Startups and Corporate Governance: The Next Catalysts of Growth in China

China has successfully leveraged corporate governance, along with political reform and the fight against corruption, as a catalyst for economic development since the 1990s

By Prof. Gregg Li, Adjunct Professor, CUHK Business School

China has successfully leveraged corporate governance (CG), along with political reform and the fight against corruption, as a catalyst for economic development since the 1990s. It will most likely diversify this action further and throughout the private sector in the next five years. The push will likely be focused on Small and Medium Enterprises (SMEs) and even startups. This appears to be one action that may help to mitigate the slowing economy, forecast to grow at a mere 7 percent by the International Monetary Fund, and the jury is still out.

Leveraging SMEs to spike the economy is not new. But what calls for a close monitoring is the use of Shenzhen as an incubator to unleash startups, venture capital and the whole mentality of combining co-working spaces, outside ownership and entrepreneurial spirit—all of which are necessary for the birth of innovation and capitalism. What makes this noteworthy is that similar efforts in Hong Kong have been so very difficult.

Since the 1990s, China’s CG reforms have been focused around State Owned Enterprises (SOEs), with the latest reform, announced in November 2013, focusing on mixing ownership structures. Under a so-called “mixed ownership reform,” China would allow six large SOEs in a pilot program to attract private investment and improve corporate governance. This is in effect a form of privatization[1]. But the real reach, in my opinion, is not on the SOEs but the SMEs, and we are just beginning to see the unleashing of new entrepreneurism in China.

Over the next few years, we should begin to witness in China — particularly in Shenzhen and the coastal regions, more experiments and policies to unleash the billions of startups and corresponding ways to help make them grow into modern enterprises through more flexible and yet robust CG architecture and mixed ownership. Devolving the authority of the SOEs to private investors is an attempt to meet this effort half way, from the top down. The real challenge lies in designing ownership and control structure for nascent organizations from the bottom up, using a combination of Silicon Valley stock options, Hong Kong-style private equity models, and a bit of the old Hong Kong can-do spirit.

The Catalytic Power of Corporate Governance

There are many ways to develop and foster an economy, as most development economists can tell you, and these have ranged from export-led measures to import substitutions, to slash-and-burn techniques in agriculture that would free up laborers for a growing manufacturing base. One of the most interesting and evolving practices is that of the catalytic power of corporate governance, in the sense of giving participating investors their due share in power, ownership and control in the life of an organization. Corporate governance has become a viable method of economic development.

China in her luck and in her wisdom, and driven by circumstances, has had to deal with massive SOEs that have been subsidized by the state. To begin attacking the problem at the root and hitting the boards of directors of SOEs at the ownership and control level, China was able to set a new economic development game in motion. CG practices by itself is insufficient but at the right timing and with the right dose, can set off a chain reaction that can propel an economy through freeing up unnecessary control and building on the power of the free market. Although this is a common-sense act in retrospect, not many other countries have the courage to take these powerful SOEs head on. Then perhaps nations like India and Japan, which have sidelined good CG practices in general, have not found the right formula to use CG as a lever of change.

“Corporate governance has become a viable method of economic development.” – Prof. Gregg Li

To understand this phenomenon, one has to see CG as a much broader instrument than just a tool in directing and controling the affairs of an enterprise. CG is fundamentally about distributing power to the level where decisions can best be made by incentivized employees. If viewed from this light, one can see that by devolving authority and control to the shareholders, at a rate that each party is able to undertake and a rate that the authorities are willing to let go, CG can become a powerful catalyst for growth.

Naturally, the state has to help develop a proper infrastructure and guidelines in the modern enterprise system such as shareholders’ rights and the establishment of a proper board of directors balanced with workers’ rights. It also has to ensure the installation of operational warning lights, such as key performance indicators that can act as the necessary brakes to bring the system back to normality.

I believe that China, having tackled some of the industrial giants, will begin to seed the startups and let loose a whole series of entrepreneurial measures in the next five years. We should see hybrids in preference shares, worker’s shares or maybe even shares that would be given only to innovators and inventors. Creating a more vibrant entrepreneurial ecosystem, fixing the shadow banking industry and unlocking capital, deregulating onerous policies and allowing exceptions for startups, and maybe even allowing more immigrants with an entrepreneurial zeal to join the workforce—all of these would be possible areas of development.

