A Large-scale Innovation Engine

Most observers would agree that in China, the government is far more hands-on in terms of shaping commercial activities than in the Western world. Home-grown, emerging multinationals such as Lenovo, Huawei, and Haier are not only dominant players in substituting imports, but they are also groomed to become national champions, competing in the global market. With its state-owned enterprises operating in industries that the government deems strategic, China appears to be an archetypical example of what state capitalism entails. 

Yet, in reality, millions of privately-held, small firms thrive alongside these state-owned behemoths. No one knows exactly to what extent such unplanned entrepreneurial activities contribute to the county’s fast-growing economy. But collectively, private firms employ most of the country’s workers. Less than 15% of the total workforce is employed by state-owned enterprises. As expected, the less centrally orchestrated private sector is usually more daring when it comes to experimenting with new practices. Spontaneous autonomous entrepreneurial activities have proven to be most effective in capturing fleeting market opportunities: Taobao (a Chinese language web site for online shopping), Sina Weibo (a Chinese microblogging website), Renren (China’s social networking giant), and Netease's Fantasy Westward Journey (China's most popular online game) all fall outside the strategic purview of the central government. 

Such bamboo entrepreneurship has its limitations, however. Resource constraints prevent individual entrepreneurs from participating in high-technology, capital-intensive ventures. State-owned enterprises may be well suited to expanding in mature industries, but they are less effective at developing new businesses where flexibility, trial-and-error experimentation, and constant learning are key.  

In the US and other developed countries, start-ups can benefit from stage-wise funding mechanisms when they require significant capital investment. An entrepreneur typically funds a startup through personal savings, along with friends and family. Startups that look promising may receive additional seed funding from angel investors. If business potential is demonstrated, a startup may attract further investment from venture capital funds before finally going public with an initial public offering (IPO). Venture capitalists and angel investors thus provide critical early capital to fund startups before they achieve a solid track record.  

Despite China’s rapid development of its capital market, it continues to focus on late-stage financing, such as for large enterprises looking to raise significant capital from the public, or for medium-size firms receiving funding during what is generally referred to as “VC institutional rounds.” Early stage investment by private investors is uncommon. Financing a startup through bank loans is also difficult. (China’s banking industry is mostly geared to provide state-owned enterprises with cheap capital.) The recent collapse of the shadow banking system further aggravated the financial constraints of startups, but interestingly, a new model is emerging to fill this funding gap.

The Chinese government has set up a number of high-technology incubators that provide finance, physical facilities, and advisory services to technology startups aiming to “domesticate” foreign technologies that the country would like to acquire. While these incubators may resemble those in the US and elsewhere, a few key characteristics differentiate them and may turn them into an important growth engine for China in the coming years.  

First, most of these high-technology incubators are directly sponsored by the government so they do not need to raise money from private or institutional investors. The resultant lower cost of capital (compared to regular venture capital) allows the incubator to take a longer term view when deciding what types of startups to fund.  

Second, these incubators actively seek technological tie-ups with major universities and research institutions both at home and abroad. Many of them co-locate within state-run science parks. The goal is to provide an efficient platform where researchers at academic institutions can commercialize their research. Scientists usually have little experience in fund-raising and marketing; incubators are designed to provide these skills.  

Third, China’s incubators tend to support startups focusing on industrial and engineering products. Because of the prolonged infrastructure boom in China, the business-to-business (B2B) markets offer some of the most lucrative opportunities. Machine tools, tooling items and other capital equipment have been traditionally imported from other advanced countries such as Western Europe, Japan, and North America. Successful B2B start-ups in China often follow a standard formula: 1) assembling a team of top-notch, locally educated PhDs; 2) reverse-engineering high-margin products that are currently imported; 3) maintaining a low-cost structure by eliminating non-critical product features; 4) producing a “good enough” product to serve the local market; and 5) building economies of scale quickly. This strategy works well because these startups are targeting the existing customer segments that are eager to switch to local suppliers rather than remain tied to expensive imports. Unlike Western internet startups that usually target end-consumers, Chinese B2B start-ups are launching low-cost versions of existing industrial products requiring very little effort in customer education.  

New business incubators traditionally run by Western venture capital firms is a concept that is as market-driven as it gets. Oddly enough, the Chinese approach adds an interesting twist: State-backed incubators – a blend between entrepreneurship and state capitalism – may turn out to be an indispensable engine to continually feed innovation into China’s fast-growing economy.  

Howard Yu is Professor of Strategic Management and Innovation at IMD, where he teaches in the Orchestrating Winning Performance and Building on Talent programs. His teaching and research activities focus on why and how some firms can sustain new growth while others cannot.  

Ben Lin is a partner at Great Oaks Venture Capital, a New York-based early stage venture firm. Prior to that, Ben worked with Great Oaks Capital Management LLC.

[This article has been reproduced with permission from IMD, a leading business school based in Switzerland. http://www.imd.org]