CUHK EMBA Forum, December 4 2006
Venture Capital Investing: Reflections and Speculations for Hong Kong Practitioners
By Gerald Chan
Thank you. I am pleased to be here. I know some people have come today to ask, ‘How do we jump-start the biotech or technology venture business in Hong Kong?’ Let me be upfront and tell you that I do not know. I have not lived in Hong Kong for thirty years. Even though I have come back regularly, I really cannot claim to know much about Hong Kong. I can only share with you my experience in the practice of investing in venture capital companies for the last twenty years. Half of that time was in the United States, and the other half in Mainland China. I left the U.S. in 1993 to live in Shanghai. By then, I had lived in the U.S. for twenty-five years. I saw in the future of China an opportunity that would come perhaps once in several lifetimes; and I could not take advantage of it from a distance. I have been in China for the last thirteen years. For this speech, I will draw from my experience investing in three areas of venture capital investments—the Internet, media and biotechnology.
In the venture business, one ventures into the unknown. It is a high-risk business. You are trying to create something that has never existed before, often using new technologies. (Instead of applying new technologies, some people apply new business concepts in venture investing.) My exposure in doing venture investing is largely with technologies. Small companies, especially the start-up companies, are truly economic engines. If you look at job creation in the U.S., you will see that young companies are providing jobs for the population, whereas the mature, big companies are laying people off.
Venture investing is generally a fast-moving business because of the rapidity of technological innovation. Some areas are faster than others. The Internet certainly was the fastest I ever experienced; biotechnology moves more slowly. The environment of venture investing is dynamic and often chaotic. If you are not a person that can easily deal with chaos, I feel this is not the business for you. This is also a business in which things often seem out of control. Half of the time you are putting out fires. Risks are high. Most start-ups fail. Many investors are attracted by stories of success and glory such as Google or eBay. But for every Google or eBay, there are thousands of companies that have sucked up a lot of capital only to fail at the end.
What do venture capitalists do? A venture capitalist is not the founder of the company—that is the entrepreneur. The venture capitalist is an investment professional interposed between the providers and the consumers of venture capital. The consumer of venture capital is the entrepreneur. The provider could be from various sources. In the U.S. and Europe, these tend to be institutions—financial institutions, pension funds, endowments and the like. In recent years, many so-called alternative asset classes have been established. Even conservative investors like pension funds are investing significantly in venture capital. That is why the industry is quite awash with liquidity, and this is problematic for the industry.
The term ‘venture capitalist’ does not apply to an ‘angel investor.’ The latter is someone who puts up the initial US$50,000 or US$100,000 to get the business started. In venture capital jargon, he is sometimes called ‘friends and family.’ I refer, instead, to the practice of the venture capitalist as an institutional player. Let me give you an example. You probably all know about a company in the Mainland called Sohu, which is an Internet portal. That company was started by a gentleman named Charles Zhang. He finished his Ph.D. in physics at MIT and wanted to go back to China to build the Internet. This was around 1996 when most people in China did not even have computers. He had two angel investors, who each put up US$20,000. One was Nicolas Negroponte from the MIT Media Lab; you probably have heard of him. The other is a gentleman named Ed Roberts, a professor who taught technology management at the Sloan School of Management. Eventually, their US$40,000 turned into maybe more than US$10 million. These were the angel investors who put in the seed money which is generally not a big sum.
Later on, the institutional venture investors came in. After Negroponte and Ed Roberts put in their money and got the business started, the next round was an institutional round in which Morningside, Intel and IDG came in. What I am talking about today is not angel investing. It is about institutional venture investing. We make financial investments in start-ups and young companies to help them grow. If you think the venture capitalist can just put down his money and go away, or come by every three months for board meetings, that would be way too easy. You really have to get involved with these companies and help them grow. Oftentimes, the entrepreneur or person who started the company is a technologist with very limited business experience. He really relies on the venture capitalist to provide guidance and support for the growth of the company.
It is a very high-risk business. If you look at the portfolio of any venture capitalist, you will see that out of, say, ten companies, five of them will probably fail. Maybe only three of them will return the investment. Nevertheless, two of them may be big winners. That is painting with a very broad brush, of course. If we only knew which two would be the winners out of the ten, we all would be really, really rich. You just do not know. That is why the risk is generally controlled by taking a portfolio approach. Instead of investing in one company, you invest in a portfolio of companies. We have a company in our portfolio called The9. It is a NASDAQ-listed company with a market capitalization of probably US$700-800 million. We invested early in that company; however, if you had asked me six or seven years ago to pick the winners from a portfolio of twenty companies, The9 would not have been one of them. It turned out to be a huge winner for us. Therefore, to ameliorate the risk, the venture capitalist takes a portfolio approach.
