Tea Leaf Nation

Froth and Frenzy in China’s Start-Up Scene

Euphoric narratives are fast getting ahead of reality.

Customers flock to an Apple store where the latest version of the Apple iPad went on sale in Apple stores in Shanghai on July 20, 2012.  Apple began selling the latest version of its market-leading iPad in China, on the heels of Apple paying 60 million USD to end a dispute over the iPad name in China, giving the US tech giant more certainty in selling its tablet computer in the huge market.      AFP PHOTO / Peter PARKS        (Photo credit should read PETER PARKS/AFP/GettyImages)
Customers flock to an Apple store where the latest version of the Apple iPad went on sale in Apple stores in Shanghai on July 20, 2012. Apple began selling the latest version of its market-leading iPad in China, on the heels of Apple paying 60 million USD to end a dispute over the iPad name in China, giving the US tech giant more certainty in selling its tablet computer in the huge market. AFP PHOTO / Peter PARKS (Photo credit should read PETER PARKS/AFP/GettyImages)

Spend a little time with young, urban 20-somethings in the cafes and universities of China’s major cities, and it will quickly become obvious that a tech start-up frenzy is taking the country by storm. The stunning success of Ma Yun, founder of e-commerce giant Alibaba, and his company’s historic $25 billion initial public offering in December 2014 seem to have helped inspire a new generation of entrepreneurs. Young people across China have begun quitting schools and jobs to start companies, and coffee houses in Beijing, Shanghai, and Guangdong burst with venture capitalists and young entrepreneurs dreaming of their own rags-to-riches (or middle-class-to-riches) story. But clouds have started to gather on the edges of China’s start-up scene. Recent reports of outlandish product claims and exaggerated funding are fueling growing concerns about too-good-to-be-true start-ups and the risky bubble driving the phenomenon.

Until July, William Joy seemed like the Chinese start-up scene’s next wonder boy. That’s no small feat in China, where seven new businesses were registered every minute between March 2014 and May 2015. Joy, a Shanghai native and at the time a self-proclaimed Harvard undergrad, had co-founded Venvy, a company that embeds information tags in interactive videos, in February 2013. The company had made a big splash at its Shanghai launch event in December 2014, when media coverage proclaimed that Venvy’s team had developed a technology that Google had tried for seven years to create, to no avail. In March, Joy was named among Forbes China’s “30 Under-30 Entrepreneurs in China.” Announcing a teleconference in July, Venvy’s press release boasted that the company was valued at an eye-popping $97 million in its Series A round of funding, the first significant round of venture capital financing for start-ups.

But all that buzz soon drew scrutiny. The trouble for Venvy began on July 29, when Chinese media outlet Jiemian published an article, titled “Crazily Retweeted Venvy Is Perhaps Challenging the Public’s IQ,” arguing that the company’s so-called proprietary technology was vastly exaggerated and that the tech was not much better than applications developed by other companies. The next day, an article published on Chinese media outlet B12 characterized several flashy young companies including Venvy — previously the darlings of media and venture capital alike — as “shameless” frauds. The article went viral on Chinese social media platforms like WeChat and created a public relations disaster for the companies. On Aug. 7, Forbes China wrote that Joy had misrepresented his educational background, stating that he was not a current undergraduate student on leave from Harvard College, but rather an alumnus of the less selective Harvard Extension School. (Harvard’s registrar confirms Joy was never enrolled in Harvard College.) The Forbes 30-under-30 article was subsequently taken down. Moreover, an investigative report by Tencent found that the adoption of Venvy’s technology by hundreds of websites and apps, as the July press release claimed, was far exaggerated. Venvy responded to Foreign Policy’s request for comment by stating that it will “use its products to respond to past rumors.” (The company is holding its next online product release on Oct. 31.)

A wave of online skepticism also lay in store for another entrepreneur named in the B12 article, 27-year-old Huang Xiuyuan, the founder of electric-car company Youxia Motors. Ahead of a new round of fundraising, Huang’s team organized a demo in Beijing on July 26 to reveal its prototype car, Youxia X. Huang told investors at the event that the car, dubbed by the media as “China’s answer to Tesla,” would “enter mass production in 2016, but wait until at least 2017 to enter markets.” Chinese netizens lambasted the company: They claimed that Youxia X is actually an amateur, nonfunctional modification of Tesla Model S, labeled it “a car built on PowerPoint,” and questioned how a team of just a few dozen people could hope to design and produce independently its own electric car. Huang, in a subsequent interview with Chinese media, retorted that “valuable imitation is so much better than useless innovation.” A senior manager at Denza, a Shenzhen-based electric-car manufacturer and Daimler joint venture, told Chinese media outlet Tencent that given Youxia’s shallow industry experience and lack of funding, its goal of entering markets by 2017 “has almost zero likelihood to be achieved.” Responding to a request for comment from FP, Huang explained via social media platform Zhihu that “we have never been fraudulent; I just think people misunderstood our original intent. Fundamentally,” Huang continued, “Youxia wants to start from modifying cars, to making concept cars, to making prototype cars. If displaying an imperfect concept car counts as fraud, I think that is a little harsh.”

There is no question that Chinese start-ups now face a growing perception problem. It is widely known in China’s entrepreneurial circles that certain companies collude with venture capitalists to inflate reported fundraising numbers; an investigative report by Tencent Technology in September suggested that more than 80 percent of start-ups exaggerate their funding numbers. One Chinese entrepreneur, who requested to remain anonymous, told FP that start-ups in China commonly report around three times the actual amount of funds raised. Zhu Chao, founder of Career Dream, a Beijing-based start-up online platform for recruiting finance professionals that recently raised $10 million in its A-round funding, explained in an interview with FP that some start-ups exaggerate to “scare off competitors,” jockeying for attention in a frenzied market. In addition, said Zhu, some venture capitalists tacitly consent to this behavior because it makes for good publicity. Xu Xiaoping, the founder of Beijing-based angel investment fund ZhenFund, became so concerned about this phenomenon that in February he made a public call for start-ups to reveal realistic financing amounts, even threatening to expose untruthful companies under his portfolio on Weibo, China’s Twitter-like microblogging platform.

