Venture Capital in Europe and the Financing of Innovative ...


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Venture Capital in Europe and the Financing of Innovative ...

  1. 1. Venture Capital in Europe and the Financing of Innovative Companies Laura Bottazzi∗ Universit` Bocconi, IGIER, and CEPR a and Marco Da Rin Universit` di Torino and IGIER a July 2001 Abstract Venture capital is considered to be the most appropriate form of financing for innovative firms in high-tech sectors. Venture capital has greatly developed over the last three decades in the United States, but much less so in Europe, where policy makers are striving to help channel more funds into this form of financial intermediation. We provide the first assessment of venture capital in Europe. We document its development in the 1990s, also providing a conceptual framework for this analysis. Comparing the evolution and structure of European and American venture capital, we find the wedge between these two industries to be large and growing. We then look at the involvement of venture capital with some of Europe’s most innovative and successful companies: Those listed on Europe’s ’new’ stock markets. Venture capital is effective in helping these firms overcome credit constraints, and thus to be born in the first place. Using a unique, hand collected data set from the listing prospectuses and annual reports of these companies, we then find European venture capital to have a limited effect on their ability to raise funds, grow, and create jobs. We conclude that public support of the European venture capital industry should look at both its growth and at its maturation. Forthcoming, Economic Policy, v.34, 229-69, April 2002. ∗ We thank Erik Bergl¨f, Jean-Bernard Chatelain, Jan van Ours, Henri Pag`s, Guido Tabellini, and partic- o e ipants to the Economic Policy 33rd Panel Meeting for valuable comments. Detailed suggestions by Richard Baldwin (the editor) helped us improve the quality of the paper. Veronica Guerrieri, Giuseppe Maraffino, Gaia Narciso, and Battista Severgnini provided excellent research assistance. We also thank all the companies which provided us with data and prospectuses. Financial support from Fondation Banque de France and from Universit` Bocconi (Ricerca di Base) is gratefully acknowledged. All errors remain our own. a
  2. 2. 1 Introduction The ability to encourage and sustain technological innovation is one of the main sources of economic growth. In the last decade, the increasingly rapid pace of innovation induced by en- trepreneurial firms has substantially contributed to the strong competitiveness and protracted growth of the US economy. Several studies have documented the ability of US venture capi- talists to select promising companies, provide adequate financing, and spur innovative firms to behave aggressively and emerge as market leaders (see Hellmann (2000) for an overview). A wide consensus among economists, business leaders, and policy-makers exists that a vibrant venture capital industry is a cornerstone of America’s leadership in the commercialization of technological innovation, and that the lack of venture capital hinders European firms from competing on an equal footing (European Commission (1994)). Several official documents of European governments and institutions suggest bolstering venture capital and revamping the regulation of stock markets as remedies to Europe’s eco- nomic slugginesh and dismal unemployment. For instance, the European Commission’s 1998 Risk Capital: A Key to Job Creation in the European Union Communication states as its main message that ‘[d]eveloping risk capital in the European Union, leading towards the development of pan-European risk capital markets is essential for major job creation in the EU’ (European Commission (1998) p.1). As the title of the Communication indicates, the creation of a pan-European equity market for innovative companies was identified by the Communication as a crucial step not only for providing risk capital to companies, but also for the creation of a substantial number of new jobs. More recently, the ’Final Report of the Committee of Wise Men on the Regulation of European Securities Markets,’ ’urges governments and the European institutions to pay par- ticular attention to ensuring that there is an appropriate environment for the development of the supply of risk capital for growing small and medium sized companies, given the cru- cial importance of this sector for job creation’ (Committee of Wise Men (2001) p.10). The Committee goes on to argue that ’[t]oday there is still an inadequate supply of risk capital in the EU with venture capital only one fifth of US per capita levels. However, if the Euro- pean Union’s financial markets can integrate (...) European venture capital financing will be encouraged from the bottom up’ (p.78). Other official documents and reports identify the immaturity of Europe’s venture capital industry and the hostility of its stock exchanges towards young firms as powerful obstacles to the growth of European entrepreneurial firms (see for instance Bank of England (2000)). In 1
  3. 3. turn, entrepreneurial firms are viewed as major contributors to economic growth and to the creation of new jobs (see German Federal Ministry of Economic and Technology (1999a,b)), and venture capital as an important tool for job creation, technological innovation, export growth, and regional development (European Investment Bank (2001)). There is a growing perception that Europe’s growth problems may be caused not as much by rigidities in labour markets, as by weakensses in capital markets, and in particular in the access to risk capital. These documents raise important policy issues. In particular, it is crucial to understand how policy can actually contribute to the growth of a dynamic venture capital industry in Europe. European official documents, but also industry reports like the White Paper of the European Venture Capital Association (EVCA (1998)), tend to focus on the supply of funds and on the creation of favorable structural conditions for entrepreneurship. However, it is far from evident which policy measures would be most appropriate to nurture venture capital in Europe. Here the lack of rigorous investigation is felt most. In this paper we provide a contribution in this direction by developing the first systematic analysis (to the best of our knowledge) of venture capital in Europe. To get around the dearth of firm-level data on European venture capital, we exploit the unique opportunity offered by the opening in 1997 of Euro.nm, the alliance of Europe’s ’new’ stock markets for innovative companies in high-growth industries–along the lines of America’s Nasdaq. Euro.nm brought under its wings the ’new’ markets of Amsterdam, Brussels, Frankfurt, Paris, and (since June 1999) Milan. Euro.nm ceased to exist as an alliance in December 2000, but its five members have continued to operate independently. Over its life span, Euro.nm has allowed nearly 600 companies to list and raise over 40 billion euros of equity capital. We collect a unique data set from issuing prospectuses and annual reports of more than 500 Euro.nm listed companies. These data provide an excellent opportunity to study the effects of venture capital on Europe’s innovative companies, given the wealth of information which they are required to disclose in order to go public. We focus on three key issues. First, we develop a conceptual framework for appraising the role of venture capital in the financing of innovative companies. Second, we document the development of venture capital in Europe, compare it to that of US venture capital, and assess the extent and determinants of venture financing to companies listed on Euro.nm. Third, we study the effect of venture capital on the ability of these companies to raise funds, grow, and create jobs. The evidence we provide is useful in assessing the extent to which European venture capital helps create and nurture innovative companies. We challenge several common beliefs on the role of venture capital in Europe, and question its ability to make a difference for economic 2
  4. 4. growth and job creation. In particular, we argue that venture-backed companies do not grow and create jobs faster than non venture-backed companies. Whether this is due to a lack of ’stars’ among European firms or to the immaturity of European venture capital is not possible to tell apart, but several pieces of evidence make the latter possibility more than likely. We also have good news. We find that venture capital does help European innovative companies by providing them with financing crucial for their creation and development. This also means that an increasing number of (venture-backed) companies benefits from the possibility to go public on Euro.nm, with a positive effect on the growth of Europe’s ’new’ stock markets. Since venture capitalists benefit, in turn, of the possibility to exit their investments through a listing on a stock market, this may have triggered a self-reinforcing virtuous circle. These findings provide support for the European Commission’s stated policy of promot- ing European venture capital. The major action of Commission in this respect has been transformation of the European Investment Fund (EIF) into a major investor in venture cap- ital funds. Our findings suggest that the ’quality’ of European venture capital should be as urgent a concern for the EIF as its sheer ’quantity,’ so as to advance both the size and the maturation of the industry. The rest of the paper is organised as follows: Section 2 provides a primer on venture capital based on the extant economics literature and on the available empirical evidence. Section 3 develops a statistical portrait of the European venture capital industry, comparing it to its American counterpart and assessing its involvement in financing Euro.nm listed companies. Section 4 evaluates the role of European venture capital in the companies it finances. Section 5 concludes. A Data Appendix contains a detailed description of our data collection, and a Web Appendix provides additional tables and material. 2 Venture capital and the creation of innovative companies 2.1 History, definitions and jargon In 1946 Georges Doriot, a professor at Harvard University, created American Research and Development (ARD) together with Karl Compton, president of the Massachusetts Institute of Technology, Merrill Griswold, chairman of Massachusetts Investors Trusts, and Ralph Flan- ders, president of the Federal Reserve Bank of Boston. ARD was created to raise funds from wealthy individuals and college endowments and invest them in entrepreneurial start- ups in technology-based manufacturing: Modern venture capital was born. Half a century 3
