Foreign entrepreneurs and investors who want to follow the Silicon Valley venture capital model in Japan can do so, but it will cost a fortune, raise tax risk, and might not work as expected. John Sasaki, a Silicon Valley lawyer based in Tokyo for the past 15 years, explains why.
The Silicon Valley VC model evolved to make it easier for entrepreneurs lacking money to start innovative new businesses. Without the Valley model, founders would pay the same price as investors for company shares. Much wealthier investors then end up owning most of the company. Everyone loses, because founders owning little equity lack motivation to champion the business.
To solve that problem, the Valley created another class of potentially more valuable shares for investors called preferred stock. The higher priced preferred stock carries special rights, allowing investors to reach risk-reward equilibrium with the founders. Preferred stock was worth many multiples of common stock. The actual multiple was determined by negotiation, as startup companies are difficult to accurately value. Eventually a 10 to 1 multiple emerged as the rule of thumb. The US’s Internal Revenue Service accepted the 10 to 1 rule, preferring not to second guess the judgment of those involved.
According to Sasaki, a similar rule of thumb never arose in Japan. Here, tax authorities appear to be much more likely to question a firm’s share price. (America’s IRS has recently become more aggressive in requiring justification, but tax authorities in Japan remain comparatively much more aggressive.) Their attitude seems to be, “Prove it. If you can’t, we’re going to tell you what it is worth.” Another reason is that Japanese investors have never risked testing the model. “Nobody wants to be the test case, so nobody knows if the Silicon Valley model of stock valuation works,” says Sasaki.
Just as important, nobody knows if all of the rights attached to preference shares are legally enforceable. Here, all shareholders must be treated equally by law. While US holders of preferred stock are guaranteed a return on their investment before founders get paid anything, lawyers cannot guarantee that investors in Japan will get their money back first. “They might, but then they might not. It’s an enforceability issue,” explains Sasaki. “How many foreign VCs are going to be investing in Japanese startups without a guarantee?” he asks. Not many, he suggests.
The Silicon Valley model is based on founders and key staff committing to work in the business for at least four years. If they fail to fulfill their commitment, then the company takes back some of their stock. There is a one year cliff, meaning that founders who leave within the first year get nothing. Those who get past the first year keep 25% of their shares. After that, shares vest on a monthly basis. The company also has the right to buy back shares from those who leave within four years, based on the time spent at the company. For example, the firm can buy back half the shares of founders who leave after two years. Those who remain all four years get to keep all their shares.
Vesting is widely used as a founder incentive in the US. In Japan, however, it is less common. The reasons are largely cultural. In the past, founders personally guaranteed their businesses to get needed funding. Perhaps they have developed a sense of entitlement from putting so much at stake? For whatever the reason, founders in Japan normally get to keep all their shares, regardless of when they quit.
Japanese employees also prefer cash over stock options. Given the choice between taking a job for $100,000 at Sony versus $50,000 plus stock options at a hot startup, a top engineer usually prefers to work for Sony. “That’s not a legal issue. It’s cultural,” says Sasaki.
The Silicon Valley model further depends on the ability of investors to profitably exit from firms they invest in. Consider the VC which invests in ten startups. One might turn out to be a ‘star’ which, through an initial public offering, recoups the losses incurred by, say, five ‘dogs’. The VC profits by selling the remaining four ‘question mark’ investments. That is easier to achieve in the US than in Japan.
In the US, 80% of startups which exit do so by sale to a larger company. Firms like Facebook and Google aggressively buy innovative startups in the hope that one will become a hit. In Japan, however, only 20% of exiting startups are sold to bigger firms. That’s because large Japanese companies prefer to develop technologies in-house, having developed the staff and research facilities during the post-war years under the tradition of lifetime employment. With few buyers, VCs have difficulty selling their ‘question marks’. “If they can’t sell them, the Silicon Valley model doesn’t work,” notes Sasaki.
Tax risk also thwarts acquisitive foreign firms from buying Japanese startups in the way they are accustomed (by triangular merger). In the case of a domestic buyer, the shareholders of the target company can defer tax liability through a share exchange agreement (kabushiki koukan), a method of acquiring a company which cannot be used by foreign firms. In the case of a foreign buyer, the transaction most likely results in a tax liability for target company shareholders. Foreign firms can alternatively buy company shares direct from individual shareholders. However, this can be a burdensome procedure, especially if the target company has many shareholders.
Unlike in the US, tax and company laws in Japan do not incentivize entrepreneurship. Here, more bureaucratic and patronizing tax authorities hinder people from building great companies like Facebook, Amazon and Google. More importantly, Japan’s risk-averse culture discourages entrepreneurship.
Sasaki believes the Silicon Valley model might not work in Japan, even if the tax issues and legal uncertainties were removed. What works in one culture may not work in another— equity incentives are a case in point. Sasaki asks, “Should Japan really be trying to replicate the Silicon Valley model?” That might take a generation. Alternatively, he thinks it would be better to adopt a model which actually motivates the Japanese.
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