The market for innovation in the United States and Japan: Venture capital and the comparative corporate governance debate

Northwestern University Law Review

Volumn 91, Issue 3, 1997, Pages 865-897

  Milhaupt, Curtis J ^a  

^a WASHINGTON UNIVERSITY   (United States)

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EID: 0041053079     PISSN: 00293571     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (178)

1. Marcus Licinius Crassus, reputedly the richest man in Rome, financed a private fire department for the city, which lacked public fire protection. His fire fighters would assess the value of a burning structure and adjoining buildings. If they deemed the structures worthy of their attention, they would make an offer to buy them. If the offer was accepted, they would close the deal and extinguish the fire. If refused, they would move on to other business opportunities, leaving the owner with the charred remains. JACK S. LEVIN, STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY, AND ENTREPRENEURIAL TRANSACTIONS 24 (1994).
2. WILLIAM D. BYGRAVE & JEFFRY A. TIMMONS, VENTURE CAPITAL AT THE CROSSROADS 228-40 (1992).
3. Widely accepted perhaps, but not widely studied. Venture capital has been described as the "least understood[] segment of the Nation's capital markets." JOINT ECON. COMM., 98TH CONG., 2D SESS., VENTURE CAPITAL AND INNOVATION 22 (Joint Comm. Print 1984) [hereinafter VENTURE CAPITAL AND INNOVATION]. While the venture capital process has received some scholarly attention from financial and management theorists, see Christopher B. Barry, New Directions in Research on Venture Capital Finance, 23 FIN. MGMT. 3 (1994) (containing a survey of the existing literature), very little work in the academic legal literature is devoted to the topic. The few existing studies include Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737 (1994); George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029 (1992); and Ronald J. Gilson & Bernard S. Black, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (July 14, 1996) (unpublished manuscript, on file with author).
4. Widely accepted perhaps, but not widely studied. Venture capital has been described as the "least understood[] segment of the Nation's capital markets." JOINT ECON. COMM., 98TH CONG., 2D SESS., VENTURE CAPITAL AND INNOVATION 22 (Joint Comm. Print 1984) [hereinafter VENTURE CAPITAL AND INNOVATION]. While the venture capital process has received some scholarly attention from financial and management theorists, see Christopher B. Barry, New Directions in Research on Venture Capital Finance, 23 FIN. MGMT. 3 (1994) (containing a survey of the existing literature), very little work in the academic legal literature is devoted to the topic. The few existing studies include Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737 (1994); George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029 (1992); and Ronald J. Gilson & Bernard S. Black, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (July 14, 1996) (unpublished manuscript, on file with author).
5. Widely accepted perhaps, but not widely studied. Venture capital has been described as the "least understood[] segment of the Nation's capital markets." JOINT ECON. COMM., 98TH CONG., 2D SESS., VENTURE CAPITAL AND INNOVATION 22 (Joint Comm. Print 1984) [hereinafter VENTURE CAPITAL AND INNOVATION]. While the venture capital process has received some scholarly attention from financial and management theorists, see Christopher B. Barry, New Directions in Research on Venture Capital Finance, 23 FIN. MGMT. 3 (1994) (containing a survey of the existing literature), very little work in the academic legal literature is devoted to the topic. The few existing studies include Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737 (1994); George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029 (1992); and Ronald J. Gilson & Bernard S. Black, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (July 14, 1996) (unpublished manuscript, on file with author).
6. Widely accepted perhaps, but not widely studied. Venture capital has been described as the "least understood[] segment of the Nation's capital markets." JOINT ECON. COMM., 98TH CONG., 2D SESS., VENTURE CAPITAL AND INNOVATION 22 (Joint Comm. Print 1984) [hereinafter VENTURE CAPITAL AND INNOVATION]. While the venture capital process has received some scholarly attention from financial and management theorists, see Christopher B. Barry, New Directions in Research on Venture Capital Finance, 23 FIN. MGMT. 3 (1994) (containing a survey of the existing literature), very little work in the academic legal literature is devoted to the topic. The few existing studies include Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737 (1994); George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029 (1992); and Ronald J. Gilson & Bernard S. Black, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (July 14, 1996) (unpublished manuscript, on file with author).
7. Widely accepted perhaps, but not widely studied. Venture capital has been described as the "least understood[] segment of the Nation's capital markets." JOINT ECON. COMM., 98TH CONG., 2D SESS., VENTURE CAPITAL AND INNOVATION 22 (Joint Comm. Print 1984) [hereinafter VENTURE CAPITAL AND INNOVATION]. While the venture capital process has received some scholarly attention from financial and management theorists, see Christopher B. Barry, New Directions in Research on Venture Capital Finance, 23 FIN. MGMT. 3 (1994) (containing a survey of the existing literature), very little work in the academic legal literature is devoted to the topic. The few existing studies include Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L. REV. 1737 (1994); George W. Dent, Jr., Venture Capital and the Future of Corporate Finance, 70 WASH. U. L.Q. 1029 (1992); and Ronald J. Gilson & Bernard S. Black, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets (July 14, 1996) (unpublished manuscript, on file with author).
8. BENNETT HARRISON, LEAN AND MEAN: THE CHANGING LANDSCAPE OF CORPORATE POWER IN THE AGE OF FLEXIBILITY 220 (1994).
9. Ronald J. Gilson, Corporate Governance and Economic Efficiency: When Do Institutions Matter?, 74 WASH. U. L.Q. 327, 337 (1996).
10. VENTURE CAPITAL AND INNOVATION, supra note 3, at 22.
11. JOSEPH W. BARTLETT, VENTURE CAPITAL: LAW, BUSINESS STRATEGIES, AND INVESTMENT PLANNING 12 (1988). Another recent study concludes that "[i]nnovative entrepreneurship is America's best chance of realizing a national competitive advantage in the twenty-first century. . . . [V]enture capital itself is a vital element of the entrepreneurship equation . . . ." BYGRAVE & TIMMONS, supra note 2, at 285.
