VENTURE CAPITAL IN CHINA: A VIEW FROM EUROPE

Transcription

1 VENTURE CAPITAL IN CHINA: A VIEW FROM EUROPE Mike Wright Centre for Management Buy-out Research Nottingham University Business School Nottingham NG8 1BB UK Tel: mike.wright@nottingham.ac.uk Published in Asia Pacific Journal of Management Acknowledgements: Thanks to Garry Bruton and David Ahlstrom for comments on an earlier version, and Mike Peng for editorial guidance.

2 Abstract This article provides commentary on the analysis of venture capital in China by Ahlstrom, Bruton, and Yeh (2007). The article considers issues relating to the scope of venture capital and private equity, the nature of venture capital and private equity organizations, the life-cycle process of VC investing, internationalization, and foreign venture capital firms. The paper identifies areas for future research and compares the Chinese VC context with those in Western Europe and Central and Eastern Europe. Keywords: venture capital; China; returning entrepreneurs 1

3 The development of firms in emerging economies poses formidable strategic challenges (Hoskisson, Eden, Lau, & Wright, 2000). Encouragement and support for entrepreneurship may be especially important contributors to such development (Peng, 2001). Venture capital and private equity has become a global phenomenon (Wright, Pruthi, & Lockett, 2005). Venture capital and private equity offers interesting potential for and challenges in financing the creation and development of entrepreneurial ventures, especially where alternative funding sources such as bank debt are problematical (Le, Venkatesh & Nguyen, 2006). Ahlstrom, Bruton, and Yeh s (2007) authoritatively written article provides fascinating insights into issues concerning the development of venture capital in China and its support for high tech entrepreneurial ventures. In this article, I comment on the points raised by their article and suggest a number of further areas for research. In particular, I consider issues relating to the scope of venture capital and private equity, the nature of venture capital and private equity organizations, the life-cycle process of VC investing, internationalization, and foreign VC firms. The paper also compares the Chinese VC context with those in Western Europe and Central and Eastern Europe. Although I have conducted VC research in Asia, notably in India, Singapore, Hong Kong and Japan (Wright, Kitamura & Hoskisson, 2003; Pruthi, Wright & Lockett, 2003; Wright, Lockett, Pruthi, Manigart, Sapienza, Desbrieres & Hommel, 2004), my perspective primarily stems from my work focusing on VC in Europe, in countries such as UK, France, Netherlands, Belgium, Germany, Hungary and Sweden (Wright & Lockett, 2003; Manigart, Lockett, Meuleman, Wright, Landstrom, Bruining, Desbrieres & Hommel, 2006; Karsai, Wright & Filatotchev, 1997; Manigart, De Waele, Wright, Robbie, Desbrieres, Sapienza & Beekman, 2002). 2

4 The scope of venture capital and private equity A broad definition of VC includes the range of finance from early stage classic venture capital through to later stage private equity for management buy-outs and buy-ins (Wright & Robbie, 1998; Wright, Pruthi & Lockett, 2005). Recognizing this broader perspective, Ahlstrom et al. specifically focus on venture capital relating to the funding of high tech ventures. A future research agenda might usefully consider other dimensions. First, entrepreneurial growth ventures may include sectors other than those in high tech areas. This may be especially the case in emerging economies where there is a need to grow service and consumer goods. Second, there is also general evidence that venture-backed management buyouts and buy-ins may involve entrepreneurial activity in uncertain environments (Wright, Hoskisson, Busenitz, & Dial, 2000; Bruining & Wright, 2002). Management buy-outs are present in China even though they have been quite controversial. In a post-centrally-planned economy, the release of bureaucratic state constraints on ventures through privatization or liberalization may lead to the emergence of established organizations that have growth potential and which need investment capital to help realize that growth. In such environments, there may be an important need to reconfigure state-owned enterprises, including the divestment of parts with growth prospects that may be better off as independent entities. Third, examining other dimensions may also help in identifying successful role models that can contribute to building investor confidence and encouraging business owners to consider this source of funding. As Ahlstrom et al. note, early stage high tech investment typically is associated with high failure rates. Investing in 3

