China’s tech start-ups kiss goodbye to cash burning as investors focus on profits

Iris Deng

The failed WeWork IPO has signalled the end of the days when tech start-ups could burn cash to scale up their business before going public – a strategy that was last used in the dot-com era of Silicon Valley 20 years ago.

So-called blitzscaling has been an effective strategy for some Chinese start-ups, especially those in services like group buying and ride hailing, where companies gave out cash incentives to lure customers in a highly competitive market.

For some, that all came to an end in 2019, which will go down as one of the toughest years for Chinese tech start-ups. China is experiencing an ongoing decline of its venture capital market amid an economic slowdown and uncertainties about the US-China trade war.

In 2019 Chinese companies raised US$35.6 billion in 2,047 rounds of funding from January to mid-November, compared to US$93.4 billion from 2,795 rounds over the same period in 2018, according to Crunchbase.

“Investors who view cash burning and fast capital raising as a competitive advantage are becoming extinct,” said Genping Liu, partner at Vertex Ventures. “All investors are becoming more rational and are looking more closely at operating or financial unit economics to reduce waste and focus on returns.”

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Chinese internet giant Tencent Holdings, one of the most active investors in the technology world, significantly scaled down this year after a bullish investing spree in 2018. The Shenzhen-based company put money into 108 deals globally, 33 per cent fewer than the 162 deals in 2018, according to Chinese research firm IT Juzi.

In the wake of the bursting of the latest tech bubble, the company dubbed the WeWork of China – Ucommune – is struggling to keep going with its attempt to list publicly in the US.

Like WeWork, Ucommune went on a spending spree to acquire more co-working space to scale up its business. The Chinese company posted a net loss of 572.8 million yuan (US$81.38 million) for the nine months ended September, according to its prospectus.

Investors have since questioned its inflated valuation, with Citigroup and Credit Suisse dropping out from the IPO process after failing to agree on a valuation that matched Ucommune’s target, Reuters reported earlier this month. In 2018 Ucommune raised US$200 million giving the company a valuation of $2.6 billion, according to Reuters.

Co-working businesses like WeWork and Ucommune, along with bike-sharing firms like Ofo, are examples of start-ups that have burned cash in exchange for growth, much like the original dot-coms in Silicon Valley when it was eyeballs over profits. However, amid a cooling capital market, this type of business model is increasingly being shunned by investors who are now favouring start-ups with cash flow and profits.

Niche smartphone marker Smartisan was sold to Bytedance. Photo: Reuters

2019 will go down as a tough one for Chinese tech start-ups, with some of the country’s biggest and once-promising names, including Ofo, Shenzhen-based autonomous driving company and niche smartphone maker Smartisan, falling from great heights. Ofo is struggling to keep its business afloat, is undergoing bankruptcy proceedings, and Smartisan was sold to Bytedance.

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Smartisan founder Luo Yonghao, who once bragged that he might one day buy Apple, was added to China’s “deadbeats” list, barred from taking flights or high-speed train travel, as well as any sort of lavish spending, due to unsettled debt issues.

In a social media post titled “Confessions of a deadbeat CEO”, Luo said he raised tens of millions of yuan more to help save the company at its “most difficult” period. Smartisan later sold a set of patents to ByteDance and transferred some of its employees to the internet giant amid financial difficulties.

“Starting a company is a hard thing … filled with distress and embarrassment along the way,” said the CEO.

Yet the worst may still be ahead for China’s tech entrepreneurs. Alibaba Group founder Jack Ma told a conference in Shanghai last week that the world was “entering a period of great change and the Chinese economy is facing huge adjustment”, adding that “the hardship of 2019 is probably just the start” of difficulties. Alibaba also owns the South China Morning Post.

One of the latest casualties in the capital market’s “winter of discontent” is Taojiji, an e-commerce start-up once hailed as a challenger to Pinduoduo, which in turn claimed in October that its GMV surpassed that of Taojiji declared bankruptcy in December after burning through millions of US dollars. Its Series A investors included Russian venture capitalist DST and US-based Tiger Fund.

The insolvency came after the platform was unable to raise fresh funding over the past two months, Zhang Zhengping, founder and chief executive, said in an open letter posted on the company’s Weibo account.

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“The only driving force [for me] was fighting for the chance to survive and reducing losses as much as possible,” Zhang said. “I am sorry that the transaction of attempted merger didn’t pan out and I let everyone down.”

A liquidity crunch was the main reason for the bankruptcy, according to Zhang. “My team and I will try to repay the debt through [new] ventures, hoping we can be given the chance to start new businesses again,” said Zhang, who so far has avoided the fate of Luo by staying off the deadbeats list.

Liu from Vertex Ventures believes the capital winter will affect the consumer sector the most because some business models relied on heavy subsidies from momentum investors who were driven by fear of missing out on the next big thing.

“Overall it is positive … as valuations won’t be pushed up unreasonably by irrational investors and entrepreneurs will be encouraged to focus on fundamental business drivers rather than inflated metrics,” Liu said.

WeWork saw its valuation slashed to US$8 billion, less than one fifth of its peak of US$47 billion, after the company’s much anticipated IPO was scrapped. Some of the unicorns that made it to the public market are disappointing investors too, as celebrated companies including ride-hailing pioneer Uber and Chinese smartphone maker Xiaomi continue to trade below their IPO prices.

Landmark cases would have a domino impact in the venture capital market, according to Hu Bin, founding partner of Ince Capital and former partner of Qiming Ventures.

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“Imagine, after investing so much money and the valuation is cut, some companies still can’t make it to the IPO,” said Hu, who was a serial entrepreneur earlier in his career. “The sentiment would first affect late-stage [private equity firms], before spreading to early-stage PEs and late-stage VCs.”

Start-ups that survive the capital winter will be those that can outlast their competitors with enough cash, said Hu. “Cash flow is a high priority for [entrepreneurs] who need to be prepared for not being able to raise capital in the coming two years.”

Indeed, analysts believe it could be a long winter for the capital markets.

“After reaching record highs in China and the US, VC funding has dropped in China and will likely drop in the US as investors realise profits are lower than expected,” said Jeffery Funk, former associate professor at the National University of Singapore, who now works as an independent technology consultant.

“It will take years before VC funding recovers,” he said.

However, faced with the worst of times, entrepreneurs should not go to the other extreme and pursue nothing but profits, according to Jiang Yiwei, founding partner of N5 Capita, who spoke at the Lieyun CEO Summit in Beijing earlier this month.

“Before it was all about business scale, while now it’s all about profit. Neither is right, as seeking a balance is the most important thing … how to strike a balance between scaling up and ensuring profitability,” Jiang said.

Meituan was able to outcompete hundreds of other group-buying sites in the early 2010s and eventually merged with its biggest rival Dianping to become the food delivery and on-demand service giant it is today. Hong Kong-listed Meituan surpassed search engine giant Baidu to become the third largest listed Chinese internet company in terms of market capitalisation.

“Numerous capital was invested in fields where there shouldn’t have been so much investment. The capital driven method only works in certain industries,” said Hu, adding that success was more dependent on factors like the nature of the business and how well each company was managed.

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