Recently, Signifiant gave a presentation entitled “Establishing the Startup Ecosystem in Japan” at the seventh meeting of the Study Group for Risk Capital Supply for the Fourth Industrial Revolution hosted by the Ministry of Economy, Trade and Industry. The following is a summary of the content of that presentation. The presentation material is available at the end of this column.
The Booming Private Startups, and Struggling Post-IPO Startups
In 2017, the total amount of financing raised by private companies in Japan reached approximately 270 billion yen. In 2012, this amount was only about 63 billion yen, so the supply of risk capital for private companies has grown more than four-fold in the past five years.
The recent economic strength and influx of capital to startups has helped drive an increase in the number of new companies going public. In 2009, in the immediate aftermath of the global financial crisis, only 19 companies went public, but in 2017 that number bounced back to 90 companies.
It seems fair to say that proactive startup support measures and initiatives by entrepreneurs, investors, and other startup stakeholders are succeeding, with a helpful tailwind in the form of global money abundance.
Meanwhile, many startups that saw steady business growth in their private phase face a variety of issues as they grow after going public.
In 2016, the average market cap for newly listed companies in Mothers was 6.6 billion yen. This makes it clear that many of these newly listed emerging companies are still in the growth phase. They most definitely have not reached their final form as a company.
Many of these Post-IPO Startups in Japan are led by executives with no experience in managing a public company. Many people have already commented on the lack of serial entrepreneurs in Japan, and by extension this means that the founding executives of these emerging companies are only rarely experienced in the management of a public company.
This lack of startup executives with public company management experience may not strike those of us in Japan as being unusual. However, when talking with investors from outside Japan, this fact is often met with surprise. For someone used to there being a talent pool of available managers with experience leading a company to a certain size, the idea that in Japan a team with no public company management experience could be taking the lead in managing a Post-IPO Startup could certainly strike them as being strange.
Post-IPO Startups with this management lineup that are still in the process of growing then face a second “Death Valley[KL1] .”
The first “Death Valley” refers to when a startup is in the growth phase where they are converting a product developed in R&D into an actual business. In this “Death Valley,” many startups struggle when they are unable to raise the funds they need to turn their technical phase achievements into a specific product, develop a customer base, and bring their product to market.
In contrast to the first “Death Valley,” which occurs in the early stages after a startup is founded, the second “Death Valley” is a term I created to indicate the phase when Post-IPO Startups lose business and capital support.
If companies are in the pre-IPO phase, then venture capitalists who specialize in investing in private companies provide risk money. Some of these venture capitalists also provide valuable advice for the startup in its early days to help it grow, and are very hands-on with their support. In recent years, there has also been more active providing of risk money by angel investors with experience in company founding and exits.
As I mentioned earlier, the total amount of financing raised by private companies has been on the rise, and this zone is booming.
However, when a startup goes public, due to limitations in investment policy, many venture capitalists (VCs) must sell their shareholdings in that startup. Limited partners (LPs), who provide capital to the VCs, are only providing those funds with the aim of investing in private companies. To provide a return to those LPs, the VCs must collect the return on their investment upon the IPO of the startups they have invested in.
Meanwhile, many of the institutional investors who specialize in public stocks cannot invest in a startup with a market cap less than about 100 billion yen. Institutional investors evaluate corporate value with a professional eye. They can use their voting rights to keep public companies on the right path, which makes for effective governance. But it is rare for institutional investors to target the types of companies generally labeled “small cap” for investment.
Private companies have the VCs, while mid to large cap companies have the institutional investors—in both cases, professional investors. However, small cap companies, which includes many Post-IPO Startups, fall into a zone where the main investors usually are individual investors, and in general there are no professional investors who can provide risk money and management insight.
Amid the above situation, Post-IPO Startups then face many complex problems that accompany their growth and appear simultaneously. Some examples include management, organizational, business, investor communication, and financing issues, like the ones shown below.
Why is Risk Money and Management Insight Not Provided to Post-IPO Startups?
