Tech Incubators Could Reboot Japan

Affiliation with large firms will always carry cachet in Japan, but smart startups looking for seed money will turn to VCs and incubators, especially foreign ones that can take them global.
by Louis Ross

Louis Ross (lross@obsidiancapital.com) is managing director of Obsidian Capital Limited, a global private equity/venture capital group. Earlier he was an equity strategist with Merrill Lynch Japan, as well as a research fellow at the University of Tokyo.

I recently read with surprise and slight consternation a column appearing to be negative not toward incubators per se, but toward foreign ones. As the column was written by a foreigner, and an experienced Japan hand at that, I feel obliged to address some of the points it made and provide an alternative to what it suggested.

The incubation business is in a sense perfectly competitive -- the barriers to entry are nil. Anyone with a shingle and some space can make an attempt to incubate a company. Japan's government, the mother of all incubators, has been quite successful during most of the postwar period at incubating Japanese industry as a whole, at least up till around 10 years ago. More recently, new incubators have been established by large Japanese companies, a handful of new Japanese entities devoted entirely to incubation, and some foreign groups. Like the first wave of Net companies, the first wave of incubators will have its winners and losers. Those that survive will provide real value added. They will have expertise in a variety of key areas -- investment banking, venture capital, product development, technology evaluation, management consulting, sales/marketing, and recruiting. They will have the right partnerships with later-stage VCs, and synergies between portfolio companies. They will be operating not only in Japan, but overseas, and be able to help a company export its ideas

It has been verified that VC participation in the funding of a private company greatly enhances its chances of doing well in the public marketplace. Stock price performance proves this point. And the companies become more attractive as M&A plays for larger companies. VCs help to screen private companies for the public marketplace, making it easier for analysts to cover a venture in its post-IPO life. VCs often are more likely to fund a firm that has been supported by a certain incubator, since some incubators essentially perform the same role they do, but at a much earlier, and much more risky, stage.

Incubators play a catalyst role in repackaging the startup for the next phase of its venture financing. It's their obligation to the companies they incubate to excel at this function, as long as the company continues to show promise. The more time and money an incubator spends on a company, the more long-term support that company is likely to receive. The fact that incubators have access to VCs is a surprise only to laymen.

Why are entrepreneurs who use incubators willing to give away part of their company? Because they realize the value of doing so -- they need the financing, the polish, the access to professional managers, and the logistical support. They know they must work through intermediaries. They are rational in their attempt to reduce the risk associated with starting a business, so they share it with an incubator. Such entrepreneurs know they're better off owning a small piece of a big thing than a large piece of a small thing.

As an entrepreneur, you deal with an incubator for a variety of services, for access to capital, and for the value added they provide. Often, VCs only look at companies on referrals. They take referrals from a limited number of groups. This sounds familiar -- in Japan, having a guarantor is pretty common, and those providing introductions are often held accountable in regard to the state of the new relationship they just created.

It is the function of early-stage incubators or angel investors to ensure that the company does well in its later stages, and naturally they'll use their connections to later-stage functionaries. They have been properly incentivized. Can many entrepreneurs perform this function on their own? No. They are busy enough running their business, and should focus on what they do best. Is it worth giving up equity in their company? Probably, especially if they consider going public in the future and want to develop an overseas market and investor base. It's worth it if that incubator or VC will give them a better shot at being successful.

The large VCs are looking at specialized VCs and/or incubators in much the same way that an institutional investor would look at an investment in a fund of funds. Such an investor picks several specialized funds -- ideally most are not directly correlated with each other -- to put his money into in order to reduce overall risk. This performs the function of a larger research staff, and is often more efficient. The larger you get, the more pressure you have to invest all of that money, so finding suitable partners is essential. You become skilled at picking the right ones.

There are many incubators with different functions. Some have no Internet companies in their portfolios and only invest in companies with defensible technologies -- companies that have rights to exclusive products or processes. Others were started on a whim and will invest in anything with a dot-com to its name. One must be careful of generalizing in this area. Also, many incubators are very well funded before taking in companies. They do not find the company first and then go to a VC. There are costs involved in being an incubator -- it's not a job where one can act as an agent only and incur a fee for passing the company off after receiving it.

Now I would like to make a few comments about incubators in Japan:

Many Japanese entrepreneurs will be more risk averse and have less capital to put into a business as the state of the Japanese economy worsens. The public and private sectors in Japan are carrying a massive amount of debt on their books. They will always earmark money for investment regardless, but more people will be unemployed and in a weaker position to fund a startup beyond the seed stage. More people will be in a position to entertain a startup idea because there will be much less security at the big companies.

