NUS BUSINESS SCHOOL

FIN4112G
Baidu-Individual Question
Foong Chee Hong A0078667J

Baidus Financial Position

Should Li invite Google to invest in Baidu?

1999

2000

2001

2002

2003

2004

King and Integrity Partners invested $1.2m in Baidu

Baidu raised another $10m

Baidu cash dwindling; Adopted Googles business model

Baidu made its first profit in 2004 and raised another $15m from DFJ Planet

Baidu officially established on 18 Jan 2000 in Beijing

Dot-Coms and portals bust

Figure 1: Baidus funding timeline from 1999 to 2004

Up to 2004, Baidu has successfully secured approximately $26.2m of funding from several investors. Despite able to generate their first profit in 2004, Baidu needed more cash to sustain its rapid growth and investment. (Refer to the appendix below on Baidus balance sheet and income statement) The Dot-Com bust in 2001 caused many investors to scale down their investment leaving Baidu little option to source for funding. Without information in hindsight, it is important to evaluate whether Li should invite Google to invest in Baidu in 2004. Looking into the financial aspect of Baidu in 2004, it is important to measure how confident is Baidu in their growth, projected free cash flow, capital burn rate, operating needs and profit margin in the future in order to determine the funding requirement of Baidu. Baidus free cash flows were negative from 2001 to 2003. Nevertheless, Baidu income/ (loss) has grown/ (fallen) exponentially since year 2002 to 2004 after they adopted Googles business model. Their investment was approximately $5m in 2004 up from $1m in year 2001. According to their financial statement, most of the investment was used to purchase additional servers and other computer hardware to sustain growth. Baidu expected that these investments to increase in future years. Based on Baidus financial, it appears that Baidu will need further capital injection to sustain its rapid growth. The availability of sources of capital changes at different stage of growth. Based on their balance sheet and investment rate, the amount of capital Baidu require to sustain its growth is expected to be in the sum of few millions dollar where it is unlikely to be sustainable based on their revenue stream. In the case of Baidu, private equity, venture capitalist and corporate (strategic) funding seem to be feasible choices for Baidu.

Google as Corporate (Strategic) Venture Capitalist When working with corporate funding sources, it is important to be vigilant on the corporations philosophy and culture as well as their historical investment track record with other businesses. Most often than not, corporations invest in start-ups that are relevant to their own industry in order to reduce their own costs of research and development or in order to enter new markets. Corporate venture capitalists resemble conventional venture capitalists in the sense that they look for young companies that are growing. However, corporations tend to be more risk-averse and specialized. Careful selection of types of investors is important as bringing the right investors may add or reduce the value in a company.

Pros

Cons
Access to Trade Secrets Potential Take-Over Conflict of interest Regulations and Political Issues Potential restriction on management team

Evaluating Advantages and Disadvantages inviting Google to invest in Baidu

Assistance in technical know-how Potential Exit Opportunity Credibility and Connections Satisfy funding needs

Issues on Intellectual Property

Figure 2: Evaluating Advantages and Disadvantages inviting Google to invest in Baidu

Inviting Google to invest in Baidu may benefit Google in terms of technical know-how and broadens Baidus business connections. Google may be willing to provide assistance in terms of technical experience and provide important business networks such as original equipment manufacturers (OEM), banks, appropriate legal and accounting firms and banks. On the flip side of the coin, having Google in Baidus stake allows Google to access to technical, trade and operational secrets of Baidu. Having Google as a dominant investor may substantially improve the credibility of Baidu particularly in the early stage of growth. This can potentially allow Baidu to secure more investors and even customers in the early stage. In addition, Google may assist Baidu in negotiating contracts with OEM and other key players in the market. The willingness of Google to assist Baidu ultimately depends on the strategic intention of Google and the amount of stake Google has in Baidu. Without hindsight bias, Google may invest in Baidu to monetize its investment or, alternatively, Google may have intention to acquire Baidu in order to enter the Chinese market. These have critical implications on Lis decision. Whether Li is looking for exit opportunity or that Li intends to grow Baidu to a global player, Lis final decision must complement with Googles intention. Based on information from the case, it appears that

