Silicon Hutong

China and the World of Business • China Business and the World

Silicon Hutong - China and the World of Business • China Business and the World

Beijing’s New Internet Buzzphrase

Hutong Forward
Planespotting at Reagan National
1655 hrs 

In a ten minute speech last month in London at the 50th Meeting of ICANN, Lu Wei, the Minister of China’s Cyberspace Affairs Administration, introduced a set of seven principles under which, according to him, the Internet should be governed. While not much attention was paid Mr. Lu or his speech outside of the confines of the attendees, we can assume that it was an official statement of government policy, and therefore worth understanding, analyzing, and discussing.

His principles, as I heard them, are:

  1. The Internet should benefit all mankind and all of the world’s peoples, rather than cause harm;

  2. The Internet should bring peace and security to all countries, instead of becoming a channel for one country to attack another;

  3. The Internet should be more concerned with the interests of developing countries, because they are more in need of the opportunities it brings;

  4. The internet should place emphasis on the protection of citizens’ legitimate rights instead of becoming a hotbed for lawbreaking and criminal activities, let alone becoming a channel for carrying out violent terrorist attacks;

  5. The internet should be civilized and credible, instead of being full of rumors and fraud;

  6. The Internet should spread positive energy, and inherit and carry forward the outstanding culture of human beings;

  7. The Internet should be conducive to the healthy growth of young people, because that concerns the future of mankind.

There is a lot to grist in these, but what jumped out at me was this catchphrase “credible Internet.”

There is a ring to it that suggests that we are going to be hearing this much more in the coming months, but the aim seems clear. While in the past the boundaries of online expression have been defined by prurient content on the one hand and seditious content on the other, there is now a third piece to that troika: rumors.

This is worrisome: “non-credible” content implies a much wider scope for restriction than the modus vivendi we have enjoyed in the past, and opens to official censure a vast swath of online content. You can avoid posting prurient content rather easily by avoiding adult themes and illustrations. You can dodge seditious content by steering clear of domestic political issues. But “non-credible” content is in the eye of the beholder, and can easily extend to commercial content and company web sites as well as posts on Weibo or WeChat.

Watch this space, as I suspect we are going to learn more about where the authorities are going to be drawing the line. In the meantime, any company or individual producing a content-laden Chinese site or posts on Weibo or WeChat should err on the side of caution. Chinese law is unkind to those whom the authorities accuse of spreading rumors, and demonstrable veracity may not be enough to keep you out of the wrong kind of spotlight.

A Cloud with Chinese Characteristics

Software as a Service

Software as a Service (Photo credit: Jeff Kubina)

In the Hutong
Doctor, Doctor, Gimme some news
0917 hrs.

In addition to the matter of whether China remains a suitable regional headquarters for international firms, the recent government-imposed internet clotting also points to major changes that are taking place in the global topography of the Internet. Despite the long-treasured hope of Internet Libertarians that the ‘net would remain unified and self-governing, Bill Bishop’s prognostications of an internet fragmenting along national lines is looking increasingly likely.

Earlier this year I moderated a panel on the Cloud in China at the 2012 Roundtable on Intellectual Property Rights Protection convened by the U.S. Embassy in Beijing. There were representative of both foreign and Chinese entities on the panel, and while the focus was on the Cloud and its role in either helping or exacerbating the problem of copyright piracy, a few interesting bits came out that are relevant to the recent blockage.

First, the panel understood that there are two Clouds: one for China, and one for everyone else. The reason is not technical, but regulatory: the government has built a policy framework  that hampers access to Cloud-based services based offshore to the point where they are not viable alternatives to local storage. You don’t see very many ChromeBooks in China (I haven’t seen even one,) I can’t get workable access to Amazon Prime Videos, and downloading a movie from iTunes takes 16-20 hours – on a good day.

Second, that international firms seeking to offer software as a service (SAAS) in China must either base their offerings onshore or not bother. As the Google affair made clear to all, however, data based onshore remains particularly vulnerable to local compromise. Why do the cops need to bother with hackers when they can just show up at the door of the server farm and demand access?

Third, all of the panel participants noted a growing willingness on the part of Chinese businesses and consumers to pay for SAAS and Cloud services. There is an irony in that for the foreign SAAS providers, but there is an insight as well. Government policies that restrict access to foreign SAAS providers are functionally protecting local Chinese companies who want to get into the game.

What we face, then, is the development of a parallel Cloud sector in China that will mirror the SAAS business outside of the PRC. That sector will likely consist of two elements: local companies (i.e., Baidu, Tencent, Sina, and service-specific start-ups) that will provide Cloud/SAAS offerings; and international firms who find ways to address the challenges of latency and government access restriction, usually by setting up a subsidiary in China with localized offerings (i.e., Evernote.)

For the international providers, this means figuring out how to operate two separate services while still offering the advantages of a global service to customers in China. This adds yet another degree of operational complexity to an already challenging market.

Yet for the local Chinese SAAS/Cloud service companies, it means a doubling of their home court advantage. Not only are they arguably better suited to offer more culturally relevant Cloud services than their foreign counterparts, they will also be playing inside of an electronic fence built for them (inadvertently or or otherwise) by government policy. Long term, though, this will make the effort to compete overseas more difficult.

Whether the meiosis of the Internet continues beyond the split twixt China and the rest of the world is unclear, but for the SAAS industry, the world now has at least two separate internets, and it needs separate clouds to go with it. Long term, the SAAS and cloud companies that succeed will be those who can thrive in an internet with increasingly high walls.

The Business of China is NOT Business

In the Hutong
Bandwidth-starved
0842 hrs.

Last week I had a chance to talk with Carlos Tejada at The Wall Street Journal about how Google services have become all-but-inaccessible for users in many parts of China, and how this all seems to have gotten worse over the last several weeks. What is worse, access to virtual private networks (VPNs,) most of which require offshore payment to access and upon which many business are dependent, has been all but severed.

The Hobbled Headquarters

I made the point to Carlos that there are a growing number of businesses who depend on cloud access – not just foreign firms, but organizations based in China who actively collaborate with groups overseas to conduct research and development as well as commerce. To these companies, access constriction is a man-made disaster that is in some aspects worse than a natural one: at least with natural disasters, even one like Superstorm Sandy, there are ways to fix or work around problems of data disruption. With access constriction like this imposed by an unaccountable, unseen human entity, there is no telling when it will end, and the work-arounds are cut off as well.

The longer this goes, the more it will force businesses to re-examine the wisdom of locating headquarters or back-office operations in China:

“If China insists in the medium and long term of creating another Great Firewall between the China cloud and the rest of the world, China will be an increasingly untenable place to do business.”

Anyone who wants to do business in China is well-advised to have a presence here. But China has long made it a goal to get foreign companies to locate their Asia-Pacific headquarters in places like Shanghai and Beijing rather than, say, Hong Kong and Singapore. How many companies are likely to consider that option with a sword of Damocles hovering over their links to data and the outside world?

A Lesson in Chinese Political Economy

There is a wider issue here than just the risk and inconvenience of having to do international business through an increasingly impermeable data force-field. The past two weeks have been a rude reminder that the government and the Party place social stability and continued Party control far above commerce; that they see commerce as serving the interests of the government and the Party rather than the other way around; and that the implicit conflict between the interests of the Party and the interests of business (especially SMBs and foreign-invested businesses) are more fundamental and closer to the surface than we might wish to think.

Let us not kid ourselves, then, and suggest that when you scratch a Chinese official you will find a capitalist not far under his Communist skin. There will ever be opportunists in positions of power, but in the end all business in China remains subject to the whim of the central government’s leadership. Thirty-five years after Deng Xiaoping declared China’s reforming and opening to the outside world, political risk for every company operating in the PRC remains as real and immediate as ever.

And it shouldn’t take an internet outage to remind us of that fact.

