Empowering Startups in Japan: The Role of Venture Capital and Cultural Reforms

Japan's startup ecosystem is growing but lags global peers, hindered by limited funding, cultural aversion to risk, and structural inefficiencies. Enhancing equity funding, fostering entrepreneurship, and addressing labor-market rigidity are key to unlocking its potential for innovation and growth.

The International Monetary Fund's working paper "Riding Unicorns: Startups and Venture Capital in Japan," authored by Salih Fendoglu and TengTeng Xu of the IMF’s Asia and Pacific Department, explores the evolving landscape of startups in Japan and the critical role of venture capital (VC) in fostering innovation. The Japanese government has recently taken bold steps to boost entrepreneurship through its "Startup Development Five-Year Plan," which aims to increase startup investment tenfold by 2027. Using data from PitchBook, a leading private market database, the study examines the drivers of startup financing, the impact of equity funding on growth and innovation, and the influence of cultural factors on entrepreneurial outcomes.

The Rise and Challenges of Japan's Startup Ecosystem

Japan's startup ecosystem, while growing, remains modest compared to global leaders like the United States, China, and the United Kingdom. In 2023, Japan had only seven unicorn startups valued at over 1 billion dollars representing a mere 0.5% of the global total. Tokyo has emerged as the epicenter of the country’s entrepreneurial activity, hosting 80% of all startup funding and ranking among the top 20 global VC ecosystems. However, venture capital investment in Japan as a percentage of GDP is only one-tenth of that in the United States. Most Japanese startups are small, with funding concentrated in the early stages, limiting their ability to scale and achieve significant market impact.

Corporate venture capital (CVC) has become a distinguishing feature of Japan’s startup landscape. Large Japanese corporations have leveraged their substantial cash reserves to invest in startups, participating in over half of the country’s VC deals between 2015 and 2022. These investments are predominantly in the IT and healthcare sectors, although recent years have seen increased funding for business-to-business (B2B) and business-to-consumer (B2C) industries. Despite these efforts, Japan’s share of startups in clean technology remains below the global average, highlighting an area for potential growth.

The Impact of Entrepreneurship and Firm Dynamism

A cross-country analysis reveals that entrepreneurship and firm dynamism characterized by high entry and exit rates are critical drivers of capital investment and valuations. Japan, however, lags in both areas. The country’s entrepreneurial activity, measured by the Total Early-Stage Entrepreneurial Activity Index, trails significantly behind nations such as the United States and South Korea. This disparity can be attributed to rigid labor markets and cultural aversion to risk-taking, which discourage individuals from pursuing entrepreneurial ventures.

Higher entrepreneurship is strongly associated with greater risk tolerance, which supports increased investment and higher valuations. Additionally, dynamic entry and exit rates enable more efficient resource allocation, promoting innovation and growth. Japan’s low firm dynamism, compounded by the prevalence of unproductive "zombie firms," impede this process. Addressing these structural inefficiencies is crucial to unlocking the potential of Japan’s startup ecosystem.

The Transformative Power of Equity Funding

The firm-level analysis highlights the transformative impact of equity funding on startups. Well-funded startups consistently outperform their less-funded peers in innovation, growth, and successful exits. These firms generate higher patent outputs, employ larger teams, and have a significantly higher likelihood of exiting through initial public offerings (IPOs) or mergers and acquisitions (M&A). For instance, well-funded startups are predicted to employ 1.5 times more personnel and exhibit a 43 percentage-point higher probability of successful exit compared to less-funded startups.

The study also addresses the challenge of measuring the true impact of early-stage funding, given the tendency of investors to select startups with the highest growth potential. Advanced statistical methods, such as matching firms based on observable characteristics like age and industry and using endogenous treatment models, were employed to mitigate selection bias. These analyses confirm the critical role of equity funding in driving startup success.

Cultural Barriers and Opportunities for Reform

Cultural factors significantly influence entrepreneurial outcomes. Societies with lower uncertainty avoidance and less hierarchical rigidity exhibit greater positive impacts of equity funding on startups. In Japan, cultural norms emphasizing stability and hierarchy often deter risk-taking, a critical component of entrepreneurial success. Policies aimed at reducing labor-market rigidity, encouraging merit-based promotions, and fostering job mobility could help address these cultural barriers.

The Japanese government has initiated several reforms, including the establishment of entrepreneur development hubs and the launch of a 200-billion-yen venture growth fund to support later-stage startups. However, fostering a more dynamic startup ecosystem will require sustained efforts to improve firm entry and exit rates, reduce personal liabilities for entrepreneurs, and enhance the overall vibrancy of the business environment.

A Roadmap to Boosting Startup Success

The findings underscore the potential of equity funding to transform Japan’s startup ecosystem, not only by providing essential financial resources but also by offering value-added services such as operational insights and market access. To maximize this potential, Japan must address structural, cultural, and financial barriers to entrepreneurship. Reducing the dominance of zombie firms and reallocating resources to more productive ventures can further enhance the efficiency of the startup ecosystem.

Japan’s journey toward a thriving startup culture is a multi-faceted challenge requiring financial investment, policy innovation, and cultural shifts. By embracing these changes, the nation can create an environment where startups thrive, contribute to innovation, and drive economic growth, positioning itself as a competitive player in the global startup landscape.