China started this direction on leveraging SMEs (not startups) as early as 2002 when it announced the setting up of joint-stock companies. In 2013, it made such companies a major form of public ownership. The latter policy means letting loose the millions of SMEs. It also means allowing private investors into the SOEs. To me, what is important in the November 2013 announcement was not allowing mixed ownership into the SOEs, but the encouragement of qualified private enterprises or SMEs to establish modern enterprise systems. This stroke of genius, I believe, will set loose a barrage of energy. We are seeing the corresponding growth of the middle class in China, and many will be propelled by private enterprises and the successes of SMEs and even startups.

In the United States, Finland and Israel, where entrepreneurism has been strong, startups play an intricate and necessary role in these countries’ economic developments. Silicon Valley, Tel Aviv, Helsinki, Austin and other hubs of high-tech innovation have become synonymous with new economic growth, particularly in the New Digital Economy. But even in the United States, entrepreneurship is apparently on the decline. Startup activities have slowed, and according to a study conducted by the Miller Center at the University of Virginia in 2014, small businesses accounted for a staggering 60 percent of net job loss from 2007 to 2012[2]. More importantly, the study also referenced how the middle class would lose from this, as many SMEs are in fact founded by those in the middle class. Such lessons, no doubt, will be studied very closely by the authorities in Beijing to see how SMEs and startups are necessary for vibrant new growth.

The creation of a vibrant entrepreneurial ecosystem has a good deal of parallel to the creation of smart cities. In China, where there are over 300 smart cities in development, we are beginning to sense the direction of new policies that help to establish and sustain these new cities, or “smart areas.”

What Makes a Smart City?

Ingredients for successful smart cities seem to be proximity, density and diversity. All three ingredients are present in Shenzhen, and more so with diversity if we bring Hong Kong in the mix. Being the birthplace of Tencent and many more startups, Shenzhen is loaded with diverse talents from throughout China. With its proximity to various forms of capital in Hong Kong, it is indeed one location worth monitoring.

Dr. Ryan Chin of the MIT Media Lab brought a new perspective on smart cities at a seminar at the Hong Kong Science Park on January 2. Based on his experience and research, he has found a good deal of evidence that points to certain pre-requisites in the creation and sustainability of a smart city. These are proximity, density and diversity—the ingredients for an innovative entrepreneurial high performance city. With the “right amount of new urban systems, we then can see the creation and sustainability of a smart city,” he said.

In his speech, Dr. Chin cited the work of Thomas Allen, who suggested that proximity brings greater frequency of communication. The right amount of “density” would increase interactions among the players, he said, citing the work of Paul Krugman, a Nobel Prize Laureate, which states that density and proximity would bring dense interactions among manufacturers. Here we are reminded of the fact that density of component manufacturers in Shenzhen and Dongguan is one of the highest, if not the highest, in the world.

Dr. Chin also cited the work of Waber and others on how stronger social ties can in fact raise productivity. Cities with dense urban cores have good correlation in having higher levels of skilled and talented people, higher wages and other good things but would also bring more traffic, more diseases and other bad things, with too many people fighting over limited spaces.

Shenzhen’s Potential

Interestingly, in Shenzhen, we can see the three elements coming together quite nicely. What started as a town with 50,000 inhabitants has grown to house a population slightly larger than Hong Kong’s own 7 million. Proximity to Hong Kong and the establishment of Qian Hai special economic zone, just across the border of Hong Kong, will be a fascinating laboratory for the development of modern enterprise systems, including new CG practices and architecture, in the world of the New Digital Economy.

With this insight, stepping forward as students of Chinese businesses, we should perhaps be asking the following questions:

What new forms of CG in terms of ownership, control and decision making should we expect to see in Qian Hai that we won’t be seeing in Hong Kong?

Why should or shouldn’t we establish our next business hub in Qian Hai or Shenzhen?

If we should, how can we participate? And the ultimate question is: Can we, the new modern leaders, recognize Smart Governance in its formative stages in startups, so that we can adapt it for ourselves and for our modern enterprises before our competitors do?

References:

[1] “Developing Mixed Ownership Structures and Modern Enterprise Systems,” Boston Consulting Group and the China Development Research Foundation. China Development Forum 2014, May 22-24, 2014, Beijing, China.

[2] “Can Startups Save the American Dream?” Milstein Commission on Entrepreneurship and Middle-Class Jobs. Commission Co-Chairs, Steve Case and Carly Fiorina, January 2015, University of Virginia.