Chinese investment in U.S. startups under scrutiny for espionage

When he was an undergrad at UC Santa Barbara, Alon Raphael cofounded a startup called Femtometrix. It sells technology to computer chip makers that detects mind bogglingly tiny defects buried within chips.

“It’s the bleeding edge of the most advanced chips that are coming out that we are applicable to,” he said. Raphael eventually hired engineers, including three who were Chinese nationals whose work visas he sponsored. Two came on board in 2018, the third in 2020. Over time they grew close, he said. After a little while, one of them said he wanted to invest in the company.

“One of the requests for the investment was to know the details of the patent portfolio,” Raphael explained.

When investors and startups connect, investors can get significant access to a company’s information. Startups set up what are called “data rooms,” where prospective investors can view proprietary data and plans. Once they consummate their investment, they can obtain more information.

“I didn’t accept the investment funds until he’d already been working at the company for a term — I considered him a friend,” Raphael said.

A friend he was not, apparently. Nor were two other employees, as Femtometrix alleged in a lawsuit filed last August.

“They absconded with hard drives and the technology,” Raphael said, and fled with it to China. That was just the beginning.

“Led by a Chinese venture capital fund,” Raphael alleges, “[they] set up a sister company with the stolen technology in China and began to produce our technology and market to our customers from China.”

The alleged copycat company called Weichong Semiconductor Group also filed patents in China for the stolen technology, Raphael said. Weichong Semiconductor Group did not respond to an inquiry through their attorneys before air. Shoshana Raphael — Alon’s sister — is an attorney for Femtometrix.

“The difficulty is that China is beyond the reach of the courts,” she said. “So if we are successful, we really think we will be left with an injunction that has limited effect — it would restrict them to China at best.”

The Femtometrix case is emblematic of a wave of alarm currently rippling through the world of startups and venture capital in the U.S. Not simply over potential IP theft from China, but over Chinese investment itself.

“It’s a very serious concern,” emphasized Andy Weber, a senior adviser at the Council on Strategic Risks and former Assistant Secretary of Defense for nuclear, chemical and biological defense programs.

“Chinese affiliated or owned VCs are seeking to acquire Western companies, oftentimes to obtain access to technologies in priority sectors,” he said. Priority sectors including semiconductor chips.

The scale of China’s industrial espionage effort is staggering, according to Michael Brown, a partner at Shield Capital and former director of the Defense Innovation Unit at the Department of Defense.

“No country has ever applied the amount of resources to ingest technology that the Chinese Communist Party has,” Brown said — and venture capital investing is one small slice of it.

“Over a quarter million people in the People’s Liberation Army are focused on stealing IP and secrets, meaning commercial secrets that could be valuable for companies in China,” Brown said, citing a 2014 estimate from intelligence and strategy advisory group BlackOps Partners. Its CEO, Casey Fleming, said he believes the numbers have grown higher since then.

U.S. law can prevent foreign investors from taking a controlling stake in companies with sensitive technologies, but it doesn’t apply to small investments of less than a 10% stake. Even small investments can secure access to valuable information and field awareness of up and coming technologies.

“In essence, it’s the perfect cover for industrial espionage,” said Weber. Startup founders may not grasp the threat, Weber said, because the line between private sector and government in China is murky compared to what they may be familiar with elsewhere.

“Unlike American companies, Chinese-owned companies are required by their government to support the military, it’s called civil military fusion,” he said.

Chinese venture capital firms are also required to support government goals of acquiring advanced technologies, according to Nate Picarsic, senior fellows at the Foundation for Defense of Democracies.

“To raise a venture capital fund [and deploy money overseas], investors in China have a requirement to explain their investment thesis and mandate in terms of the strategic emerging industries that tie to the long run Chinese science and tech planning apparatus,” he said.

“And they’re not hiding it if you’re looking at the Chinese sources,” added Emily De La Bruyere, also a senior fellow at the FDD. “Just to underscore that this isn’t any kind of fear mongering out of the potential concern it’s a very real goal.”

Several Chinese investment groups did not return requests for comment. Not every Chinese venture capital firm is a conduit for industrial espionage, cautions Scott Kennedy, senior fellow at the Center for Strategic and International Studies. “There’s probably a whole lot of Chinese venture capital firms that are just venture capital firms that are looking for technologies to invest in and support and making money,” he said.

But he added it may be hard to tell the difference. And startups are facing a difficult market, with investment anticipated to continue to drop from 2021 and 2022 levels, according to Ernst & Young.

“If a company wants to stay alive, they’re gonna go anywhere,” said Ellen Chang, Vice President of Ventures at BMNT, an advisory firm that also has a startup accelerator, H4XLabs, that Chang runs. “The U.S. investor tends to shy away from certain types of deep tech, hard tech companies.”

She and other groups, including Deep Tech for the National Interest, Shield Capital and private investors, have begun investing in startups of strategic technological importance to the U.S.

Similarly, the Department of Defense’s Office of Strategic Capital offers investment to startups to promote technological innovation. “We do need to look at things more long term, more in the national interest in order to secure our future and make sure America is competitive,” Chang said.

Still, some American startups may find themselves in a bind — they’re increasingly aware of the possible risks of Chinese investment, but in a rough market are also increasingly desperate for funding.