, including a low-cost highly-educated workforce, these companies can become global leaders as well as regional leaders.

With the increasing globalization of trade and technology, it's imperative to understand the global factors and implications of each business. As the positive trends affecting Asia become better understood in the United States and Europe and the global equity markets continue to reward successful Asian stories, we believe it is inevitable that more international venture capital firms will increase their focus on Asian companies. This inflow of additional venture capital should speed up the innovation and growth cycles in the region. It will also mean more competition for deals with international management teams where language and culture are less critical barriers for newer investors. However, established Asian players will benefit from opportunities to sell stakes to other financial buyers or to close follow-on rounds for their portfolio companies at more attractive valuations.

In the technology, media and telecom sectors, we believe consumer applications and services, payment services, wireless network infrastructure upgrades and display components are near-term opportunities while digital television and business services are mid-term opportunities. We closely monitor local developments for additional opportunities. For example, China's SARFT (State Administration of Radio, Film and Television) recently promulgated regulations promoting minority foreign ownership of film and television production (which were previously prohibited) in order to speed up domestic development of those industries.

Asian economies have already been enjoying rapid growth in the last few years, especially in China with a 7.8 percent average annual GDP growth rate from 1997 to 2002. However, the recent pickup in global equity markets has also substantially increased the valuations for Asian markets and companies. However, we feel that compared to their brethren in the U.S. and Europe, promising Asian companies are under-covered by international private equity players, and cultural and language barriers make it harder for new entrants to negatively impact the market. These factors make it more difficult for private valuations to rise as rapidly as they do in developed countries.

As more success stories come out of China and other Asian countries, there will be more sophisticated entrepreneurs who have experienced venture financing and liquidity events. This will create additional opportunities for venture capitalists to find promising opportunities and management teams to back. This will also increase efficiency in the process since standard venture capital financing terms and requirements will be better understood and time can be devoted to more value-creation activities.

This is only the start of a promising virtual cycle of private equity in Asia and the players who get on the ground early with the right investment professionals with the balance of local relationships and international experience will be the top beneficiaries.

Advice

The advice we would give fellow venture capitalists is to really develop roots in the markets you cover and understand the personal, cultural and business dynamics at play before plunging into an investment.

To entrepreneurs, we would say that private equity financing is only a step toward the long-term goal of establishing your company as a market leader and enriching your shareholders and your employees. You should pick a partner who will get you to that goal, not necessarily the partner willing to throw the most money at you at the highest valuation.

Golden Rules for Successful Venture Capital Deals in China

  1. Identify the sectors that are benefiting from strong local markets and local cost advantages and invest in the sector leaders. A good example is the rapidly growing online gaming market in China.
  2. Understand the local management team, make sure their long-term interests and goals are aligned with yours and put in minority investor protections to make sure the interests and goals of the parties will continue to be aligned.
  3. Focus on understanding and mitigating the risks in the investment and invest at a reasonable entry valuation reflective of the risks to protect your downside. Leave enough room for error in your entry valuation.

About the Authors

Andrew Y. Yan

Andrew Y. Yan is the President and Executive Managing Director of SAIF Advisors Limited, the advisory firm to the Softbank Asia Infrastructure Fund. Prior to joining SAIF, Mr. Yan worked at Emerging Markets Partnership, the Principal Advisor to the $2.7 billion AIG Asian Infrastructure Funds, from 1995 to 2001 as Managing Director and Head of the Hong Kong office. Mr. Yan has also worked at Sprint International Corporation as Director for Strategic Planning and Business Development for the Asia Pacific region, the Hudson Institute, the World Bank and the State Commission for Economic Restructuring of the State Council of China. Mr. Yan received a Bachelors degree with distinction in engineering from the Nanjing Aeronautics Institute, a Masters degree with Top Honorary Prize for his thesis from Beijing University and a Masters degree from Princeton University where he also worked toward a Ph.D. He also studied international finance at the Wharton School Executive MBA Program. Mr. Yan is a director of Shanda Interactive (listed on NASDAQ), Bocom Digital, Mobi Antenna, Mobile Digital Corporation and Ness Display, an independent director of China National Offshore Oil Service Corporation and Stone Electronics (both listed on the Hong Kong Stock Exchange) and of China Eastcom Corporation (listed on the Shanghai Stock Exchange) and a governor of the Chinese Venture Capital Association. Mr. Yan has published a book entitled "Trial after Triumph: East Asia after the Cold War" (1992).

Brandon Ho-Ping Lin

Brandon Ho-Ping Lin is the Director and General Counsel of SAIF Advisors Limited, the advisory firm to the Softbank Asia Infrastructure Fund. Prior to joining SAIF, Mr. Lin was a Vice President in the technology investment banking groups of Credit Suisse First Boston and Donaldson, Lufkin & Jenrette in New York where he executed M&A, equity and debt financing transactions for technology companies, specializing in communications technology. Prior to that, Mr. Lin was an associate with the law firm of Sullivan & Cromwell in Hong Kong where he worked on securities and joint venture transactions throughout Asia. Mr. Lin was qualified in the State Bar of California. Mr. Lin received a Bachelors degree with Distinction from Stanford University and a Juris Doctoris degree cum laude from Harvard Law School.

Softbank Asia Infrastructure Fund

Softbank Asia Infrastructure Fund ("SAIF") makes private equity investments in technology, media and telecom ("TMT") companies primarily based, or with significant operations, in the Asia-Pacific region. The fund focuses primarily on China, South Korea, India, Hong Kong, Taiwan, Thailand and Malaysia, and to a lesser extent on Singapore, the Philippines, Japan, Australia, New Zealand and other Asia-Pacific countries.

SAIF has been one of the most active private equity investors in the region in the past several years. The fund was established in early 2001 with $400 million in commitments from Cisco Systems as sole limited partner. SAIF is a member of the Chinese Venture Capital Association and the National Venture Capital Association of the U.S. One of SAIF's largest portfolio companies, Shanda Interactive, successfully completed its IPO on NASDAQ in May 2004.