As I have said, Post-IPO Startups face many challenges in their growth process. But on the other hand, Post-IPO Startups are also an attractive category of companies that have exciting potential for growth, which does not apply for the mid and large cap companies. START TODAY, MonotaRO, M3, and Kakaku.com, all representative examples of emerging companies from Japan, were in the low tens of billions of yen market cap category when they went public. All of them went on to grow their market cap 20-fold or more, and some have exceeded a 50-fold increase.
So, why are there no professionals who provide risk money and management insight to these potentially promising investment targets, the Post-IPO Startups?
I believe there are two reasons: the unique challenges of these companies as investment targets, and the lack of the necessary skill set and mechanisms on the supply side. Let’s look at each of these in turn.
Challenges as an Investment Target
First, it is difficult to buy and sell small cap stocks. Post-IPO Startups tend to have high share ownership by founders, and a limited free float ratio and low market liquidity. This means there are few opportunities for institutional investors to buy and sell stakes.
Second, investments into small market cap companies are inefficient to the point of being a mismatch for institutional investors, who manage large amounts of funds. As of the end of 2017, the total market capitalization for all public companies in Japan was approximately 700 trillion yen, and of that about 70% was accounted for by companies with over 500-billion-yen market caps. On the other hand, companies with market caps less than 100 billion yen make up about 80% of all public companies, but represent only 10% of the total market capitalization in Japan. It takes too much time and effort to consider each of these many companies to pursue just a small-scale investment.
Third, small cap stocks, where most Post-IPO Startups are categorized, tend to have excessive stock price volatility. Liquidity is low, and the stock price of small caps, which are mainly targets for individual investor investment, tends to be set without a basis in the company’s fundamentals. Business scale and profit amounts also tend to be small for Post-IPO Startups, so profit tends to go up and down with each earnings announcement, and the stock price is accordingly often volatile. This volatility likely works to erode the interest of long term investors in making an investment.
Insufficient Supply-Side Skill Set and Mechanisms
Next, I’d like to discuss the lack of a supply side able to support these companies.
First, it is difficult to identify promising Post-IPO Startups. In effect these companies are in the startup stage, and to decide about the potential of a Post-IPO Startup, with limited public information, you need to have the discriminating eye of a venture capitalist. It is not enough to rely on an orthodox asset management viewpoint; rather, you need to have insight into the fundamental growth potential in the company.
Also, it is challenging to provide real value to the management of Post-IPO Startups. The mobility of executives with management experience in public companies is very limited in Japan, which means, as I mentioned earlier, there is not a talent pool of experienced executives available.
There is also a structural problem: these companies do not fit neatly into typical asset classes, so they tend to not come up as investment targets. Many asset owners who provide risk money to companies indirectly, such as through funds, will categorize their investment target as either public companies or private companies. This is part of the reason that it is difficult to have an investment that spans over both the immediate pre and post-IPO phase of a single company.
Alternative investment managers (focused on unlisted stocks) are by their nature unable to invest in public stocks. Meanwhile, investors focused on public stocks can only invest in companies of a certain market cap size, and tend to demand high liquidity. For that reason, it is challenging for them to engage in a long term, hands on investment in a Post-IPO Startup, which is in a low-liquidity market.
Building a Startup Ecosystem Unique to Japan
Recently, a variety of players have started to expand their startup support frameworks. In and of itself this is proof that the startup environment in Japan is maturing, which is a step forward.
However, the broader social aim behind incubating these startups should be to create new industries and transform industry structures, and by so doing to address the social issues that we are facing. It shouldn’t be just to increase the number of public companies.
Currently, there are some who say that the startup environment in Japan is ideal for an IPO exit.
That said, I cannot see restrictive measures aiming to reduce the number of public companies being a good idea. Limiting exit opportunities will erode the desire to found new companies, dampen the momentum in supporting startups, and must result in a reduction in the number of serial entrepreneurs and angel investors, which would hinder the formation of the Japanese startup ecosystem, rather than fostering it.
