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Funding innovation: from Silicon Valley to Shanghai, investing in innovation is exploding. Investors, corporations, and governments look beyond unicorns to sustainably nurture big ideas.


Which Companies Get Funded

Innovation in Pittsburgh

Q&A with VC Bill Gurley

Funding Breakthrough Technologies:

+ Magic Leap

+ Megascale Desalination

+ Liquid Biopsies

China Venture Capital

The Big Question

At a Time of Plenty, Some Technologies Are Shut Out

New funding methods claim to democratize investment in innovation. but important technologies still struggle.

* Today there are more ways to fund a new company than ever--from crowd-funding platforms to early-stage angel investors, tech incubators that nurture ideas in management boot camps, wealthy family foundations, corporate venture funds, and record levels of venture capital.

On crowdfunding platforms, where entrepreneurs are now raising billions of dollars a year, the big winners are companies making some kind of object that consumers can envision buying and using themselves. Among venture capital investments, software is reaping the lion's share: $21.5 billion in 2014, or 42 percent of all dollars invested, compared with $6 billion for biotechnology and $2.4 billion for industrial and energy companies, according to data from an annual study by Price-waterhouseCoopers and the National Venture Capital Association.

This limited focus is driving up the valuation of certain kinds of companies and creating an investing bubble. But an even more important issue--the central question in this Business Report-is whether the mechanisms for funding innovation today can nourish a broad range of technologies: not just car-sharing services like Uber, but valuable technologies for making energy cleaner, reducing poverty, and improving health care.

"The best ideas don't always get financed," says Harvard Business School professor Ramana Nanda, an expert in entrepreneurship funding.

Among the areas suffering from insufficient investment, according to a recent report by a committee of MIT professors: medical research into Alzheimer's and infectious diseases, cybersecurity for non-defense systems, agricultural R&D that could help address the world's soaring need for food, and even areas of next-generation computing.

Capital-intensive industries are particularly ill-suited to today's methods of funding. For example, it can take years and hundreds of millions of dollars to determine whether innovations in large-scale energy production can work, because they require the construction of a factory or some other large facility. Though venture investors showed interest in energy startups for a brief period in the late 2000s, that window of opportunity has largely closed, leaving the companies scrambling to find new options.

When Aaron Fyke founded his company Energy Cache in 2009, it was a good time for green-energy startups. The company, which was developing a mechanical battery to inexpensively store energy generated by wind turbines and solar power, attracted early seed investing from the tech incubator Idealab and others, and it used that to build a prototype. But when Energy Cache went back several years later looking for $20 million to fund two more rounds of development before the product could get to market, it was hard to find investors interested in this type of energy technology.

Now raising money for a new company, Edisun, with a faster track to commercialization and a lower cost to develop its technology, Fyke says investors--including traditional venture capitalists, corporate VC arms, and wealthy individuals--have been much more enthusiastic.

Given the lack of big money, entrepreneurs like Fyke have had little choice but to refocus on low-capital technologies that use off-the-shelf components, but while that makes sense for them, it still leaves a question: how do we fund the high-capital technologies that we will also need?

For this group, funding has to be found beyond Silicon Valley venture capital firms--perhaps led by governments or by investors with a longer time horizon, like family foundations or corporate venture funds. GE Ventures, for instance, invests $200 million a year in startups in such fields as software, advanced manufacturing, energy, and health care. It has stakes in companies including Rethink Robotics and Airware, which makes drone software. "For the most part what we are investing in, we hope to be customers of," says senior managing director Karen Kerr.

For medical-device makers--which, like energy companies, often draw little interest from VCs--crowdfunding has strategic advantages. Scanadu, the maker of a small device packed with sensors that can measure temperature, heart rate, blood pressure, and other bodily signals, has smartly use its fund-raising to prove market interest. By raising $1.6 million on Indiegogo, the company got 7,000 backers eager to test its prototypes. That provided valuable data to show regulators reviewing the device and helped persuade later-round venture capital hinders that there is a market for Scanadu's products.

