China Entrepreneur

When bank funding is tough to get, entrepreneurs may pay a steep price in equity for VC support.

What is it about the area around the Shangri La hotel in Beijing that attracts so many tech companies?

It must be the hotel itself, because it can't be the resolutely down-at-heel environment.

The interestingly-named Ether Building is typical of the location many budding tech companies choose. Cheap and cheerful, it's nevertheless located reasonably close to Tsinghua University, China's wellspring of tech talent, and not too remote from north-western Zhongguancun, the principal concentration of tech resources in China.

Beijing entrepreneurs are a special breed. Unlike their Southern cousins who love to plunge into industries like real estate, many Beijing entrepreneurs come from top schools and are driven by a fascination with technology rather than the desire to exploit any ability for smooth patter and connection building.

Shen Jiye (沈继业), president of network security firm NSFocus (绿盟科技) doesn't break the mould. Simply dressed, he has a modest and dignified bearing. When he speaks about his company, he does so with little artifice or excessive passion. Instead, he gives precise answers to questions, leavened only occasionally with a flashing smile and a joke.

Interestingly, Shen is flanked by two members of Latitude Capital Group a boutique investment bank. I assume that they are shareholders in the company, but Shen says that is not the case.

In fact, they have been hired as financial advisers and Shen's story suggests that it's money well spent.

After being founded in 1999, the company broke even in 2003 and now has 170 members of staff. In financial year 2004, the company is on track to score about Rmb 60 million in revenue and generate net profits of approximately US$250,000. The revenue figure represents 157% compound annual growth rate over the past three years.

In the company's core area of network intrusion detection systems, Shen estimates they have an overall market share of 15%. The total market for China is reportedly almost Rmb 300 million, which as a proportion to GDP is still well below the size of the market in other countries.

While the dynamic growth of the firm is unquestionable, it's unlikely Shen or his colleagues will reach the dizzy heights of China's other tech entrepreneurs. For the last two years, China's richest men have sprung from the tech sector, namely William Ding of Netease who made his billions after the company's Nasdaq IPO, and Timothy Chan, the owner of online games company Shanda Networking, who enriched himself in a similar way.

Shen admits that his biggest mistake in the past five years has been a lack of focus on management and financial issues - although that's being rectified with prospective recruitment of some top level and well paid international hires.

It's an easy mindset to get into. When management issues crop you, it's easy to ignore the problem and plunge even deeper into what you are really interested, which in Shen and his colleagues' case is the technology.

But they paid the price when they ran out of funds. A growing company is vitally dependent on financial input, especially when it's engaged in a race with similar companies for market share. Such a race can often involve lowering prices.

Even when you are winning new market share, you still need the fuel provided by funds. But that wasn't forthcoming from China's notoriously costive banks. Ironically, despite the tech sector attracting much of the country's best talent, banks are reluctant to take a bet on them because they lack the substantial hard assets banks can use as collateral.

It's possible to go via a loan guarantee company, but the typical extra cost of two percentage points over the standard 5% one-year loan made this an unattractive option - consequently, the company has no debt.

So when Legend Capital, an offshoot of Legend Hld Ltd and the Swedish company Investor AB made a bid in 2001, they were able to snap up a very substantial proportion the company's outstanding shares.

However, at board level, where there are two representatives from the company and one each from the strategic partners, all decisions need to meet with unanimous approval.

In any case, the outside investors are not especially hands-on on a day to day basis - although they are quick to intervene when they sense thing are not going well, says Shen.

However, they do offer financial advice and management input which was seriously lacking previously.

Explaining the sell-off, Shen explains: "It's difficult to get a high valuation for tech companies in China. We know of one case where a company had annual revenues of Rmb 100 million, but the Chinese buyer only wanted to stump up Rmb 60 million."

The company is now involved in a further round of funding, this time with a foreign investor who they hope will give the company a higher valuation. It's likely NSFocus will issues new shares so that the new investors will end up holding a substantial chunk of the new company with the remaining shareholders being diluted.

Given the sector the company operates in, it's perhaps not that surprising that the 12 original founders of the company met for the first time over the net.

Defying the conventional paradigm of Chinese personal relations, meeting people over the net, and creating genuine friendships, is an exploding phenomenon in China.

"Despite the fact that we met for the first time face to face only when we had out first meeting to set up the company, nobody of the original 12 has left," comments Shen proudly.

Shen, Beijing-born and Tsinghua-educated, believes that in contrast to other growing tech hubs in Shenzhen and Shanghai, being located in the capital has many advantages.

"Many of our customers are state-owned enterprises or government ministries. Both have their top leaders located in Beijing. In addition, it's important to be in Beijing for the times when you are negotiating your license," he says.

Licensing is a system much beloved by the Chinese bureaucracy, since it provides the perfect vehicle for squeeze. Thus Shen's company does not require just one license, it needs a new license for every new industry it wants to venture in, for example, telecommunications, banking etc.

Yet the system has some advantages, points out Shen. Once you have got the license, based on various criteria such as size, history, technological level and so on, it raises the entry barrier to the competition.

"Thus even if intellectual property is not especially well protected in China, small companies who rip us off will not be able to get government business," he notes.

The licensing system has another advantage: when the company gains acceptance at the most senior level in Beijing, it often happens that HQ orders all their far flung provincial subordinates to buy Shen's products as well.

The first few years were tough, acknowledges Chen, but he believes things are never that tough when you thoroughly enjoy what you are doing.

"None of the senior people left the company because we enjoy what we doing - very simple really. In 2001, we couldn't pay salaries for eight months, but we sat out the crisis and eventually everybody got paid, including the backlog," he says.

For a number of years, Shen was on a salary of less than $1000 per month, and even that often didn't come through.

Now he's got shares as well of course, with his portion being twice as large as the others' on the back of his position as the founder of the company.

When asked what he feels is his biggest success in the past five years, Shen says he's proudest of the company's tradition of focusing on producing the best and most innovative technology.

The downside of that, as he readily admits, is the early lack of solid financial structure structure.

But with the company having signed technology export contracts to the US, it's possible that not diluting the focus on the tech issue was worth it.

It's an astonishing sign of how quickly things change that China is exporting cutting edge technology to the US and shows just how volatile and competitive knowledge intensive sectors are.

"We estimate the network security sector overall lags that of the US by just a year or so, " he estimates.

And the reason for that? In an amusing irony, the Internet has made it far quicker and easier for entrepreneurs to keep up on the latest trends and developments.

It's obvious that while the company's obsession with technology may have made the route to a lucrative IPO somewhat longer, it's also made the company a much better long- term prospect.

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