POST 1 of 5

China The Sleeper Awakens

I just spent a few weeks in Japan and China on a book tour for the Japanese and Chinese versions of the Startup Owners Manual. In these series of 5 posts, I thought Id share what I learned in China. My post about Japan will follow. All the usual caveats apply. I was only in China for a week so this a cursory view. Thanks to Kai-Fu Lee of Innovation Works, David Lin of Microsoft Accelerator, Frank Hawke of the Stanford Center in Beijing, and my publisher China Machine Press. Summary: Ive lived in Silicon Valley for 35 years, Ive taught in entrepreneurial clusters in New York, Boston, Helsinki, Santiago Chile, St. Petersburg, Moscow, Prague, and Tokyo, but the visit to the heart of the Beijing startup world Zhongguancun has truly blown me away. Each of these clusters has wondered how to become the next Silicon Valley. Beijing is already there. ---------What a long strange trip China has been through. After the creation of the Peoples Republic of China in 1949, all industry was nationalized, agriculture was collectivized, and the private sector was eliminated. All companies were owned by the state, all planning was centralized, and the state determined the allocation of resources. This was the China I grew up with the one where private enterprise was a crime and marketing wasn't a profession. To say China has transformed itself is perhaps the biggest understatement one can make. China has embraced state capitalism in a way Wall Street can only dream about. Startups, Venture Capital and the Communist Party: how did this happen in China? The best analogy to describe the relationship of science and technology and the Chinese startup scene is to understand its parallels with the United States during the Cold War with the Soviet Union. During World War II, the U.S. mobilized scientists in a way no other country had. For 45 years - post World War II until the fall of the Soviet Union - the U.S. viewed science and technology as a strategic asset. We made major investments in it, understanding that establishing basic and applied science leadership was necessary for us to build advanced weapons systems to defend our country and deter and if necessary, wage and win a war with the Soviet Union. These investments took the form of building national research organizations, several for basic science (NSF, NIH) and others for applied weapons research (DOD, DARPA, DOE, etc.) Research universities also became an integral part of the military ecosystem as the federal government pumped billions into supporting science. Startups, entrepreneurship and commercial applications are happy byproducts of those military investments. For example, as the semiconductor business started, the largest customers for Fairchilds and Texas Instruments new integrated circuits were the Apollo Guidance Computer and the guidance system for the Minuteman II ICBM.

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China is following the same path

Over the last three decades, to achieve strategic parity with the United States and to construct a modern military, the Chinese have made massive investments in building their science and technology infrastructure. China has gone from a land-based army to one that can support its territorial claims to the South China Sea and Taiwan with anti-access/area-denial weapons. This evolution required a transition, moving from a reliance on the numerical superiority of its land army toward a force boasting sophisticated aircraft and naval platforms, precision- strike weapons, and modern C4SIR (Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance) capabilities. Its Second Artillery Corps not only controls Chinas ICBMs, but also its short range missiles pointed at Taiwan, Vietnam, Philippines, and U.S. bases in Guam and Okinawa. And its new terminally guided ICBMs have put U.S. aircraft carriers in harms way in any regional confrontation. Its air force and navy have gone from a selfdefense force to one that can project regional power effectively to the first island chain and beyond. Chinas military modernization depends heavily on investments in Chinas science and technology infrastructure, reform of its defense industry, and overt and covert procurement of advanced technology and weapons from abroad. Building Chinas Science and Technology infrastructure Science and startups have come a long way since the 1980s when the Chinese government owned everything and controlled it through a central planning system. But before startups could happen, Chinas basic science, technology and finance infrastructure and ecosystem needed to be built. Heres how a national policy for science and technology emerged. Beginning in the 1982, China started a series of science and technology programs in five areas: support of basic research, high technology R&D, technology innovation and commercialization, construction of scientific research infrastructure, and development of human resources in science and technology.
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The majority of the science and technology programs are driven by MOST (Ministry of Science and Technology) and NSFC (National Natural Science Foundation). As well see later, the MOF (Ministry of Finance) also has had a hand in funding new ventures.

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The diagram below from OECD's Report on China's Innovation Policy puts the ministries involved in science in context. (Note that it does not show the military technology ministries.)
Figure 3.2 Public governance of S&T and innovation in China: The institutional profile
State Council State Council Steering Committee of S&T and Education
Program Key Technologies 973 863 NNSFC

Table 3.1 Fu

NDRC COSTIND Other Ministries MOC MOF MOST MOE CAS CAE MOP

Knowledge Innovation TOTAL

Total as a share of total public S&T expenditures Oversees defence-related R&D and military applications of commercial technologies

State IP Office
Innovation Fund for Small Technology-based Firms Productivity Promotion Center Provides support to university-related R&D, science parks and human resource development

NSFC

Attracts overseas Chinese Scholars, Provides manages post-doc programmes policy advise Key Technologies

Defines policy on patents and other IPR issues

Funds basic research Conducts research and promotes innovation through the Knowledge Innovation Program

Defines and Provides tax reliefs to implements exports of high tech sectoral R&D products, and preferential policies treatment of FDI in high tech sectors

Supports innovation in SMEs

Promote the developme of key technologies needed for industrial an social development