12. See, e.g., TSŪ SHŌ SANGYŌ SHŌ [MINISTRY OF INTERNATIONAL TRADE AND INDUSTRY], TSŪ SHŌ HAKU SHO [WHITE PAPER ON TRADE] 197-202 (1995) [hereinafter MITI WHITE PAPER] (discussing the role of risk capital in economic revival and competitiveness); Ryūichi Yamashita, Benchā kigyō ikusei ni kansuru shō hōsaku no gaiyō [Overview of Policies Related to the Development of Venture Enterprises], 1444 KIN'YŪ HŌMU JIJŌ 26, 27 (1996) ("Fifty years after the end of the War, we are searching for the rebirth of the Japanese economy and the possibility of a new Japanese dream. We are looking for the next Sony, the next Honda - a Japanese Microsoft to serve as the dawn of these expectations. . . . For this purpose, . . . it is necessary to prepare an environment for the emergence of venture [business].").
13. See, e.g., TSŪ SHŌ SANGYŌ SHŌ [MINISTRY OF INTERNATIONAL TRADE AND INDUSTRY], TSŪ SHŌ HAKU SHO [WHITE PAPER ON TRADE] 197-202 (1995) [hereinafter MITI WHITE PAPER] (discussing the role of risk capital in economic revival and competitiveness); Ryūichi Yamashita, Benchā kigyō ikusei ni kansuru shō hōsaku no gaiyō [Overview of Policies Related to the Development of Venture Enterprises], 1444 KIN'YŪ HŌMU JIJŌ 26, 27 (1996) ("Fifty years after the end of the War, we are searching for the rebirth of the Japanese economy and the possibility of a new Japanese dream. We are looking for the next Sony, the next Honda - a Japanese Microsoft to serve as the dawn of these expectations. . . . For this purpose, . . . it is necessary to prepare an environment for the emergence of venture [business].").
14. See BARTLETT, supra note 7, at 12 (arguing that venture capital is vital to international competitive success).
15. Bernard S. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regulation, 92 MICH. L. REV. 1997, 2001 (1994). The literature in this area is voluminous and growing steadily. One of the major early works is Mark J. Roe, Some Differences in Corporate Structure in Germany, Japan, and the United States, 102 YALE L.J. 1927 (1993).
16. Bernard S. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regulation, 92 MICH. L. REV. 1997, 2001 (1994). The literature in this area is voluminous and growing steadily. One of the major early works is Mark J. Roe, Some Differences in Corporate Structure in Germany, Japan, and the United States, 102 YALE L.J. 1927 (1993).
17. Jonathan R. Macey & Geoffrey P. Miller, Corporate Governance and Commercial Banking: A Comparative Examination of Germany, Japan, and the United States, 48 STAN. L. REV. 73, 74, 81-89 (1995).
18. See, e.g., Roe, supra note 10.
19. These issues are typically subsumed under the nebulous and politically charged rubric of "Industrial Policy."
20. Gilson & Black, supra note 3, at 16-31. Gilson and Black theorize that the potential for entrepreneurs to regain control of their firms when venture capitalists exit in initial public offerings is crucial to the implied incentive contract at the heart of the venture capital process. For further discussion of their theory, see infra text accompanying notes 88-93.
21. The institutional environment is simply the rules of the game - "the set of fundamental political, social and legal ground rules that establishes the basis for production, exchange and distribution." LANCE E. DAVIS & DOUGLAS C. NORTH, INSTITUTIONAL CHANGE AND AMERICAN ECONOMIC GROWTH 6 (1971).
22. There is no standard definition of venture capital even in the U.S. literature, and as will become clear from this Article, attempting a universal definition is highly problematic. In broad terms, venture capital is risky, private investment of monetary and nonmonetary capital in emerging businesses.
23. RICHARD R. NELSON & SIDNEY G. WINTER, AN EVOLUTIONARY THEORY OF ECONOMIC CHANGE 364 (1982).
24. See, e.g., MITSUO MATSUSHTTA, INTERNATIONALTRADE AND COMPETITION LAW IN JAPAN 276-77 (1993) (concluding that "the post-war success of Japanese industry should be attributed primarily to the entrepreneurship of industries rather than the industrial policies of the government"); Ryuhei Wakasugi, Organizational Structure and Behavior in Research and Development, in BUSINESS ENTERPRISE IN JAPAN: VIEWS OF LEADING JAPANESE ECONOMISTS 159, 175-76 (Kenichi Imai & Ryutaro Komiya eds., 1994) (challenging the claim that the distinctive features of Japanese R&D can be completely explained by technology followership and a social system that supports such followership).
25. See, e.g., MITSUO MATSUSHTTA, INTERNATIONALTRADE AND COMPETITION LAW IN JAPAN 276-77 (1993) (concluding that "the post-war success of Japanese industry should be attributed primarily to the entrepreneurship of industries rather than the industrial policies of the government"); Ryuhei Wakasugi, Organizational Structure and Behavior in Research and Development, in BUSINESS ENTERPRISE IN JAPAN: VIEWS OF LEADING JAPANESE ECONOMISTS 159, 175-76 (Kenichi Imai & Ryutaro Komiya eds., 1994) (challenging the claim that the distinctive features of Japanese R&D can be completely explained by technology followership and a social system that supports such followership).
