VC Roundtable Discussion

All we could offer them was 200-yen coffee on a rainy Thursday. Talk amongst yourselves, we urged them, and that they did. The conversation lasted three hours and would fill 13 pages.

Many thanks to the participants for sharing their thoughts and rather valuable time. -- Editors

The participants were Bob Delaney, managing director of Goldman Sachs Japan; Yoshito Hori, chairman and CEO of Globis Group; Leo Keeley, president of Japan InfoTech (also the moderator); Ray Klein, president of Tekinvest; John MacIntosh, managing director at E.M. Warburg, Pincus & Co.; Chikara Okada, associate and M&A specialist at Broadview; and Louis Ross, managing director at Obsidian Capital. Editor at Large Daniel Scuka hosted the event.

Keeley: What's your feel in a macro sense for how much money is flowing into Japan?

Ross: Number-wise? I'm not sure. I think there's going to be a lot more angel-seed money coming in, simply because that's where it is in the US. I think initially it's going to be bara-maki-toshi, I think it's called. They'll be investing in anyone, but eventually the money will get smart a lot faster. I think it's going to take off when what I call the second generation of Japanese Internet companies come out that are going to be more value-added, more infrastructure oriented. And you're going to have more specialized VC private equity firms focusing on it, and I think the larger ones are going to play a role in it but you'll see the more specialized ones be more aggressive

Keeley: You mean overseas angels or Japanese angels?

Ross: Both. The Japanese angels are going to be the key, but there's no mechanism to organize them yet. That's the problem. And the people who have the angel money are a lot older, and they were already burned by the bubble. So they have to be officially organized and then they have to be brought investments with a lot less risk. Bring in the foreign capital to absorb some of that risk.

MacIntosh: At Goldman or Warburg, where we have very large funds with no particular country allocation, with a mandate to put them anywhere, do we assign them all to Japan or assign none of them to Japan? I think it really is a global market, and if the opportunities are here and people start to show some success, you'll get a lot of Silicon Valley money here in a flash. It doesn't actually need to be on the ground. So I think the conversation should be much more on where is this money going to go? What is the nature of the stuff on the ground? I've never really believed that the supply of money, at least in the last year or two, is any sort of a constraint. You should take it almost as limitless.

Delaney: I was talking to our managing director who covers private equity funds, and he said that probably 12 months ago, maybe three or four of these major funds were talking to us, the banking side, about coming to Japan. Three months ago that was 15 or 20. What really is going to drive how quickly this money comes over is the availability of investments here. Once people believe that this is no longer an emerging market and you can put real money to work ...

You have to say definitionally what venture capital is: is it only seed technology money, is it buyout money? But if you broadly or expansively define it, I think money can come over here in a flash. And I think it won't be limited by the distances. I think every one of these major funds will find people to manage their money at least here on the ground.

MacIntosh: And can you find the people? I mean, talk to your spies ... there are 10 searches going on now for reasonably better funds. And they were going on six months ago. I guess Goldman and perhaps Warburg are fortunate in that the best banks have infrastructure here so you don't need to build the know-how. And we've always had a slightly different model: send a young partner over who hopefully speaks the local language and build from the ground up. But if you want to start bang, you have to find someone.

Delaney: People is by far the single biggest issue. When we were thinking of setting up the operation, it would have been a different equation if we didn't have 1,200 people already, and 95 percent were Japanese here in Japan. So you can go through that and say here's a good person and let's move them over. It's impossible to go outside and find them.

Keeley: It's really hard to do. In the venture world, ideas and good business points are the commodities. They grow on trees: they're everywhere. What's scarce is qualified, motivated, available management.

Ross: Money is the biggest commodity.

Delaney: Well, the recent volatility of the market has made that a little less of a commodity than it was three months ago. I think throughout the world that is having a traumatic effect on venture companies and their ability to raise money and go public.

Ross: It's helping the VCs on valuations.

Delaney: Yeah, it's helping us on valuations. But it's hurting us on the realization side. Because the number of VCs including ourselves that have a pipeline of IPOs that were about to go public but that are now postponed or delayed is pretty high.