5 development capital and late stage transactions may help reduce the problems of asymmetric information associated with early stage transactions and hence reduce failure rates. It would thus be useful to gain insights into the behavior of VC and private equity firms at the later investment stages in the Chinese market. To what extent are these firms better able to address asymmetric information problems? Venture capital organizations VC organizations can be analyzed in terms of a 2 x 2 matrix with an independent vs. captive dichotomy on one axis and foreign vs. domestic on the other (Table 1). Ahlstrom et al. focus on one of the four cells in this matrix, that is foreign independent VCs, although they note that in an emerging economy, captive and public sector VCs may have particularly important roles to play. Drawing out the differences between different types of VC and greater use of quotes would have helped to convey the richness of the authors insights. [Insert Table 1 about here] A future research agenda could usefully build on Ahlstrom et al. s approach by incorporating more observations from categories of VCs excluded from their study. In Table 1, I suggest some possible research questions. As VC markets tend to be segmented, future research could also attempt to identify the nature of these segments and the kinds of players that may be appropriate for each segment. For example, Ahlstrom et al. discuss the regional aspects of markets in China and it may be that certain types of VC are appropriate in different regions. Similarly, some VC players in the high tech market are generalists while others are specialists (Lockett, Murray, & Wright, 2002) and it would be insightful to investigate the different human capital skills of these firms in the Chinese context. 4

6 It would be interesting to know about domestic VCs views in respect of foreign VCs. If domestic VCs differ in their behavior from classic VCs, to what extent does this pose a problem for syndication between foreign and domestic firms as a means for developing the Chinese market? (see below). The definition of an emerging market implies some dynamism. Thus, domestic VCs may need to change if they are to become active players for high tech firms what are the challenges they face in making such changes? Ahlstrom et al. specifically exclude consideration of public sector VCs. Government-backed funds are, of course, different from private VC funds. A particular issue concerns the expertise of and incentives for investment executives in such funds. Even in Europe problems arise with respect to the ability of public sector executives to add value (Knockaert, Lockett, Clarysse & Wright, 2006). Nevertheless, across Europe, public sector funds exist and new ones are being introduced to address perceived equity gaps that arise because private VC funds were reluctant to invest in very early stage ventures that were not seen to be investor ready (Wright, Clarysse, Lockett & Binks, 2006). In China, a major issue with public sector VCs also concerns the extent to which they genuinely address market failure versus whether they are politicized mechanisms for subsidizing non-viable activities. Recognizing earlier limitations, attempts are being made in Europe to introduce private sector VC expertise into these public sector funds. Whether public sector funds in China will be able to play the kind of role that they are evolving towards in Europe remains a challenge. Different types of VCs may have different investee preferences and different time horizons for their investments. For example, captive VCs may be less constrained than independent VCs with limited-life funds to exit their investments 5

7 within a particular time period (Wright & Robbie, 1996). The VC market internationally has also seen the emergence of semi-captives that enable both larger funds to be raised and executives to be remunerated more directly on the performance of their investments than may be possible within the constraints of remuneration structure of a larger entity within which the VC activity finds itself. The design of incentive mechanisms for VC executives within the Chinese context may be especially worthy of further analysis. The VC process life-cycle Ahlstrom et al. usefully adopt a VC life-cycle approach to structure their analysis. First in respect of deal sourcing, they provide insightful commentary on the downside of guanxi, notwithstanding its important role in doing business in the Chinese context (Peng & Luo, 2000; Peng & Zhou, 2005). In an environment such as China, science parks and universities may provide an interesting context for potential high-tech growth investments (Phan, Siegel, & Wright, 2005). Ahlstrom et al. show that university professors can be an important source of potential new high tech ventures but note the difficulties in locating such individuals and building relationships with them. Experience in Europe and the United States, however, suggests that further problems for VCs in exploiting technology generated in the traditionally noncommercial environment of universities include concerns about the ability of academics to become entrepreneurs, bridging the very great distance between a technological innovation and a marketable product, negotiating with university decision-makers (Wright, Clarysse, Binks & Lockett, 2006). These problems may be especially acute in the Chinese context. The location of returning entrepreneurs on science parks attached to universities who can help develop innovations may be one 6

