VENTURE FINANCE: A WHITE PAPER

Limitations on Indirect Financing
One unusual characteristic of Japanese financing for smaller companies and startups is the high proportion of indirect financing, as in bank loans. The money to start a new company is typically cobbled together from the founder's own assets and investments by friends and relatives. Then, when the growing company needs operating capital and additional capital for equipment, the usual sources are loans from private-sector financial institutions -- first from local credit associations and cooperatives, then regional banks, and, finally, city banks. According to the December 1999 Survey of Creative Business Activities of Small and Medium Companies carried out by the Small and Medium Enterprise Agency, the most common source of funds for a startup company was the founders' own contribution (80.1 percent), followed by loans from private-sector financial institutions (41.1 percent).

Banks are in fact lending more to smaller business these days, since major corporations are moving away from bank loans. Still, the credit picture for smaller businesses hasn't changed much, and many criticize banks for their reluctance to lend to smaller firms. The banks' caution is not without reason. While Japan continues to deal with the aftermath of the Bubble Economy deregulation has heated up the competition. Banks face demands to quickly improve their capital adequacy ratios, while, at the same time, their assets are losing value. The result is a credit crunch.

But the real problem in finding financing for entrepreneurial startups is not the credit crunch. It's a structural problem, not just a temporary skew in credit markets. While indirect financing may work for conventional companies, the high-tech ventures that so much hope is hanging on are in a different world. Such companies may have strong growth prospects, but what they don't have is the real estate or other collateral to put a sparkle in a bank loan officer's eye, which imposes a sharp limit on how far indirect financing can meet their needs.

What's Different About Venture Companies?
Let's look at the conditions under which entrepreneurial companies seek funds in the startup period.

1. Venture companies typically go through a long research and development period before an idea becomes commercially viable. In the biotech field, an initial R&D phase of nearly a decade is not unusual. Naturally, the company will have no sales and will be operating in the red during this period. Its ability to make payments on principle or interest is zero, zilch.
2. Most new startups have nothing to offer as collateral. The growth industries these days have a high proportion of "soft" assets -- ideas, expertise, services. Real property accounts for a smaller proportion of assets than would have been true a generation ago. Using intellectual property rights, such as software patents, as collateral is not unheard of, but valuation and liquidity (banks prefer collateral they can sell easily) are tricky. Moreover, unlike a few acres of land, software and other intangibles tend to need continual upgrading to retain their value - yesterday's hot program may be eclipsed by tomorrow's competitor with its new bells and whistles. That, too, makes loan officers wary; no wonder the use of such intangible assets as collateral has hardly caught on.
3. The risk of failure is high. Not a few fledgling companies spend huge amounts of time and R&D money without ever bringing a product to market. And even if all that effort does generate a product that seems marketable, whether the market will be receptive remains hard to predict.
4. But they have high growth potential. It is not unusual for funds invested at the startup stage to earn several hundred percent annually.

Given the nature of early stage venture companies, what kind of financing would best meet their needs? The answer is obvious: long-term funds available without collateral or guarantors, in small lots, at low fixed interest rates. Bank loans and other forms of indirect financing are not the answer.

Banks' only source of income from loans is their interest rate margin, about 1 percent annually. The bank receives only that margin even if the company receiving the loan is a roaring success and becomes hugely profitable. (The bank may, however, be able to increase its income by providing the growing company with larger loans.) And if the company can't repay the loan and the collateral won't cover the bank's exposure, it will take many, many other loans at a 1 percent margin to cover the loss.

Deposits and other funds for which the bank guarantees the principal are recorded as liabilities. Loans are on the asset side of the ledger, where the risk of not recovering the principal is hard to accept. Banks, therefore, basically make loans on the assumption that all funds lent can be recovered from all borrowers; even if the borrower goes bankrupt, they expect to recover their money by disposing of the collateral. Normally, too, a bank first tests the waters by handling notes or other settlement services for a company; after dealing with the company for a certain period of time, it may then become confident enough in the firm's prospects to offer credit.

Given the necessarily risk-averse nature of indirect credit, it is unlikely to make much contribution to financing high-risk startup companies. This point is obvious to investors outside Japan, but entrepreneurs in Japan haven't gotten the message. Founders of venture companies here dislike having others invest in their companies, for fear of losing managerial control. Instead, they depend on loans, and what they want most is access to credit, as the White Paper on Small and Medium Enterprises in Japan indicates.

