Startups and venture capital work differently in Japan.

The rounds are smaller, the priorities distinct, and while the same terms are used, people quickly discover that the definitions are often subtly different. The game is played differently in Japan.

Today we get a chance to clear up a lot of the confusion as we sit down with James Riney, founder of Coral Capital and head of 500 startups Japan. We talk about some of the most significant changes that Japanese venture capital has seen over the past five years, and we look at how things are going to develop going forward.

James and I also break down the business model behind venture capital funds themselves. It’s something that all serious startup founders should understand, but few do.

It’s a great conversation, and I think you’ll enjoy it.

Show Notes

  • How venture funds raise funds
  • Why Japanese banks and corporates are changing their attitudes towards Japanese startups
  • The tradeoff between sector-specific and general VC funds
  • What the hell is a Series-A anyway?
  • How VCs try to appeal to the “right kind” of startups
  • The real problem with IPOs in Japan
  • How Japan’s new, bigger funds will change Japanese VC in the long term
  • What you never want to tell a VC when you are raising money
  • What VCs do with their portfolio companies that don’t work out
  • How Softbank’s Vision Fund is changing the market
  • Advice to foreign founders who want to raise money in Japan

Links from the Founder

Transcript

Welcome to Disrupting Japan, straight talk from Japan’s most successful entrepreneurs.

I’m Tim Romero and thanks for joining me.

Today, we’re going to do something a little bit different. We are going to talk about the state of venture capital in Japan. If you are raising money in Japan or thinking of investing in Japan, you really want to listen to this.

Now, normally don’t interview VCs on Disrupting Japan. It’s not that VCs are not interesting. I’ve got nothing against VCs. I mean, some of my best friends are VCs. No, it’s just that VCs have a tendency to talk in the abstract. T

hey talk about general trends and their portfolio companies, and I have always found that it is far more informative to go straight to the source, to talk to the founders about what they specifically are doing to capitalize or respond to those market trends, to have them tell you about the real challenges that startups are facing right now, and how that fits into the bigger more important society-wide stories.

Well, today, we’re going to do both. Today, we sit down and talk with James Riney of Coral Capital, and we examined the business of venture capital, how VCs view advertising and customer acquisition, and what causes some VCs to make money and others to lose money.

It is not exactly like it is for startups, but it is surprisingly close. We talk about the most important changes happening in Japan’s startup community, of course, but we also dig into the challenges facing venture capital funds in Japan, and Coral Capital in particular.

We talk about what VCs look for when evaluating a pitch, things you should never tell a potential investor, what the next few years of venture funding in Japan will look like, and hopefully, we will clear up some of the confusion about the difference between seed and pre-seed, and pre-series A and series A rounds.

But you know, James tells that story much better than I can, so let’s get right to the interview.

Interview

Tim: So, we’re sitting here with James Riney, the founding partner and CEO of Coral Capital and former head of 500 Startups Japan, and we are going to be talking about venture capital.

James Riney: Yes, it’s good to be back, Tim.

Tim: It’s great to have you back on. Now, a lot has changed since – when was that, four years ago?

James: Yeah, it must have been three, 3 ½ years ago, something like that. 2015, right? Something like that, yeah.

Tim: Now, so much has changed about venture capital and startups in Japan. We will get into that, but first, I want to dig into venture capital as a business, what the business model behind venture capital? Because that’s something that many startup founders understand.

James: Yeah, I mean, I think especially in Japan, but even broadly as the venture ecosystem, the fundraising side for venture firms is a little bit opaque, and maybe some founders don’t necessarily realize that especially the sort of startup funds like us, we have to go out and raise our own capital.

Tim: Yeah, yeah, in much the same way startups do, but actually, even before that, so stepping back before that, when someone decides to start a fund, what do they do? Do they start with investing theses, do they start with a couple of high net worth individuals?

James: Yeah, so in a lot of ways, we have to tell a story as to how we are going to win in the market, and in our case, money is our product and money is commoditized. So, what we have to sell to investors is why we have some sort of unique advantage and why entrepreneurs are going to take our money as opposed to the other 10, 20 guys in the market, right? And then also, the founding team, the partners of the fund, they may or may not have history together, so in a lot of ways, it’s similar to a series A startup in the sense that we don’t know the dynamics among the managing team they are going to go and how are they going to market and what kind of investments they are going to make?

Tim: So, in the case of like Coral or 500, what is the pitch to the investors? What is that advantage you are selling them?

James: So, in our case, we launched our first fund under the 500 Startups brand, for the first story for us was selling the fact that there were not brand name Silicon Valley firms really investing in Japan, and so the selling proposition was PR a Silicon Valley style firm operating in Japan, and because we are bringing that sort of know-how in that brand, entrepreneurs will choose us over others.

Tim: Who are the investors? Are they banks? Are they pension funds? Are they other startup funds?

James: Yes, so this is a dynamic that is sort of unique to Japan, so in Silicon Valley, one of the firms will raise from institutional investors. In fact, most of the capital is from institutional investors, so that includes pension funds, insurance companies, endowments, etc., whereas in Japan, a lot of the capital for startups come from corporate, and so that is in the form of corporate venture capital or in the form of funds like us that have to raise from corporate. Up until recently, there has not been a lot of institutional capital be invested into the market, but now, some of the funds including us are able to raise from these institutional investors, and so it is starting to move and starting to change.

