(Written by Masafumi Asakura, Final Aim)
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Although there are many expressions and definitions of startups, including those defining the difference between startups and business ventures, let us define “a startup” here as “a company focusing on rapid growth aiming for IPO or M&A with support mainly from angel investors and/or venture capitals”. Needless to say, there are a wide range of individual cases, such as a startup that reaches IPO without receiving any investments, or a startup that receives corporate venture capital to reach M&A.
As an overview, individual fund providers such as angel investors or venture capitals support startups as stakeholders, and capital gains from IPO or M&A are the incentives for such investments in Japan. In the U.S. in 2021, SPAC (Special Purpose Acquisition Company) and a process called Direct Listing have been drawing a lot of attention.
Of course, there are differences between the systems in Japan and overseas: in the U.S., there is a way to obtain capital gains in the secondary markets prior to IPO or M&A. The large markets are in the U.S. and in China, though the market for startups in Japan also has been growing largely in recent years.
What distinguishes startups from small business companies in a general framework is a way of calculating corporate values: for a small company, its corporate value is the current value calculated by using a net asset approach, whereas the corporate value of a startup is calculated mainly by using a method called discount cash flow, which estimates the current value based on its expected future value.
For the financing method, startups seek not for debt financing, which is usually a bank loan, but for equity financing, which is a method of raising funds from angel investors and venture capitals who finance startups based on the current value that is converted from the future estimated value of the startups. Of course, there is also a scheme that combines both debt financing and equity financing together.
Though slightly reduced from 701 billion yen in 2019, the amount of fund raised for startups in Japan in 2020 is still around 680 billion yen in total. (The fundraising amount in 2020 slightly changes depending on references, and we refer to the number from “STARTUP DB” here.)
The global center of startups is in the U.S., including Silicon Valley and Bay Areas as well as New York and Texas where startups are showing their presence. Startups such as Airbnb, Slack, and Clubhouse that had grown rapidly in short term are creating novel industries one after the other. Investments in startups have continued to increase in North America despite the Coronavirus pandemic.
The investment trend for startups has been on the rise over the past few years not only in the U.S. and Japan but also in Europe. Germany and France have been actively trying to attract startups from their own countries, and even reaching out to Japanese startups.
If you look at the global investment trend in startups from 2011, you can see that the global startup market has grown significantly over the last decade.
Next, we will discuss the money flow surrounding startups. A typical flow of money surrounding startups is as follows: a startup company focuses mainly on increasing its valuation with the fund raised by venture capitals, where the venture capitals collect investment money from their Limited Partners (limited liability partner, LP) and the venture capitals invest the money invested by the LPs into the startup.
LPs are usually institutional investors having a long-term growth perspective, and the venture capitals invest such capital invested by LPs into startups. In such a system, you must hit a home run, not a single hit. Due to this background, many startups are expected to grow rapidly in a short term. In some cases, corporate venture capitals and angel inventors also fund startups.
Equity financing is an allocation of new stocks to a third party, while debt financing, such as bank loans, involves the borrowing of money on security of real estates or joint surety. Equity finance is different from debt finance in that collateral such as joint surety or real estates are unnecessary in Japan. Thus, equity finance enables entrepreneurs having no collateral real estates to raise funds only by offering their stocks. As an ex-bank employee who was in charge of corporate financing, I personally have an impression that the method of equity financing is a very useful scheme for an entrepreneur who is in need of fundraising in Japan. Of course, there are pros and cons on both sides, and it is not always the case that equity finance is better than debt financing.
The environment surrounding fundraising for startups has been changing in recent years, and, with such changes, the timing of obtaining returns from capital gains has also been changing. Some startups with unlisted stocks may be able to raise big funds over 10 billion yen in Japan, while some entrepreneurs may choose a strategy aiming for not an early IPO but going public after taking enough time to build up their strength. We are seeing in Japan that some startups deliberately develop their strength before being listed in the market.
While startup founders have various backgrounds, designer-found startups have been gaining much attention recently. Companies like “Airbnb” whose founders include Brian Chesky and Joe Gebbia, and “YouTube” whose founders include Chad Hurley are good examples. At this point, Japan has only a few startups founded by designers.
For the upper management CXOs (COO, CFO, CMO, etc.), a title called CDO (Chief Design Officer), which is given to an executive who is responsible for overseeing design of the company’s products and services, is not yet well acknowledged or appreciated by angel investors or venture capitals.
When receiving fund from venture capitals, giving seats on the board at CXO level often becomes an important issue for the startup company. If hiring of a CDO is directly linked to fundraising, the importance of design in startups will be further acknowledged and appreciated.
The history of startups is still relatively short. However, the world of startups has been maturing rapidly over the past few years. Especially, as investors, the venture capitals in the U.S. seem to have been changing their system. To be more specific, they shift from the existing style, which emphasizes only on investments, to a new style, which focuses on improving the valuation of startups as well as on investments.
Overseas, especially in the Bay Area, we can see an increase in the number of venture capitals that support startups hands-on, covering widely from design to human resources (HR). I believe that the number of startups focusing on improving their valuation with hands-on support is also increasing in Japan. This trend will continue to be accelerated further.
A startup company receives a fund from a venture capital, which operates on the capital provided by LPs. Just as the startup company undergoes a due diligence (DD) when raising its fund, so does the venture capital when receiving capital from its LPs.
This DD includes investigation into the track record of the past investments. LPs have their own policies, and the trend is that the venture capitals make investments based on the LPs’ policies. So, if a startup company pays attention not only to “which venture capital should we receive money from” but also to “which LPs provide capital to which venture capital”, then the startup company may be able to receive funds from a venture capital seeking for the similar aim or goal as their own.
In view of such points, the stance or perspectives LPs and venture capitals have on design will affect their future investments. If a venture capital is highly aware of design, then the venture capital may give thought to include a fair amount of design related budget, including budget for cooperation with a design office.
In addition, if the LPs are highly aware of “value of design” as an element that leads the startup to its success, then the awareness about design by the venture capital as well as the startup company invested by the venture capital will also be raised.
In this article, we have talked about the features of startups, investment trends, and relationships between fundraising and design. In the chapters to follow, we will discuss what effects and efficacy design can bring to startups with such features.
Written by Masafumi Asakura, Final Aim
October 7th, 2021