The Iron Curtain of Venture Capital Finally Falls

By Jiaxiang Shi

Edited by Jing Liu

On August 9, 2023, U.S. President Joe Biden signed an executive order establishing an "investment review regime for China" (hereinafter referred to as "the new rules"). After more than 500 days of wrangling, they took effect today. In short, the new rules restrict "U.S. persons" from investing in sensitive sectors involving Chinese entities — notably semiconductors, quantum information, and artificial intelligence. Notably, the definition of "U.S. persons" is relatively broad. In addition to U.S. citizens, it includes green card holders (regardless of location), entities established in the U.S. and their foreign branches, and any individual or entity within U.S. territory (regardless of nationality). A spokesperson for China's Ministry of Commerce responded that these measures restrict American companies' investment in China and suppress the normal development of Chinese industries, representing a typical overextension of national security concerns. They violate the consensus reached by the two heads of state at the San Francisco summit, affect normal economic and trade cooperation between Chinese and American enterprises, undermine international economic and trade order, and disrupt the stability of global industrial and supply chains. China expresses serious concern and firm opposition, and reserves the right to take corresponding measures. For the already depressed venture capital industry, the new rules are undoubtedly another tightening.

First and foremost to bear the brunt are the dollar-denominated funds that have dominated China for over two decades and possess the highest risk tolerance. Over the past year, whether Hongshan, GGV, or Matrix Partners China, multiple multinational investment institutions have successively split apart. Next are the AI entrepreneurs who have thought globally from day one — an already harsh fundraising environment now has another dark cloud. They need to make clearer, more decisive choices earlier on. A lawyer told us that because of the new rules, a batch of AI application projects rushed to close before they took effect. According to the new rules, restricted investments are further divided into "prohibited" and "notifiable" categories. Gaorui Law Firm told us that the scope of prohibited transactions is far smaller than that of notifiable ones. However, the new rules contain no exemption clause for compliance with foreign laws and regulations. That is to say, strictly following the new rules to provide all project information to the U.S. government could simultaneously violate confidentiality obligations under applicable Chinese law. The specific implementation methods for "notifiable" transactions will determine dollar funds' concrete strategies in AI investment. The other shoe has dropped. Whether you're a GP or an AI entrepreneur, navigating this uncertain new environment requires understanding the new rules of the game.

Over the past two weeks, we spoke with Mindy Huang, partner at Tsar & Tsai's New York office; Zhen Liu, China managing partner at U.S. law firm Gunderson Dettmer; and Ruiyuan Zhang, partner at the same firm. Under this contest, Chinese entrepreneurs and funds today cannot have it both ways — they must "pick a side." The following conversation has been edited by Waves:

The Strictest Iron Curtain in Venture Capital History

Waves: Can we start by sketching a specific profile of who is affected by the new rules?

Mindy Huang: To understand the new rules, you need to grasp three key points: they prohibit or restrict (1) U.S. persons (2) from making equity or similar investments (3) in sensitive industries of countries of concern. The final rules target three broad areas — semiconductors and microelectronics, quantum computing, and artificial intelligence — while dividing U.S. investment in these sectors into prohibited and notifiable categories. For the former, no U.S. person may invest; for the latter, notification to the Treasury Department is required.

U.S. citizens and permanent residents, U.S. companies, foreign entities controlled by U.S. persons, and others are all subject to these restrictions.

Waves: In the AI field, how do the new rules set training compute thresholds for prohibited versus notifiable categories?

Ruiyuan Zhang: Under the new rules, AI systems with training compute reaching 10^25 FLOP, or those reaching 10^24 FLOP and primarily trained on biological sequence data, are classified as prohibited. The Treasury Department adopted the 10^25 threshold that the EU AI Act currently uses to determine whether a large model poses "systemic risk." Most of today's top global models (such as GPT-4 and Gemini) already meet or exceed this standard.

For AI business categories requiring post-hoc notification, the threshold is training compute of 10^23 FLOP. Based on our interviews with industry technical experts, this compute standard is quite low and would basically cover the vast majority of current mainstream large AI models.

Waves: What is the current attitude of various parties toward the new rules?

