Download On Venture Capitalists’ Decision-making in China

On Venture Capitalists’ Decision-making in China
Gao Zhi
School of Management Dalian Jiaotong University, P.R.China,116028
(Ph.D. candidate of School of Management, Dalian University of Technology)
Abstract Despite significant academic research undertaken in the field of venture capital
decision-making process, most of them are for developed countries. Aiming at developing an
understanding on how venture capitalists select venture projects, this research uses interviews and
follow-up questionnaires with a sample of Chinese venture capital firms and yields two important results.
The first is a VC decision-making model for transitioning economies that diverges from previous
research. The second result is a modified set of investment criteria that reflect some of the unique
difficulties venture capitalists face when evaluating deals in transitioning economies. Several differences
between their criteria and those used by venture capitalists in developed countries are identified.
Keywords: China; venture capital; decision-making process; economic transition.
1. Introduction.
There is an extensive body of literature examining the criteria used by venture capitalists when
evaluating potential investments. This work includes papers by Wells (1974), Poindexter (1976),
Tyebjee and Bruno (1984), and MacMillan et al. (1985), Fried and Hisrich (1994). Despite significant
academic research undertaken in the field of venture capitalists decision-making in the US and Europe,
its examination in other settings has been limited. In Asia, the examination of the industry is almost
nonexistent, especially in China. It cannot be assumed, however, that Western practices are universal
around the world.
Institutional theory holds that the beliefs, goals, and actions of individuals and groups are strongly
influenced by various environmental institutions (Scott, 1987, 1995), and that their role in doing this is
subtle but pervasive (Boisot and Child, 1996; Child et al., 2000; Clarke, 1991). However, to date,
research from the West has only started to account for the role that different institutional environments
play in transition economies, such as China’s, (Boyacillier and Adler, 1991; Shenkar and Von Glinow,
1994) and how these differences can help create different organizational and commercial systems (Peng,
2000; Peng and Heath, 1996). This paucity of examination on institutions in transition economies is
particularly true of entrepreneurial domains (Giamartino et al., 1993).
China’s institutional environment is quite different from the West (Boisot and Child, 1996; Peng, 2000;
Peng and Heath, 1996). The nation’s socialist tradition and strong culture together create a distinct social
and commercial milieu (Boisot and Child, 1988; Child, 1994; Scarborough, 1998). For example, private
firms in China still have limited discretion to acquire and allocate resources and conduct operations
(Peng, 2001). Additionally, firms must often engage in some transactions where personnel connections
matter more than firm capabilities (Boisot and Child, 1996; Peng, 2000; Xin and Pearce, 1996). Also,
few managers in China have much experience in competing in a market-based economy (Bjorkman and
Lu, 1999). Corporate governance and property rights are typically spotty, and fund allocation, even by
private firms in China, must often observe political and other non-market motivations (Clarke, 1991;
Peng, 2001; Peng and Heath, 1996; Tam, 1999). Thus, for researchers in entrepreneurship, China’s
institutional environment provides a compelling context to examine and refine our understanding of how
institutions may impact firms (Boisot and Child, 1996; Peng et al., 2001), and in turn create differences
in entrepreneurial efforts from those of the West (Peng, 2000, 2001).
To investigate how venture capitalists make decision in China’s environment, this article begins with a
brief review of literature on venture capitalists’ decision-making. Next, based on interviews with VC
firms operating in China, the article yields two important results. The first is a VC decision-making
model for China. The second is a modified set of investment criteria when evaluating deals in China. A
conclusion of these findings then follows.
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2. Literature review
The existing research on VCs’ decision-making can be classified into two broad streams: one is
processual research—i.e. research focusing on the course of events and activities that constitute the VCs’
decision-making process (e.g. Wells 1974, Tyebjee and Bruno 1984, Silver 1985, Hall 1989)—and the
other is criteria research, i.e. research focusing on the criteria used by VCs when assessing proposals
(e.g. Poindexter 1976, MacMillan et al. 1985, Khan 1987). While most of the studies can be positioned
within one or the other research stream, some represent a combination of the two, having produced
models outlining the phases of the decision-making process and the criteria used in each phase (e.g.