26. See Michael C. Jensen, Eclipse of the Public Corporation, HARV. BUS. REV., Sept.-Oct. 1989, at 61.
27. ADOLF A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932).
28. Anil K. Gupta & Harry J. Sapienza, Impact of Agency Risks and Task Uncertainty on Venture Capitalist-CEO Interaction, 37 ACAD. MGMT. J. 1618, 1619 (1994). There is evidence of institutional investor bias against small businesses caused by such factors as a lack of expertise in small business lending, excessively risk-averse behavior, high portfolio transaction costs, and high information costs. See VENTURE CAPITAL AND INNOVATION, supra note 3, at 42-44 (citing a Joint Economic Committee survey). The Congressional Report states that "the phenomenal growth of the venture capital industry owes much of its success to its ability to fill the capital market gap caused by the apparent unwillingness of large institutional investors to become involved in financing high risk, entrepreneurial companies on the [sic] adequate scale, as determined by market forces." Id. at 43.
29. See BYGRAVE & TIMMONS, supra note 2, at 1-4.
30. Marcia Vickers, Nothing Ventured, Less Gain, N.Y. TIMES, Apr. 21, 1996, at F3 (citing study by Securities Data Company showing that of the companies that have gone public since 1986, offerings backed by venture capital rose an average of 135.1%, while others gained an average of 32.5%). The superior stock performance of venture capital-backed firms could also reflect reputational effects and the success of the "screening" function performed by venture capitalists in deciding which firms to support.
31. See BYGRAVE & TIMMONS, supra note 2, at 95-123 (explaining venture capital's role in fostering the semiconductor, computer, and biotechnology industries).
32. See W. BRIAN ARTHUR, INCREASING RETURNS AND PATH DEPENDENCE IN THE ECONOMY 116-18 (1994).
33. A network externality is the benefit that accrues from conforming behavior to widely followed patterns of conduct. It is the mechanism by which some areas of the economy experience increasing, rather than decreasing marginal returns. The compact disc player in the late 1980s provides a good example of the phenomenon. Each person that purchased a compact disc player provided a benefit to every other purchaser by increasing the market for compact discs, thus increasing the incentive for compact disc manufacturers to produce musical recordings in that format. This "increasing marginal returns" school of economics is associated with noted Stanford economist Brian Arthur, who advanced the concept as an alternative to the traditional neoclassical economic perspective. See id. at 1-31. In the corporate law context, Michael Klausner has shown how the network externalities associated with corporate contracts call into question the conventional notion that economic forces promote the development of optimal corporate contracting. See Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 VA. L. REV. 757 (1995).
34. Douglass North and Arthur Denzau have shown how cognitive and heuristic limitations can pose obstacles to change that have the same effects as the economic obstacles that Brian Arthur identified. See Arthur T. Denzau & Douglass C. North, Shared Mental Models: Ideologies and Institutions, 47 KYKLOS 3 (1994). For an application of the North-Denzau analysis to the general problem of legal change, see generally Lynn M. LoPucki, Legal Culture, Legal Strategy, and the Law in Lawyer's Heads, 90 NW. U. L. REV. 1498 (1996).
35. Douglass North and Arthur Denzau have shown how cognitive and heuristic limitations can pose obstacles to change that have the same effects as the economic obstacles that Brian Arthur identified. See Arthur T. Denzau & Douglass C. North, Shared Mental Models: Ideologies and Institutions, 47 KYKLOS 3 (1994). For an application of the North-Denzau analysis to the general problem of legal change, see generally Lynn M. LoPucki, Legal Culture, Legal Strategy, and the Law in Lawyer's Heads, 90 NW. U. L. REV. 1498 (1996).
36. The seminal work is Mark J. Roe, A Political Theory of American Corporate Finance, 91 COLUM. L. REV. 10 (1991).
37. See, e.g., Erik Berglof, Capital Structure as a Mechanism of Control: A Comparison of Financial Systems, in THE FIRM AS A NEXUS OF TREATIES 237 (Masahiko Aoki et al. eds., 1990).
38. Id. at 244.
39. For an extensive analysis of the role of banks in Japanese corporate practices, see THE JAPANESE MAIN BANK SYSTEM (Masahiko Aoki & Hugh Patrick eds., 1994). The stylized account in the text no doubt highlights the centrality of bank monitoring at the expense of countless other forces that also shape Japanese corporate governance. In fact, not all scholars would even agree on the centrality of bank monitoring to Japanese corporate governance. See YOSHIRO MIWA, FIRMS AND INDUSTRIAL ORGANIZATION IN JAPAN 100-22 (1996).
40. For an extensive analysis of the role of banks in Japanese corporate practices, see THE JAPANESE MAIN BANK SYSTEM (Masahiko Aoki & Hugh Patrick eds., 1994). The stylized account in the text no doubt highlights the centrality of bank monitoring at the expense of countless other forces that also shape Japanese corporate governance. In fact, not all scholars would even agree on the centrality of bank monitoring to Japanese corporate governance. See YOSHIRO MIWA, FIRMS AND INDUSTRIAL ORGANIZATION IN JAPAN 100-22 (1996).
41. For an extensive analysis of these relationships, see Curtis J. Milhaupt, A Relational Theory of Japanese Corporate Governance: Contract, Culture, and the Rule of Law, 37 HARV. INT'L L.J. 3 (1996).
42. See, e.g., WILLIAM A. KLEIN & JOHN C. COFFEE, JR., BUSINESS ORGANIZATION AND FINANCE 43, 170-76 (6th ed., 1996) (stating that the literature of economics, management, and investment tends to focus on incentive and self-dealing problems in joint economic activity).
43. See, e.g., John C. Coffee, Jr. Liquidity Versus Control: The Institutional Investor as Corporate Monitor, 91 COLUM. L. REV. 1277, 1290 (1991) (contrasting corporate monitoring in "the internal capital markets in Japan and Germany and the more developed external capital market in the United States"); Roe, supra note 10.