  5. 5. later venture capital has become the form of financial intermediation most closely associated with dynamic entrepreneurial start-ups, especially–though not exclusively–in high-tech in- dustries like biotechnologies, computer hardware and software, information technology (IT), e-commerce, medical equipment, and telecommunications.1 Many of today’s most dynamic and successful corporations received venture capital at the initial stages of their lives: Ama- zon, Apple, Cisco, e-Bay, Genentech, Genetic Systems, Intel, Microsoft, Netscape, and Sun Microsystem, to name just a few. As a result, venture capital has developed into an impor- tant, established form of financial intermediation (see Gompers and Lerner (2001)). The maturation was not smooth, though (see Gompers (1994)). Until the 1980s, ven- ture capital firms were in large part publicly funded Small Business Investment Companies (SBICs). While SBICs trained many venture capitalists and helped the industry reach a critical mass by channeling large sums to start-ups, their ability to perform was limited by bureaucratic constraints, lack of professional expertise, and a faulty design of capital structure and incentives (Lerner (1994a)). Their investment record was in fact mixed, and spurred a fall in investor confidence and in committed funds around the late 1980s. Also, many venture firms, including ARD, were organized as closed-end funds, but this attracted retail investors with short-term horizons, whose needs clashed with the long-term returns of venture capital. Only in the late 1980s were SBICs and closed-end funds superseded by the limited partner- ship as the dominant organizational form of American venture capital firms. Another major contribution to the adoption of a more efficient organizational form was the clarification, in 1979, of the Employment Retirement Income Stabilization Act, which allowed pension funds to invest in venture capital. This resulted in a staggering increase of funds invested, and in a faster professionalization of the industry. Until the early 1990s, venture capital remained essentially an American phenomenon. Its success in supporting dynamic companies which create jobs and wealth brought many governments to look for ways to nurture a national venture capital industry. At the same time, the high returns enjoyed by US venture capital firms induced venture capitalists to become active also in other countries. Venture capital is by now a sizeable industry also in Europe and Asia. While no standard definition of venture capital exists, there is wide consensus that it corresponds to the professional financing of young, unlisted dynamic ventures through equity or equity-like instruments like convertible securities. Unlike wealthy individuals who occa- 1 Dynamic firms in traditional services, like Federal Express, Staples, or Starbucks, also received a sizeable share of venture finance. 4
  6. 6. sionally invest in start-ups (’business angels’), venture capitalists are professional investors, organised in small limited partnerships, who raise funds from wealthy individuals and in- stitutional investors and invest on their behalf. They specialise in financing young firms which typically have not yet produced any sales, but which have high growth and earnings potential–many investees are ’start-ups’ which come into life through venture financing. Box 1 provides an explanation of some common terms of the venture capital jargon. 2.2 Financing an innovative company: The alternatives 2.2.1 How to start a start-up Why do innovative companies in high-tech industries get financed primarily by venture capi- talists? To set the stage for our empirical investigation, it is useful to consider what we know about this question, and therefore what one would expect to find from companies backed by a venture capitalist. Consider the hypothetical case of a brilliant academic engineer who has just discovered in his lab a technology to produce a new type of circuit for mobile phones. He believes his product would make an important breakthrough by opening a market for three-dimensional messaging. He thinks he could get rich and famous by creating a start-up which could hope- fully go public. However, the industrial implementation of his product requires an investment in the order of three million euros. This sum far exceeds his personal wealth and that of his family and friends. He asks his bank for a loan, but is told that the bank does not lend to start-ups–unless enough collateral is pledged to cover the full value of the loan. The same disappointing answer comes from several other banks he then contacts. 2.2.2 Why banks won’t do Why do banks typically refrain from investing in start-ups? The reason is that they are not a suitable financier for this type of projects. Banks specialize in raising deposits from the public, lending these sums to businesses, and earning an interest margin in the process. The high liquidity of deposits requires that loans be made only to businesses likely to repay within a relatively short period and with high probability. Banks also rely heavily on a firm’s tangible assets for collateral, but the assets of entrepreneurial start-ups are in large part intangible, like marketing knowledge or technology. In other words, the very nature of banks makes them suitable to lend to firms in established industries, with reasonably predictable cash flows. 5
  7. 7. Box 1: The jargon of venture capital Start-up: a new company which is created by an entrepreneur in a high-tech industry, often with the goal of going public within a few years. Limited partnership: the typical form of organization of a venture capital firm. Its ’general partners’ (venture capitalists) manage the firm and assume full liability, while ’limited partners’ (investors) provide funds and assume no liability beyond the contributed capital. Captive: a venture capital firm which is owned by an industrial company or a finan- cial intermediary. Captives are common in Europe, whereas in the US ’independent’ venture firms, which raise money from institutional investors, are the norm. Convertible securities: equity-like financial instruments which offer venture capi- talists strong protection in case of liquidation, while ensuring participation in the upside should the project succeed. Vesting: a legal term which indicates the process by which a person comes into possession of corporate stock. It usually applies to entrepreneurs or employees whose right of possession over their stocks is contractually deferred until a certain date or until certain targets are met. ’Exit’ : the mode of exit from an investment. Venture capitalists typically exit their investee companies through an IPO, a trade sale, or by writing-off (liquidating) a non-performing company. Initial Public Offering (IPO): the offering of corporate stock to the public through which a company ’goes public’. It is the most sought after way of cashing in their investment by venture capitalists and entrepreneurs, since it allows the highest val- uation. Trade sale: sale of a start-up to another company, typically a large competitor. It is a common way for venture capitalists to liquidate their investment when a company is not growing enough for an IPO or the stock market is experiencing a downturn. Write-off: the disaster scenario. When a funded company fails, the venture capital writes off the investment from its assets. Most venture investments end up as write- offs. 6
  8. 8. A start-up, on the contrary, is an utterly risky business: Most start-ups go bust but are extremely profitable if eventually successful. Another reason for banks’ reluctance to finance start-ups is their being heavily regulated intermediaries which face severe limits to holding equity. 2.2.3 Some possible alternatives... What other options could our engineer consider? The embryonic form of his project rules out direct access to capital markets, which is feasible only for firms with a proven business model, a solid organization, and a clear earning potential. Moreover, the capital needed by a start-up (three million euros in our example) is far below the minimal threshold for an Initial Public Offering (IPO). Government grants are also unsuited for such a project, since they are typically targeted at very small firms, and often require a proven track record which no high-tech start-up may provide (see Gordon (1998) and Lerner (1999)). Four practicable options remain: convincing a ’business angel’ or a financial company to invest in the start-up, finding an established industrial company interested in supporting the project (a ’corporate venture capitalist’), or going for a venture capitalist. A business angel is a wealthy individual who invests directly in a private company (see Benjamin and Sandles (1998) and Prowse (1998)). In some countries associations or groups of business angels provide some legal and organizational support, but these individuals largely invest based on personal relationships. In some cases they also provided expert knowledge of an industry, since many of them are (or have been) executives. A financial company is a holding company which invests in industrial companies. Finan- cial companies rarely invest in start-ups. They prefer more mature firms which are close to going public, to which they often provide ’bridge financing’ to strengthen a company’s equity base in the wake of the IPO. A corporate venture capitalist is an industrial company which invests in start-ups directly or through a dedicated subsidiary–such as Innovacom, the venture capital arm of France Telecom. Established companies invest in new ventures in order to keep up with technological developments and acquire a foothold on possible breakthrough. In other words, they invest for financial but also strategic reasons (see Hellmann (2001)). Corporate venture capitalists bring to new ventures not only money but also knowledge of the market and organizational strength (see Gompers and Lerner (2000)). 7
