Startups, investors may bear brunt of escalating US-China tensions

Last week, U.S. trade representatives traveled to Beijing for a round of trade talks with the hope of coming to an agreement that would end the U.S.-Chinese trade dispute. Alongside large corporations, many U.S. tech startups are watching the results of these talks with a close eye because they face significant concerns over the impact that increased tariffs will have on their business. But while tariffs have garnered most of the press attention, U.S. startups also face reduced access to foreign capital, increased regulatory scrutiny, and potential talent issues. Conversely, China is developing new strategies to ensure that more investment dollars will remain in their domestic startup capital community.

With tariffs set to rise up to 25 percent on numerous types of imported products on March 1, tech startups that manufacture key components or assemble their products in China will face a significant increase their costs. While larger, more established firms may be able to absorb those costs with little impact to consumers, most startups do not have such ability due to limited cash reserves. This is especially a concern for startups trying to enter into new markets or gain traction in the U.S. mass market because increased costs will increase the price on their products.

While U.S. startups wait nervously for the end of the U.S. and China trade dispute, the Chinese government and Chinese investors are distancing themselves from the U.S. startup and investment ecosystems. In November, the Chinese government announced the creation of a national Technology Innovation Board – a Nasdaq-style board for Chinese tech startups to sidestep complex IPO hurdles and access easier funding. The intent of this board is to help protect the next generation of Chinese tech companies from U.S competitors and list a public offering at home instead of in foreign countries.

Although detailed rules have yet to be published, the board will launch in June. The key rule change for the new board is intended to address a major hurdle faced by Chinese tech companies — it will allow companies that have yet to make a profit to file for an IPO. Under current Chinese regulatory laws, companies must produce a profit before being allowed to file for an IPO. This tight regulatory environment has led many Chinese companies to claim that they had to delay their IPO for months or even years due to not achieving the probability threshold.

This new board may also be well positioned to attract capital from Chinese investors that typically would have gone to U.S. startups. As new Trump administration policies look to curb access to U.S. innovation due to concerns about intellectual property threat. Chinese investors, including big family offices, are quickly exiting the U.S. startup investment market. While 2018 marked a record high for investments by Chinese investors in U.S. startups (approximately $3.1 billion), the pilot rules to the Committee on Foreign Investment in the U.S. (CFIUS) is likely to make Chinese investors look elsewhere in 2019 and beyond.

Under the pilot CFIUS rules, the federal government will expand its powers to non-controlling investments by a foreign entity into a ‘critical technology’ company (e.g., AI, IT, robotics, etc.) if the investment has certain characteristics. Currently, the federal government will only review investments that have a foreign investor(s) with controlling interest of a startup. The pilot program will allow the government to review an investment by a foreign investor(s) regardless of the size of the investment.

The threat of these rules being finalized has already caused many Chinese investors to walk away from transactions and not take meetings with U.S. startups, according to Reuters. New York-based Rhodium Group, an economic research firm, predicts that nearly 75 percent of Chinese investments in U.S. startups will be reviewed by the U.S. government.

While some startups are concerned about the decrease in capital, other startups are concerned that a lack of Chinese investors and co-founders will make it more difficult for U.S. companies to gain access to the world’s second largest market. Historically to enter the Chinese market, startups needed to have a strong connection with a Chinese citizen. For several key industries regulated under CFIUS, startups also may face a challenge hiring foreign-born employees due to concerns that their company will face similar increased scrutiny by federal regulators as companies with foreign investors – especially if equity is included in the compensation package.