What, then, can bridge the gap between entrepreneurial need for credit and private-sector financial institutions' disinclination to lend? One answer is credit from public institutions such as the national and local governments. There is, however, a little-noted glitch in the government-as-angel scenario: Credit provided by public sources to high-tech startups has much the same problem as bank credit.

Public Support for Startup Companies
Several systems for providing public subsidies for smaller companies and high-tech startups exist: national systems implemented directly by central government institutions, nationwide systems implemented consistently throughout the country by local governments, and local systems developed and implemented independently by local governments. Each system is designed in accord with specific policies to support a certain aspect of running a company: providing startup money, supporting R&D, investing in facilities, or expanding employment, for example. They take several forms, including long- or short-term low interest loans provided through national government financial institutions and local governments, credit guarantees for corporate liabilities and subsidized interest payments, investments by the small and medium business investment and consultation corporations and the venture company foundations set up by prefectural governments, subsidies, and tax breaks (including the "angel" tax system).

For public institutions to invest or lend in ventures the private sector will not touch, it has two choices: reducing the risk or accepting that risk as the social cost of promoting entrepreneurship. A public sector lender might reduce the risk by doing a better job of screening applications, to achieve a better risk-return ratio than the private sector could. Or it could improve the odds by providing a full suite of support services to the new company's management. If such public institutions are burned by investments in high-tech startups, they may well be raked over the coals in, for example, the prefectural legislature, and required to take a substantially more conservative stance on giving credit, even to adopt the risk-reduction measures private-sector financial institutions use. That would be unfortunate. Before that happens, the role of the public sector in lending to startups needs to be revisited.

Other Possibilities?
Is, then, indirect financing hopeless as a source of funds for venture companies? Not necessarily, but structural changes need to be made. For example, revising interest rate levels for smaller companies, where the returns may not correspond to the risks, to form a midrisk, midreturn market, could help. At present, private-sector financial institutions are competing feverishly to provide credit to the small businesses they deem creditworthy. In the bubble period, the prime rate -- by definition the premium rate given only the soundest of borrowers -- was applied to a majority of corporations' loans. The interest rate margin shrank to a level that hardly reflected the likelihood of default. Thus, once bad loans came to light, banks had to turn away corporations without collateral, since they would threaten profit margins.

Those companies, denied relatively inexpensive bank loans, were driven to borrow from nonbanks lending at high interest rates. Credit for small firms has, thus, become an all-or-nothing market -- interest rates are very low or painfully high. That suggests an interesting opportunity: If Japanese society and the business community could accept interest rates that appropriately reflect risks, a new, profitable market would emerge and attract participants, including foreign-affiliated financial institutions.

Another idea is to build equity participation into the credit system, structuring it so that increased income from a successful company covers the losses of another that fails. The Japan Key Technology Center, an external organization of the Ministry of Posts and Telecommunications and Ministry of International Trade and Industry, has a special credit system for R&D-type companies that has an equity component, which makes it possible to recover its capital from the successful companies. In this system, the projects given loans are assigned to one of five ranks according to their degree of success. If a project does not do well, the borrower can be excused from returning up to 80 percent of the principal. But if a company has succeeded in commercializing the project on which it was doing R&D, it must return a commission on sales (on average, about 2 percent) to the center during the 10 years of the loan. Commission payments stop, however, when the total commission paid equals the principal of the loan (the double payback rule). Such a system, if skillfully implemented and based on a careful statistical study of the risks, could make more credit available to early stage firms.

Where Is the Equity Financing Market?
The possibility of including an equity component in lending and thus creating a medium-rate credit market is attractive, given Japanese entrepreneurs' preference for loans. The natural source of funds for high-risk startups is, however, equity participation, by public or private investors. The equity finance market in Japan, however, is often criticized as being too underdeveloped to provide the funds an early stage high-tech company needs to grow. Venture capital tends to be invested later, at or just before an IPO, when the company is already looking successful. The ability to find promising early stage companies and grow them is the factor in short supply. There is also a dearth of angels -- individual investors who develop and support the growth of early stage companies.

The United States has done this better. Informal risk money and equity financing is provided by angels and venture capitalists in the seed-to-startup stage. That links smoothly to the provision of public risk money and equity financing at later growth stages through an IPO and the stock markets, whether the company is traded on the Nasdaq or reported on the OTC-market pink sheets. Improvements in Japan's venture capital system are indeed needed, but before mapping the changes, the underlying terrain needs to be understood. And the improvements that have been made in the past few years also need to be appreciated.