Toward an Asian Venture Capital Model

Asia has recently witnessed a marked increase in funds available for venture capital financing, and in companies seeking this kind of financing, especially in Asia’s fledgling Internet industry. Traditional venture capital financing is characterized by equity investments made at an early stage in a company’s growth and based primarily on the future potential of the company to succeed in its market; it therefore carries a high degree of risk. In practice, however, the term “venture capital financing” has come to mean an entire method of incubating and growing companies, with the expectation that the venture investor will provide not only capital, but often other expertise that will contribute to the ultimate success of the venture.

This method of developing emerging companies has become closely associated with the high technology industry centered predominantly in Silicon Valley, the companies that are started there, and the venture funds that operate there. The importation of the Silicon Valley venture capital model to Asia is still quite new and it is unclear at this point to what degree Asian entrepreneurs and investors will adopt venture capital financing as an alternative business model for Asia. To assess the prospects for wide-scale success of the venture capital model, it is necessary to understand the specific business and institutional conditions in which Silicon Valley style venture capital financing arose, as well as the unique characteristics of Asian markets that will need to be addressed.

The Market Background

The general conditions driving demand for venture capital financing in Asia and Silicon Valley are quite different. Venture capital financing has developed in the unique conditions of Silicon Valley. These conditions included a strong technological environment, an exceptionally deep pool of engineering talent and a culture of risk-taking for both entrepreneurs creating startup companies and financiers providing the capital to allow them to grow. By contrast, the Asian business world has in the past been broadly characterized by a preference to invest in tangible assets, especially property, rather than in unproven ideas and technology, and by entrepreneurship that is based more upon individual effort and family resources than upon taking risks with other people’s money.

One tenet of venture capital financing is that portfolio return is what matters - that is, a significant number of investments will fail for every one success, but that the one success will be so successful that the losses in the other investments will be covered and the investor will still be able to recoup a handsome profit. The failed investments, while not welcomed, are viewed as an inevitable element of a learning process for the entrepreneurs involved, as well as for the investors. This recognition that a certain amount of failure is inherent in the development process is so strong in Silicon Valley, that it is sometimes said that you cannot be a serious player there until you have had at least one or two failures behind you. In Asia, on the other hand, failure in the business world has traditionally been looked upon quite critically as a loss of face, discouraging the level of risk-taking that has driven innovation in Silicon Valley, and that has created the environment for venture financing.

The recent wave of venture capital financing in Asia appears to have focused mainly on Internet investments. Despite an environment for strong technological innovation in several Asian locations, including Singapore, Taiwan, Korea and Mainland China, venture capitalists have not participated in many investments in companies focussed on technology innovation. Instead, Internet businesses, which can draw upon strong histories of business method innovation, have been seen as the most attractive investments for venture capitalists. In Silicon Valley, however, business innovations brought on by the Internet have been reinforced by continuing technological breakthroughs, and those breakthroughs in turn create new opportunities for business method innovation. For example, the recent trend in the U.S. toward outsourcing a broad range of information technology services has created an entirely new Internet-based service business, that of “application service provider,” which arose largely from the Web hosting sector (which depended in turn on network computing and software innovations). As a result, the opportunities for venture capitalists are greatly expanded, since innovations in both technology and commerce can lead to the creation of new companies, and the expansion of investment and business opportunities. It remains to be seen whether this cycle of expansion can be replicated with similar success in Asia unless venture capitalists participate in all sectors involved in the cycle.

Another key difference between Silicon Valley and Asia has been the existence in Silicon Valley of a number of viable exit strategies for venture capital investments. First among these has been the relatively easy ability to list companies on the Nasdaq National Market. Unlike the more traditional New York Stock Exchange, Nasdaq has listing standards that are relatively easy to meet, allowing venture capital investors to realize on their investments by selling shares into the public market. Exchanges in Asia have been far less hospitable to young companies. The need for “track records” going back at least three years and other requirements have essentially made offerings on Asian stock exchanges impossible for start-up technology companies. Recently, local exchanges have realized that without significant changes to listing requirements, they risk having companies in a large sector of their local economies bypass local exchanges and list directly on Nasdaq. As a result, Hong Kong has created the Growth Enterprise Market (“GEM”) as part of the Stock Exchange of Hong Kong Limited to encourage young technology companies to list in Asia. It is too early to tell whether this new market will develop into the kind of source of liquidity and value creation the Nasdaq has proven to be. However, simply by the creation of the new market, Hong Kong regulators have signaled their understanding that, in order to create a true Silicon Valley type of high tech and Internet business sectors, there must be a way for emerging but dynamic companies to access the public capital markets.