8 mechanism by which this potential source of deals for VCs could be exploited. However, there is some evidence to suggest that returning entrepreneurs with knowledge and patents transferred from abroad tend to locate in non-university science parks and subsequently grow significantly faster than those locating on university parks; VCs may do well to target these entrepreneurs (Wright, Liu, Buck & Filatotchev, 2006). We come back to returnee entrepreneurs below. Second, Ahlstrom et al. rightly point to the problems arising from the lack of institutional stability, poor property rights and weak rule of law in China. The work of Armour and Cumming (2006) on the important institutional characteristics of different environments that may help to stimulate VC markets also adds to this argument. Asymmetric information may be especially problematical in an emerging economy such as China. Ahlstrom et al. discuss the problems of accounting information and due diligence in China at some length. Evidence from multi-country studies suggest that VCs adapt their due diligence approaches and information sources according to the institutional context (Wright et al., 2004). This research suggests that information sources are not easily transferred between contexts but that valuation techniques may be. In particular, VC firms in Asia are less likely to use information from interviews with entrepreneurs or business plan data than their counterparts in the US and Europe; market information, for example available from the business press, and own due diligence may be especially important. Third, Ahlstrom et al. note the difficulties for VCs in negotiating contracts. In the uncertain context of entrepreneurial investments, VCs may make use of contingent contracts (Kaplan & Stromberg, 2003). These contingent contracts may include convertible and redeemable financial instruments whereby equity stakes are adjusted depending on whether performance targets are met. We know that there is differential 7

9 use of convertible instruments in different contexts (Kaplan et al., 2005). Even in developed markets there may be post-contractual flexibility; deviations in outturn from expected performance may mean intense discussions regarding the terms under which instruments are actually converted. The course of these discussions may depend greatly on how well relationships have been built between the VC and the entrepreneur. Nevertheless, in economies with established rule of law, the contract can form a backdrop to the operation of relationships in these circumstances. In a weak institutional environment such as China s, enforcing contingent contracts in this way may be problematical. The development of longer term relationships involving trust may be a substitute. Fourth, while there may be an expectation of an exit through IPO, generally speaking in VC markets, the most common form of non-failure exit is sale to a strategic partner. If strategic sales are to be an important exit route for VCs in China this suggests a role for VCs in developing networks with potential purchasers both inside and especially outside China. The concerns about majority versus minority stakes discussed by Ahlstrom et al. are important ones. The exit issue may be especially important in an institutional context like China where relationships are central. Having built a relationship with an entrepreneur, bringing it to an end through the traditional forms of exit may be problematical. In the European context, partial sales of VC investments to strategic buyers are quite common. These could be viewed as part of a process towards eventual full integration or they may be longer term. Secondary deals may provide a feasible exit mechanism for one or more of the initial VC investors in China in the context of under-developed stock and corporate asset markets. Knowing more about the approaches of different types of VC to the timing 8