  9. 9. 2.2.4 ... and their drawbacks Our engineer ponders over these possibilities. He discards business angels, since they are a good source of funds, but only for smaller start-ups. Moreover, business angels lack the financial power which is needed at later stages–and he would rather not risk being stranded once his business starts rolling. Corporate venture capitalists have their drawbacks, too. Sometimes, especially in Europe, they are bureaucratic and slow, while start-ups need speed and thrust to succeed. Also, a start-up which threatens to ’cannibalise’ a major source of revenue of its corporate venture capitalist may end up being delayed or even stopped. In fact, start-ups backed by a corporate venture capitalist have been found to choose a less aggressive strategy than those financed by independent venture capitalists (Zahra (1996). Our investor believes his project to be highly innovative, and therefore wants to avoid the risk of being put on hold by a corporate venture capitalist. His scant experience in business suggests that a professional venture capitalist, with his extensive business contacts and experience in mentoring start-ups, may be a better solution. These gains of being financed by a venture capital seem to outweigh its costs, which consist of a constant scrutiny of all decisions, of the risk of losing control if performance is unsatisfactory, and of the large amount of equity the venture capitalist takes in exchange for his money and support. Our engineer decides to seek support from a venture capitalist. What should he expect? 2.3 A conceptual framework for venture capital 2.3.1 The soft side of venture capital Systematic accounts of the operations of US venture capital firms are provided by Barry et al. (1990), Sahlman (1990), and more recently by Kaplan and Str¨mberg (2000). These studies o show that venture capital constitutes a special form of financial intermediation, with contrac- tual arrangements substantially different from debt contracts. The nature and complexity of these arrangements suggest that the financial ’hard’ side of the capital contribution is complemented by a non-financial ’soft’ side consisting of mentoring and monitoring. Venture capitalists are often thought of as providing firms with expert advice together with stringent incentives to perform. Venture capitalists’ expertise and network of contacts with potential suppliers and customers allow entrepreneurs to focus on what they are best at–technical de- velopment. Their industry knowledge is precious for honing strategies. They concentrate on start-up firms located nearby, and use their knowledge of industries and markets to evaluate and mentor entrepreneurs. Indeed, most venture capitalists have higher degrees, and a tech- 8
  10. 10. nical, not economic or financial, background. Venture capitalists also provide ’reputational capital’ by allowing firms to boast being venture-backed so as to lure top-fly executives or to obtain new contracts. But venture capitalists are also demanding investors, who retain the right to remove the entrepreneur from his post of chief executive officer should she fail to meet any agreed upon milestone. The combination of these ’soft’ sticks and carrots is widely seen to provide venture-backed start-ups with an advantage over others firms, since it should increase the chances of survival, and help start-ups attract further funding as they expand. The narrative literature on venture capital documents extensively these ’soft’ aspects of venture capital. For instance, Gorman and Sahlman (1989) find that the lack of business experience of many entrepreneurs makes mentoring from expert venture capitalists crucial to their chances of success. Survey evidence from four countries collected by Sapienza, Manigart, and Vermeir (1996) shows that venture capitalists see themselves as mentors and advisors. Sapienza (1992) also finds that the involvement of venture capitalists increase with the degree of innovation pursued by a firm. Rosenstein et al. (1993) find that entrepreneurs who are financed by leading venture capitalists regard these as the most useful board members. More formal studies of how venture capital works in the US corroborate this anedoctal findings. For instance, venture capitalists do not provide full financing upfront, but disburse money in installments at different stages of a firm’s development. contingent on the achieve- ment of milestones such as the construction of a prototype, a certain amount of sales, or the hiring of key management figures. Financing at different stages is found to take different roles (see Box 2) and to allow venture capitalists to gather information over time, thus keeping the option of abandoning firms whose hopes of success have dwindled (Gompers (1995)). Venture capitalists are also found to closely oversee investee firms, and to be active board members who step in and take control when times get difficult (Lerner (1995)). Some recent analyses of the influence of venture capital on corporate strategy and per- formance provide even tighter evidence that non-financial aspects are crucial to define the activity of venture capital. Venture-backed firms are found to be faster in developing their products and in bringing them to the market (Hellmann and Puri (2000))–an important ad- vantage in technology markets, where timing is essential to achieve market leadership. This implies that venture capitalists provide dynamic companies with money but also with support and monitoring of their management. Venture-backed companies are in fact found to pursue more radical and ambitious product or process innovations than other companies (Hellmann and Puri (2000)). Venture capitalists also play an important role in the professionalization of the firms they invest in, for example by helping them hire experienced financial and marketing 9
  11. 11. executives and by firing under-performing chief executive officers (Hellmann and Puri (2002)). Very importantly, venture-backed companies produce more, and more valuable, patents than non venture-backed firms (Kortum and Lerner (2000)).2 Venture capitalists also shield com- panies from the need to rush to markets, thus prematurely disclosing strategic information to competitors. They also allow firms to go public only when market conditions are most favorable (Lerner (1994a)). Box 2: The stages and roles of venture capital financing Seed finance: Small investment, in the order of a few hundred thousand euros at most, which allows an entrepreneur to verify whether his project is feasible and eco- nomically attractive. At this stage the venture capitalist helps explore the viability of a project. Start-up finance: Investment aimed at making a firm operational by attracting the necessary employees and executives, developing a prototype and/or implementing marketing tests. At this stage the venture capitalist may become involved in the organization of the company. His contribution to shaping corporate strategy is felt most heavily at this stage. Expansion finance: Investment aimed at reaching the scale of industrial production, upgrading the production facilities and attracting further employees. At this stage the venture capitalist may help find additional financing and help the company contact clients and suppliers. As the company grows and needs revenue, he may also help recruit marketing and other non-technical executives. Later stage finance: Investment aimed at helping the firm grow fast enough to be- come a market leader and unleash its earning potential and to make it ready for a trade sale or for listing on a stock exchange. At this stage the venture capitalist may help set the stage for either a trade sale or an Initial Public Offering. 2 Venture capitalists also play an important role in the process of going public. Their experience helps companies choose the most favorable time for their IPOs (Lerner (1994a)) and experience lower underpricing (Megginson and Weiss (1991)). Venture-backed companies which went public in the US in the 1970s and 1980s are also found to perform better than non venture-backed companies over five years spells (Brav and Gompers (1997)). 10
  12. 12. 2.3.2 Venture capital as a package of services Why should the ’hard’ and ’soft’ sides of venture capital coexist under the same roof? In ’standard’ economic conditions straight debt contracts provide the optimal form of financing (Gale and Hellwig (1985)), so that the separation of financing and mentoring would also be optimal. However, technological start-ups are not ’standard’ borrowers. A start-up relies on the talent and skills of its founder, who knows more about its technical aspects than anybody else. This makes it particularly difficult to evaluate her performance, and requires of the financier a technical and not purely financial expertise. Moreover, running a laboratory requires more freedom than operating a factory, so that an entrepreneur can more easily appropriate funds than a manager in an established firm. Finally, entrepreneurs can use privy information, like the status of technical tests, to pursue strategies which conflict with the interest of investors–like rushing to market to gain a reputation of first-comer at the cost of long-term profitability. Moreover, the very nature of entrepreneurship prevents start-ups and financiers to write ’complete’ contracts which specify all conceivable future contingencies (Hart and Moore (1998)). The right to control future strategic decisions is in fact even more important in determining success for start-ups than for mature firms. These characteristics of start-ups provide good economic reasons for the coexistence of the ’hard’ and ’soft’ sides of venture capital. Financial economists have produced several justifications for why the optimal contract between entrepreneur and venture capitalist should be different from debt. Optimal financing should not arrive all upfront but should be ’staged,’ coming once new milestones have been met, in order to reveal information on the venture as it arises (Admati and Pfleiderer (1994) and Bergemann and Hege (1998)). Financing of start- ups should also take the form of convertible securities in order to induce the entrepreneur to behave efficiently (Cornelli and Yosha (1998), Repullo and Suarez (1999)), and to allow financiers to take control of the venture if the entrepreneurs under-performs (Bergl¨f (1994). o A key aspects of these models is that, unlike in standard financial contracting, both the entrepreneur’s effort and the venture capitalist’s mentoring and monitoring are not verifiable by a court, and therefore cannot be contracted upon. A start-up therefore creates a situation where both sides have special skills to contribute for which they experience a problem of moral hazard. This situation is fundamentally different from that of a bank loan, and in the context of start-up finance a standard debt contract simply does not work. A formalization of these results can be found in Casamatta (2000), who focuses on the complementary role of the hard and soft sides of venture capital, and in Hellmann (1998), who shows that the expertise of 11
