An institutional view of China���s venture capital industry Explaining the differences between China and the West Garry D. Brutona,*, David Ahlstromb,1 aDepartment of Management, M.J. Neeley School of Business, Texas Christian University, TCU Box 298530, Fort Worth, TX 76129, USA bDepartment of Management, Chinese University of Hong Kong, Shatin, N.T. Hong Kong, China Received 30 June 2000 received in revised form 30 August 2001 accepted 31 October 2001 Abstract Institutional theory argues that institutions in general, and culture in particular, shape the actions of firms and individuals in a number of subtle but substantive ways. The theory has been used to explain a number of significant and substantive managerial differences found in different parts of the world. To date, the examination of venture capital outside the US and Europe, however, has been rather limited. Institutional theory also suggests that there would be differences in how venture capital may operate in other parts of the world, such as Asia where the culture is substantially different from the West. Based on interviews with 36 venture capitalists in 24 venture capital firms investing in China, this exploratory research finds that China���s institutional environment creates a number of significant differences from the West. The article discusses the impact of these findings on future research on Asian venture capital, theory development, and the activities of venture capital professionals in that region. D 2002 Published by Elsevier Science Inc. Keywords: Venture capital Institutional theory China Private equity 1. Executive summary Venture capital has been widely studied in the US. However, its examination in other settings has been limited. In Asia, the examination of the industry is almost nonexistent, 0883-9026/02/$ ��� see front matter D 2002 Published by Elsevier Science Inc. doi:10.1016/S0883-9026(02)00079-4 * Corresponding author. Tel.: +1-817-257-7421. E-mail addresses: g.bruton@tcu.edu (G.D. Bruton), davidahlstrom@cuhk.edu.hk (D. Ahlstrom). 1 Tel.: + 852-2-609-7748. Journal of Business Venturing 18 (2003) 233���259

despite the fact that the industry raised new investable capital of over US$7.4 billion in 1998 alone. It cannot be assumed, however, that Western practices are universal around the world. China is one of the world���s fastest growing economies and is home to approximately one- quarter of the world���s population. Based on three dozen interviews within venture capital firms active in China, this article examines that nation���s venture capital industry. It establishes from this information a basic understanding of how institutions within the country shape the venture capital industry. It is clear from the information developed that both the challenges encountered by venture capitalists and the nature of the investment framework employed in China differs markedly from that of the West. For example, the screens employed to initially evaluate ventures are different than in the West. The need to fund ventures within reasonable physical distance to accurately monitor those firms and the avoidance of firms without proven or checkable financials are among two differences from of the US. Similarly, since the ability to accurately obtain full information on a firm is so constrained, due diligence commonly focuses on the entrepreneur���s background and their contracts even more so than in the West. Once the deal is funded there will also be fewer value-added activities provided by the venture capitalist than would occur with funded firms in the US. Chinese culture promotes resistance to such activities since they are viewed as more intrusive than would be seen in most Western settings. Additionally, the nature of the monitoring function by venture capitalists is far different in China than it is in the US. There is a need in China for much more direct monitoring of funded firms. Overall, it is clear from the evidence presented that the institutional environment in China, and possibly Asia in general, is different enough to make the practice of venture capital different from that of the West. Thus, venture capitalists from the West must be careful to ensure they understand these institutional differences when participating in the market. 2. Introduction Institutional theory holds that the beliefs, goals, and actions of individuals and groups are strongly influenced by various environmental institutions (Scott, 1987, 1995), and that their role in doing this is subtle but pervasive (Boisot and Child, 1996 Child et al., 2000 Clarke, 1991). However, to date, research from the West has only started to account for the role that different institutional environments play in transition economies, such as China���s, (Boyacil- lier and Adler, 1991 Shenkar and Von Glinow, 1994) and how these differences can help create different organizational and commercial systems (Peng, 2000 Peng and Heath, 1996). This paucity of examination on institutions in transition economies is particularly true of entrepreneurial domains (Giamartino et al., 1993). China���s institutional environment is quite different from the West (Boisot and Child, 1996 Peng, 2000 Peng and Heath, 1996). The nation���s socialist tradition and strong culture together create a distinct social and commercial milieu (Boisot and Child, 1988 Child, 1994 Scarborough, 1998). For example, private firms in China still have limited discretion to acquire and allocate resources and conduct operations (Peng, 2001). Additionally, firms must G.D. Bruton, D. Ahlstrom / Journal of Business Venturing 18 (2003) 233���259 234

