Venture capital investment in South Korea: market and regulatory overview
A Q&A guide to venture capital law in South Korea.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
To compare answers across multiple jurisdictions visit the Venture Capital Country Q&A Tool.
This Q&A is part of the global guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Venture capital and private equity
In the Republic of Korea (Korea or South Korea), the use of venture capital and private equity for investment purposes generally falls in the "financial investment business" category from a Korean legal perspective. However, venture capital and private equity are substantively different from each other not only in investment objectives but also in terms of applicable laws.
Private equity funds are regulated under the Financial Investment Services and Capital Markets Act (FSCMA) and are principally used to make and hold controlled (buyout) or significant-minority (growth capital) equity investments in established corporations.
In contrast, venture capital investments are expressly excluded from the scope of the FSCMA regulations and are subject to different regulations depending on their fund or management company type (that is, the type of venture capital company) or the investment target. The three key regulations for venture capital investments in South Korea are the:
Support for the Establishment of Small and Medium Enterprises Act, which regulates investments in small and medium enterprises (SMEs) that have innovative technology or are managed by companies registered with the Small and Medium Business Administration Office as "SME start-up investment companies". SME start-up investment companies typically establish and manage funds registered as "SME start-up investment partnerships".
Specialised Credit Finance Business Act, which regulates investments made in new technology by companies registered with the Financial Services Commission (FSC) as "new technology investment companies". New technology investment companies typically establish and manage funds registered as "new technology investment partnerships".
Act on Special Measures for the Promotion of Venture Businesses, which regulates investments in SMEs typically in the form of registered "South Korean VC investment partnerships", managed by SME start-up investment companies or new technology investment companies.
Sources of funding
The majority of financing for early stage SMEs (less than four years from formation) is sourced from bank loans, policy lending, and venture capital. Although the early 2000's saw active venture capital investment in early stage SMEs, venture capital investments are gradually shifting focus to more established companies (typically seven or more years from formation). Early stage SMEs typically rely more on bank loans than venture capital investments for start-up financing.
Types of company
Local regulation plays an instrumental role in determining the types of company that benefit from venture capital investments. The three key regulations (see above, Venture capital and private equity) provide various tax and other benefits for venture capital investments in companies that meet certain requirements, such as industry, size, and number of employees. As a result, venture capital investments still tend to be highly concentrated in start-ups (in spite of the recent shift to more established companies), SMEs or new technologies that meet specific requirements for incentives provided in relevant regulations.
Industries boasting consistently robust venture capital investment include telecommunications, manufacturing, culture and media. Other active sectors include biotechnology, service/education, and distribution.
Venture capital investment was most active in South Korea in 2000, when a total of 147 SME start-up investment companies were registered. Since then, this number has declined to 105 in 2004 and 101 as of September 2014. On average, about ten new start-up investment companies are registered each year, while ten existing start-up investment companies de-register or wind down each year.
The number of registered new technology investment companies, on the other hand, has seen an increase from 19 in 2001 to 36 as of 2012 (Annual Conditions of New Technology Investment, 2012, Credit Finance Association).
Amounts of committed venture capital have followed similar trends. The aggregate amount of venture capital committed to SME start-up investment partnerships and South Korean VC investment partnerships reached about KRW1,434 billion in 2000 but stagnated between 2001 and 2008. These committed capital amounts peaked at KRW2,285 billion in 2011 before levelling off at about KRW1,581 billion in 2013 (Venture Capital Newsletter, Vol. 87, 2014 3Q, Korea Venture Capital Association).
In contrast, aggregate amounts of venture capital committed to new technology investment partnerships have steadily increased to about KRW930 billion in 2012 (Annual Conditions of New Technology Investment, 2012, Credit Finance Association).
As previously noted, government incentives keep venture capital focused on start-ups, SMEs, and new technologies. Telecommunication, manufacturing, culture and media, biotechnology, service/education, and distribution remain the most active industries for venture capital investments.
Geographically, venture capital investment in South Korea is heavily concentrated in the Seoul metropolitan area and the surrounding areas of Gyeonggi Province and Incheon. Of these regions, there has been a noticeable increase in the amount of venture capital invested in Gyeonggi Province.
Recent or proposed regulatory changes affecting the venture capital industry are as follows:
Planned Amendments to the Specialised Credit Financing Business Act. In addition to the currently existing new technology finance companies, proposed revisions to the Specialised Credit Financing Business Act would create "new technology specialty finance companies". These companies would focus solely on financing new technology investment companies that would only require capital of KRW5 billion rather than the KRW20 billion required by other specialised finance companies.
