China has been a tough market for foreigners, historically, and the Internet sector is getting tougher as local firms increase their dominance and the Chinese government asserts more control. The record of U.S. Internet firms in the People’s Republic is poor. Most have either offloaded their operations to Chinese companies through joint ventures or “strategic partnerships“, or, like Google, pulled out entirely. The truth is that outsiders are unlikely to succeed, and in the process of trying, liable to waste valuable resources. For most companies, the China Fantasy is more like the China Syndrome.
The market indicators are, indeed, mouthwatering. In particular, China’s Internet data are very appealing:
- approximately 400 million users of the PC Internet
- hundreds of millions more connected to the mobile Internet
- $2 billion+ on online advertising in 2009, projected to grow more than 30 percent in 2010
- $3.6 to 3.8 billion in 2009 revenue from online games and sale of virtual items, projected to grow 25-30 percent in 2010
Numbers like these lead many firms to leap headlong into what looks like virgin territory — but they tend to underestimate the challenges. For anyone serious about expanding into China, the highest priority is to line up advisors who have experience there, from venture investors to lawyers to accountants to, in some instances, market-entry firms. It’s critical to understand the competitive, regulatory, and legal topography of any given industry and sector.
You may be surprised to learn that China does have laws that protect patents and intellectual property — but only if you apply to the relevant government agencies and, in most cases, do it before you’ve entered the market or even engaged in discussions with potential partners. U.S. laws also present hurdles. Public or soon-to-be-public companies need to undergo rigorous Sarbanes-Oxley disclosure requirements as well as increased risk exposure under the Foreign Corrupt Practices Act.
Hiring experienced help can be expensive, but there’s no alternative to making the investment. I know of several executives who believed they could get into the PRC on the cheap by sending a Chinese émigré to develop their market-entry plans, build and exploit special relationships, and run the business. Generally that approach has failed. Just because someone was born in China or speaks Chinese doesn’t mean he or she has a clue about the market there. If you can’t afford to do the proper market-entry work and due diligence, then you probably can’t afford to operate in China.
A little research may reveal that your niche is already sewn up. If you’ve achieved traction in the U.S. or Europe, if you’ve publicized a venture investment, or if you’ve received positive coverage on a relevant blog or news site, it’s likely that some enterprising Chinese entrepreneur has already added your best features to an existing service or copied your service outright. Chinese developers and engineers are skilled, fast, plentiful and much cheaper than their U.S. counterparts. Imitation in China is more than flattery; it’s expected.
Due diligence will also prove that nothing is simple on the mainland. On a revenue basis, operating in the PRC tends to consume a vastly disproportionate amount of management bandwidth. One of the more striking aspects about Google’s China experience was Sergey Brin’s revelation that managing the operation consumed more and more of his time. “China was ever-present,” he told the Wall Street Journal in March. “One out of five meetings that I attended, there was some component specifically applied to China in a different way than other countries.” All for an operation that contributed less than 1 percent of Google’s total revenue!
One reason for this managerial overhead is the government’s penchant for regulating media and communications. Several government bodies share jurisdiction over the Internet, including, but not limited to, the Ministry of Public Security (MPS), Ministry of Industry and Information Technology (MIIT), Ministry of Culture (MOC), and General Administration of Press and Publications (GAPP). A fairly convoluted corporate structure is required to obtain all the required licenses and permits. It can be done, and any competent law firm with experience in China knows how, but you need to be prepared for a time-consuming and frustrating process.
Foreign firms willing to play by China’s rules have had some success, especially in online gaming. Tens of millions of Chinese play games online, making this the country’s most lucrative Internet industry. Most revenue comes from massively multiplayer online role-playing gaming (MMORPG), of which the most successful foreign example is Activision Blizzard’s World of Warcraft. However, foreign participation in the game market is restricted, and consoles like Xbox 360 and PlayStation 3 are illegal (even though hundreds of thousands have been sold in the gray market).