 

Where is Tencent Going?

QQ Icon

QQ Icon (Photo credit: Wikipedia)

China’s Tencent Raises $600 Million from Note Offering
Josh Ong
The Next Web
August 29, 2012

Chinese Internet giant Tencent Holdings Ltd. (TCTZF.PK) is raising some $600 million from a senior note offering this week. Given that in the second quarter they posted $492 million in profit on $1.7 billion in revenue on top of having some $3 billion in cash, the question has to be “why?”

There could be several reasons, one of which could be a desire to buy back the shares of one or more major shareholders. Keep in mind that South Africa’s NASPERS Group is a major shareholder, and in a volatile regulatory environment policy could shift against foreign holdings in Chinese internet companies at any time. A full or partial buyout of foreign shareholders could insulate Tencent from that problem quickly.

What I think is more likely, and what I told Josh at TNW, is that the company will use the money to support expansion in two non-core but highly strategic areas of its business.

Fighting the China E-commerce War

First, the money will go to e-commerce. The company has already made a huge push into the area, and told analysts at the end of Q2 that it was planning on expanding its effort.

As Amazon discovered when it reached a certain point in its growth, to be truly competitive in e-commerce you need to make major investments in logistics infrastructure. That is especially the case here in China. Being an online e-commerce platform with lots of online bells and whistles is not enough: you have to support merchants and customers with a logistics infrastructure.

At the risk of getting too granular, Bill Schereck, who was the driving force behind the founding of Australia’s TV Shopping Network and its expansion across Asia in the 1990s, defined e-commerce logistics as the effort to surmount five challenges:

1. Get the signal to the customer (i.e., get your portal online, and get people to find it.

2. Get the customer to place an order.

3. Get the order to the customer.

4. Take the payment from the customer

5. Be able to take a return in a way that is both convenient for the customer and economical for the firm.

For Tencent, the first challenge is a matter of having a good website, and the second a matter of marketing and the quality of merchandise being sold.

In many parts of the world, the last three are easy. In certain parts of China, like the downtown areas of major coastal cities, this is all relatively simple, especially if scale is modest. But Tencent wants to sell to users in all of China, and it wants to scale to a point that is likely to exceed the capacity of locally-available package couriers. That is going to mean investments  well into the hundreds of millions of dollars, especially if they want to match Alibaba‘s Taobao.

Tencent’s leadership also understands that Taobao will not be standing still, and that to pass the market leader they will need to outpace Alibaba’s rate of investment, innovation, and improvements in customer service.

For these reasons, I suspect that if this new war-chest is allocated to capex and not buyouts, this is the largest direction that the allocation will take.

Tencent on the Street

The second direction is mobile. Tencent has made some excellent progress in this area with its Weixin/WeChat messaging service, which in its most recent iteration also incorporates much of the functionality of Instagram.

The challenge with mobile is that nobody has quite figured out how to turn a great mobile experience into revenue. People are using the services, but somehow the industry has yet to figure a way to get someone to pay for it all.

Tencent has the sheer mass of users, and it has them engaged not only in social media and chat, but most of the top online games as well. They need to create a mobile platform that replicates their PC experience, and I would wager that is where they are going to focus their efforts.

A case can be made that the future of mobile involves finding a way to mix three technical capabilities: fourth generation wireless broadband networks (4G); the ability to make web pages to essentially become powerful applications that is implicit in version 5 of HTML; and a new, slick version of rule set that governs how the web operates, IPv6. I know that might sound like a lot of technical hogwash, but together these three technical changes mean that the smart phones of the future may be web-based rather than based on apps running on a computer-like operating system.

If and when that change happens, it will give companies like Tencent a phenomenal degree of control over the experience they can offer on a mobile device, and, by extension, the things that they can do to turn that experience into cash. Tencent understands this, as does search giant Baidu, portal/socials Sina and Sohu, and e-commerce leader Alibaba. Each is investigating how to offer web-based mobile operating systems.

The stakes are immense for Tencent. If it can create an immersive, sticky mobile experience, it can tie that into its e-commerce infrastructure and bring both merchants and advertisers to its half-billion plus users via the mobile phone. This looks tiny now, but it could be what makes the difference between decline (as users shift from desktop to mobile) and dominance of mobile social media, mobile commerce, and mobile advertising in the country with the most mobile users of any in the world.

If that’s not worth taking out a little $600 million loan for, I’m not sure what is.

Update: Peter Schloss, who in over two decades in China has been in the middle of some of the most interesting and complex deals in the media and internet industries, makes an excellent point about why Tencent is doing this deal now. “Tencent was able to tap the markets at a good time for the company, and getting money was cheap,” Schloss noted. “They also wanted to break new ground for Chinese issuers.”

I think Peter offers a reasonable explanation for Tencent’s timing. I do not think the company intends for the money to sit idle, however, hence this post.

Bringing Chinese Equity Home, Continued

Chinese RTOs Covertly Going Private – Seeking Alpha.

In the Hutong
Heading to Shanghai
2044 hrs.

As I have noted here and in Euromoney Magazine, we are witnessing the beginning of an important shift for Chinese enterprises and the way they are financed. A growing number of Chinese businesses that have listed overseas, especially mid-sized and growing companies, are quietly de-listing from the NYSE and NASDAQ.

Adam Gefvert offers two more examples of this delisting trend at Seeking Alpha, China Medical Technologies and ZST Digital Networks, and offers a description of how they are doing so by hiring proxies to purchase shares on their behalf.

Leaving aside questions of propriety or legality of this process, it offers an important insight. While the Chinese companies that have listed in the U.S. did so with great fanfare, they will most likely depart quietly, attracting as little attention as possible. I suspect we will wake one morning and find that NYSE and NASDAQ no longer boast a bevy of mid-sized Chinese stocks.

Why is this important? For Chinese companies, it means that they will focus on listing in places where their value is understood by the common punter. For the small investor, participating in China’s economy will become more difficult.

VIEs: The Long Resolution

In the Hutong
Prepping the Pack Meeting
0917 hrs.

In the course of some debates about China, all you learn is how strong peoples opinions are. Yet in a few cases, the debate itself is a socratic-style graduate seminar not only on the topic but on China. The back-and-forth online around the status and eventual fate of Chinese companies who have listed abroad via a structure called a Variable Interest Entity (VIE) has been just such a debate. The most prominent participants have been:

  • Digicha, the blog by Bill Bishop, Beijing-based investor, former China online game company executive,  co-founder of CBS MarketWatch, and MVP of the China Twitterverse.
  • China Hearsay, by Beijing-based Stan Abrams, a technology and intellectual property attorney and law professor; and
  • China Law Blog, Dan Harris’ award-winning forum that chronicles the intersection of Chinese law and global business, among other things.
  • In particular, take a look at this post on China Law Blog, “China VIEs: The End of a Flawed Strategy – an Update/Rebuttal,” along with all of the comments, which alone are a seminar on a very hot topic.

Rule of Policy

I had started to see this issue as a matter wherein the rule of law clashes with the political expediency of accommodating elites. But the aforementioned post on China Law Blog convinced me that this is not the case. As with most Chinese legal codes, the statutes are vague, there is huge room for political and administrative interpretation, and there are overlaps and conflicts among the laws that leave in question which agency has the authority to make or enforce a ruling against any or all of the companies involved.

The matter will be decided not on the basis of law, therefore, but on the basis of policy, and probably at the State Council level. Bishop, correctly, notes that no bureaucrat has the political cojones to take on the wall of entrenched interests that protect the VIE-based companies, and suggests that the easiest way to handle the situation would be to issue clarifying regulations about the legality of VIEs and to grandfather all current VIEs.

I agree, and I suspect that is what will happen, but I also suspect that this will not be the end of the matter. Even though no policy maker would be willing to risk his or her career by slamming the door on VIEs, if such structures are considered politically undesirable by China’s leaders, then we still have a problem.

