The Shanghai Government Is Compensating VCs For Sour Startups

Starting February 1st, the Shanghai government will compensate investment firms for losses incurred while investing in early stage and seed funded tech startups.

Called the “Provisional Measures on Managing Shanghai Angel Investor Risk Compensation” (our translation), the new policy promises up to 3 million RMB (around $456,000 USD) per unsuccessful investment, with a limit of 6 million RMB (around $916,000 USD) in “risk compensation” per investment firm per year. The amount of risk compensation allocated is calculated using the difference between the profit made from the startup’s exit and the amount of money invested in the startup.

It’s a hefty load of money to throw at venture capital firms, aimed vaguely at encouraging local startups, specifically those that bring “global impact” and “innovation” (the Chinese government is obsessed with the word ‘innovation’) to the tech industry. By mitigating the financial risk of investing in startups, the Shanghai government hopes to promote more “public businesses” and the “innovation of the people.”

“The [risk compensation] policy will have some impact but in the end it still comes down to startup’s culture and its ability to grow,” says Ken Xu, a Partner at Gobi Ventures, a venture capital fund for IT and digital media companies in China and Southeast Asia.

“Startups are characterized by their potential for explosive growth and the factors of uncertainty within them,” he says. “There’s no simple guide [to their success].”

The “risk compensation” policy reveals a lack of basic knowledge on how venture capital works. The financial consequences of a bad exit are a natural disincentive for reckless investment. In order to be successful, VCs must make smart and careful investments, through business acumen, experience, and yes, luck. By undercutting this dynamic with “risk compensation”, the new policy runs the risk of bloating Shanghai’s startup ecosystem with VC firms and startups that are dependent on government funding for financial success, not their own merit.

The Shanghai government is not the first provincial government in China to implement a “risk compensation” policy. In 2013, the Jiangsu government announced a “Provisional Measures for Guiding Angel Investment Funds” (our translation), which also offered “risk compensation” to investors who invested in early stage tech startups.

In addition to financial incentives, provincial governments have also implemented policies to improve their local talent pool for startups. For example, in September 2015, the Shanghai government announced a new policy that would make it easier for tech entrepreneurs in Shanghai to obtain the much coveted Shanghai hukou (户口) or permanent residence.

In any case, China’s netizens are not happy with the news of Shanghai’s “risk compensation” policy. Many are horrified that their tax money is being funneled en masse to investment firms. Some called the subsidy “brain-dead,” among other colorful terms. One netizen commented that “if Chinese people could vote, these kinds of governmental officials would never have been elected.”