Techno-Darwinism | How China Innovates and Why Foreign Companies Fail

+8* ABL Column ChinaPublished November 15, 2009 at 6:08 pm No Comments

This column takes the angle of a field naturalist to consider Asian ecosystems and find reasons for success, failure and innovation. It is a guest column written monthly for the Chinese business magazine “China Electronic Business” (invested by Jack Ma of Alibaba), IT news site Interfax and the magazine “Business Forum China“. It also turned as the basis of an MBA class we gave at Berkeley. A recent TechCrunch article gave a great illustration with the matchmaking service Zhenai.

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In the early 19th Century, Charles Darwin embarked on a five-year journey as a field naturalist. On a visit to the Galapagos Islands he observed animals that were closely related but had some distinctive features. That triggered his thinking about possible common ancestors and the formulation of the theory of evolution. The story of this discovery teaches us that a lot can be learned from small differences. This applies to China’s digital scene as well. Here is how.

Diverging Species

China was a latecomer to the internet, and it is natural that the first ideas that were introduced, such as web portals Sina and Sohu and search engine Baidu, were from more advanced markets, notably the US. However, just like a group of animals on an island evolves in a certain way within its specific environment, so too did Chinese web companies. Mainly financed by foreign venture capital, they started off as the “common ancestor” recently stranded on an island. From then on, they had to survive in the local environment.

Domestic organizations have since evolved and diverged significantly to the point that, aside from the outward general looks, most of the “organs”, “instincts”, and even their “diet” have been affected. What exactly are the factors that influenced such evolution? They can be called the “Five C’s of Chinese Innovation” (note: jump ahead if you have already read about this in a previous column :-) ).

• Copy. This is the starting point. With experience, capital, and low costs, several entrepreneurs – including a number of foreign-educated Chinese – tried their luck at becoming the “XXX” of China.
• Competition. Competition forced companies to differentiate – how can you make a difference when a handful of competitors pick the same US model as you did? You’ll have to be creative in some way: marketing, product, business model, you name it!
• Constraints. Revenue models had to be adapted to low incomes and the limited online advertising market. While advertising alone could sustain many web properties overseas, the lower income and younger demographics of Chinese internet users slowed down the shift of advertising budget and the retail of various products to digital. This drove business model innovation.
• Combination. One solution to overcome constraints and competition was to combine ideas in new ways. Instant messaging with avatars (graphical representations of a user’s identity, e.g. at Tencent’s QQ service); social networking with e-commerce (communities for young parents, e.g. at RedBaby and BabyTree); and user-generated content with a virtual currency system (basketball-focused community, e.g. by HoopChina) are all examples of this.
• China. The unique market scale has enabled alternative business models to become viable, which Tencent and online gaming companies have cleverly exploited by charging only cents for certain services, but multiplying them by many millions. Travel agencies cTrip and eLong could not rely on the inefficient IT systems of airlines and have made use of low-cost call centres to process customer orders despite being based online; Taobao is an online platform with escrow and product delivery succeeding in a low-trust online environment.

Copy, Paste, Create

The best way to conceptualize the driving force of the “Five C’s” is through examples. Web entrepreneurs of the first wave, in the late 1990s, quickly realized as they were depleting their personal or venture capital that advertising-based models were not working well in China. They had to find other ways to generate revenue. Some got inspired by non-US models, from places where conditions were more similar to China’s, such as South Korea; others tried out brand new models.

Today, the two most successful internet companies in China are probably Tencent and Taobao, both distant descendants of Western models – ICQ and eBay, respectively. Tencent’s revenue passed USD 1 billion in 2008 with 40 per cent net profit. Its market capitalization is over USD 30 billion. Meanwhile, who really remembers ICQ? Time-Warner’s, who never did much of ICQ after its acquisition and Tencent market capitalization is likely to pass Time-Warner’s (at 36 billion USD) soon. Taobao has formed an e-commerce empire that announced on its 10th anniversary its intention to “create 100 million jobs” by empowering individuals and companies.

Like its local competitors in the instant messaging (IM) space, Tencent could not cover its costs with advertising only and decided to offer personalised avatars – likely based on their success at various companies in South Korea. Later on, Tencent added casual games and more services. Today, about 90 per cent of its revenue comes from its virtual currency (a prepaid account that allows easy transactions within a closed system to buy designs for personal pages, power-ups, etc.), and barely ten per cent from advertising.

