Investors are again betting on mainland start-ups

PUBLISHED : Monday, 10 December, 2012, 12:00am
UPDATED : Monday, 10 December, 2012, 2:28am

Four squares on a phone screen show photos of four women. Tap the one you like and profiles appear showing age, occupation, education, and current location: a 27-year-old dentist and a 23-year-old garment buyer in Beijing; a 24-year-old designer in Hong Kong, and a 32-year-old sales executive in Taiyuan.

Tap the application to reveal the background of your photo-based choice, and a photo of your background-based selection. Whom should you message? One knows Will, your college friend, while the other works at the same company as your roommate, Peggy.

This is Qiuqiu, or "cupid" in Chinese, a dating app that steers users to potential partners. It is the vision of former JP Morgan Chase New York analyst 27-year-old Michael Lewis, who moved to the mainland to chase his start-up dreams.

Daters have three categories to assess: appearance, background and people they know in common. "It's more in line with how people naturally meet," says Liuzhou-born Lewis, who emigrated to the US aged six. "If you have 10 friends, and those 10 friends each have another 10 friends, that's 100 people you can meet. It's quite exponential." Enormous too: the mainland has the world's largest singles population, estimated at 180 million.

To some, Qiuqiu is also an investment opportunity. Rich individuals bought a stake in the firm at an early stage, acting as so-called angel investors. These are investors that provide critical capital and guidance to a promising firm just as it is getting off the ground.

Such investors are "angels" in that they look over fledgling firms and nurture them with money and guidance in their early years. Angel investors fill a crucial niche in that they provide capital to new firms before they are big enough to get the attention of professional investors at venture capital funds, who generally won't look at any opportunity under US$1 million.

Because angel investors come in early, taking risky bets on firms that have yet to establish themselves, they typically get to buy into the company at a low price. The pay-off usually in comes in the form of a share sell-down at the firm's initial public offering or in an acquisition.

This is high-risk investing. Casey Lau, the organiser of Startups HK, which brings local entrepreneurs together, says he expects just two out of 10 start-ups to succeed.

But the pay-off can be huge. AngelVest, which introduces investors to entrepreneurs, seeks returns of at least 10 times an initial investment within 10 years.

Simon Squibb, of Nest, an incubator which nurtures start-ups, offers an example of how successful angel investing can be. Eighteen months ago Squibb and partners put HK$1 million into a Hong Kong magazine called Foodie. He estimates the investment is now worth HK$25 million.

Most of the start-up activity involves technology, in general, and the internet, in particular. Hong Kong investors are lucky to be sitting on the doorstep of the perhaps the world's most promising tech start-up market: the mainland.

The mainland lags behind the rest of the world in developing web businesses, but the potential is huge, thanks to the population and the growth in consumer spending. The mainland is also cranking out scores of promising new firms, particularly in Beijing's Zhongguancun district, the country's main technology hub.

AngelVest co-founder David Chen - who teaches a Beijing University entrepreneurship seminar in his spare time - says a wave of entrepreneurs is emerging on the mainland, and their ideas need funding.

"There's interest, especially in the past two years. The grads are highly motivated, although they require some education," he says.

Top-tier academe like Tsinghua and Beijing University churn out graduates much as Stanford serves Silicon Valley, creating an ecosystem ripe for Chinese entrepreneurs.

Beijing-based Natasia Guo, founder of website Nuandao, which specialises in goods with a sharp, original design, speaks of an "anything goes" mentality in the capital. She likes the mainland's scrappy start-up scene and thinks Silicon Valley is oversaturated. "I'm from the Bay area. Everybody is an entrepreneur there," she says with reference to San Francisco Bay, which encompasses Silicon Valley.

Like many mainland start-ups, Nuandao is a Chinese version of a successful Western business. It follows a similar business model to Fab, a design-focused online retailer valued at US$600 million.

The reason for copying a tried-and-tested formula is that it's an easier sell. Investors have a reference point and can also see a way to exit.

Although Chinese companies have come up short on innovation, they have excelled at adapting existing business models. "We may have copied Fab in terms of business direction, but we're now pivoting away from that to solve our users' unique needs," says Guo. "Weibo copied Twitter but they evolved and now they're more fun than Twitter."

Crucially, while the start-up scene in Silicon Valley is saturated with venture capitalists and it can be hard to find decent opportunities, mainland entrepreneurs are hungry for money. This is partly because local investors are less experienced and comfortable with angel-style investing. Investors from the mainland generally want to see an operating business with a tangible product before they commit capital, and many of the tech start-ups looking for funding are too conceptual for their tastes.

