Japanese Venture Capital: Frustrated Investors Face-up to Risk

In the middle of the worst recession since the 1950's, Japan is starting to change its attitudes about risk and reward. It has been hard for those with money to see the bull market in the US roll on year-after-year, and know that they are receiving 0.05% or less interest on their bank accounts here in Japan. Japanese newspapers are naturally analyzing the US market to death, and the inevitable conclusion is that the vitality of the US technology business is underpinning the boom. Yoshinari Yoshikawa The analysts know very well that technology comes from innovation, which in turn comes from capital sources willing to take a risk. Therefore, a lot of attention is now being focused on venture capital. In the US the venture capital system is well established, and ranges from individual "angels" to pension funds and government-run small business funds. Some of the biggest success stories in the US arose from humble venture-funded beginnings: Apple Computer was funded by Arthur Rock & Co; Compaq Computer received money from Sevin Rosen; Cisco Systems from Sequoia Capital; and Netscape from Kleiner, Perkins, Caufield & Byers. So how to do it in Japan? Some background Japan's venture capital (VC) business was born out of the banks and securities companies in the 1970s. At present, there are 160 VC firms in business. Of these, 21 are securities company related (such as the leader JAFCO--who count Nomura Securities' Group as a major shareholder), 74 are bank related, and 12 are insurance company related. The remaining 19 companies are independents. The most common form of investment vehicle is an investment partnership known as a toshi jigyo kumiai. Money is placed into the partnership as a separate legal entity from the investor companies, and the investment is made from the partnership. There are currently 244 investment partnership funds, with a combined capital of \753.5 billion. How the funds are used The total amount of money invested by VC firms and partnerships was \919.3 billion as of March 1997, and of this, \723.2 billion was used to buy new shares in third-party companies. The breakdown of where the funds were placed include 32.9% in manufacturing ventures and 15.6% in wholesale/retail and restaurants. So where are the technology companies? Well, of the manufacturers, the majority of money went to the area of greatest deregulation, the communications industry, which had fund growth of 150%. Second was information processing, which saw a funding increase of 37.1%. Funds flowing overseas Surprisingly, about 20% of all Japanese VC funds were earmarked for offshore investment, a 33.4% increase over last year. Leaders in overseas investment were JAFCO and Nippon Investment & Finance Co. Ltd. (NIF). "Overseas" meaning the US and Asia, with the most active players being in those countries chasing telecommunications and multimedia start-ups that have technology and Japanese market potential. Asia is particularly attractive now because of the turmoil in the local stock markets. There are a large number of mid-sized companies who want to list, and who are likely to bring good returns to alert investors. Interestingly, there are very few investments by Japanese VC in Japan-based foreign-owned start-ups. The major reason is that few such companies are interested in a Japanese IPO because of the low returns, and therefore set their sights on the NASDAQ. [Computing Japan's advice is for foreign-owned start-ups to talk to JAFCO and NIF about a US IPO. -- Ed.] Investment in start-ups The Japanese media has lashed the financial establishment for its lack of support and interest in start-ups. However, when we analyze the numbers, we see that in fact, Japanese VC does get involved in the early stages of a company. In 1997, of all the companies to do an IPO, 76.7% of them had received investment from VCs while they were still privately held. So, while not as active as the US investors in the first year or two, within three years the volume of investments by Japanese VCs increases rapidly. Of course, this still makes it very difficult for capital-intensive ventures to get off the ground -- especially revolutionary new products requiring heavy investment -- but it does give distributors, software companies, and other incrementally developed service/product providers a good boost. This behavior is confining Japan's start-ups to the lightweight category in terms of technology, but makes them more financially independent and less vulnerable to sudden business failure. Competition for quality investments Traditionally very risk-averse, Japanese VCs are being forced into earlier capital involvement because of the competition for quality investments. The recession has changed the perspective of many people. Normally the focus was to latch on to an established family company where the president is getting old and wants to cash out. In 1995, JAFCO estimated there were more than 2,000 such companies. The VC would buy in at the mezzanine level just before the IPO and make a modest but safe profit. However, the number of such companies is limited, and at the same time Japan's abnormally low interest rates are bringing more and more capital into VC funds. In addition, the various rule changes for doing an IPO on the Tokyo Stock Exchange (TSE) along with other changes, are bringing VCs closer to the US model of investment at the very inception of the investee company. JSDA report has major ramifications In July 1998, the Japan Securities Dealers Association (JSDA) released a report called, "Reforms of the Over-the-Counter Market." The report has attracted much attention because it is wide-ranging and not just limited to a relaxation of current standards, but reviewing the Japanese stock market as a whole. Acceptance of the recommendations in the report will have a great influence on start-ups having an IPO vision. Common wisdom had it that although a company might list on the OTC, it was desirable to continue on to an eventual listing on the TSE (or other Japanese stock market) second level. In other words, the OTC in Japan was seen as ineffectual. An amendment in December this year in the Securities and Exchange Law, however, will legally position the OTC to be on an equal footing with the TSE. From looking at the US, we can see that the NASDAQ has equal power to the NYSE, and therefore heavyweights such as Microsoft and Intel remain on the NASDAQ. It is obvious that the Japanese OTC is remarkably inferior to the NASDAQ. It has only 1/7 the number of companies, 1/100 the trading volume, and 1/24 the aggregate market value. With an average drop of 41.1% over the period December 1996 through July 1998, the OTC stock plunge has also been much worse than for other indexes such as the Nikkei (-15.4% over the same period). The report goes on to recommend abolishing the current classifications of "regular" and "special" companies, and instead introduce a selective registration system having two major categories that are assigned depending on the growth stage of the company. Of interest to start-ups would be the growth category that would even be open to companies that are running at a loss. The idea will be that such companies would register, but would be required to meet certain performance requirements (with input from the shareholders) or face de-listing. The report recommendations will be compiled into a specific plan, following reform legislation recommendations, in November this year. Several other legal moves that will improve the funding opportunities of start-ups include the removal of the stock options ban, the creation of tax benefits for angels, and the "TLO bill," which promotes technology transfer between academia and business. For VCs there is also the "Limited Investment Partnership Law," enabling the formation of an investment entity. The future The current recession has been a double-edged sword for business start-ups. On one hand, it is freeing up attitudes, money, and laws that now make it easier to take a risk and try something new. On the other hand, it is also requiring that the people running those start-ups prepare proper business plans, lay legal groundwork, and provide reporting -- something that has traditionally been the antithesis of the Japanese entrepreneur. This gap between vision and responsibility represents an ideal opportunity for VCs to insert themselves into a business and be useful beyond just providing money. Just as in the US, Japanese VCs now understand that the relationship has to be tactical to the start-up, with recommendations for hiring key staff, and advice on how to structure and operate. This is a whole new direction for Japan's entrepreneurs and should take some of tarnish off of new businesses and help them present themselves as serious investments for the future. As the first few success stories start to rise from the ashes of today's stock market, there will be a strong -- and if managed right -- continued move of funds out of the Japanese post office and into industry -- where it surely belongs.� Yoshinari Yoshikawa is President of Digital Magic Labs, a media, technology, and consulting company in Tokyo. He can be reached at smile@digital-magic.co.jp. Back to the table of contents