Startup Shadows: Peeling Back South Korea's $1 Billion Tech Market Struggles

At the end of 2023, financial markets were buzzing in South Korea over the story of Padu. 

Listed on the KOSDAQ market in August of this year, Padu succeeded in its initial public offering with an enterprise value of ￦1.5 trillion($1 billion) in recognition of its technology and future business value, despite low financial results of ￦17.3 billion in revenue and ￦4.3 billion in operating losses in the first quarter of 2023.

Padu is a fabless company that designs and sells controller ICs for SSDs, a popular storage product. Controllers are the key component that drives flash memory, which is a tricky area for SMEs to commercialize.

Having succeeded in mass-producing controllers, Padu has been aggressively promoting the acquisition of large tech customers such as Meta, Amazon, and NAVER, raising expectations of reaching the ￦120 billion revenue target in its securities filing.

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The trouble started when the company announced disastrous Q3 results in 2023, with revenue of 300 million KRW and an operating loss of 14.8 billion KRW. To add to the shock, the company's second quarter financial results, which were still under review, were later revealed to show a revenue of 59 million won and an operating loss of 15.2 billion won.

It takes months for a company to file a preliminary review request with the exchange and receive listing approval, and in most cases, it is common for companies to submit audited financial statements for only the most recent quarter at the time of filing.

In Padu's case, it submitted its audited financial statements up to the first quarter of 2023, as it filed for review with the exchange in March this year. However, even considering the lack of finalized financial statements, many have expressed doubts that the significant impairment that occurred during the exchange review period was not reflected in the evaluation.

Institutions and individuals who invested in Padu after the IPO are outraged that unfavorable investment information was not properly disclosed. There are calls for the issuer to be held accountable, as well as the VCs who were shareholders and the lead arrangers who handled the listing process.

The criticism directed at the VCs has given me a lot to think about, as someone who works in the industry.

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Public markets in a prisoner's dilemma?

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The idea of multiple entities with competing interests in a single company reminds me of the game theory popularly known as the Prisoner's Dilemma. Considering the game we're playing might give us some clues to resolving the recent crisis in the public markets, so let's talk about it in more detail.

Game theory is a mathematical theory that studies what are the most rational decisions that participants can make in a game with specific rules. There are "rules" to a "game" with multiple players, and people make decisions based on those rules in their own best interest. While math may seem like a vaguely profound and difficult subject, there are many simple game situations that we can easily encounter in our daily lives.

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1. Prisoner's Dilemma (Non-Zero Sum Game)

A classic example is the Prisoner's Dilemma. It's a very simple game where two players decide whether to cooperate or betray each other.

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Game description :

• When you and your friend are taken to the police as accomplices, will you confess to the crime?

Game Rules :

• If one of you confesses to the crime, the other gets 10 years in prison and the confessor is released.
• If you both confess, you both get 8 years in prison.
• If neither confesses, they both get 1 year in prison.

This game is a mind experiment to explore what happens when participants act to maximize their own interests. At first glance, you might think that it would be natural for them to cooperate and live together for a year without confessing.

Quite unexpectedly, the math tells us that betrayal (confession) is a rational decision for both of them if they are making choices to maximize their own self-interest.

The idea is that even though cooperating is the best outcome (a year in jail together), it is most rational in terms of expected value to betray because the other person might betray my cooperation. Ironically, this creates a situation where everyone gets the worst possible outcome ("both serve 8 years").

You've probably heard the textbook statement that the capitalist system is sustained by all actors acting rationally in their own self-interest, but the Prisoner's Dilemma theory tells us that when everyone acts to maximize their own self-interest, the equilibrium is tilted in a way that makes the whole unhappy.

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2. When the game doesn't end with a single shot

Our game doesn't end with a single betrayal, it continues until death. Everyone is faced with the choice between cooperation and betrayal at every moment, but what this means is that after this game is over, you'll still be playing the same game with the same opponent, so you have to take into account that the trust you lose through betrayal once will become an arrow and come back to you in the next game.

In a situation where the same Prisoner's Dilemma game is played over and over again, the (hopefully) most effective strategy that math has determined (the so-called Tit for Tat strategy) is as follows.

• Cooperate by default
• If your opponent cooperates, continue to cooperate
• If they betray you, you betray them back.

As an investor, what do you think?

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3. VC cooperation and betrayal

It occurs to me that perhaps we as VCs are playing a prisoner's dilemma game every time we bring a company to the public market.

