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Emerging Technology Report #18: August 15, 2002

The Failure of NASDAQ Japan: A Note on Why it Happened

Louis Ross (Global Emerging Technology Institute)

The demise of the main banking system in Japan and the rise of alternative sources of capital for technology companies, arguably, has been dealt a minor setback recently. NASDAQ, operator of the world's largest electronic stock market based in the U.S., will send officials to Japan apparently to discuss how the firm can pull out of its investment in NASDAQ Japan. NASDAQ Japan, the TSE's Mothers market and JASDAQ are the three emerging company exchanges in Japan, JASDAQ on all counts the largest. A weak economy and a shrinking number of listings have put a good deal of pressure on NASDAQ Japan's bottom line. NASDAQ's plans to develop a global brand and presence off of the startling success and rapid growth it experienced during the 1990's boom in the U.S. has led to unimpressive results related to forays into Europe and Japan. Though there probably is a future for a more sophisticated market in Japan, which caters to emerging companies, especially technology companies, we will need to wait to see it come to fruition. Myopic American business planning and the inability to persevere through difficult times, along with a weak global economy, led to the embarrassing failure. Of course, the peculiarities of the Japanese market also had a hand in things.

NASDAQ and major Japanese Internet investor Softbank Corp. are the two biggest shareholders in NASDAQ Japan, each owning a 43% stake in the joint venture and initiated the operations of the exchange a little more than two years ago. Actually, NASDAQ would have never established NASDAQ Japan unless it was funded by a local company in a big way. Unfortunately, the other partner is not in great shape and the idea of supporting a market that could have functioned as a catalyst in taking Softbank-funded companies public, in hind sight, is really starting to look like a bad idea, another bad investment for Softbank. NASDAQ Japan was opened in June 2000 within the Osaka exchange for Japanese venture businesses and about 100 companies are now listed on the market. The rate of growth was negligible, and from the beginning a number of people, including the author, found it difficult to believe that you can have several small cap markets exist in a fairly illiquid environment unless there is substantial participation by local investors, both institutional and individual. Liquidity has always been a problem on JASDAQ, with at least half to two thirds of its shares not trading though it has done relatively better than its two competitors. The offerings by the competitors included mproved trading rules and easier capital requirements for listed companies. NASDAQ Japan ended up accumulating approximately a 5.3 billion yen loss as of the end of last year. NASDAQ reported last week it would write off the $20.1 million it invested in and loaned to NASDAQ Japan.

Local investors simply weren't convinced enough to support the market. The amount of funds raised by newly listed start-ups continues to shrink. Firms going public on the country's three stock markets for emerging companies raised an average of 1.02 billion yen in their initial public offerings in the first half of this year, the fourth consecutive half-year of decline. According to the Nikkei, the expected price/earnings ratio, the barometer of expectation for a company's growth potential, fell to an average of 21 on an IPO-price basis in the first half of this year, down from the 31 in the first half of last year. Even though underwriters purposefully kept IPO prices low in order to attract investors demand was still slack. The quality of the companies listing on the exchanges was in question and the quick deterioration of earnings by newly listed firms has helped to scare away investors. This may have something to do with the significant decrease in the amount of time it took from a start-up company to be founded till the time it was taken public, a harmful derivative of the securities firm's efforts to stimulate new revenue sources. Also, the total number of technology companies that went public was disappointing and a number of them, especially in the IT sector, were brought to the market prematurely.

The lesson to be learned from the failure of the emerging company exchanges in Japan is important. You can forget about nurturing these types of exchanges unless you also nurture and support other areas. NASDAQ in the U.S. grew in line with a maturing venture capital market and the institutionalization of private equity investing and somewhat organized bands of angel investors. Foreigners cannot be the only people who are ready to provide real risk capital in the market. The decrease in direct bank lending in Japan was met with a rise in venture capital investing and is a positive sign of things to come. However, companies still struggle in obtaining risk capital from local investors and even when they do, especially before they go public, the capital is not "smart." For example, accepting foreign venture capital enables Japanese firms to obtain advice from a global perspective and assists with building their overseas client base. Also, there is more deeper involvement by these investors than by Japanese venture capital firms.

In regard to technology companies, it would help if Japan has a more mature venture capital market and a more participation by professional angel investors. These entities cannot simply function as surrogate banks and match-making firms. They need to really add value. Though it is questionable whether or not all start-ups should tap institutional venture capital, companies funded by VCs tend to perform better after they go public. Also, it is absolutely necessary to encourage the importation of foreign intellectual capital. Vibrant growth of U.S. technology start-ups owes tribute to foreign entrepreneurs with technical backgrounds. One observes this dependency on foreign talent in the U.S. when visiting cutting edge research institutes. For example, start-up technology companies clustering around MIT and Harvard in Boston or in Silicon Valley often look like mini-United Nations. As a result of this and an increasingly sophisticated private equity market, NASDAQ functions properly. Of course, the market has taken a beating over the past two years but the point is that it has assisted a number of small companies to grow into large global competitors that retain a diversified set of institutional investors interested in being shareholders. Many of these firms, by the way, decided to stay with NASDAQ instead of defecting to the NYSE though they could have easily done so. It has also attracted many foreign companies from all over the world to list on its exchange.

At this point, perhaps for at least two years, small and medium sized technology companies will increasingly tap sources of private equity capital in order to meet their financing needs. Japanese companies should realize that welcoming such investments can be strategically beneficial since they should start early in regard to cultivating the foreign investment community. This issue extends to the public equity realm as well. The Nikkei will simply not be able to sustain a strong bull market without the maturation of the private equity market in Japan. The end of the traditional main bank system must be replaced by something more flexible, dynamic and more courageous than what exists presently. Perhaps then companies will find it easier to grow, be profitable, and become attractive enough for Japanese investors to select them as viable investment opportunities.

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