Zhen Liu: In fact, before the draft was issued, the vast majority of dollar funds in the market had already scaled back their investments — behavior had already shifted due to macro factors.

So when we discuss the impact of the new rules with clients now, the general consensus is that it's better than the worst-case scenario expected. Unlike CFIUS (Committee on Foreign Investment in the United States), which requires pre-approval before closing, these new rules involve post-hoc notification. From an industry perspective, having clear rules for practical guidance is better than having no rules and constantly guessing whether you're crossing a line.

Waves: Were there any similar restrictive regulations before the new rules were introduced?

Mindy Huang: Almost none. The U.S. has previously imposed export controls, embargoes, economic sanctions, and other measures on specific countries or industries, but none have had an impact as significant as these new rules.

The defining feature of the dollar is free movement and convertibility. The logic behind it is simple: the dollar has value because it can be exchanged for money and goods anywhere, so any regulation restricting dollar flows diminishes the dollar's competitiveness in the market — only the degree varies.

Waves: Some argue that the new rules are just posturing and may not be fully enforced, so the actual impact may not be that great.

Mindy Huang: Looking at past enforcement of similar policies, the number of cases investigated by U.S. federal agencies isn't large — that's a fact. But whether any investment institution is willing to risk being investigated to continue investing, or rather, what level of return would justify taking such risk, is questionable in the current environment.

Zhen Liu: These new rules rely on restricted transaction parties to voluntarily comply or complete notifications, so how much manpower and other resources government agencies devote to pursuing investments they believe should have been reported or avoided depends entirely on the enforcement priorities of those agencies at any given time.

From this perspective, enforcement intensity will inevitably be tied to the political environment. CFIUS, as a legal framework restricting foreign investment in U.S. projects, has existed for a long time, but U.S. officials — some facing the end of their terms — have only in the past few years suddenly and intensively, deeply, and persistently scrutinized U.S. projects with Chinese investors.

This new regime is similar. On one hand, everyone is watching who will be the first to "eat the crab" (make these notifications) after January 2, and how much they disclose. On the other hand, influenced by shifting winds under the incoming Trump administration, we can expect to see the Treasury Department's enforcement of the new rules tighten and loosen at different times.

How Funds Are Navigating the New Rules

Waves: Which category of dollar funds is most affected after the new rules take effect?

Zhen Liu: For covered new funds, the new rules distinguish between two types: funds that are themselves U.S. entities (such as those with American GPs) and have direct compliance obligations; and funds that are themselves non-U.S. entities but whose GPs have certain compliance obligations "transferred" to them due to their U.S. LPs' compliance requirements. The former's investment activities are directly restricted with almost no safe harbor; the latter have some room to negotiate a compliance framework with their LPs.

For the latter, for blind-pool funds, only funds raised and established after January 2, 2025 are directly affected by the new rules. Capital calls for investments by existing funds are exempt for U.S. LPs, who cannot refuse to fund them.

When we help many fund clients design responses to the new rules, we find that different funds have different risk appetites.

Some funds have relatively strict and conservative risk controls, believing that filing notifications for transactions involves disclosing too much sensitive Chinese information. U.S. LPs, particularly university endowments, are also unwilling to actively expose themselves in government records, so such transactions are off-limits. This means fund managers need to commit in writing to LPs that the fund will not participate in prohibited or notifiable projects, greatly reducing their deployable capital in currently hot sectors like AI.

Other funds, however, view notification as a form of compliance — since there's a legal channel for investment, why not use it to participate in promising projects? They might limit themselves to X notifiable investments per year, so that if a star project emerges later, LPs won't ask why they missed an opportunity they could have taken.

Waves: Have any GPs faced direct difficulties in recent fundraising because of the new rules?

Zhen Liu: Difficulties wouldn't stem from the new rules alone. Capital has always been sensitive to the macro political and economic environment; in fact, over the past few years, dollar fundraising and investment have been challenging under multiple converging factors.

But we must also recognize that capital's nature is to make money. During China's golden decade-plus of venture capital, the Chinese market was where investors made the most money outside the U.S. market — bar none. U.S. LPs have been scared off by many objective factors including the new rules, but they're still watching.

