~This Issue's Index~

Is it Real?
A Look at Japan's Internet Venture Boom

By Hironubu Tamaki

The Internet venture business is booming in Japan. Not a single day passes without reports in the mass media about venture businesses: "Liquid Audio Japan goes public. The capitalization of the company, which had no revenue a year ago, has surpassed 50 billion yen"; "Internet Research Institute's capitalization has surpassed 1 trillion yen"; "Softbank raises a 150 billion yen venture fund."; "Japan has caught up with Silicon Valley." Is this boom real or is it the stuff of dreams?

Forces behind the Boom

The answer to this questions lies in some of the important factors that brought Japan to where it is now. Since the beginning of the recession in the early 1990s, the myth of the almighty giant Japanese corporation has been collapsing. Yamaichi Securities' bankruptcy in November 1997 was a symbolic event. The number of new hires from universities decreased, and students also started to question the stability of large corporations. Before the recession, working for a bank was considered a guarantee of lifetime employment security. Now, if one takes a job with a bank, relatives will ask, "Are you sure you really want to do this?" At the same time, commercial use of the Internet started in 1994, and the success stories of Internet ventures such as Netscape and Yahoo! drew the attention of bright graduates.

One unexpected factor that has also contributed to the current Internet venture boom is the unique career path of management consultants. In the US, consultants from prestigious firms such as Boston Consulting Group and McKinsey & Company become management executives at major companies. One prominent example is ex-McKinsey consultant Louis V. Gerstner, now CEO of IBM. At major Japanese corporations, however, almost all management talent is promoted from within. Consultants in their mid-30s are forced to make a choice between being a consultant for life or starting their own company. For these consultants, starting a new venture appears to be a very attractive option. Mr. Mikitani from Rakuten, the most popular online shopping mall, Ms. Namba from DeNA, a popular online auction site, and Mr. Sasaki from Auto-By-Tel, were all consultants. There are even more former consultants at non-CEO levels of management.

The low interest rate policy of the Bank of Japan and the booming US economy have also pushed the venture boom ahead. Former Prime Minister Obuchi aggressively promoted a low-interest rate policy as a means of ending the worst domestic recession since World War II. Accordingly, the Bank of Japan's official interest rate was lowered to 0.5% in 1995. Equity became a more viable financing option as institutional and individual investors shifted assets to riskier investment vehicles. Life insurance companies, which had not been allowed to invest in risky assets, recently started investing in private equity. US funds have also flowed into Japan from other areas.

The red-hot US economy and huge fund inflows to Silicon Valley led to absurdly high valuations of venture firms. As venture funds achieved astronomical returns, buyout funds such as Kohlberg, Kravis, Roberts & Co. entered the venture business field, unable to resist investors pressure to do so. Once too much money was chasing too few deals, excess capital started flowing into Europe and Asia. The rise in valuation in these areas is evidence of this trend.

Japanese firms, Softbank and Hikari Tsushin, have played major roles in venture investment. Backed by the high stock prices of its portfolio companies, which included NASDAQ companies such as Yahoo! and E*Trade, Softbank formed venture funds and started investing in domestic Internet ventures. The amount raised or announced by Hikari Tsushin and Softbank combined totaled approximately US $3 billion. Their investment strategies are typical of portfolio investment. Though each individual company may not be a diamond, as the sector grows, investments will certainly generate good returns.

It is worth noting that Softbank has put together a complete value-chain of components necessary for venture business incubation. Softbank Internet Funds provide seed money; Softbank Technology Corp. builds e-commerce systems; Pasona Softbank dispatches engineers and people with necessary skills to venture firms; Softbank Investment Corp. advises them on how to go public; E*Trade Japan underwrites public offerings and bond issuances; NASDAQ Japan offers an exchange for venture firms; the Nippon Credit Bank provides loans to venture businesses; and so forth. This means that if the seed of a business is especially promising, Softbank can certainly take it public.

As a competitor to NASDAQ Japan, the Tokyo Stock Exchange created MOTHERS, a new stock exchange for high-growth companies. The name is an acronym for Market Of The High-Growth and EmeRging Stocks, and also implies that the market will incubate Japanese ventures as a mother would nurture a child. Its requirements for listing are very loose compared to its predecessors or even NASDAQ Japan, which applies practically the same listing and delisting requirements as NASDAQ. A venture firm can go public in MOTHERS simply if a security firm decides to underwrite the IPO.

