Venture

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					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.
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.
    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
(‘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.