In the risky world of start-up investing, it's sometimes difficult to draw the line between making a bad investment decision and being an unwitting victim of a swindle.
After all, if an investor decides to buy stock in a China-based start-up, is it wise to assume that the venture's intellectual property (IP) will be protected by China's legal system? And if the answer to that question is no, should that investor feel confident that the Chinese government will not swipe the venture's IP and compete forcefully with the start-up?
These questions come to mind when considering what the New York Times reported about Goldman Sachs' (GS) participation in a $120 million investment in Cathay Industrial Biotech (CIB) -- a Chinese nylon ingredient maker. Before describing how the Chinese government allegedly absconded with CIB's IP, let's take a look at a concept that I believe is at the heart of explaining why capital flows more to some countries than others.
And that's the entrepreneurial ecosystem (EE). As Srini Rangan and I described in our book, Capital Rising, capital flows to countries and regions based largely on the relative strengths of their EEs -- consisting of four factors: corporate governance, financial markets, human capital, and IP regime.
CIB's CEO Liu Xiucai was born in China and earned a chemistry doctorate in the U.S. He figured out a way to use microbes to turn wax into a nylon chemical building block called diacid. And diacid can be used to make lubricants and diabetes drugs.
Using the proceeds from a previously successful start-up and $4 million from venture investors, Liu got CIB off the ground in 1997 on the strength of his fermentation process for producing diacid. CIB then attracted $120 million in capital from Goldman and others after Dupont (DD) became a big CIB diacid customer. CIB was poised to go public.
Then a frustrated CIB plant manager left with six workers to start a competitor -- Hilead Biotech that got a $300 million loan in 2010 from a Chinese bank and now makes diacid through a very similar process -- and charges a much lower price for it. That forced CIB to cut its prices and slashed its profits by about 20%.
CIB's survival is imperiled and so is the value of that $120 million investment.
This tale reveals important differences between the EEs of China and the U.S. Here's how:
- Corporate governance. In the U.S., minority investors like Goldman and its partners would be able to approve the offer of stock options to motivate and retain CIB's key people. But CIB's key people did not get such options and thanks to what appears to be a combination of poor management and low pay, CIB's key technical people jumped ship. And when Hilead went after CIB's market, the Chinese government used its power to make it more expensive for CIB to get capital and to buy utilities such as electricity and waste water treatment, according to the Times.
- Financial markets. In the U.S., financial reporting standards are stricter than in China. This has tripped up many Chinese companies that may be used to engaging in business practices that get them into legal trouble if they list their shares in the U.S. Hilead co-founder, Cao Wubo, also owned a NASDAQ-traded company, Jiangbo, that was delisted after the SEC sued it for failing to disclose a $25 million payment to Hilead.
- Human capital. Liu tapped the U.S. educational system to get his PhD in Chemistry from the University of Wisconsin. And after getting training with U.S.-based companies he returned to China to start his venture. The freedom that Chinese-born students enjoy to take U.S. training and use it to start ventures back in China puts the U.S. in a long-term weaker position.
- IP regime. The U.S.'s IP regime is hardly perfect but it's better than it is in China. While here companies use each other's patented IP quite often, there is at least a court system where patent disputes are often settled through a combination of cross-licensing and cash payments. But CIB could not protect its patents in China and the Chinese government's decision to help out Hilead slashed the value of the $120 million that Goldman and its peers invested in CIB.
There are many lessons that arise from this case. But one stands out -- the odds are very low that a provider of capital to a Chinese business that competes on IP will earn an attractive return.
What the Chinese government did has a name: "guojin mintui." As the Times pointed out, this can be translated as: "while the state advances, the privates retreat."
What good does it do an investor to boost the value of such Chinese IP only to have the government take that IP without paying through guojin mintui? And if so, how can a capital provider profit from investing in China?
As we described in Capital Rising, the answer to that is to invest in a business that provides a service to the Chinese market based on a well-established U.S. business model -- think Chinese versions of Amazon (AMZN) or eBay (EBAY).
The general point is that investors cannot afford to ignore how emerging market EEs differ from the one in their home country. Goldman and its co-investors in CIB are paying the price for that analytical neglect.
And Liu's experience with China's flawed EE might lead him to take CIB elsewhere -- perhaps to the more start-up friendly US that gave him his chemistry training.