What Sequoia’s Mike Moritz doesn’t understand about startups in China (SOSV Redux)

Beware the Chinese unicorns!

This post was first published on VentureBeat — thanks to Mo Marshall for her excellent editing! The version below includes a few extra bits for SOSV fans.

Sequoia Capital was the second most active VC in China in Q4 2017. Its local team is well respected and has good insights.

Yet, in an op-ed for the Financial Times last month, Sequoia Chairman Mike Moritz surprisingly argued that the Chinese entrepreneurial ethic is outshining Silicon Valley’s and that Silicon Valley would be wise to follow China’s lead.

The story drew strong reactions, mostly defending the Silicon Valley work-life balance and employee perks that Moritz derided. But as someone who’s lived and worked in China on and off since 2005, I think there are many more important things Moritz gets wrong with his China/Silicon Valley comparison.

0. First, Let’s Hear From Other Recent Visitors

Cyriac Roeding (@cyriac1), Founder of Shopkick (sold to SK Planet for $250mln), met dozens of people in the Chinese ecosystem during his visit in May 2016. He noted the size of the market, the speed to scale, the 24/7 availability, the divergence from mere copycats, and the growing local high-tech scene.

Jason Costa (@jasoncosta), EIR at GGV Capital, a cross-border VC firm with $3.8bln under management (Jason previously worked of Pinterest, Twitter and Google), visited in December 2016 and observed the booming in China of services that are just nascent in the US: personal broadcasting, virtual gifts, self-expression apps, new e-commerce models, WeChat growing as a super-app, the spread of mobile payment notably with QR codes. And also… the hunger, summed up as ‘my parents didn’t get opportunities like this, so it’s my responsibility to make the best of this moment’.

Let’s note here that ‘personal broadcasting’ — sometimes called YouTubers or live video bloggers in the West— became popular in South Korea before China (they are called broadcasting jockeys there), and that QR codes, invented in Japan, spread there widely way before but were not used for payment.

More recently, Jason M. Lemkin (@jasonlk), Founder of SaaS-focused platform/VC SaaStr and founder of EchoSign (sold to Adobe for $400mln), tweeted in January 2018 about what he learned from five weeks in Beijing and Shanghai:

As you can tell, the reactions of visitors over the past 18 months have been quite consistent. Now let’s take a step back to understand how China got here, what it means, and what’s next.

1. China and the U.S. are on different paths

The idea that the U.S. should blindly follow China’s lead completely misses the fact that the two startup ecosystems are on different paths. China is where it is due to specific circumstances. Let’s look at a few key examples:

China has been a growth story for 40 years. There is a general sense of optimism and belief that modernization is beneficial. There is much less debate in China about the risks of automation or self-driving cars, and the Chinese government is funding robots to modernize factories rather than trying to protect manufacturing jobs.

China has been a growth story for 40 years and is not afraid of modernizing and shifting job markets.
40 years of GDP growth in China and U.S. — they’re not starting from the same level, but still.

Also, China is a large market of close to 1.4 billion people (vs. 320 million in the U.S.), including about 660 million smartphone users (vs. 220 million in the U.S.), with widespread talent (China graduates twice as many students per year as the U.S. — 8 million, vs. 4 million — and eight times more STEM students).

Above: China has STEM covered

China’s tech ecosystem — including its offline and online infrastructures — trailed behind the U.S. for a long time. As a result, the current opportunities in China are much larger than in the U.S. and attract many startups and investors. That’s the oft-touted benefits of emerging markets: They not only fill gaps but also leapfrog.

Emerging markets can fill gaps and leapfrog.

In the words of Dr. Song Li, an investment banker turned entrepreneur who sold his startups to Sina, Monster.com, and founded Zhenai, the largest online matchmaking company in China (invested by Match.com):

“Every ambitious young man and woman in China feels that the nation’s time has come and is highly motivated to play a part in what they perceive to be ‘China’s Century’ .”

As a result, competition is brutal, and speed is key. Being first is not enough, you also need to out-execute others.

But a fast-growing economy also creates problems: with high inflation and rising housing costs, many people in China feel the financial pressure and “status anxiety” from peers getting ahead. They also feel more responsible, as the decades-long one-child policy put children partly in charge for their parents. For Chinese founders, startups are not fun things where you play around with technology or loftily plan to “change the world.” They are pragmatic affairs that have to turn into hard cash at some point.

The time to work hard to get ahead is now, and some founders end up paying the ultimate price for this urgency, their hard work and anxiety, in a society that does not deal well with issues of mental health.

All of these elements, unique to China, define the country’s startup mindset. Urging Silicon Valley entrepreneurs, who deal with an entirely different landscape of experience, expectations, and motivations, just doesn’t make sense. The two ecosystems are on different trajectories.

Still, those trajectories do intersect at times. More on that below.

