Series C crunch will leave hundreds of Chinese startups without funding in 2015, says local VC

TECHINASIA: The lack of venture capital against the background of increased demand for it may lead to a shortage of money for growth-stage (Series C) startups in China

Startups in China raising series A and series B rounds found it exceedingly easy to secure funding in the past two years. Evaluations skyrocketed and early stage startups repeatedly made headlines with their “tens of millions of dollars” in investment. It happened so often we couldn’t keep up with writing about them all.

But the fortunes of all those startups lucky enough to fundraise in an overheated market are about to change, according to one prominent investor. Ran Wang, founder of Chinese venture capital firm ECapital, earlier this week published an article in China’s Entrepreneur Magazine that predicts tough times ahead for growth-stage startups in China.

90 percent of those startups who soared through their series A and series B rounds will not be able to raise series C rounds, Wang writes. Here’s his logic:

In 2014, according to Chinese startup database ITJuzi, 812 companies received seed stage rounds, 846 got series A funding, and 225 got to series B, and 82 reached series C. And those are just the ones that reported their rounds.

The time between series A and series C for many startups in the country is less than one year. To match or improve on the sky-high series B rounds, those startups each need to raise anywhere from US$30 million to US$200 million.

Unfortunately for all those companies at A and B stage, the number of C stage investments hasn’t kept pace with the early stage rounds. Wang says that about 1,000 of these companies will seek series C funding in 2015, but the number of series C rounds probably won’t exceed 100. That leaves 90 percent – 900 companies – without VC capital to keep them afloat.

To make things worse, most of these startups aren’t earning much revenue yet, and many don’t have established revenue models at all. They will face what Wang calls “the C round of death.”

Told you so

Back in November, Wang warned of an impending downturn in China’s startup ecosystem. He advised startups that were considering raising funds to do so while they still can. He echoed the gloomy sentiments of David Zhang, who sent an open letter to his portofolio companies warning them of a bubble on the verge of causing a major cooldown.

Many startups will look to their previous investors for salvation, but Wang says they can’t all be helped. Early stage investors don’t suddenly switch to growth stage investments because their portfolio company is in trouble. They have set investment requirements, funding cycles, manpower, and, of course, limited money. After all, the money used to fund a single series round could alternatively be used on 10 early stage rounds.

Additionally, early stage investors know full well that most of the startups they invest in will fail. That’s just the reality of early stage investing, so they will have little sympathy for those who can’t find fresh investors at the next stage.

Wang says that the oversized funding rounds for early stage companies were a double-edged sword: indeed, they accelerated growth, but they will also accelerate death.

Hung out to dry

Wang lays out which companies are mostly likely to face “the C round of death” this year. First is companies whose valuation is too high. For a US$3 billion valuation, for instance, the target market needs to be worth US$100 billion to support it. A US$10 billion valuation requires a US$1 trillion market. If startups have reached a valuation that’s already outsized its market, series C investors won’t be interested in pumping in more money, because the company can’t grow enough for them to reach a desirable exit.

Next, companies in highly competitive sectors are more likely to die out. One-off O2O services are especially at risk. For instance, real estate buying and renting startups are competing with traditional real estate companies, and secondhand car marketplaces are up against old-school dealers. These kinds of startups – which customers tend to use just once – are in for a rough ride ahead.

Finally, companies need to be in either first or a close second in their respective fields. If your startup isn’t already leading the pack, then there had better be less than 50 percent market share gap between you and whoever is number one. And if the number one company has been invested in by Baidu, Alibaba, or Tencent, then that gap narrows to 20 percent. That’s because those web giants have powerful and popular avenues through which to market and distribute their portfolio companies’ products, such as Tencent’s WeChat.

Survival guide

Part of the problem lies in Chinese startups’ bad habit of lying about their funding numbersand valuations. This is common practice among most Chinese startups, who usually misrepresent their funding rounds by a factor of two to three or purposefully confuse the yuan and the dollar.

This puts companies in a position where they cannot achieve sustainable growth, and the real numbers are exposed to investors in later rounds. And in an environment where “everyone is doing it,” it’s extremely difficult to know how much a company should actually raise in order to keep pace with competitors.

To tame these unrealistic expectations held by both entrepreneurs and investors, Wang says startups need to be prepared to adjust their valuations if the market doesn’t warm to them.

Secondly, startups shouldn’t waste time wooing investors who don’t understand their industry. People with deeper knowledge of the startup’s market will be more quick and decisive when writing a check.

Wang’s next tip is obvious – don’t burn through your cash expecting to get your next investment by a specific date. The normal funding process alone takes nine to 12 weeks. Be thrifty and cut costs when possible. Start shaking hands and making introductions six months before the end of the current runway.

Fourth, don’t set an exclusivity period for investors. That means don’t try to force investors to fork over cash before an arbitrary deadline for the promise of a better deal. Allow time and flexibility, otherwise investors will move on to the many other startups queuing at their doorsteps.

Finally, don’t be afraid of strategic investments. Entrepreneurs are often wary of investments that have more strings attached than just money. Namely, they often include incorporating a startup’s tech into the investor’s tech. Baidu, Alibaba, Tencent, Xiaomi, JD, and Ctrip are some of the biggest strategic investors in China. True, you might have to divert from the original vision, but at least you’ll survive through the winter.