  13. 13. a venture capitalist in replacing an under-performing entrepreneur as CEO of his company is a necessary ingredient for convertible securities to entail an optimal allocation of control rights. 3 Venture capital in Europe: A statistical portrait 3.1 Venture capital in Europe and the US: A comparison The first step in assessing the contribution of European venture capital to the creation of innovative companies requires a quantitative look at the state and structure of the European venture capital industry and at its evolution over time. Since the US venture capital industry is the most mature and developed, we use it as the term of comparison for European venture capital. We base our analysis on the aggregate statistics published by the European Private Equity and Venture Capital Association (EVCA) for Europe and by the National Venture Capital Association (NVCA). These data come from extensive surveys of venture capital firms in both economies. For Europe, EVCA distributes each year a survey to venture capital firms irrespective of their EVCA membership status in cooperation with PricewaterhouseCoopers. For 2000, the last available year, the number of respondents was 949, corresponding to a 70% response rate. The yearly statistics published by NVCA are based on the commercial database VentureXpert by Venture Economics, a division of Thomson Financial Securities, which contains data on over 5,000 American venture capital firms. Tables 1 through 6 and Figures 1 and 2 report our elaborations on these aggregate data for 1991-2000. There is much that one can learn from these data. Figure 1 shows the amount of funds raised by venture capital firms, and Table 1 provides a break-down of the sources of finance. The explosion in venture capital activity during the 1990s is apparent, but has been uneven. In the US, the amount of funds raised increased by a factor of 80. Figure 1 about here In Europe, only by a factor of twelve. What is intriguing is that the level of funding in Europe increased mostly after the opening of Euro.nm in 1997, which paved the way for the listing of high-tech start-ups. Whether this coincidence conceals a causal link or reflects broader changes cannot be told apart based on simple inspection of these figures, but it suggests a challenging research topic. Figure 1 also shows a widening gap in the amount of 12
  14. 14. funds raised in the two economies (which we express in dollars for sake of comparability). The figure also shows that growth has been smoother in the US, whereas Europe has experienced several ups and downs. Venture capitalists finance their activity by raising ’funds’ from institutional investors like pension funds, insurance companies, or endowments. Each ’fund’ is invested in a number of firms with a five to ten years horizon. Once a ’fund’ is ended, its cash proceedings, which come from IPOs and trade sales, are distributed to investors together with any remaining equity holdings. Table 1 uncovers a substantial difference in the structure of venture capital funding across the Atlantic. Institutional investors (mainly pension funds) are by far the largest contributor in the US, accounting for nearly two thirds of all funds, as compared to less then one third in Europe. The stability of the share of institutional investing in the US is also worth pointing out as a sign of maturity of that market. European venture capital is in- stead dominated by funding from financial institutions (mainly banks), which still remain the largest source of funding. Funds controlled by a financial or corporate entity (’captive’ funds) are in fact more common this side of the Atlantic, where the share of corporate investment has doubled in the second half of the 1990s.3 The table also highlights the lower reliance of American venture firms on ’other’ sources (individual investors and realized capital gains), another sign of the maturity of that market. Government funding is virtually inexistent in the US, where publicly-funded Small Business Investment Companies are not considered venture firms, and it is low in Europe. These profound differences in funding patterns largely reflects the different structure of capital markets in the two economies. Europe is still dominated by banks, which control a large part of the mutual funds industry. Since also the nascent pension fund industry is likely to be controlled by banks, we should expect these differences to persist, and to influence the behaviour of venture capital firms. 3 The drop in the share of corporate funding in the US in 2000 is partly due to the shift from corporate funds to ’in-house’ corporate investing, which does not get recorded in NVCA statistics. 13
  15. 15. Table 1. Venture capital: Sources of finance Europe Institutional Investors Corporations Financial Government Other (%) (%) (%) (%) (%) 1991 15 5 48 2 30 1992 13 6 45 9 27 1993 16 5 40 6 33 1994 20 9 41 3 27 1995 29 5 36 3 27 1996 34 3 35 2 26 1997 26 11 42 2 19 1998 24 10 37 5 24 1999 23 10 43 5 19 2000 31 10 32 5 22 United States Institutional Investors Corporations Financial Government Other (%) (%) (%) (%) (%) 1991 76 5 6 - 13 1992 67 4 17 - 12 1993 73 8 12 - 7 1994 69 9 10 - 12 1995 59 5 20 - 16 1996 70 20 3 - 7 1997 56 25 6 - 13 1998 66 12 10 - 12 1999 61 14 16 - 9 2000 61 4 23 - 12 Notes: Institutional investors includes endowments and pension funds, corporations include invest- ments by corporations (including corporate venture capital through dedicated funds), financial insti- tutions includes banks, insurance companies, and funds raised from capital markets, other includes individuals and realized capital gains. European data in millions of euros (ECUs before 1999) and US data in millions of dollars. Source: Authors’ calculations on EVCA and NVCA data. 14
  16. 16. Taken at face value, the aggregate funding data shown in Figure 1 would suggest that in the second half of the decade Europe has seen an impressive growth in the amount of funds raised, which increased nearly twelve-fold between 1995 and 2000 after remaining stagnant in the first half of the decade. Unfortunately, this is not the case. Figure 2 and Table 2 tell us why. The problem is that aggregate data for funding comprise two very different types of data. They include funds raised for venture capital, but also funds raised by firms which specialize in management buy-outs (MBOs). These are financing operations which enable management to acquire (’buy out’) an existing business from its original owners. MBOs typically involve established companies in mature industries, and are therefore quite distinct to venture capital, which is directed to new ventures.4 Figure 2 about here That the resulting bias is serious is shown by Figure 2, which plots the amount of funds invested each year. Aggregate data on investments separate between funds which go into venture capital proper and into MBOs.5 Once we compare the amount of funds raised with that of funds invested into venture capital proper, we see that the performance of Europe is less thrilling than suggested by Figure 1: The growth of funds invested in venture capital between 1995 and 2000 has been near six-fold, a mere fourth of that experienced in the US. A similar results holds if we look at the whole decade, since its early years saw sluggish growth in both economies. Despite the rise of venture capital activity, the gap between Europe and the US has actually widened, and at an increasing pace. Table 2 reveals that European venture capital invests an increasing share of its funds at ’early stage,’ which are those where its contribution is expected to be most significant, though the monetary amount invested in early stage in Europe is about a fifth of what is invested in the United States. In Europe, the share of early stage financing has more than doubled between 1997 and 2000, and since 1999 it has been greater than in the US. Again, though one is intrigued by the coincidence of the opening of Euro.nm and the increase in this riskier type of investments, a causal can only be conjectured at this stage. In both countries the majority of funds goes to expansion investments. These go to companies which have 4 EVCA started separating the amount of funds raised for these two purposes only in 1999. 5 It should be noticed that the amount of funds raised and invested each year may diverge, since venture capital firms invest the money they raise over a three to five year time span. Therefore they may accumulate resources when good investment opportunities are scarce, and invest more when good projects abound. For instance, US venture capital firms raised 29.1 billion dollars in 1998, but invested only 19.2 of them, whereas in 2000 they invested about 8 billions more than they raised. 15
  17. 17. survived the perilous early years and have shown good success prospects. As for funding, the higher variability of investment patterns in Europe can be taken as a sign of immaturity of the industry, which still has to find a stable structure. Table 2. Venture capital investments, by stage Europe Total of which in VC (Early stage %) (Expansion %) (Later stage %) 1991 6,381 3,429 10 80 10 1992 6,354 3,828 10 76 14 1993 4,639 2,794 8 78 14 1994 6,635 3,707 10 75 14 1995 7,370 3,952 11 77 12 1996 8,389 4,652 12 71 18 1997 8,992 5,388 15 70 15 1998 15,662 7,636 23 62 15 1999 25,628 12,623 27 64 9 2000 33,177 19,516 32 63 5 United States Total of which in VC (Early stage %) (Expansion %) (Later stage %) 1991 2,464 2,257 32 47 21 1992 5,059 3,759 25 43 32 1993 4,919 4,560 40 36 24 1994 5,263 3,723 35 32 33 1995 5,471 4,810 40 38 22 1996 11,211 9,676 38 37 25 1997 17,213 14,931 26 47 27 1998 21,981 19,190 30 46 24 1999 59,372 54,111 24 53 23 2000 103,494 100,622 24 56 20 Notes: Data are in millions of current dollars. Early stage includes seed and start-up financing. Source: Authors’ calculations on EVCA and NVCA data. The gap between Europe and the US is also evident from Table 3, which compares the amount invested in venture capital as a percentage of GDP in the US, in Europe, and in some 16
