IN TERNATIONAL CONFERENCE ON - CIFBA 2020 VENTURE CAPITAL INDUSTRY IN VIETNAM: CHALLENGES AND POLICY DEVELOPMENT Minh Chau Dao Faculty of Law, University of Economics and Law, Vietnam National University Ho Chi Minh City ABSTRACT Venture capital is the key in the development process of many countries Although Vietnam has a huge potential for start-ups, its venture capital market still remains modest in Asia The purpose of this paper is to fully examine the challenges that Vietnam is encountering in order to strengthen its market The most concerning problems are the lack of incentive mechanism and governmental support for the development of venture capital Notably, in terms of organization, there are three key factors contributing to the success of a venture capital industry that Vietnam is still in lack of: (i) The guideline for limited partnership model; (ii) The effective operation of Vietnamese preferred stock; (iii) The alternative routes for exiting the investment Regarding the public policies, the incomplete legal framework on this market and inexplicit guidance on tax incentive schemes make Vietnam a less attractive destination for investors In the context of Vietnamese current market conditions, this paper provides discussions on possible solutions to tackle the aforementioned issues To draw more interest from venture capitalists, it is urgent for the government to finalize laws on the existence of venture capital firms and give more guidance on specific tax incentive and separate accounting system of a Venture Capital Fund In addition, the capital market also needs to be improved by offering an explicit guideline for the limited partnership structure, providing more advantages for other financial tools such as preferred stocks or operating an efficient stock market for venture capitalist easily to exist Keywords: Venture capital, Incentive Mechanism in American model, Legal Reform * Corresponding author Email address: chaudm@uel.edu.vn 172 VIETNAM NATIONAL UNIVERSITY - UNIVERSITY OF ECONOMICS AND BUSINESS INTRODUCTION In the global context, venture capital refers to the financial capital provided to high growth, high risk and it is often associated to high technology firms In the U.S, venture capital, since its emergence in 1940s (Cetindamar, D., 2003), has been a powerful engine that pushes forward the nation’s innovation, employment rate and the growth of economy The most significant example of venture capital success in the U.S policy is the Silicon Valley which is the hub of the world’s innovation and technological advancement Furthermore, apart from the U.S, many countries have made substantial effort to develop and strengthen their venture capital markets such countries are Japan, Germany, Australia, Singapore, China, Taiwan to name a few In the case of Vietnam, despite the recent changes in policy, Vietnam is still behind the world in adapting its governmental framework to support the development of venture capital industry Although the economic growth is phenomenal, Vietnam has the smallest venture capital in Asia (Klingler-Vidra, R., 2014) It imposes significant difficulty to startups and individuals who possesses high impact ideas and technology Notably, business in Vietnam is traditionally financed by personal funds and direct loans However, in practice for almost of Small and Medium Enterprises (SMEs) and start-up companies, access to the capital of the banks is really difficult As such, Vietnam is moving toward the 4th Industrial Revolution when entrepreneurs need to mobilize funds to support their businesses, there is an urgent need for Vietnam to promote its venture capital market to increase the competitiveness of the economy To be able to enhance the venture capital market, we need to first determine the challenges that Vietnamese venture capital market is facing In the scope this paper, I will discuss in depth the challenges of Vietnamese venture industry in different aspects such as incentive mechanism and governmental support Subsequently, I briefly discuss possible solutions for Vietnam to overcome these issues OVERVIEW OF VENTURE CAPITAL INDUSTRY IN VIETNAM 2.1 Background of Venture Capital Venture capital is a type of equity financing, which focuses mostly on providing financial capital to early-stage, high-potential, and high-growth entrepreneurial enterprises, especially for those working in the area of technology It has been widely recognized as a powerful engine to boost the national economy growth, facilitate the emergence of more start-ups and job creation Additionally, to promote such industry, more favorable conditions for the development of the financial market have been met up, such as a regulated and efficient stock exchange There is a variety of research literature analyzing the critical role of venture capital market in commercializing cutting-edge science, finance and innovation (Gilson, R.J., 2003) In light of potential benefits of this industry, it requires a number of factors that should simultaneously present to help the engineering of venture capital market in a country, including a transparent environment and an open startup ecosystem 2.2 Venture Capital Development in Vietnam Venture capital industry in Vietnam increased remarkably in the 1990s after the 173 IN TERNATIONAL CONFERENCE ON - CIFBA 2020 liberalization of the economy However, after the Asian Financial Crisis in the end of the 20th century, 400 million USD