Tim: Why is it changing? Do you think it is just because institutional investors feel that startups are a more safe or valid investment or that the number of startups have grown big enough that it is an investable asset class for them?

James: It’s a bit of both, right? So, institutional investors want to – I mean, unlike corporate, they are investing for purely financial return, right? And, for institutional investors, they have seen the likes of Mercari that grew to multibillion-dollar IPO within just five years, and then we have like Rakusul and a few other pretty big exits in the ecosystem, and so institutional investors look at those returns and they feel that there is actually something here domestically. Mind you, a lot of these managers in the institutional firms have invested outside of Japan into the top tier firms in Silicon Valley, so they are familiar with it as an asset class, but they have not really look to Japan as a place to get similar returns.

Tim: Okay, and when you are pitching these investors, so obviously, you have to pitch your strategy or the advantage you have. Do you or do most funds pitch a specific target, say we are going to be investing in B2B software or we’re going to be investing in life sciences, we’re going to be investing in anything we think is interesting?

James: We are a sector agnostic firm. If you look at all the top tier firms in the world, almost all of them are not sector specific. They don’t focus on a particular area. Now, that said, if from a marketing perspective on both the fundraising side and be investing side focusing on particular area could be important. For example, AI or blocking are like hot topics in Japan right now. Because it is a specific mandate and it checks boxes for a lot of these corporate executives, they feel more comfortable investing in a fund like that, whether or not viable in terms of creating superior returns.

Tim: So, are most funds general or are they focused?

James: I would say most funds are general, but I think the sort of trade-off you have here if you focus on a particular area is that even though you might see all the AI and blocking companies, you might not see any of the other companies, right? That is sort of the trade-off that you have, and in Japan specifically, I don’t think that the market is big enough to specialize in a particular area. There is only a handful of really big accident and they vary across multiple different areas, and so you don’t really know where the great companies are going to come out of, and if you are pigeonholed into a particular area, you are going to miss out.

Tim: There do seem to be a lot of these targeted funds in Japan. That is a drone fund, there is a couple of AI funds.

James: Right. It’s probably more feasible to have a broad perspective because if you have an idea of where you want to invest, but the dream team never presents themselves, then it really doesn’t matter actually whether you have that thesis or not.

Tim: Yeah, that’s true and trends come and go pretty quickly in startups.

James: Exactly, yeah.

Tim: Okay, once you have raised the money and for a seed fund, how big is the fund is one of those, how long is a piece of string? Funds are like, what, $10 million to like, $80 million, $100 million funds?

James: Okay, so in Silicon Valley, it has evolved quite a bit, right? And so, before the series A, you have Angel, pre-seed, seed, post-seed, pre-series A, and so it’s just like – there’s so much fragmentation, right? Because the market has just evolved so much.

Tim: Actually, let’s dig into that. Are those well-defined terms? Because they used to be.

James: I think they are less well-defined than people like to think.

Tim: So, I always thought like, series A was when the price was set and convertible notes are all pre-series A. Is that still the case or not anymore?

James: no, it’s not. It’s not the case. Yeah, it’s not the case. You might have a couple of rounds. Raised on a convertible notes or equity, and then someone will come and have a lead investor in like a pre-series A, for example, or a Mango seed – I think I heard another term in Silicon Valley. In that case, they might want to just price the round and then clean up the cap table, right? But what’s happened in Silicon Valley is that you have seed funds that are like $200 million now, right? And so, what’s happened is that people have moved up, and so the seed funds, even though they still call themselves seed, actually, they have evolved into the series a funds of the past, and so everyone has sort of moved up, right? Sequoia has also raised bigger fund –

Tim: Sort of like round inflation.

James: It’s round inflation, yeah. People have sort of moved up. They still pretty much call themselves the same thing, but the reality is that there’s much more fragmentation and they are playing in just different spaces.

Tim: I mean, I know Silicon Valley kind of exists in a world of its own. We read about these $5 million seed rounds and $10 million seed rounds and that is not a seed. That’s not a startup, you can’t go searching for product market fit and running experiments when your plan is to spend $5 million in the first 12 months.

James: Right, it depends on what you are doing, but –

Tim: Yeah.

James: What kind of experiment it is.

Tim: Are there still what were traditionally called seed rounds, people writing $10,000, $50,000 checks?

James: Are we talking about Silicon Valley or Japan?

Tim: Both.

James: Okay. Well, yeah, in Silicon Valley, of course, there’s like the friends and family, Angel around, and so that still exists, but in Japan, a seed round was, you raise 100,000 and it’s like oh, wow, and then a series A was like, 1,000,000 to 3,000,000 and it’s like oh, wow. Now, that has sort of bumped up and so I think a seed round is probably like, 600K to 1 million in Japan, and then a series A will be probably something like a 3 to 10 on the bigger side, and so there’s a more capital in the market. Funds like us have been able to raise bigger funds, and so there’s more capital to deploy and that sort of creates that same sort of inflation that you see in Silicon Valley.

Tim: So, mostly seed and series A these days, it’s just the size of around determines what people call it?