  18. 18. of its national economies. Two facts stand out. First, Europe invests a smaller share of its GDP into venture capital than the US, a difference which widened in 2000, reflecting the boom in venture capital investment on the western side of the Atlantic. The second striking fact is the large and persistent variability of venture capital intensity across European countries. One also notices that a higher venture capital intensity does not necessarily corresponds to a higher number of stock market listings. Countries like Sweden, Belgium or the Netherlands, with a high venture capital intensity, have very few companies listed on Euro.nm. One likely explanation is that many venture-backed companies from these countries list in the US on Nasdaq, or in their national ’traditional’ stock markets. For instance, 25 Dutch companies are listed on Nasdaq, 9 of which did so since 1997. One intriguing fact is that the opening of Euro.nm seems to have spurred also venture capital intensity at national level, albeit with some delay. Indeed, intensity increased more than sixfold in Germany since 1997, and nearly doubled in France since 1996, the year the Nouveau March´ opened. Not all countries e experienced such an upsurge, though. Venture intensity in Italy and Belgium, for instance, has languished. Table 3. Venture capital investments as a percentage of GDP US Europe UK Germany France Sweden Italy Belgium Nether. Spain 1990 0.05 0.01 0.11 0.04 0.06 0.02 0.02 0.04 0.07 0.02 1991 0.04 0.01 0.09 0.04 0.07 0.01 0.04 0.03 0.07 0.04 1992 0.06 0.01 0.08 0.03 0.06 0.01 0.04 0.08 0.06 0.03 1993 0.07 0.01 0.07 0.03 0.06 0.01 0.02 0.05 0.06 0.03 1994 0.05 0.04 0.09 0.03 0.06 0.05 0.02 0.05 0.09 0.02 1995 0.06 0.04 0.09 0.03 0.04 0.02 0.03 0.05 0.12 0.03 1996 0.12 0.05 0.09 0.03 0.06 0.11 0.04 0.05 0.13 0.04 1997 0.18 0.06 0.11 0.05 0.10 0.04 0.04 0.08 0.19 0.05 1998 0.21 0.09 0.16 0.07 0.07 0.06 0.06 0.10 0.24 0.05 1999 0.58 0.14 0.21 0.13 0.13 0.20 0.06 0.27 0.34 0.10 2000 0.78 0.17 0.38 0.30 0.10 0.21 0.07 0.10 0.80 0.08 Notes: Venture capital spending from EVCA and NVCA data. National GDP data from the Inter- national Financial Statistics of the IMF, GDP for Europe (EU-15) and for the US from the Monthly Bulletin of the OECD. Source: Authors’ calculations on EVCA and NVCA data. 17
  19. 19. Table 4 provides data on the sectoral distribution of venture capital investments.6 While differences in sectoral classifications make it difficult to closely compare EU and US patterns, some facts stand out. Most notably, manufacturing–which includes consumer and industrial products–plays a major role in Europe, but only a marginal role in the US. While this is partly due to the inclusion of MBOs in the European data, its lower propensity to high-tech investments is confirmed by the relevance of investments in agriculture and finance (’other’ in the table). The evolution of investment patterns is also telling. Europe is much less dynamic, and the relevance of investment in more advanced sectors has only begun in 1999. The US, instead, shows a more flexible investment attitude. For instance, the share of money put into biomedical companies has shrunk the last few years, which have seen a boom of computer investments, which include Internet-related companies. 6 Unfortunately data for Europe are inclusive of investments in MBOs, since a sectoral breakdown for venture investments is not published by EVCA. This may be one reason behind the predominance of investment in traditional sectors in Europe. 18
  20. 20. Table 4. Venture capital investment destination, by sector Europe Telecom Computer Manufacturing Biomed Electronics Other % % % % % % 1991 2 6 56 6 3 27 1992 4 4 58 5 3 26 1993 1 6 59 6 4 24 1994 2 4 61 5 4 24 1995 5 7 56 8 4 20 1996 4 5 52 6 4 29 1997 6 7 51 7 5 24 1998 9 9 46 7 3 26 1999 12 11 50 7 2 18 2000 14 13 43 10 4 16 United States Telecom Computer Manufacturing Biomed Electronics Other % % % % % % 1991 12 19 13 25 17 14 1992 21 12 8 22 10 27 1993 21 30 8 21 7 13 1994 17 18 9 23 10 23 1995 18 21 12 22 12 15 1996 15 27 9 20 7 22 1997 16 30 8 27 8 11 1998 16 36 8 17 11 12 1999 17 56 6 7 6 8 2000 17 58 7 6 8 4 Notes: European data in millions of euros (ECUs before 1999) and US data in millions of dollars. Biomed includes biotechnologies, medical technology and healthcare; Computer includes online and In- ternet start-ups; Manufacturing includes industrial products, consumer products, energy; Electronics includes computer hardware and semiconductors. Other includes agriculture and financial services. Source: Authors’ calculations on EVCA and NVCA data. 19
  21. 21. Table 5 shows another interesting difference between the structure of venture capital investments in the two economies. While Europe invests much less in venture capital than the United States, it supports a much larger number of companies, nearly twice as many. This means that the average amount invested per company is much smaller in Europe, where money is spread very thinly across companies. Table 5. Venture capital backed companies US companies EU Investments EU companies 1991 1,088 5,615 n.a. 1992 1,294 5,088 n.a. 1993 1,150 4,422 n.a. 1994 1,191 4,459 n.a. 1995 1,325 3,891 n.a. 1996 2,002 4,081 n.a. 1997 2,697 5,044 3.967 1998 3,149 6,062 5,083 1999 3,969 9,470 7,335 2000 5,412 12,958 9,574 Notes: Data are counts of exits. Source: Authors’ calculations on EVCA and NVCA data. An interesting way of looking at the evolution of the venture capital industry is also to consider the number of venture capital firms. A problem in this respect is that no standard definition or registry of venture capital exists. Therefore—unlike banks or brokers—one must resort to a subjective criterion to identify venture capitalists. What we did was to consider a venture capital firm as such if it belongs to EVCA, whose directories since 1990 are available.7 Based on this definition, Table 6 provides some interesting insights in the dynamics of the venture capital industry. The numerosity of venture firms confirms that Europe still has some way to go before boasting a venture capital industry as thick as in the US. The number of venture capital firms in Europe remains nearly half than in the US. It also interesting to notice that the high growth of the American industry has started at least 7 Despite contacting the major national venture capital associations, we could not obtain their pre-1999 directories. 20
  22. 22. in 1995, together with the growth wave in funding and investment. In Europe, instead, the number of venture capital firms almost doubled over just three years, raising again the question of what role the opening of Euro.nm might have played in this. Indeed, the five countries where a ‘new’ stock market opened accounted for almost half of the total growth in the number of EVCA members since 1997. Also the numerosity of venture capital firms is much greater in those countries with an active stock market for innovative firms. Italy is the only exception, with a small and less dynamic venture capital industry. Taken together with the difference in organizational structure (Jeng and Wells (2000)), funding sources and investment behavior, these numbers offer a picture of deep differences in the venture capital industries of the US and Europe. What might that mean for the financing of innovative companies is the object of the rest of this article. Table 6. Venture capital firms, EU and US US EU UK Germany France Sweden Italy Belgium Spain Netherlands 1991 389 163 42 11 30 1 10 12 5 21 1992 397 161 38 15 29 2 12 11 6 20 1993 401 159 40 13 29 3 11 12 7 19 1994 400 162 42 15 27 5 11 14 8 17 1995 425 169 40 18 32 5 11 13 8 16 1996 460 176 42 20 31 4 13 13 8 18 1997 507 184 52 27 32 5 12 16 8 19 1998 547 210 61 36 33 7 12 17 10 25 1999 620 331 79 51 48 11 16 23 14 32 2000 693 424 90 75 59 22 19 30 17 33 Notes: Venture capital firms members of EVCA and NVCA. Source: Authors’ calculations on EVCA and NVCA data. 21
  23. 23. 3.2 Venture capital in the winner’s circle: venture-backed companies on Europe’s ’new’ stock markets Aggregate data provide an intriguing picture, but they raise more questions than they can answer. One is left with the impression that European venture capital has substantially developed over the last decade, but that it has also lost ground to the US industry in its ability to fund innovative start-ups. Aggregate data cannot tell us much about how effective European venture capital has become in nurturing fast-growing companies. Has the growth in the size of the industry corresponded to a growth in its ability to support the creation of innovative companies, or not? The only way to obtain a convincing answer is to turn to firm-level data. Here we face serious obstacles. While in the US commercial companies like VentureOne and Venture Economics have been gathering comprehensive and reliable data on venture partnerships and venture-backed firms since the 1970s, in Europe systematic data collection of this sort has begun only very recently. Therefore we cannot yet rely on adequate data for in-depth empirical inquiries. A number of studies conducted for industry associations portrait venture capital as con- ducive to job creation and to the growth of technologically oriented firms. Venture-backed firms are found to grow faster, create more jobs, and export more than established firms. For instance, between 1993 and 1997, British venture-backed companies increased employment by an yearly 24%, and sales by an yearly 40%. By comparison, employment at the hun- dred largest British listed companies grew by 7%, and sales by 15% (BVCA (1999)). On a European scale, between 1991 and 1995, employment at venture-backed companies grew by an yearly 15% and sales by an yearly 35%, as compared to 2% and 14% for the 500 largest European listed firms (EVCA (1996)). Suggestive as they are, these studies are based on a few ’stylized facts’ which are still to be rigorously tested.8 At least two problems make their findings unconvincing. First, they suffer from severe survivorship bias, since they only look at successful start-ups without considering the much large number of those which failed. A correct comparison should look at both winners and losers, taking into account that small and medium enterprises (SMEs) suffer from a high mortality rate (OECD(1998)). The contribution of SMEs to economic growth or net job creation is in fact far from obviously positive, and has been recently 8 Stimulating case studies on the difficult gestation of European venture capital in the 1980s and 1990s are provided by Becker and Hellmann (2000) and by Freeman (1998). 22