K million RMB (2004) Total funds raised

O O O

Main tasks of MOST

O O O O O O

Formulates strategies, priority areas, policies, laws and regulations for S&T Promotes the building of the national innovation system Conducts research on major S&T issues related to economic and social development Guides reforms of the S&T system Formulates policies to strengthen basic research, high-tech development and industrialisation Designs and implements programmes to fund basic and applied research, to induce firms to innovate, to create science parks, incubators, etc. Develops measures to increase S&T investments Allocates human resources in S&T and encourages S&T talents Promotes international S&T cooperation and exchanges

Government funds Gov. as % of total

Origin and S

Funds raised (million RM % government

Main tools of MOST

O

3 core programs: The National Key Technologies R&D Program; the National High-Tech R&D Program (863 Program); the National Program on Key Basic Research Projects (973 Program) Two group programs (Construction of S&T infrastructures; Construction of S&T industrialisation environment)

% enterprise % bank loans % overseas % others

NDRC: National Development and Reform Commission MOC: Ministry of Commerce MOF: Ministry of Finance MOST: Ministry of Science CAS: Chinese Academy of and Technology Sciences Source: OECD based on data from MOST and other sources.

COSTIND: Commission of Science, Technology and Industry for National Defence MOE: Ministry of Education MOP: Ministry of Personnel CAE: Chinese Academy of NSFC: National Natural Science Foundation of China Engineering

%
"

Basic research: National Natural Science Foundation (equivalent to the U.S. National Science Foundation,) ~$1.75 billion budget. The 973 program (National Basic Research Program) part of the Ministry of Science and Technology.
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High technology R&D: 863 Program (State High Technology R&D Program) headed by ex leaders of Chinese strategic weapons programs, and the National Key Technology R&D Program. Technology innovation and commercialization: National New Product Program, the Spark program for rural innovation, and probably the most important one for startups in China , the Torch Program Science research infrastructure: National Key Laboratories Program, and the MOST program for the construction of research facilities, R&D databases, and a scientific research network Development of human resources in science and technology: Programs for attracting returnees or overseas Chinese talent: from the Ministry of Education - the Seed Funds for Returned Overseas Scholars, Chunhui Program, and the Cheung Kong Scholar Program. From the Ministry of Personnel - the Hundred Talents Program. From the National Science Foundation - the National Distinguished Young Scholars Program. %

% Part two the next post, describes Chinas Torch Program, the largest government-run entrepreneurial program in the world. Lessons Learned China is working to build basic and applied science and technology leadership Like the U.S. and the Soviet Union in the Cold War they are using science and technology to build advanced weapons systems Unlike Russia theyve found the path for a thriving system of commerce in between State Owned Enterprises Technology startups are a side effect from these investments >>>>>>>>>>>>>%