Now four years old, the company has $49-7 million in backing--including funds from two strategic Chinese backers, the Internet giant Tencent and the investment group Fosun, which has a large health business. It has begun thinking of rolling out in China after the U.S.

The dominance of venture capital in the innovation-funding environment is not just a U.S. phenomenon. China, once exclusively a bastion of government-funded research, is now the second-largest VC market, behind the United States. Companies in China collected 18 percent of global VC investment in 2014, or about $15.6 billion, compared with $4.8 billion the year before, according to data compiled by the global accounting firm EY. India's share has been climbing too, with $5.2 billion invested in 2014--more than double the 2013 total of $1.9 billion.

Yet in this increasingly global funding picture, certain innovations are still struggling: potential breakthroughs in energy production and medicine, among others, that take too much money and time to develop. A better financing system, says Harvard's Nanda, would support a sort of Darwinian evolution of technology. "Each new technology is like a mutation," he says. "Most will end up failing. A few will be an incredible success. We want to develop financial systems that will encourage experimentation and a high rate of new variations and then be quick at shutting down those that don't work." --Nanette Byrnes

Innovation Hub

An Innovation Case Study: Pittsburgh

Can a midsize Rust Belt city compete with Silicon Valley?

* Shortly after Luis von Ahn helped launch Duolingo, his popular language-learning app, he started to receive the same piece of well-meaning advice from investors and fellow entrepreneurs: Why don't you move from Pittsburgh to Silicon Valley, where you can really grow?

Presumptuous? Sure. But not that surprising. The Bay Area is the center of the tech world, a siren for software developers, deep-pocketed investors, and enterprising businesspeople. Companies based in San Francisco and San Jose pulled in $22.6 billion in venture capital funding in 2014, dwarfing the cities' closest competitors, Boston ($4.4 billion) and New York ($4.2 billion). Pittsburgh firms scored a paltry $338 million.

Smaller tech cities do have a serious downside when it comes to the tech world: they often lack big-time venture capitalists and the pool of startup-savvy business and marketing talent that can help a small company grow.

Von Ahn and other startup CEOs, though, are beginning to push back against this argument.

They make the case that Pittsburgh and other second-tier tech cities--including Raleigh, St. Louis, and Minneapolis--are places with strong university pipelines, affordable living costs, great quality of life, and collaborative tech ecosystems. "Despite the fact that a lot of people have told us to leave," von Ahn says, "we're happy here."

Expanding the tech economy beyond the West and East Coasts could support inventors tackling problems that those based in the Bay Area might overlook. "The culture of Silicon Valley is really a bunch of twentysomethings solving twentysomethings' problems," says Matt Zieger, the vice president of the Forbes Funds in Pittsburgh, which has invested in local startups that fight human trafficking and provide voice-based apps for the visually impaired.

Pittsburgh "has a culture of a broader purpose," says Zieger. "We have a legacy of building things." Some of the hottest companies in the city today are working on complex technologies with real-world applications, including advanced robotics, low-cost batteries to store renewable energy, and self-driving cars.

Pittsburgh has not always evolved smoothly. Thirty years ago, it was a hollowed-out, crumbling Rust Belt city whose economic engine had seized with the meltdown of the American steel industry. As unemployment soared and home values plummeted, young people left to find jobs and lives elsewhere.

Today, that's history. Neighborhoods are undergoing building booms, industrial wastelands on the riverfronts have become bike trails and parks, and the city's percentage of educated 25- to 34-year-olds is among the highest in the country. While a strong manufacturing base remains, health care and technology have become the twin economic engines of the region. They're supported by the neighboring urban campuses of the University of Pittsburgh, which pulls in over $400 million in National Institutes of Health funding annually, and Carnegie Mellon University, which has top graduate programs in computer science, engineering, and robotics and tight connections to industry. Duolingo's von Ann remains a CMU faculty member, as does Jay Whitacre, the founder of Aquion Energy, a battery company based on his invention. Andrew Moore--who ran Google's Pittsburgh office for eight years--recently returned to academia and is now the dean of CMU's computer science school.

