Over the past year, companies and startups in China’s tech sector have been chilled by what many refer to as a “capital winter”—a significant slowdown in investment and fundraising activities—aggravated by political and economic uncertainties as well as growing caution towards major Chinese tech firms.

A startup report found that a growing number of entrepreneurs in China expect fundraising to be more difficult in 2019, due in part to government efforts to reduce financial risk. According to data from China VC Tracker, both deal value and deal volume dipped in April.

Earlier this month, Reuters reported that venture capital firm Sequoia Capital China was planning to lay off up to 20% of its investment staff, which the company shrugged off by saying that regular review of its workforce may result in personnel adjustment. However, the report did shed light on the malaise of venture capital fundraising in China.

Some investors believe that a slowdown is part of a natural cycle and the tech sector needs a cooling-off period.

The financing winter

The data shows that Chinese venture capital activities in the first three months of 2019 have not kept up pace with last year’s figures, but analysts say it’s not yet time to despair.

“While the rate of capital raising and deployment is slowing, it is far from being depressed,” said William Clarke, senior communications manager at financial data provider Preqin. Clarke said that the recent boom has set expectations unreasonably high, noting that 2019 is still on course to see more VC investment than any year before 2014. However, for a fairer comparison, we should take into account how much the Chinese economy has grown since 2014—and note that the technology sector has been a contributor to the country’s GDP growth for years, benefiting from favorable government policies.

VC fundraising and tech-focused VC in China has indeed seen a slowdown since 2016. However, there is still a significant amount of capital flowing into venture investments in China.

“Looking ahead, while deal activity in 2019 so far has not kept pace with last year,” Clarke said, “we estimate that Asia-focused venture capital firms more generally have about $95 billion in capital they’ve already raised that they are waiting to deploy.”

It’s not the lack of money or interest from investors, said Tilo Bonow, an investor at Hong Kong-based accelerator Nest, but rather that investors are becoming more critical and selective. In addition to running Berlin-based public relations agency PIABO, Bonow also works with startup VCs including 500 Startup and Infinity Ventures.

And while it seems like the cards are stacked against China’s formerly red-hot tech sector, the slowdown could turn out to be a boon.

“China is a super-attractive market for foreign investors,” Bonow said, referring to European countries such as Switzerland and Germany, which have a lot of capital and are looking to invest in Chinese companies. He added that these investors bring not only buying power but also demand for cutting-edge technologies such as artificial intelligence (AI) as European industries continue to pursue digital transformation. This is an opportunity that Chinese tech companies can tap into.

Bruno Bensaid, angel investor and co-founder of Shanghaivest, a Shanghai-based cross-border investment banking advisory firm, observed that fundraising has become more difficult and early-stage startups have been hit the hardest.

Winter may be colder for some

In China, says Bensaid, sectors such as medtech, healthcare, and B2B businesses—especially areas such as cloud services and software security—are promising markets to be in.

AI, however, is not. Although some Chinese AI companies have received significant funding over the past few years, Bensaid believes there is still a lot of fluff in the market—startups that are having difficulty gaining traction and securing funding. Given the number of AI companies that are struggling to find the right talent, the industry still needs to invest more in research.

In the last quarter of 2018, investments in AI startups started showing signs of cooling down. Not only have many of the larger funds matured, but investors have also become reluctant to invest in young startups that are considered riskier, said Raheel Ahmad, co-founder of mltrons. His Shanghai-based startup, which builds AI-powered predictive analytics platform for enterprises, is seeking to raise funds in China. “[AI investors in China] are not just looking for an idea to invest in. Now they are looking for a viable business,” said Ahmad.

As the chill starts to set in, startups in the later stages attract more interest from VCs, he added. “What it has done is make entrepreneurs work harder to get to the seed round.” On the upside, any entrepreneur who puts in the work to reach that point does stand a better chance of raising more funds.

Ahmad said the ongoing trade war will also have an effect on his company’s fundraising strategy. It is especially important for companies that serve clients in both the domestic and foreign market, he said, adding that his startup hopes to raise funds as soon as possible and is considering approaching global VC firms.

Roy Lu, CEO and co-founder of AI-driven social app developer Timepop Technologies, offers a similar assessment. “We’ve met more scrutiny than comparable projects launched in the capital summer in 2015 to 2016, where an angel round of $2 to 3 million was commonplace,” he told TechNode.

