In Search of Brand

Chinese Creators and Greedy Bankers

This week, I had a drink with a former newspaper editor who, four or five years ago, had asked me: “Do you think China is capable of innovating?” My reply, after pointing to the many Chinese entrepreneurs who have innovated in Silicon Valley, for example, had been: “To create, you need to accept a dose of chaos. Are you ready to accept chaos?” At the time, the unspoken answer was clearly negative, and I don’t think I was ever quoted in his article. But things are slowly changing – at the margin.

* * *

In Chengdu, one of the country’s fastest-growing metropolises and China’s gateway to the West, I visited a small incubation center for computer-game design companies. It may be a sign of things to come.

The local government sponsored a young entrepreneur to launch an incubator company for computer and video game designers. The entrepreneur’s main venture writes software to manage video game arcades (automatic, sometimes daily updates from game producers, networking, etc.) and he personally owns four game arcades. So, outside of his excellent academic credentials, he had first-hand knowledge of the business and its market.

The government put at the entrepreneur’s disposal a floor in a “wired” building located in a technology park, plus a grant of 300,000 RMB – apparently with no strings attached. While this is only about $40,000 dollars, the old rule of thumb stands (except perhaps in Shanghai or Beijing), by which – in terms of living standard – this is equivalent to $300,000 in the United States. Further grants also may be forthcoming and, after protracted negotiations, Microsoft contributed the equipment (PCs, X-boxes and software).

So far, four small companies (really teams of 4-6 people) have been invited to join the incubator from Beijing, Shanghai, Shenzhen and Chengdu – presumably lured by the free rent, congenial atmosphere and the Chinese’s attraction for the laid back and friendly reputation of Chengdu. When the games they are developing go commercial, the teams will owe the incubator 30% of their revenues. Apparently, the government is happy to help develop non-polluting businesses.

The atmosphere, accounting for cultural differences, could have been that in Silicon Valley: totally informal, more like a commune than an office. Among the very young-looking, somewhat nerdy kids dressed like skateboarders, those who were not playing video games (I mean testing prototypes!) or frantically typing on their PCs were playing ping-pong, sharing sodas in the kitchen area or eating fast food at their console. No rules seemed to apply to anyone and, if it was not really chaos, it certainly was a step in the right direction.

* * *

Video games are not the only industry where things are changing. Until fairly recently, my former-designer wife often lamented that there were no home-grown Chinese designers. Local apparel companies were mostly busy imitating foreign brands for which the public was voracious -- hence the proliferation of names like Marco Polo, Rudolf Valentino and Raidy Boar (try it phonetically, since the spelling means nothing in Chinese^*).

But in the last three years or so, trendy boutiques have appeared where true, original Chinese designs are displayed. These are not only creative and often elegant, but they also are clearly aimed at the Chinese market, as indicated by the range of available sizes into which few western women would fit.

I had the opportunity to meet two young designers in Shenzhen, a city which may be the richest per capita in China and with one of the fastest rates of growth. Since I do not take notes on these visits, my figures may not be exactly accurate, but they certainly are indicative of what I saw and heard.

The two companies share many similarities, both in size and business model. Annual sales of $40 million to $80 million; 120 to 300 boutiques, about two-third company-owned and one-third franchises (really more like exclusive distributorships). Neither actually manufactures, as both use outside contractors. Most retail prices range from RMB350 to RMB1000 (remember the rule of thumb: this is only $45 to $120 but, in terms of living standards, this would compare to dresses or ensembles in the $350 to $1000 price range in Europe or the United States). The clientele is “women professionals between 30 and 45”. Both companies claim rates of growth in sales in the 30% to 50% range. Both have boutiques in all major cities, but neither brand was known to a few ladies we interviewed in Chengdu.

One designer, a man, is very methodical about business processes, company culture and the like. Although already well endowed with diplomas in business and economics, he nevertheless recently returned to complete an executive MBA from a prestigious school in Shanghai. After designing himself in the early years, he more recently associated with a French-born designer, to be able to concentrate on the business aspects of the company.

The other, a woman, is more of the glamorous style. Every year, she designs a collection of gowns, some worn by famous actresses, which have little to do with what is sold in her stores but give her opportunities for fashion shows and editorial coverage. She recently associated with an American-trained Chinese woman-banker-turned-investor. All in all, however, her total sales are only a bit more than half those of her colleague and competitor.

In my opinion, however, both designers shared one major risk: the bankers.

* * *

So far, the spectacular growth of our two designers’ companies has been largely self-financed, with very little debt incurred. Investment needs are low as are working capital requirements, since “franchisees” pay one-third of every order in advance. Yet, both feel under intense pressure to take their companies “public”, i.e. to list their shares on a stock market. In both cases, the desire is justified by the ambitious goal to be among the first in China to create a truly-national brand.

The man argues that being a public company will add to the brand recognition, in a nation where the newly well-to-do are living a love affair with the stock market. He merely wonders whether the floating of the company’s shares (IPO) should be done on the Shanghai Stock Exchange or the Hong Kong Stock Exchange.

The woman has visions of a brand that would make a name for itself (or at least establish a presence) in America, adding to the allure of her line among Chinese customers. Her adviser has located a corporate shell, e.g. a company without assets or, hopefully, liabilities that is already listed in the United States -- presumably on the “pink sheets” reserved for penny stocks. A “reverse merger” is envisioned, whereby the listed company would officially acquire our designer’s business but she and her partner would wind up owning the whole thing. The net result would be that the Chinese business has acquired a listing in the United States.

The pressure from bankers on Chinese entrepreneurs to take their companies public has become all but irresistible. One can see bankers in every hotel lobby in China, these days, and every entrepreneur I have met has been approached by several. Yet, few of these young entrepreneurs have the experience to realize the downside of running a public company.

First and very generally, even in the absence of legislation such as Sarbanes-Oxley, the compliance and administrative costs and burdens rise exponentially when running a public company, at a time when all the entrepreneur’s energies and resources should be directed to generating and managing growth.

More importantly, it is simply dangerous for a small company to be publicly traded. Let’s say, for example, that your company with $80 million in sales is publicly floated at a share price that implies a total value of $100 million. You only place 20% of the shares in the public, retaining the rest for yourself. The stock market value of the publicly-traded shares is thus only $20 million. Such a small float is easily manipulated by fraudsters. They can aggressively acquire shares and start pushing up the price, which is easy with shares that trade sparsely. Small speculators, attracted by the stock’s upside momentum and the speculation that “something is happening,” join in and push the shares price further up, eventually purchasing as well the shares initially bought, and gladly sold back to them, by the fraudsters. When there is no one left to buy and no broker following the stock, the volume dries up to a few shares a week and the price collapses.

Needless to say, this type of experience leaves a sour taste in investors’ mouths and can taint your reputation and your company’s name for a long time to come. Not only will it reflect on the brand name you were trying to build, but is is likely to make very difficult any future financing when it is really needed.

By necessity, entrepreneurs and creators must be dreamers. The Chinese are no exception. Unfortunately, with the help of greedy or simply irresponsible bankers, the dream can easily turn into a nightmare. I hope our promising designers do not wake up to one.

François Sicart, in Hangzhou
April 9, 2007

^*: “sounds like” Eddie Bauer