Planned Amendments to the Support for the Establishment of Small and Medium Enterprises Act. Current regulations permit venture capital companies to engage in foreign investment:
only after first investing at least 10% of their paid-in capital domestically; and
in amounts not exceeding 40% of their paid-in capital.
Proposed revisions to the Support for the Establishment of Small and Medium Enterprises Act would rescind these foreign investment restrictions. In addition, proposed amendments would reduce required paid-in capital of start-up investment partnerships from KRW3 billion to KRW2 billion.
Planned Amendments to the Special Tax Treatment Control Act. In relation to the stock options of venture companies, proposed revisions to the Special Tax Treatment Control Act would tax stock options at the time the equities acquired (through the exercise of such stock options) are sold (rather than at the time the options are exercised, as is currently the case).
Tax incentive schemes
Taxation for partnerships
Venture capital funds in the form of partnerships may be treated as "pass-through entities" for tax purposes (that is, they may be taxed at the level of the investor rather than the fund).
Deductions and exemptions for investors
In addition, certain tax benefits for venture capital investments are provided under the Restriction of Special Taxation Act, including:
Tax exemptions for venture capital companies. Venture capital companies are exempt from corporate tax for dividend income arising from shares acquired, directly or indirectly, in their venture capital-backed investee companies, and are also exempt from capital gains taxes arising from the transfer of such shares.
Tax deductions and exemption from capital gains tax for individual investors in venture capital funds. Individual investors in venture capital funds are given the following personal tax incentives:
exemption from personal income tax with respect to capital gains arising from venture capital funds' transfers of shares in venture capital-backed investee companies; and
eligibility for certain income tax deductions with respect to dividend income arising from venture capital-backed investee companies, subject to mandatory holding periods.
However, such tax benefits do not apply if the venture capital fund acquired shares in the investee company through the secondary market (rather than from a direct investment in the investee company).
Government-sourced funds have historically dominated South Korean venture capital, although regulations on "Motae funds" (funds using government funding or funding from other government or policy-related agencies to invest in venture capital funds) were introduced in South Korea in 2005. Since the introduction of Motae funds, the overall share of private venture capital investments in South Korea has increased significantly, although venture capital funds still remain heavily dependent on funding from the South Korean government and other government or policy-related agencies.
Other main sources of venture capital include financial institutions such as banks, insurance companies and securities firms, and venture capital companies. Some of the major venture capital contributors include Motae funds and the Korea Finance Corporation, which is a quasi-sovereign agency owned by the South Korean government.
However, there has been much movement recently to increase venture capital investments from the private sector, including new policies and regulations, such as the amendments to the Specialised Credit Finance Business Act (see Question 2).
Venture capital funds are subject to various investment requirements and restrictions depending on the applicable laws and regulations.
Within three years of their establishment, SME start-up investment partnerships are required to invest at least 40% of their capital in either:
Unlisted start-ups or SMEs that have been established for less than seven years.
Venture companies, as defined in the Act on Special Measures for the Promotion of Venture Businesses.
However, South Korean VC investment partnerships and new technology investment partnerships do not have any particular investment requirements.
Restrictions on investment strategies and investment activities
SME start-up investment partnerships and South Korean VC investment partnerships are only allowed to invest in start-ups or SMEs, and are prohibited from investing in "enterprise groups subject to limitations on mutual investment" (as defined in the Monopoly Regulation and Fair Trade Act), specially related entities, or real estate.
Restrictions on foreign investments
SME start-up investment partnerships may spend up to 40% of their capital in foreign investments but there are no express provisions of law that allow foreign investments by South Korean VC investment partnerships or new technology investment partnerships. However in practice, many new technology investment partnerships have been making foreign investments. In addition, there is a proposal to amend the relevant regulations to specifically allow such investments (see Question 2).
Although it is not common in South Korea for venture capital funds to invest with other funds, there are no specific restrictions that prohibit such investments. Since venture capital investments tend to be smaller in size compared to other private equity investments, it is rare for a venture capital fund to co-invest in order to meet the capital requirement, but it may become a co-investor as a result of venture-backed companies tending to be funded by various sources.
Venture capital funds in South Korea are typically established as partnerships rather than corporations, and the three key types of venture capital funds are:
SME start-up investment partnerships.
South Korean VC investment partnerships.
New technology investment partnerships.
(See Question 1, Venture capital and private equity.)
Such partnerships are not legal entities distinct from their partners, but may have standing in the name of the partnership in the case of litigation.