Mothers stands for the “Market of the high-growth and emerging stocks,” and in Japan in effect is a substitute for some of the functions of late stage venture capital investment. In that view, I believe that a framework to continuously support Post-IPO Startups, just like what exists for the private startups, is necessary.
As of now, 2018, there are about 3,700 public companies in Japan. Of those, more that 3,000 are companies with a market cap less than 100 billion yen. Of the Post-IPO Startups, some will be able to grow on their own—but others are now the “living dead.” Given that Post-IPO Startups are companies that are still growing, it’s reasonable that some of them might not be successful in their efforts to continue growing. But from a broader perspective, giving them the opportunity to grow is by no means a negative thing.
However, of these 3,000 companies, some of them might have achieved growth more quickly if they had had a helping hand immediately after going public, and some of the living dead might have successfully avoided that fate. Looking at the Post-IPO zone that exists between the private companies and mid to large cap companies, it’s clear that the category breakdown that splits public companies and private companies is not ideal for the current startup environment. The way I see it, the deceleration and stagnation of companies in this stage is acting as a bottleneck on creating new industries.
To address these issues, it is important to strengthen support for later stage private companies, and explore possible paths to help these companies go public at a larger scale. However, in parallel, we believe that we must create a framework to support the Post-IPO Startups that have gone public at a smaller scale to grow larger. Considering the current Japanese startup environment, I believe it will be both realistic and effective to pursue both goals in parallel.
To achieve company growth, having multiple options ready will be the key to forming a more full and unique ecosystem in Japan. By doing so, I believe we will see new companies emerge in Japan that will have true social impact.
To make sure that the current good momentum we are seeing in startups does not end up being just a short-lived boom, and instead see startups putting down a solid foundation that will support them in their endeavors, we cannot simply imitate a Silicon Valley approach.
We must form an ecosystem that is unique to Japan, that considers the particular Japanese situation, such as the few serial entrepreneurs and early IPO timing, and also aims to support not just private companies but also those that have just gone public.
Development of the Startup Ecosystem in Japan
It has long been said that the formation of a Japanese startup ecosystem is indispensable for the creation of new industries in Japan. This involves establishing the mechanisms and environment conducive to the creation of many startups, just as exists in Silicon Valley. Compared to Silicon Valley, the startup ecosystem in Japan has only just set off on its journey to formation, but in terms of fundraising, in the past few years the Japanese startup environment has changed dramatically.
In 2016, the total amount of financing raised through equity in private companies in Japan reached 209.9 billion yen. In 2010, when I was engaged in the management of a tiny startup, that total amount of financing raised was 69.1 billion yen. The damage caused by the global financial crisis still lingered, and there was very little financing liquidity even globally. My software development startup was somehow able to raise 100 million yen, but at the time raising 100 million yen or more was an incredibly rare feat for a private IT company. Compared to then, the total amount of financing raised in 2016 by Japanese startups has grown almost three-fold in just 6 years. You now see stories about startups raising over 100 million yen on tech media almost every week.
When exploring the factors behind this rise in the total amount of financing raised, one factor that jumps out is the macro trend of higher capital liquidity on a global scale.
Recently a variety of measures supporting startups have been undertaken by the Japanese government, symbolized by a policy regarding accelerating industry metabolisms and startups[KL1] that is part of the second Abe administration's economic policy. Investment in startups through public & private funds and public institutions, as well as investment in VCs is becoming more proactive. Meanwhile, as a part of the transformation of universities, major national universities like Tokyo University, Osaka University, Kyoto University, and Tohoku University are seeing increased investment as more and more VCs are established to invest in their research findings.
In the private sector, many kinds of large companies, including financial institutions, internet companies, and manufacturers, are investing in startups and VCs, and in addition, we are seeing increased momentum in corporate venture capital (CVC) investments, which involve partnerships between large organizations and startups.
And most importantly, we cannot forget that the unflagging efforts of startup stakeholders, such as their management and investors who have been participating in Japanese startups up to now, are starting to bear fruit.
The Startup Ecosystem “After Market”
So, what needs to happen to make sure that the momentum behind the formation of this kind of startup ecosystem in Japan does not peter out, and instead reaches a new dimension? In my opinion, the development of the After Market holds the key to the startup ecosystem.