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POST 2 of 5 Chinas Torch Program - the glow that can light the world I just spent a few weeks in Japan and China on a book tour for the Japanese and Chinese versions of the Startup Owners Manual. In these series of 5 posts, I thought Id share what I learned in China. All the usual caveats apply. I was only in China for a week so this a cursory view. Thanks to Kai-Fu Lee of Innovation Works, David Lin of Microsoft Accelerator, Frank Hawke of the Stanford Center in Beijing, and my publisher China Machine Press. The previous post described how China built its science and technology infrastructure. This post is about the how the Chinese government engineered technology clusters. -The Torch Program In size, scale and commercial results Chinas Torch Program from MOST (the Ministry of Science and Technology) is the most successful entrepreneurial program in the world. Of all the Chinese government programs, the Torch Program is the one program that kick-started Chinese high-tech innovation and startups. Torch has four major parts:Innovation Clusters, Technology Business Incubators (TBIs), Seed Funding (Innofund) and Venture Guiding Fund. Innovation Clusters Industries have a competitive advantage when related companies cluster in a geographical location. Examples are Hollywood for movies, Milan for fashion, New York for finance and today, Silicon Valley for technology entrepreneurship. The early clusters occurred by happenstance of geography or history. But the theory is that you can artificially create a cluster by concentrating resources, finance and competences to a critical threshold, giving the cluster a decisive sustainable competitive advantage over other places. Israel, Singapore and now China are the three countries that have successfully put that theory into practice. The Torch program created Innovation Clusters by creating national Science and Technology Industrial Parks (STIPs), Software Parks, and Productivity Promotion Centers. The first Science and Technology Industrial Park was Zhongguancun Science Park in Beijing. It has become Chinas Silicon Valley. (This was the area I visited in this trip to China.) In addition to the one in Beijing, China has set up 53 additional industrial parks and in them are ~60,000 companies with 8 million employees. Industry or technology specific versions of these clusters have been set up; for example Donghu in Wuhan - specializing in optoelectronics, Zhangjiang in Shanghai - focusing on integrated circuits and pharmaceuticals, Tianjin - biotech
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and new energy, Shenzhen telecommunications and Zhongshan medical devices and electronics. The Science and Technology Industrial Parks contributed 7% of Chinas GDP and close to 50% of all of Chinas R&D spending. In addition to the 54 Science and Technology Industrial Parks, the Torch program also set up an additional 32 Torch Program Software Parks. Another key part of Chinas cluster strategy was collaboration between research and business, as well as between large enterprises and tech-based small and medium enterprises. It did so by building a national network of a 1,000+ Productivity Promotion Centers. They provide consulting, promotion, product testing, hiring, training and incubation services to startups. Technology Business Incubators (TBIs) While the Innovation Clusters designated specific areas of the countries where high tech was to occur, its the Technology Business incubators located inside these clusters where the startup companies physically reside. Much like incubators worldwide, they provide startups with office space, free rent, access to university technology transfer, etc. By 2011, there were a total of 1034 Technology Business Incubators across China, including 336 as National incubators, hosting nearly 60,000 companies. (20% of the National Incubators were privately-run and their percentage is steadily increasing.) In recent years Business Incubators have developed into diverse models. For example, the Ministry of Education and the Ministry of Science and Technology teamed up to put 45 incubators in universities. There are close to 100 specialized incubators for companies founded by returned overseas Chinese scientists and engineers. There are a dozen sector-specific incubators (a Biomedicine Incubator in Shanghai, Advanced Material Incubator in Beijing, a Marine Technology Incubator in Tianjin, etc.) These incubators are mostly clustered in the eastern coastal regions, and disproportionately target TMT (Technology Media and Telecom) and Biotech. Some of the startups coming out of these incubators have become large international companies including Lenovo, Huawai, Suntech Power, etc. Seed Funding (Innofund). The best analog for Chinas InnoFund is the U.S. governments SBIR and STTR programs. Set up in 1999, Innofund offers grants ($150 - $250K), loan interest subsidies and equity investment. Innofund is designed to bridge early stage technology companies that have innovative technology and good market potential but are too early for commercial funding (banks or VCs.) Innofund applicants have to be in high-tech R&D, have less than 500 people, at least 30% of the employees have to be technical and the majority of the company owned by Chinese. The ultimate goal of Innofund is to get the startups far enough along in technology and market validation so other sources of financial capital (banks, VCs, corporate partners) will invest.
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Since its establishment, theres been over 35,000 applications with 9,000 projects approved and close to a $1 billion allocated. Most Venture Capitalists in China viewed the Innofund the same way most U.S. VCs treat the SBIR and STTR programs they never heard of it, or they think it takes too much time to apply for too little money. And with the same complaints; tedious, relationship driven application process, bureaucratic reporting requirements, and outcomes often measured in quantity and not quality. However, for startups who have gotten an Innofund grant, it does provide the same positive cachet as an SBIR and STTR grant the government has reviewed your technology and thought it was worthy. Venture Guiding Fund In 2007 the Ministries of Science and Finance raised the stakes to get VCs focused on funneling more VC money into growing startups they set up a Venture Guiding Fund. The Venture Guiding Fund invests directly into VC funds, co-invests with VCs, and covers some VC bets. It does this with four programs: 1) A fund of funds, holding < 25% equity in VC firms, requiring only a fixed rate return; 2) the fund will co-invest with other VC firms matching up to 50% of other VC firms equity investment or a maximum of $500K; 3) Risk subsidies for VC firms, where the fund will be compensated for the cost and loss of VC firms which have made investments in technology-based startups; and 4) Grants for portfolio reserves, where the fund will provide grants for technology-based startups which are being incubated and coached by VC firms.

Torch Summary In the last decade Torch managed to break free of China's state central planning bureaucracies. Of all the Chinese innovation programs, Torch is the one that was run like a startup iterating and pivoting as it learned and discovered. This enabled Torch to evolve with China's rapidly global economy. Part 3, the next post describes the rise of Chinese venture capital. Lessons Learned The Torch Program is the worlds largest lets engineer entrepreneurial clusters experiment Torch has four major parts: Clusters, Business Incubators, Seed Funding, and Funds to support Venture Capital firms Torch was the rare government program that was run like a startup iterating and pivoting as it learned and discovered. -------

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POST 3 of 5

The Rise of Chinese Venture Capital

I just spent a few weeks in Japan and China on a book tour for the Japanese and Chinese versions of the Startup Owners Manual. In these series of 5 posts, I thought Id share what I learned in China. All the usual caveats apply. I was only in China for a week so this a cursory view. Thanks to Kai-Fu Lee of Innovation Works, David Lin of Microsoft Accelerator, Frank Hawke of the Stanford Center in Beijing, and my publisher China Machine Press. The first post described how China built a science and technology infrastructure to support advanced weapons systems development. The previous post described how the Torch program built Chinas innovation clusters. This post is about the rise of Chinese venture capital and how it helped build the countries entrepreneurial ecosystem. The Rise of Chinese Venture Capital Chinas move away from a state system that solely depended on a command and control economy started in the 1990s. The first wave of startups began when R&D centers and universities began to provide the technology and seed capital for new startups that were spin-outs or spin-offs. This could be a group of individuals leaving a university or research center or an entire department leaving. For example, in the 1990s 85% of the start-up funds of the new technology companies founded in Beijing came from the research center or university they left.

