Why capital doesn`t venture in Japan
Interview with Paul Dali, Convergence Partners, Menlo Park, California
Paul Dali is managing general partner of Convergence Partners, a Silicon Valley-based venture capital firm assisting entrepreneurs in high-technology products and services. Convergence was founded in April with US$60 million from major limited partners NEC and Sumitomo Bank. Dali was recently interviewed by Ed Korczynski, Solid State Technology`s West Coast Editor.
Ed: To start with, is venture capital in the US managed very differently than in Europe or in Asia?
Dali: Yes. In the United States, the early-stage venture capital business model is based on pure equity. In other words, we provide the capital and we take a piece of ownership. You don`t pay us back any interest or dividends, and we absorb most of the investment risk.
However, venture capital as practiced in the UK involves debt and equity financing together. That is, they provide the capital, and they require part of that money paid back as interest and dividends in addition to their equity. Their return is less volatile because they`re getting periodic dividend repayments of some of their initial capital investment. If a company is modestly successful, they`ll get an adequate return.
In our case, since we`re only doing equity, our return is going to be substantially bigger if the company is successful. If the company doesn`t do very well, we`re much more at risk since we don`t get any of our dollars back. That`s how we do it in America, and we`re one of the few countries where that pure model exists.
There are several different kinds of venture capitalists in America: early-stage equity players like us, management buyout groups, and hybrids in the middle. The conversation that I`m conducting is all based on early-stage, high-risk, equity-based venture capital - active partners. While there might be $20 billion raised in venture capital in the United States each year, only $5-10 billion is high-risk equity.
Ed: The high-risk venture capital model has obviously been very successful. It`s generated tremendous wealth, jobs, and technologies. There`s a common stereotype that US companies are innovators, while Japanese companies tend to be extremely thorough in manufacturing but less inclined to foster radical change. Is this at least somewhat true, and are different venture capital environments important factors in this possible distinction?
Dali: Well, it`s a very complicated situation that is based more on cultural than on financial phenomena. I feel that the way people are employed in Japan creates a mindset that is not particularly conducive to entrepreneurism. Spinning out and starting a new company based on a great idea is not something often seen in Japan - for several reasons.
Number one, you`re taught to go to work for a company and stay there and give that company all of your loyalty, and hopefully the company will give you back the same treatment as long as it does well. Number two, if you have a worthy idea, the Japanese are very good at incorporating that idea into their thinking and making whatever it is that they do incrementally better. Number three, I think they have very few entrepreneurial role models.
For example, if you are an engineer at Hewlett-Packard, and you live in the valley for five years, you`ll have seen so many of your neighbors make a fortune that you`ll get the fever. Venture capitalists rely on that; that`s why we`re here. To help it along, Silicon Valley has a lot of capital, a great university system, and a very big labor pool. With the inspiration of entrepreneurial role models, young people can`t wait to get out of business school to go start a business.
In my opinion, if there were a few role models in Japan to show that you can start a company and be successful, then there would be more entrepreneurism. However, the established culture shows people the exact opposite example. It`s almost contradictory to break away and do something new when you`re taught to work for Toyota or Honda for your entire career.
Another inhibiting factor is the decades of history within Japanese companies. A big manufacturing company has been doing business in a certain way with its suppliers and vendors for so long that the distribution and sales system has tremendous momentum. If a company is interested in increasing its profits by selling direct and cutting out the middle distribution layer in Japan, it`s really hard to do because it`s cutting out a partner. Whereas in America, companies do that in a heartbeat if there`s a way to increase margins. If you look at Apple over the last twenty years, they`ve changed distribution methods several times. They`ll hire reps to build up sales in a certain region, and then when the volume is big enough they`ll go direct and get rid of the reps. It`ll flip back and forth. Compaq went through that eight or ten years ago, and changed their distribution system dramatically.
US companies change quickly because their goal is to maximize shareholder value - to increase revenue, but foremost to make profits. Theoretically, the goal of a Japanese company is to increase revenue, and not necessarily maximize profits. Why? Well, if the company increases revenue then it can keep its people employed. The profit motivation may still be there, but the real goal is to continue to grow so that people stay employed, with job security, for life.
Culture of entrepreneurism
Ed: If you can keep good people employed, keep them secure, and keep them from jumping ship, then you avoid having the expense of retraining. Just as you said that venture capital is a high-risk model, is having a culture of entrepreneurism somewhat risky for the entire industry because it is much more expensive for all the companies to maintain their work force with all the churning over of employees? It`s obviously less stable, and only pays off as long as enough fundamental new innovations emerge.
Dali: Your question reminds me of an old joke about a guy that has one hand in fire and the other hand in a bucket of ice, and theoretically he feels perfect. What you ask is theoretically true, but the facts prove otherwise. America is now the leading producer in the world, with the number one productivity per employee. Japan is slipping; I think it`s now 10 or 11 in the world.
Also, more jobs were created than were eliminated in America. Why is that, if your logic is true? It`s because Americans are very productive. So, I`m a strong believer in the entrepreneurial model. I also believe that new technology leads the way for other industries. Today, if you don`t use a lot of technology in your business, you will be made obsolete by your competitors.
The question is very logical, but in reality it is productivity spurred by entrepreneurism that`s important. Sure, it costs a lot of money to train a new secretary or manufacturing person. The distance-learning and retraining industry in America is about a $15 or $16 billion dollar a year business. I would love to see America take a little more of the Japanese mentality of retraining and retaining people whenever possible.
