RIETI-CARF Policy Symposium

What Financing Mechanisms and Organizations of Business Entities Best Facilitate Innovation?


Session 1: "Finance and Investment - A theoretical framework"

In this session, discussions were held centering on the framework of the theoretical aspect of venture capital (VC) and its current status in Japan, especially concerning ways to theoretically consider the connection between the financial system and real investment. KOBAYASHI Takao (Faculty of Economics, the University of Tokyo), who served as session chair, gave a summary of the overall session including the presentation on the current status of VC in Japan performed by TAKAHASHI Fumio (Graduate School of International Management, Aoyama Gakuin University), and UEDA Masako (University of Wisconsin-Madison) made supplementary comments.

There are two views in considering finance and real investment. Joseph Schumpeter takes the approach that "finance indeed is the driving force behind the real economy," while Joan Robinson holds the view that "finance is merely a result of the reflection of the real economy." Both views are extreme, and the answer seems to lie between them. If financial activity becomes more overheated than that of the real economy, this hurts the real economy in the form of a bubble, as experienced by the Japanese economy. However, the financial system is not merely a result of the reflection of the real economy. Just as plants cannot bud in hard soil at the time they break into leaf, and bread does not rise even with good flour and water if yeast is not added to it, in the overall economy, too, it is essential to remove old systems, structures, and ways of thinking. And the financial system plays this very role.

(1) Macro-finance perspectives (facts)
The dependence of investment on external finance varies according to sector. The high-tech industry, for example, has a high dependence. Also, even within the same sector, younger firms have a higher dependence on external finance while mature firms have a lower dependence. A comparison of the G7 countries shows that external finance accounts for 50%-56% of Japanese investments - the highest proportion among the G7 countries. Meanwhile, the dependence on external finance for the United States stands at only 20%-23%, indicating an extremely strong dependence on internal financing.

A comparison of the debt-equity ratio for these countries reveals that nearly 100% of investments in the U.S. use debt financing, while Japan ranks behind the U.S. with a dependence on debt of 80%. As opposed to this, Britain has the highest dependence on equity financing at 45%. As such, it can be said that Japan's economy is highly dependent on external financing and debt financing.

(2) Micro-finance perspectives (concept and theory)
Mainstream corporate finance has an image of firms as being asset-intensive, i.e. that capital goods are the essence of management resources, and the features of such firms are as follows.

  • As seen in economies of scale and economies of scope, the competitiveness of firms increases if their scale, i.e. the scale of capital goods and production capacity, is expanded.
  • Asset-intensive firms can be easily vertically integrated.
  • The bargaining power of human resources is extremely weak, and workers therefore are easily controlled.
  • If public outside investors own equity in a dispersed form, ownership becomes dispersed.

From the standpoint of corporate finance and corporate finance theory, a firm can be deemed a "nexus of contract." In view of this, the value of a firm, which is a nexus of contracts, is the sum of the value of all component financial claims outstanding (additivity of corporate value). This characteristic is the premise that theoretically supports the field called finance. On the other hand, corporate financing choices have almost no effect on corporate value (Modigliani-Miller theorem).

If corporate governance was defined to be the method by which outside providers of finance ensure themselves of a return and the mechanism for assuring that the same, this would result in setting the policy objective of maximizing shareholder value when considering the implications for corporate governance. This is because when a firm takes action, its shareholders are affected the most by such action. Shareholders therefore are the largest stakeholders for a firm. As such, maximizing corporate value is tantamount to maximizing shareholder value.

In reality, however, there is an agency problem. Although shareholders hold the residual claims on contracts, a firm's decisions can actually affect those who are not shareholders as well, resulting in a conflict of interest among stakeholders.

Meanwhile, taking the contract view, a firm's authority rests with top management. An entity that concentrates its power in top management may be said to be the most asset-intensive. In that case, however, the resolution of the conflict of interest between top management and shareholders becomes the focal point. Here, the objective of corporate governance would be to remove, to as great an extent as possible, obstacles to the realization of interests of all shareholders. But issues such as ensuring transparency and accountability, as well as whether there are conditions under which the market for corporate control operates competitively and ways to reconcile the incentive structure for the managers and the shareholders, may arise.

Furthermore, there are two typical arguments for the agency cost of debt-financing - asset substitution effect and debt overhang. What is often pointed out in the cost of equity is the underinvestment problem that arises from adverse selection. This is the effect where firms stop making value-increasing investments from the standpoint of economic structure.