The Shanghai-based company’s founding team members include former Intel and Facebook employees, but even with these industry credentials and experience, they faced hurdles raising the last round, which closed in December. “The capital winter in China stunted our fundraising plans, forcing a later close at a lower valuation,” said Lu.

During their last fundraising effort, when the company spoke with more than 40 Chinese VCs, Lu found that investors were more interested in their short-term achievements—such as usage data and app traffic—than the experimentation and iterations that will likely pay off in the long run.

“Such mentality spells trouble for early-stage startup founders, whose business meets higher uncertainty,” said Lu.

Lu pointed out an emerging trend in Chinese VC investment where the fundraising dollar amount is increasing but the deal count is falling, which means VCs are preferring later-stage companies in an attempt to avoid risk. “The audacity of VCs is rapidly diminishing in China’s capital winter, and that’s hurting founders who are building for the long term,” said Lu.

A natural balance

Tony Verb, founder of investment firm GreaterBay Ventures & Advisors, told TechNode that the tech sector is currently witnessing a natural balancing force. “What we are seeing is a correction, because there was a lot of hot money in the tech startup scene over the past many years,” he said. “The cash and capital in China have a tendency to flow to certain asset classes in particular periods and cycles,” Verb said, adding that this phenomenon is especially pronounced in tech. This, in turn, created what Verb describes as a “global warming kind of unnatural heat” in tech startup financing. He pointed to the quick rise and fall of China’s bike-sharing industry as one example.

From an investor’s perspective, Verb said, the cooling of financing activity could be positive in the long run. “It might bring down valuations of Chinese tech companies to more healthy levels.”

The financing slowdown is not so much a capital winter, he said, but a maturation process which is weeding out weaker business models and faulty products, driving “sophistication of the startup technology financing ecosystem.”

The companies that pull through will be those with business models and products that actually make sense, said Verb. Such startups will still attract interest from investors.

None of this is to downplay the downturn yet to come. According to Verb, the startup financing winter alludes to broader political and economic issues. The trade tension between the US and China, for example, will likely bring more uncertainties, negatively impact tech companies, and close off markets, he said. The knock-on effect that trade tension has had on Huawei and ZTE will likely happen to other Chinese tech startups.

“We have to bear in mind that 2020 is the presidential election and this is going to continue freezing part of the asset allocation towards China,” according to Bensaid of Shanghaivest. The US presidential election will be a “slowing factor” for VC financing—something that will weigh heavily on market sentiment. Bensaid went on to explain that when limited partners, spooked by economic and political uncertainties, become uncomfortable about investing in Chinese companies and the VC asset class, general partners encounter difficulty raising additional funds—prompting some to focus on their existing investment and making sure they get proper exits.

Silver lining?

With the trade deficit, efforts to deleverage the economy, and the broader economic slowdown, the government cannot fuel the economy as they were doing before, Bensaid said, as all of this has an effect on market sentiment.

The return to a healthy market, he added, will correspond to the maturity of the new tech board. Those companies that do survive will have more opportunities for exit by the time the cycle ends. “In a way, the timing is right,” said Bensaid.

“For 2019, my focus will be on the growth of the new Shanghai tech board as a testimony that [tech startups] could exit,” he said. Some tech companies listed in the US could also relocate back to China and be listed in Shanghai, he added, so that China creates or recreates a strong stock market for tech stocks. “That will give, in my opinion, a lot of opportunities for people to get more confidence if they don’t get the confidence from the political side,” said Bensaid.

With much uncertainty looming on the horizon, natural selection will push out many weaker players, experts say. Only the fittest will survive.

Bonow told TechNode that while startups should not ignore these broader economic factors and regulations that are beyond their control, neither should they wager their success too heavily on the whims of the political and economic environment in the domestic market.

It is important to have a working business model and attractive products, he said, but it is also important for Chinese entrepreneurs to diversify their business and look at opportunities in overseas markets.

“At the end of the day, the time has come to really open up and think globally,” Bonow said.

It’s not just about tapping into overseas markets, he said, but also about gaining access to talent pools, forming new partnerships, and accessing new networks abroad.

Nicole Jao is a reporter based in Beijing. She’s passionate about emerging trends, news, and stories of human interest within the world of technology. Connect with her on Twitter or via email: nicole.jao.iting@gmail.com.

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