Three Major Problems Of Equity-Based Crowdfunding With Chinese Characteristics

摘要: Recently, it was reported that something went wrong with an energy crowdfunding project of Hongli Energy run by 36 Kr’s crowdfunding platform. Hongli Energy’s reported sales in 2015 didn’t match with its practical one, and thus it was charged with fraud. What's wrong with equity-based crowdfunding with Chinese characteristics? What are the major problems out there? What role did Chinese crowdfunding platforms play in the process?

(Chinese Version)

Recently, it was reported that something went wrong with an energy crowdfunding project of Hongli Energy run by 36 Kr’s crowdfunding platform. Hongli Energy’s reported sales in 2015 didn’t match with its practical one, and thus it was charged with fraud. Based on 36 Kr’s official response, there was indeed such fraudulent behavior. Despite all these charges, we’ve become increasingly aware of a rapidly-developing start company in China, 36 Kr.

As 36 Kr enjoyed the benefit as an early internet startup, it soon rose to become a star company, and its founders also rose to fame at a young age (though no longer young now). However, there are numerous challenges on the way from fame to success, and whether one could appropriately address these challenges or not will determine if one could rise from fame to success.

Fame begets trouble?

With the rapid development of internet, promising young Chinese entrepreneurs, especially those who were born after 1985 or 1990 and grew up with internet find it easier to become the focus under the glare of media spotlight, and many young Chinese entrepreneurs have already become quite popular among public.

Yet, when their startup projects develop into a certain degree, they would have to calm down and figure out ways to make profit out of their startup project. Oftentimes they would find that running a startup was no different from running traditional business fundamentally, and that operation experience of traditional businesses and in traditional industries were equally important. For example, internet new media 36 Kr has to make profit through financial approaches, and internet social networking brand 3W Coffee has to turn to the real estate industry in order to make profit.

However, young Chinese entrepreneurs are lacking in enough operation experience in these traditional industries.

Therefore, Chinese startups might often find themselves bounded by the natural limit of their founders.

Fortunately, these star startups have already accumulated enough advantages in terms of brand awareness, first-moving ability and capital support, etc., so that can just recruit professional managers to make up for the limits of their founders. However, when a startup reaches this stage, it’s no longer a company centered around product, but a rising company centered around management. Thus, some fundamental difference, whether cultural or conceptual, between newly-recruited professional managers and original members in the startup will be fully exposed:

  • Above all, is a startup well-known enough so that elites from traditional industries will be willing to join it?
  • Secondly, will the newly-recruited professional managers be able to fully understand the culture and advantage of the startup and give full play to their own advantages?
  • Thirdly, is there enough time for professional managers to carry out the entire profit-making plan?

Take 36 Kr for an example: after 36 Kr set internet finance, equity crowdfunding and financial advising as its major business, it followed that the introduction of veteran workers in the finance industry would become the first and most important thing to do. Thus, if these newly-recruited professionals will be able to make it clear their business model and manage risks will directly determine if a startup will continue to rise.

In this sense, the “scandal” shows that the introduction and integration of professionals from traditional industries to startups might not be as smooth as expected. Instead, we see lots of obvious mistakes for professionals from the scandal.

Three problems of equity-based crowdfunding with Chinese characteristics

At present, amid the craze for entrepreneurship and investment, numerous equity-based crowdfunding platforms are established in China. Players from various backgrounds are able to conduct such a promising business. In this case, it should have been a great choice for 36 Kr, a gateway towards huge traffic, to decide to list equity-based crowdfunding as one of its main businesses.

However, there are three fundamental problems of equity-based crowdfunding with Chinese characteristics.

Problem One: Letting people with low risk tolerance bear high risk

In the US, angel capital investors mainly invest money on an individual basis. Although there are lots of angel capital investors, the number of angel capital investors for a startup project is generally quite limited, and they are generally well aware of the possible risk venture capital investment.

In China, however, internet-based equity-based crowdfunding platforms often gather money from too many “angel capital investors” for a single startup project. Such diversity in the source of investment means that some investors might not be able to bear the risk, others might not really understand what venture capital investment really is.

At the same time, it is well-known that the success rate of internet startup projects is low. In other words, most startup projects will end up in failure. However, are these large crowds of investors well-prepared for the possible failure?

In a word, Chinese equity-based crowdfunding platforms brought venture capital investing to ordinary people, but failed to change its high-risk nature. The paradox is obvious: how can ordinary people properly understand equity-based crowdfunding, let alone bear the risk?

Problem Two: The lack of a proper exit mechanism

One will have to shorten the cycle of return on investment to lower the risk of equity-based crowdfunding. As is known to all, it usually takes a long time for a startup to gradually rise and develop and finally enable an IPO or be acquired and make profit, so investors who are looking for return in a short time shouldn’t have invested in such projects. At abroad, there is a mature system defining and regulating the role of investors in different round of investment, from angel capital, venture capital, private equity, to IPO. So generally speaking, angel capital investors usually drop out before the next round of investment and enjoy a steady return. This is exactly why YC Incubator succeeds.

In China, however, guanxi, or relationship, play a great role in the decision if investors will invest in a startup project or not, and investors generally will continue to invest in a startup project in the next rounds of investment so as to show their trust in a startup project and not damage the “guanxi” with the startup. In other words, it’s pretty hard for Chinese investors to “exit” halfway. When angel capital investors continue to invest in a startup rounds after rounds, the cycle for return on investment will be prolonged.

Although Chinese equity-based crowdfunding platforms such as 36 Kr have already successfully raised financing for several startup projects, the lack of a clear-cut exit mechanism and the uncertainty of the cycle of return on investment conspire to raise the risk of investment and stir up doubt for investors who take part in without a proper understanding of what they are really doing.

Problem Three: The huge political risk caused by circumventing government policies

Although the Chinese government has strict rules regulating public fundraising behaviors such as equity-based crowdfunding and has laid out the maximum number of shareholders, most Chinese equity-based crowdfunding platforms circumvent the regulation by setting numerous legal persons. Although the number of shareholders on-the-table may be in line with the government regulation, there are so many more “hidden” shareholders (crowdfunding investors), which significantly raise the risk.

However, nobody knows if the startup will be denied in the bidding for IPO due to so many “hidden” shareholders. That is to say, although Chinese equity-based crowdfunding platforms circumvent the government regulation temporarily, startups might be left in an embarrassing situation one day. So there is huge potential political risk here.

At the same time, it will certainly take a long time for ordinary investors to improve their understandings of venture capital investment and for a mature venture capital investment mechanism to be established. This is a challenge not only for the entire industry, but also for internet startups such as 36 Kr.

It’s easy to rise to fame due to a startup project, yet difficult to succeed at last.

On the one hand, a startup has to go through several stages of development, continuously upgrade itself and break through the glass ceiling of its founders in order to succeed at last. And for sure, the road to success will be filled with hardship, negative reports as well as all types of crises and scandals.

On the other hand, the development of a startup has to do with not only the development of its own team, but also social, legal and market environment as well as the change of the entire industry. Without a favorable background environment, the road from fame to success will be a long and torturous one. To succeed, a startup will have to find a good timing and geographical environment as well as maintain good human relations.

Again, I want to reiterate that it’s easy to rise to fame due to a startup project, yet difficult to succeed. Sometimes, fame might even become a burden. In an age of impetuousness and impatience, the only way to shorten the road from fame to success might be to always stay humble, patient, cautious and pragmatic.

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[The article is published and edited with authorization from the author @bondluan, please note source and hyperlink when reproduce.]

Translated by Levin Feng (Senior Translator at PAGE TO PAGE), working for TMTpost.

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