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VENTURE Introduction The purpose of this section is to 1. present a general overview of Korea's venture capital ("VC") industry and practices employed therein; 2. outline the current structural strengths as well as outline structural problems in Korea's venture capital; and, 3. present potential suggestions for improving Korea's venture capital environment. General Overview and Practices of Korean Venture Capital Explosive Growth in VCs and Assets Deployed to VC Investing (in 2000 1997 1998 1999 US$ million) Oct Number of Venture 56 68 94 147 Capital Firms Assets Under 1,430 1,592 2,053 2,708 M anagement (1) Note: (1) Assets Under Management defined as equity capital of VCs and their fund partnerships under management. Source: Korea Venture Capital Association 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 Won 10 billion in paid-in-capital. As of October, 2000, there were 147 licensed VC firms in Korea. The companies are considered and classified legally as a 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, allowed to 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 get 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 M ay 2000, of 111 VCs in Korea, only 54 were managing funds. The remaining were investing via their own leveraged capital base. Of the approximately Won 1.8 trillion (US$ 1.5 billion) invested by Korean VCs as of M ay 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 promote 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 a fter 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 draw -down 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 fu nd, 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 VCs invest in is low and very binary. In other words, investments that pay off can be big, but those that do not are often completely written off. T o be able to leverage the capital used to make such investments can leave investors highly vulnerable particularly in an investment downcycle 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 riskiness 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 should 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 needs to 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. M oreover, there is a strong need - economically, politically and socially - for Korea to rely less 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 a ttention in Korea, it is important to note that a total of only Won 1.8 trillion (US $1.5 billion) has been invested or lent to Korea's start -up enterprises as of M ay 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 y ou compare it to the amount of capital the chaebol are able to access. Continued public support is necessary to promote this industry in Korea.