Venture Investing Process
I would like to dissect the whole venture investing process for you, and talk about each segment of the process. I hope that will demystify the venture investing business for you. First, you start with generating deals. How do you source deals? How do you get a deal flow? What are you investing in? How do you get to see investment opportunities? Then once you have the deal flow, you analyze the deals. How do you make your investment decisions? How can you tell a good opportunity from a bad one? Third, you have to execute the deal. This is what I call deal mechanics or deal structuring. How do you structure a venture capital deal? Then once you have made the investment, you have to grow that investee company in your portfolio. What is the experience like working with these companies? How do you guide these companies and work with them from a start-up to, hopefully one day, a NASDAQ-listed company? Finally, how do you achieve liquidity by exiting that investment? I will talk about each of these five segments of the venture investing process.
Starting with deal generation, there are two ways to do it. Like any investment, one is the top-down approach and the other is the bottom-up approach. The top-down approach would take a macro view of the world or of a certain economy, and try to see where the opportunities are. The bottom-up approach would be on a deal-by-deal basis.
Deal generation in the VC business is undoubtedly a networking exercise. VCs run in packs. If you want to see good deal flow, you have to be in the right place and be with the right people. It is hard to be aloof and yet be in the deal flow. It is through your friends that you see the deals and the opportunities. You have to make friends with all kinds of people. My point to you is: do not just make friends with people who are like yourself. Try to broaden your horizon. Maintaining a network takes a lot of investment in time and energy. I do not do as much of that today as I used to when I was younger and had more energy. Back then I really pounded the pavement and tried to meet all kinds of people. I would chase down leads and go out of my way to meet people. So far that has really served me well.
As to the friends that you make, are they in the mainstream or on the fringes? The question is actually more philosophical than you think. People who start up companies are, almost by definition, not in the mainstream. They are more likely to be a little off the beaten track. When everybody consumes the same services, there is this person who thinks about doing it differently. When everybody looks in the same direction for a scientific solution to tackle a disease, there is this person who looks in a different direction. People who succeed in starting companies are people who think out of the box. Almost by definition, they are on the fringes. One should never write them off.
Moreover, try to meet quality people. The key is this: if you want to meet quality people, you yourself must be a quality person. I had this practice in Morningside. We did not carry titles. We had no presidents or vice-presidents. We had no associates. I did that deliberately because I did not want my people to hide behind titles. If you meet somebody and you spend an hour with him, he will know whether you are a panther or a cat. My advice is to upgrade yourself constantly. By this, I do not mean climbing some organizational ladder. What matters is who you are. Who you are and your quality as a person will be reflected by the network that you are able to generate.
High Probability Networks
What are the high probability networks? They are the networks that will give you a high probability of seeing good deals. If the deal is a good one, chances are there will be more supply than demand of capital. Why then would somebody want you to be in the deal? I just saw this professor who was starting a company with a wonderful and very innovative technology. This was in Boston. There were two major VC firms in the deal for some time. I tried to budge in as a third party in the seed round. They said there was no room for another institutional investor, but invited me to join personally in the ‘friends and family’ round because they valued my contributions. It is nice to be invited, but you have to possess the right stuff such that people see you as bringing value to the table. You must have some angle or edge; you must be an asset in some way.
Another area that I think one can build a high probability network is in meeting serial entrepreneurs. In Silicon Valley in California, one sees a lot of serial entrepreneurs. In Hong Kong I do not think we have that phenomenon yet. In China’s Internet circle, we are beginning to see these serial entrepreneurs. They started companies in the late 1990s and had successfully exited those companies, perhaps through a NASDAQ listing. Now sitting on a pile of money, they are moving on to their next company. There are a lot of serial entrepreneurs in Silicon Valley who are almost addicted to starting up companies. If you can tap into a network of these people, that will be a high quality network.
I worked in the life sciences where basic research is done mostly in universities, medical schools or research institutions. I spent a lot of time going around universities, talking to professors and looking at the research they do, and then gauging whether there is an opportunity to start a company with a piece of research. Networking among academics is another area that you might be able to find deals.
