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.