James: Yeah, it’s the size of the round, and to be honest with you, a lot of it is just messaging. In some cases, you might want to call it a series A. in other cases, you might want to call it a pre-series A because of the later the stage, the more that downstream investors want to see progress, and so if you are considered series B, they will want to compare you with other series B deals, and so you will be expected to have better KPIs.

Tim: Alright, alright, that makes sense. Getting back to the business model of VCs, so now that you have raised your fund, how do you make money?

James: So, VCs make money from management fee and carry, so the management fee is 2% usually on the assets under management. You raise $100 million fund, you have $2 million per year that you can work with. Now, with that, you have to pay staff, you have to pay rent, you have to pay lots of different things, so that is your sort of operating budget, but the carry is where fund managers really make their money. Carry is basically the percentage of profit that you receive on the fund return.

Tim: Okay, so basically, if you make whatever percent of the returns you make for your investors, you would keep 20% of that?

James: Exactly.

Tim: Now, the 2% annual fee, I mean, if you are running a $500 million fund, that is a lot of money but there is a lot of $10 million funds or $20 million funds. We are looking up by $200,000, $300,000 which, I mean, if you put that on the table on a big pile, that’s a lot of money, but that’s not a lot of money to run every year.

James: It’s not. Basically, a lot of people will raise small funds like that just to get started and put some points on the board, and then raise a bigger fund off the momentum of their investing from previous fund.

Tim: So, how do these micro funds support themselves? Are they subsidized externally? Do the partners just they mostly the expenses out of their pockets? How does that work?

James: There is a lot of different scenarios. In some scenarios, the fund managers have had some sort of previous exit, and so they don’t really need the management fees and they might pay other staff, but in general, they won’t really take a base salary.

In other cases, as you are alluding to, they will run of events, they will do, and especially in Japan, they will do open innovation consulting kind of stuff for big corporates. That will generate some sort of consulting related cash flow, and that is how they run things – they keep the lights on.

Tim: Before, you mentioned that money was kind of an undifferentiated product, right, and that is true on your cell site as well when you’re getting your investors, but now that you’ve got your fun together and you are looking for startups to invest in, you’re still kind of an undifferentiated product, right? So, how do you convince startups to let you as opposed to the other funds invest?

James: There are many sort of components here. One is just reputation. You have a reputation for investing at your company, you have a reputation for being a helpful partner for entrepreneurs, that will increase your ability to win deals. So, within the deal sourcing process, there are three components. One is the finding, another one is the picking, and the last one is about winning, so the finding is knowing that the deal actually exists, and so – especially at seed stage, knowing the deal exists is a lot harder because of these deals are not covered by tech crunch, right? They are not in the press. Now, the next one is the picking part, so the picking is okay, amongst those deals that you have looked at, which are you going to try to invest in? And then, there’s this last component that is underestimated and not really well-known is the winning part. It is not a public market, so you can’t just go and just buy any stock that you want to buy if you have the money. You have to convince the management that they should take your money is supposed to other people’s money, and so the winning side is a critical component in a lot of cases, the hot deals, everyone knows it’s a great deal, and so they want to invest in it. A lot of cases, there is consensus that this is a strong team and they want to invest, and so you have to compete.

Tim: So, it’s basically lead generation, lead qualification, and sales.

James: Right, basically.

Tim: Fundamentally.

James: Yeah, yeah, it’s sales, it’s sales, and so reputation is the one component, but then there’s the other component on okay, outside of the money, what do you actually provide, right? If so, what we of been outside of the money is we have an in-house high manager that recruits two or three people per month for our portfolio companies, we have an in-house PR person that helps with making sure that they are getting into the press, we built a proprietary database, so fundraising options, so that they can raise downstream capital, and so we have built sort of these functions in-house, so that we are not just providing this money as a commodity. There’s services bundled up with that.

Tim: That makes a lot of sense, and just my own question struck me as odd as soon as it came out of my mouth, simply because I have been raising funds for one project to another, pretty much continuously over the last 30 years, and the idea of VCs having to compete for startups is relatively new. Right now, it is a seller’s market. If you’ve got a good team and a bit of traction in your startup, you’re going to have a lot of VCs want to invest in you, but that wasn’t the case particularly in Japan 10 or 15 years ago. Have a lot of Japanese firms had trouble adapting to this new reality?

James: I don’t want to say that they’ve had trouble adapting to this new reality, but I do think that they have realized recently that they need to adapt, and so we can take all the credit for it, but I think it’s fair to say that we were one of the first to really start providing services outside of just capital, and that mindset is quite different from someone that is thinking okay, what we do is we raise money from investors, we invested and just try to get a couple gained.

If you are LP-focused rather than entrepreneur-focused, when the market shifts to a seller’s market like it is now, then you are going to struggle because all this time, you have been serving the LP is when you really should have been serving entrepreneurs.

Tim: Right, but it seems to me, there’s three kind of business models that can and do exist in VC. There’s the one that you described which is very entrepreneurial in its sense when you are out generating leads and closing deals, and being very proactive in selling your value add to investors, there is the other model which was traditionally the Japanese big VCs which was we’ll invest in you, we will groom you for IPO, and this is your track to IPO, but it seems like that model is less and less attractive in Japan right now from the startup side.

