As I wrote Sunday, a lot of venture capitalists who’d rushed headlong into China in recent years pulled back in 2012, as a dearth of IPOs and mergers tamped down prospects for high returns.
Tim Chang was one of them. When I first met him two years ago, Chang was at Norwest Venture Partners, and China represented a significant chunk of his investment activity. He thought that would continue to be the case after he decamped for Mayfield Fund; instead, he tells me, “I haven’t been back to China in more than a year now. I gave up.”
Chang continued: “For a while, China was this big, shiny thing. Then it erupted into a bubble.” From the second half of 2008 through 2010, he said, valuations for private Chinese companies shot through the roof. “Everybody was on this crazy race to try to IPO based on the China macro-growth story,” Chang said. (For a neat look at how China’s economy has grown in recent years – and how it compares to those of other countries – check out this link.)
With Chinese entrepreneurs touting eye-popping revenue growth and eager to hop in the IPO queue, investors were doing “drive-by diligence,” Chang said. Today, a lot of those deals are underwater; Chang says he put money into half a dozen Chinese companies while with Norwest, and about half of them didn’t pan out (which, statistically speaking, isn’t a bad batting average for VC). His best performers, he said, were deals he did in early 2008, before the land rush heated up.
“In China, we used to joke about startup locusts,” he said.
“As soon as a field would get hot, thousands of copycats would descend” and start nearly identical businesses. That trend was partly fueled by a surfeit of venture funding, Chang says now. (“The funny part is,” he added, “is that Brazil is the new China.”)
Things started unraveling, Chang said, once a few Chinese IPOs actually went through. “A lot of these Chinese management teams had no experience with investor relations or investment banks,” he said. “Their numbers were opaque, and after a while people said, ‘Screw this: I can’t trust their numbers, their ethics are different and I don’t get clear predictions on earnings.’”
Wall Street’s pull-back, in turn, caused venture capitalists to look at Chinese startups with a more critical eye before investing. “The big shell game for a lot of Chinese companies was that people were depending on top-line revenue growth to go public,” he said. “The problem is, people started saying, ‘Wait a minute.’ It’s one thing to juice the growth of a company by spending craploads on advertising or selling things at ridiculously low prices. But as the lens becomes more focused on profitability, a lot of these momentum stories fall apart.”
And that, Chang suggested, offers hope for the future. As venture funding dries up, fewer “copycat locusts” will get funded. Companies that remain will have to focus on things like cash flow and breaking even. Chang even envisions the day he might get back into the game: “As sour as I sound on China,” he said, “it’s not like I gave up forever.” (Indeed, others in the valley remain bullish on China: Venture giant New Enterprise Associates on Tuesday announced that Carmen Chang, who joined up last year as a special advisor after leading Wilson Sonsini‘s China practice, has been promoted to partner and will spend about a quarter of her time in China.)
As part of Mayfield, Tim Chang has the advantage of seeing how the firm’s China-based partner, GSR Ventures, operates. While he freely admits it was tough to make an impact in China while based in Silicon Valley, GSR is “all about feet on the street. They can be a feeder for us to do late-stage rounds.”
Still, he added, Chinese entrepreneurs will have accept that sky-high valuations are a thing of the past before he jumps back in. “I think it’s becoming a lot more rational, but not to the price discount I’d want to see given the challenges in China,” Chang said. “There’s so many better deals in the U.S.”