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Image: Shutterstock

Image: Shutterstock

The goods news is investors still have plenty of money. They just become more cautious when making investment decisions

The coronavirus (Covid-19) outbreak has hit China's startups hard, but they were already contending with a decline in funding long before this blow landed.

In the latter half of 2015, articles about China's capital winter began to appear in the media. Back then, China's food delivery giant Meituan slashed its valuation from a lofty $15bn to around $10bn in two months. The social commerce startup Mogujie reduced its valuation to $1.6bn from $2bn, as the renowned private equity firm Carlyle Group withdrew from the negotiations for its Series E funding. 

Many startup founders were worried about the possible shift in the capital market. China's stock market crash in August 2015 added to their concerns. But it was not until 2019 that they began to feel the real chill, with funding deals nearly halved from a year before. During the first 11 months of 2019, Chinese startups raised a total of RMB 753bn funding, only 43% of the amount raised in 2018 and the lowest since 2015. 

The slide accelerated this year. During the past month and a half, venture capital activities in China, both in terms of deal numbers and the invested in startups, dropped over 60% compared with the same period last year. 

Latest blow from Covid-19

The Covid-19 outbreak has exacerbated an already difficult situation.

As the Chinese government tried to curb the virus spread, countless businesses were shut and millions of people were stuck at home. Startups, especially those relying on offline operations and spending, were significantly affected. 

Leading investor Zhu Xiaohu considered it a life-and-death matter for many of them. “The situation is much worse than the 2003 SARS crisis. Startups need to have cash at hand for at least six months to survive the epidemic,” said Zhu on February 2 via his WeChat Moments.

Neil Shen, the founding partner of Sequoia Capital China, expects the outbreak to pose a big test for startups as they cope with sustaining business operations as well as with fluctuations in fundraising. As part of China's containment efforts, strict travel restrictions have made it nearly impossible for investors and startup founders to schedule face-to-face meetings. 

Sequoia Capital China, one of the most active tech investors in China, tried to get deals done by moving fundraising online. In February, nearly 30 startups pitched to more than 50 investors via its online event “Demo Day.”

The current situation is much worse than the 2003 SARS crisis

Despite the decline in the coronavirus infection rates in March and the easing of restrictions on movement, VC activities remain likely to be disrupted for some time to come. 

“For tech startups like us, the cashflow can only last for three months,” said an anonymous founder of a Shenzhen-based IoT startup. His company started a funding round last November, and one prospective investor planned to proceed with due diligence after the Chinese New Year. The founder no longer knew where things would go amid the outbreak.

A shrinking funding pool?

In the longer term, the Covid-19 outbreak may be seen as reinforcing prevailing trends affecting funding.

“It’s commonly agreed that startups [in China] face a hard time raising money,” said David Zhang (Zhang Ying), the founding managing partner of Matrix Partners China, via a WeChat Moments post in October 2019.  

This statement led to speculation that his VC firm was running out of money, which  Zhang denied immediately. But the truth is that it had been getting much harder for many VC funds, especially smaller ones, to raise money in 2019 because of the economic slowdown and the uncertainties brought about by the US-China trade war. 

According to data released by the consulting firm ChinaVenture, the total of VC/PE funds managing to raise money in 2019 was 562, compared with 858 in 2018. The amount of money funds raised increased from to $140.8bn from $111.6bn in 2018, with the top 10 institutions accounting for 44% of the total. 

Although leading investors still have abundant cash to invest, they are becoming more cautious and slowing down their investment-making. In 2019, 2,923 out of a total of 4,650 VC/PE firms made only one deal each. Only 16, or 0.34% of the total, made over 30 deals. “It took three to six months to finish a financing round before, but the cycle lengthens to six to nine months this year [in 2019],” said Zhang Lijun, partner and executive director at Sinovation Ventures.

But that doesn’t mean investors don’t want to invest in startups. They just don't want to waste money on those that failed to live up their expectations, and a sustainable business model is what they are looking for, according to David Zhang.

Generally speaking, investors now prefer growth-stage startups to early-stage ones. In 2019, seed funding deals account for 21% of the total, compared to 42% in 2017.  Investors also have their favorite sectors. The IT sector landed the largest number of deals in 2019 - 808 in total. 

Founders should figure out how to better run business and control cost

Internet-related startups were the most-funded sector, raising about $10.5bn. Earlier this year, Hillhouse Capital Group spun off its VC business as an independent fund, named GL Ventures, to invest in Chinese startups. With RMB 10bn under its belt, GL Ventures will mainly put money into four areas: biomedicine and medical devices, software services and tech innovations, consumer-oriented internet and technology, and emerging consumer brands and services.

How to survive the winter? 

Despite their willingness to fund promising startups, investors think the winter might last long. Spring will not come back until startups improve their operational efficiency and profitability, and unsustainable businesses are forced out of the market. 

A capital winter is not all bad news for investors. After all, “we will see more reasonable startup valuations and higher capital efficiency,” said Fu Jixun, managing partner of GGV Capital. During a capital boom, many startups end up with unreasonably high valuations, which would keep investors away when investment in startups has entered a cooling-off period. 

Investors have turned against the business model that burns cash in early days to win market share, as shared-bike startups used to do amid the venture investment boom. That fiasco has proven that the costly user-subsidies model is not sustainable. 

As to how to survive the tough funding conditions, investors say startups should focus on their products and innovation while reducing reliance on funding to keep their business afloat. More importantly, “founders should figure out how to better run business and control cost,” added James Shen, Vice President of Qualcomm and Managing Director of Qualcomm Ventures.

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Edited by John Gee

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