Wells 1974, Boocock and Woods 1997).
The most thorough work on the VC process is by Tyebjee and Bruno (1984). Using a mailed, structured
questionnaire, they investigated both the process and the factors which influenced the VC investment
decision in an analysis of 90 deals evaluated by 41 different VC firms. Over 75% of the 90 deals were in
the semiconductor, telecommunications, or biomedical industries. Tyebjee and Bruno developed the
five-step decision model. They use factor analysis to identify the basic characteristics used by venture
capitalists to evaluate potential deals.
MacMillan et al. (1985) replicate the results of Tyejbee and Bruno (1984) for a larger sample of venture
capitalists and a later time period and this line of research is extended to venture capitalists outside of
the USA by several authors. All of the research into investment criteria uses some variation of the
Tyejbee and Bruno (1984) methodology, i.e. the venture capitalist is provided with a list of evaluation
criteria and asked to rate a recent proposal based on these criteria.
Fried and Hisrich (1994) attempted to address these issues by extending their analysis to examine the
entire investment process. They interviewed 18 venture capitalists and employed a two-stage research
methodology to develop a set of generic investment criteria and a model of the VC process. In the first
stage, case-study data was collected and analysed; the second stage utilized an industry panel to critique
and verify the criteria and model. Their results yielded 15 common criteria across three broad categories
originally identified in Hisrich and Jankowicz (1990); concept, management, and returns. The VC
process model of Fried and Hisrich (1994) includes six phases as follows : origination, VC firm-specific
screen, generic screen, first-phase evaluation, second-phase evaluation, closing. The Fried and Hisrich
model is similar to the one presented by Tyebjee and Bruno (1984), with several important differences.
Tyebjee and Bruno’s model has a single stage for initial screening, while Fried and Hisrich suggest a
two-stage screening process in their model. Fried and Hisrich also break evaluation into two stages,
without the separate pricing stage used by Tyebjee and Bruno. Finally, Fried and Hisrich find that
pricing issues are negotiated earlier in the process, and as an integral part of the other evaluations, rather
than as a separate step.
Research into international comparisons of venture capital firms is rather limited and has focused on
cross-country comparisons (Sapienza et al., 1996) of risk assessment and sourcing information between
developed countries, notably the U.S. and Europe (Manigart et al., 1997, 2000). More recently, Lockett
et al., (2002) conducted studies over a period of time and presents cross-cultural comparison from
countries including U.S., Hong Kong, Indian and Singapore. In parallel, two case studies, Bliss (1999)
and Silva (2004), took place in Europe to test the decision-making process in transitioning economy (the
case of Poland) and in small equity market (the case of Portugal) respectively. In Asian, approaches to
dealing with asymmetric information have been examined with respect to screening venture capital
investment in a developed economy like Japan (Ray and Turpin, 1993), in newly industrialized
economies such as Korean (Rah et al., 1994), Singapore (Ray 1991, Zutshi et al., 1999) and HongKong
(Chu & Hisrich, 2001). More recent research of Wright et al., (2002) compared the differences in risk
assessment and information usage between Indian and U.S. venture capital firms operating within India.
However, about the case of China, only Bruton and Ahlstrom (2003) to date give us some guidance
results of “selection of firms to fund”. Their study was based on field research conducted from 1998 to
2000 in Greater China, which includes Mainland China, Hong Kong and Taiwan. They tried to examine
four broad topical areas based on 36 interviews within 24 venture capital firms. There is, however, still
an absence of research work on the venture capitalists decision making process relating to Mainland
China (not including Hong Kong, Taiwan and Macao), which is currently in economic transition from a
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command economy to a market-oriented economy but with a high economic potential.