Campus talent has been a draw for major companies, including Apple, Disney, Intel, and IBM. Google arrived in 2006 and now has 400 engineers on site.

This past February, Uber announced it was partnering with CMU to open a 53,000-square-foot research and development facility focused on designing self-driving cars. It also hired away more than 40 of Carnegie Mellon's researchers, prompting grumbles about the big tech companies swiping the best local talent. But most people are glad to have them here. "As you're recruiting executives to move here [for a startup job], Google provides a sense of stability," says Sean Ammirati, a partner at Birchmere Ventures, a local investment company. "If the startup doesn't work out, there is a place to transition to. And a lot of people who work at those big companies get bored pretty quick, so they look for something different to do."

The Pittsburgh sell to out-of-staters: despite being relatively small (the population hovers around 300,000), the city boasts top-notch sports, arts, culture, and outdoor attractions. Within driving distance of Philadelphia, Washington, and Baltimore, it is well positioned for companies needing to distribute physical products. Also, housing costs 10 times more in San Francisco than it does in Pittsburgh.

One piece of evidence that Pittsburgh's profile is rising in the tech community comes from Silicon Valley: more than 100 national venture funds have invested in Pittsburgh companies in the past five years.

There are cons to a smaller tech city, too. Finding nontechnical talent--from lawyers to salespeople to marketing staff--remains a challenge, and even securing a flexible workspace from landlords can be tough. "We have 55 employees right now, and next year we will have 155," says Duolingo's von Ahn. "It's impossible to convince someone here to sign a lease that makes sense for a startup. We cannot sign a lease for 10 years--by then, we will either disappear or we will be 10 times larger!"

Getting direct flights to San Francisco to woo investors or talent can be tough; for three months in 2015, there were actually no direct flights from Pittsburgh to the Bay Area. There are also few tech employers here with the HR and legal know-how to secure H1B visas for international employees.

And the region's affordability, in many ways a virtue, can also cut the other way. "The sense of urgency here is not as apparent as it is in the Bay Area," says Phil Marzolf, a Silicon Valley veteran who now works as a Pittsburgh-based advisor to startups. "When somebody has an idea in California, you have to run nonstop. Here, too many people get complacent."

The largest challenge, though, is the lack of big-time investors. Duolingo raised all its money outside the region, while other companies that started in Pittsburgh, like Anki (a robotics company) and BlackLocus (a business software startup), have followed investments out of state. The founders of Modcloth, a clothing retailer that started out selling vintage styles online, found that while Pittsburgh was a great place to bootstrap their company and find affordable warehouse space, they eventually outgrew it. When they raised their second round of venture capital, they moved their headquarters to California to tap into their investor networks in the Bay Area.

"Pittsburgh is a great place to have a startup," says cofounder Susan Gregg Koger, "but it's not a great place to keep scaling yet."

"What we really need is for someone to become an icon," says Dave Mawhinney, the co-director of CMU's Center for Innovation and Entrepreneurship. "Harvard has Facebook, Stanford has Google, and Carnegie Mellon has ... fill-in-the blank." Without that, Pittsburgh lacks the abundance of tech wealth that gets reinvested in new startups so regularly in Silicon Valley. Observers say there are a handful of local companies that have the potential to get there (see sidebar), but they are all still a few years away from the point where a public offering might make sense.

Local entrepreneurs, though, say that a large IPO is only a matter of time. "When that happens," says von Ahn, whose company is on the short list, "that's when we're going to see a big change." --Patrick Doyle

Expert Q&A

VC Bill Gurley Tries to Bust the Bubble

A prominent Silicon Valley venture capitalist argues that tech startups are overvalued, profits are underrated, and a bust is coming.

