China’s tech hopefuls may have global ambitions, but the country lacks a funding pool to match. Local entrepreneurs continue to brave regulatory restrictions and currency controls to seek out foreign capital. It’s likely U.S. dollars will drive China’s innovation leaders for some time to come.
While venture capital in China today is mostly in yuan, most is in the early seed stages of funding. Local-currency funds accounted for 72 percent of venture capital investment deals in 2012, according to Zero2IPO Research, but 80 percent of those were below $10 million.
Chinese investors may be comfortable sticking to “seed” funding, but are reluctant to take on the risk of investing larger amounts over a longer time horizon. According to 2012 research from Zhen Fund, 60 percent of Chinese angels will exit by selling to a venture capital fund.
For companies looking to scale, that mostly means flipping into an offshore structure, typically routed through the Cayman or British Virgin Islands, to tap into foreign funding. Sina and Sohu pioneered this in 2000, but the model is now used by everyone from search giant Baidu and gaming operator Tencent to dating network Jiayuan. It’s not ideal – setting up these structures requires legal fees. There’s regulatory risk too, since most of the structures, which circumvent restrictions on foreign ownership, are untested legally.
Going offshore also has one big advantage: exit options. China’s initial public offering market remains frozen with a backlog of some 800 companies. Nasdaq and Hong Kong remain open. Social network YY’s shares have tripled in price since it listed in New York in November 2012. China’s tech giants’ own offshore holding companies mean takeovers too can be easily struck in the West as in the East.
As China’s internet sector grows, its domestic financial market should evolve accordingly. Many funds, such as Blackstone and IDG Ventures, already have China funds that offer both yuan and US dollars. For China’s next generation of tech moguls though, the road to success is still paved with US dollars.