3. Methodology
In order to evaluate the VC process in China, the case study research methodology was selected and
interviews were conducted with personnel at the forty VC firms. These firms were from Shanghai,
Beijing and Shenzhen which are emerging as the centers of the Chinese venture capital system and they
represented the domestic venture capital firms (government venture capital firms, university venture
capital firms, and corporate venture capital firms), foreign venture capital firms and Sino-foreign JV
firms, respectively. Thus, although the sample is small, it is representative of the overall industry.
In each interview, the venture capitalist asked to describe the investment process from beginning to end,
using a recent example. This allows the sequential decision-making process to be examined. As in Fried
and Hisrich, the focus is on an actual, recent deal in order to mitigate the problems associated with
hypothetical responses or the tendency to choose a favored transaction. The financial outcome of the
investment was not known at the time of the interview, so there should be fewer problems with
self-reporting bias.
Transcripts of the interviews were used to fit each case into the Fried and Hisrich model shown. The
individual cases generally fit the model, but there were some important deviations. These differences
were noted, and after all of the interviews were reviewed, the exceptions were examined for consistency
across cases. The results of this were used to make modifications to the original model. The interview
transcripts and the follow-up questionnaires were also used to analyse the investment criteria used by
Chinese venture capitalists and to highlight differences between their criteria and the generic criteria
developed by Fried and Hisrich.
． Results
4
This research yields two major results. The first is a new model of the VC decision-making process for
transitioning economies. The second result is a modified set of investment criteria and activities that
reflect the unique economic conditions and operating environment in China. Both results are discussed
in more detail below.
4.1 A VC model for transitioning economies: The resulting transitioning economy VC model also
includes six stages similar to Fried and Hisrich. But this process differs from the Fried and Hisrich
model in two significant ways: (1) variation in the origination stage, and (2)distinction in firm-specific
screens.
The difference in the origination stage of the model involves the pro-active solicitation of proposals by
the VC firms. There is no shortage of deals, just a perceived lack of ‘good’ deals. The adjective good
does not refer to the deal’s quality or potential for return, but rather its suitability for even preliminary
evaluation. Many deals offered to the VCs interviewed were not even worthy of a cursory screening.
The venture capitalists attribute this to misconceptions in the market about what VC activity means. The
result is numerous proposals from firms that don’t fit the VC profile, and a dearth of deals from
companies most suited for VC funding. For example, several venture capitalists cited entrepreneurs
seeking funding with ‘no questions asked’. Another popular request was for working capital financing.
Thus, education about the role of VC in China is an important part of the origination stage.
The other main difference between the transitioning economy model and the Fried and Hisrich model is
found in the firm-specific screen stage. Their study of US VC firms found that most initially screen
proposals using criteria such as deal size, industry, geographic location, and stage of financing. This is
not typically the case for VC firms in China. Venture capitalists pay special attention to proximity factor
and inadequacy of legal protection resulting from bankruptcies and outright fraud. China’s regulations
are largely generated and interpreted by local and regional authorities and not the central government
(Clarke, 1991; Lubman, 2001; Peng, 2000). Thus, China may be thought of as more like the European
Union than a single state—multiple sovereign agents with varying regulatory structures and interests (Li,
1998; Lubman, 2001; Reynolds, 1984) and different laws, regulations, and traditions within and across
provinces (Clarke, 1991; Lubman, 2001; Tan, 1999). Indeed, numerous venture capitalists and
entrepreneurs interviewed emphasized the importance of understanding the local setting. Thus, in China
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venture capitalists often try to fund firms that are located nearby and seek to build relationships with
local authorities in order to be able to understand and manage the local regulatory regime that their
funded firms face. Understanding and controlling the risk from regulatory institutions can become
unwieldy if the venture capital firm’s investments are geographically diverse. Therefore, most
preliminary screens in China focus attention on firms within specific regions. Few legal protections
(regulatory institutions) in China against outright fraud, imperfect market information, and the rapid
nature of change in the market heighten the venture capitalist’s risk and encourage such a screen.