Given that we all have limited time and energy, you may ask whether you should have some industry focus in building your network. For example, if I say I am a software person, I only try to build my network with people in the software business. That is a valid way of thinking; however, you have to decide for yourself whether you want to build your network with industry focus or with more diffused coverage. Nowadays, demarcations among different industries are crumbling, and one often finds an opportunity in one field by looking in another field. I suspect that having a strict industry focus is going to be less and less productive.
The top-down approach is to look at macro trends. Big trends change with time, this is especially true in the investment business. The Internet is a good example. I started working in the Internet space in China in 1996/97. That was a big trend, but one that will never come back again. There will not be the opportunity to do another Sohu or The9. Things have to move on. Today if you want to do Internet deals in China, it is an extremely competitive environment. There is another example. Before the energy crisis ran up the world oil price to US$80 a barrel, very few people were thinking about alternative energy. Now biomass and biodiesel are big—turning agricultural products into energy sources. All that has become a hot area for venture investing. To be able to pick up these trends, you have to be a very keen observer of the world. Nobody is going to discover that for you.
Coming back to this question that you all want to ask me about Hong Kong, I think Hong Kong is a very small place, one that is very constricting. If you only observe Hong Kong, your views will be very limited and probably distorted. You must look at the whole world. You must be aware of what is happening in California or Taiwan. This is what I mean by staying in tune with global leaders in different industries. If you are in the semiconductor industry, you cannot afford not to know what the Taiwanese companies are doing. They are global leaders in the industry. Of course you also want all these observations of major world trends to be relevant to your local conditions and the local idiosyncrasies. For example, a couple of years ago I asked my colleagues in Shanghai why we could not do something like Facebook or MySpace in China. They told me that owing to different local conditions, it would be extremely difficult to replicate the same in China. By the same token, there are companies in China which would be very difficult to replicate in America, for example, QQ.
If you are to have such a broad coverage in venture capital, you must be a generalist and must be able to study quickly. There are venture capitalists who are specialists. In some venture capital firms, there are different partners specializing respectively in semiconductors, software, biotech, etc. Even in a so-called specialty field, one has to be a very general person in the sense that one has to look at a broad scope within that field, and get at the major and critical points quickly when presented with a new situation. As venture capitalists, we are presented with investment opportunities all the time. How do you, in the course of ninety minutes, get to the crux of that opportunity and ask the right questions? You can go home and do your homework for a few more days, but you have to study quickly and be able to get to the crux of problems very quickly. I think to be able to ask the right question is a great skill. It is not so much to be able to come up with the right answer. Unfortunately, our education system is such that we encourage students to come up with the right answers rather than to ask the right questions.
Attributes of a VC
What attributes are needed in a VC for successful deal generation? First of all, you must be an optimist. When you look at a situation, you are confident that somebody can come up with a better solution. Venture capitalists tend to be unbounded optimists. There is always a better tomorrow, and we will make a better tomorrow. You have to be an activist and an agent of change. Spot an unmet need, and you treat it as a way to create value or create companies by bringing in certain solutions to address the unmet need.
Second, you have to be a risk taker. This is not a business for the faint-hearted. You probably know there is a medical condition called ‘Attention Deficit Disorder.’ Attention deficit people have short attention spans and the propensity to live on the edge. They are exhilarated when they take risks. ADDs make for good venture capitalists. If we can develop different attributes of ourselves, risk taking should be one of them—to have the courage and be able to take calculated risks.
You ought to be curious—intellectually curious and even nosey. I was once on a plane from San Francisco to Shanghai when the plane developed a mechanical problem and had to land in Seoul. Dumped into the terminal in the middle of the night, the passengers were standing around in clusters. I overheard a woman talking in a loud voice about some optical stuff. I worked my way into the crowd that had gathered around her. As the crowd lost interest and dispersed, I kept probing her about this optical stuff. To make a long story short, her idea is now one of the companies in my portfolio. I am curious, and enjoy talking with people at length on any topic.
As a venture capitalist, I must also do detective work. I once went to a conference and listened to a talk about applying nanotechnology to medicine. The speaker said that there was only one area where the application was pretty good. Right after the meeting, I obtained from the speaker the name of the person to whom he had referred. I made a trip to Chicago to talk to the person, and spent months cultivating a relationship with him. His technology is one of the companies in my portfolio today. Sometimes people do not tell you everything. You have to chase things down and find out what is real and what is not. With the portfolio approach, a venture capitalist will need to be working on multiple tasks at any given time. You have to conduct parallel processing in many projects.