  24. 24. challenged in a series of studies (see Audretsch and Thurik (1999)). Second, these studies compare venture-backed firms with large firms, which are, by their nature, less dynamic (Davis, Haltiwanger and Schuh (1996)). A correct comparison should instead pit venture- backed against non-venture-backed start-ups. These studies, therefore, are unable to separate the effects of venture capital financing from those of being a (naturally fast-growing) start- up, and risk to capture effects due to a spurious correlation between being a start-up and receiving venture capital. In other words, it could very well be that the purported vitality of European venture-backed firms is due to factors other than venture capital. A deeper analysis is therefore warranted, and our paper provides a first attempt in this direction. We do so by looking at the involvement of venture capital with companies which listed on Euro.nm between 1997 and 2000. Looking only at companies which make it to the stock market has the obvious limitation of disregarding what happens to those which are still private, or choose to remain so. However, in our case this limitation should not be too much of a concern. Start-ups which go public are arguably among the most successful ones, since the pecuniary and reputational rewards for founders and financiers are highest in this case. Founders can get a much higher valuation with a flotation than with an acquisition or a private placement. The ability to bring companies public is one of the key abilities venture capitalists boast about with institutional investors, since IPOs are the most lucrative exit from a venture investment, on average four or five times more profitable than acquisitions (Gompers and Lerner (1997)). Since venture capitalists are profit-seeking organizations we would expect them to bring as many of their portfolio companies public as possible, and since they crucially rely on reputation for their business, we would also expect them to select the most promising firms as investees. Therefore we might over-estimate the impact of venture capital on corporate growth by looking only at listed companies, a possibility we will return to in the interpretation of the data. An advantage of looking at Euro.nm listed companies is that they belong to a small number of high-tech industries, are of fairly similar age, and come from a small number of countries. This makes them a relatively homogeneous group of ’venturable’ companies where we naturally find a reliable control sample, avoiding sample design problems. Focusing on Euro.nm listed companies also gives the advantage of obtaining detailed information thanks to the tight disclosure requirements of Euro.nm, which makes companies disclose information not only for the years starting with the IPO, but also for the three pre-IPO years. Such breadth and depth of information can not be attained for private firms. 23
  25. 25. 3.2.1 Euro.nm: Europe’s ’new’ stock markets Euro.nm was created in the spring of 1997 as an alliance of the newly born ’new stock markets’ of the stock exchanges of Amsterdam (Nieuwe Markt), Brussels (Euro.nm Brussels), Frankfurt (Neuer Markt), and Paris (Nouveau March´, which had opened in March 1996). In e June 1999, Milan’s Nuovo Mercato completed the ranks of the alliance. The stated purpose of Euro.nm was to attract dynamic, innovative companies with high growth potential by offering them suitable admission and trading rules, along the lines of what Nasdaq does in the US (Euro.nm (1999)). Euro.nm offered admission criteria and listing requirements appropriate for young companies with bright prospects but no established track record, willing to accept tight disclosure rules in order to attract investors (see Box 3). Box 3: Euro.nm admission and listing criteria • Shareholder equity (pre-IPO): at least 1.5 million euros • Age: at least three years (waiveable) • IPO volume: at least 5 million euros and 100,000 shares. At least half of the IPO volume must come from a capital increase • IPO prospectus according to international standards • Lock-up: existing shareholders must lock-up their holdings for at least 12 months after the IPO (6 months on the Neuer Markt) • Free float: at least 20% of the nominal capital must be floated • Only ordinary shares with no restrictions to negotiability can be floated • At least one sponsor (an investment bank regulated by the stock exchange) must be designated by the firm to coordinate the listing process • Timely release of annual and quarterly reports and of price sensitive informa- tion The listing rules of Euro.nm were less restrictive than those in use for ’traditional’ ex- changes, and thus more appropriate for dynamic new ventures. However, listing on Euro.nm was more demanding than listing on a traditional exchange in terms of disclosure require- 24
  26. 26. ments. The Neuer Markt, which adopted the strictest rules, required prospectuses and an- nual reports to be published also in English, acceptance of the German Takeover Code, and compliance with international accounting standards (IAS or US-GAAP). Euro.nm closed in December 2000 after the merger of the Paris, Amsterdam, and Brussels stock exchanges into Euronext, but its constituent markets have continued their activity independently. In Bot- tazzi and Da Rin (2001) we analyse the evolution of Euro.nm and provide an assessment of its contribution to the financing of European innovative firms. Tables 7 and 8 provide an overview of the structure and evolution of Euro.nm in terms of total number of listings and funds raised. Table 7. Euro.nm summary statistics Nouveau Neuer Nieuwe Euro.NM Nuovo Euro.nm March´ e Markt Markt Brussels Mercato Number of IPOs 567 165 333 15 15 39 (of which in the data set) (511) (157) (306) (6) (6) (36) Total capital raised 41,618 7,986 26,673 470 225 4,633 Capital raised at IPO 29.4 10.1 38.2 5.7 8.1 44.0 Notes: The number of IPOs includes 16 financial companies which we exclude from our data set. Capital raised in millions of euros. Capital raised at IPO: median values. Source: Authors’ calculations. More than half of the IPOs occurred on the Neuer Markt, almost a third on the Nouveau March´, while the Nuovo Mercato attracted almost as many companies as the Neuer Markt e in its first eighteen months. Our sample closely replicates the market composition of the population, apart for the two smaller markets–which are under-represented. Notice that the Neuer Markt accounts for a larger share of capital raised than of listed companies. Therefore, the (median) amount of capital raised at IPO is far larger on the Neuer Markt than elsewhere.9 Table 8 summarises the evolution of IPOs on Euro.nm. It is worth noticing that IPOs on the Belgian and Dutch markets has tapered off with time, and that the Neuer Markt shows a robust and uninterrupted growth pattern, unlike the uneven growth of the Nouveau March´. e 9 The large amount of capital raised on the Nuovo Mercato is due to a small number of very large telecom companies. 25
  27. 27. Table 8. Number of IPOs on Euro.nm Nouveau Neuer Nieuwe Euro.NM Nuovo Euro.nm March´ e Markt Markt Brussels Mercato 1996 18 18 — — — — 1997 44 20 17 5 2 — 1998 103 43 46 8 6 — 1999 182 32 138 1 5 6 2000 220 52 132 1 2 33 Total 567 165 333 15 15 39 Source: Authors’ calculations. 3.2.2 The data set We develop a unique, hand collected data set with information from the listing prospectuses and annual reports of companies which went public on Euro.nm since its inception to Decem- ber 2000. We obtained the listing prospectuses and annual reports in several ways. Whenever possible, we downloaded electronic copies from the company (or stock exchange) web site. For prospectuses which were not electronically available, which was often the case for earlier years, we contacted the issuing company by phone, fax, or e-mail. In some cases we photo- copied the documents at the relevant stock exchange. Overall, we collected 527 prospectuses out of 567 IPOs which took place in the sample period, or 92% of the total. We also collected 1,790 annual reports, about 94% of the total. Listing prospectuses are valuable for studying the role of venture capital in innovative companies because they contain detailed information on the financial and business situation of the company. Such information is not confined to the IPO year, but extends back in time, up to the three previous years. We use prospectuses and annual reports also to derive quantitative information on several financial and business variables. For each company we collect all the available data for pre-IPO years from the issuing prospectus, which usually contains data for the preceding three years. We also collect data for all the available post-IPO years from annual reports. Each company in the data set is assigned to a sector through a procedure we describe in the Data Appendix, which also contains a detailed description of the data collection process and a list of the variables we use in this study and of their definition. Our final data set, which does not include sixteen companies in financial services, consists of 26
  28. 28. 511 companies.10 Finally, we collect data about financing from venture capitalists and their involvement with these companies. We put particular care in extracting relevant information from our sources. This turned out to be an extremely time-consuming task which required careful search of each single prospectus and cross-checks with several other sources.11 The process of identification of venture capitalist was made particularly difficult by the fact that, unlike for banks, no standard identification criterion is available. We were able to collect data on the extent of ownership and on the timing of venture capital financing, while the exact amount of funding generally remains undisclosed. The details on the construction of the venture capital data set can be found in the Data Appendix. 3.2.3 Venture-backed companies on Euro.nm The first question one wants to ask is what was the actual involvement of venture capital with companies listed on Euro.nm. The answer is that venture-backed companies constitute a substantial part of Europe’s new public companies: The first two rows of Table 9 show that nearly 40% of the listed companies were backed by at least one venture capitalist. This proportion is higher for companies listed on the Nouveau March´ than for those listed e elsewhere. The proportion of listed companies which receive venture finance has doubled since the opening of Euro.nm, a trend which is most noticeable in Germany, a fact we will return to. Notice also that no company listed in Amsterdam or Brussels was backed by a venture capitalist. This is at odds with the numbers in Table 3, where these two countries were shown to have a relatively high venture capital intensity. One possible explanation is the long tradition of listing on Nasdaq of Dutch companies (Blass and Yafeh (2000)), which might be helped by venture capitalists to go through a more expensive listing in the more established American market. Ease of access to Nasdaq could also explain the overall dismal performance of the Nieuwe Markt. More difficult to explain is instead the lack of venture- backed companies on Euro.nm Belgium, and a Parisian dominance cannot be invoked: only one Belgian companies is found on the Nouveau March´. e 10 Companies in the financial services sector are not considered because their financial structure, funding requirements and strategic behavior differ substantially from those of industrial and (non-financial) services companies. 11 We are grateful to our research assistants for the enthusiasm they put in this demanding and tedious job. 27