Bringing the Capital Home

As someone quite wise once said to me, “the Chinese government likes to boil its frogs slowly, not all at once.” What this sage meant was that when dealing with any issue that affects a wide range of powerful interests, Chinese policy makers tend to eschew immediate and radical solutions in favor of a gradualist approach. In a system that depends increasingly on tenuous consensus, this is perhaps the only possible approach. Each step taken moves the matter closer toward resolution without causing severe disruptions for any of the interests involved. All that is necessary to understand whether a solution can be considered temporary or permanent is to look for the larger national goal that is driving the change in the first place.

An idea of what might be driving the government’s efforts around VIEs can be found in an article in New Century magazine last week that sums up the current state of play with the VIE issue. The article quotes a situation report provided to attorneys and the industry three weeks ago as saying that in the early days of the development of the internet in China, the local A-share market was inadequate to the capital needs of the industry, thus it was decided that overseas listings of these companies offered more good than harm. The report goes on, however, to suggest that it would be in China’s interest to arrange the earliest possible return of the shares of such “leading enterprises” to China’s own local exchanges in Shanghai and Shenzhen.

If repatriation of share ownership is (or becomes) the goal of the government, that is a more reasonable target than abruptly pulling the plug on VIEs, but it does point to a long-term dissolution of those arrangements by substituting offshore capital with capital from China’s own markets, either via domestic listing, private placements with domestic enterprises or sovereign funds, or all of the above. To give a simple example, were Jack Ma to recover the 40% of Alibaba that Yahoo! currently owns, he could replace the cash thus expended by a domestic share issue in China. Using similar mechanisms, the VIEs could be dissolved in a manner that would harm none of the powerful interests involved, yet would satisfy the government’s policy goals.

None of this would take place quickly, nor should it, and I do not think that regulators have come to an agreement yet on how to proceed, and things may roll out quite differently. The point is that a short-term accommodation with the VIE structure in the name of political expediency neither institutionalizes the structure as a long-term funding option, nor signals a change in the fundamental drivers of policy. It should, rather, be seen as the high-water mark in China’s effort to tap offshore capital to fund the growth of the nation’s leading online enterprises, and perhaps the beginning of the next phase in the maturation of China’s own domestic capital markets.

But it is Bigger than All of This 

If you think this is an issue of parochial interest to lawyers and China geeks only, think again. The reason the VIE issue is important goes beyond the effect the recent uncertainty has had on nearly 100 Chinese companies that have listed abroad (and their shareholders.) It is more important to anyone doing business in or with China because of the implications that the issue and its eventual resolution will have on foreign investors and business in the PRC in the coming decade.

A recurring theme of this blog of late has been the apparent shift in attitudes in China toward foreign enterprises and capital. Since the beginning of reforming and opening, foreign participation and foreign investment in the Chinese economy has always been seen as an expedient means to hasten development. What has changed is not the attitude, but China’s perception of itself and the extent to which it still needs the necessary evils of foreign capital and expertise. China still needs both more than either the Party or the people are willing to admit publicly: alongside other considerations, what will slow movement toward a resolution of the VIE issue is disagreement within China’s leadership over how much the door to such structures needs to remain open, and how much local capital is actually available to local high-growth businesses.

But the long-term goal should not be in doubt, and it is that desire for financial self-sufficiency, followed by global financial leadership, that guides the evolution of policy (and law) toward VIEs and all offshore listings.

Update: In what may be the first step in that share repatriation, Shanda Interactive’s founder Chen Tianqiao, his wife Luo Qianqian, and his brother Chen Danian have formed a group to buy the publicly-owned shares of Shanda (NASDAQ: SNDA) that they do not already own. J.P. Morgan is issuing the debt to finance the transaction.

Jack Ma’s American Journey

Jack Ma, Founder of Alibaba Group

Image via Wikipedia

In the Hutong
And…We’re Back!
1151 hrs.

Amidst all of the recent speculation about Alibaba, Jack Ma, and his intentions toward Yahoo!, the real story keeps slipping below the fold: Jack Ma’s pledge to spend a year living in the United States. It is hard to discern whether that was a genuine promise or a trial balloon, but let’s assume that Jack intends to carry through on it.

Mr. Ma deserves praise for what cannot be an easy move. He appears to understand that if you are going to do business in one of the most complex and competitive markets in the world, you had better know that market in your guts, and not designate some subordinate to do that understanding for you. It is long past time for American and European CEOs to start doing the same in China. We are waiting for the first one to do so, and that little problem is a factor in the challenges that foreign companies face here.

Yet if Mr. Ma believes that his expressed desire to live in America will soften the discomfort of the American public and the Committee on Foreign Investment in the United States will feel toward the purchase of Yahoo! by a Chinese company, he is too late. Assuring both Washington DC and Main Street USA that Alibaba is not the long arm of the Party and is trustworthy enough to be the custodian of a massive storehouse of information on American citizens will demand a lengthy campaign, not well-meaning gestures. A year under American law building visibility, accessibility, and trust is a good start, but no more, and any bid for Yahoo is likely to happen sooner than that.

Finally, before venturing into the North American wilds, both Alibaba and Mr. Ma would do well to consider an adjustment in their approach to the global media. I spend a lot of time with journalists who represent the world’s leading media outlets in China, and whenever the subject of Alibaba comes up, the response is always a shaking of the head. The word is that not only does Mr. Ma appear increasingly inaccessible to the global media, his international PR staff is allegedly not above haranguing journalists whose coverage of Alibaba is deemed less than supportive. If true, this is an approach that will make neither Ma nor Alibaba many friends in the United States. The primary coverage of the company is still going to come from China, and alienating foreign correspondents ill-serves the purposes of a company with audiences outside of the PRC. The global media can be allies or enemies in Alibaba’s leap abroad, an effort that will demand the help of all the friends the company can get. At the moment, that list of friends – inside the Beltway, across America, and in the fourth estate – seems a bit short for Alibaba’s ambitions.

Time to change that.

Hutong Weekend: Top Ten Signs that it is Time to Leave Foursquare

In the Hutong
Mid-Autumn Festivus
1515 hrs.

After much angst and contemplation recently, I gave up on Foursquare.

I wasn’t stalked, and it has nothing to do with something the company did to offend me. I just woke up one day and realized that I was probably putting a lot more into the service than I was getting out of it, and that of all of my social media outlets, it was giving me the lowest return on my investment.

I do not think I’m alone in this predicament, but as a public service in order to help you assess whether you should give up on the service or stick with it, I have prepared the following list of signs and symptoms indicating that you no longer need Foursquare in your life.

10. You have not earned a new badge in six months, despite regular use.

9. You have not only created a spot for your home, you have checked in there at least 50 times.

8. You realize that do not care where the latest B-grade actor or actress had dinner last night.

7. The highlight of a night out at a new restaurant with your significant other becomes checking in at a new location

6. You keep swapping mayorships at the same half dozen places with the same half dozen people

5. You start asking your spouse to drive so you can do more “drive-by” check-ins.

4. You start doing “drive-by” check-ins – while flying in an aircraft.

3. You stop reading the “specials” because you know you cannot qualify for them.

2. You start wondering when Foursquare is actually going to evolve the experience

And the number one sign that it is time for you to leave Foursquare:

1. You realize that, since you are not Lady Gaga or POTUS, nobody cares where you are at every minute of the day.

It’s Media, Chief, But Not As We Know It

In the Hutong
Hoping rain will clear the air
1224 hours

In late July I noted in “The Alipay Warning” that an overlooked editorial from Xinhua might be an early warning to foreign investors in many Chinese online companies that the party is almost over. My point was that the government is signalling that virtual ownership structures have run their course, and are now more liabilities than assets. Signs that this is the case have become more common in the time since, as Bill Bishop notes over at DigiCha:

In the space of a few weeks we have heard from various official or semi-official media about the dangers of online rumors, the risks from excessive foreign ownership of China’s Internet companies, new rules that could potentially invalidate the corporate structure of most Chinese Internet companies, rumors of a real name registration policy for microblog and other social media users, and the launch by Sina of new rumor busting features. Tightening is coming, the question is how far it will go.