44. Gilson, supra note 5, at 336-39.
45. DOUGLAS C. NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE 80-82 (1990).
46. Id. at 80.
47. In the parlance of evolutionary economic theory, a "search" is a routine-guided, routine-changing process (such as R&D) that plays the role of mutation in biological evolutionary theory. The concept of a "search as being partly determined by routines of the firm parallels the treatment in biological theory of mutation as being determined in part by the genetic makeup of the organism." NELSON & WINTER, supra note 17, at 18.
48. Id. at 402. Nelson and Winter argue that "flexibility, experimentation, and ability to change direction as a result of what is learned are placed high on the list of desiderata for proposed institutional regimes." Id. at 394.
49. NORTH, supra note 36, at 81.
50. Gilson, supra note 5, at 334-45.
51. Innovation, of course, also can occur within large firms. In Japan, for example, innovation typically takes place within the boundaries of large, well-established firms and is funded by banks. I argue in Part III infra that this type of "in-house" innovation, however, is likely to be tied to existing industries, markets, and corporate cultures, diminishing its contribution to adaptive efficiency.
52. For data on Germany, see Gilson & Black, supra note 3, at 6-8.
53. Yūji Tanahashi, Benchā bijinesu no shinkō to benchā kyapitaru no yakuwari [Promoting Venture Businesses and the Role of Venture Capital], 1072 JURISUTO 64, 71 tbl. 2 (1995). Yen amounts have been converted to dollars at a rate of $1 = ¥100 for the convenience of the reader.
54. Table 1 is not weighted for the size differential between the economies of the United States and Japan. At an exchange rate of $1 = ¥100, Japanese GDP is approximately 75% of U.S. GDP. See INTERNATIONAL MONETARY FUND, INTERNATIONAL FINANCIAL STATISTICS 354, 638 (Oct. 1996) (showing GDP for Japan and the United States at 1990 prices).
55. William A. Sahlman, Insights from the Venture Capital Model of Project Governance, 29 BUS. ECON. 35, 35 (1994) (emphasis added).
56. See, e.g., Joshua Lerner, Venture Capitalists and the Oversight of Private Firms, 50 J. FIN. 301, 310 n.2 (1995).
57. Christopher B. Barry et al., The Role of Venture Capital in the Creation of Public Companies, 27 J. FIN. ECON. 447, 448 (1990).
58. Id.; Sahlman, supra note 46, at 35.
59. Barry et al., supra note 48, at 448.
60. PAUL GOMPERS & JOSH LERNER, THE USE OF COVENANTS: AN EMPIRICAL ANALYSIS OF VENTURE PARTNERSHIP AGREEMENTS 3 (Harvard Business School Working Paper No. 95-047, Jan. 1995).
61. See generally Sahlman, supra note 46.
62. Id. at 36.
63. Independent private partnerships constituted 81% of the total venture pool in 1993. VENTURE ECONOMICS, VENTURE CAPITAL YEARBOOK 9 (1994) [hereinafter 1994 VENTURE CAPITAL YEARBOOK].
64. See VENTURE ECONOMICS, VENTURE CAPITAL YEARBOOK 35 (1996).
65. See id.
66. Approximately 250,000 individuals invest $10 billion annually in 30,000 ventures in the United States. Regina Fazio Maruca, Venture Capital: The Invisible Angels, HARV. BUS. REV., July-Aug. 1993, at 8 (citing study by the Center for Venture Research).
67. MITI WHITE PAPER, supra note 8, at 199. Roughly comparable data collected by a U.S. trade organization can be found in 1994 VENTURE CAPITAL YEARBOOK, supra note 54, at 53.
68. MITI WHITE PAPER, supra note 8, at 199. See also 1994 VENTURE CAPITAL YEARBOOK, supra note 54, at 53 for roughly comparable data.
69. Tanahashi, supra note 44, at 67 tbl. 4. Of the 121 venture capital firms in Japan, 22 are affiliates of major banks, 15 are affiliated with securities firms, 40 are affiliated with regional banks, 10 are affiliated with insurance companies, 4 are foreign owned, and 30 are classified as "other." Id.
70. Kazunori Ozaki, Benchā kyapitaru no kinō to yakuwari [The Function and Role of Venture Capital], 110 SHIHON SHIJŌ 21, 24 (1994).
71. See infra note 118 and accompanying text.
72. Kazuyuki Funahashi, Benchā kyapitaru no jittai chōsa [Venture Capital Survey], 1410 SHŌJI HŌMU 2, 6 fig. 4 (1995).
73. Ozaki, supra note 61, at 29. For the reasons why pension funds do not make venture capital investments, see infra note 83.
74. Yamashita, supra note 8, at 30-31.
75. Funahashi, supra note 63, at 4.
76. Id.
77. Control stock ratio is the ratio of the value of "controlled company" stock owned by the venture capital firm to the firm's total assets. Id. A portfolio company is deemed to be "controlled" by a venture capital firm if the venture captial firm owns (a) 50% or more of the portfolio company's outstanding stock or (b) 10-50% of the outstanding stock and otherwise exercises control over the portfolio firm. Kōsei torihiki iinkai [Fair Trade Commission], Benchā kyapitaru ni taisuru dokusen kinshi hō dai ku jō no kitei no un'yō ni tsuite no kangaekata [Thoughts on Enforcement of the Venture Capital Guidelines under Article 9 of the Anti-Monopoly Law], reprinted in 527 KŌSEI TORIHIKI 24 (1994) [hereinafter FTC Guidelines].
78. Funahashi, supra note 63, at 4. While no directly comparable data are available for the United States, U.S. venture capitalists maintain concentrated equity positions in and substantial practical control over their portfolio companies. See supra notes 46-51 and accompanying text.