10 and nature of exit may contribute significantly to understanding the prospects for development of the Chinese VC market. Internationalization Given their focus on high tech ventures, Ahlstrom et al. say surprisingly little about the markets that such ventures may need to penetrate in order to be successful. In particular, the challenges in entering international markets may be more important. In order to help internationalize high tech ventures based in China, domestic venture capital firms in China may need to develop extensive international social capital, that is networks with foreign venture capital firms. Foreign venture capital firms may also have reputations that can enable them to certify IPOs of Chinese firms on foreign stock markets. By the same token, local VC firms may be attractive to foreign investors because they have information about the operation of the local market, including access to deal flow. Local VCs are also likely to have dense networks of contacts which can help foreign VCs build social capital and familiarity with different legal requirements. Local investors can play a certification role regarding potential investees for incoming investors, that is identify attractive deals, and by being in close proximity may be more able to provide monitoring and value adding activities than is possible for a distant foreign investor. This suggests that the VC market in China may be able to develop through the syndication of investments between domestic and foreign VCs (Maula & Mäkelä, 2003; Mäkelä & Maula, 2006). Ahlstrom et al. comment on the problems in staffing foreign firms in China. This is an area that is generally under-researched in the VC literature and further insights could be obtained in the Chinese context. Wright et al. (2002) find that over 9

11 nine-tenths of executives in foreign VCs in India were Indian nationals and a third had VC experience outside the country. Pruthi et al. (2006) in their analysis of internationalizing VCs from the UK suggest that recruiting local executives was significantly more important than deploying expatriates, and expatriation was significantly more important for transferring knowledge than for other motives. If VCs in countries like China recruit executives who are mainly trained in US approaches to VC, these may not easily carry over into an emerging economy context, especially with respect to the kind of information to be used in screening and monitoring. A further challenge to investment in high tech ventures concerns the locus of entrepreneurs who have the technological expertise as well as expertise to internationalize the venture. The internationalization of firms from emerging market economies such as China is itself under-researched (Wright, Filatotchev, Hoskisson, & Peng, 2005). However, in general, human capital linked to considerable industry specific knowledge, dense contact networks and previous international experience appear key to the internationalization of new and small firms (Westhead, Wright & Ucbasaran, 2001). In an emerging market such as China, until quite recently few managers have been exposed to international markets. A particularly important role in resolving a deficit of entrepreneurial leadership in China (Tan, 2006) and in stimulating the internationalization of technology-based firms in emerging markets may be played by returning entrepreneurs. Ahlstrom et al. note the potential role of returning entrepreneurs who are scientists and engineers returning to start up a new venture in China, after having gained business experience and/or education in the US or other OECD countries. Filatotchev, Liu, Buck,and Wright (2006) find from a sample of 728 firms based on the largest science park in China, Zhongguancun 10

12 Science Park (ZSP), of which 42% were returnee owned, that the presence of a returnee entrepreneur was significantly associated both with whether the firm exported and with the proportion of turnover that was exported. These findings suggest that VC firms may find it advantageous to build social capital with returnee entrepreneurs and to identify possible investees prior to their return. Foreign venture capital firms An important issue regarding foreign venture capital firms relates to the extent to which they attempt to replicate behavior from their domestic market or whether they adapt to the local market. A central point relates to what aspects of behavior are transferable to the foreign context and which are not. Wright, Lockett and Pruthi (2002) compare the behavior of foreign and domestic VC firms in India and VC firms in the US regarding information usage and valuation approaches; they suggest that foreign VC firms have a greater tendency to adapt their behavior as they enter overseas markets. Similarly, Pruthi, Wright and Lockett (2003) find that foreign VCs in India were more likely to be involved in investees at the strategic level while domestic VCs were more likely to be active at the operational level. It would be useful to examine whether this pattern is also reflected in China. Important influences on the behavior of foreign VCs in China concern the extent to which they are embedded in the country and the impact on their reputation of particular actions. If a foreign VC is more embedded in China through other investments or co-investments with the same investors it may be more committed to monitoring and dealing with under-performance. Foreign VCs may face damage to their reputations if they are perceived to withdraw too precipitously from an under- 11

