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Venture Capital’s Red Flags

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Venture Capital’s Red Flags

Growing investment in U.S. startups by China and other foreign players needs greater scrutiny. Spring 2020
Economy, finance, and budgets
Politics and law

Technology and global finance have radically reshaped employment, social progress, investment, and national fortunes. With a robust and committed policy of openness, America has been a prime beneficiary of these developments. Free markets ensured that the right people could be mobilized in the right places with the right investments. Global capital seeks the best opportunities wherever it can find them, and, fortunately for the United States, that investment often comes to American shores.

The intersection of free markets and global capital is venture capital (VC), the investment dollars behind startup companies. Compared with more liquid public markets, VC has traditionally been under-regulated. After all, why should the government stop someone willing to risk money for potential gain when it can unleash technological progress, innovation, and job growth? That’s starting to change, though, because investing in a startup is no longer just about funding the next wave of innovation. Venture capital today can involve much more—including intentions not aligned with a company’s purposes, as well as goals at odds with the national interest. The openness that has, until recently, been a clear strength in the VC sector is now increasingly a point of vulnerability.

Much of this new challenge comes from China, which is waging an active economic war on American industry the likes of which the U.S. hasn’t faced since the Cold War. As China economic specialist Julian Gewirtz recently wrote in Politico, Chinese elites are “indicating, subtly but unmistakably, that they see global finance as a rising theater of conflict and are considering new ways for China to defend itself and even to retaliate.” While China is by far the most important national actor to watch, it’s not alone in posing challenges to America’s innovation economy, which leads the world in attracting VC investment. Russia, Saudi Arabia, and other nations with less than savory governments have similar objectives—and wallets to match. Saudi Arabia is among the largest investors in Silicon Valley, for example, and China, Russia, and the United Arab Emirates have invested heavily in the coming wave of companies in key emerging industries like artificial intelligence, quantum computing, and next-generation silicon semiconductors.

Everyone from economic-development leaders and national security officials to startup founders and policymakers should be alert to the changing composition—and intentions—of America’s VC investors. The Trump administration has begun to address these new realities, but a much broader conversation is needed about how to defend the openness that defines the American innovation economy from bad actors. One important part of a solution: better enforcement of disclosure requirements around company ownership and VC investment to ensure clarity about the origins of these investments. No foreign adversary should be able to access America’s most promising startups without raising a red flag. How the U.S. handles this shifting economic and political landscape will determine who owns—and ultimately profits from—technological growth.

The concept behind venture capital is straightforward. VC investors allocate money across a portfolio of early-stage companies that they believe will increase in value dramatically in the coming years. It’s not uncommon for one company to provide the bulk of returns for an investor’s portfolio, while many other startups yield nothing. The investors help the companies grow, secure follow-on investment, and ultimately exit when the company is acquired by a larger firm or when it debuts on public markets in an IPO. Historically, the dollars underwriting VC firms came from a handful of players: university endowments, nonprofits, family investment offices, and pension funds (which started investing in such alternative assets in the 1970s). VC offered a compelling proposition: investors could secure a financial return while also supporting innovation and job growth.

Venture capital is flooding U.S. markets today. Over the past two years, according to the National Venture Capital Association, VCs invested $138 billion on average annually, compared with $36.5 billion annually at the start of the past decade. Heavy demand from overseas investors looking to seed promising startups has been a major driver of this expansion. Financial-data service Refinitiv estimates that foreign VC in U.S. companies totaled roughly $51 billion in the first three quarters of 2019, the most recent data available.

Venture Capital, China (Illustration by Patric Sandri)

And yet, while more money for more startups sounds good, the interests of some overseas investors and those of the domestic startups that they invest in are diverging. The disconnect is most obvious in regard to China, which has made catching up with, and surpassing, American technological supremacy a national mandate through its Made in China 2025 plan, which envisions market leadership in critical technology industries. China has invested billions in startups in the United States through various state-backed VC fund entities. Why does China invest overseas if it wants market domination at home? Unpacking this puzzle gets at the deeper challenges of global VC. Venture capital isn’t just money wired to a company’s balance sheet, but rather a preferred security that typically affords additional protections to investors and can also offer them secondary advantages. Among those advantages: information rights, governance rights, and employee-data rights, plus opportunities to rebrand their reputations.

Information rights are perhaps the most important. Investors have the right to see a company’s books, and often its technology, in order to understand the context for their investment. Individually, information rights provide vignettes of an emerging market; in aggregate, they can provide a comprehensive picture of the course of a new industry—often before any other source of data makes it clear.

Conducting hundreds of VC deals in recent years, China’s investors have secured access to the financial and business data of many of America’s next-generation startups—and perhaps to their technological road maps, too. For years, researchers and Justice Department prosecutors have watched as China launched state-directed industrial-espionage campaigns against America’s top tech companies and defense contractors. Add the data gleaned from those campaigns with the aggregate internal data of hundreds of startups on the technological frontier, and together, the country has at least a blueprint for reaching the goals of Made in China 2025.

