Structural defects in Chinas economy, including overreliance on low value-added manufacturing and export-led growth, have led the PRC leadership to emphasize the importance of indigenous innovation as a national development strategy to sustain Chinas competitiveness and economic growth. In turn, the government has also begun to view venture capital (VC) as an important means of fostering indigenous innovation. VC has played an important role in the economic development of many countries, especially in fostering the stunning growth of the Internet and high-tech sectors. Venture capitalists can assume this vital role because they focus on entrepreneurs, who are the driving force behind indigenous innovation. Through advisory, selection, and investment capacities, venture capitalists provide valuable commentary on the feasibility of entrepreneurial endeav- ors and absorb much of the risk involved in entrepreneurial experimentation.

Venture capital pours into China

Against the backdrop of the global economic downturn and the concomitant decline in investment, VC investment in China remains a relative bright spot. According to Dow Jones Ven tur eSo urce, venture capitalists invested a record $4.2 billion in 245 deals in China in 2008, up from $2.8 billion in 290 deals in 2007. Information technology (IT)related investments led the way as investors injected $1.6 billion in 86 IT deals in 2008, up 60 percent from the $1 billion invested in 1 17 deals in 2007. At $10 million, Chinas 2008 median VC deal size was the largest in the world.

China's domestic VC market

China has relatively limited domestic sources of VC funding - it comes mostly from government investment, enterprises, and wealthy citizens. PRC law limits the scope of financial services and securities companies. For example, it prevents financial institutions, such as banks and insurance companies, from engaging in VC investment. This contrasts with developed Western economies, where large institutional investors, such as pension and mutual funds and financial institutions, constitute significant sources of VC investment in nonfinancial sectors. The result is that large institutional investors and high-net-worth individuals are the primary sources of venture- capital funding in the United States and Great Britain, but the PRC government, enterprises, and foreign funds account for the vast majority of venture- capital funding in China.

Though government investment can play a vital role in the development of a healthy VC market, the issue of governments acting as venture capitalists has stoked heated debate. Much of the concern stems from questions about whether the government is capable of selecting investments that will lead to the most profitable returns. Critics of governmental VC investment have argued that bureaucratic funding decisions are sometimes removed from market concerns and may result in the subsidization of unviable enterprises, impede development of private sector VC, and, in the long term, dampen entrepreneurship. In addition, because many Chinese enterprises that make VC investments are partially or wholly state-owned, whether corporate investors can make independent investment decisions is a significant concern.

The relative absence of domestic sources of VC funding has led many Chinese companies to seek foreign VC. For example, successful Chinese companies such as Baidu.com, Inc.; Sun tech Power Holdings Co., Ltd.; and Focus Media Holding Ltd. all received funding from foreign VC sources in their early developmental stages. Though government restrictions on pensi on- fund investment in the VC market were recently lifted for two companies, and though there have been reports of greater relaxation of VC regulations, substantive changes have been gradual and their long-term effects remain unclear.

Hurdles for VC funds in China

Despite growing VC investment in China, venture capitalists still face many challenges, including the lack of an efficient exit route by which they can recoup their initial investments. In the United States, one of the most frequently used exit mechanisms is to sell shares through an initial public offering.