Venture capital partnerships may be treated as pass-through entities for tax purposes, in which case the following tax benefits apply:
Capital gains tax is exempt at the partnership level.
The partners are not subject to dividend income tax until dividends are actually distributed by the partnership.
The partnership's expenses are deducted from the total taxed dividend income.
The average life of a venture capital fund is seven years. The most common method of exit is a private sale of shares or redemption of preferred shares. Another common exit is an initial public offering (IPO).
Although IPOs may be the intended exit at the time of investment, because IPO exits may be quite time-consuming in South Korea, IPOs appear to be a less common exit strategy than private sales. The average time for achieving an IPO in South Korea is about 12 years following establishment; venture capital-backed companies reach IPO in about 11 years (on average, whereas companies that have not received any venture capital reach IPO in about 14 years on average (Sale of Fund’s Shareholding for Early Exit, 3 July 2013, Korea Capital Market Institute).
Fund regulation and licensing
Registration of venture capital companies
In order to receive the benefits provided under the Support for the Establishment of Small and Medium Enterprises Act, and to conduct the business of investing in SME start-up companies, a venture capital company is required to register with the Small and Medium Business Administration Office as an SME start-up investment company.
In addition, in order to invest in new technologies and receive the benefits provided under the Specialised Credit Finance Business Act, a venture capital company must register with the Financial Services Commission as a new technology investment company.
SME start-up investment companies and new technology investment companies must appoint certain experts that meet certain qualifications regarding experience and education.
Representative director and executives
The representative director(s) and executives of SME start-up investment companies and new technology investment companies must meet certain qualifications, including not having been criminally sanctioned and complying with the relevant rules and regulations regarding matters including bankruptcy or insolvency, and financial credit.
The FSCMA regulates financial businesses, such as private equity firms, and establishes certain requirements and restrictions regarding marketing and solicitation activities. However, the FSCMA expressly excludes venture capital companies from these requirements if their managed venture capital funds are offered on a private basis. If a venture capital fund is offered publicly, however, a securities registration statement and the related prospectus must be filed, as is required of other public funds regulated under the FSCMA.
In addition, SME start-up investment companies, new technology investment companies and their respective managed funds must each register with the applicable government agency (see Question 9).
Venture capital funds are typically established as partnerships and their partners may have either limited or unlimited liability. Investors typically become limited partners of the relevant fund, while the venture capital company becomes the general partner or managing partner of the fund. Accordingly, investors, as limited partners, will not be involved in the management or operation of the fund and will be limited in liability up to their limited partnership interest in the fund.
The general partner responsible for the management and operation of the fund, is typically a registered SME start-up investment company or a new technology investment company, and owes legal and contractual fiduciary duties to the fund and its investors.
Additional protections are provided under South Korean law regarding conflicts of interests, such as transactions with specially related entities and proprietary investments. A fund's constitutional documents may also provide further protections.
Interests in investee companies
Venture capital funds typically acquire preferred shares, common shares, or convertible bonds/bonds with warrants, or engage in project-based investments where the SME develops and operates the project separately from other projects or businesses. Venture capital funds tend to invest in common shares when the investee company is larger, whereas the funds may invest in preferred shares when the investee company is smaller. In general, there appears to be a preference for preferred shares over common shares.
Since the burst of the IT bubble around the year 2000, in order to ensure dividends and redemptions, venture capital funds in South Korea have actively invested in redeemable convertible preferred shares (RCPS), as commonly seen in the US market.
However, the stability and various rights provided to investors in convertible bonds, bonds with warrants, and other hybrid securities, has caused these types of investments to remain popular options for venture capital funds.
Valuing and investigating investee companies
Venture capital funds in South Korea use both qualitative and quantitative methods of valuing an investee company.
The Korea Venture Capital Association recommends the following methods of equity valuation, in order of preference:
Recent independent third party pricing.
Market-based multiple analysis.
Other methods (including discounted cash flow, and net asset value).
There are various factors that impact the development of a start-up or growing company which are difficult to value qualitatively, such as the attributes of the company's founders and the company itself, including the personnel, and whether the company receives support or backing from other organisations or the government. However, all of these factors may be used by a venture capital fund to value the investee company.
To maximise cost efficiency, most venture capital investments are based on focused investigations of key assets, employees (such as the founder), or business operations of the investee company (rather than extensive legal or financial due diligence, as is typically conducted for most other transactions).
Depending on the type of investment, the following documents are used for venture capital transactions:
Subscription agreements or purchase agreements for common shares, redeemable convertible preferred shares or convertible bonds/bonds with warrants.