In other words, while the hammer has still not fallen, evidence is growing that the blacksmith seems ready to strike.

I am betting that the hammer is coming for several reasons, but one important one: the way China’s regulators look at and understand internet companies has changed.

Laissez Tech-Faire

Ever since the early days of China’s internet in the late 1990s, regulators have seen a distinction between online services and media. Internet companies tended to be stuffed with engineers, work closely with the computer and telecommunications industries, and offer services just slightly beyond the comprehension of cadres in their 50s and 60s. The bureaucrats were not entirely credulous: they enacted regulations restricting foreign investment in Chinese online firms. At the same time, though, they turned a blind eye to companies that used highly contrived investment structures to channel foreign capital and expertise into China’s online giants.

I see three reasons why they allowed a high degree of virtual foreign ownership of these companies. First, they saw foreign investors as unwitting accomplices in a government plan to ensure that local companies dominated the Chinese internet. Foreign capital and the Silicon Valley-sourced know-how that came with it would create local champions in an industry that was unlikely to get much support from state-owned policy banks. Indeed, with time and a little luck, some of these local companies might even turn out to be global players.

Second, ever since the start of reforming and opening, the government’s approach to new developments has been to allow a new practice, a new industry, or a new kind of company to grow first, and then step in and regulate only when such experiments got out of hand. Did the foreigners want to invest a little through a multi-layered ownership structure? Hmm. Let’s see how that works out – we might come up with something that can be used elsewhere in the economy.

Third, though, is that many regulators saw online services as, to borrow from Douglas Adams, “mostly harmless,” the technological playthings of a young generation out to find love, diversion, and a little shopping. Sure, the potential for misbehavior was there, but the people running the services were near at hand, easy to rein in if things started to go awry. They were not, therefore, like film or television.

Not Your Father’s Media

Imagine the reaction of these leaders in late July, in the wake of the train wreck, when they wake up and realize that there are a half billion Chinese citizens online; that a quarter billion spend more time watching TV online than watching state-owned, Party-controlled broadcasters; and that a quarter billion now get at least as much “news” from Weibo and QQ as they get from newspapers or TV. What must have been even more sobering was realizing that the demographic most affected by online services is the very demographic that has driven every popular rising in modern Chinese history.

Suddenly, these aren’t “telecommunications value-added services,” or “online sites,” or “technology companies.” They are media, privately-owned media in a country where media must be state-owned; partly owned, influenced, and controlled by foreign interests in a sector where foreign ownership is explicitly forbidden; and influential media largely outside of the control of the Party. Such a situation calls for a change. But what?

The Art of the Possible

The question that faces China’s regulators, then, is not merely whether to continue to allow variable interest entities to exist, but whether an entire sector of the telecommunications and technology industries has been transmogrified by growth and events into media, and thus whether and how to extend Party control and state ownership into the hearts of these companies. What stays the hammer is not, I would argue, any hesitation about whether to make a change, but how to unravel the ownership and control issues without destroying online properties that are of immense potential value to the nation.

Politics complicates matters further. There are powerful people and entities in China with a vested interest in the outcome, and in a nation governed by consensus these interests must be addressed rather than ignored. That this is all taking place on the cusp of a generational change in national leadership is sauce for the goose.

Together these factors mean that action taken will be more incremental than sudden. That is both good and bad. It is good in that it offers foreign investors who catch the wind soon enough to work through the problem, create new and fair structures that recognize the value of the investments, and possibly even to influence thinking in Beijing on the problem. But it is bad in that the heat will build slowly, allowing many companies and investors to deny that anything is changing until they find themselves completely boiled.

“Hope,” Bill Bishop correctly notes, “not an investment strategy, and given the current political climate, including the buildup to the 2012 leadership change, investors would be justified in wondering if something bigger is going on.”

Something bigger is going on, and the appropriate strategy if you are invested in any of these entities is to go out and learn all you can, accept no easy answers or placation from the executives of the companies in question, and start thinking about what you will need to do to ensure the best possible outcome.

What China’s Online Companies Can Learn from the MySpace Implosion

This is icon for social networking website. Th...

Image via Wikipedia

The Patio, Hutong West
Hawks screeching overhead
1215 hrs.

In what has to be one of the best almost-postmortems of an Internet company I have ever read, Bloomberg BusinessWeek’s Felix Gillette’s June article on “The Rise and Inglorious Fall of MySpace” offers a set of insights that apply far beyond the doors of the benighted (and recently sold at a 94% write-off) social network pioneer. I have extracted three lessons that I think are particularly germane for online companies in China.

Perception is Reality

Social networks are sufficiently new that they are still a little scary to your average consumer, less so than space tourism, perhaps, but more so than a trip to the grocery store. Fears about privacy, identity theft, stalkers, pedophiles, and a host of unseen and unimagined dangers lurks in the subconscious of even the most adventurous user. As willing as we are to flock to something new, we will take flight like spooked ducks if our sense of security is credibly threatened, leaving a once-hot network foundering. As Gillette notes:

One of the reasons social networks are so combustible is that they have proven to be particularly sensitive to public perception. In February 2006, Connecticut Attorney General Richard Blumenthal announced that he was launching an investigation into minors’ exposure to pornography on Myspace. The subsequent media frenzy helped establish the site’s reputation as a vortex of perversion. “If you have a teenager at home, odds are they’ve visited the blog site myspace.com,” Hannah Storm warned CBS News viewers in 2006. “And there are fears that this popular social networking website, and others like it, have become places where sexual predators easily prey on children.”

Researcher [Danah] Boyd of Microsoft believes that alarmist press ended up crippling the company. “The news coverage of teenage engagement on Myspace quickly turned to, ‘Oh my gosh, there are all these bad teenagers doing bad things and this is crazy!’ ” says Boyd. “Quickly, it turned into a big narrative about how this was a dangerous, dangerous place.”

This situation brings to mind an editorial that serial entrepreneur and Mahalo.com CEO Jason Calacanis wrote in 2008, suggesting that Internet startups didn’t need PR people, and that the CEO can and should be the PR guy for a company. I am inclined to agree with Calacanis to the point where the CEO is the chief spokesman for a company with media, bloggers, analysts and the general public, presuming of course that the CEO is not a reclusive nebbish who gets flop-sweat in front of reporters (and there are plenty of those.)

What the MySpace case suggests, however, is that somebody on staff or on retainer needs to be spending his or her days anticipating and addressing potential scares and other reputation busters, because waiting for such things to happen and then responding is already too late. As quickly as MySpace reacted, reaction was not enough, and in a world with five-minute news cycles it never will be. Besides, a CEO has far more things to worry about. And how IS Mahalo doing these days, Jason?

If It Does Not Look Broken, You Aren’t Looking Hard Enough

The old expression that “a rising tide raises all boats” has an unwritten corollary that applies to fast-growing businesses: “a rising tide covers all rocks.” High growth can mask a huge range of fundamental problems, and smart companies like Amazon go and dig them out even when they aren’t real problems. They understand that failure to do so will only mean problems later, when the growth slows, the tide goes out, and the rocks start sticking holes in the boat.

MySpace did not. As Shawn Gold, former head of the company’s marketing and content efforts, told Gillette, “when you’re growing at 300,000 users a day it’s hard to imagine that you’re doing anything wrong.”

In retrospect, that sounds almost delusional, but you have to be in one of these organizations to realize how dead easy it is to overlook or ignore critical problems. Hubris is as easy to catch as a cold when things are really good and you are being lionized by media and users alike, and even those immune to the hauteur virus are likely to be so wrapped up in just keeping the wheels on such a fast growing organization that they set “important but non-urgent” problems aside.

