China is powering ahead of the US in the race for mega start-ups

Chinese start-ups are growing faster than their American peers.

A prime example is Luckin Coffee, the self-declared Starbucks rival in China that is set to go public in New York on Friday. The Chinese company began operations in the fourth quarter of 2017 and achieved a $2.9 billion valuation about 18 months later, with investors such as BlackRock.

In January, researchers from Boston Consulting Group said they expect Luckin’s store count in China to surpass that of Starbucks in this quarter. The American coffee chain has been operating in China for 20 years and has 3,600 stores in more than 150 cities, while Luckin had more than 2,300 stores in 28 cities in March this year.

China’s young people are more willing to spend than previous generations, and the government is supportive of new technologies, said Zhou Wei, founder and managing partner at China Creation Ventures. This kind of business environment is helping start-ups, he said, and that also means that in the initial stages of development, gaining market share is more important for a company than building up operations.

Chinese unicorns — or companies with a valuation of more than $1 billion — now account for 91, or 28%, of the world’s of such companies, according to CNBC’s analysis of January data from CB Insights. The U.S. has 159 unicorns, accounting for 48% of the total — or nearly half.

But the Chinese companies have gotten there far more quickly.

It takes an average of four years for a Chinese start-up to reach unicorn status, versus seven years for a new company in the U.S., according to a September 2017 report from Boston Consulting Group. An analyst for the firm was not available to provide an update on that statistic in time for this article.

“Overnight success is more likely in China than in the U.S.,” the authors wrote.

In the last decade, the Chinese path from launch to U.S. IPO has also taken a median of 8 years, two fewer than the overall median of 10 years, said Matt Kennedy, senior IPO market strategist at Renaissance Capital.

The surge of growth is a testament to a unique business environment, as well as a population more than three times larger than the U.S. At the same time, it bears all the points of concerns global investors have about an overheated Chinese economy.

“I do think that the reason some of these companies can justify their valuation is because at the end of the day, the addressable market is double the size of the U.S., on mobile particularly,” said Edith Yeung, partner at early stage investor 500 Startups. “I understand why the valuation is so high. But the key thing is not just the future, but healthy growth towards the future.”

She pointed to Chinese bike-sharing companies Mobike and Ofo as examples. Both grew quickly in the last few years, driving a trend that spawned many other bike-sharing companies in China, but the business model proved unsustainable. Mobike was acquired last year, while Ofo is reportedly on the brink of bankruptcy.

Luckin bills itself as a homegrown coffee chain and began delivering to customers months before Starbucks officially did. The Chinese company has quickly set up its stores — many of which have little to no seating. It attracts customers with cheaper prices and aggressive deals, such as a promotion which gave customers five coupons, each good for 72% off.

Yeung said a key factor to watch is Luckin’s ability to retain and make money.

In the first quarter of this year, the average number of customers making a purchase each month was 4.4 million, according to Luckin’s prospectus. That’s just 2% growth from the prior quarter, compared to a 130% increase in average transacting customers between the third and fourth quarter of last year.

New customer acquisition costs have fallen sharply to 16.9 yuan ($2.44) per customer in the first quarter from 103.5 yuan a year ago, Luckin said. The company also disclosed that its customer retention rate has remained around 35% or less.

Within a short 18-month period, Luckin managed to achieve a $2.9 billion valuation. Not since the dotcom bubble from 1999 to 2000 has a company achieved a $3 billion public valuation less than two years after its launch, according to Renaissance Capital, which also manages IPO-focused exchange-traded funds.

Like U.S. IPOs, Chinese companies going public in America are increasingly unprofitable, according to University of Florida finance professor Jay R. Ritter. Three-quarters of Chinese listings in the U.S. between 2001 and 2011 were profitable — but that has fallen to 43% in the years since, Ritter said.

In the case of Luckin, the company posted an operating loss of 527.1 million yuan in the first quarter this year, compared to 125.2 million yuan in the same period a year ago. Net revenues rose to 478.5 million from 13 million over the same time period.

The coffee chain filed with the U.S. Securities and Exchange Commission as an “emerging growth company,” which only requires audited financial statements for two fiscal years, instead of three. Luckin provided financial results since its inception in June 2017.

Going public, especially for Chinese companies in the U.S., is often seen as a stamp of approval for a business. An IPO usually implies a company is mature and large enough to handle more stringent disclosure standards, gain prominent underwriters such as Goldman Sachs and Credit Suisse, and deliver on quarterly performance for shareholders.

The race has sped up for start-ups to prove their worth, since it now takes only two or three years from launch to IPO, said Zhou, who was formerly managing partner at venture capital firm Kleiner Perkins Caufield & Byers China.

Facing this uncertainty, Chinese entrepreneurs must find their success quickly, Zhou said, according to a CNBC translation of his Chinese-language comments. They can do this by iterating a test of concept — even if it’s imperfect — in order to quickly gain the market’s feedback, adjust strategy and products, and stay slightly ahead of market expectations.

In this way, they may have a greater chance of winning, he added.  “If they wait until they have a perfect plan, ‘the game is over,'” he said. “This kind of rule is not only still applicable, it’s also, in China’s competitive environment, more applicable than it is in America.”

It may be that for China, “fail fast” is being played out in a big way.