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The second wave of technology investors were Chinese banks, who provided the majority of the later stage investments in the Torch Program. By 1991, 70% of the Torch funded startups were getting bank financing for expansion and later stages of the new ventures, with local governments acting as guarantors. Like the U.S. SBIR and STTR programs, the Torch Programs funding for new ventures was limited to seed funding the front end. Being designated as a Torch Program startup gave banks comfort to provide loans to these ventures for technology commercialization. Technology zones with Science and Technology Industrial Parks were the third source of support for new ventures. Inside the zones were Torch Technology Business Incubators with startups licensed by the local governments. These local governments financially supported the startups because, by locating in these zones, the new ventures were seen as contributing to local economic development. This helped the startups qualify for funding from banks and venture capital firms. By the mid-1990s, Chinese leaders realized that the Torch program couldn't be the source of all capital for startups. At the same time neither banks nor local governments had the cash to finance startups on the scale the country needed. The problem was that in China the government didn't recognize venture capital firms as a legitimate organizational type. The founding of domestic VC firms began with the establishment of local government-financed venture capital firms (GVCFs), followed by university-backed VC firms (UVCFs). (The State Science and Technology Commission and the Ministry of Finance formed the China New Technology Venture Investment Corporation in 1986, but it was a government agency supporting national technology venture policy objectives, rather than a profit-oriented private enterprise. It went bankrupt in 1997.) A few foreign VC firms like IDG Capital Partners entered China in the early 1990s. Gradually, from the mid-1990s, the perception of venture capital shifted from its being a type of government funding to being a commercial activity necessary to support the commercialization of new technology. But it wasn't until 1998 that corporate-backed VC firms could be established, and that started a wave of VC funds backed by government, corporate and foreign capital. A great summary diagram below from OECD's Report on China's Innovation Policy traces the evolution of China's Innovation Ecosystem.

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Figure 3.1 Chinas innovation policy: institutional reform and learning curve
The incubation phase (1975-1978) The experimentation phase (1978-1985) Structural reform of the S&T system (1985-1995) Deepening of the S&T reform (1995-2005) Toward a firm-centered innovation system (2005+)

Systemic efficiency threshold ?

Stock Exchange started in Shenzhen (1990) Provisional Bankrupcy Law for SOEs (1986) Launch of the open door policy (1978) Special economic zones created (1980) Private ownership recognized (1999) Decision to join WTO (2001)

First Company Law (1994)

Action Plan for Promoting Trade by S&T (2000)

2006 national S&T conference and adoption of the Medium and Long Term S&T Strategic Plan

Innovation Fund for Technology-based SMEs (1999) Technology Spreading Program (1990) Torch Program (1988) CAS Knowledge Innovation Program (1998) 973 Program (1997)
Share of transactions conducted at market prices 100 80 60 40 20 0 1978 1985 1991 1995 1999 2003 Producer goods
(% of transaction volume)

Innovation policy learning curve

Deng Xiao Ping outline report for reform (1975)

National Key Technologies R&D Program (1984) State Key Laboratory Program (1984) University reform (1985) Start of the reform of the S&T system (1985)

Adoption of the National Natural Science Foundation Revitalizing the nation through science and of China (1986) education strategy (1995) 863 Program (1986) Spark Program (1986)

Retail sales

Source: National Reform and Development Commission.

Government Universities Firms

Government Universities Firms

Government Universities Firms

Government Universities Firms Universities

Government

Evolution of the innovation system

Public labs Public labs Launch of the reform of the economic system Learning by doing bottom-up experimental reforms Public labs The reform of the economic system expands into the S&T sphere Learning by designing and implementing top-down systemic institutional reforms Reform public research organisations (PROs),including the university system and the conversion of public labs specialised in applied research into business entities Reduced public institutional support to applied research in public labs. Launch of the first large public competitive support programmes Public labs Fast economic growth, pressure from technology-based competition in domestic and international markets Accelerated learning from international good practices fostered by WTO membership and obververship in OECD CSTP Enhance firms innovation capabilities & commercialisation of public research

Firms

Public labs Mounting concerns regarding the sustainability of the current growth trajectory Toward endogenous institutional learning and evidence-based policy making, including international benchmarking Complete the shift from a PRO-centered inovation system to a firm-centered one. Better mobilise S&T for achieving sustainable development Improved mix of instruments to support more efficiently both market-led and mission-oriented S&T development and innovation

Context

End of the cultural revolution. Urgent need for modernisation of the economy. Learning from self reflection and criticism

Type of learning

Policy focus

Remove conceptual / ideological barriers to S&T development

Address the shortcomings of the soviet model of a S&T system, especially the lack of science-industry links. Initial reform of the university system Initial experimental changes of institutional funding, by relaxing the control of funding channels

Funding instruments

Direct public institutional support

Further differenciation of the public support system through the launch of new programmes. Emergence of new publicly sponsored funding channels, e.g. venture capital

Source: OECD.

Investing in China Today Fast forward a decade, today the Private Equity and Venture Capital business is booming in China with over 7BBB%9-1C4%(D"-$#'E%-)$#4"-)6. Most of the early deals were done by offshore venture funds with their fund registered in countries outside China and using dollars. The latest trends are as Renminbi (RMB) funds (the Renminbi is the official currency in China.) In the past foreign funds who wanted to invest in China had to set up funds using dollars with complicated offshore structures with exits through offshore listings. The Renminbi funds have fewer restrictions on what industries the fund can invest in, less regulatory oversight and access to listing a portfolio company in China. There are two types of Renminbi funds: domestic funds and foreign-invested funds. Domestic Renminbi funds are fully owned by Chinese investors, !"#$%&"'(()" while foreign-invested Renminbi funds may be partially or fully owned by non-Chinese investors. Both types of funds are organized under Chinese law and use Renminbi to invest in Chinese companies. The other big change was the creation of ChiNext, Chinas equivalent of NASDAQ stock exchange for start-ups, in 2009. The market was created to provide startups and their investors liquidity. Over 100 startups were listed on ChiNext the first year of its launch at sky-high valuations (average of 66 times earnings.) About 60% of the startups listed on ChiNext were
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backed by Renminbi funds, making the investors of these funds one of the main beneficiaries of the exchange. Part 4 Zhongguancun in Beijing - China's Silicon Valley and part 5, the Gold Rush and Fire Extinguishers describe the Beijing entrepreneurship ecosystem. Lessons Learned Chinas venture capital system has made a remarkable journey from the state owns everything to the free market Its done it in a series of evolutionary stages, each new one learning from the last