James: Yeah. No, I think so, so historically, if you wanted to raise 20 million-plus, it was very hard to do in Japan, and so a lot of companies kind of had a necessity, they have to go to the public markets, and so the positive side of that is that you get liquidity sooner, but the negative side is that if you go public and you are in hypergrowth mode, immediately, your shareholders shift to short-term and they want to know every quarter whether you are going to be profitable, and when you are growing, you are investing in growth and you don’t necessarily want to think about profitability if it means sacrificing growth, so I think what it does is it just stunts growth, and so you have maybe multiple hundred-million-dollar exits, but if you had been more patient and invested in taking the entire market, maybe you could of had multiple billion-dollar exits.

Tim: Traditionally, the Japanese VC, it’s been this pipeline to IPO where a US VC might assume 90% of their portfolio is going to go bankrupt and 10% will provide a fantastic return, in Japan, it’s always been kind of the other way where 90% would have a nice stable IPO and 10%, something would go wrong. What you are talking about, this double down, this more growth options to raise more and more money later definitely goes against that safe steady IPO. So, how much is that changing among Japanese founders? I mean, are Japanese art of founders wanting to stay private longer and double down or roll the dice again and are Japanese VCs okay with that? Are they resisting the trend? What is happening there?

James: So, first of all, the 90% versus 10% comment, it’s probably exaggerated, but I can see what you are saying. There’s definitely –

Tim: Yeah, you are right, those numbers, I just kind of pulled those out of my – unintelligible –.

James: Yeah, yeah, no, so the audience understands. Whether it’s change or not, the answer is yes, and so the number of $20,000,000+ a rounds in private markets of increased quite a bit, and there is the outliers like Mercari, for example that have raised over 100 million in the private markets, and to sort of set the example that you can raise that amount of money in the private markets and still have a spectacular return, and so this is influencing both founders and investors, so the founders are thinking, okay, maybe I shouldn’t just look for a quick flip. I should go for the unicorn, right? If the investors are keen to invest in the private markets, you sort of have both sides of the marketplace are pushing for the bigger exit.

Tim: But I mean, from my discussions with founders that have been on the show, I mean, there are definitely founders were pushing for the large exit, but it requires a really big shift in VC strategy, so are you seeing that shift either in the attitude of individual VCs or in the actual structure of Japanese VC funds?

James: Yes, I will give you a very, very easy signal that it is changing. In addition to the size of the rounds increasing, the site of the funds are increasing. You have Globis that have raised 316 million roughly. Global Brand has also got much bigger, Whil has gotten much bigger, JAFCO has gotten bigger, and so all of the funds have gotten bigger, and it’s a signal of the intention to invest growth capital. Especially in the case of Globis, it is a Japan-only VC, and so if they are raising that amount of money, they are raising it with the intention of investing quite a bit of money into the later stage rounds as well, and so when they announced it, part of their PR is that they can invest up to 50 million into one company, and so there is a clear intent there. That is a change in the market thinking that okay, we need to raise bigger funds so that we can capture that value.

Tim: Yeah, so like, 10, 15 years ago, a typical IPO, you might of a company with a market cap of like $20 million or $25 million.

James: Right, which is insane, right?

Tim: Yeah, it’s insane.

James: That’s a series A in the US.

Tim: Right, right, but if you’ve got companies that want to invest $50 million in one company, obviously, that has to be later and more aggressive growth. Okay, that’s a really good sign.

James: Yeah, if US 50 million, you have to go for unicorn.

Tim: Yeah, that’s two of those little IPO companies, right, that’s buying them?

James: Right, and if you raise a fund like that, that means that your investing strategy is dependent on hitting those unicorns, right? Because remember, you have to 3x to 5x that fund.

Tim: Okay. So, getting back to your startup final, as it was, how you find companies to investing, so how do you reach out? How do you find those deals? Is it reputation? Do you actually do marketing? Is it kind of a personal network?

James: So, it’s a combination of a lot of things, but what is core to our strategies that we have been very proactive about publishing helpful information for entrepreneurs. You can think maybe Anders and Horowitz or First Round in the US, they publish a lot of content, right? Y-Combinator is another example of that, so because we are publishing a lot of content, we have a strong foothold in sort of like the mind share of entrepreneurs in Japan, and so when they want to raise money, we are at the top of the list in terms of where they are going to talk to first. We also have a lot of introductions, and then even when we see, let’s say a press release or news about an interesting company somewhere, when we contact them, in pretty much all cases, we are able to meet with them because they’ve heard about us or they follow our blog.

Tim: So, what do the numbers look like for every, say 100 companies you talk to, how many do you end up doing due diligence and seriously consider, and how many do you end up investing in?

James: So, we are very fortunate in that we see 200 to 300 per month, that’s a lot in Japan. We’re trying to figure out what is the 100% of the market? I actually don’t know, but I don’t imagine that it’s probably not more than 300 a month in Japan, but in any case, we see that many companies and we invest in one or two.

Tim: How do you make a decision? I know that that is probably too broad a question, but are there any red flags and green flags? I mean, the red flag being something like if you see this in a pitch deck, you are just going to pass immediately on it, and a green flag being if you see this in a pitch deck, even if everything else looks a little questionable, you are going to look harder at this company.