"In California, there are many generations of entrepreneurs and angel investors, but in [mainland] China the cycle only started five to 10 years ago," says AngelVest's Chen.

Rui Ma, China adviser to California-based 500 Startups, believes the lack of experienced angels - she estimates there are 300 to 500 active angel investors in China - often results in deals that are highly favourable to investors.

"The terms investors offer are not always reasonable," she says. "Instead of a straight equity instrument, the deal is often more like a debt. Or they will ask for big chunks of the company. They might say, 'If you don't perform and meet targets, you have to give me more shares. I up my stake from 30 per cent to 50 per cent without putting in more money.'"

It's a supply and demand issue, Ma believes. Fewer early investors make for greater leverage. "As more investors emerge, it will become normalised," she says.

Lewis says mainland tech start-ups are starved of capital because many local investors are reluctant to put money into unproven entities.

"Investors in China are a lot more cautious than in the West," he says. "There are fewer angel investors, they don't take as much risk, and they invest later. They want to see traction over investing in a strong team."

This is an opportunity for rich Hongkongers looking for a high-return investment and who might have the stomach for this brand of risk. Many wealthy investors from Hong Kong are entrepreneurs themselves, and are therefore in a position to understand the potential of a start-up.

Those interested in such opportunities might get in touch with angel clubs such as AngelVest, which offer a good entry point. Launched by Chen and a Harvard MBA classmate in 2007, it is the mainland's largest angel investment group with more than 60 members.

It has since invested in 16 mostly tech-related deals, with ideas ranging from a web service that helps users carpool (Wodache), to fitness software that lets joggers try out the world's best running locations around the world, thanks to simulation in high-definition video (Paofit).

The group applies strict rules on its invitation-only membership. Would-be angels must be recommended by two existing members, and they have to be wealthy: they must have a net worth of US$1 million or income of more than US$200,000 a year in the last two years, and a reasonable expectation to exceed US$200,000 in the current year.

AngelVest generally gives between US$100,000 and US$500,000 in seed money to start-ups. It plans to launch a Hong Kong chapter early next year aimed at networking Hong Kong investors with mainland entrepreneurs, and vice versa.

Hong Kong investors, of course, have already had dealings with the mainland tech story, in 1999-2000, when scores of internet firms rushed through IPOs on the Hong Kong exchange. The experience did not end well for many, as early investors in Tom.com, PCCW, china.com, hongkong.com, e-kong or Asiacontent.com can attest.

So, before throwing money at the first computer science major with a bright idea, Chen advises investors to determine whether they have experience in, and an understanding of, the business they are looking to invest in. "If you're a doctor and invest in a gaming company, I'm not so sure," says Chen.

Investors also need to be ready to take on an advisory role. "It's not a passive investment like property - you invest, and then you're mentoring and connecting," says Lau of Startups HK.

The Nest group is nurturing 10 young companies, giving them office space in Sheung Wan and an initial investment of HK$500,000.

More importantly, it offers plenty of industry know-how and guidance. Squibb set up his first company at the age of 24 and has two decades of experience building companies, while his other Nest partners include a lawyer, a Google veteran, and marketing and branding gurus. For the first three to six months, Squibb says he meets with the entrepreneurs every day. After the company has got off the ground, he meets with them once a week, usually over coffee or lunch.

Although he recognises that many angel investors can only commit spare time to a company, being involved is the smartest way to invest, he says. "I learned, by losing money, that I have to be in the businesses a little bit more. I started like everyone else, having a day job and angel investing on the side. Fast forward five or six years, and I had companies that did well and ones that didn't do so well. The ones that didn't do well were the ones I hadn't spent time on. If you do something part time, you get part-time results."

Angel investors can hope for a rich pay-off for their work, but many find the role of mentor and of being a part of exciting start-up to be rewarding in itself. Angel work has a large social enterprise element, says Squibb. He notes that rich Hongkongers have recently become fascinated with investing in car parking spaces that can be bought for up to HK$1 million apiece. He says that car parks might provide reasonable financial returns, but result in nothing exciting. "If you put that into an entrepreneur, imagine what they could do," he says.

"People invest to make a return and that's certainly what we do; I'm not shy about that. But I think a lot of people invest because it's a good thing for the community. You're helping a human be successful, feed their family, helping the city. That's a lot more interesting than a car park."