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Venture

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  • 1. Venture Introduction The Korean public’s formerly negative attitude toward foreign investment has improved considerably in recent years as senior levels of the Korean government continually stress the importance of foreign investment for Korea’s future. At the same time, there has been a gradual shift away from traditional chaebol-style business models toward other less-traditional ways of doing business. As in other countries, the rapid growth in the numbers of smaller, typically more nimble start-up companies, often high-tech, has helped spur the development of venture capital firms. Recent changes in Korea’s financial laws, including the removal of most restrictions on financial transfers into and out of the country, have encouraged foreign participation in Korea’s venture capital sector. Nonetheless, while South Korea has made considerable progress in fostering a positive environment for venture capital growth, the continued chaebol domination of the Korean economy causes substantial business problems for many venture capital investors. For example, small-and medium Korean companies may be reluctant to deal with foreign firms for fear of jeopardizing a valued chaebol relationship. For smaller firms, obtaining access to credit may be complicated by the privileged relationships the chaebol enjoy with local banks, though regulations limit a bank’s exposure to any single chaebol group to 25% of capital and stipulate that 35% of lending must go to small and medium enterprises. The full development of Korea’s venture capital sector has also been at a disadvantage, as Korea shareholder culture has yet to be fully developed. As a result, venture capital firms take on average about ten years to be listed on the KOSDAQ, challenging the ability of venture capitalists to realize their investment by selling off their shares on the stock market. Yet these challenges notwithstanding, many of Korea’s newer and more innovative companies are increasingly looking to non-traditional sources for financing their growth, thus offering opportunities for venture capital. For the past year and a half, developments in the Korean venture capital sector have tracked those of venture sectors elsewhere in much of the world. Many leading venture companies have been losing substantial money, while many others are almost bankrupt. This is reflected in the KOSDAQ’s Venture Index, which had spiked eightfold to its peak in March of 2000, but fell about 85 percent by October 2001. The Softbank Research Company indicated in a November report that Korea’s venture capitalists have sharply reduced their investment in new, start-up companies this year, highlighting the sharp decline in investor interest in the high-tech industry. This reduction in investor interest is depicted in the estimated 60-70 percent fall in venture funding during the first nine months of 2001, on a year-on-year January-September basis. However, although investor interest enthusiasm for high-tech industries and related investment remains weak, there have been some bright spots, most notably the local film industry, which has seen a spurt in venture capital investing this year. Over the next couple of years, it is expected that investment in entertainment and biotechnology will steadily increase, while mobile telecom, components, security and the education sectors also should do fairly well.
  • 2. Recognizing the importance of the venture sector to the country’s future, the Korean government has recently begun to minimize administrative regulations, which had been hampering the ability of venture companies to taking full advantage of their inherent creativity and technological strengths. Changes in its legal code governing business law, including an ‘Act on Special Measure for Promotion of Venture Business’ were implemented to assist venture companies in such areas as start-up production, financing, manpower, technology and plant sites, and additional steps are currently under development. However, some changes remains to be undertake, as detailed in this chapter, which describes Korea’s venture capital (‘VC’) industry and practices employed therein. This section also outlines the current structural strengths as well as outlines structural problems regarding venture capital in Korea, and offers potential suggestions for improving Korea’s venture capital environment. Click this link to see chart on VCs and Assets Deployed to VC Investing Note: (1) Figures in chart are revised numbers for Assets Under Management defined as equity capital of VCs and their fund partnerships under management. Source: Korea Venture Capital Association (2001) www.kvca.or.kr General Overview and Practices of Korean Venture Capital • Creation and Classification of VC firms as Non-Bank Financial Institutions with Loose Definition of Investment Scope Korean VC firms are licensed entities with the primary licensing criteria of KRW 10 billion in paid-in-capital. As of June 2001, there were 146 licensed VC firms in Korea. The companies are considered and classified legally as Non-Bank Financial Institutions and are allowed to perform various financial activities aside from equity (or equity-linked) investments in start-up enterprises. Korean VCs are allowed to make loans to their portfolio companies, make investments in other asset classes aside from private equity investments in start-ups (such as listed company investments) and are solely viewed as providers of capital, not partners who are heavily involved in assisting entrepreneurs build their businesses. • Korean VC Firms are Structured as Corporations Given the paid-in-capital requirement, Korean VC firms are registered as corporations with their own balance sheet and shareholders. Some are even listed entities. The VC firms themselves are allowed to borrow against their capital base and operate with considerable operating leverage. While debt levels vary, many VC firms are highly leveraged, with debt/equity levels of on average 150%. Thus, Korean VCs have two forms of capital to invest: (i) their own leveraged capital base and (ii) funds raised via limited partnerships. As of May 2000, of 111 VCs in Korea, only 54 were managing funds. The remaining was investing via their own leveraged capital base. Of the approximately KRW 1.8 trillion (US$ 1.5 billion) invested by Korean VCs as of May 2000, over two-thirds of such funds were sourced from VC’s own leveraged capital base.