Li is open to cash-out opportunities and Google has intention to enter the Chinese market. It is also noted that the internet industry was highly acquisitive at that time. From 2001 to 2004, Google alone has made 13 acquisitions in the US market. Despite the potential benefits that Google can offer, Li has to be aware of the potential disadvantages when inviting Google to invest in his company. One of the main disadvantages is the potential conflict of interest which may arise when Google decides to officially enter the Chinese market in the future (Google has entered the Chinese market as early as 2000). This will make Google a direct competitor with Baidu as they compete with the same customers. The conflict of interest also arises when Baidu has to make decisions that are against the philosophy of Google in terms of information and privacy issue. Having Google invested in Baidu may also reduce the control of Li over Baidu. Depending of the covenants and types of funding, Google may place unintended restriction on Baidus management team which could inadvertently affect Baidu growth opportunity in the Chinese market. This situation is further aggravated with potential misalignment of interest in both parties as discussed above. There is also an issue regarding political and regulatory environment in China where officials in China disfavor the idea of having foreign companies investing in domestic telecommunication and mediarelated industry. 1On top of that, the Chinese government bans all political sensitive information in their internet content; a regulation that is against Googles philosophy of free flow of information. Inviting Google to invest in Baidu may incapacitate Baidu development and relation with officials in China. Again, this may affect Baidus growth in the Chinese market. Lastly, there is a lingering concern over intellectual property as Baidu copied Googles pay-per-click business model and applied it in the Chinese market. Despite having able to avoid any lawsuit operating in China, inviting Google to invest in Baidu can add on further complication over future potential lawsuits that could arise when Baidu expands to the international market. Despite operating in different market before 2004, Baidu is a direct competitor to Google in terms on operating model. Inviting Google to invest in Baidu possesses both pros and cons. Ultimately Lis decision on whether to invite Google depends on Lis long term intention and whether Googles strategic intention complements with Baidus.

Evaluating Lis intention and Baidus Position

From the case, it can be interpreted that Li is an aspiring man who wanted to develop the internet content management industry in his home ground. Inspired by his former bosses who pocketed millions from his business, Li decided to try his own luck. Li also desires to follow his predecessors footstep and hence exit opportunities are widely welcomed by Li. In many cases, Lis intentions appear to complement with Googles strategic philosophy. Another critical issue to discuss regards to the types of funding and covenants. Important terms of funding to negotiate include the amount of capital to invest, amount of stake to give up in exchange for
1

http://dealbook.nytimes.com/2012/01/23/a-loophole-poses-risks-to-investors-in-chinese-companies/?_r=0

the capital, preferred rights, board representative, voting rights and operational control over Baidu. Li as the founder of Baidu would want to raise as much capital as possible with least restraining clauses and covenants. This ultimately boils down to the bargaining power of each party. Analysis Baidu Funding Alternatives

Evaluating Potential Funding Alternatives

Search for other investors Wait for capital market to recover

Limited after Dot-Com bust and time-consuming Time-consuming, not feasible as Baidu needed cash as soon as possible

Search for Debt/Loans/Grants

Difficult as Baidu still a start-up, burden from interest payment

Difficult after Dot-Com bust
Figure 3: Evaluating Potential Funding Alternatives

Request existing investors to invest more

The Dot-Com bust rendered most funding alternatives unavailable. Google seems to be the most accessible source of funding for Baidu. However, this also reduces Baidus bargaining power over terms of funding. Before negotiating with Baidu, Li should be prepared to position and market itself as high growth firm to obtain the most favorable terms. Li and his team should highlight their expertise and experience in the domestic market. Baidus position, at that time, was critical period as they have just shown signs of growth. Running out of cash when Baidu has just started showing sign of growth is the most undesirable. (Refer to the appendix to see Baidu cash position from 2001 to 2003)

Conclusion
Given the timing of growth is the utmost important decision particularly in the technology industry where potential first entrant to new market tends to absorb most market share, sacrifices have to be made in terms of equity and control over Baidu. According to research2, most founders only retain 2030% of equity stake in their company upon IPO. Furthermore, potential investors willing to invest in Baidu seem to be limited after the Dot-Com bust. Also, it must be noted that most investors, to some extent, do place control over management team. Jeopardizing investment rate and timing for growth for the sake of safeguarding control is not a wise tradeoff for Li. In a market where time and availability of capital is scarce, it is not time for Li to be fussy over investors. Li should invite Google to invest in Baidu in 2004 and bargain for the most favorable terms for them.

Timmoms, Jeffry A. & Spninelli, Stephen c2009, Chapter 14 , Page 446: New Venture Creation, Entreprenuership st for the 21 Century, Mc Graw-Hill/Irwin, Boston

Appendix

Table 1: Baidus Cash Flow Statement

Table2: Baidus Income Statement

Table 3: Baidus Balance Sheet