Another significant exit strategy for venture capital investors is the possibility of a sale of an investee company to a strategic investor. In Silicon Valley, this process has been facilitated by the large number of high tech and Internet companies that have already been taken public, and thus can use their own stock as an acquisition currency to acquire other companies. In Asia, this kind of acquisition is still relatively rare, although it is becoming less so in the Internet industry.

Another kind of exit strategy for venture capital investors with a broad portfolio of investee companies is to arrange for one investee company to merge with or take over another company in a complementary line of business. While entrepreneurs tend to resist this in Silicon Valley as well as in Asia, the resistance in Asia may well be greater because of the traditional patriarchal form of corporate management in Asia. Until recently, even very large Asian companies have tended to be run by one founder, with family members in other key management positions. With a few notable exceptions, professional management is still a relatively recent development. As a result, convincing an entrepreneur that it will be better for his company and for him to merge with another company is perhaps a particularly difficult task in Asia. The availability of mergers and acquisitions may additionally be limited by the lack of a clear legal structure supporting merger transactions, both internally within Asian countries, and especially in cross-border transactions.

In spite of the potential roadblocks, the general sentiment among market participants is that cultural norms are changing as Asian entrepreneurs see and seek to emulate the success of the Silicon Valley model, and that more opportunities for realizing on venture investments will develop. Thus, it appears that the appetite for transactions in the Asian region will continue to rise. There will, however, be a continuing need to evaluate the venture capital model to ensure that particular characteristics of the Asian market and the Asian institutional framework are taken into account. One area where there may be some need for special consideration is in addressing the various legal requirements of jurisdictions in the region, often whether or not a business is currently operating in the jurisdiction.

While the United States is known for a sometimes stringent legal and regulatory environment, for an investor it is a relatively safe one. A venture capitalist investing in a start-up company in Silicon Valley can be fairly certain that, in the event that the company’s management fails to abide by its agreements with him, or its directors fail to exercise their fiduciary duty to the company’s minority shareholders, he will have recourse to a well-developed system of courts and laws that will provide a fair opportunity to be heard, and rational rules for resolving the dispute. This is not always the case in all Asian countries that are trying to attract venture capital. Accordingly, prudent investors in Asia would be advised to build in even more contractual protections or clarifications in their agreements than would be common in the United States. In particular, special attention is often needed to limit and regulate related party transactions, which continue to be common for both established companies and start-ups in Asia, but raise special concerns for both private and public investors.

Local legal requirements present further challenges for venture capital investors in Asia through sometimes confusing, and often forbidding, restrictions in various markets on foreign investment and on operations of investee companies in many industries. The ongoing confusion over foreign investment in the Internet industry in China is perhaps the foremost recent example. While currently foreign investment has been declared by the Ministry of Information Industries to be banned (which presumably remains the case even after the recent bilateral agreement with the United States on China’s accession to the World Trade Organization, since China will not need to implement its concessions until it has actually joined the WTO), there is already extensive foreign investment in the Internet industry there and new investments continue to be made without protest from the Ministry. Even for wholly domestic companies, the regulatory environment is far from clear. The Ministry states that all Internet content providers must have an ICP license. However, until recently, virtually no ICP licenses had been issued, and even PRC government organizations that operate content-providing web sites aimed at the public have not been properly licensed.

This kind of confusion is not limited to China alone. For example, laws in Malaysia suggest that every web site that can be accessed by an Internet user in Malaysia must, as a technical matter, obtain a license from the Malaysian government. Given the global reach of the Web, this is a requirement that presumably is being ignored by the vast majority of web sites in the world. However, a pan-Asian e-commerce (or portal/community) company may need to be more careful, even if it has no physical presence in Malaysia, as it may actually now or in the future be doing business with Malaysian citizens. The situation is further complicated by the fact that to date no regulations have been put in place that would allow a company to obtain a license. The still immature state of Internet regulation throughout Asia means that the investment environment for a venture capitalist is far less certain than it would be in the United States. Here, too, traditional venture capital techniques for protecting investments must be supplemented by a more intensive due diligence process and, in appropriate cases, additional contractual protections. Contingency plans for cases where there are potential regulatory pitfalls should be thought through at the time the investment is made, rather than later.