Keeley: Liquidity events are not what they used to be, are they?

MacIntosh: We can argue about whether in 30 years the last Japanese person turns off the lights and the whole country goes bust, but in the short run, for the next decade, this country is absolutely totally completely awash with money. So even if absolutely no funds flowed into Japan, you could fund all the ventures that could conceivably exist here. They don't need us, just from an availability of capital view.

Keeley: I think we're all in agreement that there's clearly not a shortage of capital, both foreign and Japanese, to apply to the situation here.

Ross: I disagree in the sense that for the type of capital you're talking about -- risk capital -- there is a big shortage. The reason it hasn't flowed into the market is because they're not fighting to do that. They want to avoid the risk. If you have a startup company here and it's funded and it's successful, then you market it to the larger Japanese companies, and they're interested in putting in their own money. Usually. Some of them are taking chances, some of the trading companies are putting a lot of money into deals, crossing their fingers like Hikari Tsushin and Softbank did, but the money that is needed to fund the market is held back due to cultural/psychological reasons. Once that barrier is overcome, then ...

Keeley: Things can happen. I was very disappointed when I saw all those postal funds that matured in April ... you know, like, 47 cents came out, and the rest they rolled over on even worse terms. So to me that was a phenomenally disappointing event, but you make a valid point.

What impact do you guys think the market slide will have in terms of the Japanese capital markets?

MacIntosh: They don't understand it yet. If you were to talk to Bob's equity capital markets colleagues, they would tell you that while they're telling people the IPOs are delayed, they're really done. The Japanese entrepreneurs don't believe that yet. So from our perspective, for a couple of months, say, not much happens because value expectations are so different. And unless some people who are really dumb come in and sort of bridge the gap, and we all just wait, valuations come down and the market starts to clear again.

Keeley: [To Okada] Extending it to your business [Broadview specializes in MBOs], does it have some sort of positive impact on the M&A world if IPOs are no longer the option they want ...

Okada: Now that venture capital and venture firms aren't able to raise capital, aren't seeing the IPO market as the end of the rainbow, some companies are looking to merge with companies of equal strength so that they can become one plus one equals three, and take that combination public and make it a bigger deal. We've seen a few instances of that but not as many as we would like.

Hori: The bigger thing will be the downturn of the Internet market in the US. Almost all the issues on Mothers have fallen lower than the public issues' prices. That has a big impact on private equity investment. I would say it's one-half or one-third of what it used to be. So that makes it easier to invest, but at the same time it's been only since about last year that all the foreign venture capital came in. And at the same time all the big companies, the new animals like Softbank and Hikari, invested only last year. And other corporate investment like Oracle and Intel, and also Dell, are coming in, and at the same time consulting companies came. Most of them are looking for Internet deals because they have seen Net bubbles in the US and they think the next one is Japan. They have to realize that the US market has gone down so that means now there won't be any more deals to look at.

Klein: Mothers is great for marketing high-profile private placements, but there isn't that much liquidity in the market. Yeah, the problems with liquidity are related to the market slide and so forth. Well, the party was fun and it's over now. And the hangover is a real son of a gun. But for people who choose a value-approach to venture capital investing, there were no good values in the party. So everyone would come in and companies like Hikari and Softbank would buy the market, which means any private company, and the market rose. We couldn't play in that game, so it wasn't any fun. Now that that game is over, we think that is more encouraging overall. The partygoers will go home and we can get back to work.

Ross: I think it's obvious that there are just too many markets in Japan. I mean, they went from literally zero to several. And I think it's not going to last. I think there's going to be some merging. The problem is that you have so much money bidding up valuations, and people really don't know about these companies. I see that as the first era of Japanese Internet financing. The second one is going to be very different; there's going to be a lot more value added.

Hori: Before Mothers and Nasdaq Japan, there was no way that companies making a loss could go public. In the case of Nasdaq in the US, most of those companies are making a loss, but they have strong potential to grow. So Mothers and Nasdaq have a very good role because companies who are still making a loss can go public. But the problem we have right now is that there aren't many good potential companies. The companies on Mothers are not very strong, in terms of their growth potential and so forth.