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POST 4 of 5 Zhongguancun in Beijing - China's Silicon Valley I just spent a few weeks in Japan and China on a book tour for the Japanese and Chinese versions of the Startup Owners Manual. In these series of 5 posts, I thought Id share what I learned in China. All the usual caveats apply. I was only in China for a week so this a cursory view. Thanks to Kai-Fu Lee of Innovation Works, David Lin of Microsoft Accelerator, Frank Hawke of the Stanford Center in Beijing, and my publisher China Machine Press. The previous post described the evolution of the Chinese Venture Capital system. This post (and the next) are what I saw and learned in my short stay exploring Beijings entrepreneurial ecosystem. Entrepreneurship in Beijing In the few days I was in China I met with several VCs, angel investors, business press and spoke to hundreds of entrepreneurs. I was blown away by what I saw in Beijing. First, I was amazed by the physical impact of the city itself. This was a modern city in a hurry to make a first impression think of what Rome looked like in the time of the empire or New York in the 1920s now its Beijing announcing that China has arrived. However if you scratch the surface, you can still find a bit of the old Beijing in the hutongs. Drive 50 miles outside the city into the surrounding villages and you see the distance China has to travel to bring the rural areas into the 21st century. In Beijing we hadnt seen air so badly polluted since we had been in Agra in India in the winter where I swear there was a day you could wave your hand in front of you and see traces of it in the air (and their excuse was they burn dung for heat.). David Lin and the Microsoft China Accelerator was gracious enough to host two wonderful days of events for me. I trained the Startup Weekend Next Beijing mentors and instructors, presented to several hundred entrepreneurs, and had a great fireside chat with Zhen Fund founding partner Xu Xiaoping in front of another roomful of entrepreneurs. Kai-fu Lee of Innovation Works was equally generous with his time. We had a fireside chat with a room full of eager entrepreneurs. And he was generous in sharing his insights about the current state of entrepreneurship and investment in China. And through it all Louis Yuan my patient and wonderful publisher from China Machine Press kept me moving through the events.
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But what made the overwhelming impression for me was finding an entrepreneurial software cluster on par with the Internet software portion of Silicon Valley. The physical heart of the Beijing startups is in Zhongguancun in the Haidian District, located in the northwest side of Beijing. Startups here are primarily in what they call the TMT (Technology, Media and Telecommunications) segment. Not only does Zhongguancun have Chinese startups, but global technology companies (Nokia, Ericsson, Motorola, Sony Ericsson, Microsoft, IBM, Sun, Oracle, BEA, Alcatel Lucent, Google) all have offices here or elsewhere in Beijing. If there ever was any question about the value of Chinas Torch Program walk around Zhongguancun. It was the first of the 54 Science and Technology Industrial Parks. China Venture Capital An entrepreneurial ecosystem is driven one of two ways; either by a crisis (i.e. innovation in the U.S. during World War II,) or during peacetime by profit. If its driven by profit then the ecosystem needs both entrepreneurs as well as Venture Finance. China now has plenty of both.

China has the biggest Venture Capital industry outside the U.S. To compare the two, in 2011 U.S. venture capitalists invested $26.5 billion in all deals. Out of that total, they funded 967 Internet deals with $6.7 billion.

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By comparison, in 2011 Chinese VCs invested $13 billion in all deals. Out of that total, they funded 268 Internet deals with $3.2 billion. About 1/3 of all Chinas Venture Capital investment is made in Beijing and the majority of those investments are in the Technology, Media and Telecommunications (TMT) sector Ill describe shortly. As vibrant as the China venture business has been, 2012 was a different story. VCs pulled back and only invested $3.7 billion in all deals, funding just only 43 deals with $563 million.

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Closed for You, Open For Us First a bit of context in what the VCs in Beijing are investing in. China has essentially closed its internal search, media and social network software market to foreign companies who wouldnt play with the government rules on the Great Firewall (China blocks objectionable website content and monitors everyones Internet access.) Google retreated to Hong Kong and Baidu took its place. Facebook was too frightening to Chinese censors, so Renren is the leading social media player. Email? Working professionals/white collar use emails, but most users grew up instant messaging on TenCents QQ and most are moving to Weixin/WeChat. Twitter? No, its Sina WeiboF and if you want games with your chat - TenCent. Amazon and Ebay? Nope in China its Alibabas Taobao%81% 360buy.com. If youre outside of China, you never hear about these companies or interact with them because theyre geared to serve only Chinese users. This closed but very large market means that greater than 90% of Chinese software startups focus exclusively on the Chinese market. (The <10% that decide to go global early do so by starting outside of China. Another 10% may try to go global when theyre larger and have the resources for two languages, cultures and regulations. ) This has resulted in a completely different consumer software ecosystem than found elsewhere in the world. Given the closed market to U.S. Internet companies, VCs in China have guided startups to execute the copy to China model. Thinking, if it worked in the U.S., copying a known model is less risky than trying something new and untested. The problem is that this space is getting really crowded from the bottom up as everyone tries the 200th clone and from the top down, as the major incumbents try to fill every possible market niche. The table below maps the type of software in China to their global equivalents in each product category in the Technology, Media and Telecommunications (TMT) sector.