In this conference, we would like to hold discussions based on the image of human knowledge-intensive firms as the opposite concept of asset-intensive firms. What is crucial in this approach is that there are many stakeholders, and situations will arise in which each stakeholder has enormous bargaining power.

In discussions based on asset-intensive firms, it would not be a major mistake to deem the firm as a nexus of contracts. But in reality, there are many matters that cannot be written into contracts. The concept of verifiability indicated here does not mean that it would be adequate for the parties to a contract to verify matters among themselves. It refers to whether or not the contents of a contract can also be verified by a judge, who is a third party, when trouble arises and a case is brought to court. As such, there are matters that firms cannot specify in contracts, and therein lie the critical issues. The issue of the allocation of the rights of ownership becomes crucial.

In the case of human knowledge-intensive firms, ownership of multiple stakeholders is divided into property rights (rights to receive income stream), control rights (allocation of rights to decide), and furthermore, the rights to sell such rights. The theme hereafter is that such ownership needs to be discussed individually.

Comparison of Venture Capital in Japan and the U.S.

An explanation of the unimportance of venture capital (VC) through a comparison of Japan and the U.S. reveals that in the U.S. entrepreneurs often rely on sources of finance called informal money, such as funds from friends, family, founders, and fools. Thus, the proportion of VC is small. (Figure 1-P.3 [PDF:108KB] ) Listening to American entrepreneurs gives you the illusion that their business is very promising. However, since entrepreneurs are super-optimistic, those who provide funds to such entrepreneurs are considered fools.)

There are two reasons why VC is not deemed important. Since the VC strategy aims to invest in high-risk, high-return projects, VC is not used in low-risk ventures such as starting small restaurants. On the other hand, a VC firm needs to also keep a close eye on the management of invested ventures. For this reason, it cannot invest in too many ventures or ventures involving excessive risk. The VC approach does not bear the risk involved in new product development where clinical tests begin only after 5,000 experiments on animals. In the U.S., only super-rich philanthropists or government funds provide funds in such development projects. No VC firm would provide funds at this stage.

What startups need are such funds, as well as legal support for preparing contracts. Because most of the startups do not succeed, it is highly likely that VC firms and startups will not be on good terms. As such, a lawyer, who can write contracts by taking into account such situations, is needed. Moreover, economies of scale exist in technology clusters. Although many ventures end in failure, it is easy to find jobs at other ventures near the former locations of such ventures. This is the secret of Silicon Valley's strength.

In the U.S., VC enters after the super-rich have financed early-stage startups. This is an indication that income distribution is extremely unfair. This case may not apply to Japan, where income is distributed more fairly. Even though VC is effective in the U.S., it may need to be adjusted to Japan's reality. Not only VC but also the ecosystem of innovation needs to be taken into consideration.

Current Status of Venture Capital in Japan

Although VC investment in Japan has been following an uptrend in recent years, it does not even amount to one-tenth of the combined figure for Europe and the U.S. (Figure 2-P.26 [PDF:452KB] ). Furthermore, more than half of the portfolio firms are engaged in IT or biotechnology (Figure 3-P.27 [PDF:452KB] ). (However, investment in domestic firms, as well as overseas investment, is included.) Also, while many of the VC sources in Japan are subsidiaries of financial institutions in the securities, banking and insurance sectors, most of the VC sources in the U.S. are independent.

Next, in the U.S. there are many hands-on type VC sources. In Japan, however, most of the investments have been made purely for investment purposes due to the existence of the fair trade problem and regulations, with more investments made in late-stage firms rather than early-stage firms. Recently, however, the proportion of investments made in early-stage firms is increasing in Japan as well.

When considering hands-on investment, especially investment in early-stage firms, the firms' hands-on capitalist and VC, rather than pure investment, would be required. In other words, this is a human resource issue, in which normal VC investment cannot be made unless the VC source is equipped with human resources who can lead management. Investments in early-stage firms have a greater need for human resources. In the case of Japan, however, the duty of a hands-on VC source to provide human resources cannot be discharged unless the system of dispatching personnel according to the human resource circumstances of the parent company is changed.

In connection with the conflict of interest, in Japan, outstanding investments are made directly by the firms while inferior investments are made through investment funds. And as such, a large proportion of investments are made directly by the firms. It may be necessary to also lead the industry in urging it to focus only on investments through investment funds. Furthermore, there is a conflict involving return to the shareholders of VC firms and return to investors of VC firms. From the standpoint of shareholders, there is an incentive to increase commissions by expanding the scale of investments. But since this does not raise return on investments, it does not lead to return to investors. Conflict of interest arises between expansion and the seeking of return. These are the organizational issues facing Japan's VC firms.