Limited partnership agreements for interests in venture capital funds.
Protection of the fund as investor
The following are common contractual protections investors seek:
Representations and warranties regarding the investee company and its financial condition, liabilities and corporate status.
Specification or covenants on the use of the invested capital, such as limiting the capital to be used only for the development or production of new technology.
Certain rights to protect the return of the investor's investment, such as a put option, or tag along or redemption rights such as redeemable convertible preferred shares.
Rights of participation in management.
Pre-emptive rights that provide the venture capital company or fund with the option to purchase new shares issued by the investee company in proportion to its initial shareholding in the investee company (see Question 19).
In many cases, liquidated damages in case of a breach of contract (including breaches of representations and warranties), where the amount of damages may be difficult to calculate.
Forms of equity interest
In 2000, venture capital investments were mostly in common shares, but the trend has been shifting to preferred shares (or redeemable convertible preferred shares) over the years. The Korea Venture Capital Association reports that the percentage of these investments (as a share of all South Korean venture capital investments) rose from 22.5% in 2005 to 36.3% in 2014 (Venture Capital Newsletter, Vol.87, 2014 3Q, Korea Venture Capital Association) (see Question 12).
The Korean Commercial Code allows preferred shares to be issued in various forms, including cumulative, non-cumulative, participating, and non-participating preferred shares with different rights such as priority in dividends or priority in liquidation.
One of the most commonly issued types of preferred shares is redeemable convertible preferred shares with the following rights:
Redemption rights on both principal and interest, provided that the redemption right is exercised only when the company has sufficient distributable earnings.
Conversion rights to different type of shares, typically common shares.
In some cases, venture capital companies or funds may obtain certain managerial participation rights or a put option with respect to such preferred shares.
Venture capital funds will typically obtain the following types of management control over the activities of an investee company:
Rights to receive certain reports and notices, and consent rights for material decisions or changes.
Rights to appoint directors and executives.
Reports, notices and consents for material decisions or changes
For venture capital investments in South Korea, most subscription agreements, purchase agreements or shareholders' agreements will include:
Provisions that require the investor's (that is, the venture capital fund's) consent.
Requirements that notice be given to investors about important business decisions that may have a material effect on the assets or business of the investee company, such as IPOs, mergers and acquisitions, capital increases or reductions, and the winding down of key business operations.
Agreements may also include liquidated damages provisions or the right to terminate in cases of breach by the investee company's major shareholder. In addition to contractual obligations, the Korean Commercial Code requires shareholders' approval for certain material corporate actions.
Appointment of directors and executives
Many venture capital transactions provide the investor with the right to appoint a director to serve on the board of directors or the right to appoint a key executive such as an auditor or officer with managerial rights. In many cases, however, such measures serve the purpose of monitoring, rather than controlling, the management of the company.
Venture capital companies will usually retain the rights to review or audit the financial statements of their investee companies.
Share transfer restrictions
In many cases, the investment documentation imposes a transfer restriction on the shares held by the major shareholder(s) or founder(s) by subjecting such shares to a tag-along right of the investors. In other cases (for example, where the major shareholder is the founder or owns most or all of the investee company's technology or network), the following may be restricted or subject to the venture capital shareholder's approval:
Transfers of shares by major shareholders or founders that are likely to result in a change in management control or operations of the investee company.
Transfers between specially related entities of the investee company.
In addition, the transfer of shares to competitors of the investee company is usually prohibited.
Venture capital funds typically hold minority interests in investee companies. There are no specific provisions of law that protect such minority shareholders in the sale of the investee company. However, in practice, the venture capital fund will usually obtain tag-along rights with the major shareholder through the shareholders' agreement to protect its investment.
In addition, to facilitate the exit by the venture capital fund, venture capital transactions may also include:
Registration rights granting the fund to demand an IPO as a shareholder.
A put option allowing the fund to exit by selling its investment at a prescribed price.
It is not common for venture capital funds to have drag-along rights.
In principle, any shareholder of a company has pre-emptive rights in relation to any additional issues of shares by an investee company, and therefore may participate in any such capital increase in proportion to its pre-issuance shareholding (Korean Commercial Code).
However, in practice, companies can issue new shares by way of third party allocations without regard to any shareholder pre-emptive rights if their articles of incorporation permit this. Therefore, venture capital investors commonly require that investee companies' articles of incorporation are amended to prohibit third party allocations of new shares, and also to obtain a contractual right to pre-emption along with the major shareholder under the shareholders' agreement.
