Learning From the French Revolution In Startups
Amending Kishida’s Tax Incentive
Source: OECD Dataset: Venture capital investments at https://stats.oecd.org/Index.aspx#
All too often, even well-intended reforms in Japan that look good on paper end up not changing things very much. A perfect example of this problem is Prime Minister Fumio Kishida’s new tax incentive for investments in startup companies. It is the only substantial measure in his proclaimed drive to recreate the entrepreneurship drive that characterized the post-WWII high-growth era. If the devil is in the details, the problematic detail in this case is that using that tax break requires retail investors to take on inordinate risks by having to send their money to individual companies rather than professionally-managed angel funds that have a diversified portfolio of startups (Angels invest in smaller and younger firms than Venture Capital funds). Few ordinary investors will do that; nor should they.
Figures from American angel funds show why. While the average angel fund got back a terrific 2.6 times its initial investment in just 3.5 years, it lost money on half of the startups in which it invested. The other half earned enough to produce outsized overall returns. If experts lose money in half the cases, then requiring Japanese laymen to pick and choose a firm is ill-advised. The real tragedy is that Tokyo could have copied the very successful French plan which offered a hefty tax incentive to invest in angel funds. Just like investing in a mutual fund in the stock market, this reduces the risk.
Worse yet, it’s not easy for ordinary investors to place their money in a fund due to restrictions in Japan’s Venture Capital law (professional angels in Japan are legally structured as Venture Capital firms). No more than 49 investors can invest in any single fund. Moreover, in an effort to protect ordinary people, these investors are limited to corporations, institutional investors, or individuals with at least ¥100 million ($750,000) already invested in securities like stocks and bonds. This limitation is the main constraint on generating more angel funds because, in order for funds to spend the necessary money on investigating firms in which to invest, they need enough investors paying fees to support those costs. So far, officials have been reluctant to change the rules. Many countries have “qualified investor” rules, but, as France and the UK have shown, it is possible to make adjustments that allow the middle class to invest in angel funds while still protecting them from excess risk.
Fortunately, there is still time for Tokyo to correct these design flaws before legislation is written. Unfortunately, that’s not likely. Perhaps, if policymakers find the program attracting few investors, they will remedy the problem down the road.
Kishida’s Proposal
Tokyo wants to increase annual investment in high-growth startups more than tenfold to ¥10 trillion ($80 billion) per year in order to launch 100,000 startups. It’s a worthy goal. Countries need dynamic, innovative startups to help drive overall growth. However, without improvement in the tax plan and the addition of some other indispensable steps, Japan is not likely to come close to its goal.
Under the current proposal, retail investors who sell up to ¥2 billion ($14 million) worth of stock in either a listed or unlisted company will not have to pay the 20% capital gains tax as long as they reinvest their profits in a qualified startup under five years old. The criteria for a qualified firm still need to be fleshed out.
Kishida’s proposal was modeled after an American program called the Qualified Small Business Stock (QSBS) program. However, that is the wrong model for Japan. For one thing, the investors in QSBS are not just amateurs but also private equity firms, venture capital funds, and professional angels. More importantly, the American business culture and institutional setup are very different from Japan’s.
The French Revolution in Startups
A better model for Japan is France’s tax incentive plan since, two decades ago, its obstacles to entrepreneurship resembled those in Japan. I was clued-in to the French case by Mark Bivens, who in 2016 co-founded a VC firm in Japan called Shizen Capital. Having dual American and French citizenship, Bivens had worked as a venture capitalist in France before moving to Japan. Bivens said he “applauds the Kishida administration’s initiatives for startups,” but adds that Tokyo could find even more opportunities for improving Japan’s startup ecosystem by drawing inspiration from France, as well as from a similar scheme in Britain.
Back in the 1990s, Bivens recalled, “If you told your parents you wanted to start a company, they would banish you from the family or you’d never get married. If you had the misfortune of taking the risk to start a company and you failed, you’d have a black check mark at the Bank of France and be ineligible to get a mortgage for ten years. Failure was stigmatized.” He could have been describing Japan.