Companies have to build such organizational debugging into their culture and allow time and resources to address those issues. MySpace, by the admission of both Gold and its founders, were more seat-of-the-pants, and they paid for it.

Leaders Must Be Users

MySpace co-founder Chris DeWolfe made a point he felt was critical to the company’s long, slow slide to the middle of the social network pack:

“After we left, the guys that took over were never Myspace users,” says DeWolfe, who now runs a startup called MindJolt. “They didn’t have it in their DNA.” According to a source familiar with the sale, DeWolfe is also a finalist to buy the company. DeWolfe declined to comment.

This might be so much positioning, or even a bowl of sour grapes given the rough handling News Corporation dealt to the MySpace founders when they were shown the door. Let’s resist the temptation to get all ad-homenim for a moment and look at his point.

The owner or executive of a media company has to be in the audience, and for social media he or she has to be a participant. There is simply no other way to understand or manage the business. The idea of a newspaper executive who cannot read or a movie mogul who won’t watch films is ludicrous. It is the same for online companies, and especially social media.

This is particularly relevant for foreign companies setting up online businesses in China. You do not want to put someone in charge who is not a user, or, worse, who because of a language or cultural barrier is unable to be a user. The experience for these companies, not the content, is everything, and if you cannot evaluate the experience you have no business being in charge.

Don’t Go There

The history of social media and the Internet is sufficiently short that we should be squeezing as many lessons as we can out of every case. We will be analyzing the MySpace story for years, but Gillette gives us an excellent starting point. This is a superb article that should be mandatory reading for anyone putting their money into an online company, particularly in China, where we enjoy a surfeit of engineering talent and suffer from a dearth of capable managers.

The Alipay Warning

Hutong West
Watching the Overcast Burn
1120 hrs.

Sometimes, when the Chinese government is considering or planning a policy change, they will make some sort of formal announcement in advance. But not always: often, they will signal their intentions more subtly. That is the kind of behavior that keeps policy analysts in business, and that keeps all of us watching for statements and remarks that may signal a warning of an impending change.

VIE another day?

Xinhua may have issued such a warning to foreign investors in Chinese online companies a few weeks ago. In an article examining the Yahoo!-Alipay dispute, Xinhua suggested that the structure Yahoo! used to invest in Alibaba – and that is used my a number of overseas investors to circumvent laws restricting foreign investment in the Internet – may no longer escape government scrutiny.

The structure, called a variable interest entity, or “VIE,” is essentially a set of technical service agreements between a foreign entity and an internet company in China, allowing a foreign company to be paid for its “services” based on the performance of the Chinese company. One hard look at how these deals actually work would reveal them to be what my mentor Jeanne-Marie Gescher calls “functional equivalents,” in that they are the functional equivalent of an investment. While keeping within the letter of the law, they stray outside its intent.

And that is the problem. As Xinhua notes:

Fang Xingdong, founder of blog provider bokee.com, said that there is tendency among Internet companies and foreign investors to gamble on whether the government will actually enforce its rules.

The Alipay case shows that the VIE structure may not be safe for foreign investors anymore and it is hurting the credibility of Chinese regulators, according to Fang.

Remembering Zhong Zhongwai

Those who are skeptical that the government would step in this way would do well to recall (or look up) what happened in the case of another functional-equivalent structure used during the 1990s to siphon foreign investment into the restricted Chinese telecommunications sector. That structure, called a “sino-sino-foreign” (SSF) arrangement, circumvented the letter of the law by creating an onshore equity joint venture between a local company and a foreign investor. The joint venture, ostensibly a Chinese company, would then make the investment in the local telco.

After ignoring them for several years the government pulled the plug on those entities in 1998, declaring them to be illegal under the law restricting foreign investment in Chinese telcos. The government required the local companies to buy out the foreign investors, most of whom were large global players like Deutsche Telekom, and rode roughshod on the process to make sure it happened. The denouement of SSF was ugly, a distraction for all involved, and an unequivocal warning from the Beijing aparatchiks: you may sneak around the law, but eventually we’ll catch up.

When Will the Bell Toll?

The bell will probably ring at some point for the VIEs, and it might be soon: the Alipay case could serve as a first warning shot, and it need not require some sweeping, high profile legal or policy change to end the validity of these arrangements, just a small change in the administrative rules of a single ministry. In the Alipay case, according to Xinhua:

The central bank created a rule last September that requires all payment-service companies in the country to obtain a specific type of business license, which can only be granted to Chinese-owned entities.

For online entities, the axe could fall from any of a number of directions: the Ministry of Commerce (MofCom), the State Administration for Radio, Film, and Television (SARFT), the Ministry of Industry and Information Technology (MIIT), or a player to be named later. If history is any guide, the only real question is “when?”

Right Soon, Probably

For many companies, operating in the gap between law and enforcement is the only available way to participate in the market, and when your competitors are doing the same thin, it is hard to resist the opportunity. Many of us have done it, and it is more common that any of us would care to admit. But that is no justification for complacency.

There are varying degrees of regulatory risk in China, but when you count on either lax enforcement of the law or enforcement limited to the letter of the law, you place your money at the mercy of bureaucratic whim. Regulators tend to get very jumpy during times of political change, looking for ways to clean up their patch to show the new leadership that they are on the case. As we approach 2013 and the handover to a new generation of national leaders, we are on the cusp of such a change in China.

So the Alipay case and Xinhua’s response to it should be construed as a warning. Companies depending on a VIE for an investment in China or for a local business operation need to start thinking about those two magic words: “exit strategy.”

The Advertising Sales Problem

Hutong West
Laying low
1824 hrs.

I have spent a lot of time at Internet industry conferences in Asia over the past year, meeting, speaking with, or hearing from companies seeking to start or grow internet or mobile businesses in China. One thing that amazes me about the current flock of China online hopefuls is how many of them plan to rely on advertising to pay the bills.

To their credit, most of them understood from their experience elsewhere that this was going to be a difficult task, and they were ready for the challenge. What most did not know is that there are a couple of reasons why running an ad-supported online business is going to be tougher in China than elsewhere.

Moneyball Advertising

First, it is common knowledge in the ad industry that many (if not most) of the advertising dollars spent in China are allocated based on habit, fear, ignorance, longstanding relationships, or corrupt practices like kickbacks and under-the-table payments. Even if you can prove that what you offer is the most efficient way to spend ad dollars since the Romans invented graffiti, do not expect a warm welcome. Most Chinese marketing managers are more concerned about creatively enhancing their personal income or avoiding potentially job-threatening risks than about demonstrating how much bang they’re getting for the buck.

Second, making an effective pitch to advertisers in China depends on doing three things really well:

– Identifying the precious few intelligent and creative marketing managers who care about efficiency and effectiveness above all else;
– Framing the sale in terms of what the advertiser needs, not what you want to sell; and
– Finding advertising sales managers who can do both of the above.

The last is the toughest one of all, and is the bottleneck restraining the faster development of online business in China.

The Ad Sales Manager Crisis

I have worked with online firms in China for over a decade, from foreign brands to local start-ups, and the one speed bump each of those companies hits is the problem of finding a good sales manager. Initially, the CEO serves as the chief salesperson, and most large advertisers and agencies won’t negotiate with anyone else. The boss winds up going on all but the coldest of sales calls.

Unfortunately, the CEO of a startup or high-growth Internet company has a lot of other things demanding his or her attention, like actually running the business. Given the importance of revenue, however, either those other things start to slip, or the CEO starts working 18 hour days for months on end. Not even the most enthusiastic CEO can last long with that kind of schedule.

The solution is to hire sales managers who are intelligent, experienced, and trustworthy enough for the company to grant them considerable latitude in framing the creative (and legal/ethical) deals, and who close business or do everything but the final handshake.

