The Lack of Efficient Exit Channels for Chinese Domestic VCs

The fourth chapter has analyzed the shortage of incentive mechanisms in the operation of Chinese domestic VCs in comparison with their American competitors. More importantly, on the basis of this analysis, the hypothesis that the underdevelopment of incentives suffered by Chinese domestic VCs is closely linked to the institutional barriers imposed by the control-based model of Chinese state-controlled listed companies has been demonstrated. Following the fourth chapter, this chapter will explore the last section of the whole cycle of VC—its exit from successful portfolio companies. Prior to making a performance comparison between American VCs and their Chinese counterparts in this aspect, it is essential to answer two relevant questions. First, why does a VC need to exit from successful venture enterprises? Second, what is the optimal exit channel for the principal participants of successful ventures? As for the first question, Bernard Black and Ronald Gilson have made a plausible explanation through the two dimensions below. First of all, the economies of scope between financial contributions and non-financial ones supplied by VCs for portfolio companies require its exit. Practically, venture capitalists provide both capital and non-capital inputs for their portfolio companies. The non-capital inputs, such as management assistance and reputational capital, are especially valuable to startup companies. As the early-stage companies gradually become mature, the relative value of non-pecuniary contributions decreases. Therefore, by the time of the success of portfolio companies, the transfer of non-financial contributions to new startup companies is more efficient and beneficial for VCs. But because non-financial contributions are linked to financial ones, redeploying the former inevitably requires the simultaneous redeployment of the latter—the exit of VCs. Secondly, the relationship between VC investors and venture capitalists also requires the exit of VCs. As capital contributors, VC investors need to rely on a benchmark to estimate the capability of venture capitalists who act as their agents. Exit with the payment of capital proceeds for VC investors just provides such a criterion for the purpose of measuring venture capitalists’ skills. In addition, by means of a successful exit, venture capitalists accumulate valuable track records for their future fundraising as well. The explanation of exit through the perspective of the relationship between VC investors and venture capitalists also includes a standard to guide us to answer the second question—the optimal exit channel. In light of the above analysis, a profitable exit is desired by both VC investors and venture capitalists. Naturally, one characteristic of the optimal exit channel ought to be the highest level of profitability compared with the other available approaches. However, the standard of profitability itself is not enough to help us identify the most efficient exit approach without combining with entrepreneurs’ recouping of control over venture enterprises. As existing statistics have indicated, the likelihood of failure for high-technology startups is fairly high. Thus, many entrepreneurs may not quit their decent jobs to start such a venture if they do not put a large private value on control. Even though entrepreneurs highly desire control, they generally have to hand it to venture capitalists as an incentive mechanism when they seek financial inputs. But at the time that venture capitalists choose to exit as startup companies turn out to be successful, handing over the control to entrepreneurs is more efficient than other choices because those entrepreneurs have proved their managerial skills and have been more familiar with those entities. In addition, the opportunity to regain control also provides an incentive for them to make great efforts which are necessary for success. Thus, besides mere profitability, the most efficient exit channel must guarantee the reversion of control to entrepreneurs as well.