Overzealous start-ups are by no means unique to China, but hypercompetition backed by the huge amount of capital available to prop up new companies has created the conditions for scams to spread. Over the past two years, China’s start-up boom has been accompanied by a massive, unprecedented injection of capital. In 2014, $15.5 billion in venture capital was invested inside China, more than three times the amount in the previous year. This trend continued into the first quarter of 2015. Venture capitalists bid up the valuation of tech companies for fear of missing out on the next Baidu, Alibaba, or Tencent, in turn raising expectations for similar companies and attracting more investors. Chinese-American entrepreneur Randy Wan, who founded Woo Space, a start-up in Beijing that rents out collaborative spaces to incubate other start-ups, told FP that the level of competition in China is “ridiculous.” Wan said that “in the United States we have around 15 companies [competing for a certain market],” while “in China there are thousands.” Venture capitalist Sun Zhichao of Beijing-based Innovation Works came to the start-ups’ defense, writing on Zhihu, “Some entrepreneurs are hard-working, some are superficial, and of course there are some with poor morals, but we cannot make a sweeping statement by calling all entrepreneurs ‘shameless.’” An environment of hypercompetition among start-ups means that exaggeration is often necessary for survival. “What many start-ups lack,” said Sun, “is the ability to ‘sell’ but not to cheat.”

Increasingly, investors and entrepreneurs are becoming concerned that such a boom is fueling a dangerous bubble. Jui Tan, Asia partner for Menlo Park, California-based BlueRun Ventures, said in a March interview with Chinese media outlet BlogWeekly that while funds had previously invested in around 10 tech companies per year, the average had gone up to 30 in 2014 and would likely double in 2015. According to Tan, venture capitalists competing with each other have bid start-ups to unrealistic valuations early in their A rounds and, “by the end of 2015, around 70 percent of start-ups could have difficulty funding in the B round, or they could fail to meet their founders’ expectations.” Even Richard Liu, founder of e-commerce giant JD.com and one of China’s most successful entrepreneurs, harangued companies riding the Internet bubble in a September speech.

Chinese government support seems to have played a major role in fueling the bubble. In the past year, Chinese Premier Li Keqiang has spoken frequently about “entrepreneurship and innovation by all,” calling it a new engine for growth in China. Adding fuel to the fire, the State Council, China’s top governing body, announced in January a massive $6.5 billion venture fund to invest in seed-round tech start-ups. In March, the State Council introduced an “Internet Plus” plan to support companies that tie Internet activity to the real economy. The policy raised expectations for state support in the information technology sector, contributing to a record-breaking rally of Internet stocks in the A-shares market and making the average price-to-earnings ratio so expensive that it outstripped even that found on the Nasdaq composite index at the height of the U.S. dot-com bubble in 2000. For the Chinese government, encouraging entrepreneurship helps relieve growing employment pressures for young college graduates and offers an outlet for capital locked in China. A survey on employment of Chinese college graduates from Beijing-based research firm MyCOS shows that while the employment rate for 2014 graduates increased year on year, the bump was due to more students choosing entrepreneurship — fewer are actually hired for full-time jobs. Chinese investors, meanwhile, are limited in where they can put their money abroad due to tight capital controls, and they also lack more formal outlets domestically, given that a short-term recovery for China’s property market remains unlikely, while interest rates on bank savings fail to keep pace with inflation.

To be sure, competition and even the specter of a burst bubble have their silver linings. A burst tech bubble, though causing short-term disruption, could leave a positive legacy over the long term. To support the Internet Plus initiative, the State Council has ordered China’s state-owned telecom companies to reduce fees and improve speed and access to the Internet. Much like the dot-com bubble of the late 1990s, improved infrastructure could help sustain the tech sector’s long-term development, even if it were to fizzle out in the short term. Zhang Du, the 20-year-old founder of Shunshun Liuxue, a study-abroad counseling platform that raised $18 million in its A round, told FP in an interview that given the wide availability of capital, incubators, and policy support, the environment for entrepreneurship in China is at its historic peak. Investment fever encourages financiers to fund projects that would have otherwise languished, making it likely that some great companies will be born out of the current euphoria.

But for the rest, the start-up hype may have blown their narratives out of proportion. Investors falling in love with ideas rather than products have made founders of modest companies into instant millionaires, putting them in a position where expectations become difficult to check. The B12 article, which criticized Venvy and Youxia, also speculated that “these young men are also in a state of shock. After all, they never had malicious intentions … but there is only a thin line between exaggeration and fraud. At a deeper level, the craziness of these entrepreneurs is part of a common plot involving all of society.” For now, though, the two companies have continued operations after weathering their respective online fallouts. Zhang, Shunshun’s founder, described the zeitgeist with help from a classic Charles Dickens novel: “This is the best of times; this is the worst of times. This is a time flooded by ready money, and this is a time when countless young people lose themselves and start a company just for the sake of doing a start-up.”

Liu Yuan, vice president of investment at ZhenFund, thinks a reckoning is on the way. “There will be a cyclical correction,” Liu told FP. “Good companies are always valuable and will get funding even when the bubble bursts.” But when the bubble does burst, he warned, the “pigs that were blown into the sky” will likely fall back down heavy.

Photo credit: AFP/Getty Images

Ben Yunmo Wang is a researcher at Eurasia Group.

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