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A Huge Market Is Finally Real For a hundred years the fantasy of global marketers was well if everyone in China would buy one That day is final here. The numbers of mobile subscribers are staggering - 1.18 billon, 260 million are 3G. Chinese Internet companies live in a large closed, self-contained ecosystem with 564 million web users with 420 million having mobile web access. 309 million use microblogs and 242 million shop online. (BTW, market research, financial and other statistical information are usually unreliable in China, but even taken with a grain of salt these are staggering numbers.) The table below from web2asia.com shows the number of users of online social networks as of 2009. Did I mention this is a huge market.

Investment in the Technology, Media and Telecommunications (TMT) sector The charts below from David Lin, Microsoft Accelerator detail investments in the Technology, Media and Telecommunications (TMT) sector - almost all of it is centered in Beijing. (Note that these numbers differ from the Zhen Fund data -welcome to statistics in China - but they both provide an overall sense of the market size and direction.)

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45% of all Venture Capital Investment in China went into the Technology, Media and Telecommunications (TMT) sector.

1
! $14.04 billion raised for 219 Venture funds ! 1143 deals totaling $10.57 billion
12

VC Investments During 2007-H1/2012

976 775 842 728 637 8.9

VC Investments During 2011-H1/2012 by Sector (1143 deals) 14% 7%

2
45%

8 438 4 3.9 5.5 5.3

TMT Manufacturing Consumption & Services Energy

5.9

8%
3.6 167 1.6

10% 16%

Healthcare Others

0 2006 2007 2008 2009 2010 Deals 2011 2012H1

Amounts (USD B)

The number of deals in Technology, Media and Telecommunications more than doubled in 2011 over the previous five years and slowed back down dramatically in 2012. More than 1,600 VC investments in TMT have been made since 2007, with a record high of 436 in 2011.

Internet investments makes up more than 50% of all the deals in Technology, Media and Telecommunications made since 2011, while, E-commerce investments, in turn, accounts for nearly 50% of the investment deals in Internet. Investments in Mobile Internet makes up roughly 11% of all the deals in Technology, Media and Telecommunications, and have been on the rise since 2011.

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Series-A round investments dominates Technology, Media and Telecommunications (TMT) deals, making up 60% of all.

Beijing, Guangdong (including Shenzhen) and Shanghai came out as the most dynamic spots for Technology, Media and Telecommunications (TMT) investments

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Beijing Venture/Angel Ecosystem While Beijing has VCs and Angel investors happy to write a check there arent as many angels/VCs in China versus US per capita. Several VCs mentioned that theres a funding gap for seed stage investments. The Angel/Seed network in Beijing feels fragmented and mostly inexperienced (as are a good number of the China VCs). Kind of reminded me of the drivers in Beijing they were all driving in a way that made me think they all just got their drivers license until I remembered that they did. Car sales in China went from 1 million in 2001 to 14 million in 2011.

Other Beijing ecosystem issues I heard about were the things we take for granted: the lack of knowledge sharing (pay it forward isnt part of the culture,) limited mentoring (few experienced mentors,) and a lack of open source education, and no AngelList model. In the U.S. its easy to share and browse ideas and deals, but in China theres a long legacy of guarding knowledge as power, and the justifiable paranoia of someone copying your idea prevents sharing. Liquidity Unlike the U.S. there are almost no mergers or acquisitions in this market segment. Its much easier to just steal their ideas and hire their employees. So big companies rarely acquire startups. Liquidity for most Internet startups happens via IPOs. 70% of exits in China are via IPO (in the U.S. on NASDAQ or the NYSE or on ChiNext, Chinas equivalent of NASDAQ) compared to the 90% of exits in US via mergers or acquisitions. Alibaba (commerce), Tencent (games/chat) and Baidu (search) all have market caps over $40 billion.
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The next post, the Gold Rush and Fire Extinguishers Beijing entrepreneurs, startup culture and some conclusions. Lessons Learned China has the biggest Venture Capital industry outside the U.S For software, the action is in Beijing China has closed its search, media and social network software market to foreign companies Beijings VCs primarily invest in the Technology, Media and Telecommunications segment Liquidity is via IPOs not buy outs POST 5 of 5 The Gold Rush and Fire Extinguishers I just spent a few weeks in Japan and China on a book tour for the Japanese and Chinese versions of the Startup Owners Manual. In these series of 5 posts, I thought Id share what I learned in China. All the usual caveats apply. I was only in China for a week so this a cursory view. Thanks to Kai-Fu Lee of Innovation Works, David Lin of Microsoft Accelerator, Kevin Dewalt, Frank Hawke of the Stanford Center in Beijing, and my publisher China Machine Press. The previous post, part 4, was about Beijings entrepreneurial ecosystem these are my final observations. Land Rush For the last 10 years China essentially closed its search, media and social network software market to foreign companies with the result that Google, Facebook, Twitter, YouTube, Dropbox, and 30,000 other websites were not accessible from China. This left an open playing field for Chinese software startups as they copy to China existing U.S. business models. Of course copy is too strong a word. Adapt, adopt and extend is probably a better description. But for the last decade innovation in Chinese software meant something different than it did in Silicon Valley. The Chinese Social Media Landscape diagram below from Resonance does a great job of illustrating the players in the Chinese market. (Note that the inner ring shows their global equivalents.)

