Barriers to Innovation in the Land of the Rising Sun

Why Japan, once the global leader in tech, has failed to keep up with Silicon Valley. And how it might catch up.

Lately, it’s become trendy to declare the death of Silicon Valley.

Influencers are increasingly pushing the notion that the U.S., specifically the Bay Area, has lost its dominance as the global hub for radical innovation. Whether or not this is true — the record numbers of successful billion-dollar exits and huge VC deal sizes last year suggest otherwise — many international cities are calling themselves the “next Silicon Valley,” from Silicon Docks in Dublin to Silicon Wadi in Tel Aviv.

These attempts to replicate the region’s innovative spirit, which fostered the rise of so many of the world’s most valuable companies, should be celebrated. After all, innovative new products and services can come from anywhere, and global competition only benefits consumers. However, these new tech centers have met mixed success, with only a handful churning out unicorns, and even fewer producing truly novel products and services.

Even Japan, once the world’s dominant tech power, which still has a strong base of STEM professionals just like the Bay Area, has lagged considerably behind it for many years now. Though it has made strides in nurturing a new startup ecosystem within its borders, especially in Tokyo, this effort has been slow-going. By taking a deeper look at the challenges of growing a robust venture ecosystem in Japan, still one of the largest economies in the world, perhaps we can identify ways to better encourage innovation in Tokyo and beyond.

Challenge #1: Culture

For all its shortcomings, American culture is in many ways perfectly suited to radical innovation. Compared to much of the rest of the world, there is little stigma here toward business shutdowns, unemployment, or even bankruptcy, which are often seen as temporary missteps on the way to success, rather than career-defining failures. It’s hardly surprising that the lean startup, “fail fast, fail often” mentality of iterating from one’s mistakes took hold here. This isn’t always the case, and there have been tragic instances where stress and poor mental health have driven founders to suicide, but these are fortunately a rare exception.

Japan’s work culture on the other hand, which once assured its dominance in tech, has now hindered its ability to keep up. Whereas long hours, expertise in engineering, and an incredible drive for perfectionism were once perfectly suited to developing more and better tech products, now they only harm productivity and slow the pace of innovation. Worse, the stressful hours and tremendous pressure to perform have given rise to an epidemic of karōshi, or “death by overwork,” in addition to a high, albeit improving, suicide rate.

Takahashi Matsuri, whose suicide in 2016, labeled as karōshi, ignited public outcry

The differences go beyond just work culture. In a collectivist culture like Japan’s, any actions that might ‘rock the boat’ are discouraged, while social harmony and the collective good are encouraged. The benefits are clear: Tokyo continues to top the Safe Cities Index. Personally, in all my time there, I have not once felt unsafe (the same can’t be said of my home city, Rio de Janeiro). Unfortunately, it also means Japan would never produce a revolutionary company like Uber, one willing to spit in the face of the status quo and butt heads with regulators around the world.

Differences in education may play an even greater role. While the less rigid primary and secondary education of the U.S. may produce less technically-competent students on average, the system demands much less conformity of its students — at least, I’ve never heard of an American school ordering students to dye their hair black — while encouraging experimentation and creative extracurricular pursuits. Even students who blossom later in their academic career, or neglect their grades but show a predilection for entrepreneurship, are given what they need most: a chance.

Challenge #2: Exit Market

Last September, the Tokyo Stock Exchange was hit with one of the most highly-anticipated IPOs in several years, in one of the most popular startup categories in Japan. The startup was Wantedly, a 7-year-old recruiting company empowering professionals to find new jobs based on passion and value fit. After years of buildup, Wantedly did not raise $1 billion, or $500 million, or even $94 million, the median U.S. IPO size in 2015 (the lowest in the past decade). It raised ¥114.4 million, or about $1.07 million. That’s it.

A poor exit market, with awful valuations, does little to encourage smart people with innovative, potentially lucrative ideas to leave their stable corporate jobs and take a chance on a new venture. Job security in big Japanese firms is exceptional, after all, with most salarymen keeping their jobs for life. Ironically, the industry expertise and network one might develop working at a large or mid-size firm would be exceptionally useful for those willing to forego these stable positions and strike out on their own.

Even in its weaker years, the U.S. IPO market incentivizes strong valuations

A strong exit market pushes foreign investors to get involved, encourages the formation of more local VCs, and incentivizes wealthy individuals to get involved as both angel investors and mentors. Of course, a big exit also means a big payout for founders and employees, which means a new cohort of angels, reinvesting their windfall profits — as well as their time, as mentors — into the next generation of startups. It’s a cycle that we’ve seen in the Valley before, and there is no reason it couldn’t take hold here.