  29. 29. Table 9. Venture capital and Euro.nm listed companies Nouveau Neuer Nieuwe Euro.NM Nuovo Euro.nm March´ e Markt Markt Brussels Mercato Without VC 292 68 186 6 6 26 With VC 219 89 120 0 0 10 VC before Euro.nm 67 27 34 0 0 6 VC after Euro.nm 130 41 86 0 0 3 (VC entry date unknown) 22 21 0 0 0 1 Notes: With (without) VC identify companies which received (did not receive) venture capital fi- nancing. Before (after) Euro.nm identifies companies which received venture capital financing before (after) the opening of the ’new market’ they list on. The last row lists companies for which we could not ascertain the date of venture capital financing. Source: Authors’ calculations. 3.2.4 Venture capital and Euro.nm listed companies We then want to know the extent to which European venture capital has been involved with listed companies. Table 10 documents that the involvement of European venture capitalists with Euro.nm has been substantial. We look at the number of venture capital firms financing companies listed on Euro.nm. In the second column we list the number of venture capitalists firms, and in the third those which also finance at least one listed company. The first row shows the total number of EVCA members, plus the members of the French, German, or Italian venture capital associations which are not also EVCA members. The other three rows show the number of national association members, which includes both EVCA members and members of the national association only. These constitute the largest sets of professional venture capitalists we could identify at the European or national level. Nearly one third of the ’core’ group of European venture capital firm was involved with companies which listed on Euro.nm. This represents a substantial involvement, given that about 70% of Europe’s venture capital firms have been members of EVCA since less than three years and therefore may not have had enough time to take investee companies to the stock market. The lower proportion recorded at the national level is due to the fact that a small number of venture capitalists with international reach (often US or UK based) finance a very large number of companies. These are European but not French, German, or Italian association members. 28
  30. 30. Table WA-2 in the Web Appendix shows that the sectoral composition of venture capital investments is very close to the sectoral structure of Euro.nm, except for a slightly lower involvement with Media & Entertainment and a higher involvement with Biomed. Table 10. Venture capital firms and Euro.nm Venture capital of which: firms financing a listed company European 601 172 German 152 42 French 153 40 Italian 73 6 Notes: European venture capital firms are members of the European Venture Capital Association (EVCA) and of national venture capital associations. German, French and Italian venture capital firms are members of the respective national venture capital associations (and possibly also of EVCA). Source: Authors’ calculations. Figure 3 examines the distribution of venture capital investments. It plots the number of venture capital firms which finance 1, 2-4, 5-9, or more than ten listed companies. Only 24 venture capitalists (out of 172) finance more than five companies, and only eight more than ten. This reflects the fact that many European venture capital firms are still very young, and have not had the time to get many companies public. Information in the Web Appendix shows that it is the larger venture capitalist with an international presence who tend to support the largest number of listed companies. Figure 3 about here Figure 4 looks at the other side of the coin, namely the number of venture capital investors by company. It shows that syndication of venture investments is not very common in Europe, unlike in the US (Lerner (1994b)): More than half of the 219 venture-backed companies only had one venture capitalist. Figure 4 about here Another way to look at the involvement of venture capitalists with listed companies is to look at their equity holdings, which we examine in Table 11. While fairly volatile, holdings are far from negligible. Moreover, these numbers are likely to under-estimate the involvement 29
  31. 31. of venture capital, since in many case ’bridge financing’ from specialised intermediaries is used in the wake of the IPO to increase the equity base. Venture capitalists often sell part of their stakes at this stage, but we are not able to see these transactions. The table also show that at the time of going public, venture capitalists sell only about 40% of their holdings, and remain involved with the company after it has gone public. As a comparison, Barry et al. (1990) find that US venture capital firms had a higher average pre-IPO equity stake (32%) and sold about a third of it. European venture capital thus seem to have lower shareholdings. Table 11. Equity holdings by venture capital firms Pre-IPO Post-IPO Mean St.Dev. Min Max Mean St.Dev. Min Max Neuer Markt 10 17 0 100 6 9 0 43 Nouveau March´ e 14 18 0 85 8 12 0 53 Nuovo Mercato 7 14 0 46 4 9 0 32 Source: Authors’ calculations. Our last piece of information comes from Table 12, which lists the nationality of venture capital firms and investee companies. Reported numbers are counts of investments by venture capital firms (row) in a certain country (column). One would expect venture capitalist to invest in firms geographically close to them, given their need for constant interaction with their investees. Several studies based on US data document the fact that venture capitalists tend to invest in the proximity of their headquarters (Lerner (1995)). The table confirms that this is the case for our sample, as the vast majority of investments is made within a venture capitalist’s own national borders, as one can see by looking at the diagonal in the table. The only seeming exception is represented by venture capital firms with an international reach, and American venture capitalists which invest in Europe. But this impression is deceptive, since both categories possess local offices in several countries. 30
  32. 32. Table 12. Venture capital and investee companies, by nationality Investee companies Venture Capitalists Germany France Italy Israel US Others Germany 134 3 0 0 2 1 France 2 139 1 0 1 0 Italy 0 0 10 0 0 0 Israel 2 4 0 5 0 0 US 11 9 1 0 2 1 International 44 32 2 0 1 1 UK 5 9 2 0 0 0 Others 5 1 0 1 0 5 Notes: Others includes venture capitalists from Austria (5 investments), Denmark (1), Ireland (1), Netherlands (8), South Korea (1), Switzerland (5). Source: Authors’ calculations. 3.2.5 Which companies are venture-backed? Before proceeding to the analysis of the effects of venture capital we want to know which characteristics of a firm are associated with receiving venture capital financing. Theory predicts venture capital to be associated with young, innovative companies that, being at an early stage of development, are characterised by low profitability and a small amount of sales.12 We have seen in Table 2 that European venture capitalists have been increasing their early stages investment. Therefore we expect our findings to conform to the predictions of the theory. We estimate a probit regression in which the dependent variable is a dummy variable that takes value one if a company has obtained venture capital financing. The independent variables are measured before the arrival of the first venture capitalist (’preVC’).13 Unfortunately we cannot use in this analysis all the companies in the data set, since there are some missing observations, and since 30 companies, i.e. 14% of the venture-backed 12 We are not aware of any statistical study of the determinants of venture financing for the US, except for Hellmann and Puri (2000), who look at a sample of venture-backed start-ups and find that those which pursue more radical innovations are more likely to attract venture capital. 13 For non venture-backed firms, we use the average of the pre-IPO values. We also experimented with alternative measures, such as measuring variables in the years before the average date of entry of venture capital in venture-backed companies, but we found no substantial difference in the results. Hence we stick to the simpler pre-IPO measure. 31
  33. 33. companies in our sample, have received venture capital funding before they started reporting accounting information. Still, this leaves us with 359 companies. Table 13 reports the probit regression results. We find that sales negatively affect the probability of obtaining venture capital financing, while leverage has a positive effect, al- though it is not statistically significant. We control for sectors of activity, but these are found to have no effect. Table 13. Probit regression–dependent variable venture capital Independent Marginal increase Coefficient z-statistic Variables in probability Sales(preVC) - 0.003 -0.01 *** -2.651 Leverage(preVC) 0.117 0.34 1.482 Constant -0.45 -1.131 Number of obs. 349 Log likelihood -184.82 W aldχ2 (7) 19.74 P-value 0.006 Notes: ‘preVC’ denotes variables measured before the arrival of a venture capitalist. Significance levels are indicated by * (10%), ** (5%), and *** (1%). Huber-White corrected standard errors are used to obtain robust estimates. Our findings are consistent with a view of venture capital getting involved with firms which are still at a very initial stage of development and are therefore not yet able to sell: A marginal increase in sales decreases the likelihood of receiving venture financing by 0.3%, an economically small but statistically highly significant result. The positive effect of leverage is consistent with a view of venture capital as an important source of financing. In other words, the ’hard’ side of venture capital goes well along its ’soft’ side. Alternative (unreported) specifications have considered the level of debt, its maturity, the amount of assets and a national market effect as possible determinants of venture financing.14 We have done so to check if companies whose debt is mostly short-term might be more credit 14 The national effect is measured through dummies which take value one for companies listed in France, Belgium, Italy, and the Netherlands. As in all other regressions, the latter three never turn out to be significant, also due the low number of observations. 32
