HK’S VENTURE CAPITAL SYSTEMAND

THE COMMERCIALIZATION OF NEW

TECHNOLOGY

Kevin AuChinese University of Hong Kong

Steven WhiteChina Europe International Business School

Objectives

• describe and assess the performance of Hong Kong’s venture capital system – beyond the strict financial definition of venture

capital (VC) to address the system of actors and institutions that finances the commercialization of new technology

• generate actionable recommendations to improve its efficiency and effectiveness in increasing the positive role of new technology in Hong Kong industry

Agenda

• Startup process & financing• Venture capital system

– General situation of the HK VC industry– Institutional framework for an evolutionary analysis

• VC Cycle, investment process, VC system• “West coast” vs “East coast” VCs in the US

• Evolution of HK’s VC industry– Other key actors: angels, stock market, institutional

investors

• Inhibitors to VC’s support to Commercialization– Suggestions for the medium term

Financing of New Firms

•With great idea, you need finance for additional research or produce a prototypes

•With great idea, you need finance for additional research or produce a prototypes

Expansion Expansion Expansion Expansion Early stageEarly stage Early stageEarly stage Start-upStart-up Start-upStart-up Pre-startPre-startPre-startPre-start

•No sales yet, you need finance for working capital such as,

salary, development & testing

•No sales yet, you need finance for working capital such as,

salary, development & testing

•Having a few sales, finance is required for marketing and operations, in order to make the business fly

•Having a few sales, finance is required for marketing and operations, in order to make the business fly

•With profits and well established business operation, funding is required for new product development and exploring new markets

•With profits and well established business operation, funding is required for new product development and exploring new markets

up to US$0.1Mup to US$0.1M up to US$1.0Mup to US$1.0M US$1 - 3MUS$1 - 3M US$3M and upUS$3M and up

Cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures, which may be too small or young to qualify for traditional loans

Flow of Funds in a VC cycleVC funds managed

by general partners (and sometimes with special partners)

(VCs or GPs)Portfolio companies

(startups, established companies, buyouts)

Exits: 　 IPO or trade sale (of portfolio companies)

Limited partners

(Investors or LPs)

Venture Capital Pool

Number of VC Firms

Investment Stage of VC FundsDisbursement　by　Financing　Stage　in　Hong　Kong　

(in　$)

29%

4%

32%

17%

17%1%

Startup

Seed

Expansion

Messanine

Buyout

Turnaround

Disbursement　by　Financing　Stage　in　China　(in　$)

54%

0%

41%

5%

0%

0%

StartupSeedExpansionMessanineBuyoutTurnaroundDisbursement　by　Financing　Stage　in　Singapore　(in　$)

22%

1%

66%

4%7% 0%

StartupSeedExpansion

MessanineBuyout

Turnaround

Disbursement of VC Funds –Local or Overseas

1,132

8,744

411

3,169

136102

509

1,668

650

30,073

13,417

2,776

0%

20%

40%

60%

80%

100%

HK China Singapore All　Asia

countriesNon-Asian　CompaniesOther　Asian　CompaniesLocal　Companies

General situation of VC Industry

• have the largest pool of venture capital • Most of them not interested in investing in early

stage• A lot of funds being parked in HK for

investments outside Hong Kong– Especially mainland China in recent years

Venture Capital Process

“West Coast” vs “East Coast” VCs

• West coast VCs are dreamers and want to see how technology can change the world, whereas East Coast VCs only treat venture investment as another asset class.

Udayan Gupta, Author of Done Deals

Larry Sonsini, of the law firm Wilson, Sonsini, Goodrich & Rosati

• “The West Coast model of venture capitalism has always been a very intense business partnership with the entrepreneurs.

• The providing of capital was one function of the venture capitalist. Being actively involved in developing the business model, managing the enterprise, and recruiting management

• They thought of more than investing money. They thought about mentoring, training, and providing business solutions. The goal was not only to make a successful investment but also to be a part of building a successful venture.”

Morton Collins, founder of DSV Partners in 1968

• “The East Coast, the financial center of the world, has traditionally been fixated on financial engineering. There, with a priority placed on the structuring of deals, has often mattered less what a company did or what would be involved in ensuring its long-term success than whether the deal would provide tax benefits and financial returns.

• On the West Coast, by contrast, the driving spirit has been innovation in science and technology. Technologists and investors, many of whom are refugees from the East, have long gathered around the campuses of Stanford University and Cal Tech to create a new economy and a new entrepreneurial culture (p. 293).”