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The downside is that with so much venture and angel capital available, investors have been willing to fund the 10th Groupon clone. For the last few years, there really hasnt been a demand to innovate on top of the ecosystem thats been built. New Rules for China Not only is the Chinese ecosystem completely different but also the consumer demographics and user expectations are equally unique. 70% of Chinese Internet users are under 30. Instead of email, theyve grown up with QQ instant messages. Theyre used to using the web and increasingly the mobile web for everything, commerce, communication, games, etc. (They also probably havent seen a phone that isnt mobile.) By the end of 2012, there were 85 million iOS and 160 million Android devices in China. And they were increasing at an aggregate 33 million IOS and Android activations per month. It was interesting to learn about Chinas digital divide the gap between East China and Midwest China, and between urban and rural areas. Internet penetration in Beijing is greater than 70% while its less than 25% in Yunnan, Jiangxi, Guizhou and other provinces. While there are 564 million web users with 420 million having mobile web access, 74% of Chinese Internet users make less than $500/month and are students, blue-collar workers or jobless. Unlike U.S. websites that are sparse and slick, Chinese users currently expect complicated, crowded and busy web pages. However, theres a growing belief that the design preferences of Chinese consumers are just bad design. TenCents WeChat, (designed for an international market) is the first incredibly popular app in China to dramatically raise the bar for what a good user interface and user experience looks and feels like. WeChat may change the game for Chinese U/I and U/X experience. The one caveat about online commerce is that while Chinese users will buy physical goods online (Taobao is huge), they seem to hate to pay for music or software, and the model for games seems to be moving to free play with in-app-purchases for accessories and powers. An interesting consequence of the rigid censoring and control of mainstream media is that blogging reading and writing is much higher than U.S.
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My guess is the current wave of copy to China will burn itself out in the next few years as the smart money starts to move to innovate in China (i.e. like WeChat.) Competition If youre a software startup competing in China, the words that come to mind are ruthless and relentless. The not so polite ones Ive heard from others are vicious, unethical and illegal. Intellectual property protection is great on paper and limited in practice. The large players like Alibaba, Baidu and Tencent historically would be more likely to simply copy a startups features than to hire their talent. The large companies strategy seems to be to cover every possible market niche by copying successful models from others. The slide below from the Zhen Fund shows the breadth of business coverage of each of the Chinese Internet incumbents. Each column represents a company (QQ, Sina, Baidu, Netease, Sohu etc.) and the rows indicates their offerings in open platform, group buying, online games, microblogging, Instant Messaging, BBS, Q&A and E-commerce.

Small startups act the same way, simply cloning each others products. Sharing and cooperation is not yet part of the ethos. I cant imagine a U.S. company setting up some subsidiary here and expecting them to compete while they were following U.S. rules. In some ways, the best description of the market dynamics would be imagine you were competing with 100 companies who are as rapacious as Microsoft was in the 1980s and 1990s. Eventually, Chinas innovation-driven economy needs intellectual property rights and anti-trust laws that are
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enforced. Sea Turtles and VPN the connections to the rest of the world Entrepreneurs in Beijing were knowledgeable about Silicon Valley, entrepreneurship and the state of software and tools available for two reasons. First, there are continuous stream of sea turtlesChinese who have studied or worked abroadreturning home. (The Chinese government must be laughing hysterically over U.S. immigration policy thats forcing Chinese grad students out of the U.S.) Many of these returnees have worked in Silicon Valley and startups or went to school at MIT and Stanford. (There is a huge difference between the Chinese who have never left and those who went to school abroad, even for a few months at least a difference in their ability to relate to me and have a conversation on the same wavelength. Its clear why families try so hard to send their children abroad. It changes everything for them.) Second, most websites that a non-Chinese would use are blocked including Facebook, Twitter, Youtube, Google Docs, Scribd, Blogspot, Dropbox, New York Times, etc. Almost every entrepreneur I met was using VPN to circumvent the Great Firewall. When the Chinese government censors (run by their propaganda department) shutdown access to yet another U.S. web site, they create another 100,000 VPN users. And when the government tools to detect encrypted VPNs get more sophisticated, (as it did last year), Chinese users just use stealthier tools. Its an amazing cat and mouse system.

(Note to Chinese Communist party - the best name for your propaganda department should probably not be the Propaganda Department.) Beijings Academic Hub Right next door to Zhongguancun are Chinas top two universities, Peking University and Tsinghua University. Northwest of Beijing is also home to other universities, including technical universities like USTB, BIT, BUPT, and Beihang. Like Silicon Valley, Zhongguancun also has a critical mass of people who are crazy enough to do startups. Equally of interest is a good number of them end up in the PLAs GSD 3rd Department (the equivalent of our National Security Agency. ) And some of their best and brightest have ended up in the organizations like the 2nd Bureau, Unit 61398 tasked euphemistically for Computer Network Operations. While I didnt get much time with the academic community, in talking to students, education seems to still be one of Chinas bottlenecks rote lectures, passive learning, follow the process, exam-based performance, etc. And while startups and entrepreneurship courses are now being added to the curriculum, How to write a business plan seems to be the state of the art. Chinas education system needs to give more attention to fostering students innovative thinking, creativity and entrepreneurship.