Taobao started off like eBay, but really stepped up its game when it stopped charging commissions on transactions between users. Instead, it focused on adverting and its Business-to-Business (B2B) offering of various hosting services and tools for merchants. In doing so, it surpassed Eachnet, the market leader at the time, which had been acquired by eBay. Taobao also introduced many interesting service innovations, from reputation systems to the recent Alimama advertising platform that allows any website owner to retail its ad space in a market place. It also brought in the Taoker retail system, which enables retailers to offer commissions to website owners selling its products on their site.

These are just two examples of companies that have managed to survive and grow in an environment where the initial business models did not work. They did so by evolving towards viable forms that are superficially similar but conceptually poles apart. Unfortunately, the present obsession by outside observers with uncovering and labelling promising services the “ICQ of China” or “eBay of China” will prevent them from identifying other real Chinese success stories.

Aside from the internet, domestic firms have also been able to develop unique business models in mobile telecoms. One such example is Huicard, which charges users for coupons and vouchers redeemable at retail and dining outlets. It works because the “old way” of the West – is impossible in China. This involves distributors trying to charge the retailer for advertising, but the combined difficulty of B2B ad selling and tracking coupon usage have proved rigid obstacles. The CEO of a European mobile content provider was so impressed after a meeting with the company that he fired off three emails right away to his team to explore whether they were able to develop a similar service.
Such cases show that the peculiar conditions of the internet in China have led “web creatures” to evolve differently from those in the West. China could be brushed aside as a separate microcosm, but as we can see with virtual goods, e-commerce, or mobile coupons, some of these species are not only thriving but are also resilient and adaptable to other environments. It is quite possible that these new products and services could undermine the existing online order – as the gaming industry is realising with the rising popularity of virtual goods. For instance, could a company become the “Tencent of the West”? And will some of the 10 highly profitable Chinese online gaming companies listed on NASDAQ enter Western markets successfully?

Learning from Past Mistakes

Now that the “survival of the fittest” idea has been put forward to describe the Chinese internet market, it is quite simple to explain why most foreign companies failed in this market. Some acquired local firms that looked similar to those back home, only to realise later that their source of income was from an entirely different business, which was often neither stable, scalable, nor replicable overseas. Others tried to run their business like back home, but failed to recognize the local market structure and differences in income, usage, and business practices.

The casualties suffered by foreign firms are numerous, though they have generally tried to hide the corpses. Mobile content providers such as Index from Japan and MonsterMob from the UK, social networks like Xing from Germany, or matchmaking sites like Meetic from France have all been victims. In most cases, the market entry was hastily done, the market poorly understood, and many – quite appropriately named – red flags ignored. When selling a China story to investors, simplification helps. When running the business, simplification hurts.

Yet there is still hope for companies who are willing to be innovative and adaptable, or at least willing to embrace the evolutionary process through partnerships. In their own way, among the most successful entries into China have been:

• Google. Though the profitability of its Chinese operations is doubtful, it has grabbed some market share thanks to its gradual adaptation to local conditions while maintaining its global standards. China is now the laboratory of new business models for its operations, such as its experiments with ad-supported music downloads. Nevertheless, the recent resignation of its China CEO sends an uncertain signal about its future.
• Yahoo. By exchanging its local sites and cash for shares in Alibaba Group, which owns Taobao, Yahoo might just have entered a better operation than it could ever have run by itself.
• Online Gaming. Several gaming companies are writing a strategy for success by establishing studios to develop games in China for the rest of the world and taking the time to adapt to the domestic market before releasing any game locally.

A Darwinian Effort

Fueled by the hope of receiving venture capital, the majority of local entrepreneurs still try first to replicate Western services – discovering rapidly that revenue does not come. Like their predecessors, some explore different directions while they can, while others simply disappear.

It is commonly pronounced that “China innovates”, but many advocates are at a loss when trying to pinpoint a specific case. Tencent is convenient as it is highly visible, but the reality is that its business has been mostly the same for over five years. To put it bluntly: the exact same ideas were at work five years ago but most observers are only just finding out now, suggesting that the “attention threshold” would be the 1 billion USD figure. This will continue to be the case unless the mindset of foreign companies changes.

Aside from Tencent and Taobao, however, there are quite a few interesting service concepts and business models being explored. Some are successful, others are not. A few would be very well adapted to foreign markets; a sizeable proportion is resolutely local. But in order to understand better the business chances in China, non-domestic IT organizations need to embrace the field naturalist spirit of Darwin.

Below is the presentation on “Techno Darwinism” given at Ignite in Amsterdam.

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