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To the (Few) Victors Go the Spoils
Venture Capital
To the (Few) Victors Go the Spoils
  • By matthew
  • May 8, 2015, 09:30
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2015 has more in common with the late 1990s than just a Star Wars franchise re-launch and a Clinton on the campaign trail. In the world of global high-tech these days, they are partying like it’s 1999, a year in which “dot com” mania reached a fever pitch in Silicon Valley.  According to a recent article in Forbes, more than 80 tech startups can now be considered “unicorns,” the nickname given to startups which attain an enterprise valuation of greater than US$1 billion.  Companies like Uber and Snapchat are considered “deca-corns,” with valuations well north of US$10 billion. Korean entrepreneurs and their venture capital (VC) partners have enjoyed a recent run of great success as well. Coupang, Korea’s largest online retailer, has a post-money valuation of over US$2.5 billion following a recent injection of US$300 million by its VC investors. Other VC-backed companies doing well locally include Yello Mobile and 4:33 Creative Lab.

The rapid growth of these companies, fueled by the tremendous flow of intellectual and financial capital, has not gone unnoticed by the Korean government. At last month’s Seoul Financial Forum, participants touted the potential of a new government program creating an entrepreneurial hub to rival California’s Silicon Valley and seeking to attract large amounts of foreign venture capital. But are Vcs, inherently complex and risky endeavors, realistic answers to Korea’s current structural growth woes? To answer this question, one must understand the structure of a VC firm, the goals of VC investors, and the experience of technology investment abroad. The results of this review suggest that a VC typically benefits only a select number of investors and companies.

Because of the high costs, non-liquidity and uncertain timing associated with VC investments, LPs demand a premium above the returns available on public equities, usually between 2 and 5 percent. Thus, GPs are seeking particular types of investments that are potential “home runs” for the fund. These are defined as investments which yield six to seven times the amount invested by the VC. But investment is very risky.  Most funds are likely to write off at least a third of the amount invested completely in failed companies, while perhaps 25 percent of invested capital will move “sideways,” meaning roughly break even. This means that the remaining half of the average portfolio must generate a six times invested capital return for the entire fund to return about 3X, which is a standard benchmark for a fund to be considered a success and to have any chance of raising money in the future. To achieve these lofty goals, a VC must only pursue investments with the potential to yield 6 times.

Which industries can yield potential investment returns like this? The list is short. Typically, software, storage, social media, e-commerce, and biotech, among others, comprise a large number of companies with high potential investment returns. This is because successful entrepreneurs in these industries can develop disruptive products and applications quickly, develop a defensible “moat” to protect the product’s market either through patents or branding, and then scale them to serve consumers everywhere. Facebook is a great example of the power of the scaling phenomenon.  The company’s social networking site only reached 1 million users in 2004, but grew 1,000 percent to over 1 billion users within a decade. With very little capital expenditures and no debt required in the interim in order to achieve this tremendous growth, Facebook’s founders and early (VC) investors enjoyed staggeringly high returns.

But the fantastic, low capital-intensity return potential in technology investment has some critical limitations for government policymakers. While the growth of traditional industry companies has historically meant growth in direct and indirect employment, the residual benefits of tech company growth have been far more limited. Despite a market capitalization of US$200 billion, Facebook currently has only about 4,000 employees.  In contrast, General Motors, with a market capitalization of $57 billion, has over 200,000 employees. Given this troubling disparity, the Korean government should guard against irrational exuberance when considering the potential of venture capital and technology to grow jobs and generate wealth effects for the broader national economy. The primary winners in technology’s growth worldwide have been entrepreneurs and shareholders, particularly early-stage investors like VCs and angels. More alarmingly, the share of productivity gains, usually viewed as the fruits of the investment cycle, that have accrued to ordinary workers has grown proportionately smaller with each global economy recovery since the early 1990s. If policymakers in the U.S., Europe, and Japan have failed to diagnose the causes of, let alone the remedies for, this established trend, it would be wildly optimistic to expect a different outcome in Korea.  

Patrich Monaghan is a senior foreign legal consultant at one of Korea’s largest law firms, and a principal equity investor. His practice includes cross-border private equity, venture capital, and technology.  He can be reached at patrickjmonaghan3@gmail.com.