After circling India, Southeast Asia, Africa, Latin America... U.S. LPs also realize that China's innovation market and investment environment remain relatively more mature. They'll say "we'll keep watching," but rarely "we'll never invest in China again."

For GPs, the more direct impact of the new rules is: what's my fundraising story? If AI is the hottest sector that everyone's doubling down on, and we can't make Chinese AI investment our core fundraising pitch because of the new rules, then what is my new fund's investment thesis, and how do I build the team?

Waves: So what are U.S. LPs' main concerns right now?

Zhen Liu: Quite a few U.S. LPs have come to China this year. While they're deploying less capital, they've been watching with curiosity. So I don't think they have more concerns than they want to know where the opportunities are and when the window opens.

Investors who were shouting that China was "uninvestable" two years ago have quieted down. After all, as "born global" Chinese entrepreneurs capture markets worldwide, any investment logic that completely excludes China is unwise.

At the end of the day, U.S. LPs' demands haven't changed: they want to have their cake and eat it too — avoid government red lines and make money, and Chinese or China-originating companies can make investors money.

Waves: If a dollar fund has only one GP who is a U.S. citizen, is it still subject to the new rules?

Mindy Huang: (1) If the dollar fund is established in the U.S., it will be subject to the new rules regardless of its partners' nationalities. (2) If the dollar fund is established in a third country (such as the Cayman Islands), and is considered controlled by that general partner, the fund is also subject to the new rules. "Control" leaves substantial room for interpretation — it won't be limited to 50% equity; influencing fund decisions through various means may constitute control. From a conservative perspective, dollar funds with U.S.-citizen general partners should consider complying with the new rules. (3) Even if the fund is not considered a controlled entity of that U.S.-citizen partner, the partner should take reasonable measures not to knowingly direct the fund to violate the new rules.

Waves: Can Singapore-licensed dollar funds effectively avoid the impact of the new rules?

Mindy Huang: For funds established outside the U.S., the key is still whether the fund is controlled by U.S. individuals or companies. For funds intending to invest in the Chinese market, having U.S. nationals in management positions or holding primary financial rights becomes quite delicate.

Waves: For example, if a startup's financing was in a non-restricted category, but later its compute power rises to a prohibited category, does the GP bear responsibility?

Ruiyuan Zhang: At the time of investment, did the GP know this would happen in the future? If you had no reason to "know," there's no problem. In determining whether someone "knew," the U.S. Treasury Department considers holistically what information the U.S. person had access to at the time, or could have obtained through reasonable and diligent investigation. For example:

• Whether the fund made efforts to obtain relevant non-public information;
• Whether the fund deliberately refrained from acting to avoid obtaining information that might prove the target was restricted;
• Whether the target company exhibited warning signs such as deliberate evasion, deflection, or silence on relevant issues;
• Whether the fund reasonably utilized public information and available commercial databases to verify the target's situation.

If the U.S. Treasury Department obtains information about the target company's restricted business activities through media, think tanks, or other channels, it would be untenable for the fund to claim complete ignorance at the time of investment.

Waves: How do you view the survival environment for dollar funds going forward? What specific predictions do you have for them?

Zhen Liu: Those who stay at the table are definitely optimistic; those who are bearish left long ago. They see no hope — that's understandable — but market development depends on those willing to take risks.

Dollar LPs earned more profits in China over the past decade-plus. They can't find a substitute for China in other markets, so as participants in the venture capital market, dollar funds will exist for the long term.

Thinking about this inversely, the most scaled high-tech enterprises in China today were basically developed with the consistent support of dollar funds.

Dollar funds need the Chinese market, and the Chinese market needs dollar funds. Like any curve, there are micro-level valleys in its development, but it will rebound sooner or later. The key is who can hold out until that day.

The Entrepreneur's Multiple Paths

Waves: How significant will the impact of these new rules be on companies, especially in the AI field?

Ruiyuan Zhang: The impact on models is very clear; applications are indeed a bit tricky. The new rules devote substantial space to explaining their legislative background and why notification is required — they may want to understand through all cases how far China's sensitive industries have developed.

