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The Real Impact of CFIUS on Silicon Valley

Originally published in China-US Focus

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Even before trade tensions really started flaring up, the passage of the Foreign Investment Risk Review Modernization Act (FIRRMA) in August 2018 threatened to severely curtail China backed venture capital in Silicon Valley. And it has.

FIRRMA greatly expands what kinds of foreign investments in US companies will require filings and review by the Committee on Foreign Investment in the United States (CFIUS). Filings used to be strictly voluntary by the parties involved, and limited mostly to cases of mergers and acquisitions. Now FIRRMA has expanded the scope to include many venture capital investments in sensitive technology areas as well.

Following passage of FIRRMA, a pilot program was rolled out that has required mandatory filings for investments by foreign funds in startups falling under certain NAICS industry codes. This program was put in place as a stop-gap measures using antiquated industry classifications, which fail to describe modern day sensitive technologies such as artificial intelligence and computer vision. The Department of Commerce BIS has already made clear that many such sensitive technologies will be on the final list when it ultimately comes out.

Impact #1 - Chinese-backed VC Funds Struggling to Deploy Capital

Chinese-backed venture capital funds are struggling to deploy capital in hand.

First, even if certain advanced technologies are not yet explicitly covered, they will be shortly when the pilot program ends. Second, existing CFIUS rules already gave it the discretion to stop many deals in these areas on more general national security grounds. And subsequent transactions such as follow-on investments or other joint ventures and acquisitions will be covered once the pilot program ends. Therefore, the pain is just being delayed.

So why not just file voluntarily and take your chances? Simple, because startups move at a fast pace and government filings of any length and delay are effectively non-starters for competitive deals.

Regardless of sector, there are safe harbor conditions to avoid reviews. A key concession in the final bill was to exempt passive investments by Chinese investors. In practical terms this means that the investor cannot have any form of control over a startup – (1) no board seat or board observer rights, (2) only a limited ownership stake (e.g. at least less than 15%), and (3) no rights to access technical information that is non-public.

Can a Chinese fund meet these requirements in its investments? Well, a substantial number of Chinese funds’ investment thesis is to add value by helping their portfolio companies access the China market and not just look at pure financial returns on their investment. But FIRRMA would now prevent joint ventures or non-standard commercial technology license deals, making joint market access more difficult. That has only gotten worse with recent events surrounding Huawei.

The FIRRMA changes also effectively prevent a Chinese firm from leading an investment round in a sensitive technology startup now. Beyond the official sticker price (e.g. company valuation) that investors pay, much of the extra hidden value VC investors traditionally derive on both upside and downside protections comes through preferred share rights which are standard in venture capital circles. On the downside protection side, many of these preferential rights are exercised and maintained via board seat or other contractual veto provisions, which now might now be deemed “control” for purposes of CFIUS review. On the upside, venture capital firms almost always have rights to make follow-on investments in subsequent capital rounds to maintain their pro-rata equity ownership. Exercising these rights may now subject subsequent rounds to CFIUS reviews once the pilot program ends.

The other safe harbor exemption for Chinese-backed funds is to essentially not be Chinese. Under FIRRMA, even if 100% of the limited partner investors in a fund are Chinese, if the general partners of the fund are US citizens and fully empowered with discretion to make all investment decisions on their own, the fund is considered a US fund and exempt from CFIUS filing and review requirements. Some Chinese funds with capital already committed to invest in the US face the difficult choice of (1) trying to fit their investment thesis into the narrow paths that CFIUS still allows, (2) rolling up the fund early and returning unused capital to investors, or (3) swapping out existing Chinese general partners and surrendering real control to American general partners. Certainly option 3 will be looked at with scrutiny by regulators and startups receiving investment from these funds, but it is being internally discussed as a real choice for funds to pursue.

Impact #2 - Chinese Corporate Venture Capital Cannot Realize Natural Synergies

The in-house venture capital division of strategic investors such as Alibaba and Tencent face even more challenges. Post-FIRRMA, even if a Chinese corporate investor could meet the passive investment requirements discussed above, the investor would be prevented from setting up a joint venture in China (this would at a minimum provide access to material non-public technical information), licensing the technology for its business in China (covered by a catch all provision in FIRRMA), and of course, M&A.

Are these corporate development divisions of major Chinese internet companies simply packing up shop in Silicon Valley? Not yet. A small but significant number of founders in Silicon Valley are ethnically Chinese. Chinese venture funds, especially corporate venture funds, are now asking the founders of these startups three distinct questions:

(1) Are the rest of the key employees Chinese?

(2) Can the core IP be separated cleanly and applied to the Chinese market?

(3) Are you willing to reincorporate and move back to China?

Impact # 3 Entrepreneurs Hurting on the Margins

Silicon Valley will survive any withdrawal of Chinese-backed capital. It makes only a relatively small percentage of total VC activity. But there will be impact on startups on the margins:

1. Seed stage companies rely on aggregating multiple small checks from micro-VC funds (US$5-25 million in capital) before getting a proper “Series A” funding round from a major firm. Chinese-backed micro VC funds have been an important source of funding for these companies.

2. Chinese funds had also been a source of help for market entry to China, a massive market that many US startups cannot delay engaging for too long. Without Chinese investors, they will by flying a bit blind when trying to enter this market on their own.

3. Startup founders, especially ethnically Chinese founders, engaged in sensitive technologies will increasingly be forced to pick a market. One of the key advantages for ethnically Chinese founders has been an ability to leverage Chinese funding and supply chain sources which now may have to be curtailed. With a massive market awaiting them in China, and a relatively unwelcome reception in the US in the current environment, they may decide to move or start their businesses in China instead.

4. Many other startups are hesitating to take investment from Chinese funds, at least in the short-term. Even if the rules clearly provide safe harbors for passive investments, the rules and the current trade war environment create a degree of uncertainty and confusion which has caused startups that have a choice of investors to shun Chinese capital. Today in Silicon Valley, the perception of this new law is worse than the actual letter of the law. A startup presented with a potential investment by a Chinese fund would have to balance the risk of future potential CFIUS scrutiny on later funding rounds or acquisition as well as added difficulties trying to secure government contracts all versus the potential reward of having Chinese investors bridge the company to enter the Chinese market. Right now, many startups are still choosing the former path and reduce their risk to uncertain future scrutiny.

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