79. Funahashi, supra note 63, at 5 tbl.2.
80. MITI WHITE PAPER, supra note 8, at 199. Later stage financing accounts for 21%; 63% is classified as "other." Id.
81. Funahashi, supra note 63, at 4.
82. Tanahashi, supra note 44, at 68.
83. Funahashi, supra note 63, at 5 fig.2.
84. NORTH, supra note 36, at 100.
85. See id. North employs the term "entrepreneur" to mean any agent of change within an economic or social structure, a broader use of the term than the standard usage adopted in this Article.
86. Barry, supra note 3, at 13.
87. See supra notes 54-55 and accompanying text.
88. See, e.g., John D. Lutsi, Pensions Turn to Long-Haul Venture Capital Funds to Raise Returns, 16 CORP. CASHFLOW MAG., Dec. 1995, at 36; Venture Capital: Something Gained, ECONOMIST, Oct. 29, 1994, at 91.
89. See, e.g., John D. Lutsi, Pensions Turn to Long-Haul Venture Capital Funds to Raise Returns, 16 CORP. CASHFLOW MAG., Dec. 1995, at 36; Venture Capital: Something Gained, ECONOMIST, Oct. 29, 1994, at 91.
90. Joshua Lerner, Venture Capitalists and the Decision to Go Public, 35 J. FIN. ECON. 293, 295 (1994).
91. Pub. L. No. 93-406, 88 Stat. 829 (codified as amended at 29 U.S.C. §§ 1001-1461, and in scattered sections of 5, 18, 26, 31, and 42 U.S.C.).
92. Under the Department of Labor's "Plan Asset Regulation," promulgated under ERISA, investment entities are subjected to substantial regulatory burdens if their assets are treated as "plan assets" of employee benefit plans that invest in the entity. However, a specific exemption is provided for the assets of a "venture capital operating company" (VCOC). In order to qualify as a VCOC, the company must, on an annual basis, (a) have at least 50% of its assets invested in venture capital investments in which the VCOC retains "management rights" (defined as contractual rights which entitle the VCOC to substantially participate in or influence the conduct of the management of the portfolio company), and (b) actually exercise its management rights with respect to at least one such portfolio company in the ordinary course of its business. See 29 C.F.R. § 2510.3-101 (1996).
93. The legal and regulatory environment in Japan effectively bars pension fund participation in the venture capital industry. The exposure of pension funds to unlimited liability under prevailing organizational forms in the venture capital industry, see infra text accompanying notes 112-19, makes this form of investment undesirable from a legal standpoint. Equally important in damming the flow of pension money into venture capital funds are the protective policy goals of Japanese financial regulators. As part of its longstanding policy of segmenting the financial industry into discrete regulatory universes, MOF, which regulates the insurance companies and trust banks that manage pension funds in Japan, does not permit these institutions to invest in venture capital funds. For similar policy reasons, mutual funds are prohibited from investing in the shares of companies that are not publicly held.
94. See Hiroyuki Nishimura & Masato Ishizawa, Industry, Bureaucrats Strive to Turn Venture Capital Puddle into Deep Pool, NIKKEI WEEKLY, Aug. 1, 1994, at 1, available in LEXIS, News Library, Non-U.S. File.
95. See Tanahashi, supra note 44, at 69 tbl.1.
96. Emiko Terazono, Survey of Venture and Development Capital, FIN. TIMES, Sept. 24, 1993, at VII, available in LEXIS, News Library, Non-U.S. File.
97. In Japan, banks have traditionally been the source of financing for high-risk, in-house innovation. See Michael Gerlach, Business Alliances and the Strategy of the Japanese Firm, CAL. MGMT. REV. 126, 139-40 (1987). It might be argued that bank financing of risky, innovative projects fully substitutes for the venture capital market, eliminating the significance of any underdevelopment in the venture capital market in Japan. Such bank financing, however, does not appear to be a close substitute for venture capital because it has been concentrated in the postwar period on large corporate borrowers linked to the lending bank through keiretsu (corporate group) affiliations. This leaves less risk capital for small, entrepreneurial borrowers, and ties the funding of innovation to pre-existing corporate networks and cultures.
98. Gilson & Black, supra note 3, at 14.
99. Id. at 14-15.
100. See VENTURE ECONOMICS, EXITING VENTURE CAPITAL INVESTMENTS 5-6 (1988) (listing six commonly used methods of exiting portfolio companies).
101. Id. at 7.
102. Gilson & Black, supra note 3, at 16-22.
103. Id. at 18.
104. See supra Table 1.
105. There are conflicting data on exactly how much time is required, with figures ranging from 17 years, see Tanahashi, supra note 44, at 71, to 29 years, see Emiko Terazono, Venture Capital Becomes a Scarce Resource, FIN. TIMES, Sept. 30, 1992, at 32, available in LEXIS, News Library, Non-U.S. File.
106. James W. Borton, Venture Firms Eye Japan's Deep Pockets, JAPAN ECON. J., Aug. 12, 1989, at A2, available in LEXIS, News Library, Non-U.S. file.
107. See, e.g., Kazuo Ueda, Institutional and Regulatory Frameworks for the Main Bank System, in THE JAPANESE MAIN BANK SYSTEM, supra note 31, at 89.
108. See Hiroyuki Nishimura, Roadblocks to Going Public Will Ease, NIKKEI WEEKLY, Jan. 9, 1995, at 13, available in LEXIS, News Library, Non-U.S. file; Emiko Terazono, Daring to Go it Alone, FIN. TIMES, June 20, 1995, at 18, available in LEXIS, News Library, Non-U.S. file. A special section of the OTC market was established very recently to allow start-up firms to be listed even if they are operating at a loss.
109. See Hiroyuki Nishimura, Roadblocks to Going Public Will Ease, NIKKEI WEEKLY, Jan. 9, 1995, at 13, available in LEXIS, News Library, Non-U.S. file; Emiko Terazono, Daring to Go it Alone, FIN. TIMES, June 20, 1995, at 18, available in LEXIS, News Library, Non-U.S. file. A special section of the OTC market was established very recently to allow start-up firms to be listed even if they are operating at a loss.
