Venture capitalists learning a hard lesson: tech start-ups often collapse in waves

China’s venture capitalists (VCs) are learning a hard lesson: collapses of technology start-ups can happen in waves.

A growing number of budding e-commerce players, crippled by fierce competition and lofty operational costs, have been on the hunt for fresh capital injection from their investors, only to find that venture capital funds react in lukewarm fashion.

The results has been a rising number of mainland start-ups, particularly those internet-related businesses, have been shutting shop, after running out of funding before attracting enough customers to survive.

According to analysts, however, the worst is yet to come, as venture capitalists expect more portfolio firms to face a funding crunch in the second half of this year, meaning the VC community is unlikely to be quite so willing to come to the rescue of embattled businesses.

“All good things come to an end,” said Ray Lu, an investment director with Hotung Ventures.

“The fervent investment spree in the past two years proved to be overdone.”

Beijing’s “Internet Plus” strategy – using the latest internet technologies such as big data and cloud computing to target a wider range of customers and boost business efficiency – ushered in a massive fund influx to the technology sectors.

Venture capital funds focusing on the mainland market raised a record 785 billion yuan (HK$913 billion) in fresh capital in 2015, buoyed by optimism about the rosy prospect of the internet-related business.

According to pedata.cn, a subsidiary of fund consultancy Zero2IPO, the number of new venture capital funds created last year hit 2,970, quadruple the number in 2014.

VC investment was valued at 525.5 billion yuan last year, with the portfolio firms receiving an average 68 million yuan each.

The government has pinning high hopes on online businesses to help transform the mainland economy into its so-called “New Normal” pattern of economic growth, driven by consumption and entrepreneurship, rather than industrial investment and exports.

“Go-digital” has also become a buzzword among the investment community and small business owners as they crowed about developing more “e-commerce intimacy” with millions of mainland consumers.

The vast majority of VC funds gravitated to e-tailers or online-to-offline (O2O) businesses amid the firm belief they could eventually create profit-making models after attracting larger client bases.

“For a time, some general partners would prioritise whether the target company belongs to a ‘hot field,’ rather than making sure its business model is in line with the logic of business development,” said Zhou Xinhua, a partner at Shanghai based Zhong Wei Capital.

“A general partner may be questioned by the limited partners if he or she missed out some hot field companies.”

The competition among funds to scramble for a share in the prospective blockbuster start-ups has given birth to a philosophy known as the “market share first, profit next”.

Many start-ups have been using the money they raised as subsidy for customers to attract online traffic and force out rivals.

“I understand the companies are splashing out tonnes of money to attract people like me, but I really doubt their business model,” said Joe Zhou, a Shanghai resident who is used to ordering goods and services via the internet.

“As a first-time registered user, you get a huge discount, free products and services from the business operators, and I keeping trying one after another to enjoy the benefits.”

Last year, an app with a million users could be valued at 1 billion yuan, regardless of its real turnover and its business engagement with potential customers.

Salivating over the frothy valuation, thousands of youngsters ventured into the cyber world to set up on their own, selling consumer goods, offering transport services, or serving as matchmakers between buyers and sellers.

Zhang Jingfen, an online shop owner, said that the threshold to the e-tailer business was low and a fundraising from angel or venture capital investors was the ultimate goal.

“It looked as if everybody could make a success,” she said.

“Those who successfully raised funds from investors suddenly became free-spending in operating the businesses with the number of registered users soaring.”

After seeing a wave of new businesses collapses recently, Zhang said she realised the party was over.

“I used to be picky about investors who wanted to buy a share of my business,” Zhang said.

“The grim reality now, is that they don’t have money to invest or they just shut the door on e-tailers.”

Yi Ji Shopping, a wine trading platform that failed recently, used up 38 million yuan raised in earlier round of funding in less than a year. When it started in June 2015, it used to pay back 100 yuan for every 400 yuan buying order, mainland media reported.

Tao.117go.com, branded as “On the road”, an online customised travel package platform, has confirmed it has been in the process of liquidation since late June, despite millions of US dollars in investment from Alibaba Group Holdings, Redpoint Ventures, Softbank Corp and New Horizon Capital.

As Chinese economic growth slowed to the lowest speed in 25 years last year, the central bank has been cutting interest rates and pumping fresh liquidity into the market to spur investment and growth.

VC liquidity has effectively been fuelling start-ups since 2014, targeting those with the potential to tap the world’s fastest growing internet community and rising consumer power.

In Shanghai, the country’s commercial capital, the city government rolled out what were claimed to be loss-proof incentives to compensate for any losses by business angels and venture capital investors, encouraging them to speed up their investment in the technology start-ups.

The policy reflected Shanghai’s desperation to nurture the growth of technology firms, but it was also surrounded by strong criticism about its effectiveness.

A venture capitalist who asked not to be identified said that the loss-proof measures could have created a hotbed for cheating and fraudulent deals, to swindle the authorities out of millions of yuan.

Anecdotal evidence showed that some of the start-ups, to try and dress up their business performance, fabricated transactions to attract new users and further rounds of financing.

In a typical case, a business operator creates thousands of accounts themselves to “buy” products and services on its own online platform to catapult their apps into national prominence.

“The apps with big business volume can attract a larger volume of eyeballs and some of the start-ups are hiring people to “buy” their own products to dress up their business results,” said Zhou Shiyu, a heads a logistics company that serves several e-tailers in Shanghai.

“The VC funding was effectively misused, to boost the falsified transactions.”

Venture capitalists have been turning increasingly cautious in recent months about feeding more investment into cash-burning start-ups, after the China Securities Regulatory Commission (CSRC) stepped up its scrutiny of initial public offering, and merger and acquisition applications.

“The investors are feeling the pinch, as the regulatory headwind makes exit more difficult, while a gloomy economic outlook makes investment return uncertain,” said Zhou of Zhong Wei Capital. “After around two years of frenetic investment, venture capitalists are calming down.

“At one time, people would throw money at a company before they touched the whole pulse, to avoid missing out on a potential good opportunity that may offer manyfold in returns.”

Now spooked by weakness in the economy, a stock market facing uncertainties, and a global risk preference decline, more investors are slamming the brakes on generous financing.

While the total value of investment also declined, to US$2.21 billion in the second quarter, from US$2.64 billion same period last year.

Norma Chu, founder of online cooking and lifestyle startup Day Day Cook, said she found investors had adjusted their standards when evaluating a company.

“Before a lot of them emphasised total sales, or traffic, then they played up the importance of platform. Now more value the content, the brand, and the team’s ability to manage customers,” she said.

Chu said her firm stresses original content, while maintaining a light-asset strategy.

She expects Day Day Cook to become profitable this October, based on the volume of advertisements in the pipeline.

The firm raised 35 million yuan from investors this March, and she expects to finish her next round of financing worth around 30 million yuan next month.