Being personable also helps. It helps if people like you.
As far as deal generation is concerned, there is always the issue of the intermediary—the investment bankers, the business brokers, the financial consultants. I would submit that there is an inherent conflict of interests between the buy side and the sell side. The sell side’s incentive is to sell the deal. Once it has sold the deal, you—the buyer—have to live with the deal and its consequences. The sell side has taken its commission and moves on to the next deal. I do not like to rely on intermediaries. I would much rather go upstream to the entrepreneurs at the source. That is where you probably find higher quality deals. The market is fairly inefficient, in the sense that there is no central clearing house of information in venture investing. You really have to build that network if you are to see deals.
Having a history helps. If you have a track record, people know you for your successes, especially high-profile successes. Having a reputation helps. In the Internet circle in China, we at Morningside have built up this reputation of really being supportive of the companies in which we have invested. People know that and the word gets around. When the Internet bubble burst, Sohu’s share price plunged from something like US$13 to about US60¢ a share. I was in California when the CEO called to ask us to support the stock. We went into the market that day and spent over US$1 million buying stock to support that company. These anecdotes get around. People know that you will stay with the companies in which you invested during good times and through hard times. With such a reputation, entrepreneurs will do the deal with us even though we are only willing to invest at a lower valuation than some other VCs. If your reputation is really strong, you become a brand. In Silicon Valley there are big VC firms which are brands. For example, it is generally accepted that if Kleiner Perkins would invest, the deal must be good. The net effect of such brands is that the haves will have more. It is a self-reinforcing phenomenon.
Now let me go on to analysis. What is a good deal? When I first came into the VC business, this was the most troubling question. How could I tell a good deal from a bad deal? Picking a venture or start-up company is unlike picking a stock. When you pick a stock, you refer to financial statements and past performance, and you can interview the CEO or the CFO. In venture investing, you have none of that. You are looking into the future and you have very little to go by.
So how do you tell a good deal from a bad deal? I can make some points here. It is multivariate in the sense that there are many, many factors which characterize a good deal or a bad deal. The distinctions are often fuzzy. Information may be hard to come by—unlike a listed company in respect of which the stock exchange sets disclosure requirements. You do not have perfect information. At the end it becomes a judgment call. Judgments are made on instincts rather than mental analysis. However, I would add that these are not just raw instincts, but instincts which have been perfected by a lot of analysis and a lot of experience.
Let me try to put that in more concrete terms. It helps to take a reductionist approach—scientifically reducing the problems to discrete variables. Some analysis can then be applied. I will give you some examples in a two dimensional space.
In Example 1, the x-axis represents operational intensity. Suppose you run a factory or an assembly line where operation is very intensive. A company such as Federal Express would be such an example. On the y-axis I put barrier to entry for competitors. If you look at this two dimensional space, you want operational intensity to be low and the barrier to entry for competitors to be high. So the business opportunity that you are looking for is in that upper left-hand quadrant.
In Example 2, dependence on creativity is put on the y-axis, and the cash that is required to break even on the x-axis. You want both the cash required to break even as well as the dependence on creativity to be low; therefore, the opportunity that you are looking for should fall into the lower left-hand quadrant. Consider also the following scenarios. The newspaper business requires a lot of cash to break even, but it does not depend as much on creativity as a magazine does. With a magazine, on the other hand, you require less cash to break even, but you have a higher dependence on creativity.
Example 3 probably applies to the telecom business. The life-time revenue per customer is on the x-axis, and the cost of customer acquisition is on the y-axis. You want the cost of customer acquisition to be low, but you want the life-time revenue per customer to be high. This is a sort of matrix you use in some wireless businesses or Internet businesses.
At the end, if you have in your mind a number of these discrete variables, you can really construct a mental space that is n-dimensional, onto which you can map any given opportunity. To me, analysis is not an abstract exercise. It is entirely contextual. The problem with new people in the business is that they have no context. They have seen or done too few deals before to understand why some deals succeed and others fail. It is a big problem not being able to tell a good opportunity from a bad one. Having seen a lot of deals does not necessarily guarantee that you will have that ability. Having context is necessary, but not a sufficient condition. I call this contextual epistemology. How do you know what you know? It is by having that context, that n-dimensional space onto which you can map any opportunity that you are looking at, and determine what is desirable and what is not. That is why case study methods work in business school.