110. See, e.g., BENCHĀ KIGYŌ NO KEIEI TO SHIEN [MANAGEMENT AND SUPPORT OF VENTURE FIRMS] 145-46 (Shūichi Matsuda ed., 1994); Nishimura & Ishizawa, supra note 84.
111. Initially, MOF suspended all IPOs, then limited to between three and five the number of new issues that could go to market in any given week. Nishimura & Ishizawa, supra note 84. These limits were abolished in 1995 in an effort to invigorate the OTC and venture capital markets. Nishimura, supra note 98.
112. For example, one study showed a 33% increase in sales volume of the 20 fastest growing firms on the Japanese OTC market, compared to a 183% increase for the comparable U.S. firms. See Matsuda, supra note 99, at 96.
113. See J. Mark Ramseyer, Takeovers in Japan: Opportunism, Ideology and Corporate Control, 35 UCLA L. REV. 1, 21-49 (1987).
114. See Dan F. Henderson, Foreign Acquisitions and Takeovers in Japan, 39 ST. LOUIS U. L.J. 897, 902-03 (1995). In 1994, there were 1917 mergers and 1153 transfers of business among Japanese companies. KŌSEI TORIMKI IINKAI [FAIR TRADE COMMISSION], KŌSEI TORIHIKI HNKAI NENJl HŌKOKU [FAIR TRADE COMMISSION ANNUAL REPORT] 181 (1994). About half of these were very small acquisitions in which the resulting entity had less than ¥1 billion ($10 million) in assets. Id. at 184-85.
115. See Dan F. Henderson, Foreign Acquisitions and Takeovers in Japan, 39 ST. LOUIS U. L.J. 897, 902-03 (1995). In 1994, there were 1917 mergers and 1153 transfers of business among Japanese companies. KŌSEI TORIMKI IINKAI [FAIR TRADE COMMISSION], KŌSEI TORIHIKI HNKAI NENJl HŌKOKU [FAIR TRADE COMMISSION ANNUAL REPORT] 181 (1994). About half of these were very small acquisitions in which the resulting entity had less than ¥1 billion ($10 million) in assets. Id. at 184-85.
116. See William A. Sahlman, The Structure and Governance of Venture-Capital Organizations, 27 J. FIN. ECON. 473, 489-503 (1990). As partnership investments are harvested, venture capitalists typically receive 20% of the gains, in addition to a management fee. This performance-based compensation scheme provides the primary incentive for the venture capitalist to increase the value of the portfolio firms. Sahlman, supra note 46, at 36.
117. See Dent, supra note 3, at 1044. A small body of literature has begun to develop on the role of lawyers in Silicon Valley. See, e.g., Lawrence M. Friedman et al., Law, Lawyers, and Legal Practice in Silicon Valley: A Preliminary Report, 64 IND. L.J. 555 (1989). The crux of these studies is that in the highly relational context of the American venture capital industry, lawyers perform different functions than elsewhere in corporate America. While I agree with the assertion that lawyers play different roles in highly relational versus arm's length transactions, see Curtis J. Milhaupt, Shōji torihiki ni okeru bengoshi no yakuwari: Nichibei no hikaku bunseki [The Lawyer's Role in Business Transactions: Japan and the United States in Comparative Perspective], 96-2 AMERIKAHŌ 266 (1996), it is important to recognize that the American venture capital industry is facilitated in large part by sophisticated contractual mechanisms, the development of which is the traditional province of American corporate lawyers.
118. See Dent, supra note 3, at 1044. A small body of literature has begun to develop on the role of lawyers in Silicon Valley. See, e.g., Lawrence M. Friedman et al., Law, Lawyers, and Legal Practice in Silicon Valley: A Preliminary Report, 64 IND. L.J. 555 (1989). The crux of these studies is that in the highly relational context of the American venture capital industry, lawyers perform different functions than elsewhere in corporate America. While I agree with the assertion that lawyers play different roles in highly relational versus arm's length transactions, see Curtis J. Milhaupt, Shōji torihiki ni okeru bengoshi no yakuwari: Nichibei no hikaku bunseki [The Lawyer's Role in Business Transactions: Japan and the United States in Comparative Perspective], 96-2 AMERIKAHŌ 266 (1996), it is important to recognize that the American venture capital industry is facilitated in large part by sophisticated contractual mechanisms, the development of which is the traditional province of American corporate lawyers.
119. See Barry, supra note 3, at 3. As Barry notes, The venture capitalists seek out promising ventures, eventually placing money in risky ventures managed by entrepreneurs whose skills are unknown and whose future efforts are not predictable. Such investments are often made in firms that have not yet registered one single dollar of revenues; have no products in existence at the time of investment, only unproven and untested ideas; and do not have a complete, experienced management team. The entrepreneurs have information not possessed by the venture capitalists. Id.
120. For an extensive survey of contractual protections, see Dent, supra note 3, at 1044-61.
121. Sahlman, supra note 104, at 506-14.
122. Id. at 504; ROBERT J. HAFT, VENTURE CAPITAL AND SMALL BUSINESS FINANCINGS § 2B.02, at 13 (1991).
123. HAFT, supra note 109.
124. Sahlman, supra note 46, at 36.
125. See Hideki Kanda, Politics, Formalism, and the Elusive Goal of Investor Protection: Regulation of Structured Investment Funds in Japan, 12 U. PA. J. INT'L BUS. L. 569, 570-71 (1991) (discussing legal attributes and tax treatment of organizational forms in Japan).
126. See Shōhō [Commercial Code], Law No. 48 of 1899, arts. 535-542 (containing provisions for the "undisclosed partnership" [tokumei kumiai]).