James: Right. Yeah, I will give you one that is top of mind right now, and it’s not necessarily a red flag. It’s just kind of at the motivator for whether I want to investigate this company at all. For some reason in Japan, under sometimes don’t include a team slide in the deck, so there is a great presentation about what they are doing and they are like, “Oh, man, this is really interesting. I wonder what team is pursuing this amazing idea,” and I scroll all the way down and I still don’t see any slight about who is doing it, and it’s insane. It is such a crazy thing because –

Tim: Is that just because it’s like a solo founder or –

James: No, no, no, no, no. In some cases where I’m really interested in the idea, I will reply and I say, can you add a team slide? But in other cases where I’m kind of so-so in the idea, I just don’t even pursue it further because it’s just a waste. I don’t even know who the team is and I need more information to really assess whether I should meet them, and it’s a strange dynamic in Japan where the team slide is not included, or even if it is included, it will just say like, CEO, CTO, etc. – or COO. And so, it won’t include any information beyond that in the sense of what they were doing in their previous companies and what they accomplish up to that point. You really have to sort of digging the information to pull it out of them.

Tim: Why do you suppose that is? Because it seems to me, particularly at a seed stage, you are mostly investing in the team.

James: Right. At the seed stage, you are investing in a team, so that – I think that at different stages, the weight that you put on each category, it shifts, right? And so, as the company progresses, for example, the weight that you put on traction gets higher. In the early stages, the weight on team is really, really heavy, right?

Tim: Well, if you don’t have traction to look at, yeah.

James: Yeah, if you don’t have traction. You don’t have traction, so it is such a waste, right? In Japanese, you say mottai nai, but there’s no team slide.

Tim: Alright, okay, and what about a green flag, something you see would get you excited enough to really dig in, even if everything else looks really questionable?

James: I think there is a few, so one is, they have already built the product, and so they have had limited resources, but they have managed at least to ship product. That is a really strong signal, right? It means that this team can build. Even if there is zero traction, they have shipped it before they even come to us.

Another one is the depth of thinking in their pitch deck, like the organization of the information, how they are thinking about the market, how they are going to attack the market, and that gets very tactical in terms of what they are going to do. It is not just strategy. They are going to IPO in five years, right? It’s tactical in the sense that this guy has a relationship here and we are going to first approach this and etc., etc. They may be wrong, but that’s totally fine – if they are wrong, it’s just that they are thinking deeply about how they are going to approach it.

Tim: Yeah, you can tell they have a plan that they are executing.

James: Exactly, exactly. So, those are strong signals there, and so we have invested in companies that just contacted us from our website and it’s clear from their pitch deck that they were very smart and thinking very deeply about their market, and so we met them and ended up investing.

Tim: Alright. Okay, and kind of coming back to the business model of funds, so funds have a certain lifespan, right? Because you hear about seven-year funds or 10-year funds, but does that mean?

James: In most cases, venture capital funds are 10 years, and so what that means is that the life of the fund is 10 years, but in most cases, the investment period is somewhere like two, three years, maybe longer cases, five years. That is the capital deployment., And so once you have investment, you have planted receipts, that 10-year period is your harvesting time. By the end of that period, hopefully, you are getting IPOs, you are getting MNA, you are getting exits, right? You’re getting liquidity.

Tim: So, if you raised $100 million on a 10-year fund, the idea would be in the first 2 to 3 years, you would invest all of that capital?

James: Yes, yeah.

Tim: And, for the management fees, do those keep churning out at 2% the whole 10 years or is it only that first three years?

James: There is different approaches to this. In general, the average is 2% over the life of the fund. In some cases, there is upfront, so they are safe in the investment period, and so that might be 2.5% or something, or in private equity itself, it is maybe 2% for the first three, four years, and then it stumps down from there, and so there’s different dynamics there, but in general, the average is 2%.

Tim: Well, that makes sense because for the first two or three years where you are actually having to evaluate 200, 300 startups –

James: Exactly, that’s the bulk of the work.

Tim: Right, and in the last few years, it’s just financial filings and compliance, and account.

James: Right, yeah, it’s portfolio management. I mean, you might sit on a board, you might help out with fund raising in next rounds, like there’s still stuff that you do, but it’s just not as active.

Tim: So, during the life of the fund, you are going to have – some of those investments are going to go bankrupt, some of them will be bought and IPOed, but at the end of the 10 years, you’re still going to have a handful of companies that maybe have evolved into safe stable companies that are not going to go bankrupt and they are not going to IPO. What do you do with those at the end of the 10 years?

James: Yeah, the zombie companies, right, as they say in Japan?

Tim: Well, for the owners, they are not zombies, but –

James: Yeah, yeah, they’re not zombies. They are zombies for us. There’s a few things that you can do, so one is in our case, we have a two-year extension. Let’s say that we have an AirBnB in the portfolio, right, so it’s not a zombie company, but it’s just taking a long time to go public. At the GP discussion, you extend it for two years, then there’s other ways where you can sell to another investor, and then there are certain scenarios where, let’s say that there is an LP that does not feel comfortable waiting out longer, and so that help people sell their stake in your front. There is lots of letters that you can pull.