* Since last year, Bill Gurley--a partner at the venture capital firm Benchmark, known for early investments in Uber, OpenTable, and Zillow--has stood out from his VC counterparts for his insistence that there's a bubble in tech startup valuations. In particular, he says "unicorns"--startups valued at $1 billion or more--are the most visible sign of an explosion in valuations that he thinks will end in a bust just as surely as previous bubbles did.

Nonetheless, Gurley told contributing editor Robert Hof he remains optimistic that entrepreneurs will keep innovating even in a downturn. He highlighted innovations in his own field, such as Internet-driven crowdfunding and early-stage startup incubators, that are opening entrepreneurship to more people.

You've complained for more than a year that we're in a tech-startup investment bubble. Why does that concern you so much?

Great entrepreneurs are relatively disadvantaged in these markets where so much capital is available. In a market where capital is hard to come by, they can still raise money. In this market, they can raise a ton of money, but so can a lot of [less capable] competitors that wouldn't be in business otherwise.

Many investors say seemingly excessive valuations of startups are actually justified because they have real revenues and growth prospects.

Imagine two companies. One is told, "I want you to get to $100 million in revenue and you have to be profitable when you get there." The other is told, "I want you to get to $100 million in revenue and I don't care if you lose $40 million getting there." Which of those two exercises is harder, and by how much? I would argue it's at least 10 times harder to do the first.

Until you can prove that you can generate cash flow, you don't have a sustainable business. No matter which of these unicorn boardrooms you walk into, everybody thinks it's perfectly okay to burn tons of money.

Amazon was losing lots of money years ago but managed to create a huge, sustainable business.

Look what they had to go through. The stock went from $106 [in December 1999] to $6 [in October 2001], a 94 percent reduction in market value. They had to lay off 1,300 people, 15 percent of the head count. I don't think there's a single unicorn out there that's thought in their mind, "Wow, what if my market cap goes down by 94 percent?"

But if you don't join the race, you can't win it, right?

Once your competitor raises $400 million, you don't get to choose whether you're in that game or not. But I've lived through crashes and it sucks. When these markets correct, they correct hard. There's no soft landing in Silicon Valley.

Despite your warnings, startups continue to get big funding. Do you wonder if you're still right?

No. There have been some signs very recently of a shift in the winds. You've got the stock market down dramatically for the year. You've got contraction of multiples [valuations that are a smaller multiple of annual sales than they were a few months ago] in most of the tech startups. I've seen venture companies that normally would keep all the deals for themselves start soliciting other people's money to help fill up new rounds.

Would a bust cool spending on innovation?

Good companies are started in all parts of the cycle. Capital is cyclical, but I don't think innovation has ever not happened in Silicon Valley.

How has venture capital changed in the face of alternatives such as incubators, super-angel investors that put small amounts of money into early-stage startups, and crowdfunding?

Six or seven years ago all of our limited partners got scared because there was this notion that the super-angel was going to get rid of the venture capitalist. It didn't play out that way. Only a handful have proven themselves.

If you're an inventor, the crowdfunding thing is cool because you probably couldn't have gotten an [initial round of venture capital] and you might succeed [with crowdfunding]. I think that's great. Y Combinator is also an innovation. Venture is a business that is not really prone to systemization. [Benchmark cofounder] Bob Kagle used to call it a shoe-leather business. So anyone who builds a new type of system is interesting. But we do have a fundamental belief that company building is an art, not a science.

Where would you like to see more investment?

Health care. The tools like the smart-phone that have disrupted other industries should be so useful in solving the health-care problem. But most of the startups we find have basically discovered some opportunity to help one of the incumbents maximize their value extraction in the system. They use the technology to make the system worse as a whole rather than better.

Virtual Reality, Real Cash

Magic Leap had no trouble raising money from a cache of A-list investors enthusiastic about the changing economics of virtual reality.