You must analyze the value proposition. The value proposition may be technology based. These tend to be universal, and the intellectual property tends to be the repository of value as well as the defensibility for the business. Alternatively, you can have a value proposition which is business model based. These are more likely to be only locally relevant, and ultimately you rely on first mover advantage or the customer base that you have already built up as defence and the repository of value. As an example, an Internet portal would fall into that category.
In analyzing risks, they must not be looked at merely quantitatively. They involve more than the consideration of volatility and beta, as students of finance may perhaps think. In the VC business, I would submit that risk is more a qualitative matter than a quantitative matter. There are many different kinds of risks. There are financial risks: Are you overpaying? Is it a business that consumes a lot of cash? There are technology risks: Is it going to work? In the pharmaceutical business, you saw Pfizer just gave up, two days ago, this big blockbuster drug that they were working on to increase the good cholesterol—the HDL—because in clinical trials it showed unacceptable side effects. That is a technology risk that has become a major hit to Pfizer. There are also market risks, execution risks, people risks, regulatory risks, political risks, etc. I am constantly amazed at how stupid I have been in failing to foresee certain risks which would later come to haunt me. The VC business is a very humbling business.
The business plan is, of course, very important. In the interest of time, however, I must move on. I trust you all have courses on writing business plans.
Deal mechanics is about the structure of the deal. What is important in the deal? Pre-money valuation? Are you overpaying? What is fair value? There are no rules; but there are ballpark estimates. Subject to market sentiment, you may be willing to pay US$10 million for a company, whereas I may be willing to pay only US$5 million. Beauty is in the eye of the beholder. The round may be an up round, flat round or down round. That generally reflects the condition of the company. If the company is in tough shape, it will be a down round. Sometimes there is what we call a cramp-down round, in which you wash out all the existing or previous investors. That is one of the cruel things about the venture business: it is today’s money that matters. If the money that people had put in before did not do what it was supposed to do, the earlier investors could just be washed out. How much do you invest? You try to protect yourself by investing in tranches, based on milestones, rather than putting it all in at once.
What financial instruments do you use? Generally the financial investors put in the money and get preferred shares. The founders and management get common shares. Sometimes investors get warrants. Sometimes you put money in as convertible debt so that you can be in an even more senior position in the capital structure. Oftentimes when companies run out of money, shareholders have to do a bridge loan. The bridge loan is often convertible at a discount to the valuation of the next round. Providers of the bridge financing may also get warrants as sweeteners. There are other terms of the deal such as an option pool for management and employees. Liquidation preference for the preferred shareholders entitles them to get their money out plus a pre-specified return before the common shareholders get to share the rest of it pro rata. Sometimes there are performance ratchets: the founder may get twenty percent of the company in common shares, but only if the company reaches a given performance milestone by a given time; otherwise, his twenty percent goes to a lower percentage. Sometimes you will work the other way: management gets ten percent today and ten percent more two years from now if the performance milestone is reached. With so many variations in the deal terms, it is no wonder that we need lawyers.
Growing the Company
Once you have invested in a company, you must grow the company. Giving birth is the easy part; raising the kid is the hard part. Working with these young companies is like fighting one fire after another. You are in a constant state of crisis. You want management to execute the business plan. You want to have discipline. You have new information coming in, suggesting that your original business concept was way too optimistic and you have to adjust the business plan accordingly. It is not uncommon for these young companies to have multiple incarnations. They set out to do one thing, run out of money and get nowhere. Then the VC puts in some new capital, rewrites the business plan and tries again. This process continues until the company succeeds or until the VCs give up and admit defeat. This happens all the time. That is why I say that VCs must be people who are able to live and deal with failure. They are undaunted by failure, and are able to rise from the ashes like a phoenix.
Growing the company involves a lot of hiring and team building. How do you attract quality staff? How do you get people to sign on to the vision of the company? Generally, working for a young company is not as secure a job as working for a big company. You want to control the burn rate. The boards of these companies tend to be much more activist than what we are accustomed to in large companies. (I sit on the boards of a couple of listed companies in Hong Kong.) The board really has to work with management to grow the company. Sometimes you have outside board members because they provide certain expertise. Even the VC firms now have what are called venture partners. These are people who have run companies before. They are not investors, but they have run many companies in similar industries and can bring value with their experience.