The government doesn’t allow U.S. firms to operate online games directly. Activision Blizzard licensed World of Warcraft to Netease, a local Chinese operator, which handles approvals, operations, and customer support and pays the U.S. publisher a large percentage of the revenue. Blizzard transferred the license from The9 to Netease in Q2 2009, causing a regulatory dispute that sidelined the game for several months. Note that China’s online game market is quite mature by now, so unless you have a proven, successful MMORPG, you’re likely to have a difficult time bringing it to market.
In contrast, foreign firms are mostly absent from the fast-growing market for social network service (SNS) games. China has several Facebook-like networks with tens of millions of users, including Renren.com, 51.com, and Tencent’s Xiaoyou.com. However, the SNS environment differs from that in the U.S. in important ways. The monetization rate is much lower than it is on Facebook, and the network controls billing and payments. Moreover, the government has stated that SNS games will be regulated just like traditional online games.
Many Chinese SNS developers, especially those that have, like 5Minutes and Rekoo, raised money from foreign VCs, are aggressively expanding onto Facebook, as they understand how hard it is to monetize their products at home. I know of several publishers whose main business model is to license promising Chinese SNS games, localize them in English, and run them on Facebook and MySpace.
Still, there are ways to build a presence in Chinese gaming. You could set up an insourcing studio, leveraging the cheaper labor costs and learning about the features and innovations (yes, there are innovations on the Chinese Internet) that work in this market. You might even find ideas you can use in your products back in the West. And it’s also possible to partner with Chinese firms trying to enter the U.S. Tencent has made investments in California-based Riot Games and Outspark; Shanda Games acquired San Franciscan developer Mochi Media.
Apart from gaming, China’s consumer Internet market has proven deadly to U.S. firms. eBay, Google and Yahoo are the most famous examples (although Yahoo was able to turn its struggling operation into a deal for 40 percent of mainland giant Alibaba, a stake now worth more than $5 billion). A post-mortem on these companies’ misadventures would fill a book. Here is an abridged catalog of their mistakes:
- underestimating the local competition
- misjudging the velocity of change in the market
- underestimating the challenge a China operation posed to their internal management structure and corporate culture
- ignoring the potential damage to their brand of working within the laws set by the Chinese government
- neglecting to build local management teams with enough autonomy to successfully navigate the Chinese market (that is, handicapping the business by micromanaging from the U.S.)
- insisting that local operations migrate to a global back-end that caused massive latency, critically degrading the user experience
- failing to capture significant advertising revenue from the top Chinese portals and Baidu
- complying with FCPA — as any American business must — in ways that interfered with winning advertising contracts
- running afoul of rules and regulations that tilt the playing field in favor of Chinese firms
Despite the numerous pitfalls, one entry model appears to have potential. Many large U.S. venture firms have operations in China or affiliate relationships with Chinese VCs. U.S. Internet companies should consider working their VC relationships to find partners or management teams in China that can set up local, autonomous versions of their business. The U.S. firm might end up owning less than 50 percent, but it would gain a toehold in China while mitigating some of the risk and preventing the operation from becoming a huge drain on time and resources.
All told, expanding into China is one of the most challenging moves a U.S. business can undertake. Those who aren’t daunted can learn valuable lessons by studying the bitter experience of U.S. pioneers as well as the products of innovative Chinese Internet firms like Tencent.
Increasingly, though, U.S. executives are realizing that the rewards of opening a Chinese office aren’t worth the expense, risk, and distraction. The U.S. is still the largest Internet market by revenue and will remain so in the foreseeable future. It’s also probably the easiest place to build a business. For most U.S. Internet firms, the best thing for employees and investors is to focus on winning at home.
Disclosure: The author is an angel investor in Stocktwits, which is backed by True Ventures, a venture capital firm that is an investor in the parent company of this blog, Giga Omni Media. Om Malik, founder of Giga Omni Media, is also a venture partner at True.