Welcome to another edition of my China Tech Law Newsletter. I talked about the evolution of startup fundraising in China in an earlier post here. This post is on tech startup fundraising in China and elsewhere during current, more difficult times. As many news agencies have reported, startup fundraising since Q2 this year, especially for tech companies in China, has dramatically decreased. This cycle of course repeats itself every 2-3 years or so. I distinctly remember the freeze immediately after COVID and then prior to that the end of 2016 or so.
Its a perfect excuse to talk about some of the issues that come up as companies are trying to hold on to as much “runway” as possible until liftoff and escape velocity towards that future IPO. Its not just startups, of course. We've seen the recent, spectacular collapse of NASDAQ listed Miss Fresh - a business which was burning too much cash without sustainable unit economics.
Some points I’d like to mention:
(1) Investor downside protections don't matter too much
My friend Benjamin Qiu and I talked about this once on a podcast. Venture capital funds, especially in China, build in lots of “downside protection” with things such as redemptions and anti-dilution protections. Redemptions meaning an investor can get their money back after a certain period of time if no IPO or M&A transaction has happened by a certain date. Anti-dilution protections meaning in case a company raises a new round of funding at a valuation less than the current investor’s price per share, the current investor can get some or (gulp) all of the benefit of that lower price automatically (kind of like a MFN clause). This is a penalty provision which in practice takes shares almost entirely out of the founders hands and into the investors.
In reality of course, a redemption is rarely used because the company is either (1) doing well, so why would the investor simply want their money back? Or (2) the company is doing poorly - so no cash is available to pay for the redemption.
This goes to the bigger point - that founder penalty provisions can only be taken and enforced so far by investors. At the end of the day, if they are too harsh and leave the founders without enough shares, the founders may simply decide that they have been sweating away, underpaid for too long now and pack up their bags to do something else with their lives. Investors know this, and these provisions are there more as a means of leverage only when there is a fundamental disagreement on strategy, timing for an exit, or bringing on new investors.
Nor of course are investors chomping at the bit to enforce these penalty provisions, as sinister as some people think venture capitalists might be. Make no mistake, a downround coupled with anti-dilution triggers is a not a positive message to the market (both the investor market and the customer market) and startups will try everything possible to avoid it short of having to pull the plug on the business.
(2) Bridge rounds and signaling
In times like these, one of the biggest tensions out there is where existing investors are asked to help bridge a company to its next round by raising a minimum amount of funding through a convertible note or SAFE to get through to brighter fundraising times ahead. Many investors, with sufficient skin in the game, will fund the bridge. Kind of like a game of poker.
Nothing, of course, signals extreme caution to the external market more than when existing investors are not willing to fund the bridge. And existing investors contemplating funding a bridge round know this, and will think twice about not funding. Those investors should have the most insider insight into the long-term prospects of the company and the team.
While funds, especially seed stage funds, won’t have the powder or desire to invest too much into one portfolio company beyond their pro-rata amounts, later stage funds will. The general rule is, a later stage company will have larger investors making fewer bets on different companies. They’ll have more incentive to see their fewer big bets fight on and fund a bridge round.
(3) Don’t expect litigation
Another approach investors love to use when times are good, is to hold founders to their usually unrealistic (hockey stick) growth projections either in reps and warranties about the business or putting founders’ equity on a vesting schedule. Yet when things do go poorly, rarely would you see at any stage an investor sue against founder or company reps and warranties or other covenants made in an investment contract, absent outright fraud or other insider dealings with the company. Investors know the risks of investing in startups, and know the costs of litigation - both legal costs and reputational costs. Founders in turn, understand investors are not likely to sue and so will be tempted to agree to provisions they know investors will not ultimately enforce.
(4) Funding alternatives
For all these reasons, we see new companies turning to crowdfunding, particularly these days when traditional venture capital investors are more cautious or when a company is pre-revenue with a long product development cycle. Make sure you get on an established platform which is fully vetted on the regulatory side. There are very clear do’s and don’ts for both platforms and founders in raising money in these quasi-public ways to avoid the issue of triggering or violating SEC disclosure and registration requirements on a securities offering.
(5) There are still active VCs
They are out there, although a bit harder to find right now. But some of the best funds invest now when the bargains are there and founders are forced to make their businesses more focused. Its been well documented that some of the best startups like Airbnb were born in difficult economic and fundraising times.
We have seen for some time now established China venture capital funds diversifying out of China more and more with a focus on using their China experience to find the next Meituan, Pinduoduo, or Xiaohongshu in Southeast Asia or India. But there is still capital being raised by the big boys here in China for deployment in China (case in point Sequoia China’s new $9 billion fund). These major funds are also investing in smaller checks at earlier and earlier stages, even at US$5 million and under.
The startup fundraising market in China (and globally) may be down now, but if history is in any indicator, it will be back again before too long.