13 performing investment (Mäkelä & Maula, 2006). Further research might aid understanding of the Chinese context if the influences on commitment and reputation were examined. For example, are VCs that are more geographically and culturally distant likely to be less committed? Internationalizing VCs may implement firm-wide policies regarding various aspects of their investment behavior but there may need to be significant discretion in decision-making for local offices overseas. It may also be important for VCs that internationalize into China to take a longer perspective to become familiar with local information sources and networks. Otherwise, VCs run serious risks of investing in poor deals on the basis of inadequate information. This is not specific to China; many internationalizing VCs have experienced similar problems in Europe. Concluding comments That China is a large economy that warrants attention in its own right goes without saying. Yet, going beyond this paper, viewed from Europe a nagging question that still needs to be addressed is: what s different about China? Is China unique or are similar aspects affecting the development of the Chinese VC market seen in other contexts? For example, is the phenomenon of returnee entrepreneurs unique to China? To what extent is institutional instability and weak rule of law seen in other emerging economies? How do access to information problems in China reflect those found elsewhere? These issues are of relevance both for academic and practitioner perspectives. Following Meyer (2006, 2007), Asian management research needs to be contextualized in the local environment but to be loosely coupled to global debates. Benchmarking China against the US only may miss interesting insights to be had 12

14 from comparisons with other emerging economies or other developed markets, such as Europe (Peng, 2005). I would suggest that this argument also applies to VC in China. Table 2 presents a comparative summary of issues relating to the development of venture capital and private equity markets in selected European countries and China. The table shows the UK and Germany as two markets in Western Europe with contrasting regimes. The table also considers the transition economies of Central and Eastern Europe (CEE) which are developing from central planning to market economies. [insert Table 2 about here] In Western Europe, the developed UK market has a strong entrepreneurial culture. In Germany, the entrepreneurial culture is not traditionally strong and may not be as strong as that in China. In both UK and Germany, VC investment role models are available. Reluctance by entrepreneurs to give up control of their companies is a major concern for VCs in many countries besides China. However, more entrepreneurs are now willing to open up their capital to VCs in the UK and to a lesser extent Germany. In contrast to China, accounting information is typically more robust in the UK and Germany but informational asymmetries still present problems for deal screening and post-investment monitoring (Wright & Robbie, 1998). In the UK, VCs make extensive use of convertible quasi-equity instruments for dealing with uncertainties but this is less the case in Germany (Farag, Hommel, Witt & Wright, 2004). In the UK and Germany, monitoring through contractual rights to information access and board seats is common. These provide an enforceable contractual backdrop to relationships between investor and investees that appears to be particularly problematical in China. Even in Western Europe, IPOs are not the most common exit 13

15 route for VCs and secondary tier stock markets have been problematical due to lack of liquidity. As a result, greater emphasis has been placed on trade sales, and increasingly, secondary sales. CEE is similar to China in that the economies are in transition but there are some notable differences. The influence of privatization of state assets has been more important in CEE than in China because of the different trajectories that the two have pursued towards market economies. In CEE, the entrepreneurial culture in general has developed strongly, especially among the post-collapse of communism generation and there has been some influx of managers with Western commercial experience. As transition has progressed, role models are now available of entrepreneurs who have successfully grown and developed their businesses alongside private equity firms; in China this lags somewhat but seems to be emerging. Issues of property rights and their enforcement have arisen in CEE as in China. In the states that acceded to the European Union, enforcement of property rights has become more established than in other CEE countries that have not progressed as far with transition. Accordingly, in CEE countries, there has typically been greater emphasis on a combination of significant if not majority ownership stakes by VCs, convertible securities and covenants such as anti-dilution provisions, board veto rights and drag-along clauses (Farag et al., 2004). In contrast to China, restructuring to create a private sector banking system in CEE has meant growing availability of debt finance for smaller firms to complement VC investment (Wright, et al., 2004). This has also been underpinned by the development of hard budget constraints associated with bank lending. As in China, in CEE countries exit through IPO is generally problematical due to low liquidity in domestic stock markets and low profile of many CEE firms overseas. Thus trade sales to incoming foreign firms or, as transition progresses, to 14