There are no legally required consents to approve the execution of investment documentation. However, in most cases, the fund documents will require approval of the investment committee of the fund manager (that is, the venture capital company) for the execution of investment documentation, as well as implementation and execution of the investment.
Typically the fund documents will require the costs of the venture capital fund to be allocated proportionately to each partner's partnership interest in the fund. In some cases, the venture capital fund's costs, which can be viewed as funding costs of the investee company (such as the cost of due diligence with respect to the investee company) may be borne by the investee company.
Founder and employee incentivisation
As an incentive, the executives and employees of the investee company may be awarded performance-based bonuses or stock options.
With respect to venture-backed investee companies, the Restriction of Special Taxation Act permits employees electing to exercise the stock options the ability to apply for exemption from withholding tax and, in some cases, deferred dividend tax payment.
Investors will typically seek covenants that key persons, such as the founder of the investee company, will remain in an executive position in the company during the life of the investment. Alternatively, they may require covenants that ask for prior approval of any transfer of founders' or major shareholder's interests in the company. Performance-based bonuses are also used as incentives to retain founders.
Venture capital investors usually include non-competition or confidentiality clauses in shareholders' agreements to prevent founders from engaging or investing in a competing business.
If an investee company is unsuccessful, the related venture capital fund may not be able to recover its investment by selling its investee company shares in the market. As a downside protection against such risk, venture capital funds typically implement two exit strategies: use of a put option or redeemable convertible preferred shares.
A put option
Use of a put option essentially provides a guarantee on the fund's investment from the major shareholder (or founder). Whether the fund will be able to exercise its put option, however, depends on the financial ability of the major shareholder or founder who, in many cases when the company itself is struggling, may not be able to oblige.
Redeemable convertible preferred shares
On the other hand, redeemable convertible preferred shares obligate the investee company to redeem the shares at a prescribed price. If the company does not have distributable profits as calculated under the Korean Commercial Code, however, it is not allowed to exercise its redemption right. To protect against such risk, the venture capital investor usually requires a capital reduction to meet the redemption requests.
The most typical exit strategy of venture capital funds for successful companies is an IPO. Unlike in other countries, the frequency of exits by mergers and acquisitions in South Korea for successful companies has been considerably low.
Although IPOs, if successful, tend to be the more profitable exit strategy because they are so time consuming (see Question 8), the number of IPOs through which venture capital funds have exited investments has decreased significantly (from 76 in 2010 to 60 in 2011, 22 in 2012 and 37 in 2013 (Venture Capital Newsletter, Vol. 87, 2014 3Q, Korea Venture Capital Association)).
In most cases, the investment documentation will include specific terms for exiting the investment. These may include specific terms regarding an IPO, merger or trade sale (including tag-along and drag-along rights) in case the investee company is successful, or a put option or redemption requirement in case the investee company is unsuccessful.
South Korean Ministry of Government Legislation
Description. Official up-to-date website of the Republic of Korea's Ministry of Government Legislation. English translations are potentially out-of-date, for guidance purposes only and not always binding.
Hyunsoo Doh, Senior Attorney
Kim & Chang
Professional qualifications. Korea, 2001
Areas of practice. M&A; foreign direct investment; capital markets; banking; acquisition finance; securities regulations; securities; labour and employment.
- Actively involved in many high-profile transactions in South Korea or relating to South Korean businesses.
- Represents private equity funds, corporate clients and both foreign and domestic financial institutions on various mergers and acquisitions, private equity transactions, capital markets and other projects.
Languages. Korean, English
Professional associations/memberships. Korean Bar Association.
Publications. The International Capital Markets Review: Korea section, Law Business Research Ltd., 2012, co-author.
Jae-hong Park, Attorney
Kim & Chang
Professional qualifications. Korea, 2010
Areas of practice. M&A; capital markets; securities regulations; securities; insolvency; labour and employment.
Languages. Korean, English
Professional associations/memberships. Korean Bar Association.
Ryan Russell, Foreign Attorney
Kim & Chang
Professional qualifications. New York, 2011; District of Columbia, 2012
Areas of practice. Acquisition finance; M&A; foreign direct investment; North Korea, ship finance; private equity; project finance and arbitration.
Advising the seller (bank) on the cross-border sale of its portfolio companies.
Advising the issuer on cross-border issuance of bonds with warrants and redeemable convertible preferred stock.
Advising export credit agency on emerging market infrastructure project finance.
Advising engineering, procurement and construction companies on coal power project-related arbitration.
Languages. English, Korean
Professional associations/memberships. New York State Bar Association.