If you were starting a company, what would you look for in a good venture investor? You want a strong capital base, and someone who can really support the company all the way. You want the VC to be informed and to have realistic expectations. You want the VC to be supportive and to provide guidance to the company. You want the VC to have a lot of peripheral visions because entrepreneurs tend to have deep but narrow visions. The VC should be able to connect the dots and spot other related opportunities of which the entrepreneur is unaware. You want the VC to bring connections as well as brand equity.
What is a bad VC? He is someone with an ego that is out of control. He is too authoritarian or too indulging. You want a VC that actually helps and enforces discipline in the way that the company is run. You do not want a fair-weather friend who is there for you only when the going is good. You want people who will be there through the thick and thin. (I am really happy to say that in the Internet world in China, we at Morningside have built up the reputation that we are investors who will stick with our companies and see them through to a good ending.) Furthermore, you do not want someone who sees the world as a zero-sum game.
We come finally to the exit. For this, I am not particularly worried. For one thing, we are not investing or handling investments for third parties as a fund. Funds have a finite fund life and exits must be had by the end of the fund. I am at ease that good companies will always have exit alternatives for their shareholders. There are different public markets for growth companies. Different markets may have different valuations for the same company. The varying depths of markets also mean that the amount of capital that could be raised per company also differs from market to market. You have to catch the IPO window that opens and shuts for various reasons.
Let us assume that your company gets listed. Do you sell or hold on to the shares? If you hold on to your shares, you become a stock market player. One philosophy is that, as a venture investor, I invest in start-ups, grow them, and my job is done once they get listed. I sell the stocks as soon as I can. There is the opposite view: there is no difference between a private company and a listed company. Just look at the company’s fundamentals and prospects, and time your stock disposition accordingly.
Let me give you a good example. MIT had some shares in an Internet company called Akamai. As a university, it did not want to play the stock market. As soon as Akamai got listed, MIT sold its shares for some US$700 million. If MIT had held those shares through the cycle of the Internet bubble burst and subsequent recovery, I am pretty sure they would be worth more than US$700 million today. Anyway, it is a philosophical question. In case you want to sell shares on NASDAQ, you are subject to SEC rules—windows, trading volume restrictions, etc.
An alternative exit to an IPO is a trade sale. From an investor’s standpoint, it is much more desirable to sell to another company where you are not subject to SEC rules. Trade sales tend to be for cash rather than for stock.
Finally, I am asked to talk about how venture capital and technology relate to Hong Kong. My honest opinion is that I do not know what is going to happen to Hong Kong. In a way, I am sorry to say that it is not my business. Hong Kong has a very small population. Such a small economy has a lot of limitations. That is why I keep saying that you have to look at the rest of the world—that includes the U.S. and Europe, as well as China and the rest of Asia. If your views as an investor are only derived from Hong Kong’s small economy, they would be very distorted. Hong Kong is a very mature economy with oligopolistic characteristics. That is probably true of all mature economies where any industry would consolidate towards an oligopoly. The fact is that the conditions which made for Hong Kong’s past development are quite different from the conditions which are conducive to a technology-based economy.
Hong Kong today is by all measures a wonderful place—good GDP, good economic growth, etc. However, whatever former advantages that Hong Kong had are now eroded to some extent or marginalized by China’s development. In 1993, when I moved back to Asia, I took the deliberate decision not to come to Hong Kong. In my view, the future at that point was not in Hong Kong. I told people then that I was a Hong Kong bear and a Shanghai bull. (I am of Cantonese ancestry, not Shanghainese.) I invite you all to think about that. I do not mean Hong Kong will not have a future. But what should you do?
Real Estate vs Intellectual Property
In Hong Kong, the owners of financial capital tend to be family-run fortunes. The capital here tends to be impatient capital. It is a trading mentality that has been exacerbated by a refugee mentality. We who grew up in Hong Kong are accustomed to looking only at the short term. We grew up in the shadow of the cold war. The capital resources in Hong Kong tend to be more comfortable with real estate properties than with intellectual properties. People with capital would much rather buy a flat than to invest in a technology company.