It is perfectly rational for VCs, who need to get a return on their investment (exit), to sell the company at a high price, packaged as a good product, and conversely, it is rational for institutional and retail investors in the public market to buy a good company at the cheapest price to maximize their own profits.

The math says that the most "rational" strategy for VCs is to overpay for a bad company that will stab public investors in the back, and then throw up their hands. However, our game is not over once and for all either: clever market participants, sensing the Tit for Tat strategy, may no longer trust VCs as their game opponents and respond with betrayal.

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Charlie Munger's thoughts on venture capital

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Charlie Munger passed away shortly before his 100th birthday, leaving behind a legacy of practical knowledge and all-encompassing wisdom from the podium of a shareholder's meeting just a few months ago, and we can't help but assume that investing wasn't just a way to make a fortune for him.

A translated version of Charlie Munger's interview script was recently posted on the Buffett Club webzine, and unlike other interviews, it's quite impressive as it includes quite a bit of his thoughts on venture capital. If you're interested in learning more, you can listen to the podcast yourself or read the transcript via Buffett Club.

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(20:59)

Ben: Do you think the role of venture capital is being properly fulfilled in society?

Charlie: No, I think it's very poorly done

We've written before about how VCs have an important mission in deploying capital for society, which is why this interview with Charlie Munger hits home.

Not only is he saying that VCs are not doing a good job of fulfilling their social role, but they are also creating overly favorable fee rules to the detriment of their clients, the LPs, and being perceived by investment firms as a group looking out for their own interests, not their partners.

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(22:17)

Ben: I'm curious back to this point of the role of venture capital in a society, if you could design a perfect system to fund...

Charlie: It's a very legitimate business if you do it right. If you want to give the right people the power and nurture them, help them. You know a lot about the tricks of the games so you can help them run their business yet not interfere with them so much they hate you.

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Is Mr. Munger telling the truth? (Role of a VC)

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I've been talking to a lot of industry veterans lately, and it always seems to come back to the question of when to exit and what the criteria should be.

Some people tell me that they limit the scope of their activities as a VC until they go public. Others say that they mechanically sell shortly after the IPO in order to stay out of the capital markets, and while I think that a good company should be held for as long as possible without selling, I actually wonder if I would have come to a different conclusion if I had been in the same boat as them.

In this context, Charlie Munger's interview gives me a lot to think about. He criticizes VCs for prioritizing capital gains and points to Berkshire Hathaway's culture: his firm prioritizes partnerships with the companies they invest in, so if someone offers to sell at a high price ("20 times earnings") as long as the business is doing well, they don't take it.

Still, Korea is a market with a very low shareholder return rate compared to the global average. I think that maybe VCs' usual exit strategy is a reasonable behavior for our market.

It's at this point that I wonder what we juniors can bring to the table in terms of the conclusions our seniors have drawn from their years of experience with domestic capital markets, which are quite different from the US.

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Stag Hunt Game Begun

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For a long time, more than a decade, I believe capital markets were playing the Stag Hunt Game.

It was a market where if two hunters worked together, they could catch a stag, but if they didn't work together and betrayed each other, they could catch a rabbit alone.

When institutions and individuals cooperated, a virtuous cycle was created where good companies were continuously funded and great companies (the deer) were born. When they didn't cooperate, they still benefited from the abundance of liquidity, and both institutions and individuals could make a tidy profit (the rabbit).

As liquidity dried up in the market, the old rules disappeared and the Prisoner's Dilemma game began.

Given that this game will be played over and over again for a long time (everyone is now predicting "Higher for Longer" in the market), it's a reasonable guess that betrayal by someone other than cooperation will now return like a boomerang, destroying trust and creating catastrophe.

I'm not writing to blame anyone for the recent developments - I'm sure both the organizers and the VCs who invested had their own interests and circumstances. I think public market investors looking for short-term capital gains were also doing their part, but the fact that something went wrong despite everyone reasonably pursuing their own interests means that now a different game has begun.

There are certainly things that need to be set right and someone needs to be held accountable in the process. Furthermore, we need more market participants to recognize that things are much changed (less incentive to betray) than they used to be and send a clear message. Including VCs.

What if more VCs announced a clear philosophy that they would only raise money for companies with good growth and good businesses, and then put that philosophy into action? Is this really just idealistic rhetoric that has no place in our market?

💡 No one knows the future, but at least the attitude of a committed and responsible investor would build an incentive structure where more capital would be focused on companies with good potential.

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Written by DS2M (Link)

Original Text: Exit만 하면 나몰라라... VC가 가치 있는 산업으로 인정 받는 방법