16 local groups present the most feasible exit route, with buybacks important for early stage cases. These similarities and differences between China and both Western Europe and CEE suggest that researchers and practitioners need to tease out: what aspects of VC investing are common across all markets, which are common to transition or emerging economies generally, and which are specific to China? Which aspects become less problematical as transition progresses and which may persist due to the form of transition? To what extent does VC in China differ from other big emerging economies, notably Brazil, Russia, and India? This more fine-grained research could contribute significantly to our understanding of the differences between VC markets and to addressing the challenges posed for internationalizing VCs (Wright, Pruthi, & Lockett, 2005). References Ahlstrom, D., Bruton, G., & K. Yeh Venture capital in China: Past, present, & future. Asia Pacific Journal of Management, forthcoming. Armour, J. & Cumming, D The legal road to Silicon Valley. Oxford Economic Papers, 58: Bruining, H. & Wright, M Entrepreneurial orientation in management buyouts and the Contribution of Venture Capital. Venture Capital: An International Journal of Entrepreneurial Finance, 4: Farag, H., Hommel, U., Witt, P. & Wright, M Contracting, monitoring and exiting venture investments in transitioning economies: a comparative analysis of Eastern European and German markets. Venture Capital: An International Journal of Entrepreneurial Finance, 6: Filatotchev, I., Liu, X., Buck, T. & Wright, M The export orientation and export performance of high-technology SMEs in emerging markets: The effects of knowledge transfer by returnee entrepreneurs. CMBOR Occasional Paper. Hoskisson, R.E., Eden, L., Lau, C.-M., &. Wright, M Strategy in emerging economies. Academy of Management Journal, 43(3): Karsai, J., Wright, M. & Filatotchev, I Venture capital in transition economies: The case of Hungary. Entrepreneurship Theory and Practice, 21(4): Kaplan, S. & Stromberg, P Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. Review of Economic Studies, 70: Kaplan, S., Martel, F., & Stromberg, P How do legal differences and experience affect financial contracts? University of Chicago working paper. 15

17 Knockaert, M., Lockett, A., Clarysse, B., & Wright, M Do human capital and fund characteristics drive follow-up behavior of early stage high-tech VCs?, International Journal of Technology Management, 34: Le, N.T.B., Venkatesh, S., & Nguyen, T.V Getting bank financing: A study of Vietnamese private firms, Asia Pacific Journal of Management, 2: Lockett, A., Murray, G., & Wright, M Do UK VCists still have a bias against investment in new technology firms? Research Policy, 31: Mäkelä, M. & Maula, M Inter-organizational commitment in syndicated crossborder venture capital investments. Entrepreneurship Theory and Practice, 30: Manigart, S., Lockett, A., Mueleman, M., Wright, M., Landstrom, H., Bruining, H., Desbrieres, P. & Hommel, U Why do European venture capital companies syndicate? Entrepreneurship Theory and Practice, 30:. Manigart, S., K. De Waele, M. Wright, K. Robbie, P. Desbrieres, H. Sapienza and A. Beekman Determinants of required return in venture capital investments: A five country study. Journal of Business Venturing, 17(4): Maula, M. & Makela, M Cross-border venture capital, in Hyytinen, A. and Pajarinen, M. (eds), Financial systems and firm performance: Theoretical and empirical perspectives. Helsinki: Taloustieto, Meyer, K.E Asian management research needs more self-confidence. Asia Pacific Journal of Management, 2: Meyer, K.E Contextualizing organizational learning: Lyles and Salk in the context of their research. Journal of International Business Studies, forthcoming. Peng, M.W How entrepreneurs create wealth in transition economies. Academy of Management Executive, 15: Peng, M.W. & Luo, Y Managerial ties and firm performance in a transition economy: The nature of the micro-macro link. Academy of Management Journal, 43(3): Peng, M.W From China strategy to global strategy. Asia Pacific Journal of Management, 22: Peng, M.W. & Zhou, J How network strategies and institutional transitions evolve in Asia. Asia Pacific Journal of Management, 22 (4): Phan, P., Siegel, D. & Wright, M Science parks and incubators: Observations, synthesis and future research. Journal of Business Venturing, 20: Pruthi, S., Wright, M. & Lockett, A Do foreign and domestic venture capital firms differ in their monitoring of investees? Asia Pacific Journal of Management, 20(2): Pruthi, S., Wright, M. & Meyer, K Staffing VC firms international operations. Occasional Paper. Tan, J Growth of industry clusters and innovation: Lessons from Beijing Zhongguancun Science Park. Journal of Business Venturing, forthcoming. Westhead, P., Wright, M., & Ucbasaran, D The internationalization of new and small firms: A resource-based view. Journal of Business Venturing, 16(4): Wright, M. & Robbie, K Venture capitalists, unquoted equity investment appraisal and the role of accounting information. Accounting and Business Research, 26: Wright, M. & Robbie, K Venture capital and private equity: A review and synthesis. Journal of Business Finance and Accounting, 25 (5 & 6):

