VCs in the Wild, Wild East

DCM-Doll Capital's David Chao on investing in China, where business law has a short history and infrastructure for startups is mostly absent

In 1996, Silicon Valley venture capitalists were more keen on finding another Netscape next door than in going beyond U.S. borders. That year some of them shook their heads when David Chao co-founded DCM-Doll Capital Management, a VC firm that planned to invest up to 25% of its funds in Asian technology and telecommunications markets.

Nine years later, Chao is looking downright clairvoyant. Last year, two of his firm's Chinese portfolio companies went public: Chip foundry Semiconductor Manufacturing International (SMI ) and online job site (JOBS ). The latter has seen its stock rise 240% above its $14 debut price in September. Those kinds of returns have other Valley VCs clamoring for flights to Shanghai.

BusinessWeek Silicon Valley Correspondent Justin Hibbard recently spoke with Chao about the opportunities and pitfalls of investing in China. Edited excerpts of their conversation follow.

Q: Your firm has made six investments in China so far. Will you make any more?


Yes. We just finished raising our fourth fund, which is around $375 million. About a quarter of it will go into China. Of the next three deals that we think we're going to do, at least one is going to be in China.

Q: Do you have partners in Asia that help you find deals?


We have a joint venture with Itochu in Japan in an early-stage fund there, and we have a strategic partnership with Legend Capital in China. Legend was in the news recently because their group at Lenovo -- Legend and Lenovo are the same -- ended up buying IBM's (IBM ) PC unit. They're the largest PC distributors in China, and they have a venture arm. We have a strategic partnership with them to do venture investments in both China and the U.S.

Q: Which sectors look attractive in China?


There are a lot of semiconductor-design companies [which don't own their own manufacturing plants] that work on next-generation chips. Another area is media services, as the overall advertising industry grows in China. We also look at next-generation Internet infrastructure plays. And the last category would be mobile platforms, like next-generation game companies or mobile-services companies.

Q: Is a VC bubble forming in China?


On the late-stage side of the fence, there's definitely a bubble. Things are being overpriced. It's natural. You have foreign investors going into China. They probably don't have the wherewithal to do the early-stage, hands-on growing of a company. So they end up investing in late stage because they have to do less of that. When they narrow themselves to that, and there's so much money chasing that, naturally prices are going to go up.

[With respect to] early stage, I don't think that's necessarily the case. Certainly prices have gone up, but then inflation in China hasn't been small, either. Early stage is still relatively reasonable.

Q: What are the potential pitfalls of investing in China?


I call China, "The wild, wild west in the truest sense." Business law has been around there only 10 or 20 years. There's a tremendous amount of challenges relative to a U.S. startup. In the U.S., you have lawyers that only do legal services for startups. You have Silicon Valley Bank or Comerica, which do financing only for private companies.

If you're a startup in China, a bank in China is not going to give you a credit line like Silicon Valley Bank or Comerica because they only lend money based on balance sheet. So a lot of the infrastructure is just not there. And it puts an extra burden on the entrepreneurs. Because of that, it becomes a question of, "Do you have the right management team?"

It's tough [to hire good managers]. Even though you have 1.3 billion people in China, think about how many people are really exposed to the western way of management and corporate governance and American [VC] standards. It narrows down really fast. Finding a great company is like finding a needle in a haystack there. But the rewards can be big.

Q: How have you managed to find some of those companies?


Relationships play a big part. We can do due diligence extremely thoroughly because we know all the industry players there. And we already have a batch of successful first-generation entrepreneurs.

Companies like Semiconductor Manufacturing and 51jobs, if you think about it, those are infrastructure companies in the true sense of the word. 51jobs is a place where people look for jobs. It's interesting to see which sectors are hot, which companies are advertising on 51jobs. It actually shows the pulse of the marketplace. Semiconductor Manufacturing produces chips for all the semiconductor companies [without their own manufacturing plants] that are growing up in China. So through our portfolio relationships, there's a network effect starting to happen that really gives us an edge.

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