14 Oct 2009 08:10

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

By Benjamin Joffe

In the early 19th Century, Englishman Charles Darwin embarked on the survey ship H.M.S. Beagle as a field naturalist and travelled for over five years. One place that struck him in particular was the Galapagos Islands. What Darwin observed was that on these Pacific islands he could find 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 natural selection and evolution. The story of this discovery teaches us one important thing: small differences can mean a lot. 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 sites that appeared, such as web portals Sina, Sohu and search engine Baidu, were derived from similar sites in more advanced markets, notably the US. However, just as a group of animals on an island evolves in a specific way within their specific environment, so did Chinese web companies. Initially and still fuelled mostly by foreign venture capital, they started off as the "common ancestor" disembarked from a ship. From then on, they had to survive in the local environment. From then on, Chinese companies evolved and diverged significantly, to the point that aside from the outward general looks, most of the "organs", "instincts" and even "diet" were affected.

Survival of the Fittest

Web entrepreneurs of the first wave - in the late 90s - quickly realized as they were depleting their personal or venture capital that advertising-based models - the "low-hanging fruits" in the US - were not working well in China. Entrepreneurs had to find other ways to generate revenue. Some migrated to places where conditions were more similar to the US, such as South Korea; others tried out 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 surpassed $1 billion in 2008 with 40 percent net profit. Its market capitalization is over $30 billion. Meanwhile who really remembers ICQ? 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 Message space, Tencent could not cover its costs with advertising only and decided to offer personalized avatars - they likely got the idea from South Korea where avatars were already successful. Later on, Tencent added casual games and more services. Today, about 90 percent of its revenue comes from virtual currency (prepaid accounts that allow easy transactions within a closed system: purchasing a new design or background music for one's personal page, power-ups for games, etc.) and barely 10 percent from advertising.

Taobao started off like eBay but really took off when it stopped charging commissions on transactions between users, refocusing on its Business to Business (B2B) offering of various hosting services and tools for merchants. In doing so, it passed Eachnet, the market leader at the time which had been acquired by eBay. Interestingly, something quite similar happened to eBay in Japan when competing with Softbank, a leading Japanese Internet company. 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 and Taoker retail system, which enables a retailer to offer commissions to website owners selling its products on their site. It is actually so innovative that Taobao itself has a hard time explaining its concept to its SME clients. These two examples show companies that managed to survive and grow in an environment where the initial business models did not work by evolving towards viable forms that are superficially similar but conceptually poles apart. Unfortunately, observers will not find those unless they dive into the service beyond the simplistic "ICQ of China" or "eBay of China" view.

Another interesting and much smaller example is a company doing mobile coupons: most companies worldwide have tried making restaurants or shops pay, be it through advertising fees to be included in the "coupon catalog" or commissions depending on transactions. This proved hard to scale as it is based on business-to-business (B2B) advertising sales making the tracking of coupon usage difficult. The model of the Chinese company, Huicard, is to have users pay for coupons. This goes in the opposite direction of what other players have been trying so far, mostly because doing the "old way" in China would be almost impossible. Upon detailed explanation, this lead the corporate executive officer (CEO) of a European mobile content provider meeting with Huicard to send three emails right away to his team to explore whether they were able to develop a similar service.

These examples show how the peculiar conditions of the Chinese Internet lead "web creatures" to evolve differently from 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 resilient and adaptable to other environments. They could lead other species to disappear as the gaming industry is realizing as the virtual goods model is gaining ground overseas.

Too Soft to Survive?

Now that the "survival of the fittest" idea has been put forward to describe the Chinese Internet, it is quite simple to explain why most foreign companies have failed in this market. Some acquired local firms that looked similar to those back home, only to realize later their source of income was from an entirely different business, and often neither stable, scalable nor replicable overseas. With opportunities all around, retaining talent also proved an utmost challenge. Some tried to run their business like back home and failed to recognize the local market structure and differences in income, usage and business practices. The casualties are numerous, though they generally avoided advertising their difficulties: mobile content providers such as Index from Japan and MonsterMob from the UK, social networks like Xing from Germany and Viadeo from France, matchmaking sites like Meetic from France. In most cases, the market was poorly understood and many red flags ignored, as entry was often hasty. When selling a China story to investors or management, simplification helps. When running a 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. Among the most successful entries into China :

(1) 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 Google, such as its experiments with ad-supported music downloads. The recent resignation of its China CEO sends however a strong signal about its future.

(2) Yahoo: by exchanging its local sites and cash for shares in Alibaba Group, which owns Taobao, Yahoo might have made a better operation than it could ever have run by itself.

(3) Several gaming companies, by establishing studios to develop games in China for the rest of the world and taking the time to adapt to the local market before releasing any game locally.

The Process Continues

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 other directions while they can, others disappear. It is often said "China innovates" but many 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 5 years, which means the exact same ideas were at work 5 years ago and most observers are just finding out now.

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. Some would be very well adapted to foreign markets, others are resolutely local. To understand better these and business chances in China, one needs to embrace the field naturalist's spirit of Darwin.

The above is a personal opinion piece by the author. Its publication in no way implies that Interfax shares the views expressed in the article.

Your comments are welcome to benjamin@plus8star.com. Our presentation on "Techno-Darwinism" is available on www.slideshare.net/plus8star.

Benjamin Joffe founded the digital strategy company +8* (www.plus8star.com) after being part during the past 9 years of Japan's mobile revolution, Korea's Internet boom as well as China's mobile crash and web 2.0 revival.