Tim: So, there is like a secondary market for these – I hate the term zombie companies because they might be perfectly valid business entities, they’re just not going to provide a return for the investor. So, there is a secondary market for these? I mean, who buys a company like that or buys a minority stake in the company?

James: There is a better seconary market in the US. I think in Japan, it’s harder to find buyers. There’s a few funds that is focused specifically on that, but I think it’s just two or three. It’s very small. As to who they are besides VCs, there is also private equity firms and there is also corporate. They might have a strategic angle there or there are also angels that just want to invest in a company that maybe have some strong cash flow

Tim: Oh, all right. So, for startups in the growth cycle, you are raising multiple rounds, you are getting bigger and bigger rounds and higher and higher valuations, and for the fund managers, it seems to work kind of the same, like the next fund you want to raise needs to be bigger than your last one. I mean, that looks like how it is. Is that really the case?

James: No, I mean, there’s definitely that sort of dynamic where you step up and you go bigger. In our case, we stepped up a little bit, but actually, we are very fortunate to have much more interest than we were looking for, and so we raised our fund in just two months, but we could have gotten bigger and the reason that we did not go bigger is that when you go bigger as a fund, you have to shift your strategy, and so we felt comfortable with our current strategy with a certain size of fund, but knew that if we had gone to let say over 100, 150, 200 million, we would have to shift from seed to really doing series A and series B, and we did not feel like we sort of have mastered that, and so we wanted to take it little by little, but there is pressure to go bigger later just because I think that people have sort of looked at it as positive momentum.

Tim: Yeah, but I mean, it seems to me, you might have a VC who is incredibly talented at finding early-stage seed startups and working with founders and adding huge value there that might be terrible at the more –

James: Late stage.

Tim: Yeah, yeah, the more MBA spreadsheet style growth late stage analysis.

James: Exactly. Right, right. No, that is very true, and I think that there are disciplined fund managers that think small is beautiful and paste a small, and there is even some of the famous ones like USV that have consistently had the same sized fun, so that exists, but I think that what is happening and particularly in the US is that because you have the likes of Softbank coming in with ridiculous amounts of money and driving up prices, even funds like Sequoia and Anders and Hurwitz are feeling pressure to move up, and so that is a dynamic as well. It’s not necessarily that they just want to make their fund bigger. It is that they have to do that to compete.

Tim: Right, right. Well, how has Softbank kind of changed the game in late stage capital?

James: It’s the inflated prices. So, Softbank, because they have so much capital to deploy, they, one, are not particularly price-sensitive, and two, because they have so much capital, they can buy ownership in the company by paying up, by just the pouring more capital, and so if you are a relatively small – small relative to Softbank, let’s say you manage a billion-dollar fund…

Tim: That’s a little, little billion-dollar fund.

James: Small little billion-dollar fund. For you, it might be fine to lead the round with 20 million or 50 million, but once the fact that comes in and says, “No, we will do it for 100 million for the same percentage,” from an entrepreneur’s perspective, it’s like okay, which one do I choose? And, I really like these guys, but 100 million? And so, there is that sort of pressure.

Tim: Yeah, if it’s a few percentage points difference, you might go with the guys that you think will add a little more business value, but yeah.

James: But yeah, but when there’s just such a big gap between the choices, it makes the calculation a bit different.

Tim: Can they make money doing that? I mean, you could get anything you want just by overpaying for it, but that is not a winning strategy long-term.

James: We will see, we will see. Yeah, we will see how it goes. Of the other thing that should be considered is that even though they might be paying up in terms of price, there’s other downside protections that go into late stage financing that don’t get published in Tech crunch.

Tim: So, things like liquidity preference where they get their money back first?

James: Yeah, yeah, exactly.

Tim: Okay. I have noticed this in Japan and I don’t know if it is uniquely Japanese, but a lot of times, like when I’m in San Francisco, I will be talking to a young IOT start up founding team. It will be like, three smart guys in their 20s and that is great, but in Japan, I will meet like a new IOT founding team, it will be like two smart guys in their 20s and one guy in his 50s from Nissan who understand supply chain, and it’s an interesting. It is an interesting dynamic.

James: Right, right, yeah, and that diversity is important, right? They all bring different things to the table, but yeah, I mean, what I want to emphasize is that the caliber of entrepreneurs in the market have increased quite a bit, and so it’s sort of this nice combination of there’s opportunity and there’s –also entrepreneurs that are pursuing those opportunities, so that tended to be where you invested.

Tim: Yeah. I get a lot of questions from foreign startup founders in Japan who are trying to raise money. What is your best advice for them?

James: I raise money as a foreigner in Japan, right, both as a fund manager but also as an entrepreneur, and they are different things to think about. So, one is, if you can’t speak Japanese, I think it’s going to be really hard, really, really hard. Not just from a fund-raising standpoint, but even from a hiring standpoint and managing standpoint, and really understanding what is going on because there are some things that sort of can’t really transcend this language barrier and they are closely related to culture and how you have to understand what is really going on in those situations.

Tim: So, if you’ve got someone who does not speak Japanese reasonably well, you’re just questioning whether this person will be able to execute?