Even when entrepreneurs and their employees don’t turn around and reinvest their earnings into new startups, they often do something even better: start new companies altogether. Some of the most impactful businesses today were started by former operators who made it big and decided there was more they wanted to do in the world: Elon Musk’s SpaceX and Tesla, Mark Pincus’ Zynga, and Jack Dorsey’s Square, to name a few. Serial entrepreneurs like these are everywhere, and the ones I’ve met are some of the most passionate, dedicated people I know.

Challenge #3: Funding Ecosystem

Massive capital inflows are needed to sustain a burgeoning innovation hub, and while it may not be necessary for Japan to have as much VC money on hand as the U.S., it’s worth comparing the two. In 2017, Japanese startups raised the equivalent of $2.5 billion, a record amount for the country (for reference, the U.S. raised the $84 billion the same year, but that’s not as important as the next figure). More significantly, Japan’s VC per GDP was ranked 22nd in the world, with VC investment at 0.027% of GDP, compared to 0.35% in the U.S.

There is interest from local and foreign VCs to invest more, so where is the bottleneck? Is VC money in Japan just too difficult to access? Yes and no.

Japanese investors can be heard complaining about the lack of promising startups, driven by the immaturity of the startup community and a culture that discourages innovation. So, you’d think that the limited VC funding rate would be a consequence of investors holding out for better prospects. Japanese VCs did raise nearly $700 million of untouched capital in 2016, representing a dry capital overhang of about 35% of total funding . That said, while this figure may seem high, it’s almost identical to the 37% overhang seen in the American VC market. The point is, Japanese investors aren’t exactly running out of options.

What does present a problem here is the regulatory environment, which makes seeking an IPO a long, drawn-out process, one that could last as long as a VC fund’s entire life cycle and force companies to get acquired. VCs are often reluctant to invest in seed-stage startups, concerned as they are — perhaps rightly so — about the time horizon of such investments. When taken alongside the dry powder ratio and low VC/GDP ratio, it’s clear that Japanese VCs are making bigger investments in fewer, later-stage companies.

Early-stage startups remain dominant in Japan, but later-stage companies are more favorable

Instead, seed-stage startups in Japan are turning to corporate venture capital for funding. Corporations in Japan are increasingly seeking innovation outside their own walls, with funds like Sony’s recent $100 million robotics fund and Toyota’s similarly-sized AI fund targeting even companies even in the early stages. These efforts are only just beginning to bolster seed-stage startups. While successful later-stage startups may have a literal wealth of VC funds to choose from, new founders still face an uphill battle.

How does the future look?

To be clear, these factors only just scratch the surface. There are a plethora of other reasons for Silicon Valley’s explosive growth, including unenforceable non-compete agreements and the relatively hands-off regulatory environment in the U.S. compared to Japan. These differences could be overcome, however, by an otherwise-strong Japanese startup ecosystem.

For now, the consensus is that the market is still maturing, and for a market at this stage, it is getting stronger. VC firms, angels, and corporate investors, local and foreign, are taking great pains to promote Japan as an innovation center, while pushing startups that target traditional Japanese business sectors like insurance and law, which have yet to be transformed by tech. Funding numbers suggest their efforts are paying off, even as Softbank invests most of its staggeringly large Vision Fund overseas. Even Silicon Valley took many years to go from orchards to high-tech offices, and it may be just a matter of time until the culture, exit market, and funding market change for the better.

It’s a different beast from the U.S. though, with a greater corporate investor presence, and VC firms that are only now moving away from spray-and-pray investment strategies to a more focused, hands-on approach. Meanwhile, as Japan legitimizes and embraces cryptocurrencies, even designating bitcoin a national currency, we may very well see ICOs become a more popular and viable funding option there than anywhere else in the world. In many ways, even as Japan is trying to follow Silicon Valley’s example, it’s also not afraid to find its own way.

Maybe that’s what every innovation hub should do: find its own, unique equilibrium. Silicon Valley didn’t find follow anyone else’s example, after all, and it’s worked out alright so far.

Marcello Miranda is a tech fanatic, and frequently writes on startups. Follow him on Medium and Twitter, and if you enjoyed this content, hold down the clap button to help spread the word!