often engage in some transactions where personnel connections matter more than firm capabilities (Boisot and Child, 1996 Peng, 2000 Xin and Pearce, 1996). Also, few managers in China have much experience in competing in a market-based economy (Bjo ��rkman and Lu, 1999). Corporate governance and property rights are typically spotty, and fund allocation, even by private firms in China, must often observe political and other nonmarket motivations (Clarke, 1991 Peng, 2001 Peng and Heath, 1996 Tam, 1999). Thus, for researchers in entrepreneurship, China���s institutional environment provides a compelling context to examine and refine our understanding of how institutions may impact firms (Boisot and Child, 1996 Peng et al., 2001), and in turn create differences in entrepreneurial efforts from those of the West (Peng, 2000, 2001). Venture capital plays a crucial role in the West in the development and growth of entrepreneurial firms (Patricof, 1989). However, the venture capital industry in much of Asia remains largely unexplored (except for Japan, e.g., Hurry et al., 1992 Ray and Turpin, 1993), in spite of the venture capital industry in Asia (excluding Japan) raising over US$6 billion of new capital in 1998 alone (Guide to Venture Capital in Asia, 2000).2 It should not be assumed that the Asian venture capital industry is equivalent to the US industry (Ahlstrom et al., 2000 Boisot and Child, 1996 Chow and Fung, 2000). Institutional factors in China may be creating a venture capital industry with its own idiosyncratic characteristics (Bruton et al., 1999). The research employing institutional theory in China has tended to emphasize the constraining nature of institutions (e.g. Boisot and Child, 1988 Peng and Heath, 1996). Yet institutions not only specify limits, they also create frameworks that enable certain action (Garud and Jain, 1996 Peng, 2000) and minimize transaction costs (Standifird and Marshall, 2000). To illustrate, China is widely recognized as having a turbulent environment, often hostile to business (Peng, 1997 Steinfeld, 1998). The prevailing attitude of China���s government views private ownership as acceptable only to the extent it remains an appendage of public ownership (Tan, 1999). While these institutions prescribe limits on the actions venture capitalists can undertake, they also can establish an enabling framework that helps the venture capitalists and their funded firms to be successful in China when that framework is understood and utilized (cf. Peng, 2001). Therefore, both the enabling and constraining functions of institutions will be examined here (Garud and Jain, 1996). To investigate how the venture capital industry functions in China���s environment, this article begins with a brief examination of institutional theory and its application in China. It then reviews the background of the venture capital industry in China. Next, based on interviews with venture capitalists active in China and three funded firms, the article identifies a framework by which venture capital operates in China and how this compares and contrasts with that of the West. Specifically, four key aspects of venture capital in China will be examined: the selection process for prospective funded firms, structuring of relationships and 2 Venture capital is typically associated with earlier stage ventures in the West while private equity is typically seen as a more inclusive term that would also include activities that involve more mature firms such as buyouts. The industry in Asia is much younger and smaller than in the West. G.D. Bruton, D. Ahlstrom / Journal of Business Venturing 18 (2003) 233���259 235

monitoring the firm, value-added activities provided to the funded firm, and exit. A discussion of implications of these findings for theory development, future research, and practice then follows. 2.1. Institutional theory Institutions can strongly influence the goals, and beliefs of individuals, groups, and organizations (North, 1990 Scott, 1995). There is support in the West for the belief that institutions have such an impact on the goal formation and processes of venture capital firms (Wright et al., 1992 Bruno and Tyebjee, 1986 Suchman, 1995). The belief is that such institutions have led to strong uniformity in venture capitalists behaviors (Fried and Hisrich, 1995). For example, prior research has found many similarities between US and European venture capital industries (Sapienza et al., 1996). It has even been argued by others that venture capitalists have a similar worldwide model of funding, particularly for latter stage ventures (Jeng and Wells, 2000). It remains to be seen how institutions actually impact the actions of venture capitalists in different parts of the world, particularly in Asia. The conclusion reached by Jeng and Wells (2000) was based on data where New Zealand served as the only Asian representative in the sample, while the rest of the data was European or North American.3 Asia in general, and China in particular, has an environment that is substantially different from the US or Europe (Boisot and Child, 1988, 1996 