Intellectual property has certain characteristics that are in contrast with those of real estate properties. If I were to buy a piece of land, I would have a survey done to delineate clear boundaries for my property. In intellectual property, the boundaries are very fuzzy. Look at patents—what patents get granted and what patents do not, what applications are allowed and what are not. It is not black and white. At different times, the patent offices may also behave differently. There were time periods when the patent offices were more lenient and generous such as in the early 1990’s. The European Union was trying to get more people to apply for patents there. They granted very broad claims which would probably be denied if the same applications were lodged in Europe or anywhere in the world today.
Moreover, intellectual property is distinct from real estate property in that there is an unlimited supply. This is very scary. You know there are only so many square kilometres in Central. If you own a piece of land in Central, you know you cannot go wrong; however, with intellectual property there is no upper limit. We who work in the biotech industry constantly face such prospects. I think I have found the best cure for cancer, and I invest in it. Next year something else comes up that provides a better cure for cancer. Another year goes by with yet a better remedy coming out. That is the character of intellectual property. I cannot blame Hong Kong people for feeling uncomfortable with intellectual property given their background and that they have limited exposure in this area. The boundlessness of intellectual property is just a fact that we have to live with.
Scientific Research Base
Hong Kong does not have a technology-based economy. I would say the scientific research base here is too small. There is no denying that in any research, and anybody who has done research will tell you this, luck is a major factor. I used to do research at Harvard where there are all these extremely brilliant people in the medical area. Not every one of them is going to do research that will lead to great companies. In fact, success stories are few and far between. That is why you have to rely on the law of large numbers. If your base is too small, chances are that you will find it very hard to come up with good stuff. Unfortunately, Hong Kong’s base is only so big.
For me, I go beyond Hong Kong to universities everywhere in the U.S., and in Europe to a lesser extent, to look for good intellectual properties on which I can build companies. I just finished a trip last week to Memphis, Tennessee and Birmingham, Alabama. It is tiring, but that is what it takes. America is a large place. It has a big scientific research establishment.
In terms of the quality of research, I personally think that it is only mediocre in Hong Kong. I hope I am not being too critical and I am not offending anybody. Excessive pragmatism leads to short-term research agendas. In contrast with Singapore, Hong Kong does not have a long-term government policy that really fosters science and technology. (You may disagree with me.) If you look at China, it is a different story. Is all that government effort going to lead to anything? The jury is still out. At least the Chinese try.
I find Hong Kong’s society to be very inward-looking, very self-centred, very self-congratulatory. To some extent, it is like the complacent frog at the bottom of a well. I find the culture here shallow and hedonistic. Just look at the popular press. Where do you find anything in any of the newspapers that would provide any depth, compared to the newspapers that you read in London? I find the young people here growing up in greenhouses. They lack the drive to do great things. I contrast this to the Hong Kong where I grew up in the 1950’s and 60’s when this place was nothing but a hunk of rock with a sweltering mass of refugees. People then had so much drive; it was imperative to succeed. Today, I find the young people complacent and too easy-going. A young man who worked for a friend of mine came to him to resign. The reason the young man gave was that his mother had said that he should not work so hard; he had to do too much overtime. That says it all.
There is no substitute for hard work. To this day I work day and night. I enjoy it. I just do not find much of that quality nowadays with young people in Hong Kong. I do not know why. Anyway, these are my observations. As I said, I have no solutions and it is not my business to offer you any. What I would like to do is to invite you to think, and look at yourself through the lens of what I just talked about. One of the biggest benefits of business school and the case study method is that every case you do is really a mirror for you to look at yourself and reflect on what you can do differently. If there are people in Hong Kong who will do this, maybe there is a future collectively for a technology-based economy.
Anyway, I hope what I have said today will be thought-provoking for you. It is certainly not my intention to malign Hong Kong. I do rather enjoy being here. It is a nostalgic trip for me. With that I will stop, and will be happy to discuss any points with you all. Thank you.
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Hong Kong Entrepreneurs
Leung: My name is Jonathan Leung, MBA graduate of 1997. Dr. Chan, what is your recommendation to the local entrepreneur then, especially for someone in the Internet business, given that the Internet economy in Hong Kong is even smaller than the real economy? What is your recommendation, apart from moving to the U.S., Beijing, or Shanghai?
Dr. Chan: I think you said it yourself. This market is only so big, and whatever you build is only going to be so big. How many Internet users are here? This market is pretty crowded. You are fighting with a lot of people. Think about going somewhere else. Think about moving to China. Without knowing the specifics of the situation to which you are referring, I can only speak in generality. Yes, Hong Kong has only so many people, and only so many Internet users. That is it.