* In 2014, when Rony Abovitz was talking to venture capitalists and corporate backers about his latest technology company, Magic Leap, he should have had a hard sell. For starters, he had to convince them that a new idea, combining real life with augmented reality into what he calls mixed reality, could not only work but become the basis for a whole new industry.

What Magic Leap is doing is complicated, and different from other virtual-reality technologies like those behind Oculus Rift and Samsung's Gear VR. MIT Technology Review senior editor Rachel Metz, who has tested a prototype, describes it as "a tiny projector that shines light onto a transparent lens, which deflects the light onto the retina." That light then blends in with the light being seen in the real world, leaving artificial objects "nearly indistinguishable from actual objects:'

Case Studies: Magic Leap, Megascale Desalination, Liquid Biopsies

Bankrolling Breakthroughs

Every year, MIT Technology Review selects 10 breakthrough technologies, innovations that we believe will have lasting impact. Just as each technology has taken a different path to development, each has its own funding story. Here are the tales of three of those breakthroughs from 2015: the augmented-reality technology of Magic Leap, megascale desalination, and liquid biopsies.

Though Abovitz had a lot to explain, it didn't turn out to be a difficult pitch to make. In two rounds, one in February 2014 and the other in October 2014, Magic Leap raised $592 million from backers including Google and Qualcomm Ventures, Wall Street financiers KKR and Vulcan Capital, and Silicon Valley VC firms Kleiner Perkins Caufield & Byers and Andreessen Horowitz. (An October report said that the company was seeking an additional $1 billion in backing.)

That money is going into hiring engineers and other experts--Magic Leap's employees now number in the hundreds--and setting up a 260,000-square-foot pilot manufacturing facility in Florida. Abovitz says Magic Leap needed all that money "to really go to the moon" and develop brand-new technology.

Abovitz founded Magic Leap in 2010, and it became his full-time gig in December 2013 after he sold his previous business, the medical-device maker MAKO Surgical, for $1.65 billion. Nagraj Kashyap, senior vice president at Qualcomm Ventures, attributes much of his firm's enthusiasm for Magic Leap to Abovitz's track record building successful technologies and cultures. But he also sees good reason to believe that Magic Leap's technology will create something new, a "pervasive and persistent" form of augmented reality.

Although virtual reality is not new, investors have been drawn back to it because of a substantial decrease in costs. Virtual-reality headsets that existed 20 years ago cost $20,000 to make, says Philip Rosedale, creator of Second Life and High Fidelity. Because it was so expensive, he says, "virtual reality in general has been a dream always five years in the future."

In contrast, today "90 percent of the hardware in a virtual-reality headset is already in a cell phone," says Nabeel Hyatt, a partner at Spark Capital, the original backer of Oculus VR, the virtual-reality headset maker Facebook bought in 2014 for $2 billion.

Spark Capital professes to like investing in markets so new their size can't yet be determined. Even so, Hyatt says his firm believes the augmented reality of Magic Leap is still too far off to warrant investment. Significant technological puzzles still have to be solved in computer vision, 3-D rendering, strategies for mapping a room in real time, and other areas, Hyatt argues. "I am bullish on that," he says, "but over the very long term." --Nanette Byrnes

Funding Desalination

The world's biggest desalination plant, named one of MIT Technology Review's breakthroughs of 2015, is the result of government funding of both large-scale infrastructure and the underlying innovations.

* The world's largest seawater desalination plant, now operating on the Israeli coast, is a study in government financing of innovative technologies over the course of more than half a century, starting with the funding of basic research and ending with a public-private partnership to build a vast new facility.

The project was ordered by the state of Israel, its construction financed with $500 million in bank loans issued to a private consortium. Revenue from freshwater sales to the state will both repay those loans and provide built-in profits for the consortium.