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Entrepreneurial Culture Fear of Failure Though theyre familiar with technology in the valley, I picked up some important cultural difference from students and startup engineers I talked to. Even though theyre next to Zhongguancun, the hottest place for startups in China, there seems to be a lower appetite for risk, a lack of interest in equity (instead optimizing for a high salary) and very little loyalty to any one company. The overall culture still has a fear of failure. Most of their parents still tell them to work for the government or a big company. Talent I heard from a few investors that as the startup ecosystem is relatively new, theres a battle for experienced engineering talent and lack of experienced C-level execs. The lack of a previous generation of successful startup CEOs means the current pool of mentors to coach this generation is almost non-existent. Because salaries are cheap, startups seem to try to solve every problem by throwing bodies at it. Startup teams feel like they are 2-5x the size of American teams. There seems to be little appreciation or interest in multi-skilled people. Turnover of employees in capital in Beijing is very high. Employees work here for a few months and are suddenly gone. Theres a noticeable lack of tenacity in young, new entrepreneurs. They start a project, and if it isnt a home run, theyre gone. Perhaps its the weather. Silicon Valley has great weather and lifestyle, and nobody wants to leave. Beijing has awful weather and pollution, its a temporary place to get rich and then leave. Management 101 The board/CEO relationship still isnt clearly understood by either party. Ive talked to entrepreneurs who view the investors as a boss. A good number of startups in Beijing seem driven by the VCs and not the founders. This might also be a hangover from the command and control system of a state-driven planned economy. Ironically investors told me that the reverse has been true as well. Some startups acted like the VC was a bank. They took the money and then ignored their board. Over time, as investors add more value than writing checks, this relationship will mature. Creativity I was surprised that startup teams ask what seems like the kind of questions Americans learn at their first jobs. Team: We keep spending money trying to get people to our web site but they dont come back. We are almost out of money. Me: Ok. Why are you still spending money? Team: longsilencewe need people to come to the website. On the other hand, for most of them it probably is their first job. And the educational system hasnt prepared them for executing anything other than a plan. Iterations and pivots are a tough concept if youve never been taught to think for yourself. And challenging the system is not something thats actually encouraged in China.
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They also ask questions I just dont know how to answer. How do you know how to be creative? What do we have to do to be creative? You Americans just seem to know how to do things even if youve never done them can you show us how to do that? This seems to be an artifact of the Chinese rote educational system and its current system of government. Innovation Ecosystem On the plane ride home I started to think about the similarities and differences between the innovation ecosystems of Silicon Valley and the TMT segment I saw in Beijing. The motivations are the same profit driven by entrepreneurs and venture finance. And the infrastructure is close to the same research universities, predictable economic system, a path to liquidity, a stable legal system and 24/7 utilities. But the differences are worth noting its a young ecosystem, so startup management tools are nearly non-existent. But theres a difference in the culture of failure and risk taking - the current cultural pressure is to work for a big company or the government. Outward facing Universities are just starting to appear, and while theres a free flow of information inside China, it suffers from the constraints of the Great Firewall.

But there are two striking differences. The first is the lack of creativity. The Beijing software ecosystem I saw it has spent the last decade in a protected market copying successful U.S. business models. Copying, adopting and adapting, is not the same as competing, innovating and creating in a global market. Perhaps products like WeChat, designed for an international market, might be the beginning of real innovation. The second difference in ecosystems the lack of freedom to dissent goes deeper to the difference between the two systems. In the U.S. entrepreneurs are encouraged to Think Different. Our touchstone for creativity is the Apple ad that said, Heres to the crazy ones, the misfits, the rebels, the troublemakers, the ones who see things differently theyre not fond of rules You can quote them, disagree with them, glorify or vilify them, but the only thing you cant do is ignore them because they change things. This spirit of rebellion against the status quo got us Steve Jobs. In China the same attitude is likely to get you jail time. Unless you can speak truth to power, youll never have an innovation economy.

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Conclusion China is astonishing. The country has risen. Their economy is the envy of the world. The entrepreneurial and can do spirit reminds me of what the U.S. was known for. Chinese citizens are proud of their country and believe the world is theirs in the way Americans did in the 1950s. Their leadership has shown incredible foresight in engineering an amazing economic engine and formidable military. They come so far, and yet To take nothing away from what China has accomplished, a visit to Beijing had all the subtle reminders that this version of capitalism has come without democracy or justice; the guards in the Forbidden City armed with fire extinguishers in case more protestors try to set themselves on fire, the security around Tiananmen Square to prevent protestors from gathering, and the black jails to keep rural petitioners out of Beijing. And of course the great firewall, attempting to keep information about the outside world from reaching inside China. The bet the government is making is that if they can keep the economy cooking and distract the masses with ever increasing consumer goods and foreign adventures, maybe it can survive. All of these are signs of a weak China not a strong one. They are the signs of a leadership frightened not by external enemies but by their own people. It usually doesnt end well.

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