disappeared from Vietnamese venture capital market as eight foreign venture capital funds left Vietnam (Klingler-Vidra, R, 2013) In addition, the absence of domestic stock market also leads to the poor performance of venture capital industry during that time Without the stock exchange the venture capital fund cannot cash out their investment via (Initial Public Offering) IPO In 2000s, the new stage of venture capital industry arose again with modest number of both investors and investments Despite the introduction of Ho Chi Minh stock exchange (HOSE) and Hanoi stock exchange (HNX) in 2000 and 2003 respectively, the Vietnamese venture capital industry still has not met up businesses expectations Up to 2017, Vietnam has about 3,000 startups (Das, K., 2019) However, according to Tech in Asia, the value of investments in Vietnamese startups is much lower than that in other countries in the region There were only 205 million USD and 291 million USD being invested in 2016 and 2017 respectively (Kim Chi, 2019) At the end of 2017, there were only about 40 venture capital funds in Vietnam and most of them are foreign firms Few big names in the industry are IDG Ventures, VinaCapital DFJ, Cyberagent Ventures and the recent 500 Startups Vietnam Financing of Vietnamese startups also come from a spate of other regional venture capital firms such as Expara Ventures, Golden Gate Ventures, and Gobi Partners or later-stage venture capitalists like NSI Ventures, Vertex Ventures and Monks’ Hill Ventures However, in general, the amount of investment deal is still a small proportion in comparison with other countries in Asia Recently, within the Vietnam Venture Summit 2019, various venture capital funds have pledged to inject an aggregated $425 million into local startups over the next three years, which marks a promising future for this industry (Nguyen, T., 2019) 2.3 Policies on Venture Capital in Vietnam Vietnamese jurisdiction considers venture capital investment literally as innovative SMEs The policies on establishment of venture capital fund has been laid out in the High Technology Law in 2009 while the Law on Support for Small and Mediumsized Enterprises came into effect on 1, January, 2018, stipulated investments on innovative SMEs, including income tax exemption and reduction for innovative SMEs investors, and allowed localities to provide reciprocal investment for starting innovative SMEs with venture capital funds In particular, the Decree No 38/2018/ ND-CP (“Decree 38”) dated 11 March 2018 provides detailed legal framework to govern the venture capital funds This Decree provides regulations on investment funds investing in innovative SMEs; the establishment, organization, dissolution, and relevant activities of the fund for venture capital (the “Venture Capital Fund”) The objectives of Decree 38 are to identify and recognize innovative SMEs investment as a business investment; determine the legal status of innovative SMEs investment companies and innovative SMEs investment funds that Vietnam’s current legal system does not govern; and unlock capital flows for innovative SMEs by encouraging the establishment of innovative SMEs investment companies, innovative SMEs investment funds 174 VIETNAM NATIONAL UNIVERSITY - UNIVERSITY OF ECONOMICS AND BUSINESS CHALLENGES TO THE VENTURE CAPITAL DEVELOPMENT IN VIETNAM 3.1 Incentive Mechanism for Venture Capital Industry The venture capital industry has played an important role in the economic success of the United States (U.S.) until now The success of such model in the U.S comes from a lot of factors, such as confluence of laws, financial markets, regulatory systems, and social norms long in existence in the U.S In terms of organization, there are three key factors contributing to the success of U.S venture capital market However, Vietnam is now in lack of such key elements, including the lack of guideline for limited partnership model, the ineffective operation of Vietnamese preferred stock and the existence of efficient exit channels 3.1.1 Guideline on Limited Partnership Model In Vietnam, Fund’s investors can set up a Fund Management Company or simply hire an existing one A fund operates in accordance with its charter (articles of association), which is greatly similar to the popular “Limited Partnership Agreement” A fund’s accounting system must be separate from that of the Fund Management Company In addition to the aforesaid fund (partnership) form, investors may choose a corporate vehicle for their investment This corporate vehicle must, however, register “innovative investment activities” as one of its business lines In other words, the investors may join a fund like a partner, or simply hold shares in a corporate entity as a normal shareholder In sum, the new Decree of Vietnam has tried to get updated with the structure model for venture capital funds in the U.S., including “Limited Partnership” as an effective mechanism to boost the establishment of venture capital fund Notwithstanding the adoption of “Limited Partnership” model for Venture Capital Fund, the analysis on this model under the Laws has not gone into detail One of the issues is whether the enforceable partnership agreement prevails the charter in case of inconsistencies if so agreed by the partners The Vietnamese Government has not governed all of the issues regarding the structure of venture capital funds Such explanations would set a good precedent for similar investments