Delaney: The US Nasdaq market didn't get built in 12 months. It was 1972 when it started, and it was a backwater for a number of years. And all of the sudden we have the Mothers market kind of being the place where "everybody should be putting their money," and there was no liquidity so it just drove up prices. But I think the key is having very high-quality companies come to these emerging markets and develop a following over time in a reasonable way. You don't have the same equity market culture here in Japan that you have in the United States, and that makes a lot of sense. Because in the US the market's been going up for quite a long time, and in Japan it has not.

And so I think in Japan, to get these postal savings moved over into an equity market you're going to have to provide the market with high-quality companies. And you're going to have to slowly grow them. And you know I think we had a little bit of a bubble and it was over very quickly.

Okada: One phenomenon we've seen recently that's reflective of the dearth of good management is eAccess. Based on the strength of [the CEO's] track record and his business plan, it was able to generate an incredible valuation.

Delaney: They were able to attract 50 engineers within two months. One of the things that we've found in this marketplace is you need a marquis manager to attract the rest of the management team. How do you bring in that many people in a short period of time, 100 percent Japanese, from these large corporations? You need to have people feel like, This is a Japanese company, This is a company I can work in, and This is going to be a successful entrepreneurial activity. So that's the challenge. It's not just getting the top guy in, it's how do you get that large number of people quickly.

Keeley: For all of you guys that's a problem; for me that's the core of my success in business, because I run [Japan InfoTech] an outsource management model. After all these companies go around to the headhunters and private, traditional failing joint ventures, outsourcing management sounds really good.

Ross: We see a lot more companies outsourcing. Is it expanding rapidly?

Keeley: Yes, it's much easier. And it's sort of like the old saying about the crows on the telephone wire: when one flies off, they all start to fly off, and I think a lot of companies are like that. Once they see a model work, if you can do it with outsource management, but still maintain control of your Japanese operation as well as any other operation, then basically that's a win-win for everybody.

MacIntosh: Part of me worries that the entrepreneurs of today think that it's a whole lot easier than at least our history and the rest of the world would suggest. They are IPO-focused and not focused on building a company. And the guys who are leading the McKinsian droves [referring to MBA-types who have left McKinsey or other established firms to join startups] haven't really considered that despite their best efforts, most of this stuff really isn't going to work.

So one of my worries is that in two years when half those McKinsey guys don't have jobs, because they got the IPOs but they couldn't turn them into money, or we quite rightly didn't invest in the second round, there will be a sort of reaction back to old Japan, which could be bad for the country and bad for all of us.

Keeley: I completely agree, and that is a real risk we run, I think, because there seems to be so much focus on these not even pre-revenue or pre-IPO, but almost pre-common-sense companies that are so early in their development. They're getting funded on blind optimism.

Ross: [Someone at a conference recently said] there are two kinds of entrepreneurs here -- the McKinsey MBA type and the street-fighter type. Who would you rather invest in? The MBA's probably going to get you a really good valuation, but, beyond that, they're not going to grow the company. Whereas the traditional Japanese entrepreneur is really going to commit his entire life to this one thing.

Keeley: The best people I've met in almost 20 years here are without question that type, the street-fighter type. The ones who are dedicated and focused on it.

MacIntosh: I always love the entrepreneurs who say no. Two million bucks and you're going to say no? Why don't you do what some others have and take 20? Unless these management teams are willing to think a little bigger, in some cases willing to trade big thinking for ego ... If your needs are to raise a lot of money but by doing so you lose control of your company, you have two choices: shrink your vision and keep control, or suck it up and take the money.

There are situations here where there seems to be a market opportunity -- the company really could live a little bigger, take the 20 million bucks -- but because there's just no way on God's green earth they're going to raise that money and keep control and mathematically find the 51 percent, they don't do it.

