Why Your Tech Start-Up Will Fail in China
5 things every expat entrepreneur should know.
It was September 2014 and I found myself listening to entrepreneurs in Shanghai’s China Accelerator pitch their ideas at demo day. The program opened with innocuous presentations from accelerator partners and sponsors on start-up tips catered to Chinese entrepreneurs. However, they had a clear warning directed at expats: if you’re a foreigner starting a company in China, you’re doomed to fail.
As an expat who was interested in launching a tech start-up in China, I was annoyed. The presentations alone weren’t enough to discourage me so in the oncoming months I spoke with Chinese and Western VCs, angel investors and entrepreneurs to better understand the business of starting a business in China. Aside from obvious barriers such as language and VPNs for internet, I learned that the hairier barriers are structural and a construct of Chinese culture, globalization and politics*.
These are the reasons why your start-up will fail in China:
1. No, China can not be your 10x growth story
The biggest mistake expat entrepreneurs make is to assume successful business models in the West can seamlessly be copied and pasted into the East. While this strategy may work in Europe (see: Rocket Internet), it completely falls apart in China due to cultural differences. Here are two lesser known cultural concepts for the naive expat entrepreneur:
- Man can rule above law because man created law. For thousands of years, China was ruled by a Huang Di (emperor) who received his power from the Mandate of Heaven, which gives the Huang Di the right to rule based on his ability to govern fairly. This set the tone for a culture that resolves disputes through an arbiter, or a Huang Di. Although there are clear laws in place today, the arbiter method created a culture rooted in logic- and empathy-based reasoning principles. You have to empathize with the counterparty, given his or her current circumstance. For example, in the U.S., parties involved in a dispute may settle for monetary compensation after the law determines who is right; however in China, the parties will continue to debate the merits of their reasoning and principles (Dao Li) to determine who is right. The Chinese love to debate Dao Li, and in some circumstances, it’s not uncommon for the two disputing parties to ultimately become friends.
- Because China was under Huang Di rule and not a rule of law for so long, the Chinese people view their government as their head of the family. The head of the family looks out for and takes care of its people and therefore has great influence on Chinese citizens. You can’t “replace” the head of the family. This differs from the U.S. where we fear a powerful government and thus have checks and balances in place.
These Chinese cultural norms eventually evolved into business practices in China that don’t have Western counterparts. And its these norms that govern social relations and exchange.
Takeaway: Check your ego at the door. Do your homework and learn the rules of the game in China.
2. China is globalizing quickly — but at a calculated pace
The Chinese begin counting their entry into globalization during the Deng Xiao Ping era (1978 onwards), which is effectively ~35 years ago. Since then, China transformed from a poor post-Mao economy, in which many of its denizens were living below poverty, to the world’s 2nd largest economy. However, some of the more lucrative industries in China, such as finance, still remain heavily regulated. This is because China is very calculative in globalizing particular industries.
Starting in 1978, China took an authoritarian stance on its economy. China believed that a strong, central power is needed to bring an economy to a stable level before it can be managed by market forces. Otherwise, in a culture that is not fully accustomed to a rule of law, things will get very messy. Therefore, China’s strategy was to build up core “foundation” industries before moving on to higher leverage and riskier industries. Foundation industries include low-skill industries such as manufacturing, which are needed to sustain a strong economic base. Once a foundation industry reached a level of sustainability, China would slowly introduce competition and eventually let market forces prevail.
China’s strategy of government-guided, planned industrialization today stands in stark contrast to the strategy in the U.S. Here in the U.S., we use capital market forces and lobbying as incentives to drive and change industries. In China, it’s more direct — the government mandates it. Or in layman’s terms, the U.S. dangles a carrot to guide the rabbit whereas China uses a whip. And because China’s government is seen as the head of the family, policies and changes are implemented across industries at a much faster pace.
Takeaway: Know what’s off limits. Don’t start a company in China trying to disrupt a regulated industry.
3. The majority of Chinese are still focused on short term profits
So, how do you industrialize a country of 1.4 billion people? Similar to how global companies roll out new product features in test markets, China tests new policies in lower tier cities and provinces before rolling them out across the country. This is where short term arbitrage profits affect consumer and employee mindsets.
In an effort to speedily develop, it’s easy in China for the end (in this case, profits) to justify the means. As formerly regulated industries are introduced to market forces and new policies roll out across various provinces, low hanging arbitrage opportunities come quickly. However, these opportunities have bred consumer distrust and a focus on quick profits:
- The most popular crimes in China are petty cons and scams. If you walk into any hair salon in China, it’s common to be upsold into a deal where you get X% off if you buy their membership card, which essentially is a package of Y number of hair cuts. It’s also common that when you come back a month later, you’ll find a restaurant in place of the hair salon.
- In addition to scams and cons, a lot of Chinese businessmen will talk up a big game but not follow through; this is sometimes customary banter for both parties in the conversation. However, the naive expat may get strung along, only to be let down.
- Rarely will you find employees willing to work for equity at a start-up. They want to get paid yesterday. And in the rare instance your start-up builds enough momentum, one of the BATmen (Baidu, Ali Baba, and Tencent) will swoop in and either hire away your engineers for a boat load of money, or roll out a similar product across its massive distribution channels. And unlike Google Plus or Facebook Slingshot, the BATmen’s product will trump yours because they command such powerful network effects.
Takeaway: It’s hard to build a long-term, sustainable business when many people are still focused on short-term profits.
4. Market winners are chosen…creating many paranoid CEOs
One fascinating dynamic surrounding market winners in China is that they are chosen, not by market forces, but by investors. Chinese investors, either a corporate or fund, employ a “kingmaker” strategy by which the investor goes all in on an investment and forces its success. Similar models have yet to gain traction in the U.S.
In the U.S., VCs diversify their investments across many start-ups, hoping one company will at least return the fund. Through hard-work and market forces, certain portfolio companies become market leaders. However, in China, once it’s clear there are a few horses left in a race, investors will go all in on one of the horses and “king” it by making a sizeable investment and driving market leadership. This creates a culture of paranoia amongst CEOs sometimes so extreme that they don’t even trust their spouses. On the journey to become king, slander and defamation are common strategies to smear competitors. Everyone has dirt on everyone else.
Takeaway: Sometimes, the game is rigged and you don’t control your company’s destiny.
5. How to hang with the big boys
So how else do some companies become king? They not only know the right people in the right places, but they also know what the right people in the right places need. It’s common for companies to schmooze Communist Party members for favors that give them an edge over their competitors.
Communist party members are often stretched on both sides to appease their superiors and manage juniors while operating a tight budget. They basically need to make miracles happen with little to few resources. This presents two opportunities:
- If a company wants a deal done in a party member’s district, the company has to take care some of the party member’s ad hoc needs so they don’t spend government resources.
- Most deals are done under the table as long as everyone in the game benefits. This only breaks if a superior cracks down and bans certain policies.
Takeaway: How deep is your rolodex and wallet?
As the start-up pitches came to a close, I couldn’t point to any one idea that got me interested. What initially drew me to China — a land of startup opportunities, evaporated as nothing but a mere illusion. I was naive and misinformed. China is a calculative execution machine, strategically planning her path to modernization. She has her own agenda and will let disruptive technologies prosper when its beneficial to her plan.
*I don’t claim to be an expert on Chinese history or politics. The views above are what I learned from speaking with an extensive group of Chinese investors and entrepreneurs. These opinions are my own.
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