18 Wright, M., Hoskisson, R., Busenitz, L. & Dial, J Entrepreneurial growth through privatization: The upside of management buyouts. Academy of Management Review, 25: Wright, M., Lockett, A. & Pruthi, S The screening of venture capital investments in India. Small Business Economics, 19: Wright, M., Kitamura, M. & Hoskisson, R Management buyouts and restructuring Japanese corporations. Long Range Planning, 36(4): Wright, M., Kissane, J. & Burrows, A Private equity in Central Europe: Strong Growth in Opportunities. Nottingham: CMBOR. Wright, M., Lockett, A., Pruthi, S., Manigart, S., Sapienza, H., Desbrieres, P. & Hommel, U Venture capital investors, capital markets, valuation and information: US, Europe and Asia. Journal of International Entrepreneurship, 2: Wright, M., Pruthi, S., & Lockett, A International venture capital research: From cross-country comparisons to crossing borders. International Journal of Management Reviews 7 (3), Wright, M., Filatotchev, I., Hoskisson, R. & Peng, M Strategy research in emerging economies: Challenging the conventional wisdom. Journal of Management Studies, 42: Wright, M., Liu, X. Buck, T. & Filatotchev, I Returnee entrepreneur characteristics, science park location choice and performance: An analysis of high technology SMEs in China. CMBOR Occasional Paper. Wright, M., Clarysse, B. Lockett, A. & Binks, M University spin-out companies and venture capital. Research Policy, 35: Mike Wright (PhD, Nottingham) is Professor of Financial Studies at Nottingham University Business School, Director of the Centre for Management Buy-out Research, and a visiting professor at INSEAD, Erasmus University, and the University of Siena. He holds an honorary doctorate from the University of Ghent. He has written over 25 books and 250 papers on internationalization, management buyouts, venture capital, habitual entrepreneurs, corporate governance and academic entrepreneurship. His papers have appeared in Academy of Management Journal, Academy of Management Review, Strategic Management Journal, Journal of Management, Journal of Management Studies. Journal of Business Venturing, California Management Review, Research Policy, and Journal of International Business Studies. He is an editor of Journal of Management Studies. His latest books are Habitual Entrepreneurs (with Deniz Ucbasaran and Paul Westhead) and Academic Entrepreneurship in Europe (with Bart Clarysse, Philippe Mustar and Andy Lockett). He is completing editing a special issue of Journal of Corporate Finance on Private Equity, LBOs and Governance (with Douglas Cumming and Donald Siegel). 17