The underlying technologies at work in the project are also the result of government support, though in this case it was government-funded academic research on desalination membrane materials that was centered in California in the 1950s and 1960s.

The plant, 10 miles south of Tel Aviv, is called Sorek Desalination. In operation since late 2013, it now provides 20 percent of the water consumed by Israeli households, or 150 million cubic meters per year.

To finance an operation that big, a consortium led by a private company, IDE Technologies, promised to sell the water to the state at 58.5 cents per cubic meter of output--a price that can fluctuate with energy costs and local inflation. That's one of the lowest prices ever for such a plant.

About 20 percent of the cost was borne by the consortium, with the rest coming from low-cost loans made by two Israeli banks and the European Investment Bank, an arm of the European Union. After their initial investment is recouped from sales over the plant's first few years of operation, the consortium will earn profits on the investment, a structure meant to keep the plant operating optimally for decades. After 25 years, the sprawling facility will be owned by the state of Israel.

At the heart of the Sorek plant are polymer membranes inside tubes. When seawater is passed through the tubes and placed under pressure, fresh water is forced through the membranes, and saltier water is held back. Development of the membranes was funded by U.S. and California agencies starting in the early 1950s, a time of significant population growth and concerns over the supply of fresh water. The U.S. Department of the Interior created the Office of Saline Water in 1952 to fund desalination research projects; California's government did the same, establishing research labs at state universities.

In the early 1960s, private companies largely took over the work; Dow Chemical and DuPont, among others, began R&D projects in desalination. From there, decades of incremental advances in materials and system designs made such plants more and more economical, culminating in Sorek and its low-priced water, which happens to use one of Dow's membranes.

Without government funding of the early fundamental materials research, the technical challenges of effective desalination might never have been solved. The public-private financing structure of the Sorek project underscores how government support continues to be essential in scaling up this technology so that water can flow to millions of Israelis at a reasonable price. --David Talbot

Funding Liquid Biopsies

Bankrolled by private investors and governments, cancer tests of blood and urine are coming to market.

* How much does it cost to bring to market a diagnostic test that's able to measure cancer without a tissue biopsy?

In the case of Trovagene, almost $100 million.

That's the cumulative loss, or expense including salaries, R&D, and office space, the money-losing San Diego biotechnology outfit has run up since 1999, when it set out to test for cancer from a cup of urine. Just like recently developed cancer blood tests, the diagnostic the company started offering in May searches for telltale scraps of tumor DNA released by dying cancer cells. The amount of tumor DNA that ends up in urine is a readout, the company says, of whether a tumor has been destroyed or is still growing.

The idea of such liquid biopsies has leapt to prominence in just the last year. Cancer researchers now expect that the tests will offer a noninvasive way to monitor cancer, find the genetic mutations driving a tumor, or even diagnose it early, before symptoms start. It's an innovation so big that Wall Street analysts at JP Morgan expect demand for liquid biopsies to rocket toward $20 billion a year within five years, from about $100 million today.

The first DNA blood test for cancer in the United States was commercialized in 2014 by Guardant Health, a venture-backed California company, and tests to spot cancer DNA in blood, urine, or spinal fluid are now in development by a growing number of companies but remain a risky bet for investors.

One pioneering researcher, Dennis Lo, is now tracking more than 20,000 people in Hong Kong to see whether blood screening can catch liver cancer early. Some of his early and ongoing work was paid for by a $1 million grant from the Kadoorie Charitable Foundation, the charity of Hong Kong billionaire Michael Kadoorie, and he later won a $4.25 million award from the Hong Kong government. "It took us about 10 years to convince people to fund us," he says. Lo says he recently cofounded a company called Cirina to develop blood tests, and he expects initial financing of $12 million from investors.

