Is There a Tech Bubble in China?

Chinese investors have begun talking about the recent “irrational” valuations of Chinese tech startups and a potential tech bubble in China.

A couple of days ago, David Zhang, founding managing partner at Matrix Partners China, wrote an open letter, titled “A Bubble is Out There”, to all the CEOs of their portfolio companies.

Apart from worries about the U.S. stock market and the increasingly high valuations of western startups, Mr. Zhang points out the “irrational exuberance” in early stage investments in China’s TMT (telecommunications, media and technology) market.

Here are some warning signs from the letter,

— Many venture capital funds have raised a lot of money this year and they are investing in Chinese startups like crazy. For most of them, the deals made in the first three quarters this year are twice more than that for the whole of last year.

In the past three quarters, Matrix Partners China have invested in 45 startups, over 20% of the total since its inception in 2008, which seems too many to Mr. Zhang.

— A funding round of tens of millions of dollars or up to 100 million dollars, which previously wasn’t often heard of, is very common now. However, Matrix Partners China have found that it’s harder for startups who have pocketed US$20 million or more in early-stage rounds to raise the next.

— The average time between funding rounds has largely been shortened. That a startup begins raising another round at an valuation several times that of the previous round just barely completed seems to be acceptable.

Gavin Ni, founder and CEO of Chinese venture capital firm Zero2IPO Group, joked that the valuation of a Chinese startup can be doubled in half a day. He said so at an event earlier this month.

What help inflate tech valuations include the increased number of investors and total amount of funding. Older investors like Zero2IPO would feel pressured to invest in a startup valued higher than their expectations, for (1) many another investor, especially newcomers, would buy a piece of it anyway and (2) the next round may be at a way higher valuation.

Venture capital firms have invested US$3 billion in Chinese Internet/mobile Internet startups in the first half of this year, and private equity funds have injected US$4.5 billion, according to Mr. Ni. The combination is half of the total funding they had raised in the the same period, with US$7 billon going to VCs and US$8 billion to PE firms.

That so many more “angle investors” emerged in recent years must be another factor that makes the early-stage investment market more confusing. Some of them I’ve come across are funding Chinese tech startups with money earned from running IT training schools or in China’s booming real estate market.

While that investors who don’t quite understand the tech industry flock in and help inflate valuations is definitely a danger sign, some new coming active investors are not from nowhere.

Tencent, the Chinese social giant, had spent RMB30 billion (about US$4.8 bn) on M&A in the first half of 2014; that’s 56% of the total investments by the company since it went public ten years ago.

In the same period of time, Chinese e-commerce giant Alibaba Group had invested RMB45.5 billion (about US$7.3 bn), 74% of the total spent on M&A in the past ten years or so.

Though many tech companies invested or bought by the two Chinese giants are from overseas, their investments in Chinese startups obviously increased hugely in the last couple of years.

It’s hard to say whether the participation by big Chinese companies helps inflate startup valuations, it is widely considered a good thing in China anyway. Previously Chinese tech companies like Tencent preferred to hire some engineers to build me-too products instead of acquiring existing startups. For some others like Alibaba they were focusing on their core businesses — online marketplace and payments solution in Alibaba’s case — over the past years till recently they found other forms of businesses were needed to strengthen their empires.

Today it’s really easy for Chinese startups, especially those in Chinese tech cities like Beijing, to raise funding. Recently Chinese tech media got busy catching up on the funding news. We know many of them have inflated the funding figures, but the total number of deals we’ve heard about is really big.

Mr. Zhang with Matrix Partners China requires all of their portfolio companies to make sure they have enough cash for 9-12 months to weather a possible down period. He also suggests startups in the process of raising money give priority to time to completion over valuation.

If there isn’t a bubble that will burst anytime soon, it’s really a golden time for Chinese tech startups in terms of fundraising.