An engine of growth Tokyo can’t afford to ignore.

By Nicholas Benes

From today’s Wall Street Journal Asia　　Feb. 26, 2009 12:01 am ET

Since Japan’s “bubble” collapsed in 1991, its economy has been kept afloat at an unexciting 1-2% annual growth rate thanks to a combination of 13 stimulus plans and overdependence on U.S. consumption-led growth. But now that the U.S. consumption party has come to an end, the game is up. Japan must develop its own engine of growth, both to compensate for the U.S. slowdown and to allow Tokyo to pay for its earlier stimulus efforts.

For Japan, facing a rapidly aging and declining population, the end of the U.S. consumption binge means that it now needs its own domestic growth drivers just when they are hardest to get. The only way to offset these demographics is to improve economic productivity in Japan, which has been languishing. Clearly, more government spending to build “bridges to nowhere” or freeways to shrinking towns will not increase productivity or long-term growth.

So, as Japan’s government formulates its 14th stimulus plan as a supplementary budget for 2009, here is a suggestion: Instead of spending trillions of yen on additional public works or temporarily propping up the stock market, Japan should use the money to vitalize its high-tech venture capital industry and send a highly visible message to the public that entrepreneurship will be heavily supported. One trillion yen extended as an investment in venture capital — which would not be an unrecoverable expense, but rather an investment — would double the size of total venture capital funding in Japan.

Japan’s technology sector in particular would be fertile territory for such investment. Japan, which is rightfully proud of its state-of-the art applied technology and manufacturing craftsmanship, has millions of scientists, engineers, academics and other would-be entrepreneurs whose full potential is vastly underutilized. Why? Almost all of them — usually, the best of them — work at large, “stable” companies or universities. These institutions typically keep their inventors focused on narrow projects, do not commercialize many of their best ideas, do not allow them to do so elsewhere, do not incentivize them properly, and do not invest enough risk capital.

Entrepreneurs who try their luck outside these monolithic institutions are often unable to find the funding they need. Japan’s startup businesses — the new companies that will create the jobs and tax base of the future — are starved for both capital and talent. There are few “angel” investors or independent venture capital firms with technology specialists that can capably evaluate R&D breakthroughs or new products. Total outstanding money raised by venture capital funds stands at less than 4% of the U.S. level, and annual investments run at less than 8% of U.S. volume on average. The average size per investment (less than $1 million) is less than one-tenth the average size in the U.S. Moreover, most funding is for later-stage companies, instead of seed capital or early-stage.

Why are Japan’s venture capital funds so averse to investing in true startups? Whereas about 80% of U.S. venture capital funding comes from pension funds and independent institutional investors who only care about increasing investment returns, in Japan such investors provide a miniscule proportion of VC money (only about 3% comes from pension funds). Instead, most VC funds are sponsored by bank holding companies, securities firms and insurance firms with an ulterior motive: They prefer to focus on later-stage investments that are already close to doing an initial public offering, because at that point they hope to sell other financial products and services.

As a result, the industry tends to operate in a risk-averse “copycat” mode: No one invests until and unless other funds are also investing, and the amount of each single investment by each fund is small, reducing the incentives for experienced tech-sector investors to provide “hands-on” advice and assistance. Not surprisingly, the 2006 Global Entrepreneurship Monitor survey ranked Tokyo dead last among 29 major cities worldwide in terms of “total entrepreneurship activity.”

Foreign venture capitalists came to Japan during the high-tech bubble years, but many packed up and went home when the down years came. They alone cannot sustain the market. Until the supply of venture capital funding in Japan is large enough for long enough, a critical mass of Japanese young people will not develop the custom or comfort to join startups, which will therefore tend to be both understaffed and underfunded.

The government could use part of any upcoming “supplemental stimulus budget” to reverse these trends. To have the biggest impact free of any perception of bias, a government venture capital superfund would employ an independent advisory committee to select the most sophisticated venture capital fund managers to make the actual investment decisions, and to allocate the money between them with only a few important restrictions. These could include: a) only seed capital or early-stage investments will be allowed; b) no single investment should be less than a certain size (to encourage a breakout from the “copycat” investment style); c) all investments and return performance data will be made public; and d) full financial reporting and planning by a capable chief financial officer will be required of all companies receiving investments. To set an additional example and release large funds to the market, the government should also change the management policy of the Government Pension Investment Fund (worth 93 trillion yen, almost $1 trillion) and related pension funds to allow them to invest in venture businesses or venture capital funds.

The government could also play a larger role in expanding research funding for basic research and commercialization projects, especially at universities. Japan’s research capabilities are world-class, yet government funding of R&D in all Japan is approximately equal to the R&D budget of the U.S. Department of Energy alone. On the tax side, Japan has already made progress by increasing tax breaks for individual “angel” investors and for cooperative projects between industry and universities.

Taken together, these measures would make it undeniably clear, both domestically and to world markets, that Japan will build upon is most precious resource — its scientists and technicians — to address the gaping hole in its economic future. These people already produce the highest number of patent applications per capita of any developed nation. What is now needed is more money that is managed with a free hand and a clear message of commitment. Now is the time to prime this pump. The sooner Japan can fully capitalize on its own ingenuity, the sooner it will be able to overcome the crunch that its economy now faces.

Mr. Benes is president of JTP Corporation, an investment bank in Tokyo specializing in mergers and acquisitions and financings.