Victors few, spoils substantial

This year 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 start-ups can now be considered “unicorns,” the nickname given to start-ups that attain an enterprise valuation of more than $1 billion.

Companies like Uber and Snapchat are considered “deca-corns,” with valuations well north of $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 $2.5 billion following a recent injection of $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 is VC, an inherently complex and risky endeavor, a realistic answer 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 VC typically benefits only a select number of investors and companies.

Because of the high costs, illiquidity and uncertain timing associated with VC investments, investors in VC funds demand a premium above the returns available on public equities, usually between 2 and 5 percent; thus, VCs are seeking particular types of investments which are potential “home runs” for the fund (defined as investments which yield six to seven times the amount invested by the VC). But venture investment is very risky. Most funds are likely to write off at least a third of the amount invested in failed companies, while perhaps 25 percent of invested capital will move “sideways” (roughly break even). This means that the remaining half of the average portfolio must generate a 6X (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 (a fund with any chance of raising money in the future). To achieve these lofty goals, VCs must only pursue investments with the potential to yield 6X.

In which industries can potential investments yield returns like these? 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. Successful entrepreneurs in these select 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 one million users in 2004, but grew 1,000 percent to more than one billion users within a decade. With very little capital expenditure 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 return potential in technology investment has some critical limitations. While the growth of traditional industry companies has historically meant growth in direct and indirect (suppliers, lenders, etc.) employment, the residual benefits of tech company growth have been far more limited. Despite a market capitalization of $200 billion, Facebook currently has only about 4,000 employees, about the same as Twitter (market cap: $24 billion). In contrast, General Motors, with a market capitalization of $57 billion, has an excess of 200,000 employees.

Given this troubling (and widening) disconnect between shareholder wealth and employment growth, 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, accruing to ordinary workers has grown proportionately smaller with each global economic recovery since the early 1990s. If policymakers in the U.S., Europe and Japan have failed to diagnose the causes of, let alone the remedy for, this established trend, we would be overly optimistic to expect a different outcome in Korea.

*The author is a senior foreign legal consultant at one of Korea’s largest law firms and a principal equity investor.

by Patrick Monaghan