to come 3.1.2 Convertible Preferred Stock In order to minimize the high risk and agency costs concomitant with startup firms which they invest in, U.S venture capitalists normally use this common financial instrument: convertible preferred stocks (Lin, Z., 2013) Almost of the venture capitalists in the U.S always hold convertible preferred stocks With this type of securities, such investors can get profit from the sale of the potential common stocks when their investment is fruitful, and they bear less risk than that stood by entrepreneurs when the projects turn out to be failures (Schmidt, K., 2003) Notably, preferred stockholders normally have a right to receive specified dividends before the common stockholders may receive any (Korsmo, C., 2013) In addition, convertible preferred stocks also include the terms of liquidation preference, redemption rights and anti-dilution protection (Milhaupt, C., 1997) The liquidation preference provides priority rights over common stockholders in the process of allocating liquidated assets (Milhaupt, C., 1997) 175 IN TERNATIONAL CONFERENCE ON - CIFBA 2020 In practice, preferred shares are not common in Vietnam This may be due to a lack of awareness of the versatility of this funding option Additionally, preferred shares under U.S regulations is much more attractive to investors because of its liquidation preference; redemption rights and anti-dilution preference However, under Vietnamese regulations, each kind of preferred stocks has its own preferences There are also a number of disadvantages of holding those kinds of preferred shares in Vietnam from the investors’ perspective, including: (i) An ordinary shareholder is entitled to vote on important matters, attend the general meetings of shareholders or nominate a person to the board of directors or to the board of controllers A holder of preference shares has no such rights (ii) The possibility to trade preference shares is much more difficult than the possibility to trade ordinary shares That is, ordinary shares of a listed company can be traded on a stock exchange whereas preference shares cannot (iii) Preference shares can be issued only in Vietnamese dong The risk may arise for an investor if the Vietnamese dong is significantly devalued during the investment term As such, the operation of preferred stock under Vietnamese regulations should be changed to meet the expectation of investors Then, preferred stock can become an effective method to attract investors and raise the awareness of Vietnamese venture capital industry 3.1.3 Effective Stock Market as Exit Channel Another main reason which makes Vietnam less appealing to foreign investors is due to the ineffective stock market The venture capital may easily exit via an IPO by offering its shares for sale to the public IPO is a preferable exit option for the company’s management as they will likely be able to retain their control over the company after the venture capital’s exit However, an IPO subjects the company to a number of regulatory requirements and procedures The success of an IPO exit will heavily depend on the market conditions which are outside the investor’s control In contrast, IPOs are not a common exit option in Vietnam because the Vietnamese stock market has not yet fully developed Vietnam currently has two main stock exchanges, the Ho Chi Minh City Stock Exchange (HOSE) and the Hanoi Stock Exchange (HNX), which apply various (though different) listing criteria including minimum capital requirements, required periods of profitable activities prior to listing, minimum number of non-major shareholders (i.e.: the public spread) and commitments by management to retain their interests in the company for a minimum specified period Those requirements seem to be much higher than the capacity of these venture companies In fact, there is also an unlisted public company market, called Unlisted Public Company Market (UPCoM) The UPCoM is a market established and managed by HNX under rules approved by the State Securities Commission to regulate “over the counter” securities of unlisted public companies The UPCoM is expected to become an effectively mezzanine exchange for the purpose of encouraging unlisted firms to participate in the securities market, with a perspective that those on UPCoM may later transfer onto the main market For companies, inclusion on UPCoM boosts visibility and accessibility to investors, 176 VIETNAM NATIONAL UNIVERSITY - UNIVERSITY OF ECONOMICS AND BUSINESS while being a useful step towards full listing and providing them a platform to improve transparency and corporate governance to reach HNX standards However, in practice, during nine (9) years of its operations, UPCoM has neither drawn the attention of businesses nor increased its attractiveness to investors In general, the capital market of Vietnam has not been fully developed Vietnamese Law on Securities in 2010 has been outdated Most of the start-up cannot easily go listed under Vietnamese regulations after a few years of operation Thus, most of investors have no confidence in making investment’s decisions A draft of new Law on Securities is in preparation It is hoped that such amendment will make securities market in Vietnam more attractive As such, venture capital market has the opportunity to develop as well 3.2 Governmental Support for Venture Capital Industry 3.2.1 Lack of a comprehensive set of legal framework for Venture Capital