Unfortunately, good ad sales managers are rare and hard to find, and those willing to shift to the uncertainty of an internet startup are even rarer. What this means is that the internet business faces a bottleneck that is likely to last for years, and that the good ones will become the subject of virtual bidding wars, jumping to new jobs for higher pay and titles until they are out of reach to all but a fill well-funded startups.

Fishing in a Bigger Barrel

Until the current crop of young ad salespeople has had a chance to mature, and unless some higher power starts air-dropping highly qualified ad sales managers over Beijing and Shanghai, companies are going to have to start addressing the problem more proactively, and more creatively.

Pulling experienced sales people from other industries might help, although like many industries the ad sales game demands some specific skills, knowledge, and familiarity with the sector that would require some intensive mentoring and a 9-12 month apprenticeship. That may be a better approach, however, than trying to turn a 25 year-old ad salesperson with 3 years of experience into a sales manager.

There is another pool of talent that is worth considering: mid-level Chinese advertising agency executives.

Here is a group of people who are used to thinking creatively, at least compared to most of their peers. They are not only accustomed to selling to advertisers, they are used to crafting campaigns for clients based on the specific needs of that individual rather than a lump of inventory that needs to be sold. Another plus is that they understand how advertising agencies think and operate, giving the organization insight to how to frame, time, and pitch campaigns to media and creative agencies.

There are plenty of these folks as well, and their availability is not necessarily a reflection on their abilities. Large agencies have become adept at hiring young people and putting them to work, but many are having trouble keeping people happy after about 7-10 years in the game. By this point in their careers, most advertising executives have been promoted to Account Executive, pushed up by a combination of title  inflation and two decades of double-digit growth in the advertising industry. Once they reach this stage, however, they plateau, constrained by the rapidly shrinking number of positions above them, and held back by their own fairly narrow scope of experience from taking enterprise leadership positions. At about this point, the really good ones are looking for other options, and it is time to snap them up.

Time for Creative H.R.

This is not a panacea: the ad sales manager problem is not going to disappear overnight simply because the industry goes searching in different quarters. The key takeaway is this: the lack of strong advertising sales managers is a hidden choke point in the growth trajectory of an online enterprise in China; the problem must be addressed proactively, and ideally in the earliest planning stages; and the best way to address it is with a creative approach to recruiting, development, and retention.

With apologies to the IT and product people, the ad sales manager is the second most important position in the online enterprise behind that of the CEO, and it demands as much attention and focus from H.R., from boards, and from investors. Failure to give this role due attention at the very least will mean lost revenue and an overstretched and burned-out CEO at a critical point in the development process. At the worst, it could become a key factor in the failure of the business.

The Company Code: Morality, China, and Facebook

In the Hutong
Surrounded by seferim
1126 hrs.

While I was working last week on my business case against Facebook coming to China, the editors of the Financial Times decided to take a moral stand. In “Here be dragons,” the FT posited that in doing business in China, Facebook would be treading on morally dangerous ground.

Facebook may not have set itself some “don’t be evil” style mission, but its raison d’être is to encourage its users to share personal information about themselves. This is morally problematic when the representatives of an authoritarian government are peering over one’s shoulder.

The editors of the FT then call upon Facebook to “articulate a strategy that allows it convincingly to navigate the ethical shoals before venturing into China.”

While I appreciate the FT’s point, I think we are getting ahead of ourselves.

Which Morals?

Before we can judge the morality of what Facebook is doing we must first ask ourselves on what basis we are making that judgment. This is neither trivial nor pedantic.

For better or worse, we live in a world of many moral codes. While there is widespread agreement among most about some general principles (murder is wrong, theft is wrong, etc.), outside of those general principles there is much disagreement, and even within those principles there are vast variances in interpretation. Americans cannot agree on whether abortion is murder or a woman’s right; there are many who feel that the slaughter of a cow is murder, that reading a book in a bookstore without buying it is theft.

If there is great variation among moral codes in America, the question of selecting a moral yardstick becomes more complex when globalization is added to the picture. In most of the world, tolerance for different moral codes and belief systems has replaced the effort – via crusade, inquisition, holy war, and missionary colonialism – to convert everyone on the planet to a universal system of morality and beliefs.   Globalization depends at its core on this toleration, a recognition that the world consists of people with different moral codes, and that there is more to be gained through accommodating those differences in the short term than trying to eliminate them.

This happy state of affairs ends when a company finds itself operating in a country where accepted principles of behavior vary radically from those at home. Under such circumstances, is a company obliged to operate under the moral code of its host country/culture, or its home country/culture? And why? If Facebook provides user information to the Chinese authorities, that may be considered immoral in the U.S., but it may be considered good citizenship in China. And if Facebook provides UK authorities with personal information on terrorist suspects, that may be considered good citizenship in Britain, but an abominable betrayal of trust elsewhere.

Your Morals…or Theirs?

The point of all this is that asking a company to behave morally is not a simple “on/off” proposition. Indeed, a company seeking to operate morally in a multicultural and morally relativistic world thus treads treacherous ground. Does it choose a moral code by which to operate, potentially alienating individuals, groups, and even countries that may find that code offensive, and potentially closing off lucrative opportunities? Or does it take the path of least risk, attempting to dance between those codes, never taking a stand yet never giving offense?

In my experience, most companies choose the latter path, taking shelter under Nobel laureate Milton Friedman’s famous dictum that the social responsibility of business is to increase its profits.

Friedman’s point, while technically correct, comes off as anachronistic and unenlightened a decade into the 21st century. Consumers, governments, media and other audiences now expect companies to conduct themselves not only according to the law and the interests of their shareholders, but also in a moral manner over and above what the law stipulates, and in keeping with the moral codes of those audiences.

The Facebook Code

We are coming into a time, then, where companies can no longer afford to be morally ambiguous. A company that fails to articulate its own moral code of conduct will have one, two, or even several articulated for it, created by online publics using behavioral exegesis: “ah, see, their privacy controls are weak, so they put profits ahead of user interests.”

This is the situation Facebook finds itself in today. It has been much clearer and open about a code of conduct for its users than it has been for itself. We cannot count on Facebook to do the right thing in China, not because we think Facebook, its officers, and investors are necessarily bad, but because we have been given no reason to believe that they will be good when presented with the kinds of moral quandaries they can expect in China. All we can look at is whether they have transgressed somebody’s moral code in the past. Have they? Yup. Uh-oh.

Until and unless Facebook articulates and promulgates a global code of conduct that applies to itself and all of its employees, that sets forth non-negotiable principles that can cover a wide range of situations, that has the support of morally credible third parties, is subject to audit, and spells out meaningful penalties for failure to comply, Facebook’s motives and intent in morally challenging situations will be suspect. And we will, of course, suspect the worst.

Reconnoiter the Moral High Ground

None of this is meaningful unless Facebook understands the full scope of the potential moral quandaries it will face in China and addresses them right now. While it is drafting its moral code, and perhaps before, Facebook needs to conduct a due diligence process to assess not the financial or regulatory risks implicit in doing business in China (though one would hope they are doing those as well,) but also the moral risks.

Those risks are not limited to what what the government likely to demand of Facebook, both initially and in the future, in return for the right to do business in China, and the potential consequences (both in China and to the business as a whole) of those compromises. They also include the moral hazards implicit in operating in a business environment with widespread corruption, and ways in which the behavior, background, and associations of Facebook’s potential partners might cast the company in a morally unfavorable light.

If you value your money, you assess financial risk. If you value your right to conduct business, you evaluate regulatory risk. And if you value what is right, you assess your moral risk. I have to believe Facebook values all of those things.