Consequently, as in Japan, many newly discovered technologies were not being commercialized, and it was feared that this would lead France to fall behind in the new business sectors driving future growth. To take just one example, only about 20 researchers each year left government labs to create their own start-ups, another similarity with Japan. Companies are the conveyer belts that transform new technologies into economic value.
It’s remarkable how much things have changed in little more than two decades. Since 2000, France has created almost 38,000 new startups, now valued at $276 billion, up from just $11 billion in 2010. About 2,500 of the startups are involved in “deep tech,” i.e., technology solutions based on profound scientific or technological breakthroughs. Such deep tech startups received about 28% of the VC funds invested in all startups. 36 of these startups have become “unicorns,” i.e. private companies valued at $1 billion or more. In 2010, there were none. Plus, there are 90 “future unicorns,” i.e. unlisted firms currently valued at $250 million to $1 billion, who are deemed likely to become unicorns. By contrast, Japanese unicorns number only six. France’s VC investment has quadrupled to 0.12% of GDP since 2009 and now ranks 10th highest among 28 OECD countries. Japanese VC has also grown, having tripled since 2009, but Japan still ranks just 18th (see chart at the top).
The Catalyst
What triggered such a remarkable change in so short a time? In the late 1990s, the French government recognized that, while it had many world-class giants, without more startups, it would fall behind in innovation, global competitiveness, and, hence, living standards. On a visit to Silicon Valley, Prime Minister Lionel Jospin left impressed by the startups’ spillover benefits for the entire economy. The government also recognized that external finance was indispensable to potential innovators and yet, there was almost no “seed money” to get startups off the ground. And so in 1997, the government created a Mutual Fund For Innovation (FCPI) aimed at catalyzing new private financiers.
Under the FCPI scheme, and later a fund for local investment called FIP, ordinary people could receive huge tax benefits if they invested in start-ups via venture capital and angel firms. Far from being forced to take a high-risk gamble on a single company, the plan enabled them to place their money in a diverse portfolio of startups chosen by professionals who were licensed and scrutinized by the government. The startups themselves had to be certified by the government as meeting the criteria for being knowledge-intensive innovators with growth potential, having devoted at least one-third of their revenue over three years to research, having less than 500 employees, and being headquartered in the EU.
Citizens who invested in firms no older than seven years via the FCPI program received huge tax benefits. During 2000-2017, they could reduce their income tax bill every year by 25% of the amount they invested up to a maximum deduction of €12,000 ($13,000)—€24,000 for a married couple—as long as they held the investment for five years. They could reduce their misnomered “wealth tax”—whose low threshold caught many middle-class people—by half of the amount they invested up to a maximum of €50,000. On top of that, profits were exempt from the capital gains tax, while losses could be used to offset capital gains in some other, more conventional, investment. As a result, in a typical year, more than 100,000 people invested a total of €1 billion into these programs, an average of €10,000 ($11,000) per household.
In 2017, the French government declared that the program had achieved its goal of “transforming the mental software of the French populace to appreciate the importance of startups.”
In 2018, President Emmanuel Macron drastically raised the threshold at which the unpopular wealth tax kicked in, thus virtually removing this part of the incentive to invest in the FCPI. It also lowered the income tax benefit on FCPI investments from 25% to 18%. Even so, in 2020, 54,000 citizens invested €330 million via 25 management companies.
Although the initial years were difficult and program details had to be refined a few times, the program hit its stride and, for years, these funds have provided excellent returns. For example, the median fund launched in 2008 provided investors total returns over the following years adding up to five times their initial investment, and the median fund launched in 2014 provided a stunning 12-fold increase from the initial investment.
The availability of financing enabled far more talented people to create companies. Today, the number of startups is reportedly rising about 20% a year. That, in turn, has encouraged more professional financiers to devote their money to innovative startups. The OECD estimated that, as of 2015, there were 8,000 professional business angels in France. In 2021, total external funding raised by startups, not just VC or angel money, reached a record €12.4 billion. Bivens, who was skeptical when the FCPI program began, became one of those professionals. His verdict: “France’s high-tech ecosystem has now grown into a tremendous success over the past 20 years, and I assert that French government support via tax policy was the key catalyst.”
If France can succeed in overcoming its anti-entrepreneurial habits and mindset, why not Japan?