Keeley: There's a lot of that. There are a lot of entrepreneurial companies here that I think all of us know that haven't taken the plunge yet.

Hori: It used to be a trade-off, either street-fighter or MBA. But now it can be both. You see lots of research about how Japanese companies have become successful, and you see consistently that the street-fighter type can win. But now it's become so complicated. Lots of companies are coming in, so you always have to have both sides. Street-fighter types don't always understand what to do about money.

Keeley: Representing the entrepreneurial side of the equation, we find frankly there's actually a dearth of good qualified VCs around as well. You may have noticed there's no accrediting body for VCs. Some of you must just claim to be one.

Delaney: Philosophically, though, if you think about the relationship between the entrepreneurs and the VCs, I think on both sides of the equation, both on the entrepreneur side and the VC side, it may be because there's a lack of experienced VCs in the marketplace. I think the relationship or the way they should be working together -- well, it isn't quite working that way yet. And it goes back to what John says, which is there's a very strong view that I've got to maintain control. What I think a lot of the entrepreneurs don't understand is that some of the VCs have quite a bit of financial backing that can catapult the venture into a different league.

So I think on the one hand the entrepreneurs and the street fighters are saying, I want to maintain control, this is my company. The flip side is that maybe the VCs aren't showing them the additional value that's added. I think until that happens you're not going to see as many very successful ventures going forward as you see in other parts of the world.

Hori: The problem is not only because of entrepreneurs' mentality, wanting to control. It's also underwriters in Japan. They want to see more ownership by entrepreneurs, so they educate them on what percentage of the money they should get. At the same time, Japanese indigenous venture capital companies are always telling owner/entrepreneurs to have more share of the company, so that the whole industry is educated that way, and it's very difficult to change the mentality. We take at least 50 percent of the company, so we always have a fight about what to do. Entrepreneurs might not realize the value that venture capital will be able to add.

MacIntosh: We're not trying to convert them. I would absolutely say that 99.9 percent of the entrepreneurs out there, when you educate them about what you are, they don't want it. Fine, Mohammed and the mountain. But to save people's time and to find the 0.1 that does, you're going to get 100 percent rejection without an education effort. With an education effort you're going to find that 0.1 percent. I think also, for all of us -- and I think this roundtable is part of that -- that percentage is so low it has to become a pull market. You know, the view in the JAFCO's of the world has been that venture capital is a consumer product that you push through a large sales force on a public that doesn't want it. You're never going to find the 0.1 percent of the entrepreneurs by doing that. The goal is to say, "It's not good or bad: there's a group of people who are trying to do something different, this is kinda what it is. If you're interested, give us a call."

Keeley: And the more of those conversations that take place, the better. Because, again, I think the tremendous naiveté on the part of the entrepreneur is to really think that at some point that phone's going to ring and someone's going to offer them 100 million bucks for 2 percent of the company without seeing a business plan. This is actually a prevalent belief. And the quicker that gets closed, the better for everybody on both sides of the table.

Delaney: But education matters a lot for people to understand how we look at the world. Going back to Okada-san's example of bringing in strategic players, that is a very smart thing for an entrepreneur to do. But if you look at the model that we have in the rest of the world, that strategic round is a late round. And what happens is, if you have a very well-funded set of VCs backing you, you will get a much better deal on that strategic round. And what tends to happen is you have the VCs coming in on the first institution, second, and ABC rounds, and then you have a strategic round later on which locks in your revenues. When you have strong VCs backing you, what tends to happen, with large portfolios or companies, is two things happen. One, sometimes those portfolios are your revenue source. But the other side of it is you tend to be in a better bargaining position up against a large corporation. So I think the objectives can match if there is enough of a dialogue and an understanding about how to maximize value, and I think you can educate the entrepreneur and say, "This is how we can help you maximize that value over time."