Second, governance rights give investors a say in the strategic direction of a company, often complemented by a seat on its board of directors. Rights of first notification and first refusal inform investors that a change of ownership is imminent, providing them with a mechanism to counter-offer or outright block a sale. Collectively, governance rights provide investors with critical behind-the-scenes insights on the strategic direction of different industries. Knowing, say, that Google is seeking a certain artificial-intelligence technology or that Apple needs a certain chip design for its next smartphone (and how much it is willing to pay for it) gives investors a competitive edge that might be years away from being written about in the business press. Furthermore, investors can then use their board seats not just to learn about an industry but also to shape its evolution. They can determine which competing acquisition offer to select, perhaps directing a company to take a compelling overseas offer over a local one that might be more in line with American interests.

“China’s VC investors have secured access to the financial and business data of many of America’s next-generation startups.”

A third benefit of these investor rights is access to employee-salary data. Company boards must authorize the salaries and equity packages offered to high-ranking employees, including leading engineers and scientists. China has made it a top priority to repatriate thousands of talented Chinese nationals back to the mainland and to cultivate international science and technology leaders through efforts like the Thousand Talents Program.

In January, federal prosecutors charged the chairman of Harvard’s chemistry department with failing to report payments—$50,000 a month, with an additional $150,000 annually for living expenses—from these sorts of Chinese programs. The arrangement spanned several years. Meantime, a compilation of similar cases by the Wall Street Journal finds that some researchers have received as much as $14 million in payments for moving their research and know-how to China. Knowing precisely the incomes and other compensation of potential recruits provides key intelligence on America’s top talent, making future recruiting operations easier for China’s operatives.

Finally, VC offers an opportunity to launder dismal human rights records. Saudi Arabia and other nations in the Middle East have heavily invested in VC funds and directly into technology companies over the last few years, ostensibly to transition away from their hydrocarbon-dependent economies. Middle Eastern sovereign wealth became most visible with the launch of the Vision Fund by Japanese telecom giant SoftBank, which broke all fund-raising records with its debut $93 billion VC fund. Saudi Arabia invested $45 billion, and another $15 billion came from Mubadala, the sovereign wealth fund of Abu Dhabi. The Vision Fund’s ambition to bankroll the future of technology was widely lauded in Silicon Valley until the torture and murder of Saudi dissident and Washington Post columnist Jamal Khashoggi inside the Saudi embassy in Istanbul in 2018. Since then, the fund has faced a drumbeat of questions about human rights, and Silicon Valley technology workers have increasingly demanded answers to where the capital behind their companies comes from.

What’s ultimately at stake with such investments is the power of narrative. Russia can claim that it’s investing in the future even as it tests a so-called kill switch for its domestic Internet to control dissidents of Vladimir Putin’s regime. China can back a startup developing facial-recognition technology, even while it uses facial recognition to track down and imprison hundreds of thousands of Uyghur citizens in Xinjiang.

Such is the complexity of international VC that a return on investment may be the last priority for some of these overseas dollars. Collecting strategic insights, shaping a cutting-edge industry, gaining an advantage in recruiting, and transforming political perceptions may be so valuable in and of themselves that no financial return is even necessary.

Entrepreneurs are caught in a bind. On the one hand, they can’t outright reject inbound investment offers—they need venture capital, after all, and if they don’t take it, their competitors may take it instead. On the other hand, taking capital can come with severe yet subtle consequences that may reveal themselves only in the long term. Increasing recognition of some of the potentially problematic implications of global venture capital has led to policy and legal changes by the Trump administration and Congress, as well as a new program at the Pentagon. Yet such efforts are likely to have limited impact, especially in private markets, where transparency in ownership is increasingly not the norm.

The primary mechanism for protecting America’s technology companies is the Committee on Foreign Investment in the United States. Dating to the Korean War era, CFIUS is an interagency body, chaired by the Treasury secretary, that reviews foreign takeovers of domestic companies in sectors deemed critical to U.S. national security. While the committee has relatively broad remit under its enabling legislation, it has been all but useless in the intervening decades, despite the growing interest in American technology companies from foreign actors. CFIUS reviews were, until recently, mostly voluntary and submitted only for the largest financial transactions—and even then, only in cases where a majority of a company was being bought by a foreign buyer. From 2008 to 2012, a total of 538 notices were delivered to the committee, and only one was blocked by presidential order—a buyout by a Chinese construction company of a wind farm located near a U.S. Navy weapons-training facility.

One extraordinary example of a recent CFIUS action took place in early 2019, when the committee forced Chinese video-game company Beijing Kunlun to divest its acquisition of Grindr, a popular gay dating and hookup app, which it had acquired several years earlier. Trump administration officials were reportedly concerned that the app’s detailed profile data of gay users could provide Beijing with useful kompromat, information that might be used for blackmail in intelligence operations.