19 Table 1: Some research questions for different types of VCs Foreign Independent How do these firms select between an arm s length entry mode versus opening of offices? How does this affect the VCs embeddedness and commitment in China? How do these VCs adapt information sources compared to their home markets? How do these VCs build social capital? What do these VCs offer to domestic VCs in syndicating deals? What mechanisms do these VCs use as substitutes and complements for board representation and how effective are they? Do they differ from domestic firms? How/can these VCs help build international markets and target international exits for Chinese entrepreneurs? Domestic Are these VCs able to access more appropriate social capital than independent foreign VCs? What do these VCs offer foreign VCs in syndicating deals? To what extent do these VCs differ from foreign VCs in their involvement at strategic versus operational levels? To what extent do these VCs recruit executives with experience in foreign VCs/markets? How do the actions of these VCs differ from those of foreign VCs when investees under-perform? What are these VCs perceptions on nature and feasibility of exit? Captive What control mechanisms are adopted in relation to the parent and what discretion is offered? Do these investors invest in lower risk deals than independents? To what extent do these VCs benefit from local guanxi provided by parents in China? Do these links provide for greater embeddedness & commitment than for independent foreign VCs? Do these VCs have objectives related to identifying longer term clients for the parent and how does this affect deal selection and investment horizon? To what extent do these firms recruit from parent s other operations in China? To what extent do the parent firm s operations in China provide a source of deals? What is the nature of incentive mechanisms? Do these VCs have less commercial objectives than other VCs? To what extent are the investment activities of captive public sector VCs compromised by political objectives? How do the guanxi of these captive private and public VCs differ from those of independent and foreign VCs? How do the executives in these firms differ from independent and foreign VCs in terms of their expertise for selecting and monitoring deals?

20 Table 2: Summary Comparison of Factors Affecting Venture Capital & Private Equity Market Development in Western Europe, Central and Eastern Europe, and China Factors UK Germany Central & Eastern Europe China Early stage ventures Need to deal with family succession problems Need to restructure diversified groups Need to privatise state-owned companies Scope for going-private transactions Attitude to entrepreneurial risk University spin-offs; Extensive new venture creation Traditionally technology sector quite strong Increasing de novo firm creation post-communism but variable across countries Moderate High need Low Low Established patterns throughout period Well established programme from 1980s; now complete Large stock market; few initial deals now significant Was very positive from early 1980s Science parks established to support early stage high tech firms Becoming established from mid- 1990s Increasingly established in early 2000s Becoming established from late 1990s Former GDR apart, relatively little Bulk of privatizations completed Not complete and political debate surrounds larger firms Relatively small number of quoted companies Traditionally low, changing slowly Many candidates; specific opportunities must grow Positive among younger generation and growing as transition progresses Around 40 MBOs of listed corporations completed; controversial Positive but commercially inexperienced; important role of returnee entrepreneurs; unfamiliar with private equity Willingness of managers to buy High Starting to develop High, but lacking financial means. Developing but major asymmetric information & financing issues 1

21 Table 2 (continued) Private Equity and Venture Capital Grew rapidly from early Traditionally small but relative Small but developing. Developing; domestic focus on early stage; market 1980s emphasis on earlier stage foreign on later stage Supply of debt High Tradition of high leverage Low but growing Low Intermediaries network Highly developed Fragmented Quite developed Developing but fragmented Favourability of legal framework Stock markets Favourable; use of board seats, convertible instruments and covenants for monitoring Receptive to VC & private equity cos. From mid-1980s; now more difficult for MBO end of market Moderately Favourable; convertible instruments and redemption rights less evident; vesting provisions, veto rights New issues sparse; secondary tier market closed Favourable in recent EU accession states but contract enforcement more problematical elsewhere; accounting information variable; significant if not majority ownership stakes by VCs, convertible securities and covenants such as antidilution provisions important for monitoring Favourability of taxation regime Favourable Reforms in progress Moving to favourable with EU reforms in recent accession states Growing domestic capital pool and appetite Lack of exit channels; mainly Hong Kong & NASDAQ Trade sales Highly active M&A market developing Highly active Potentially important Secondary Developed as important Possible route Possible exit route Possible exit route Buyouts/restructuring/partial sales exit route Source: Own research. Research assistance by Lu Wang is gratefully acknowledged. For further details see: Wright, Kissane & Burrows (2004) Reforms to Commercial Code but continuing concerns about property rights & contract enforcement Reforms in progress 2