In general, when you think of startups, private emerging companies are what come to mind. But that is just a part of the startup ecosystem. There are also post-exit companies and businesses that have been acquired or gone public that I view as being part of the broader startup ecosystem. Without further growth from these types of companies, startup initiatives as a whole will not gain trust from society.
In 2016, 54 companies listed on the Mothers Section of the Tokyo Stock Exchange, and their average market cap at the time of listing was 6.6 billion yen, with the average amount raised by the issuing of new shares being 750 million yen. Compared to Silicon Valley startups, these companies would be roughly equivalent to early to middle stage startups in terms of scale. While this is a limited comparison to only the American market, it seems fair to say that Japanese startups are going public relatively early. Looking globally, the low barriers to going public in the Japanese market make it unique.
My purpose here is not to debate whether this is a positive or a negative thing. The role of supplying capital, which in the United States is undertaken by professional venture capitalists, in Japan is rather taken over by the average investor. So, the Japanese stock market is unique in that young companies with businesses still in the growth phase are being supported by these average investors.
Challenges Faced by Startups Post-IPO
Meanwhile, when a startup goes public many VCs take the opportunity to sell their shareholdings. For the benefit of their business, VCs need to undertake this process, but from the startup’s perspective, this means that they lose their outside support and must stand on their own.
Generally, due to the restrictions on share liquidity and investment scale, large institutional investors can only invest in companies with a market cap of 200 billion yen or more. There is also the factor of attention—according to the Tokyo Stock Exchange, in 2011 54.2% of the companies in the First Section were covered by an analyst, while only 22.7% of the companies in Mothers were. The main investors in companies that do not reach the scale required for investment by large institutional investors end up being individual investors. These individual investors must make their investment decisions based on the limited information available on the company in question, and the company then has the responsibility to explain their quarterly business trends to highly speculative individual investors.
After companies have gone public and raised funds, there are extremely limited opportunities for that company to issue shares to raise funds (one example is when changing markets). Going public ought to make it easier for companies to raise funds smoothly through the market, but when compared to the excess availability of funds for private companies, going public actually makes it more difficult to raise money.
By going public, post-IPO companies must bear the new responsibility of communicating with the capital markets, and they must also manage with less outside support than they previously enjoyed. That is no easy task.
Post-IPO Startups Will Create New Industries
Paul Graham, one of the founders of Y Combinator, said that “a startup is a company designed to grow fast.” (Link) According to Graham, whether a company was newly founded, works on technology, takes venture funding, or had some sort of “exit” is not relevant to being a startup. What is essential is growth.
If we accept Graham’s definition, that means that whether a company has gone public or not is not relevant to determining if it is a “startup.”
For startup stakeholders, the IPO is without question a major milestone. But at the same time, an IPO is simply an opportunity for a company to more broadly seek capital from the market to achieve further growth. Companies that truly seek to grow and expand their impact on society after the IPO are startups, and that includes of course freshly listed companies, but also long established companies as well.
This all makes me wonder. Would it be possible to further the development of the Japanese startup ecosystem by energizing the After Market? Would it be possible to create a system that helps emerging companies that often suffer for lack of available information in their dialogue with stock markets? Would it be possible to create a forum to share insights for managing companies after the IPO? All of these thoughts lead to the birth of Signifiant Style.
I myself have been involved in the management of a company listed on Mothers, and faced the incredibly challenging task of driving a company that was in stagnation into growth. I have also experienced the frustration of trying to share information about my company through the media, only to have that information not conveyed in the way I intended. Signifiant Style aims to try to help in solving these types of problems.
At Signifiant Style, we call companies that are trying to actively drive growth after going public the “Post-IPO Startups.”
The development of Post-IPO Startups is indispensable to the further growth of the startup ecosystem in Japan, and for the further evolution of Japanese industries.
Nothing would make us happier than to see Signifiant Style initiatives help Post-IPO Startups achieve further growth towards their next stage.