2. China has several advantages, most of which the U.S. can’t copy

Moritz noted in his op-ed that Chinese entrepreneurs are so frugal, they will reuse their teabags multiple times. That’s certainly a practice Silicon Valley could adopt if it wanted to. But some of China’s biggest advantages would be hard to replicate in the U.S.

How many times can you re-use a Chinese teabag?

Some parts of China benefit from fewer regulations, for example. The inventors of a self-driving car in Hong Kong could not test it locally and so are taking it to Shenzhen. As Chris Evdemon, Partner at Sinovation Ventures, told me:

“The resistance expected in the U.S. for self-driving trucks contrasts sharply with the red carpet attitude of the Chinese government in this sector, and for everything related to AI. Recent articles on Crispr in China are also an example. ”
Above: Let’s roll … in Shenzhen

As Sinovation’s Evdemon summarized for me,

“China’s government-led top-down push for innovation means a lot of obstacles are removed for startups. For example, the country is currently investing $2.1 billion in an AI research park. The country also has huge, more readily available data sets and “acute business and social problems that need solutions with some of these technologies. Add the abundance of capital that now focuses on all this and you have an explosive mix. ”

Evdemon also points out that:

“China may be temporarily lacking in top tier talent (their best people are still in the U.S.), but that gap will also close in the next 5–10 years.”

The massive domestic market also brings economies of scale when going global . China’s Ofo has already deployed over 20 millions bikes, and Mobike, Ofo, oBike and Gobee have all launched their service in places as far away as Paris.

Returnees and the Chinese diaspora are also important assets. The former brings back knowledge, skills and connections; the latter is a valuable resource when expanding overseas, particularly in emerging markets. China might have little immigration, but those two populations help companies level up.

Easing skilled immigration in the U.S. would avoid the brain exodus of foreign graduates — who already contributed large fees to the U.S. economy — and foreign workers who pay taxes and fill many skilled labor gaps. For example: Where to find the 200,000 cyber-security specialists the U.S. needs?

Students represent a large group or returnees: 74% go back after graduation. (Source: Daxue Consulting)

On the high level of management, China might also have ideas to contribute to complement best practices from Japan and the U.S..

Did you know Alibaba was saved from early bankruptcy by the hiring of GE veteran Savio Kwan? He brought in the corporate culture, hiring and training practices from his previous employer (what Mr. Kwan says is worth hearing). Jack Ma integrated this to his own style and China’s unique situation.

In a private conversation after the 2008 financial crisis, David Wei, then-CEO of Alibaba.com mentioned to me he was just back from visiting GE. He had wanted to if there were new ideas for the next 10 years of Alibaba. He confided that he noticed no new idea, and that former best practices (e.g. firing bottom 10%, etc.) had been partly abandoned to accommodate the crisis situation.

In short, like major world religions who took hold away from their place of birth, the GE spirit was alive and well at Alibaba. And the company had also evolved it into something new — like GE had adapted Japanese management practices and taken them to new heights.

On the ground level of management, according to SOSV’s William Bao Bean,

“China has performed well without middle management because they have innovated a distributed management model within a company as opposed to the hierarchical western model. Companies like Tencent aren’t run top-down: they are made of hundreds of ‘small companies’ within a large platform, each with its on product manager that acts as a CEO. Western companies are a giant pyramid while Chinese companies are many pyramids grouped together to make a larger one.”

On the money front, Chinese investors bet early and bet big — seed and late-stage median rounds in China are 2–3x larger. Why? Because scaling fast matters, and mega-mergers help mitigate risks at scale.

3. China isn’t interested in competing for the U.S. market (yet)

An unspoken concern in Moritz’s op-ed is that the Chinese brand of entrepreneurship is a threat to U.S. startups. It might surprise you, but most Chinese startups don’t care about the U.S. market. The opportunity in China is large enough and the competition harsh enough to require all of a team’s efforts to win.

Most Chinese startups don’t care about the U.S. market.

Beyond domestic borders, battles are taking place in emerging markets where the similarity with China is an asset for expansion. The digital civilization of the West (which includes North America, Western Europe, Australia and New Zealand and sometimes places like Singapore, Hong Kong and a few others) rarely collides directly with the Chinese one.

“It is not a clash of civilizations, but rather an organizing along civilization lines, reminiscent of when Spain and Portugal split the world in half in the 16th century,” Hans Tung of GGV Capital told me.

The fight for domination takes place in South-East Asia, India, Africa, and Latin America. (So far, Russia seems to be mostly doing its own thing.)

China’s emphasis on the One Belt One Road initiative is a good guide for where we can expect to see expansion — and where we can expect future startups to grow. And guess what? This Eurasian road, which would surely irk famed geopolitician Zbigniew Brzezinski, does not involve the U.S.

The U.S. is — unsurprisingly — not part of the massive One Belt One Road plan.
Above: One Belt, One Road. Where is America?

