VC Players Look East, to China

U.S. tech startups are competing for venture capital funding with China, a land of low costs, huge markets, and ample opportunity—and significant risks

By Aaron Ricadela

Mainland China doesn't yet boast a Silicon Valley, but an influx of venture capital funding in promising new areas could put U.S. startups at a disadvantage as they compete for funds.

Venture capital players are increasingly betting on Chinese startups that supply the software, chips, and networks to feed the country's 400 million cell-phone users' voracious appetites for wireless data. That includes applications like instant-messaging, video-uploads, and mobile Web searches, along with consumer-level Web services such as social networking. The influx of funding saw a brisk increase last year—VCs bet $920.7 million on information technology companies last year, up 34% from 2005, according to a Feb. 13 study from Dow Jones (DJ) VentureOne and Ernst & Young. And that funding shift across the Pacific could pressure Silicon Valley startups to devise business models with extremely meager cost structures as a way to attract venture capital.

Expanding Beyond China?

"The Valley investors I know are generally much more reluctant to make investments in American firms than in previous years," says Reed Hundt, the former Federal Communications Commission chairman and author of In China's Shadow, a book published last October on American competitiveness with China. Hundt also sits on several tech company boards.

Question is, can China's fledgling dragons spread their wings and expand beyond their home market? Investors hope so. If China's wireless and Internet companies make the trans-Pacific leap, it could mean new competition for U.S. startups. "Some days I wake up thinking that in areas like mobile services and social networking, the Americans better watch out," says Drew Clark, director of strategy at IBM's (IBM) venture capital group. Still, despite Chinese tech companies' success at home—Baidu.com (BIDU) and Alibaba.com have respectively given Google (GOOG) and eBay (EBAY) fits in China—"whether any of those will escape China's gravity and come over to the U.S., I don't know," Clark says.

While VCs have hedged their bets in China by backing later-stage companies, "we're also seeing a surge in early-stage deals," Clark says. Venture investments in China last year hit a three-year high of $1.89 billion, according to VentureOne, and 22% of the 214 deals struck last year were second-round investments or later—up from 15% in 2005. But early-round deals still accounted for $828.2 million in venture investing, or 62% of all deals (see BusinessWeek.com, 7/24/06, "To China, With Venture Capital").

Partnering Abroad

Overseas expansion is difficult under any circumstances, and Web and mobile-phone apps are particularly bound by culture, says Richard Lim, managing director of GSR Ventures, the Chinese affiliate of Mayfield Fund, which manages nearly $300 million in China-focused venture capital. For example, Mayfield in December, 2005, invested $1 million in PingCo.com, which makes software for sending ad-supported SMS messages that are free to users. "You can't build that business outside of China," he says—other markets lack a large enough pool of wireless Internet subscribers to make the business model fly.