Investors in the new tests could be disappointed, because while developing a new diagnostic can cost as much as creating a new drug, it's notoriously hard to make any money off diagnostic tests. Consider Foundation Medicine, a company based in Cambridge, Massachusetts, that started testing the DNA of tumor tissue samples in 2011 but is now racing to launch a liquid biopsy using blood. The company has deep-pocketed venture backers including Google Ventures, but it has spent $192 million developing its tests and continues to lose millions of dollars every quarter.

It's still unclear how the U.S. Food and Drug Administration plans to treat this new group of tests. Another challenge: insurance reimbursement can be uncertain. And patents that once protected such investments and kept competitors away are being overturned.

In 2013, the U.S. Supreme Court said genes aren't patentable. Since then, other courts have extended the reasoning to liquid biopsies. The presence of cancer DNA in the body's fluids, they say, is also a "phenomenon of nature" and can't be patented either, even if you discovered it. --Antonio Regalado

Innovation Funding

China's Latest Growth Market: Venture Capital

China's first-generation Internet entrepreneurs are now venture investors in the next generation, placing big, sometimes risky bets on early-stage startups.

* In 1999, when China's per capita income was just $850 a year, a 31-year-old entrepreneur named Neil Shen and three friends nevertheless bet that China would soon develop a huge domestic tourism industry. They created a travel-booking website, China's per capita GDP has since grown ninefold, and the domestic tourism market has ballooned to more than $400 billion. Ctrip, which had an initial public offering on Nasdaq in 2003 (and nearly doubled its price on the first day of trading), now has a market capitalization of over $10 billion--and Shen, who went on to found other travel-related companies in China, is a billionaire.

In 2005, Shen began to shift roles, from star entrepreneur to venture investor. Much like U.S. counterparts such as Netscape founder Marc Andreessen at Andreessen Horowitz or Paypal cofounder Peter Thiel at Founders Fund, Shen has made the next chapter in his career about discovering and nurturing a new generation of entrepreneurs.

He founded the independently run China affiliate of venture capital titan Sequoia Capital and now manages a portfolio that is worth, according to the Financial Times, roughly $6 billion. The range of Sequoia Capital China's investments testifies to the energy and diversity of China's burgeoning startup scene--from e-commerce platforms like luxury-bargain site Vipshop to science-oriented companies, including DeepGlint, which specializes in computerized 3-D image analysis; Magi, a search engine made by Peak Labs that gives answers instead of references; and drone maker DJI.

In becoming a venture capitalist, Shen was once again ahead of the curve in China. According to data from the World Economic Forum, Chinese venture capital, which had consistently accounted for roughly 9 percent of the global total from 2006 to 2013, spiked to 18 percent (about $15.6 billion) last year. PricewaterhouseCoopers recorded 1,334 venture capital deals in China in 2014, up from 738 in 2013 and 473 in 2012. Last year, China eclipsed Europe to become the second-largest destination for venture capital, after the U.S., according to the WEE

This boom is supporting a new kind of startup investment in China--earlier-stage and riskier. The number of investors has grown, but so too has their sophistication, says Jeongmin Seong, a senior fellow at the McKinsey Global Institute in Shanghai. In 2009, early-stage investment in China accounted for 16 percent of total venture capital and angel investment, says Seong. By 2014, it had nearly doubled, to 31 percent. Investors are putting more money into early-stage deals because the competition for safer investment opportunities has become fierce. "The risk-to-reward calculation is changing," says Rui Ma, a 500 Startups venture partner who splits her time among Beijing, Shanghai, and Silicon Valley.

Venture capital began to be available in China 10 to 15 years ago, when overseas funds started opening offices in the country to scout investment possibilities. Until then, options for would-be entrepreneurs were limited: many founders used their own savings, or pooled money from relatives living both inside and outside mainland China. Historically, China's state-owned banks have strongly favored lending to state-owned companies, because of a widely held assumption that the government would step in to save even failing ones. That's still true today.

