The New Third Rail in Silicon Valley: Investing in Chinese AI

The backlash came swiftly for Benchmark, one of Silicon Valley’s top venture capital firms, after Bloomberg News reported in late April that it was investing in an AI startup founded in China. Republican senators framed the deal as Benchmark effectively aiding the Chinese government, and suggested Congress should take action. Fellow venture capitalists said Benchmark was acting irresponsibly.

Until recently, US venture firms played a pivotal role in the development of China’s internet industry, as investors looking to replicate successful US business models abroad plowed billions into Alibaba, Baidu, Didi and TikTok owner ByteDance. The trend peaked in 2018, when US venture investors participated in over $40 billion worth of Chinese deals.

But the mood began to shift when President Donald Trump took office in 2017 and continued in the Joe Biden years. The US adopted new tariffs and restrictions on investment in China, and some US firms severed economic ties to the country. Beijing also created new barriers on foreign investment that depressed tech deals. Last year, total funding for Chinese startups dropped by almost 40% from the year prior, and only 8.5% of VC rounds included foreign investor participation, the lowest in more than a decade.

In January new US rules designed to curb investment in Chinese-owned semiconductor, quantum and AI companies took effect. The measures, a part of the Department of the Treasury’s Outbound Investment Security Program, prohibit investors from backing AI systems designed to be used for the military, government intelligence or mass surveillance. Compliance falls on investors, who must assess risks themselves and notify the Treasury when they do invest in sensitive areas.

Benchmark hired lawyers to review its investment in Manus and concluded it didn’t need to file notice because its product is merely a consumer application.  But shortly after Benchmark completed the deal, the firm received a letter from the Treasury inquiring about the investment.

If the Treasury Department decides the investment violated policy, Benchmark would be forced to divest and could face additional criminal or civil penalties, including a fine twice the value of the transaction. Lawyers unconnected to the investment say it likely won’t trigger such consequences, because Butterfly Effect is incorporated in the Cayman Islands.

The shifting landscape is presenting founders in China with a difficult choice: raise money from Chinese backers and focus on the domestic market, or sever ties with China to pursue global funding and users. Even taking the latter path doesn’t guarantee a startup will escape suspicion. 

Even as anti-China sentiment picks up in venture capital, the industry hasn’t lost its fear of missing out. Investors continue to visit China, even when they say they don’t plan to back companies there in the near term.

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