Welcome everyone to another edition of my China Tech Law Newsletter. OK, as you can see above, yes I need to get better at keeping my eyes open for pictures!
Now, for those of you who have caught more than just a few posts here, you probably know how much I enjoy working with founders of companies. You can feel the energy they have for trying to make their venture successful, and its fun to tag along for a bit of that ride.
I wanted to take this opportunity to highlight some of the amazing work of one of my clients, Dominic Penaloza and his team. And to use Dominic’s experience as an example of some of the things I’ve highlighted before on helping startups.
Dominic is founder and CEO of Peace. Its a network of large work pods, “Peace Pods”, which can each seat 4 people for “Privacy On Demand”- to take conference calls, conduct business meetings, or have a third space more comfortable and convenient than Starbucks to get work done. You book and prepay on the Peace App. The pod itself is locked, with accessory chargers, speakers, WIFI, COVID-killing air ventilation, and its soundproof.
Peace demonstrates some of the points I raised in previous posts:
1. Some of the best startups are launched during the most difficult times.
Early stage funding, even in challenging times, is still out there. Some of the best funds and other investors 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 environments.
I saw Dominic launch Peace coming at the end of an incredibly difficult 2022 in Shanghai, with lockdowns and extreme COVID prevention measures in place. That Dominic was able to secure the funding to launch in this environment is a testament to the solution and business model he has developed with his team and the experience and credibility that someone like Dom, former successful entrepreneur and former CTO at WeWork China, brings to the venture.
As mentioned in an earlier post, while 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 - still there is capital being raised for deployment in China (case in point Sequoia China’s $9 billion fund). These major funds are also investing in smaller checks at earlier and earlier stages, even at amounts of US$5 million and under. Angel investors, super angels, and seed funds (while cautious) still continue to invest in seed rounds but choose much more carefully these days.
The same can be said for founders. China is now a stepping stone for taking successful technology and business models and launching outside China quickly. Dominic and Peace will be part of that trend as well. Launched in China - but built to go global from day 1.
2. Structures and Chinese investors
Many foreign founders based in China, and especially foreign founders like Dominic with a global solution, often struggle with whether to pursue and take local funding from investors in the local currency RMB. But as I mentioned in an earlier post, its already hard enough to make a structure work where you have part of the business outside of China and part in China with a JV partner. Where the local JV partner is worried about value leakage. A similar problem occurs for financial investors if you were investing down at the local China company level and the other financial investors and founders were holding their shares at the parent holding company level offshore.
What if that parent company started keeping some of the overseas customer payments out at the offshore level instead of feeding into the local company even when the work was done locally? Or it started setting up a business in say Southeast Asia and started bringing some of the best managerial talent, IP, or other resources out of China to get that new business off the ground. The China shareholder isn’t seeing any of that value with its ownership only in the Chinese entity, right?
So for both the benefit of all investors, we generally want all investors, especially financial investors, sitting at the same (highest) corporate level in holding their shares.
3. More power to the founders
I mentioned in a previous post here, in general, the long-term trend on legal terms from investors vis-a-vis founders has gotten remarkably better. In helping Dominic close his funding round, we certainly saw some unusual and quite putative terms suggested. Luckily, Dominic again based on his experience and confidence in the business plan was able to secure investors on fair terms and turn away others with specific demands.
In the past, founders might be more agreeable to extreme pro-investor terms knowing either they were harder to enforce or simply not knowing how “non-market” those terms were in the first place compared to terms offered to founders in say Silicon Valley. But, as discussed when I was interviewed by Gary Ross for his American Bar Association VC Podcast, now that many founders in China have started multiple businesses over the years, there is no more information gap as to what is market standard across different geographies.
4. Prevalence of SAFEs as a first investment contract
One last trend I’ve mentioned before as well is the simplification of the initial rounds as far as legal documentation goes (similar to the US), even as those seed rounds get bigger and bigger (also similar to the US). Dominic’s seed round followed the same story - a simple SAFE agreement based on the template provided for by Y-Combinator (discussed in a previous post). The hardest part of a seed round is coming up with a valuation for a yet unproven business with no financial history to use a traditional valuation model. The SAFE agreement “kicks the can down the road” by having the valution for this round tied to the first formal “institutional” round where a larger VC will come in as a “priced” round with an actual valuation. For Dom’s round and others, this helps with a relatively quick closing for everyone involved.
OK, that is all for this edition! I truly enjoy working with smart, dynamic clients that bring out the best in us lawyers, like Dom. Thank you for reading and I'll see you back here in two weeks!