Moreover, the U.S. Treasury Department doesn't categorize companies by "LLM" versus "non-LLM." Rather, "developing AI systems" in the new rules — the "develop" — encompasses any stage of activity before product mass production, including "substantive modification" of third-party large models used in products. For example, removing safety measures or guardrails from an AI model would be considered "substantive modification." This means application-oriented AI companies that integrate third-party large models into their products through APIs, for instance, are not necessarily entirely outside the new rules' restrictions.

Waves: If an overseas-facing startup has a founder with a U.S. green card, whose business involves China not at all, but most employees are based in China, is it affected by the new rules?

Zhen Liu: Here's an awkward fact: many entrepreneurs expanding into the U.S. market leverage the cost differential between Chinese engineers and Silicon Valley to gain a head start.

To avoid due diligence complications for foreign investors or sensitivities around having a China subsidiary, quite a few entrepreneurs choose to keep the Chinese company employing these Chinese workers outside the offshore financing entity's group, or choose not to establish a Chinese entity at all and instead hire and manage these personnel through third-party employment agencies.

These "workaround" structures either violate Chinese laws governing foreign companies actually operating domestically, or risk imperfect control over employees and their intellectual property output. They belong to "gray areas" that the new rules intend to bring under management.

Mindy Huang: Generally speaking, the closer a business's ties to China, the more likely it is to be restricted by the new rules. Here's an example: if a U.S. company establishes a wholly-owned subsidiary in China (to handle employee social insurance, etc.) and engages in business restricted by the new rules there, and if more than 50% of the entire corporate group's capital expenditure or operating expenses come from this Chinese subsidiary, then the U.S. company remains subject to the new rules.

As long as a company's main revenue or main costs are in China, it may constitute a restricted investment target under the new rules, regardless of where the end users are.

Waves: If an entrepreneur establishes their company in Singapore, can they circumvent the rules?

Zhen Liu: Singapore, Cayman, or anywhere else — the difference is minimal. As long as upward piercing reveals Chinese control, the restrictions are the same. In fact, in today's U.S. venture capital market, seeing Singapore, many people default to assuming it's a shell controlled by a Chinese entity or individual, simply because this approach has been seen too many times over the years.

Including so-called parallel Chinese and American structures — if both are Chinese-controlled with identical shareholder compositions, the value of such separation is limited. True separation requires parsing and dividing markets, products, IP, employees, management shareholders, and external shareholders across multiple dimensions. Trying to perfectly straddle both boats basically means violating rules.

Waves: Will AI entrepreneurship projects by Chinese Americans be affected?

Ruiyuan Zhang: Beyond nationality and green card issues, you also need to look at the company's revenue, assets, and other basic conditions, and analyze the control structure at the upper levels.

If a U.S. company has (directly or indirectly) established subsidiaries in China engaged in sensitive business, and these subsidiaries meeting certain financial thresholds (referring to annual expenditure or revenue exceeding $50,000) collectively contribute to or account for more than 50% of the U.S. company's annual revenue, profit, capital expenditure, or operating expenses, then the U.S. company itself becomes a restricted entity. Depending on its specific business type, investment by U.S. persons may be prohibited or require notification.

Another example: a U.S. company established and operated by a U.S.-citizen founder engaged in sensitive business, if Chinese nationals or Chinese institutions collectively control no less than 50% of equity interest, shareholder voting rights, or board voting rights in any of these three indicators, then this U.S. company is also classified as a restricted investment entity.

Waves: What specific advice would you give to entrepreneurs affected by the new rules?

Mindy Huang: Walking the tightrope between China and the U.S. is becoming increasingly difficult. Companies often have to "pick a side," and design their equity structures and operating models accordingly.

Of course, for non-U.S. countries not directly restricted by the new rules, there are also vast overseas markets. In these markets, business can still be developed through China-centric structures.

Zhen Liu: Because the new rules directly affect what kind of money entrepreneurs' companies can access for future financing, they're worth spending some time gaining a basic understanding of the rules, and planning ahead regarding corporate structure, team composition, intellectual property ownership, entity distribution, fundraising direction, and capital sources.

This planning needs to be rigorous and tailored, not self-deceptive. Making "takes" and "gives" is an unavoidable subject.

The above content is for reference only and should not be regarded as legal advice or basis for specific matters.

Image source | Unsplash