Back to Contents of Issue: February 2000
by Katsuya Yoshi |
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Japan is said to be welcoming its third wave of venture companies. With the
rest of the economy stuck in the doldrums of recession, hopes are high that the
entrepreneurial spirit will light a fire under industry and create employment
opportunities. Venture companies need, of course, a supply of venture capital.
Last year, the Japan Regional Development Corporation commissioned the NCB Research
Institute to do unstructured interviews with about 170 startup companies. Working
from the comments elicited by that research and the observations of others closely
involved with venture companies, let's look at the funding available for high-risk
ventures at each stage in their life cycle -- from seeding to the early growth
stage.
Limitations on Indirect Financing Banks are in fact lending more to smaller business these days, since major corporations are moving away from bank loans. Still, the credit picture for smaller businesses hasn't changed much, and many criticize banks for their reluctance to lend to smaller firms. The banks' caution is not without reason. While Japan continues to deal with the aftermath of the Bubble Economy deregulation has heated up the competition. Banks face demands to quickly improve their capital adequacy ratios, while, at the same time, their assets are losing value. The result is a credit crunch. But the real problem in finding financing for entrepreneurial startups is not the credit crunch. It's a structural problem, not just a temporary skew in credit markets. While indirect financing may work for conventional companies, the high-tech ventures that so much hope is hanging on are in a different world. Such companies may have strong growth prospects, but what they don't have is the real estate or other collateral to put a sparkle in a bank loan officer's eye, which imposes a sharp limit on how far indirect financing can meet their needs. What's Different About Venture Companies? 1. Venture companies typically go through a long research and development period before an idea becomes commercially viable. In the biotech field, an initial R&D phase of nearly a decade is not unusual. Naturally, the company will have no sales and will be operating in the red during this period. Its ability to make payments on principle or interest is zero, zilch. Given the nature of early stage venture companies, what kind of financing would best meet their needs? The answer is obvious: long-term funds available without collateral or guarantors, in small lots, at low fixed interest rates. Bank loans and other forms of indirect financing are not the answer. Banks' only source of income from loans is their interest rate margin, about 1 percent annually. The bank receives only that margin even if the company receiving the loan is a roaring success and becomes hugely profitable. (The bank may, however, be able to increase its income by providing the growing company with larger loans.) And if the company can't repay the loan and the collateral won't cover the bank's exposure, it will take many, many other loans at a 1 percent margin to cover the loss. Deposits and other funds for which the bank guarantees the principal are recorded as liabilities. Loans are on the asset side of the ledger, where the risk of not recovering the principal is hard to accept. Banks, therefore, basically make loans on the assumption that all funds lent can be recovered from all borrowers; even if the borrower goes bankrupt, they expect to recover their money by disposing of the collateral. Normally, too, a bank first tests the waters by handling notes or other settlement services for a company; after dealing with the company for a certain period of time, it may then become confident enough in the firm's prospects to offer credit. Given the necessarily risk-averse nature of indirect credit, it is unlikely to make much contribution to financing high-risk startup companies. This point is obvious to investors outside Japan, but entrepreneurs in Japan haven't gotten the message. Founders of venture companies here dislike having others invest in their companies, for fear of losing managerial control. Instead, they depend on loans, and what they want most is access to credit, as the White Paper on Small and Medium Enterprises in Japan indicates. What, then, can bridge the gap between entrepreneurial need for credit and
private-sector financial institutions' disinclination to lend? One answer is credit
from public institutions such as the national and local governments. There is,
however, a little-noted glitch in the government-as-angel scenario: Credit provided
by public sources to high-tech startups has much the same problem as bank credit.
For public institutions to invest or lend in ventures the private sector will not touch, it has two choices: reducing the risk or accepting that risk as the social cost of promoting entrepreneurship. A public sector lender might reduce the risk by doing a better job of screening applications, to achieve a better risk-return ratio than the private sector could. Or it could improve the odds by providing a full suite of support services to the new company's management. If such public institutions are burned by investments in high-tech startups, they may well be raked over the coals in, for example, the prefectural legislature, and required to take a substantially more conservative stance on giving credit, even to adopt the risk-reduction measures private-sector financial institutions use. That would be unfortunate. Before that happens, the role of the public sector in lending to startups needs to be revisited. Other Possibilities? Those companies, denied relatively inexpensive bank loans, were driven to borrow from nonbanks lending at high interest rates. Credit for small firms has, thus, become an all-or-nothing market -- interest rates are very low or painfully high. That suggests an interesting opportunity: If Japanese society and the business community could accept interest rates that appropriately reflect risks, a new, profitable market would emerge and attract participants, including foreign-affiliated financial institutions. Another idea is to build equity participation into the credit system, structuring it so that increased income from a successful company covers the losses of another that fails. The Japan Key Technology Center, an external organization of the Ministry of Posts and Telecommunications and Ministry of International Trade and Industry, has a special credit system for R&D-type companies that has an equity component, which makes it possible to recover its capital from the successful companies. In this system, the projects given loans are assigned to one of five ranks according to their degree of success. If a project does not do well, the borrower can be excused from returning up to 80 percent of the principal. But if a company has succeeded in commercializing the project on which it was doing R&D, it must return a commission on sales (on average, about 2 percent) to the center during the 10 years of the loan. Commission payments stop, however, when the total commission paid equals the principal of the loan (the double payback rule). Such a system, if skillfully implemented and based on a careful statistical study of the risks, could make more credit available to early stage firms. Where Is the Equity Financing Market? The United States has done this better. Informal risk money and equity financing
is provided by angels and venture capitalists in the seed-to-startup stage. That
links smoothly to the provision of public risk money and equity financing at later
growth stages through an IPO and the stock markets, whether the company is traded
on the Nasdaq or reported on the OTC-market pink sheets. Improvements in Japan's
venture capital system are indeed needed, but before mapping the changes, the
underlying terrain needs to be understood. And the improvements that have been
made in the past few years also need to be appreciated.
Katsuya Yoshioka is associate senior analyst at NCB Research Institute. |
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