James: Will be able to execute. I’m not saying that they can’t execute, I’m just saying that some areas will be an uphill battle, so the trade off, what they have to do is they have to have something that is extraordinarily that other Japanese cofounders or members would not have, so this could be like engineering prowess, or if it is related to something outside Japan, where they pulled their way is relationships outside Japan, right? And so, something unique that no other Japanese member could bring to the table. In any case, I would very much focused on finding a strong Japanese cofounder. Now, let’s say that you do speak Japanese. There are examples of foreigners in Japan that speak fluent Japanese that have succeeded as entrepreneurs in Japan, and so it’s less of an issue, but at the same time, I do think it helps to have Japanese within the core team, so that you have that sort of diversity of thought, and let’s face it, there’s also chemistry between certain investors in certain business partners. As you go out to the market and you fund raise and you look for business partners, there are some people that will be very open to working with foreigners and others where honestly, there is probably subtle racism there, right? And, in order – you can complain about it all you want, but your goal as a founder to break through those walls, right? And so, you do it by any means necessary, and if that means that you need to get core members of your team that are Japanese, so be it. After he can bring those barriers, then you become the example, so that you can break those stereotypes.

Tim: Makes sense. Let’s talk about Japan and general. One of the most common metrics that you use when comparing Japan to the US is the total amount of money invested in venture capital, and I mean, the US, even if you adjusted for GDP and for population size, it’s like 15 times, 20 times larger than what is invested in Japan. Is that a good thing, a bad thing, a completely irrelevant thing?

James: I think it’s a bad thing. So, in places like the US or especially China, so China has gone from 0 to 50 billion or maybe more than that – I don’t know the updated numbers – but in a very short time, so they have caught up with the US in terms of venture funding, and there is a lot of bullshit that gets funded in those markets, right?

Tim: Oh, absolutely, absolutely.

James: And, yeah, and that’s fine. That is okay because a lot gets funded and you through a lot of things at the wall, and some of them will stick, right? And so, out of that, you get Tencent, you get Uber, you get these huge winners that surpass anything that you have lost, and so that is sort of like the mindset that needs to be transported to Japan, and in Japan, I think that there’s a lot of loss aversion that is not necessarily rational, and considering the size of the market, we should at least be at 10 billion invested in startups in Japan.

Tim: So, what is holding it back? Is it really just that mindset or is it also a lack of high quality startups or institutional money? Or is it really just that attitude?

James: I think there’s probably a confluence of factors. One is historically, you have not had huge, huge accidents, like you’ve seen in other markets. That is also starting to change, so we are getting some hits on the scoreboard, and then also, we’re just seeing more capital coming into the market, and where the big capital is is in the institutional side, and we are finally just getting that unlocked, right? So, Globis has raised from institutional for a while, but now, like the percentage from institutional has increased quite a bit, Global Brain, I believe has also gone that direction. Half of our fund is institutional, and so now, it’s changing, and so once we can unlock that capital, that will bring more capital to fund these entrepreneurs.

Now, on the entrepreneur side, the caliber of entrepreneurs has also gone up, as I mentioned. So now, you have smart people with capital behind them to build imported companies, and so it’s sort of a snowball effect, and I think we are sort of in this positive cycle in Japan where there’s funding for entrepreneurs and they are pursuing big ideas, and therefore, there will be bigger and bigger exits.

Tim: Okay, so you think we’re just going to see a steady solid growth. We are in this virtual cycle now.

James: Yeah. I think when things happen in Japan, they happened very quickly. Now, with the disclaimer that when things happen in Japan very slowly, except when they happened very quickly, and so I will give you an example. Cashless payments, cashless payments in Japan, so everyone was always talking about like, oh, my God, Japan loves cash and they are never going to give up cash, and all that stuff, and then all of a sudden, everyone is dumping money into cashless payments, right? You have PayPay, you have Line Pay, you have Origami, like lots of others, right? There’s this flight of capital and there’s flood of interest in cashless payments, and so I think that now, we’re probably going to see a trigger where cashless payments will be the norm. I will give you an example. Someone was telling me the other day that he was in the middle of nowhere and somewhere in Japan, in Inaka, and he went to this udon place and they accepted either cash or PayPay.

Tim: But no credit cards?

James: No credit cards, no credit cards.

Tim: Yeah, I’ve found this to be true in Japan for so long: anytime someone tells you the Japanese will never do ask for cultural reasons, there is a great business opportunity. So, even during the dotcom boom, people were saying Japanese will never buy things online because they preferred to go to the high touch department stores.

James: Right, right, it’s a bunch of bullshit.

Tim: It didn’t work out.

James: They won’t use Facebook, okay, sure. Now, 20,000,000+ use Facebook in Japan.

Tim: Online auctions, Japanese will never buy used goods. Yahoo! Auctions is huge.

James: Right, right, yeah. So, that’s all bullshit. Now, just a question of timing. It might come slower, right? So, that is a question that we asked investors, and we might have that eventually, it will happen. We just have to time it whether this is the time or not, and so cashless payments, if we had bet on it 10 years ago, it probably would’ve been a good, but now, it seems like it’s a possibility.

Tim: Right. Well, listen, James, before we wrap up, I want to ask you what I call my “Magic Wand” question – which you know well – and that is, if I gave you a magic wand and I told you you could change one thing about Japan, anything at all – the education system, the way people think about risk, the availability of risk capital, anything at all to make it better for startups and innovation in Japan, what would you change?