Peng, 2000). This has led some to the alternative belief that venture capitalists will adjust to the local institutional environment making a number of changes in the process and creating a different model of venture capital in the process (Bruton et al., 1999). Before employing the theory as the basis to evaluate the Chinese venture capital industry it is first necessary to be clear about the nature of such institutions. The two broad approaches to analyzing institutions are sociological and economic, which can be complimentary to each other (Hirsch and Lounsbury, 1997 Scott, 1992). Sociologists primarily focus on legitimacy- building and role-shaping actions of institutions (Suchman, 1995), examining in particular widely shared beliefs that shape the way people in a society think and behave, arguing that behaviors are institutionalizable across a wide range of actions. Such beliefs and actions can arise out of shared cultural and political systems (Scott, 1992 Zucker, 1987). Organizational life and commercial conventions persist due to the taken-for-granted nature of institutions and their self-sustaining ability (DiMaggio and Powell, 1991). Drawing on neoclassical economics, North (1990) argues that the institutional frame- work of a society provides a formal rule framework regulating economic activities. For economic institutionalists, the relevant framework is a set of political, social, and legal ground rules that fixes a basis for production, exchange, and distribution in a system or society (North, 1990 Roy, 1997). Such institutions tend to shape a system by structuring political, social, and especially economic incentives involved in exchange. Once institutions 3 New Zealand is culturally much closer to the UK and the US than to China (Backman, 1999). G.D. Bruton, D. Ahlstrom / Journal of Business Venturing 18 (2003) 233���259 236

are established, they create constraints that are locally rational in an economic sense, but collectively may be suboptimal (DiMaggio and Powell, 1991 Powell, 1991 Zucker, 1986). These limits to the set of choices of individuals and organizations provide, however, a predictable and understood structure one that has an instrumental if not always an econom- ically efficient basis (Roy, 1997). Building on DiMaggio and Powell (1983, 1991), North (1990), and Selznick (1957), Scott (1995) more finely categorized these formal and informal institutions into normative, regulatory, and cognitive groupings. The most formal are the regulatory institutions representing standards provided by laws and other sanctions. Normative institutions are less formal or codified and define the roles or actions that are expected of individuals. Normative institutions are often manifest through accepted authority systems such as accounting or medical professional societies. Finally, cognitive institutions represent the most informal, taken-for-granted rules, and beliefs that are established among individuals through social interactions among various participants. A principal means by which cognitive, and less formal normative institutions propagate and influence a society is through a community���s culture (Jepperson, 1991). Although this organizing scheme of institutions is not without controversy (e.g., Hirsch and Lounsbury, 1997), it has been widely used and has proved helpful for analytical purposes. Prior research on institutions in China has typically emphasized their constraining nature, such as how various types of institutions regulate economic exchanges (Xin and Pearce, 1996), limit business activity (Boisot and Child, 1988, 1996), or reduce uncertainty by lowering transaction costs (Standifird and Marshall, 2000). Less commonly examined is the institution���s ability to enable action (Garud and Jain, 1996 Peng, 2000). To illustrate, grammar prescribes limits on how sentences may be constructed. Yet, the common grammatical rules enable consistent, accurate communication and the construction of new conceptual terms. Similarly, technological standards such as the common Windows platform create a number of constraints for developers but Windows also enables more rapid advances by creating a standard allowing the sharing of work and information among developers and users (e.g. Majumdar and Venkataraman, 1998). Thus, institutions need not be viewed solely in terms of their constraining nature, they also enable actions that create opportunities for those who understand and use them. Some literature on venture capital in the West (e.g. Fried and Hisrich, 1994 Suchman, 1995) has shown that institutions present in the West play a significant role in shaping the values and actions of venture capitalists. Before large-scale empirical examinations of China���s or the broader Asian venture capital industry can occur, exploratory efforts should establish an understanding of how the institutional environment in China influences the industry in the region. This research will establish a baseline of understanding of the venture capital industry in China upon which future research can build. 2.2. Background of venture capital in China With about 25% of the world���s population and one of the world���s fastest growing economies, China���s attractive market has seen a rapid inflow of foreign capital, mostly as G.D. Bruton, D. Ahlstrom / Journal of Business Venturing 18 (2003) 233���259 237