Leung: A follow-up question. You have come across so many deals in your career, especially in recent years. Have you seen a successful entrepreneur who was originally based in Hong Kong, and had moved into China to become very successful?
Dr. Chan: Well, I will give you one example—somebody that I truly respect. I understand there was some sort of a technology award last week, or the week before. The company that got the grand award was Altai. There are two people there I truly respect. They are technology guys. One of them, a native from Fujian, had come to Hong Kong and lived in some wooden shack with his family. He went to high school here, and then received a scholarship to go to America. He received a Ph.D. from Stanford. He is really good at technology. I knew him when he was still in Silicon Valley. Eventually he came back to Hong Kong, but he knows nothing about business. There is another gentleman, Raymond Leung. He is also somebody I respect enormously. I am very pleased that I am a shareholder of that company. It well deserves to win the grand award. So it is possible. Just look at what Raymond has done in China. Fantastic stuff! There are good people here.
Portfolio and Vision
Wong: Hello Dr. Chan. I am Rosanna Wong, EMBA 2007. First of all, thank you for your frank and fantastic presentation. I am just curious to find out what your portfolio is—your current portfolio and your vision for this coming year. We would love to learn from the finest. Thank you.
Dr. Chan: My portfolio is like any VC’s portfolio; it will have a lot of failures. I am totally realistic about that. I do not know how I am going to show you the list. I cannot remember all the names; however, I will tell you that I have extricated myself from pretty much all the Internet stuff now. Over the last seven or eight years, I have groomed a couple of colleagues in Shanghai. They are native Mainlanders, who had never studied abroad. They got their MBAs from universities in China. Fantastic minds! And now they have taken over the entire Internet and media portfolio. I am totally comfortable handing that over to them.
New Model for Biotech
What have I done? For the last four years, we focused on biotechnology. I think a major, major revolution is going on worldwide. The former model of biotech is a broken model. This is how that model is supposed to work. You spend US$30 million to get to the point that you know whether there is a ‘go’ or ‘no go’. If it is a ‘no go’, you will lose everything. If it is a ‘go’, then you will get the licence and spend another US$50-100 million. For every drug that goes to clinical trial, the probability is that only one out of ten will succeed; the odds are terrible. That cost structure makes it extremely ominous for people to invest in biotech. I used to do biotech in the U.S., and then I stopped because I thought the model just did not work.
Four years ago I started to see, for the first time, an alternative. You take the science from America, and use the low-cost development capacity in China. In that scenario, you must distinguish what is science from what is drug development. Science is a lot of brilliance, and requires a lot of genius. Drug development is a process-driven endeavour: you do what the FDA tells you to do, and not more. This was not possible previously because China simply did not have the talent or the training to do that. Now all of that is coming together. Now I am probably ninety percent focused on biotech. As much as possible, I practise this model of sourcing the science from the Western world, and using the development capacity in China to get to human data as quickly as possible. That is a real value-creation step. I do not have many success stories to show you yet. It is still a very young portfolio, but we have some very, very promising drugs that we are developing.
If you like to know more, I will be happy to show you, at another time, what else is in our portfolio. You see, being a private company, we do not publish what we do.
Helping Hong Kong Kids
Yiu: Are there any more questions? Dr. Chan, you have talked about the Hong Kong economy and today’s scenario. From your experience living in Shanghai, the U.S. and also Hong Kong, is there anything in the future that you can do for the kids here to help them grow up? How would that help in the future to turn Hong Kong’s situation around?
Dr. Chan: Great, great question. I really mean that. I find the kids in Hong Kong too well-behaved. Parents may feel differently. They do not appear to be kids who take initiatives, take risks and think outside the box. Maybe the system simply does not allow that. I came from a school that is the epitome of the nerd school. By all measures, it is a very good school. I am very, very grateful for the education I got. But I think there is just something missing. Nowadays kids grow up in these greenhouses. I do not know what can be done. They are not hungry. Just like the mother I mentioned a moment ago, she told her son there was no point in working so hard. Kids nowadays mostly think about going around town to enjoy themselves. The whole culture is so infatuated with entertainment. They only have red wine in their mind after work. There is not that drive, that hunger. I cannot recreate people from the 50’s. But let us not be so pessimistic.
I am afraid I am holding up dinner. Thank you very much.