James: One, if I was Abe-san right now, I will come up with a program that either requires or strongly encourages students in Japan to study abroad because I think that has profound effects on multiple different areas for Japan broadly and also for those individual. One is, of course, learning another language. If you learn English, I think that opens up a lot of doors for you, and as a country that can interact with more people, I think that is not positive. The other thing that is important to know is that a few of those study abroad experiences, they will build valuable relationships that will lead to potential business relationships down the road that will advance the economy in Japan, and so I would strongly encourage that side. The third part that I think is important is that it opens up your mind beyond Japan and I think that when people experience cultures and circumstances completely out of their norm, it gives them a more broader perspective in the world in general and also what is possible.

Tim: So, that third reason that I want to dig down on a bit, so is that just a different approach to problem-solving or just giving someone an acknowledgment that there are other ways of doing things and being more open-minded in general?

James: Right, I think that is what it is. If you grow up in one place and have this trouble and/or conditions to think that this is the way the world is and this is the way that you should think, and you are never exposed to other ways of thinking, then you will forever be trapped in that, and if you are thrown into an environment where it is completely different, it’s like, actually no, you don’t necessarily need to be polite to your boss. You can challenge him, you know? That will change your mindset, right? You won’t necessarily come back to Japan and be a douche bag to your boss, but you’ll sort of start questioning all these things that you have been told and try to seek truth within that, and there might be multiple angles in Japan the might of been right all along, but you will never know unless you are exposed to other areas.

Tim: Now, unfortunately, that trend seems to be going in the wrong direction. There’s fewer and fewer Japanese studying abroad.

James: I know, yeah, yeah, and it’s a shame. It’s a real shame, but I think that for Japan to advance, I think it’s important, it should be noted that China and Korea have a lot of study abroad students. The schools in the US or in other places like the UK are flooded with students from those countries, so it is a shame. Korea and China are benefiting from that.

Tim: While the number of Japanese students studying abroad is going down, we’re seeing a huge increase in the number of foreign students studying in Japan. Using that could provide some of the same effect of opening people up to new ideas and new ways of thinking?

James: Yeah, I think that another lever that could be pulled and it’s already being pulled, right? So, that is one way to solve it, but it’s being solved out of necessity, right? Because you have declining population and you don’t have enough people, so yes, I think that will be a positive effect for Japan.

Tim: I mean, we’re certainly seeing the results. I mean, if you’re getting 200, 300 startup applications every month, it means people are thinking differently about things. They are coming up with new ideas and challenging the status quo.

James: Right, yeah, there’s definitely – well, don’t want to say definitely because I wasn’t a VC five, 10 years ago, so I don’t know whether it is more or less than it would’ve been if you had started earlier, but I do feel that we are getting more interest but also you are seeing more investable companies in the market, and so it’s a harder decision right now as to which ones we invest in because there’s actually a lot of good options now.

Tim: That’s a good problem to have.

James: Yeah.

Tim: Okay, James, thanks so much. I really appreciate you sitting down with me.

James: No problem, thanks so much, cheers.

Outtro

Tim: And, we’re back.

Well, I think our discussions and definitions of pre-seed, seed, post-seed, pre-series A, and series A rounds were about as clear as mud, but it covered the ground.

Like so many other terms in the startup world, these terms don’t really have a fixed meaning. They are a form of marketing, and in the startup world, any important term will be broadened to the point where it does not really convey meaning anymore.

Consider for example the terms artificial intelligence, virtual reality, big data, blockchain, or Internet of things, now, if you want to stay informed or even stay sane when talking about startups, you really need to simply ignore the terminology that is being thrown around completely and look at the problems the company is solving, and the relationship they have with their customers, and how James and Coral Capital chose to define their customers is interesting, and I think more than anything else, it speaks to how venture capital is changing in Japan.

In most businesses, whoever gives you the money, they are your customer and that is how venture capital had always worked in Japan it made sense when risk capital is scarce, but when risk capital is abundant and VCs start having to compete with each other to invest in startups, well, then it makes sense to start considering the startups to be your customers and focusing on them. You will get into the better deals, and if you do it right, you help your startups succeed, that will lead to higher returns.

On the flip side, if you’re running a fund and your returns are poor, well, that even the best relationships with your investors are not going to help you out that much. Your investors are looking for returns. Of course, all this might change in the future. The start of industry is incredibly cyclical. There will be a time in the near or maybe the distant future where investment capital once again becomes scarce, and then close relationships with investors will become more important, but regardless, focusing on startup growth seems like the right way forward.

That is what drives the large returns, and will close institutional connections are great, nothing succeeds like success.

If you want to talk more about fund raising or venture capital, James and I would love to hear from you, so come by DisruptingJapan.com/show145 and let’s talk about it. If you leave a comment, I guarantee you that James and I, or maybe both will respond, and hey, if you get the chance, check us out on LinkedIn or Facebook but even better, if you love the show, tell people about it. Disrupting Japan is grown not by social media marketing or advertising, but because listeners like you enjoy it and tell their friends about it.

But most of all, thanks for listening and thank you for letting people interested in Japanese startups know about the show.

I’m Tim Romero and thanks for listening to Disrupting Japan.