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For the past decade, Japan’s start-up scene has been like an Escher-esque optical illusion: no matter what angle you look at it from, everything appears on the brink of an inflection point that never actually inflects.
But the picture, say venture capital veterans, is finally changing: a confluence of government incentives, inflation, and demographics put Japan’s start-ups on track for an explosion of mergers and acquisitions.
Many will decide this is just another trick of the eye. Despite successive waves of excitement around the prospect of change, Japan’s start-up ecosystem remains miniature compared with its equivalents in the US and Europe. Its ability — and, possibly, desire — to produce “unicorns” (start-ups valued above $1bn) remains elusive. Its destiny as the kernel of a new, risk-taking Japanese business culture is yet to be fulfilled.
Underneath that, though, plenty has changed, albeit incrementally. In 2013, according to analysts Initial, the total value of funding deals for start-ups in Japan stood at just ¥87bn ($659mn), disbursed across 1,348 companies. By 2022, those numbers hit ¥877bn ($6.64bn) and 2,224 respectively. In its assessment of the record funding raised by start-ups last year, Initial highlighted two striking features of the achievement: it put the magical ¥1tn-a-year milestone clearly in sight; and it had happened while funding deals were in sharp decline in the US and Europe.
But Mark Bivens, the managing partner of Shizen Capital, a Tokyo-based venture capital firm, is among those who argue the days of gradual change are over. Corporate M&A for Japanese start-ups, he says, is poised to “go intergalactic”.
However, it is quite the claim: as matters stand, M&A is a relatively dormant force — not just in Japan’s start-up world, but in its stock market.
JPX, which operates the Tokyo Stock Exchange, is discussing measures to address the fact that more than half of all listed Japanese companies trade below their book value. There are several factors behind this, not least the fact that Japan as a market receives a much lower weighting in global investment portfolios than it once did, as other markets have expanded faster. Critically, though, Japanese companies trade at valuations that reflect the very low likelihood that any will be bought in either friendly or hostile deals. Japan’s market is not priced for M&A, and this is where most Japanese start-ups ultimately list themselves.
Still, there are four reasons that Bivens and others agree that — for start-ups, at least — a vigorous M&A market will soon emerge.
First, the founders of start-ups seem to be shifting to a view that selling their company through M&A is not an admission of failure. Founders had been conditioned to see an IPO as proof of success, says Bivens, and M&A as a distant plan B. But that view has been eroded, he suggests, by the critical mass of experience of start-up founders who listed prematurely and now bemoan the burdens of that status.
Second, say other VC investors, the current conditions in corporate Japan are a tailwind for M&A. Japanese companies are under intensifying pressure from shareholders and regulators to be more shareholder friendly and, in particular, to make more efficient returns. Many Japanese companies enjoy a low weighted average cost of capital. Meanwhile, the country’s start-ups face ferocious difficulties securing bank loans. This imbalance creates ideal conditions for dealmaking.
Third, demographics — as ever in Japan — could play an increasingly decisive role. Japan’s economy is already offering 134 jobs to every 100 applicants. Companies are struggling to meet even reduced targets for new hires and the worker shortage is only going to increase. Corporate Japan has not yet deployed the “acquihire” strategy — buying a company for its staff — on a grand scale, but the temptation to do so could become overwhelming. Start-ups, typically populated with the young and provably entrepreneurial, could become the juiciest targets.
Fourth, the government is now actively encouraging M&A, by planning to offer a significant tax break, starting this month, for corporations that buy domestic start-ups. The new regime allows companies to deduct 25 per cent of the acquisition price from their taxable income up to a value of roughly $40mn per deal and up to $100mn in aggregate over a single year.
This, says the chief executive of one large IT company, represents a genuine incentive to buy-in technology and expertise that Japanese companies would traditionally have attempted to generate in-house.
All that said, the surge in start-up M&A, while entirely plausible, has yet to actually begin. Inflection points in corporate Japan have a habit of happening long after those that predicted them have grown bored or frustrated and walked away. However, corporate Japan, at this point, may not have that luxury.