127. Shotokuzeihō [Income Tax Law], Law No. 33 of 1965, arts. 210-211; Shotokuzeihō shikōrei [Income Tax Law Enforcement Order], arts. 327, 288.
128. See Shintakuhō [Trust Law], Law No. 62 of 1921, art. 36(3).
129. Shintakugyōhō [Trust Business Law], Law No. 65 of 1922, art. 1.
130. See Kin'yū kikan no shintaku gyōmu no keneitō ni kansuru hōritsu [Law Concerning the Conduct of the Trust Business by Financial Institutions], Law No. 43 of 1943, art. 1.
131. See Minpō [Civil Code], Law No. 89 of 1896, arts. 667-688 (containing provisions for the voluntary partnership under the Civil Code [minpō jō no nin'i kumiai]). As of 1993, about half of all venture capital in Japan was invested through partnerships for investment purposes. Tanahashi, supra note 44, at 68. In that year, there were 155 such partnerships managed by venture capital firms, with over 3000 members. Id.
132. See supra note 83.
133. Ozaki, supra note 61, at 25.
134. Id.
135. See Interview with Kazunori Ozaki, Director, Japan Associated Finance Co., Ltd. (JAFCO), in Tokyo, Japan (July 2, 1996) (transcript on file with author). JAFCO is Japan's largest venture capital firm. Mr. Ozaki, one of Japan's leading authorities on venture capital, has worked with JAFCO in Japan and the United States.
136. Id.
137. See Tanahashi, supra note 44, at 68. Common stock comprises almost 80% of all venture capital equity investments. Id.
138. Id. at tbl. 1.
139. Recall that Japanese venture funds do not take controlling equity stakes in their portfolio firms, nor do venture capital providers play a direct role in the management of portfolio firms. See supra text accompanying notes 66-69.
140. Shiteki dokusen no kinshi oyobi kōsei torihiki no kakuho ni kansuru hōritsu [Law Concerning the Prohibition of Private Monopolies and the Maintenance of Fair Trade], Law No. 54 of 1947, art. 9.
141. Under the guidelines, a complex two-step test is applied to determine if a venture capital fund is a prohibited holding company. The first test determines whether a given portfolio firm is controlled by the venture capital fund. See supra note 68 for the control test. The second test assesses the value of the stock of companies controlled by the venture capital firm in relation to the latter's total assets (the "control stock ratio"). A venture capital firm is a holding company if its control stock ratio is 50% or more. There is a safe harbor for control stock ratios of less than 25%. A control stock ratio of 25% to 50% gives rise to holding company status if the venture capital fund does not engage in any other business activity. FTC Guidelines, supra note 68.
142. JPTC Adopts Antimonopoly Act Guideline Governing Competition and Venture Capital, 67 ANTITRUST & TRADE REG. REP. (BNA), Rep. No. 1679, Sept. 1, 1994, at 290.
143. Commercial Code art. 210.
144. Id., art. 280-82.
145. In 1995, Sony issued bonds with detachable warrants for the purchase of Sony common stock. The ex-warrant bonds were issued to institutional investors. The warrants were issued to Sony managers in connection with an incentive stock option plan. After the successful implementation of this plan by Sony, other Japanese companies adopted similar plans. Waranto wo tsukatta insentibu fuyo [Incentive Grant Using Warrants], 1416 SHŌJI HŌMU 51 (1996).
146. See Kiyoshi Kitagawa, Kaisei shinki jigyōhō no gaiyō [Overview of the Revised New Business Law] (I), 1415 SHŌJI HŌMU 2 (1996).
147. Id. at 3.
148. For example, the president of AT&T recently resigned to join a start-up wireless communications firm. See Business This Week, ECONOMIST, Aug. 24, 1996, at 5.
149. See YOSHITAKA SUZUKI, JAPANESE MANAGEMENT STRUCTURES, 1920-80, at 4 (1991) (discussing Japan's "'internal labour market,' which is accompanied by training within the firm, enterprise specific skill, inside promotion, and long-term employment, [which] appeared long after the emergence of the modern enterprise in the United States").
150. See, e.g., Matsuda, supra note 99, at 258 (reporting that 17.4% of Japanese college students surveyed wanted to work for large firms after graduation and 13% wanted to become high-level public officials; 12.7% of U.S. college students surveyed wanted to work for large firms; none wanted to become public officials). In another survey, 40% of the Japanese engineering graduates polled wanted to obtain a successful career within their existing firm, as compared with just over 20% of the Americans polled. See YOSHINORI TAMURA & KŌICHI HIRATA, TENTŌ TOKOSOKU SHIJŌ TO BENCHĀ KIGYŌ [SPECIAL OTC MARKET AND VENTURE FIRMS] 14 (1995). Other international comparisons confirm the relative immobility inherent in Japanese employment practices. See id. at 15.
151. See Tanahashi, supra note 44, at 66.
152. See TAMURA & HIRATA, supra note 137, at 15. Japanese corporate presidents have worked for their firms for a median 39 years compared to 28 years for U.S. CEOs. Moreover, 68.5% of the time, when a Japanese corporate president leaves his job he becomes chairman of the board of the same company. Steven N. Kaplan & J. Mark Ramseyer, Those Japanese Firms with Their Disdain for Shareholders: Another Fable for the Academy, 74 WASH. U. L.Q. 403, 414 (1996).
153. Kiyonori Sakakibara & D. Eleanor Westney, Comparative Study of the Training, Careers, and Organization of Engineers in the Computer Industry in the United States and Japan, 20 HITOTSUBASHI J. COM. & MGMT. 1, 5 (1985).
154. Id.
155. See Barry, supra note 3 (surveying empirical studies and concluding that venture capitalists take on high risks that appear to be rewarded on average).