The emergence of MOTHERS and NASDAQ Japan opened an exit route for venture capital. Before the creation of MOTHERS or NASDAQ Japan, it commonly took more than 20 years for a Japanese corporation to go public. By definition, a 20-year-old company is no longer a venture company and would not have much need for fresh capital. Since the standard life of a venture fund is ten years, it was practically impossible for the public to invest in a Japanese venture business at the seed stage. Now that the average time required to go public has been shortened significantly, many foreign venture funds have started investing in Japan. Suddenly, capital supply exceeds demand, and company valuations have skyrocketed. Now, the supply-demand situation of capital has become very similar to that in Silicon Valley.

Bit Valley

A symbolic event for the recipients of venture capital was the birth of Bit Valley, which was proposed and initiated by Mr. Koike, the CEO of Net Year. Bit Valley is one of many places around the world echoing Silicon Valley, though the name Bit Valley is derived from the English translation of Shibuya, where many venture businesses reside. Though the direct translation is Bitter Valley, the name was modified to eliminate the negative tone and allude to the Information Technology industry. Between 500 to 1,000 Internet venture firms currently reside in the 5 x 10 km area along Yamate St., a little west of Shibuya.

These businesses, however, do not resemble Cisco or Sun Microsystems at their inception. At a quick glance, most of these start-ups provide Web-hosting, Web-building, or content production services only-the types of work which large corporations typically outsource. Almost no company is built around unique technologies that can differentiate it from its competitors. Research on 43 Bit Valley venture firms revealed that approximately 80% of them were founded by people with no science or engineering degrees. This is completely different from Silicon Valley, where most ventures are started by engineers.

This difference is not because of a lack of good engineers in Japan, but simply because talented engineers still gravitate towards working in laboratories at universities or in large corporations. There is a shortage of talented engineers with business skills, unlike in Silicon Valley, where there are many. Quite a few Japanese engineers do not understand simple financial statements. In the past, Japanese seemed to be more risk-averse than the Americans or the Chinese, and this outlook still holds true for Japanese engineers. Nevertheless, there are significant chances that these service-oriented venture businesses will flourish. One typical example is Rakuten, an online shopping mall, founded and run by Hiroshi Mikitani, a Harvard MBA, which has achieved relative success.

Management talent is also scarce. When Jerry Yang founded Yahoo! he was still a Stanford student and was not confident about managing his new company. Yang thus decided to seek outside help by hiring Tim Koogle as CEO. His strategy worked, and Yahoo! became a great success.

Management is different in Japan. It is a norm for students graduating from prestigious universities to go straight into major corporations. The lifetime employment system protects them, and they tend to remain loyal to one company. Therefore, turnover of managerial talent is almost non-existent. And even though senior managers occasionally become available for reasons such as bankruptcy, their management styles are deeply rooted in one specific corporate culture and are sometimes not transplantable to other corporations?especially venture businesses.

Internet Businesses by Large Corporations

In the United States, venture firms played a significant role in creating Internet businesses in the early days. In the business-to-consumer arena, for example, the premier group includes America Online in consumer on-line services, Yahoo! as a portal site, Amazon in e-commerce, and E-Bay in on-line auctioning. In Japan, their equivalents are Sony's So-net, NEC's ISP Biglobe, Softbank's Yahoo! Japan, Sumitomo's Lycos, Kinokuniya's Kinokuniya Online, and Seven Eleven Japan's Seven Dreams. Only in the on-line auction arena is the lead being taken by venture firms, such as Rakuten and DeNA. Large Japanese corporations clearly learned from the mistakes of their US counterparts and entered the field of Internet business at a much earlier stage.

The Road Ahead

If the ultimate goal in starting a business is to make fortune, then this is great time to start one. A share of IRI, the first company listed on MOTHERS, was once traded at a multiple of 2,400 times sales. Even though Liquid Audio Japan had almost no sales at the time of its IPO, its market capitalization once exceeded 50 billion yen. Given the fact that corporations are growing concerned, however, the outlook for Japanese venture businesses is not very promising, for all the reasons discussed above.

Can Japan's situation be improved? There are several issues that must be addressed. Japan's educational system must be overhauled to encourage creativity. Entrepreneurship, including company structuring, fund raising, and developing new technologies, must be taught at graduate business schools. It is also essential to teach engineers business fundamentals so that they understand the risk and returns involved in starting a venture business. Since the returns from the stock market are quite lucrative, there is no question that they would leave large corporations once they understood how to start their own venture businesses. In addition, Japan needs to develop a pool of talented managers. Like engineers, they may be lured by the monetary reward, but what matters is the adaptability of their skills. There are no easy solutions to the problem, though many hope that urgent needs for economic growth will shake up the traditional culture of corporate Japan. Looking back over Japan's economic history, growth has come from many sources, such as low labor costs, inexpensive materials, improvement in production efficiency, and entrance into other markets. Because all these assets have been fully exploited, Japan needs another source of growth?real Internet entrepreneurship.