China’s Penetration of Silicon Valley Creates Risks for Startups

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Stanford University's campus is seen in an aerial photo in Stanford
Stanford University's campus is seen in an aerial photo in Stanford, California, U.S. on April 6, 2016. REUTERS/Noah Berger
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By Heather Somerville
SAN FRANCISCO (Reuters)

Danhua Capital has invested in some of Silicon Valley’s most promising startups in areas like drones, artificial intelligence and cyber security. The venture capital firm is based just outside Stanford University, the epicenter of U.S. technology entrepreneurship

Yet it was also established and funded with help from the Chinese government. And it is not alone.

More than 20 Silicon Valley venture capital firms have close ties to a Chinese government fund or state-owned entity, according to interviews with venture capital sources and publicly available information. While the U.S. government is taking an increasingly hard line against Chinese acquisitions of U.S. public companies, investments in startups, even by state-backed entities, have been largely untouched.

That may well be poised to change as the U.S. Congress finalizes legislation that dramatically expands the government’s power to block foreign investment in U.S. companies, including venture investments.

 

 

The new law would give the U.S. government’s Committee on Foreign Investment in the United States (CFIUS) wide latitude to decide what sorts of deals to examine, eliminating certain ownership thresholds, with a particular focus on so-called “critical” technologies.

“The perception is that a lot of the tech transfer of worry to the U.S. security establishment is happening in the startup world,” said Stephen Heifetz, a former member of CFIUS and now a lawyer representing companies going through CFIUS review.

The latest version of the bill exempts “passive” investors, which would cover many of the limited partners that back venture firms. But limited partners that have some control over the business, or firms whose managing partner is a “foreign person”, could be subject to scrutiny.

 

 

The university endowments and family offices that traditionally provide most of the money for venture firms are usually one of many limited partners and have minimal if any involvement in the startups they help fund.

Chinese entities also sometimes take a passive role in big venture funds. But venture capital sources say that Chinese government funds often play a more influential role in the smaller venture firms they back by providing a greater percentage of their funding. That empowers them to request information about startups or help them to open offices in China – potentially opening those startups to CFIUS review.

The possibility of a regulatory crackdown has caused unease in the startup world. Venture firm Andreessen Horowitz is counseling startups that if they raise money from a China-backed investor, they put themselves at risk of government scrutiny, a person with knowledge of the matter said.

“The window for some startups to raise money from China may be closing,” said Chris Nicholson, co-founder of AI company Skymind, which has raised money from Chinese Internet group Tencent Holdings Ltd and a Hong Kong family office.

 

SENSITIVE AREAS

Until recently, the original source of funds for venture investments has not been an issue in Silicon Valley. Venture firms are not obliged to disclose who their investors are and entrepreneurs rarely ask, leading some dealmakers to question how CFIUS could keep tabs on startup investing.

 

 

Danhua Capital, which is backed by the Zhongguancun Development Group, a state-owned enterprise funded by the Beijing municipal government, has holdings in some of the most sensitive technology sectors.

Its investments include data management and security company Cohesity, which counts the U.S. Department of Energy and U.S. Air Force among its customers. Drone startup Flirtey, which in May was selected by the U.S. Department of Transportation to participate in projects to help the agency integrate drones safely into U.S. air space, is also part of the Danhua portfolio.

 

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