The People Factor

They may believe in those things to such an extent that Facebook’s own people may not allow the company to leap into China – that’s how I read what Bill Bishop wrote in this Digicha post on Thursday. If the company does make the decision to come here, however, what will determine the propriety of Facebook’s actions will not be codes of conduct or due diligence, but the behavior and scruples of the individuals in the Facebook China enterprise.

This is a significant challenge. It is difficult enough to identify, hire, and retain individuals with strong work habits and technical skills in China’s hyper-competitive and talent-constrained labor market. It is even more challenging to find people with the requisite talents and finely-tuned moral compasses.

Yet these are precisely the kinds of people Facebook will need most, and these will be the people whose decisions, more than those of Mark Zuckerberg or Sheryl Sandberg, will determine whether Facebook operates in accordance with any ethical rectitude in China. This should not only guide Facebook’s hiring decisions, but its choices on who to partner with, and how much to trust them with the human resources task.

Because in the end, a company’s moral standing is no greater or less than that of its most morally-challenged employee. Facebook should get that: it has always been about the people.

One Final Note

I feel compelled at this point to write a brief postscript to this series of articles.

There was once a old captain who lived in a small but neat house near the mouth of the Congo River in what was then called Leopoldville. When he wasn’t off on the business of The Company, he would spend his quiet days and evenings along the docks near the river, watching boats go upstream, watching fewer come back down, and seeing in the flotsam reminders of his own lessons on Africa’s mightiest current.

One evening down at the docks, he spied a new, elegantly fitted-out, beautifully varnished yacht tied up alongside. He went into his usual watering hole to find a party of equally-well fitted-out Englishmen at the tables, clearly pausing for an evening of revelry before continuing upriver. He walked up to the Englishman at the head of the table and, introducing himself, asked if that was his vessel outside.

“Yes it is,” beamed the Briton. “She’s a beauty, isn’t she?”

“She is,” replied the captain. “And she’ll swamp at the bend below the first rapids. Her beam is too narrow,  she draws too much water, and her bows are all wrong. With respect, sir, please find yourself another vessel before continuing upstream.”

There was a brief silence at the table, and then one of the men further down jumped up and berated the captain. “Now see here, sir, but do you know to whom you speak? This man, Sir –––, is a Fellow of the Royal Geographic Society, has been up every river in Europe, plus the Nile, Amazon, and Mississippi. We here are the most experienced river crew in the world. How dare you tell him his vessel is not ready.”

The old captain smiled, tipped his hat to the table, apologized, and bade them a safe journey.

It was not three days later when the captain spied drifting downstream in the current a varnished plank of wood, and a torn Union Jack. The sight gave him no happiness.

Safe journey, Facebook, whatever you decide.

Nine Things Facebook Must Do to Better its Chances in China

In the Hutong
Up with the Birds
0615 hrs.

Over the last two decades, I have watched China’s allure overwhelm the reasoning powers of a battalion of intelligent, experienced, and successful executives. I have seen massive companies enter the market on the thinnest of pretexts without bothering to identify and evaluate the opportunity first. And in some cases I have watched, helplessly, as great companies and captains ignored good advice and their own common sense in the dogged pursuit of a billion customers.

There is something altogether too enticing in the image of a great leader, impelled by nothing more than animal drive and gritty determination, ignoring his counselors, spitting in history’s face, and in the end accomplishing what others said was impossible. If that self-conception proves too seductive for a baron of industry who bears the scars of five decades of experience, it must be irresistible to a twenty-seven year old billionaire CEO who has succeeded at almost everything he has attempted in his life thus far.

I suspect that this and perhaps pressure from investors is what draws Facebook to China.

Motivations notwithstanding, if Facebook has made the decision to enter China, all that is left is to offer advice that may smooth the path ahead.  The obstacles ahead of Facebook are formidable, and I enumerated many of them yesterday. While there is nothing Facebook could do to guarantee its success in light of those obstacles, there are steps it could take to improve its chances for success in China, should it decide to take the plunge.

At the top of the list of those steps are the following:

1. Explain exactly what you plan to do. To everyone. The largest risk to Facebook is the potential of a backlash from users and censure by U.S. lawmakers for complying with Chinese requirements to control content and provide user information on request. Google has been through that storm, and it is hard to see how Facebook can avoid it.

What Facebook can do is eschew Google’s approach, which amounted to ignoring the potential for a problem in the hopes it would never become an issue. We all saw how that turned out, and what Facebook must do is tell its investors, its users, and the public how it plans to operate in China and why. It has to assess, plan for, and communicate in preparation for the worst case scenario. And it has to be completely open with its users in China that it will hand their information to authorities on request.

Further, Facebook needs to explain how it is going to secure the personal information of users around the world from the prying eyes of Chinese hackers, whether they are simply rogue electrical engineering majors with nothing better to do or in the employ of the national government. Information released around Google’s departure from China has left the impression, right or wrong, that servers in China are something of a huge trojan horse. Facebook needs to tackle that head-on.

If the company cannot take those steps and publicly defend its approach in China today, better to avoid doing business in China altogether.

2. Build a local service from the ground up. Websites and online services that are transplanted wholesale from the US to China are doomed to die in the alien cultural soil. Facebook China should not be Facebook in Chinese, but a service that grows and evolves naturally out of Chinese culture the way MySpace grew out of the US collegiate music scene and Facebook itself grew out of American university culture. That means that Facebook in China may look nothing like Facebook anywhere else, and everyone needs to be comfortable with that.

That doesn’t mean throwing out everything that’s been created elsewhere. It means letting user preferences and local conditions dictate the thousands of little choices about what to create and how it should look, rather than allowing those decisions to be dictated by what was created elsewhere.

3. Move Mark Zuckerberg to Beijing. As I said at GMIC in 2010, there is no way any foreign web company can beat a local competitor in China, because the guy running the local competitor is here, and the foreign competitor’s boss is between 6,000 and 8,000 miles away. If Facebook is serious about China, the company should yank the CEO out of his apartment in Palo Alto and drop him into a 4th floor walkup in Haidian for at least a year if not two.

Zuckerberg’s job will not be to create the site, but to enable the team on the ground, to keep the company’s resources at hand, to provide quality control, to give the authorities comfort, and to learn what it is like to do business in China’s internet industry. And please, no objections about how he cannot run Facebook in the US while sitting in China. He’ll have a much easier time doing that than trying to run Facebook China from Palo Alto.

4. Find The Guy/Girl. Facebook needs a local CEO to be the chief site visionary and to actually create the service. The foreigners – even the overseas Chinese – cannot do it. Facebook China needs to be local down to its core, or the results will be disappointing. This will be one of the most important hires in the company’s history, and the individual needs to be selected with great care.

That person probably should be fluent in English, have SNS leadership experience, should be a coding monster, and be a natural leader in a Chinese context. And be ready – he or she will be expensive. But Facebook will fail without him or her.

5. Get a great Chinese name. If they can’t say your name (and say it without laughing at the dumb foreigners), they won’t use your service. Facebook needs to hire a locally-wise branding agency in Beijing to come up with a brand and test the hell out of the name using a great marketing research firm. The name should reflect what the service is about, and Facebook’s leaders shouldn’t worry if it they cannot pronounce it or it doesn’t sound like “Facebook.” They just don’t want to wind up with a name like feici buke (非死不可).

6. Think lean. The easiest thing to do to a China startup is to drown it with too much cash. The funds should be there when necessary, but the offices should be inexpensive and things kept as lean as possible. Great sites and great code come from people who are improvising because they cannot afford to throw money at a problem. Facebook China should forget fancy offices, company cars, and Herman Miller furniture. Replicate the dorm-room mentality, forge a tight team, and spend money on talent, IT, and the stuff that will show up on screen. Zuckerberg should take a taxi to work, or a simple Volkswagen Santana with a bodyguard.

7. Forget revenue – for now. The China service should replicate the Facebook growth story – forget revenues for 2-3 years while focusing all efforts on experience and scale. Having to go out and sell ads is a monstrous drain of senior executive time right when the focus should be on forging the product. Build something great, and the advertisers will come to you.

