Make Japan Inc great again

First published by The Japan Times

Japan Inc hungers to acquire innovative startups, but is fearful of the forbidden fruit. While large US companies enthusiastically buy startups, big Japanese firms struggle to find, acquire, and integrate innovative new firms into their wider businesses. They must acquire a taste for startup mergers and acquisitions, if the nation is to regain its global competitive advantage.

In the 1950s and 1960s, big firms everywhere relied on in-house research teams to develop new products. Since then, product life cycles have dramatically shortened. No one company, regardless of size, can innovate fast enough to keep up with the global pace of change. Western companies, especially those in high-tech industries, began acquiring innovative startups to stay one step ahead of the competition. While Apple, Google and Facebook “openly innovate,” traditional Japanese firms still conduct research and development behind closed doors.

According to Akira Kurabayashi, managing director of Draper Nexus Ventures (an early stage venture capital company whose limited partners are big Japanese firms), “open innovation” is best achieved one step at a time, first through alliances, then investments and finally acquisitions — the final goal. The first two steps are easy, he says. The third, buying startups, is hard for Japan Inc. to swallow.

A typical alliance involves a big company implementing a startup enterprise software solution for one of its customers. Both partners earn a financial return. The startup gets an added boost by aligning itself with a big reputable Japanese firm. Alliances give large corporations a risk-free first footing toward “open innovation.” Their managers avoid possible blame when startups fail, one reason why corporate sponsored startup acceleration partnerships are popping up all over Japan. “Corporate sponsorships are better than nothing,” argues Kurabayashi, who has 15 years of experience working at U.S. and Japanese venture firms. Partnerships are not risk free, he says. When they succeed, competitors buy the successful startups, denying big firms a strategic return. Therefore, Western firms prefer to invest.

Consider, a Silicon Valley-based cloud service provider that invests in innovative startups through their corporate venture capital (CVC) arm. A startup may build an unusual software application that plugs into Salesforce’s cloud platform. Because Salesforce owns shares in the startup, it can exercise the right of first refusal to take part in the startup’s future funding round. Through its early relationship with the startup, Salesforce also gains a deeper understanding of the business and the team, increasing the possibility of acquiring the startup when it is strategically appropriate. While Japan has much CVC — roughly 80 percent of all startup investment comes from big corporations — those funds are not used to buy startups lock, stock and barrel.

One reason is that big firms lack the in-house talent needed to find and make good startup acquisitions. To obtain acquisition skills, they must hire outside professionals at market price, which can exceed their CEO’s salary. “Culturally, big firms can’t accept that,” says Kurabayashi. Instead, they give in-house managers lacking M&A experience those tasks.

Another reason is that post-acquisition integration often fails. After the startup is acquired, large companies try to impose inflexible human-resources systems onto entrepreneurial founders, depriving them of their previous authority, freedom and market-based pay. A large Japanese company can only pay a 35-year-old startup chief executive officer what they pay other 35-year-olds, for example.

Entrepreneurial founders find this intolerable. After the acquisition, they soon leave. The newly acquired business unit then flounders.

Japanese companies are also under less pressure than are Western firms to maximize shareholder value, although this is changing. Some Western tax incentives encouraging “open innovation” don’t exist here either.

However, the main reason Japan lacks “open innovation” is the nation’s HR systems, which promote employees based on age rather than merit. “To improve the Japanese tech sector, we need to change the HR systems,” believes Kurabayashi.

Both of us further argue that policymakers must implement meaningful and comprehensive labor reforms to achieve the government’s average 2 percent real GDP growth rate target by 2022 (about double the rate of today). Not doing so will hamper the relocation of human resources to their best use through “open innovation” and other forms of creative destruction.

Japan Inc. is slowly changing. Nonregular workers employed under fixed-term contracts now account for almost 30 percent of staff employed by Japan’s big companies. Skilled workers increasingly pursue portfolio careers, finishing one project before moving onto the next at a different company. Recruiting firms, like BizReach, target lateral hires — a small but growing portion of the labor market. Last October Yahoo Japan Corp. announced that it will end the traditional Japanese practice of hiring once yearly from the pool of new college graduates. Instead, it will recruit already skilled workers to fill specific positions.

Japan’s large tech firms are experimenting with precursors to “open innovation.” Alliances and CVC investments are two examples, but there are others. Companies, Sony for example, have introduced new programs designed to fast-track entrepreneurial employees who quickly launch new business units. These measures are welcome, but insufficient. Bold, comprehensive and nonincremental government-led labor reforms are needed if Japan is to avoid repeating the missed growth targets of the past.

Doing so will make Japan Inc. great again, bolstering the nation’s still nascent VC ecosystem, as cashed-out founders reinvest a portion of their windfall gains back into new startups — creating the much needed virtuous cycle of investment and growth.

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