Tech Boom Sweeps China, But Some Sense a Bubble

SHANGHAI -- For entrepreneur Gary Wang, the next new thing in China is a place where the country's growing middle class, or "couch potatoes," can watch free videos to their hearts' content. His company's Web site, Tudou (Chinese for potato), has become insanely popular insanely fast -- more than 15 million users as of this month -- and Wang dreams of the day when the company will have an IPO.

Flush with $30 million in venture capital, Wang has hired 95 employees, engineered a slick Web site and leased thousands of computer servers across the country.

But there's one thing the company hasn't managed to do: make a profit.

Wang's company is typical of China's dot-com boom.

Over the past decade, start-ups have proliferated throughout China, thanks to an aggressive government campaign to attract private investment. Many of the new companies focus on Web sites, but there are also computer-chip and telecommunications equipment designers, biotech development labs and medical-device makers.

The state has created dozens of "new Silicon Valley" districts -- glittering high-tech zones and incubators as big as cities, with such incentives as no corporate income tax for the first three years. The largest is Beijing's Zhongguancun, home to 20,000 start-ups, most of them information-technology companies, with nearly 800,000 employees that together received more than half of the international venture capital invested in China last year.

The money flowing into China is transforming small towns into tech centers and a Third World economy -- based on churning out such products as cheap TVs and socks -- into a world player in innovation.

Some fund managers are wary of what lies ahead in the short term, however, and worry that China is creating a tech bubble similar to the one that burst in the United States at the start of the decade. But venture capitalists, entrepreneurs and competitors point out that Silicon Valley remains a prominent tech center, despite the bust. They say the tech sector in China, which has an estimated 162 million Internet users, will be a force to be reckoned with.

China's tech boom began in much the same way the one in the United States did, with venture capital from Silicon Valley. The frenzy of investments here began in early 2005, when venture capitalists were getting excited again about dot-coms after Google's eye-popping initial public offering a few months earlier.

David Su, a partner at KPCB China, a branch of Silicon Valley venture-capital powerhouse Kleiner Perkins Caufield & Byers, said that led to some irrational exuberance and too much money chasing too few quality ventures.

"A lot of people got excited, and way too much money went into making copies of the same thing -- there were 20 YouTubes, 50 MySpaces. Obviously most of the players are going to lose out," Su said.

Several top venture-capital and private-equity investors said that until this year they were making more money by financing entrepreneurial companies in China than in other parts of the world. Now some are beginning to scale back their investments.

David Chao, co-founder and general partner of DCM Capital Management, a venture-capital firm that has heavily invested in China, said he has started pulling out some of the company's money. "Many domestic Chinese companies that have recently gone public are getting crazy [valuations]. No matter how you see it from the outside, it certainly looks like a bubble," Chao said.

Sohu.com, an online portal similar to Yahoo, for example, has recently been trading at 74 times projected 2007 earnings. Tencent, whose instant messaging service QQ is the rage in China, and Ctrip.com International, which, like Travelocity, Expedia and Orbitz, provides comparison-shopping for airplane tickets, has been trading at 92 times earnings.

Baidu.com, China's biggest rival to Google, has been trading at a price-to-earnings ratio of 159. Google, by comparison, has been trading in recent weeks at 50 times projected earnings.

"While everybody believes the growth is going to be extraordinary, it's going to have to be really, really extraordinary to justify some of the valuations that are beginning to be seen in China," said Colin C. Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College's Tuck School of Business. "Going into China right now might end up with some bad results."

Joseph Chan, a managing partner for Pillsbury Winthrop Shaw Pittman who moved from San Francisco to Shanghai in 2006, said there are differences between the U.S. dot-com bust and what's happening in China.

"The scope of investment is much greater in China. In the U.S., it's all tech," said Chan, who published a book about venture capital and private equity in China.

In China, Silicon Valley VCs are pouring money into more traditional businesses like restaurant chains and educational services, in addition to tech. By the end of November, venture-capital firms invested $3.18 billion in China, up almost 80 percent from the year before, according to Zero2IPO Research Center in Beijing. Money going into technology, however, was just 42.5 percent of all investment this year, down from 61.5 percent last year.

But in other respects, there are parallels between the dot-com booms. Many entrepreneurs here are inexperienced and young; chief executives say the average age at their start-ups is in the mid-20s. Their offices are filled with Ping-Pong tables and stuffed animals. And like their U.S. predecessors, many Chinese start-ups are learning that a high number of "eyeballs," or Web-site visitors, doesn't necessarily translate to cash.

BabyTree (modeled after social-networking site Facebook), Baihe (similar to matchmaking site eHarmony) and Tudou (like video-sharing site YouTube) are among the most popular sites in China, but all are struggling with how to make money from their users.

BabyTree, funded by Matrix Partners, based in Boston and Silicon Valley, targets young parents who discuss, shop for, and exchange pictures of, their children. The site, which recorded more than 900,000 users last month, is not profitable and does not expect to be for at least three years.

Allen Wang, chief executive of BabyTree, said that the company hopes to bring in a mix of advertising revenue, e-commerce and unspecified experimental offline ventures. "BabyTree is a community. For a community's development and construction, you need a long, healthy environment," Wang said.

Matchmaking site Baihe has raised a total of $11 million from Silicon Valley's Mayfield Fund and other venture capital firms. While most of the site is free, several thousand users pay $1,000 a year for a VIP plan -- a major source of the company's revenue. Tian Fanjiang, co-founder of Baihe, said the company remains in the red mostly because of high spending on a national advertising blitz. He hopes to be profitable next year.

Like BabyTree and Baihe, Gary Wang's video-sharing site Tudou is a survivor. A year ago, Wang said, there were some 300 competing Web sites. Now, he said, there are pretty much only three.

Working late into the evening in Shanghai in an old converted townhouse whose walls have been covered with employees' graffiti and doodling, Wang spoke of his vision to "do away with editors, with 24-hour TV, with all these government controls."

On principle, he refuses to consider any business model that charges video creators to use the site and said that he's convinced that the key to profitability will be "click-throughs" -- the number of people who click on a video. Since the company's Web site went live in April 2005, the number of advertisers has grown steadily and it now counts Adidas and McDonald's as major clients.

Wang, 34, who returned to China after graduating with a computer science degree from Johns Hopkins University in Baltimore, refused to estimate when the company might become profitable but said he hopes it will be "self-sufficient" by the end of next year. The dream IPO is probably years away.

Wang said he knows that if the fate of his competitors is any indication, odds are against him and his investors, U.S.-based IDG Ventures, Granite Global Ventures, General Catalyst Partners and several other VCs. But, he said, "if the chance for success is low, that makes life a little more interesting."

Staff writer David Cho in Washington contributed to this report.