156. J. William Petty et al., Harvesting the Entrepreneurial Venture: A Time for Creating Value, 7 J. AP. CORP. FIN. 48, 56 (1994); Sahlman, supra note 46, at 36.
157. VENTURE CAPITAL AND INNOVATION, supra note 3, at 22.
158. Shinichi Kishima, Japan Stock Paralysis Chance for Venture Capital, REUTERS FINANCIAL SERVICE, March 16, 1993, available in LEXIS, News Library, Non-U.S. file.
159. Jonathan R. Macey, Courts and Corporations: A Comment on Coffee, 89 COLUM. L. REV. 1692, 1701 (1989).
160. The link between American institutions and attitudes toward risk in commercial enterprises was recognized long ago. See Stuart Banner, "Everybody Has Gone Joint-Stock Mad!": American Attitudes Toward Securities Trading 1792-1860, at 7 (1996) (unpublished manuscript, on file with author) (explaining that Tocqueville attributed American proclivities toward stock speculation to the form of government, which he thought acclimated citizens to risk).
161. See, e.g., Ken-ichi Imai, Japan's Corporate Networks, in 3 THE POLITICAL ECONOMY OF JAPAN: CULTURAL AND SOCIAL DYNAMICS 198, 208-18 (Shumpei Kumon & Henry Rosovksy eds., 1992); Iwao Nakatani, The Economic Role of Financial Corporate Grouping, in THE ECONOMIC ANALYSIS OF THE JAPANESE FIRM 227 (Masahiko Aoki ed., 1984) (arguing that risk sharing is a major motivation for the formation of Japanese business groups).
162. See, e.g., Ken-ichi Imai, Japan's Corporate Networks, in 3 THE POLITICAL ECONOMY OF JAPAN: CULTURAL AND SOCIAL DYNAMICS 198, 208-18 (Shumpei Kumon & Henry Rosovksy eds., 1992); Iwao Nakatani, The Economic Role of Financial Corporate Grouping, in THE ECONOMIC ANALYSIS OF THE JAPANESE FIRM 227 (Masahiko Aoki ed., 1984) (arguing that risk sharing is a major motivation for the formation of Japanese business groups).
163. Literature on implicit insurance contracting in Japan is voluminous. See, e.g., Nakatani, supra note 148; Paul Sheard, Interlocking Shareholdings and Corporate Governance, in THE JAPANESE FIRM: THE SOURCES OF COMPETITIVE STRENGTH 310 (Masahiko Aoki & Ronald Dore eds., 1994).
164. See David G. Litt et al., Politics, Bureaucracies, and Financial Markets: Bank Entry into Commercial Paper Underwriting in the United States and Japan, 139 U. PA. L. REV. 369, 430-46 (1990) (developing the concept of "preclearance"); Kanda, supra note 112, at 583-85 (discussing the role of "ex ante monitoring" in Japanese financial regulation).
165. See Hideki Kanda, Sonshitsu hoten mondai no honshitsu wa nani ka [What is the Essence of the Loss Compensation Problem?], EKONOMISUTO, Aug. 27, 1991, at 23, 24.
166. Keith W. Schilit, Evaluating the Performance of Venture Capital Investments, 37 BUS. HORIZONS, Sept. 1994, at 70.
167. Kishima, supra note 145. Another report indicates a 5% failure rate for Japanese venture capital-backed firms overall. This is still far lower than the U.S. failure rate. Robert Tomkin, Venture Capital 6: Banks have Entered the Fray with a Fury - Japan, FIN. TIMES, Nov. 26, 1990, at VI, available in LEXIS, News Library, Non-U.S. File.
168. One report indicates that the rate of return on Japanese venture capital funds is generally 40% lower than the rate of return on U.S. funds. Tomkin, supra note 153.
169. Gilson & Black, supra note 3, at 18.
170. Id. at 16-22.
171. See id. at 29-31.
172. The Japanese experience tentatively suggests that an active IPO market is not even a necessary condition for an active venture capital market. The IPO market in Japan's bank-centered system is indeed limited, and this limitation undoubtedly constrains the development of the Japanese venture capital market. See supra notes 94-96 and accompanying text. Yet Japanese venture capitalists rarely take control of their portfolio firms. See supra notes 66-69 and accompanying text. Thus, having never lost control of their firms, Japanese entrepreneurs do not need an IPO market to return control and to provide incentives to accept the contributions of venture capitalists.
173. Not all scholars agree that Japan utilizes alternative mechanisms to discipline corporate managers. See Kaplan & Ramseyer, supra note 139, at 408 (citing comparative econometric data on managerial incentives and turnover to support the assertion that firms cannot escape "the basic logic of product and capital markets").
174. For example, venture capitalists could, for a fee, assist the maturing venture business in forming an alliance with an established keiretsu corporate group. The venture business would then be integrated into the group's cross shareholding network. De facto control would remain with the entrepreneur-managers unless the business experienced financial difficulty, in which case control would pass (perhaps only temporarily) to stronger group members in return for assistance. This pattern essentially mirrors current Japanese business practices in mergers and acquisitions, where banks often serve as the deal makers.
175. NORTH, supra note 36, at 103.
176. For some rough attempts, see BARTLETT, supra note 7, at 11-12 & nn.29-30 and sources cited therein (discussing benefits of venture capital in expanding small firms into large firms, and calculating that if 1% of the small companies in existence today were to reach $25 million in sales, the U.S. economy would double); BYGRAVE & TIMMONS, supra note 2, at 1-4 (citing study showing that from 1985-1989, 235 venture-capital backed firms created 36,000 new jobs, $786 million in export sales, $726 million in R&D expenditures, and $170 million in corporate tax payments).
177. Macey & Miller, supra note 11, at 81-99.
178. Id. at 75.