JETRO, 1221 Avenue of the Americas, NYC, NY 10020September 09, 2003

New Tools for Private Equity

Outdated commercial laws and a shortage of legal and business consultants familiar with high technology and Western-style venture financing strategies plagued foreign investment during the recent e-commerce venture boom. Japan’s rigid legal system also failed to support flexible venture tools such as certain types of employee stock option plans, non-voting preferred stock, other creative stock classes, granting of third party options, etc. Venture capitalists found that their fast-paced business practices were stifled by other incomprehensibly rigid formalities such as the prohibition on board meetings by conference call.In the wake of an anemic economy and a short-lived boom in e-commerce before the collapse of the global Internet bubble, Japan’s national and local governments struggle to retrofit the economy for the 21st century. While closing companies outpace the number of new companies, national and local governments are taking steps to encourage entrepreneurs to develop new businesses. There are hopes that “bio-tech” or “BT” can help to revitalize the Japanese economy.

Regional Development of BT Industry

Japan’s Kansai region is hoping that BT can do just that. At the heart of Kansai, Japan’s second city of Osaka has been burdened by the national downsizing and the hollowing-out of manufacturing industries. Kansai’s unemployment rate outpaces Tokyo’s and as the region struggles to redefine itself amidst vanishing jobs and businesses, Kansai hopes BT ventures will spawn growth. At the center of Kansai’s BT movement are projects such as the Kobe Medical Industry Development Project (regenerative medicines and medical devices), the Saito Life Science Park (new drugs by genome and protein analysis), and the Wakayama Bio Strategy (agriculture related BT). Kansai aims to be Japan’s international life science hub.

It can be said that Kansai’s BT projects are not out of character given the region’s existing pharmaceutical interests. Roughly thirty percent of Japan’s pharmaceutical industry locates there, including firms such as Takeda Chemical Industries, Fujisawa Pharmaceuticals, Tanabe Seiyaku, Sumitomo Pharmaceuticals, Dainippon Pharmaceuticals, to name a few. Foreign interests have also established a foothold in the region (i.e., Eli Lilly Japan, Nippon Becton Dickinson, Bayer Yakuhin).

The Kansai BT base is supported by research seeds such as Kyoto University, Osaka University, Kobe University and The National Cardiovascular Center. Notable research facilities located in the region include the Kobe Medical Industry City, the Center for Advanced Genome Medical Research Development, the Institute of Biomedical Research and Innovation (IBRI), the RIKEN Center for Development Biology (CDB) and the Tissue Engineering Research Center

Opportunities for Growth and Investments

According to one survey, sixty-six percent of Kansai’s BT firms and institutions seek a partnership with foreign firms. Reasons for tying-up include joint research (both commercialization and basic), technological alliances (licenses), joint marketing and funding.

Private equity hopes BT ventures will crystallize into real businesses and IPOs. One Osaka venture, AnGes MG Inc., receives much attention as an early IPO success. AnGes MG listed on the Tokyo Stock Exchange’s Mother Index last year.

While success stories remain few, Japan’s private equity still anticipates successful BT ventures in Japan. According to one source, the Kobe Biomedical Venture Fund has already invested in at least 18 companies. The fund was established in January 2001 to specialize in medical industries.

Biofrontier Partners, headquartered in Tokyo, also placed bets on Japan’s BT industries. That firm, established in 1999, was reported to be the first Japanese venture capital firm to focus on life sciences.

It is hoped that BT will have spill-over effects in the economy. For example, budding BT ventures may increase the demand for support services such as drug design platforms, BT-related devices and support services.

New Tools for Private Equity

Outdated commercial laws and a shortage of legal and business consultants familiar with high technology and Western-style venture financing strategies plagued foreign investment during the recent e-commerce venture boom. Japan’s rigid legal system also failed to support flexible venture tools such as certain types of employee stock option plans, non-voting preferred stock, other creative stock classes, granting of third party options, etc. Venture capitalists found that their fast-paced business practices were stifled by other incomprehensibly rigid formalities such as the prohibition on board meetings by conference call.

Japan revised many aspects of the Commercial Code, such as by recognizing a new stock reservation right (yoyaku) which provides new opportunities for stock options in connection with private equity investments and other transactions supporting venture companies. For example, now companies can grant stock options to directors, employees of subsidiaries and to third parties such as lawyers, accountants and other service providers.

Commercial Code amendments have also facilitated the issuance of share classes having voting rights which differ from those provided to a company’s common stockholders. A company can issue non-voting or limited voting shares without the previously required dividend preferences. Companies can now issue limited and non-voting shares for up to one-half of total issued and outstanding shares, whereas the previous limitation was one-third.

Commercial Code rules also facilitate corporate split-offs of divisions which can be reorganized into venture companies and MBO vehicles. The number of and familiarity with split-offs and MBO’s in Japan has increased in recent years.

Certain of the Commercial Code revisions have also reduced transaction costs for venture capitalists. For example, clear limitations on the liability of corporate directors may now be established in a corporation’s articles. In addition, in Tokyo director meetings may take place by telephone conference, whereas it was previously necessary for such meetings to take place in person or via video conference. These changes can facilitate the holding of director positions by representatives of foreign venture funds.

Japan’s Venture Spirit

In the late 90’s, Tokyo boldly compared itself to Silicon Valley as a venture spirit took hold of Tokyo. In those days Japan seemed poised on the edge of a venture capital boom. The Shibuya Ward of Tokyo dubbed itself “Byte Valley”. Salaried business persons questioned their sunset careers at struggling trading companies, banks and electronics manufacturers while friends moved to venture companies, foreign PE and consulting firms, to ride Tokyo’s new wave of VC activities.

Although “Byte Valley” died a young death it provided precedent for a belief that Japan can embrace venture capitalism. These days venture capital firms are not rare. There is even a Nippon Angels Forum, which has held numerous sessions in Japan attended by hundreds of investors. The forum has opened in fourteen Japanese cities.

Perhaps the new wave of BT-venture is only a bubble right now, but it could be a tsumani. Japan’s BT industry is supported by a market said to be worth 1.33 trillion yen in 2001, and second only to a U.S. market of 3 trillion yen. By comparison, the combined European market has been estimated at less than 2 trillion yen. Even under current deflation, it has been estimated that Japan’s market could grow at a rate of over 7% annually.

Andrew H. Thorson is a partner at Dorsey & Whitney LLP in Tokyo. His opinions may not necessarily reflect those of Jetro.