8. Get humble. Facebook China needs to talk and play like the underdogs, be grateful to be allowed the opportunity, and learn to be superb listeners. The company’s success overseas only buys them a skeptical reception. The way to overcome all of that, and to create a successful company and a lot of goodwill, is by personifying humility at every step.

That also means eschewing the limelight. The first temptation will be to throw a big press conference at every milestone, starting with a big announcement of the company’s decision to enter China. Facebook has to resist that temptation. Expectations and awareness will already be high enough. Speak softly and create a superb service.

9. Play clean. There is a double (maybe a triple) standard for companies in China. There is one set of rules for state-owned enterprises, one set of rules for private companies, and a third set of rules for foreign companies. Foreign companies have to operate with greater integrity, transparency, and care than local companies do.

For this reason, Facebook needs to operate in China as if it was in the United States and being simultaneously investigated by the FBI, OSHA, and the EPA. Doing otherwise will give the competition and the government an perfect opportunity to prove that Facebook is a scofflaw company at best, and at worse subversive. Facebook cannot afford the distraction of government harassment.

I could go on, but these are the most important steps Facebook needs to take right now, some of which need to be done before setting up shop in China.

I will be watching with great interest to see how many of these Facebook decides to follow.

Tomorrow, a post on the moral question of Facebook’s entry into China.

Seven Reasons Facebook Should Stay Home

In the Hutong
Upgrading to Firefox 4
1730 hrs.

Judging by the number of calls I have taken on the subject in the past four days, the rumors of Facebook’s imminent arrival in China are reaching a crescendo. And while the lack of an emphatic denial from Facebook’s appointed spokespeople does not count as a confirmation of such plans, it is a fair bet that the company is considering it.

I think coming to China would be a bad move for the company, and I am not alone. Imagethief Will Moss has explained that operating in China by China’s rules puts Facebook’s global reputation, and thus the goodwill of its worldwide users, at risk. Gady Epstein at Forbes argues that government suspicion of Facebook’s ulterior motives will stand in the way. And Bill Bishop at Digicha thinks Facebook’s own uncoordinated communications will undermine the entire effort.

To me, the core problem with a Facebook venture in China is a weak business case: the risks are high, the costs would be significant, and the upside declines daily.  Avoiding the moral issue for now (not ignoring it, just saving it for a separate post), here are the reasons I think Facebook’s board should just say “no” to China.

1. Facebook is too late. There was a time when Facebook had an opportunity to be something amazing in China. My best guess puts that window somewhere between January 2007 and June 2008. Chinese users of the English Facebook site were on the upswing, the government had not blocked the service, and there was some real buzz about the company in the market.

But Facebook, busy with other things, decided that doing a Chinese site would fall into the “too-hard” pile. The moment passed, and local companies have had three years to to clone, localize, and improve on Facebook’s offering, then scale up, consolidate, and in Renren’s case, go public. There is no virgin territory for Facebook in China, no blue ocean, just the prospect of having to slug it out with a bunch of wily local tigers sitting atop the hill using Facebook’s own tactics and sharpening their claws.

Worse, Facebook is contemplating market entry at a time when, according to this presentation from RedTech China, Facebook-style social networking sites are experiencing a slowing in growth, something also suggested by Renren’s quiet restatement of its Q1 user growth numbers.

2. China’s users have been there, done that. As noted above, Chinese users have seen Facebook before, and they have seen it imitated in a dozen different ways. Unless Facebook is planning to offer something radically different, more enticing to Chinese users, and completely impossible for others to imitate, users will come, they will play, they will yawn, and they will go back to what they were doing.

Facebook confronts a distateful choice in China: stick with the company’s trademark formula, hoping to win on name recognition alone, or abandon its core essence in search of differentiation. Doing the former risks getting lumped into the rest of China’s social-networking has-beens, while the latter would deprive the company use of its most important asset – its code – and force it to start from scratch in China while the competition leaped ahead.

3. Competition is brutal, and it is not just RenRen. And speaking of competition, Facebook is coming into a social media environment that is not limited to Facebook lookalikes. The company must also fight chat giant QQ, Sina’s booming Weibo microblogging service, and online forums or BBSs, all of which have either mass, momentum, or both.

Weibo is the uber-threat, with Sina.com prepared to use its deep-pockets to help build its user base far beyond its current 100 million while adding features to take the service far beyond a simple Twitter clone. By the time Facebook launches in China, it may find itself without a market.

4. Facebook was not invented here. As I argued at some length in Advertising Age early last year, online services are born and grow in a specific cultural context. Sometimes those services travel well. Often they do not, and in the case of services that are transplanted from the US to China, successful transplants are all but unknown.

The most important reason those transplants fail is that they apply the formula they used for success in the United States to an online population that uses the internet in subtly but importantly different ways. Local engineers and entrepreneurs, themselves products of the local culture, can see with startling clarity where those gaps lie, and how to exploit them.

There is no reason to believe that Facebook will be any different. And before you suggest that somehow a local partner like Baidu would ameliorate that disadvantage, see below.

5. Welcome to the Post-Foreign China. There was a time when being a foreign company bestowed a cachet that meant ready acceptance among consumers and helpful policies from government. The helpful policies are gone, replaced with a mixture of suspicion, petty harassment, and a belief that foreigners have precious little to offer China anymore; the ready consumer acceptance – in the internet sector specifically – is gone, worn down by a parade of global brands that never lived up to their promise.

Today, being a foreign internet company is a liability, and Facebook will meet widespread doubt, skepticism, derision, and hostility when it launches in China. Many netizens will be pulling for Facebook to fail, will exert themselves to make that failure happen, and will find ready accomplices in competitors and their legions of fanboys/girls.

6. Don’t count on Baidu to help much. Baidu will be the best possible partner for Facebook, but that does not mean that the Chinese search giant will make Facebook’s China problems go away. Baidu has no experience running a successful social networking site, so they will be learning along with Facebook. Facebook will rely on Baidu for air cover with the government, but Baidu has its own mounting issues with the government, ranging from legal action over IPR violations to the recent appearance of two government-sponsored competitors for Baidu’s search business.

If head Facebooker Mark Zuckerberg expects Baidu to focus on the success of Facebook China, he may want to consider the company’s full plate: Baidu has to defend its search position against its own government, handle a new paid music site, build out its efforts in online video and e-commerce ventures against formidable competitors, and create a mobile operating system to beat Android, iPhone, and a dozen other competitors. That does not leave a lot of executive attention or engineering resources for Facebook China.

The Baidu partnership will be helpful, and it will look great to The Street, but it is not going to make Facebook China a success. That will devolve on on Facebook itself.

7. China is mobile, and Facebook does not do mobile very well. I use the Facebook mobile software on two Apple devices, and I am being kind when I say the experience is underwhelming. Facebook still has not figured out how to make an elegant transition to mobile, but China is maybe three years away from more users accessing the Internet on a mobile device than on a PC. Weibo on mobile is not great, but its experience translates much more readily to a mobile screen, and it is easier and more intuitive to use the Weibo app than the Facebook app. Unless Facebook can figure out the formula for success on mobile – including figuring out how to integrate ads – they are going to get creamed in China.

Come if you must

In order for its efforts in China not to backfire on it – much less to be considered a success – Facebook has to proactively address each of these issues, and deal with the implicit opposition of Chinese regulators and U.S. Congresspeople, and avoid backlash among its users, and start offering some consistent messages about how it will deal with operating in China.

Given the time and attention this will take away from keeping the service appealing to the half-billion users it already has and managing an eventual public offering, China looks like a massive potential waste of time and money with a declining upside. But if they are absolutely determined, tomorrow I’ll have a list of what Facebook needs to do to improve their chances for success.