First, the legal corridor is important for Vietnam to have an effective start-up investment market Singapore, Malaysia and Thailand have all created frameworks for venture capital Although Vietnam has already passed the Law on Support for Small and Medium-sized Enterprises and Decree No 38/2018/ND-CP on innovative SMEs investment, two basic laws are still not enough to contribute to the development of venture investment In addition, laws and regulations are also too slow to be updated and prone to change, so foreign investors not have confidence in Vietnamese investment environment Second, in Vietnam, there is an overlap between venture capital fund and private equity fund The main reason for such issue comes from the legal framework and the practical issues In practice, most of the Vietnamese funds operate as offshore vehicles and focus on investments in companies operating in the technology, media telecommunications and consumer sectors Investments tend to be in established companies seeking growth capital (equitized companies or pre-IPO companies), instead of in early-stage businesses As such, the “Venture Capital” in Vietnam currently is best characterized as “Private Equity” With regard to the legal framework, there are, however, no official legal documents which clearly distinguish the operation of “venture capital fund” and “private equity fund” Such ambiguity will slow down the development of venture capital industry in Vietnam Most importantly, it is really a matter to be labeled as an “innovative SME” because the venture capital investors are entitled to a variety of incentives as followed analysis As such, any incentives for the venture capitalists under Decree No 38/2018/NDCP requires the exact definition of “Innovative SMEs” However, pursuant to Article of Decree No 38, an innovative SME is defined as: (a) an SME; (b) established to implement “business ideas based on the exploitation of intellectual property, technology and new business models and is able to grow quickly” Such definition is too ambiguous For example, there is no exact measure to identify the capacity of “growing quickly” Thus, it will be much difficult for those investors to demand for the support in practice 177 IN TERNATIONAL CONFERENCE ON - CIFBA 2020 3.2.2 Tax Incentive Scheme Taxation impacts the Venture Capital industry’s profitability and tax incentives can be used as a tool to attract private capital to the asset class According to Decree No 38/2018/ND-CP, Funds’ income generated from investment in innovative SMEs are entitled to tax incentives However, there is no explicit guidance on specific tax incentive and separate accounting system of a Venture Capital Fund that they can enjoy PROPOSAL FOR VENTURE CAPITAL DEVELOPMENT IN VIETNAM 4.1 Incentive Mechanism for Venture Capital Industry in Vietnam First, with regard to the effective structure for venture capital industry, there is a need to provide more guidelines for the limited partnership structure As stated above, in Vietnam, most of venture capital funds are foreign funds Even though some large foreign investment funds have no offices in Vietnam, they still show much interest in Vietnamese startups Thus, such adoption and guideline will enable the formation of more “onshore” vehicles, which will help keep venture capital fund revenue in Vietnam, bring more investments from Vietnamese investors and also encourage the development of domestic venture capital expertise This proposal not only gets at the notion of designing policy to encourage a distinct venture capital market, but also expands the pool of early-stage financing Second, the operation of preferred stock under Vietnamese securities regulations should be changed Notably, it may be better to adopt the preferences under U.S model and eliminates those current disadvantages of Vietnamese preferred stocks Preferred stocks under Vietnamese jurisdiction need to soon have the rights to vote on important matters, the rights to trade on stock exchanges and the right to be issued in foreign currency Hence, the preferred stock can draw more attention from the venture capitalists, which is one the critical point to develop the venture capital industry in Vietnam Third, the regulations on security exchanges of Vietnam need to reform to facilitate for the IPOs of venture enterprises; thereby venture capitalists can easily exit from the company As such, they will have more confidence in investing into this capital market Some of the changes for Vietnamese securities market can be: (i) Establishing a stock market with listing rules which can match the relatively low level of success of the venture enterprises Like the case of NASDAQ, with respect to the requirements for initial listing of such securities exchange, the company just need to meet one of three standards: equity standard, market value of listed securities standard and net income standard (ii) The Law on Securities in Vietnam need to amend soon to meet the international standards; thus, it can attract more investors to invest in Vietnamese start-ups 4.2 Governmental Support for Venture Capital Industry First, the overall regulatory framework for venture capital should be promulgated Due to the lack of legal framework, the investors cannot have many incentives in 178 VIETNAM NATIONAL UNIVERSITY - UNIVERSITY OF ECONOMICS AND BUSINESS investing this new kind of market The current Decree No 38 is not enough to govern all of the