  • 3. • Funding Assistance from Government The Korean Government, in an effort to promote the VC industry as well as new business creations and an entrepreneurial culture in Korea, provides significant financial assistance by investing as a limited partner in partnerships raised by Korean VCs. The VCs are to contribute their own capital to a fund and the Korean Government will also contribute to the fund after considering their track records and credibility. The amount that the Korean Government contributes can vary significantly. The remaining funds are raised by the VCs from both high net-worth individuals and institutional investors. The funds operate via an annual management fee and ‘investment profit-sharing’ through ‘carried interest’ - as in the US. The average life of a fund is typically three to five years (some with an option to extend to seven years) and funds have an immediate drawdown feature (all of the capital raised is collected at the launch of the fund). Capital not used in VC investing is put in a money-market account. There is also regulation governing the proportion of funds, which must be invested in Korean technology companies over the life of the fund. For example, approximately 30% of the funds should be invested in a Korean venture company by the second anniversary of the fund, etc. Recommendations • Limit Corporate Charters of VCs - in Particular their Ability to Borrow Allowing VCs, as corporations, to borrow against their capital, and in turn, invest in what are inherently high-risk investments, creates a structure that is highly vulnerable. Venture capital, by definition, is risky business. The success rates in the companies in which VCs invest are low and very binary. In other words, investments that pay off can be big, but those that do not are often completely written off. To be able to leverage the capital used to make such investments can leave investors highly vulnerable particularly in an investment down cycle, which inevitably exists in VC investing. In the United States, where funds raised under limited partnerships by VCs are the only source of capital used to make investments, the limited partners, given the risk of this investment asset class, often prohibit the use of leverage in making investments. A similar level of prudence and discipline should be applied to Korean VCs in limiting their ability to borrow against their capital. Korean VCs may be restricted to earning their money by investing in the right companies only, not by enhancing returns through financial leveraging. • Limit VC Investing Activity to VC Investing Korean VCs should be restricted from making investments in forms other than equity and equity-linked into promising venture companies. While it sounds obvious, a VC should be restricted to doing only VC investing. VCs should not be allowed to make investments in listed companies and should not serve as a ‘bank’, leasing or loaning to other enterprises. A VC is not a Non-Bank Financial Institution. However, venture capital is more than simply providing money to start-up enterprises. A start-up enterprise, given its inherent small size and lack of resources, needs assistance and guidance on a number of non-financial matters. A VC is a partner in the enterprise and needs to provide its portfolio venture companies
  • 4. (‘venture companies’ being loosely defined as small, unlisted, hi-tech companies) with a host of strategic services for the portfolio company to grow and build its business. A VC needs to get active and provide its portfolio companies with strategic advice, help the management team implement its business plan, help build the management team with recruiting assistance, connect them with global strategic partners, and the like. A VC’s efforts should be narrowly focused on this area - not on non-venture-related investment activities. • Continue Government Assistance to VC’s Fundraising Activities The current structure of demanding that the VC contribute its own capital to a fund that it raises and providing government assistance is positive in the development of Korea’s VC industry and Korea’s entrepreneurial start-up culture. VC’s own capital contribution properly aligns incentives of the VCs with those of the limited partners in the fund. Government assistance helps promote private and institutional investors to contribute to the fund partnership. Such incentives are particularly important in Korea as the VC industry, while it traces its origins back to 1974, is essentially a new industry that became significant and recognized only two to three years ago. Moreover, there is a significant need - economically, politically and socially - for Korea to rely less heavily on a large, interlinked chaebol business model, and more on a more independent, entrepreneurial small and medium sized business model. Channeling government sponsorship via investments in limited partnerships is beneficial. While venture capital and start-ups are receiving a great deal of attention in Korea, it is important to note that a total of only KRW 1.8 trillion (US$1.5 billion) has been invested or lent to Korea’s start-up enterprises as of May 2000. This amount is relatively insignificant when compared to Korea’s GDP and its level of industrial activity, or when compared to the amount of funds supported by the Korean government in distressed assets and banking institutions, or when compared to the amount of capital the chaebol are able to access. Continued public support is necessary to promote this industry in Korea.

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