Japanese Venture Capital

An Analysis of Start-up Investment Patterns vs. Silicon Valley

Robert Eberhart, STAJE Fellow Stanford University

research questions
What are the apparent differences in venture capital investment patterns in Japan versus Silicon Valley?
How can these empirical differences be understood without cultural explanations and be consistent with the empirical data? Do the explanations - consistent with the observations - help us understand the future pattern of VC investment in Japan?

japan VC market
Japanese VC Investment Data
3000 2500

Deals, Investment in Millions of Yen

2000

1500

Total Invested Number of Deals

1000

500

0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Note: Annual figures. Figures from 1991 to 2002 are for annual periods through September of indicated year. Figures from 2003 to 2006 are for annual periods through March of following year. E.g., 2006 is for the fiscal year ending March 31, 2007. Source: VEC, Japan Venture Research

10000000000

15000000000

20000000000

25000000000

30000000000

5000000000

1995-1 1995-3 1996-1 1996-3 1997-1 1997-3 1998-1 1998-3 1999-1 1999-3 2000-1 2000-3 2001-1 2001-3 2002-1 2002-3 2003-1 2003-3 2004-1 2004-3 2005-1 2005-3 2006-1 2006-3 2007-1 2007-3 2008-1 2008-3 2009-1
0 500 1000 Deals Amount Invested 1500 2000 2500

US VC Inv e stme nt Activ ity

US VC market

japan VC IRR

Comparative IRR

Syndication
Syndication
In US, most deals One contract, several investors Claimed uncommon in Japan Preliminary Survey data:
60-70% of Japan VC deals are de facto syndicated1 Three to four firms per deal
With similar term sheets A de facto lead Lead assigns director and coordinates

1 SOURCE: Japan Venure Research 2009

Lacks the form of a US syndicate but is same function

empirical data revisited

Start with 2800 deals and @Y95M per deal
With de facto syndicates, we recalculate to obtain: Actual NET: (approx.) 1500 deals, $1.9M per deal

Versus US, 2006:

3080 deals with $7.1M per deal

So, truer picture is:

in Japans economy
deals are roughly equal, given relative economy size but average deal size in Japan is 1/4 of US

What can explain this empirical difference?

empirical summary
Any explanation of Japan VC patterns must account for:
Comparatively different deal size
US: $23.5 billion into 3080 deals (2006) Japan $2.8 billion into 1500 deals (2006)

Long term Japanese IRR is lower than U.S.

Japan LT Avg, life of fund = 3.9%1,2 U.S. LT Avg, life of fund = 16.5%2
1 SOURCE: Japan Venture zResearch 2SOURCE: Martin Haemmig 2009

is current literature explanatory?

Institutional Environment
Lack of Syndication
No common contracts Japanese VCs do not assign a director

Cultural Explanations
Japanese entrepreneurs resist loss of control Japanese VCs are risk averse
Salary motivations culturally

Ownership at IPO
Japanese firms at IPO greater founder control

Structure of VC firms
Shareholder =>Risk diversification strategy Japanese VC JPF structure =>Internal VC staff to find and persuade investments

Poorly developed reputation markets for VCs

Entrepreneurs cannot decide which VC => less opportunism

Tax Implications

Do these explain the data?

The current explanations:

1. Suggest a reduction of the supply of funds, which 2. Implies a higher return to reflect attracting the smaller supply. 3. However, Japan has lower returnso inconsistent with many explanations

analysis

Now what?
What is the explanation of the differences?
What can we learn?

Heterogeneity can explain culture

Cultural explanations may actually be path dependencies within a heterogeneous industry structure Can find a behavior depending on the founding date and strategy of a VC firm
ex. Salaryman type portfolio investment
In some firms, not others, not in new firms Persists in some firms (path dependence)

Each period of VC foundation has its own institutional path dependencies Appears cultural because a cultural explanation can be supported by behavior of some firm.

heterogeneity in governance

heterogeneity in strategy

Lower return from lower costs

agency cost differences can explain lower returns

Opportunism and agency costs

VC and entrepreneurs interests are not aligned opportunistic behavior
VC Common shareholder

opportunism
IN US
VCs control common shareholder opportunism by
Preferred shares Obtaining early control via
large investment Preferred shares

In Japan
VCs almost always common shareholders
less divergent interests

More important - less ability to control through share acquisition

Must acquire common shares for control Rights in law for significant minorities Silencing requires coalition of 71% or greater Shareholder activism can be expressed effectively extra-legally

Common control of VC is less effective

Shareholder activism not favored by courts

mitigating opportunism
U.S.
VC can control with sub 50% ownership and preferred rights Vocal minority can be silenced with involuntary buy-out Courts rely on common shareholders selling to get out

Japan
sparse preferred so VC needs 50%+ to control To silence a minority must control more than US Courts generally hear remedies to unfair practice

conclusions

Key points
Japan VCs have less motivation to seize explicit control
Common shareholder (all), less divergence of interest Legal differences reduce ability to control in Japan

With less need (or ability) to mitigate opportunistic agency costs, Japanese VCs obtain less control

Lower money needed to mitigate agency costs => less risk => less return

conclusions
Cultural explanations
Inconsistent with IRR data Can be explained by heterogeneity of VC firms

Agency costs, from opportunism mitigation tactics, may explain the difference:
US structure creates need for control by VCs to mitigate
Common shrdr opportunism Operationalize VC opportunism But, not reqd or available in Japan

Many apparent differences are differences of form not function

Is consistent with empirics Explains why Japanese founders come to IPO with more ownership

the future
Predictions of a VC shakeout in US Predictions of second lost decade in Japan But entrepreneurship is an element of recovery.. VC is a catalyst Because of the agency cost situation in Japanese VC investment And because of heterogeneous VC systems Japan has the ability to adjust to new economic reality perhaps easier than US VC firms

Thank you