The Underdevelopment of Incentives in the Operation of Chinese Domestic VCs

The third chapter has outlined that Chinese domestic VCs have fallen behind their American rivals in the first phase of the whole cycle of VC—fundraising, due to the institutional barriers resulting from the corporate governance of Chinese state-controlled listed companies. This chapter will move forward to the second stage of the operation trajectory of VC—the section regarding injecting venture funds into selected start-ups. For the sake of the success of the joint venture invested in by both venture capitalists and entrepreneurs, three aspects must be well devised in the above period. First, venture capitalists must determine with what type of organization they plunge venture funds into targeted enterprises. Under the condition that they are allowed to participate in the VC sector, investors who are rational persons will show a different extent of willingness to make investments in this industry when they face different organizations adopted by venture capitalists to structure venture funds. In turn, the different magnitude of investments made by investors has substantial influences on the sufficiency of the money supply for entrepreneurs. Obviously, the selection of venture capital organizations can be placed in the third chapter if we consider this aspect from the perspective of fundraising. However, in this book, it is preferably viewed as the outset and incentive mechanism of the investment process of VC and will be discussed thoroughly in this chapter. Second, in order to persuade themselves to contribute money to start-up firms which are associated with high uncertainty and great information asymmetry, venture capitalists must work out the contractual mechanisms that they will apply to their portfolio companies for the purpose of minimizing risks and accomplishing harvests of investment. Third, venture capitalists must ensure that the management of start-ups has incentives to perform their best for the success of the venture and to accept the reduced control over the entity in return for the pecuniary and non-pecuniary support from VC. Essentially, the three aforementioned issues collectively refer to the selection and application of organizational and contractual incentives in the operation of VC. In this regard, the successful practice of American VCs as a mirror to reflect the corresponding deficiencies besetting their Chinese counterparts will be still used. More importantly, it will be demonstrated that the absence and underdevelopment of incentive structures in Chinese domestic VCs are at least loosely linked to the control-based model of Chinese state-controlled listed companies. Here, it is to be noted that some popular incentive mechanisms with American VCs were once absent for quite a long time in China as a result of legal prohibition. This kind of unavailability was not only applicable to Chinese domestic VCs but also to the Chinese operation of American VCs. Therefore, with the equal impossibility of relying on those variables, the Chinese triumph of American VCs was largely ascribed to their advantages of other parts over their Chinese competitors. However, now that the Chinese legislature has legitimated them by revising laws, those incentive tools ought to be seen as valid variables to be analyzed by this book because American VCs have swiftly integrated them into their Chinese practice, but Chinese domestic VCs have always held an indifferent attitude toward them and even have adversely deformed them owing to the institutional obstacles set up by the control-based model. In addition, some of the incentive mechanisms analyzed below, such as staged financing, board representation, convertible preferred stocks, and stock options, usually belong to commercial secrets between VCs and their portfolio companies. Therefore, it is unrealistic to directly acquire related statistics and the contracts and agreements that stipulate such issues as evidence. In this case, only indirect proof regarding those incentive tools through carrying out interviews and retrieving secondary qualitative sources can be sought. Even so, in certain aspects of Chinese domestic VCs, only the operation of GVCs has been acquired. Consequently, in several places below, this chapter uses GVCs as the sample to conduct the analysis for Chinese domestic VCs. On the one hand, GVCs can basically represent Chinese domestic VCs taking into account their dominant position described in the third chapter. On the other hand, the unavailability of complete information also reflects the fact that every research has its own limitations. This chapter consists of three sections: The first section will briefly introduce the successful incentive structure of American VCs. The second section will prove the linkage between the underdevelopment of incentives in the operation of Chinese domestic VCs and the control-based model with the American mirror. The final section will be a concluding remark.