One particular area in which a Silicon Valley model is commonly being imported wholesale into the Asian Internet arena is in the adoption of stock incentive plans for employees, and it provides a good case study of the impact of Asian conditions on the U.S. style of growing Internet companies. These plans are seen as essential recruiting and retention tools; without them a company in the Internet space is simply not viable. Asian Internet companies are not unique in facing employee demands for options that will permit them to follow in the footsteps of so many other Internet millionaires; employees worldwide are clamoring to join pre-IPO startup companies with attractive option plans. However, since the genesis of most Silicon Valley plans is a unique conjunction of permissive U.S. accounting treatment and favorable U.S. tax laws, foreign companies need to understand the implications of such plans in the context of their own operations before adopting one.

This does not necessarily mean that a U.S.-style plan is totally inappropriate for an Asian Internet startup. The basic underlying idea - that employees who realize tangible economic returns from the success of a company will be more likely to work to accomplish that success - is universal, and its successful application in hundreds of Internet companies in the recent past encourages its duplication. The features of these plans will be familiar to many entrepreneurs, investors and potential employees who have encountered them back in the U.S.. This familiarity provides some efficiencies from using the U.S. form as a benchmark and a base.

As Asian Internet companies often hire employees who are U.S. taxpayers, there may be substantial tax benefits that can be achieved by structuring the plan to meet the requirements of an Incentive Stock Option Plan under the U.S. Internal Revenue Code. By qualifying under the requirements of the Code, U.S. taxpaying employees in most cases can defer payment of any taxes until they actually dispose of the shares obtained through the exercise of their options. The employee will generally only pay tax on the difference between the exercise price and the sale price at such disposition, and, depending on the timing of the ultimate disposition, tax will be payable at capital gains rates instead of ordinary income rates. The effect of U.S. tax law ensures that a plan participant will not have to face tax liability before he or she has the opportunity to determine that the exercise of the option will result in a net economic benefit to the participant.

To the extent U.S. taxpayer employees are working on the ground in Asia, though, and for a company’s non-U.S. taxpayer employees, the company cannot assume that the U.S. tax benefits translate fully into local jurisdictions. Unlike the U.S., many other countries will treat the grant of options as taxable salary at the time of the grant. This results in a current liability for the employee even in cases where ultimately the options at the time of exercise prove to be worthless. While the equity ownership incentives remain, they come at some additional cost and risk that could make them less effective for both the employee and the company.

The overall success of option plans in U.S. companies is based on the underlying assumption that each company will have an effective exit strategy where the optioned shares will become freely tradeable on a public market or will be exchanged for shares in some other public company. While it is by no means assured that any individual company will be successful, the current appetite for Internet IPOs in the U.S. market and the well-tested laws governing mergers and acquisitions provide an effective infrastructure to insure liquidity for the employee shareholders of successful ventures. Employees also have available the resources to exercise options and dispose of the underlying shares with little difficulty.

As discussed above, Asian capital markets are less developed than those in the U.S., and employees and companies doing business in Asia should factor into their calculations of the benefits of stock options the risk that it may take some time before Asian Internet companies have the liquidity alternatives currently available to their Silicon Valley counterparts. In addition, statutory restrictions on foreign exchange or access to foreign trading markets in some Asian countries further complicate the free exercise of the granted options.

Because of a different legal and operational environment, the Asian Internet startup must consider what adjustments need to be made to the standard U.S.-style stock option plan to fit its operating environment while retaining the usefulness of the plan as an incentive to employees to increase share value. Coordination of legal advice from each jurisdiction in which the company is operating is necessary to ensure that the effect of tax rules and other statutory restrictions on the grant or exercise of the options can be mitigated, to the extent possible, to promote the success of the plan as a whole.

There is a significant opportunity for entrepreneurs and investors to succeed with the venture capital model. In the Asian context, however, the Silicon Valley model needs to be enhanced with an Asian understanding in order to be successfully implemented in the Asian Internet space. By understanding the conditions in which emerging venture-backed companies have prospered in Silicon Valley and analyzing whether those conditions apply in Asia, the participants will gain a better understanding of enhancements to the model that may be necessary or appropriate to realize the model’s potential on this side of the Pacific Ocean.