Entrepreneurs in Japan will come from all age groups -- and at least half of them will be foreigners. It is hard to imagine that only Japanese will create a boom in startups. The US has more pure IT talent than Japan -- as do many other nations -- and you still have nearly half the Silicon Valley startups being founded by foreign nationals. Japan's aging society will be left with the option of importing people, especially skilled people, or building a hell of a lot more robots.

Entreprenuers will create new businesses across the full spectrum of the Japanese economy, largely because you have so many industries that are plagued with inefficiencies, leaving much opportunity for those who have what it takes to capitalize on this. VCs, take note.

Like their US counterparts, entrepreneurs in Japan will be interested in screening incubators. If their business is solely domestic, they may gravitate to a domestic ones; if their business has anything to do with foreign markets -- and anything to do with high-tech -- they'll be wise to look at foreign incubators, or a Japanese one with a strong relationship with a foreign incubator/VC.

I agree that entrepreneurs in Japan will not have a strong desire to affiliate themselves with "free-wheeling venture capital funds" -- whatever that may be -- but they will do themselves a disservice by becoming part of the bureaucratic, inefficient Old Economy monoliths in Japan. The best partners for startups will not be firms in the most inefficient and debt ridden sectors of the Japanese economy. Big is not always better for a startup. Did Microsoft or Cisco emanate from IBM or Proctor & Gamble? And how did Sony get its start? It certainly did not receive a gold-plated invitation to join the ranks of the large, established electronics firms in Japan -- nor did it accept playing kohai (underling).

Entrepreneurs in Japan will find Japanese money from large corporations (which may be old-line firms) to come in handy in the later stages of their development. Such investments may lead to key strategic partnerships later on, and access to associated business networks. Unfortunately, Japanese firms, including incubators, are not known for adoring risk. There is a lot of money in Japan, but a relatively small amount of risk capital. That is where the foreign investors come in. The successful among them will have a value-added, multitalented, bicultural, bilingual staff, will have funds of their own and strong connections to large VCs and institutional investors, and will be able to support a company in Japan and overseas. They will absorb some of the risk involved and make the company more attractive for later-stage investors. A large Japanese partner will lower risk and enhance business connections, but may not exactly speed up the launch time and increase the success rate of startups. Startups need access to skilled personnel, not just a large number of bodies. They don't need generalists that need to be trained. They need access to business networks in Japan and overseas. The largest, most prestigious firm in a sector in Japan may be a dinosaur outside Japan.

Can large Japanese firms build successful, independent incubators free from their own bureaucracy? For those who have spent time in Japan, does that sound like something that will actually happen, let alone work? You be the judge.

I agree that affiliations with large firms will always carry cachet in Japan, but I would humbly point out that a startup should go a long way to enhance its value before approaching them. Besides, they are only interested in companies that are much more established and profitable (i.e. safer) than the type of firm that is fit for an incubator or early-stage investment. For the past 30 years, there have been Japanese VCs investing in companies. Guess how many funded a startup with just a great idea?

In Japan, you have a situation in which a US-style, bicultural incubator with relatively patient money backing it (and free of bureaucratic inefficiencies) can do a great deal of good in promoting the cause of a Japanese or foreign entrepreneur wishing to succeed in this market. The idea that somehow, suddenly, large Japanese low-value-added companies can assist entrepreneurs in Japan to create high-value-added businesses is a little difficult to fathom. You have a lack of specialists, a lack of focus, and a desire to avoid risk. Again, there is a great deal of capital in Japan, but a very small amount of risk capital. Big companies play an important part in the economy and will play a key role in investing and supporting startups in later stages, but they will not go into the incubation area.

Japanese startups, then, can benefit greatly from the services, connections, and support of foreign-affiliated incubators. I would suggest, however, that not all of these incubators have the same objectives. I would look closely at the focus and personnel. Here, diversity is key. Once again, do they have personnel with the experience in key service areas? Do they have alliances with larger companies? Do they seek to invest in companies with real intellectual property, as opposed to only ones where it is clear that they are seeking to ride a wave of euphoria that may lead to a home run? Japanese startups should take a close look at the personnel of the VC they use. Companies in the high-tech arena should accept smart money that can catapult their idea into the global arena from the start.

It will do no good to use the old "the black ships are coming" argument in regard to the evil, free-wheeling gaijin VC money coming into Japan. Such money and the associated talent may save this place in the future.