MacIntosh: For us, we don't really feel like an American firm anymore. Half our professionals are non-American citizens, half our deals are outside the United States. You know, America may be the heartland, but I don't think we're bringing an American attitude to Japan. I guess we're bringing a world attitude to Japan. And one of the things that we say is, for management, before you get to the plan and the valuation, we want to see three things. We want to see that they actually have some experience in what they're doing; two, we want to think that they're good and honest people who are going to give us the bad news today and the good news tomorrow; and three, we need to believe that, fundamentally, we're in it for the same basic reason, which is to build a significant enterprise and thereby create shareholder value.

Most of the entrepreneurs we found here, if you actually force them to choose ... you know, when Mothers is hot and everyone's going to go public, there's no tension between their ego and the employees and shareholder value. But if you actually force them to choose -- you know, we're not asking them to be sort of ambitious killers who dupe the employees and enjoy it, but that at the margin fundamentally they are in this thing to create value for the shareholders. If you don't have that alignment of goals, you're getting yourself into a bad marriage. People can differ on tactics as long as the goals are the same. And in most cases, we've turned deals down, or not really pursued them, because if you push a little bit, they're not really in it to build value.

And you could imagine when the market's not so hot and revenues aren't so high and you've got to sort of trim your employee base or whatever, that they just won't do it, just because they never thought that was what this was about. You know and I know that there are all the cultural reasons, but that's also a big challenge for primarily financial investors.

Keeley: And it's a sea change. Because I worked for a multinational two years ago, and they did a survey of employees as to takeovers -- "What's important?" In the US, it was shareholders, customers, and employees. And in Japan, customers led the field, employees were a distant second, and maybe one vote, which was mine, was for shareholders.

MacIntosh: It's not really right or wrong. It's not education. It's more of an identification issue.

Keeley: It's an alignment of perceptions and expectations.

Klein: But the key point, if you're talking about shareholder value, is -- I mean, we're in the business of shareholder value. We're concerned about stakeholders to the extent that they enhance shareholder value.

Hori: Unless the shareholder's value becomes No. 1, we won't go in.

Klein: But so many entrepreneurs say, Well, what if I lose control of my company? What happens is that the company is an extension of the entrepreneur's lifestyle. I don't want to sell that. That's mine.

Hori: Why are they asking for money?

Klein: In many cases, some try to segment the business that they're in. They say this is the one I'll accept funding for and this is the one I want your help with. But then, we as investors typically want full commitment, because we are investing in people, because that's the fundamental business.

So the education is to say that you can make more money and enhance your lifestyle by being fluid to the idea of what the company is, and you don't have to be with the company forever. There are different entrepreneurs, there are different people who are skilled in different parts of a company's lifestyle. And so many Asian entrepreneurs feel that they have to carry it from the very beginning all the way to managing a big public enterprise. And it's not necessary. In fact, it's not feasible. Very few people have that full complement of skills. So creating a market where there's not only liquidity and equity to put it in, but people are people and are free to move and exercise their own skills. Lifestyle organization is another part of the market formation that needs to take place.

Ross: Corporate governance education I think is going to be really important. When I was at Merrill Lynch, I went to a lot of conferences on that. The larger companies still need a lot of corporate governance education.

When you talk about small, medium-sized companies, startups, you're getting into a whole different realm. So you can't just sell them on the fact that they're going to get rich. You cannot do that. And with a lot of foreign VCs, that's essentially one of the things they try to do, is put that stake out there. And I think culturally and psychologically it's not going to work at all. Actually it may turn them off.

Keeley: And it changes the quality of the deal flows. When you see a lot of the venture-backed deals of entrepreneurial companies in Japan, a disproportionately high number of them so far have been foreign entrepreneurs, right? Because I got into this business for money, not for love, you know!

Ross: I think the exit strategy here in Japan is going to be very, very different. It's not going to be straight IPO for a few more years. It's going to be a lot of M&A. In the US this is already happening. But clearly the market for these Internet firms has been overvalued. Right now, especially in New York, you can go to a lot of conferences telling you that these companies have M&A'd before they become valued. Right now they're worth $100 million, but they may be worth $2 million in two weeks.

Keeley: Some of the Mothers shareholding trajectories here follow that same logic.

Ross: Yeah, and that's really going to help M&A.