operations of the venture capital market Thus, the Government needs to make a set of legal reforms not only in venture capital market but also in a number of areas, such as Finance and Banking, Tax, Infrastructure, Intellectual Property and Dispute Resolution In addition, the Law had better distinguish the concept “venture capital” and “private equity” Based on that, the promotion policies for those markets can work effectively Most importantly, the definition of “Innovative SMEs” should be explained in details, which is the critical points to make other incentives more effectively Second, Vietnam runs the risk of not having Venture Capital funds set up locally, instead of having Venture Capital funds from Hong Kong or Singapore investing in domestic companies To attract the establishment of Vietnamese Venture Capital funds, local Venture Capital tax rates need to be competitive However, until now, there is no explicit guidance on specific tax incentive and separate accounting system of a Venture Capital Fund Thus, on the investor tax incentive side, first, it needs to offer a discounted tax rate to Venture Capital funds domiciled in Vietnam of zero (tax exempt for years) to 10% (make Venture Capital a strategic industry) In addition, a tax deduction for Venture Capitalists is also recommended The overall risk of their investment in early-stage would be lowered through their tax payment savings The tax deduction for Venture Capital investor could be piloted for five years Depending upon its ability to increase the amount of capital available to domestic Venture Capital funds it could then be discontinued or extended for another set period of time CONCLUSIONS Despite possessing huge market potential and significant growth of startups ecosystem, the bureaucracy and incomplete legal framework make Vietnam less attractive to investors Furthermore, the lack of alternative routes for exiting investment due to the short of financial tools also negatively affects decisions of investors Although strong effort has been shown by Vietnamese government in improving and reforming their legal system, Vietnam is still lagging behind its neighbors such as Singapore, Indonesia and Malaysia It is urgent that the Vietnamese government needs to finalize the laws on regulating venture capital firms and to increase the transparency and the efficiency of the system At the same time, Vietnam must maintain its investment in engineering and high technology research which is the backbone of startups ecosystem ACKNOWLEDGMENT I would like express my deepest gratitude to staffs at University of Economics and Law for their administrative support in completing this paper 179 IN TERNATIONAL CONFERENCE ON - CIFBA 2020 REFERENCES [1] Cetindamar, D., The growth of venture capital, Westport, Conn.: Praeger, 2003 [2] Das, K., Startup Ecosystem in Vietnam, Vietnam Briefing from Dezan Shira & Associates https://www.vietnam-briefing.com/news/startup-ecosystem-vietnam.html/, 2018 (Accessed January 15, 2019) [3] Evans v Galardi, 16 Cal 3d 300, 305 (1976) [4] Fu, F., Developing Venture Capital Laws in China: Lessons Learned from the United States, Germany, and Japan, International and Comparative Law Review, vol 23, no 4, 2001 Available at: http://digitalcommons.lmu.edu/ilr/vol23/iss3/4 [5] Gilson, R.J., Engineering a Venture Capital Market: Lessons from the American Experience, Stanford Law Review, vol 55, pp 1067-1103, 2003 [6] Kim Chi, Vietnamese Startups need state’s capital, Vietnamnet https://english vietnamnet.vn/fms/business/203941/vietnamese-startups-need-state-s-capital.html, 2018 Accessed January 10, 2019 [7] Klingler-Vidra, R., Building a VC Market in Vietnam: VC Policy Lessons from Europe and Asia” New Approaches to Building Markets in Asia, Working Paper No 27, 2013 [8] Klingler-Vidra, R., Building a Venture Capital Market in Vietnam: Diffusion of a Neoliberal Market Strategy to a Socialist State Asian Studies Review, vol 38, no 4, pp 582-600, 2014 https://doi.org/10.1080/10357823.2014.958054 [9] Korsmo, C., Venture Capital and Preferred Stock, Brooklyn Law Review, vol 78, no 4, pp 1163, 2013 [10] Lin, Z., Legal Ecology of China’s Venture Capital Market: Reflection in the American Mirror, Korea University Law Review, vol 13, pp 79-110, 2013 [11] Milhaupt, C., The Market for Innovation in the United States and Japan: Venture Capital and the Comparative Corporate Governance Debate, Northwestern University Law Review, vol 91, no 3, 1997 [12] Nguyen, T., Vietnam proves to be the right place and right time for venture capital, The LEADER, https://e.theleader.vn/vietnam-proves-to-be-the-right-place-and-right-timefor-venture-capital-1560334388594.htm, 2019 Accessed December 10, 2019 [13] Schmidt, K., Convertible Securities and Venture Capital Finance, The Journal of Finance, vol 58, no 3, pp 1139-1146, 2003 180 ... the engineering of venture capital market in a country, including a transparent environment and an open startup ecosystem 2.2 Venture Capital Development in Vietnam Venture capital industry in Vietnam... issues OVERVIEW OF VENTURE CAPITAL INDUSTRY IN VIETNAM 2.1 Background of Venture Capital Venture capital is a type of equity financing, which focuses mostly on providing financial capital to early-stage,... venture capital funds in Vietnam and most of them are foreign firms Few big names in the industry are IDG Ventures, VinaCapital DFJ, Cyberagent Ventures and the recent 500 Startups Vietnam Financing