Other than such rare enforcement actions, though, analysts widely considered CFIUS to be toothless in defending America’s technological interests. So with broad bipartisan support in Congress and a signature from President Trump, an overhaul of CFIUS, called the Foreign Investment and Risk Review Modernization Act, or FIRRMA, was passed in mid-2018 and is taking effect this year. Under the new FIRRMA rules, non-majority investments may need to be reviewed, particularly for companies working in “critical technologies” and “critical infrastructure” areas. These are precisely the sorts of investments typical in venture capital.

Unfortunately, these regulations remain largely voluntary. Greater enforcement and the concomitant regulatory risk will likely lead more firms to submit for a CFIUS review in order to secure a “safe harbor,” which prevents the committee from retroactively reviewing a transaction, as it did in the Beijing Kunlun / Grindr case. The long-term effects of this legislation are likely to be modest.

In addition to modernizing CFIUS, defense officials have become deeply concerned about foreign infiltration of VC in areas critical to the Pentagon’s supply chains. Last year, Undersecretary of Defense for Acquisition and Sustainment Ellen Lord launched a program called the Trusted Capital Marketplace to create a secure, nationalized source of VC for startups in the defense-technology space. The idea is to vet “trustworthy” VC investors (perhaps resembling existing background checks conducted by the department) and connect them with entrepreneurs. While the details are not fully fleshed out, the program’s first priority is the autonomous drone market. The FIRRMA reform and the outline of the Trusted Capital Marketplace should both be lauded for providing some security to American entrepreneurs, even if it comes at the expense of fully open access to global capital markets.

Venture Capital, China (Illustration by Patric Sandri)

What neither of these initiatives can account for, though, is just how little information we have on foreign ownership of American startups. Unlike public securities, which must be registered with the Securities and Exchange Commission and go through a public process of disclosure by filing an S-1 form, many startup investments are not disclosed to the SEC. Typically, startups file a Form D with the SEC declaring a new round of venture capital, which can exempt them from much of the complexity of individual state securities regulations under what are known as Blue Sky laws.

Yet investigative reporting that I conducted in 2018 and 2019 at TechCrunch revealed that the legal culture around startups and these filings has become less transparent. Lawyers I interviewed explained that, while Form Ds are often required or highly recommended in order to avoid legal repercussions, they increasingly advised clients against filing these forms, since SEC enforcement has been lax and startup founders often want to keep investment details secret from competitors—and sometimes even their own employees. It’s not uncommon for filings to be delayed months or never filed, particularly for the smallest VC rounds, making it nearly impossible for anyone to know the origins or destinations of venture capital.

Worse, startup founders themselves often don’t know where the capital invested in their company comes from. VC firms are barely required to file any information about their own fund investors, which means that a startup—even in a technologically critical industry—may not even realize that it is accepting investment from a foreign adversary. The system essentially works on reference, trust, and reputation—an open system, easily exploited by those who understand its patterns.

That’s partially why China has maintained such strict control over foreign capital in its own markets. Chinese securities remain out of reach for many global investors, and the country has also taken steps to bring greater portions of the economy under its direct control. Companies in China increasingly require their boards of directors to obtain consent from the Chinese Communist Party before making “material” decisions, and the country has launched a new stock exchange, the STAR Market, to compete with NASDAQ and offer an exit route for Chinese startups.

None of these top-down, command-and-control policies makes sense in America’s free-market context. One easy fix, however, would be to extend the ideal of the Pentagon’s Trusted Capital Marketplace to the whole VC economy. Rather than just creating a market of trusted VC partners for national security–sensitive startups, all venture firm fund-raising and startup venture-funding rounds from nontrusted foreign partners should face mandatory disclosure requirements.

Such disclosures will help policymakers comprehend the scale of this challenge, help entrepreneurs select capital that comes without strings attached, and reassure employees that they aren’t working for oppressive regimes while they program code into their keyboards. Even better, this approach is relatively noninterventionist—it can use disclosure frameworks already mandated by the SEC to minimize bureaucratic hassles. When an investor’s intentions are opaque, only further disclosure will provide the necessary sunlight to protect American markets.

America has benefited for decades from an open approach to international capital. Global capital and talent flows have flooded the U.S. with the resources and smarts that it needs to stay at the forefront of global technology innovation. America should take no action that would cripple or weaken its leadership in this area or undermine the dollar’s status as the global reserve currency.

Yet it’s also clear that international VC can no longer be considered just more dollars for more entrepreneurs, without other potential consequences. Overseas investment often comes with its own agendas, which may diverge from those of the United States and its entrepreneurs. Whether it’s learning about market strategy, changing industry outcomes, acquiring intel on workers, or remaking reputations, VC investments can have many secondary benefits beyond a return on capital.

The Trump administration and Congress should be lauded for beginning to confront these new challenges, but much more needs to be done. Policymakers need more resources and data to understand the problem, and that starts with better disclosure requirements for VC firms and startup-funding rounds that take overseas dollars without the knowledge of the Treasury or the SEC—bringing an evenhanded, if incremental, level of transparency to an otherwise dark part of the innovation market. Global venture capital needs to be understood within its national context before the advantages that the United States holds are eroded.

Illustrations by Patric Sandri

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