Zennon Kapron, founder of the financial industry research firm Kapronasia in Shanghai, attributes the rise in venture capital to the class of Chinese entrepreneurs who have grown wealthy from their own companies' public offerings. These business founders offer more than money to the startups they fund, says Kapron: "The knowledge, network, and experience that a Neil Shen can bring to the table as well is very powerful. Chinese business is still very much driven through relationships, and having that in place can be critical for any startup."

Other Chinese tech giants that have gone public in the past decade--Baidu (2005), Alibaba (2014), and Tencent (2015)--had founders who, like Shen, went on to manage VC firms. Often called the "first generation" of China's Internet titans, they include Alibaba's Jack Ma, who founded Yunfeng Capital; Xiaomi's founder Lei Jun, who launched Shunwei Capital Partners; and Pony Ma, who has overseen Tencent's transformation into an investing powerhouse in its own right.

Their impact extends beyond their direct VC investments, inspiring the swelling ranks of both entrepreneurs and investors in China by legitimizing the startup dream. "Before, there was a huge pressure for young people to graduate college and immediately go work for a stable established company and begin to send money back home," says William Bao Bean, a Shanghai-based partner at venture capital firm SOSV and managing director of Chinaccelerator. "Today the kids who want to launch startups can tell their parents they have role models." In a survey of graduates from Peking University, one of China's top colleges, only 4 percent identified as entrepreneurs or self-employed in 2005; by 2013, the proportion had grown to 12 percent.

Bob Zheng grew up in Shanghai and then went to college in Canada, where he stayed to work for consultancies for eight years. In 2008, he came back to Shanghai to launch an online education startup. At that time, it was "still a bit early for VC," he recalls, and the initial funding came from his cofounder's own savings. When his team sold the company in 2010, he plowed his earnings into a new business model that wouldn't have been possible even a few years before: launching and managing co-working spaces for other entrepreneurs, called People Squared. Today, Zheng's team runs 15 co-working spaces in Shanghai and Beijing, hosting about 250 startups, most of them tech-focused. He plans to open spaces in Hangzhou, Nanjing, and Shenzhen soon.

China's great size is both a blessing and curse for startups: there's opportunity to scale up quickly, but also plenty of competition. "In the U.S., if someone has an idea, maybe three other startups are working on the same idea," says Rui Ma of 500 Startups. "In China, maybe 10 or 20 funded companies or more are competing on the same idea." --Christina Larson

Pittsburgh's Great IPO Hopes

Despite a strong startup scene, the city still lacks a home-grown tech
icon. Here are the companies experts say have the best shot at a big
IPO in the next few years.

               University Tie  Leader(s)       Product

4M0MS          2006/n/a        Rob Daley,      High-end robotics
                               Henry Thome     products for child care
AQUION ENERGY  2008/CMU        Jay Whitacre    Low-cost batteries
DUOLINGO       2011/CMU        Luis von Ahn,   Language-learning
                               Severin Hacker  application
NOWAIT         2010/CMU        Robb Myer,      Restaurant-management
                               Ware Sykes      software

Key Venture Capital Players
The burgeoning Chinese venture capital scene includes company founders
and professional financiers.

NEIL SHEN     Founding and managing partner, Sequoia Capital
              China. Major investments include
              antivirus software maker Qihoo 360 and discount
              retailer Vipshop.
FENG TAO      Founder and CEO, NewMargin Ventures. Major
              investments include mobile ad firm
              Panshi and Internet apparel retailer Vancl.
KATHY XU      Founder, Capital Today. Major investment is
              BeiBei, a site selling baby products.
SUYANG ZHANG  General partner, IDG Capital Partners. Major
              investments include the picture and video
              app Meitu and Royole, which makes displays
              for smartphones and other devices.
XU XIAOPING   Founder, ZhenFund. Major angel and VC investor
              funding the Minerva Project, an edtech
              firm, and Nice, which allows you to
              embellish photos on social-media networks.
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Publication:MIT Technology Review
Geographic Code:1USA
Date:Jan 1, 2016
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