That doesn’t mean Chinese startups are completely steering clear of America.

Some companies that have reached critical mass in China have entered the market already via distribution, partnerships, investments, or acquisitions. To name a few:

Chinese investors and buyers have become a force in the U.S. and often pay more than their U.S. counterparts. How can they afford it? Because they can help unlock an additional market and often benefit from the high P/E ratios of domestic stock exchanges. This means an acquisition can improve their stock price by much more than they paid for it. You can call it “stock exchange arbitrage.” It is also one reason some Chinese companies de-list from U.S. exchanges to re-list at home.

For investments or acquisitions, Chinese companies benefit from huge P/E ratios, and China market access.

So what we’re seeing is that, when Chinese companies do make a move on the U.S. market, they’re not launching products there in an effort to compete directly with U.S. companies but rather are making investments, doing research and development, or making discreet acquisitions in the U.S.

The ones that do launch in the U.S. generally do so with entirely original services, some of which are already massive successes back home.

Last but not least, as China is now innovating and scaling startups at a fast clip, its successes in:

could inspire entrepreneurs abroad — like Silicon Valley does — in a kind of “reverse arbitrage”. Call it inspiration or “convergence”, FT and Wired said it: it is time to copy China.

Call it ‘reverse arbitrage’, inspiration or “convergence”, the Financial Times and Wired said it: it is time to copy China.

Beyond individual services, numerous battles have already played out in China’s fast and furious market and could serve — like military history — guide foreign companies in their domestic fights.

China’s battle can serve as military history for other markets to study.

For instance, China has become an expert in startups mega-mergers. Fritz Demopoulos, founder of Queen’s Road Capital and travel search engine Qunar (acquired by Baidu, gone IPO on NASDAQ then acquired again) told me:

“If you believe in ‘winner take all’ and invest $5 billion, the probability of success is 50% you are worth $50 billion, and 50% you are worth zero. But if you merge, there is 100% chance you are worth $25 billion but only have to invest $1 billion (because the competition isn’t as fierce). What would you do?”

4. The U.S. *is* interested in the Chinese market, but it’s having trouble getting in

Language, ecosystem differences, and regulations all put foreign entrepreneurs at a big disadvantage in China. They can’t operate at full capacity, which makes a first mover advantage insufficient. The speed often lost with reporting lines if the China branch is not autonomous (like a new startup) adds to the handicap.

Language, ecosystem, regulations and reporting are massive disadvantages for foreign startups in China.

Aside from rare companies like Qunar (a travel search engine acquired by Baidu) or Beijing-born AppAnnie (the world leader in mobile analytics), very few foreign-led startups have succeeded at scale in China. The classic exception, as often, is Apple — but does it qualify as a startup?

The most successful tech companies in China so far have been Softbank and Yahoo with Alibaba (Softbank owned 1/3 and Yahoo 40% of Alibaba at one point) and Naspers with Tencent (Naspers owned over 1/3 of Tencent).

As Yahoo’s Jerry Yang said in the recent “996” podcast interview by GGV, Yahoo failed for years in China, and that’s why it succeeded with Alibaba. Learning by doing on the ground helped them identify a unique opportunity (Disclosure: I still own the Yahoo shares I bought years ago as a proxy to Alibaba, after finding them undervalued. Altaba proved me right). Maybe even Uber will eventually do well after its retreat from China thanks to its shares in Didi.

More recently, many cross-border VCs have bets on the next wave of Chinese unicorns, which now represent 96 of the world’s 276 total, and many have already either merged or gotten wings to IPO (becoming … ‘alicorns?).

Chinese Unicorns = 96 (out of World’s 276 total)

Anyone can study Silicon Valley, while studying China requires overcoming the language barrier and building enough understanding of the ecosystem. It can take years, and makes cross-border investors and experts a rare and valuable resource. No wonder Facebook hired Hugo Barra after his experience at Xiaomi … which directly lead to the recent Oculus/Xiaomi deal.

If the U.S. is not sending enough people to study or work in other countries compared to China, it could adjust its immigration policies to attract and retain talent. Such a change might help the U.S. hold onto the many U.S.-trained Chinese who are finding China more attractive today.

Today, an estimated 300 to 400 million Chinese learn English. In 2015, Obama suggested that one million Americans learn Mandarin to prepare a new generation of China-savvy U.S. leaders. Where are we today? Some of Silicon Valley’s elite are already hiring Chinese nannies or putting their kids through Chinese school. Time will tell if the West be able to bridge the gap.

[Thanks to: Fritz Demopoulos, Hans Tung, Chris Evdemon, William Bao Bean and Dr. Song Li for their comments and insights.]

Benjamin Joffe is a partner at San Francisco- and Shenzhen-based HAX, the hardware branch of global seed investor SOSV.

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