Reasons of the differences

• Early East Coast firms were set up as Small Business Investment Corporations– Following governmental guidelines but not

technology

• General partners are bankers and accountants, not operational managers

• New York & Boston are financial centres, so lots of money from insurance firms and pension funds– Expect regular disbursement; low risk, not

particularly fond of technology

Evolution of HK’s VC System

• Tying evolving institutions to VC development

• Four stages– Prior to 1970s– 1970’s to mid 1990’s– Mid-1990s to 2001– 2001 to present

Prior to 1970s

• Trader’s mentality– Favoring arbitrage

• Refugee mentality– Short-term oriented

• Colonial government (British were guilty!!)– Positive non-interventionism– Supporting indirectly logistics, construction,

trading and financial industries • Successful lobbying from these industries

1970’s to mid 1990’s• Background

– British trading firms dominated– Booming stock market

• First VC firm: Inter-Asia Venture Management– “transfer strategy”

• 1981: ARRAL & Partners– succeeded against skepticism– Listed HK Teawood in NASDAQ, 1984

• 1988: US$150M APAC Fund launched– Grew industrial firms benefited in the China and Asia

boom– Invested almost all in late stage ventures

• 1987: HK Venture Capital Association founded

Mid-1990s to 2001

• 1994: US$1.7B Asia Infra-Structure Fund by AIG

• Tech Boom & then Bust– Entering many new VC firms, local &

overseas– Large PEs after the Asia Crisis– Government VC: Applied Research Fund– Corporate VCs

• Short-term; risk averse; didn’t know technology

2001 to present

• Dismal investment– New firms had little technology– New VCs had little operational background– Lacking qualified startup management teams– Overdue government intervention

• Not all was lost– Some success

• New opportunities & threats– Rapid development of China & HK’s economy

and financial markets

Summary

• Lots of money but not channeled to tech ventures

• “…there is not a cohesive financial arrangement, and entrepreneurs, academics, politicians and civil servants lack the appropriate skills to differentiate good ventures from bad. They have to mature in their decision-making to accept risk and how return is generated.”

• “By the time China’s stock markets become mature and the RMB circulates more widely, Hong Kong as a base for venture funds will be lost forever.”

Key actors and resource flows

VC-Backed IPO 2000-07

Inhibitors to VC’s Supporting the Commercialization of New Tech

• Government & Culture– Short-term oriented, low-tech

• VC and PE firms– “we are out to make money”

• Focused late stage, large size, low risk ventures

– Lacking operational experience

• New ventures– traditional owners expect control– Younger generations

Inhibitors to VC’s…continued

• Stock market– Welcome the listing of large firms– Technology level of firms not a focus

• Banks & Endowment funds– Lending by laterals– Investment confined by the HK version of the

“prudent man” rule

• Angels & Angel Networks– Lack knowledge in tech ventures– Not organized to share risk and knowledge

Suggestions for the Medium term

1. Stimulate more VC funds with long-time horizon and technology interest

• Channel government reserve and pension funds by lifting the “prudent man” rule

2. Develop professional qualifications for investment advisors on VC/PE industries

3. Stimulate angel investment Training, guidebooks, & templates “Accredited investor” & possibly tax breaks

for investing in technology ventures

Suggestions…continues

4. Diversify the backgrounds of the general partners – VC firms hiring general & special partners are

more likely to receive endowment, pension & government investments

5. Find new IPO exit for VC/PE invested in technology firms – setting up a new board with perhaps the main

board or the SME board in Shenzhen Stock Exchange

“The society is innovative and entrepreneurial. The Science Park is great in innovation…But there is not a cohesive financial arrangement, and entrepreneurs, academics, politicians and civil servants lack the appropriate skills to differentiate good ventures from bad. They have to mature in their decision-making to accept risk and how return is generated.”

from a foreign, early-stage VC in HK

References

• Au, K., Baark, E., Chua, B. L., & Thomas, H. (2005). Innovation policy and high growth startups. Hong Kong: CUHK Centre for Entrepreneurship.

• Gupta, U. (2000). Done deals: Venture capitalists tell their stories.

Boston: Harvard Business School Press. • Metrick, Andrew (2007) Venture Capital and the Finance of

Innovation. John Wiley & Sons, Inc., Hoboken, NJ• Murmann, J. P. (2003). Knowledge and competitive advantage: The

coevolution of firms, technology, and national institutions. Cambridge: Cambridge University Press.

• White, S., Gao, J., and Zhang, W. (2005). Financing new ventures in China: System antecedents and institutionalization. Research Policy, 34: 894-913.

Private Equity, VC & Hedge Funds