4.2 Investment criteria and activities of the venture capitalist: Fried and Hisrich identify 15 generic
investment criteria across three broad categories . There are numerous differences between their criteria
and how they are evaluated and those used by venture capitalists in China. These differences, some
substantial and some more subtle, are discussed below in more detail.
4.2.1. Concept. Two characteristics of most transitioning economies, significant governmental influence
and a nascent legal system, were mentioned as important risk factors by most of the VC firms in the
sample. They are put into the concept group because they can be ‘deal breakers’ in certain situations.
Most VC firms viewed governmental involvement in a deal as a ‘yellow flag’, but some were more
stringent than others. One VC firm would not even consider deals subject to government regulation or
licensing requirements. Another deselected proposals based on any involvement with the government,
whether as partner, supplier, or customer. Their view is that the volatile nature of the political system
creates an unacceptable level of risk.
As private property ownership, most notably real estate, is a new concept in most transitioning
economies. Questions of clear title, liens, and using assets as collateral—all relatively simple to resolve
in developed nations—may create unacceptable risks in transitioning economies.
4.2.2.Management. Several of the criteria in this group are evaluated and weighted differently by
Chinese venture capitalists than in Fried and Hisrich. The issues described create two problems for
venture capitalists in transitioning economies: assessment of managerial ability; and unrealistic
expectations on the part of the entrepreneur. Since few entrepreneurs have long track records or
extensive private-sector experience, the VC firms resort to other signals, some admittedly imprecise, of
managerial ability. In order to deal with the problems, one venture capitalist may seek out deals with
firms that hired MBAs from the USA program. Another would look for managers with exposure to
Western business practices, preferably gained through time spent abroad.
In spite of their limited experience and lack of formal business training, many Chinese entrepreneurs
harbour great expectations for their businesses. One venture capitalist observed that there are a ‘lot of
people who think they can do anything because they’ve done something’. This hubris increases the
deal’s execution risk and can also foster unrealistic pricing expectations. Unlike developed countries
where managerial talent can be readily acquired, personnel problems in transitioning economies may be
time-consuming and costly to resolve.
4.2.3.Returns. Two of their criterion, ‘exit opportunity’ and ‘potential for high rate of return’, are
evaluated differently by Chinese venture capitalists.
Transitioning economies offer limited exit strategies, primarily due to the lack of developed equity
markets that are needed to support IPOs. All of the venture capitalists interviewed felt that they had two
viable exit options: trade sales and equity put-backs. This impacted the types of deals they sought and
the way those deals were structured.
When analysing financial forecasts and computing potential rates of return in transitioning economies,
venture capitalists must take inflation and taxes into account. The move to a free-market economy is
often accompanied by spiralling inflation. Taxes were mentioned by several venture capitalists as a
confounding factor in their financial analysis of deals.
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5 Conclusion
The decision-making process and evaluation criteria used by venture capitalists have been the subject of
considerable prior research, most of it focused on the VC industry in the USA. The purpose of this paper
was to extend this previous work, primarily the decision-making model of Fried and Hisrich (1994), to
the VC process in transitioning economies. In the move from a planned economy to a free-market
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system, VC firms face conditions very different from those encountered in developed countries. These
include strong governmental influence, high inflation and borrowing rates, a shortage of skilled
managers, undeveloped capital markets.
This research was based on interviews and follow-up questionnaires with a sample of VC firms
operating in China and yields two important results. The first is a VC decision-making model for
transitioning economies that diverges from previous research in two areas. The second result is a
modified set of investment criteria that reflect some of the unique difficulties venture capitalists face
when evaluating deals in transitioning economies. Several differences between their criteria and those
used by venture capitalists in developed countries are identified. These include the following: the
increased risk of governmental influence; problems due to an untested legal system; alternative methods
of assessing managerial ability; unreasonable expectations on the part of the entrepreneur; a reduced
menu of exit strategies; and the potential negative impact of high inflation.
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