Still, it`s clear that the American system works quite well. I have had direct conversations with a couple of very senior Japanese businessmen in huge companies who say, "Entrepreneurism in my company is not very good, so we need to develop relationships in America." That`s rather specific.
Ed: If a company is relatively inflexible and there`s enough of an entrepreneurial environment and role models, innovators who have been trying to get change to happen within that organization will eventually become frustrated and start their own organization.
Dali: Yes, it happens all the time. Entrepreneurism can be described as, "My insane desire to build my own company and see my product come to market." As I see it, what motivates an entrepreneur is the desire to get his/her idea to market, and it`s not to make a lot of money and have an IPO. That`s not how they think. It`s this great idea and they want to bring it to market the fastest way.
They can go to a venture capitalist, get financed, and have that product out in a year. That`s quite powerful. As opposed to staying where they are, beating their heads against the wall to maybe get their product out in two years. So, they approach venture capitalists because they have this burning desire to do it the right way, and they want to get there fast. You won`t often see that in Japan, I think, because of the culture.
Incidentally, there are many magnificent aspects of the Japanese culture. Their decision process is slow and methodical, which causes some Americans to complain. However, when a Japanese CEO finally makes a decision, everyone in the company that needs to know is informed and there`s no more dissension. Everyone maximizes the implementation of the decision, with wonderful results. An American CEO may make a decision in a twentieth of the time, but its implementation may really be a struggle because everyone`s not completely on-board with this "decision."
Learning from the process
Ed: In your specific case, with Convergence Partners, NEC and Sumitomo Bank provided most of the capital. As you alluded to earlier, there`s a general desire to have exposure to interesting technologies early in development. Is that part of the motivation for NEC`s involvement?
Dali: NEC`s decision to do this is based on three criteria. The first one is to make money. The second one is to develop a microscope so they can see new technologies much, much earlier in the cycle. An entrepreneur in America or any part of the world is envious that NEC is a $45 billion company. It`s a mammoth electronics supplier, and companies from all over the world approach NEC with new technologies. So, it`s not that they don`t see companies; they want to see them earlier.
The venture capital process is a due diligence filter. An impetuous young company that gets to NEC is one thing, but a fully qualified company that can change the metaphor is different. NEC will be able to see new companies in a much more organized way through a venture capital group, without restricting the opportunities that still come to them at random. So, the second reason is to have a window with a great view into high tech in silicon valley.
The third and equally big reason is to observe the entrepreneurial process itself. It`s the key, because we`re starting young companies and we have regular meetings with our financial partners just like every venture capital firm does. Our partners will have opportunities to see how new companies grow and to understand the management process. They can see the entire phenomena a lot closer. Those are the three reasons they decided to do it.
Ed: The third reason is somewhat of a benchmarking. Benchmarking the venture capital process in general?
Dali: Yes. It`s like witnessing firsthand. They`re going to see the first run of this. It`s typical of them to want to study a process for awhile. Our partnerships are ten years long, so they have an opportunity to be right on the leading edge of a handful of companies for that time period. A $60 million fund means we`ll probably invest in 18-25 companies out of the thousands we`ll see. Our partners don`t have access to all our companies; they just watch the ones we invest in.
For a young portfolio company, Convergence Partners is quite attractive. Not only do we have really smart partners and a lot of money, but we also have distribution, technology, and licensing relationships in Asia. We differentiate ourselves from other venture capital firms by our contacts, which we hope will help us attract the highest-quality companies.
Ed: Given the lack of a cultural precedent for entrepreneurism in Japan, and given recent productivity gains by the US vs. Japan, is it possible that top executive levels in Japan may want to create an entrepreneurial environment there? Is there an understanding that they need to make some cultural shifts for long-term success?
Dali: I`ve had substantial conversations with three of the largest companies in Japan, and they all said essentially the same thing: being closer to Silicon Valley, understanding how it works, and getting involved with young companies is very important. They don`t have the same type of entrepreneurial spirit in Japan, and Silicon Valley is one of the few places where you can see breakthrough technology revolutions. One strategy that they may implement, after observing this process, is setting up programs to foster more entrepreneurs within their companies.
Ed: Wholly owned subsidiaries?
Dali: It could be anything. After they observe the process and decide that it works, they could give Convergence Partners money for our next fund and go start their own fund, too.
Ed: Would that be domestic within Japan?
Dali: No, here! After observing the process, they could arrive at all kinds of conclusions about how to reach the goal. Many strategies could be adapted within their culture, but some may take time to work out. They`re observing the process, while spending lots of money on relationships and technologies in increasing volumes every year.
Ed: By observing the process, is the most likely short-term scenario a strategy to capture the spirit of the situation without the specific manner of implementation?
Dali: That`s right.
Ed: Though the specific first implementations might look very different, if the motivation is the same, might the end result be somewhat similar? Might Japan eventually develop a more entrepreneurial environment?
Dali: Quite possibly. They`re very smart and they`re using a variety of clever techniques to observe the entrepreneurial process in America.
PAUL DALI received his BS degree in finance from California State University at Northridge. He is managing general partner of Convergence Partners. He has nearly 10 years of venture capital experience, after serving as president and CEO of Regis McKenna Inc. from 1983 to 1988. Prior to 1983, he was general manager of the Personal Computer Systems Division and chairman of the Marketing Council at Apple Computer. Convergence Partners, 3000 Sand Hill Road, Building 2, Suite 235, Menlo Park, CA 94025-7116; ph 415/854-3010, fax 415/854-3015.