  34. 34. constrained and might therefore look more aggressively for venture financing. A dummy that takes care of the national effect was also used to capture the higher proportion of French venture-backed companies. All these variables turn out to be statistically insignificant, and in all specifications the quality of the fit worsens. We also expect venture capital to be involved with more highly innovative companies. To check for this prediction we control for the natural proxy for innovativeness, R&D intensity, measured as the ratio of R&D to assets.15 This reduces the number of observations to 101, since few companies disclose R&D expenditure. The reported R&D figures are however reli- able, since they are voluntarily disclosed in the IPO prospectuses as a signal of the company’s quality and are not a legally required item of the accounts. All the tables with the results of our statistical analysis where we control for R&D can be found in the Web Appendix. We find that a higher R&D intensity makes a company less likely to receive venture capital financing (see Table WA-4 in the Web Appendix), but the result is not statistically significant. The amount of sales remains the driving force behind obtaining venture financing, and industry controls are all significant.16 3.3 The impact of Euro.nm on venture capital We conclude our statistical portrait of venture capital in Europe by taking a dynamic view of its involvement with the ’new’ stock markets. A close inspection of the listing data reveals in fact that something is changing in the involvement of venture capital with listed companies. We have seen in Table 6 that venture firms are growing fast in Europe. This is good news, for at least two reasons. One is that numerosity is a sign of maturity. The second is that a large part of Europe’s venture capitalist are what the jargon defines ’captives,’ i.e. subsidiaries of industrial companies or financial institutions (typically banks). Captives are not the most aggressive among venture capitalists (Hellmann, Lindsey and Puri (1999)). An important change seems however to be taking place, with a new breed of US-style, independent, venture capital firms entering the market and possibly changing the way venture capital operates in Europe. Table 9 above shows a suggestive piece of information in this respect. Of the 197 venture- 15 Our results do not vary if we control for R&D expenditure. 16 The finding that R&D has a negative (albeit statistically weak) effect is only apparently at odds with the theory, however, since we are measuring variables before the arrival of the venture capitalist. The result is in fact consistent with venture capital selecting companies at an early stage of development, when R&D intensity is still low. However, one could conceivably think of alternative interpretations, for example that companies whose R&D intensity is higher are less credit constrained and therefore less likely to look for venture financing. 33
  35. 35. backed firms in our sample for which we could identify the entry date of a venture capitalist, two thirds received venture financing after the opening of Euro.nm. Interestingly, this pro- portion is higher in Germany, whose Neuer Markt is considered the most dynamic of the ’new’ markets. Table 14 provides further evidence that Euro.nm may really be having an effect on the European venture capital industry. Here we define a start-up as venture-backed (’VC-backed’) if it receives venture finances within six months from its foundation. These are arguably the companies where a venture capitalist has most chances to use its ’soft’ side: It is much easier to affect strategy and management in a new firm than in a five years old one. There are 50 VC-backed start-ups, which we divide into those which were born before the opening of Euro.nm (pre-Euro.nm, 20 companies) and those which were born after it (post-Euro.nm, 30 companies). The number of VC-backed start-ups clearly increases after the opening of Euro.nm. We take this evidence as a suggestive indication of the positive ef- fect of Euro.nm on venture capital. We also notice differences across markets, as the positive effect seems to be much stronger in France than in Germany or Italy. No venture-backed companies are listed in Amsterdam and Brussels. Table 14. Cohorts of venture-backed companies Born VC-backed Total pre-Euro.nm post-Euro.nm Neuer Markt 120 31 16 15 Nouveau March´ e 89 18 3 15 Nuovo Mercato 10 1 1 0 Source: Authors’ calculations. Table 15 further refines this evidence. We count all venture-backed start-ups and partition them by the year of listing on Euro.nm. The relative figures can be read in the second column of the table. Then, in the third column, we count those venture-backed companies which were also born such. This way we can measure how many companies were created with the help of a venture capitalist. Several things are worth noticing. First, the number of venture-backed start-ups, whether born such or not, increases over time. In particular, the number of born venture-backed start-ups more than doubles each year. Moreover, the proportion of venture- backed companies which are born such doubles in 2000. Our data set also shows that six of the 28 companies which were born venture-backed in 2000 had a ’young’ venture capitalist, 34
  36. 36. i.e. one which had become a member of EVCA at most two years earlier. Between 1996 and 1999 only two such cases had occurred. Overall, these figures suggest a picture of increasing involvement of European venture capitalists with companies which have the potential to list, and an increasing importance of venture capitalists in the creation of innovative start-ups. Table 15. Euro.nm and new venture-backed companies VC-backed born VC-backed 1996 7 1 1997 12 3 1998 35 6 1999 72 12 2000 93 28 Total 219 50 Source: Authors’ calculations. There are good reasons to greet this evidence with optimism and hope. Several studies have recently analyzed the relationship between venture capital and stock markets. Black and Gilson (1998), for instance, offer a conceptual framework for analyzing the interplay between venture capital and capital markets, while Michelacci and Suarez (2000) develop an elegant formalization of the link between business creation and equity markets. Both studies emphasise the complementary role of stock exchanges and venture capital. In this view, venture capital and stock exchanges are more than simple sources of finance. Ven- ture capital contributes effective oversight of new ventures, selecting and supporting valiant entrepreneurs and promising new ventures. Such support facilitates the growth of these ven- tures and accelerates their arrival to equity markets. In turn, active and liquid stock markets make IPOs affordable for companies and attractive for investors, creating a complementarity similar to that modeled by Pagano (1993). The American experience with Nasdaq, which was created in 1971 to provide an equity market for high-tech companies, is certainly suggestive in this respect. Over the 1990s about 6,500 companies listed on Nasdaq, the American stock exchange focussed on high-technology industries which in December 2000 listed over 6,000 companies with a capitalization above five billion dollars. Many of these companies had been backed by venture capital, among them successful ones such as Amazon, Cisco Systems, Dell Computers, Intel, Microsoft, and Yahoo!. The evidence we provide in this paper will show that for Europe this road is still very long, but we are probably moving in the right direction. 35
  37. 37. 4 Venture capital and the financing of European innovative companies We now turn to the core of our analysis. Our goal is to provide a rigorous assessment of whether European venture capital helps select and nurture the most dynamic innovative companies, so as to provide guidance for informed policy. In Section 2.3 we have seen that venture capital is expected to provide valuable support to investee companies, and that it is indeed found to do so in the US. Does European venture capital also provide the companies it finances with ’hard’ and ’soft’ support able to make them the ’superstars’ among innovators? 4.1 Null and Alternative Hypotheses We start by setting forth our conjectures on the effects of venture capital financing on the following key aspects of corporate evolution: • The timing of the listing decision. This decision is a crucial one in the life of an innovative company. Going public helps future growth and financially rewards financiers and founders. Our first null hypothesis is that venture capital does not play any role on the process of going public, i.e. that venture capital neither speeds up nor slows down the IPO process. There are at least two alternative hypotheses. The first is that venture capitalists speed up the decision to go public. This would be the case if venture capitalists invested to reap a capital gain and therefore push for a quick IPO to cash in and turn to new ventures, or if they enabled companies to mature faster. NVCA (1988) indeed claims that, between 1992 and 1996, US venture-backed companies were 70% more likely to become listed than other start-ups. Alternatively, venture capital might lengthen time-to-listing (TTL) because it invests in younger firms and waits for them to mature. In this case a venture capitalist, by ensuring adequate financing, would bring a company public only when its potential has been fully brought out, or when the cycle in the IPO market may ensure a high valuation of the company. • The amount of funds raised at IPO. The amount of capital raised is important to deter- mine the amount of resources a growth-oriented company can rely on for its investments. Our second null hypothesis is that venture capital does not affect the amount raised at IPO. There are at least two alternative hypotheses. First, ’certification’ from a venture capitalist may reassure investors even when financial results do not still reflect the full potential of the company. In this case venture capital would increase the amount raised, 36