China Internet Firms Squeezed by Venture Capital Funding

China’s hot Internet sector is facing a problem, as it is unaccustomed to lack of money.

The world’s largest Internet market, with nearly half a billion users, gave birth to some of the world’s most vibrant Internet firms, such as Baidu Inc and Tencent Holdings.

Venture capitalists bankrolled them, making knockout returns after the firms’ successful U.S. listings in the mid- to latter half of the previous decade.

But a slew of accounting scandals and fears that the corporate structures used by China’s Internet firms could face greater scrutiny from Chinese authorities have spooked U.S. investors in the past year, dulling their appetite for initial public offerings.

With IPO exits blocked, venture capital funds have dried up.

“It’s sort of winter time for Internet companies in terms of getting finance,” said Q.D. Wang, chief executive of Internet mobile start-up Datou.

In the first quarter of 2012, venture capital firms invested just $138.5 million into China’s Internet sector, an 84 percent fall from the $866.5 million invested in the year earlier period.

Starved of funds, scores of start-ups face an uncertain future. Many are turning to unusual financing sources.

Some have dipped into their own funds, and others have tapped family and friends for the capital they need to stay in business.

It was once a joke that all a Chinese Internet entrepreneur needed to raise money from a venture capitalist was a piece of paper with a business plan scribbled on it, but the joke is no longer true.

As U.S. IPO investors caught the China Internet bug, venture capital firms poured more money into start-ups, backing new companies to feed the IPO frenzy.

Venture capitalists poured $3.6 billion dollars into China’s Internet sector in 2011, Thomson Reuters data shows, more than double the year earlier figure of $1.7 billion.

China’s online coupon companies became particularly hot.

Lashou.com, founded in March 2010, had raised $166 million in venture capital by April 2011, and was valued at $1.1 billion.

In the same month, China’s largest business-to-consumer website 360buy said it had raised $1.5 billion in new money, including $500 million from Russia’s Digital Sky Technologies, a Facebook investor.

Chinese Internet firms always favor the U.S. markets for an exit due to the lack of a profit requirement to list and the high valuations they can command.

But from mid-2011, a series of accounting scandals hit Chinese firms listed in North America, leading to trading halts, delisting, lawsuits and regulatory probes in both the United States and Canada.

The scandals dampened sentiment for Chinese listed stocks among U.S. investors, and new entrants to the market face skeptical investors and tougher Securities and Exchange Commission rules.

Listing documents now also contain more visible disclosures about the structures these companies use, the so-called VIE or variable interest entity, which allows Chinese companies to get around certain rules forbidding foreign investment in sensitive sectors, like the Internet.

As a result, there were just six exits through U.S. IPOs in 2011, data from Chinese research firm Zero2IPO shows.

In March, online retailer Vipshop became the first China tech stock to list since August, but its shares fell as much as 12 percent on its New York debut. Even a sharp cut in the offer price failed to overcome concerns about mounting losses and its complicated corporate structure.

With their capital trapped in companies like Lashou and 360buy, venture capitalists have naturally turned cautious.

“Chinese Internet companies, their main option is to go list in the U.S., so when that channel is blocked, venture capital firms are a lot more cautious,” said Jay Chen, founder of venture capital research firm, China Venture, as Reuters stated.

Venture capitalists have not turned away entirely from China Internet firms, but they are far more selective about where they will invest.

E-commerce firms took the lion’s share of 2011 VC money, but that will not be the case going forward.

he added “In the first wave of capital that goes into a sector, there’s a lot of relatively dumb money, says Gary Rieschel of Qiming Venture Partners. “The assumption on e-commerce was that everyone is going to be like Amazon, and it’s starting to be clear that that’s not going to be the case”.

Venture capital is looking for areas where barriers to entry are high.

Rieschel sees a shift towards areas like analytics and cloud computing, where intellectual property and technical skills create natural barriers to entry, and protect investment.

“I think we will have a percentage shift in that direction.”