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  1. 1. AGAINST ALL ODDS: THE LATE BUT RAPID DEVELOPMENT OF THE GERMAN VENTURE CAPITAL INDUSTRY Marc-Oliver Fiedler Thomas Hellmann Stanford Graduate School of Business forthcoming in the Journal of Private Equity May 2001
  2. 2. I.INTRODUCTION For years it was claimed that the German economy is too conservative to develop a significant venture capital industry. Yet, in a period of few years, German venture capital transformed itself from a small, stagnant and obscure niche industry into one of the fastest growing and most visible segments of the economy. What happened? Why did the reasons for Germany’s inability to develop a venture capital industry suddenly vanish? What made the industry leap forward in a space of two or three years? And are these changes only part of a bubble, or is the German venture capital industry here to stay? Historically, the overall market for private equity investments has been underdeveloped in Germany. While the first investment funds date back to 1965, the number of private equity funds remained small; approximately sixty funds were active in Germany in 1995. The gross investment volume had stagnated at approximately DM 1 billion a year in the earlier nineties. In 1995, the volume of all private equity investments in Germany represented a mere 0.03% of the gross domestic product, compared to 0.11% in the United States.i The private equity industry in Germany seemed to be dormant. Then something remarkable happened. In 1997, the private equity industry suddenly came to life. The volume of gross private equity investment almost doubled year-on-year from DM 1,4 billion in 1996 to DM 2,6 billion in 1997. The industry association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften or BVK) saw its membership jump by 20% per year. By 1999 the investment volume had expanded to DM 6,2 billion, representing more than a fourfold increase over only four years (see Figure 1). 2
  3. 3. Figure 1: Private Equity Investments in Germany 1990-99 ii Gross Private Equity Investments (Billion DM) 941 995 1,229 1,112 1,449 1,141 1,367 2,607 3,837 6,178 DM Million 7.0 5 6.0 (1)Other 5.0 +61% Turnaround 4.0 LBO/MBO/MBI +47% 3.0 Bridge +91% Expansion 2.0 Seed/Startup 1.0 .0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Even more intriguing than the growth in overall investment activity was the source of that growth. In Germany, the term “venture capital” is used loosely and includes a lot of LBOs, MBO/MBIs, turnarounds and expansion investments, which in the U.S. would have been classified as (non-venture) private equity. This kind of financing traditionally dominated the German venture capital industry. The spectacular growth after 1997, however, was clearly driven by “proper” venture capital investments. Seed and start-up investing experienced an incredible explosion, growing by almost 1,300% between 1995 and 1999—three times faster than the overall private equity investment volume (see Figure 2). In 1999, venture capital investments had reached a level of DM 2,0 billion, almost 50% higher than the entire private equity investments in 1996. 3
  4. 4. Figure 2: Growth of Private Equity Investments by Type 1995-1999 Growth of Investment Volume by Type (Indexed) 1500 + 1,262% Seed/Startup 1300 1100 + 959% Bridge 900 700 500 + 441% TOTAL + 282% LBO/MBO/MBI 300 + 262% Expansion 100 -80% Turnaround -100 1995 1996 1997 1998 1999 Why this extraordinary boom? Most industry pundits have pointed to the March 1997 introduction of the Neuer Markt, the German stock market equivalent of the NASDAQ. They argue that the Neuer Markt created a new exit channel that provided liquidity for venture capitalists. The liquid stock market promised higher returns than trade sales or management buy-outs could offer. With better return, investors became much more willing to make venture capital investments. According to this “pull” theory, entrepreneurial activity was “pulled” or triggered by changes in the financial market. We argue that this “pull” theory is grossly oversimplified. It captures only a small part of the real driving forces behind the dramatic industry developments. For one, it ignores the advent of the Internet, which changed the nature of technological opportunities. Interestingly, however, there appear to have been many other factors that, while they did not always make headline news, nonetheless seemed to have been equally if not more important. In this paper, therefore, we explore the more complex confluence of several factors that were necessary for the spectacular boom. Indeed, we emphasize that there were a number of “push” factors that made entrepreneurship and venture capital more attractive to Germans. 4
  5. 5. Why should we care about what happened? The first reason is because this offers many lessons for other countries developing their own venture capital industries. For the longest time there was a belief that Germany would never be home to a vivid venture capital industry. Yet, against all odds, it happened. If venture capital can flourish in Germany, perhaps there is hope for many other countries as well. Second, a proper understanding of what happened is critical to scripting a prognosis for the industry’s future. A simplified explanation that overemphasizes a single factor would imply that as this factor changes, the industry would again recede. In particular, with the recent bursting of the stock market and Internet bubble, it might seem that the time has come to write a requiem for the German venture capital industry. Our analysis, however, allows for a subtler, and interestingly more optimistic, prognosis. The purpose of this study is to examine the underlying reasons for the sudden rise in German venture capital. While it is difficult to draw an exact line between private equity and venture capital activities in Europe – the distinction in Europe is not as clear-cut as it is in the United States – we will focus primarily on the early stage venture capital market. Our methodology involved an extensive study of available literature, such as business magazines, newspapers and industry statistics. The core of the research was an extensive series of interviews with a wide variety of key industry participants.iii The different perspectives expressed allowed us to thoroughly develop our main argument. After offering a brief history of German venture capital, we explore the central factors that explain the explosion of the industry in the late nineties. We also evaluate the current state of the industry and conclude with questions about the future. II.HISTORICAL DEVELOPMENT OF VENTURE CAPITAL IN GERMANY Slow growth over the first thirty years 1965 probably marks the birth year of the German venture capital industry: the founding of the first four organized venture capital funds. In the following years, more funds were started, but 5
  6. 6. most produced disappointing results and perished quickly. By 1975, the total investment volume had reached DM 372 million.iv In 1975, the industry witnessed its first significant event with the creation of the Deutsche Wagnisfinanzierungsgesellschaft mbH (WFG). This was the first ambitious effort to create a proper venture capital vehicle. It was founded by a consortium of all the leading German financial institutions and supported by the federal government. The motivation was a belief that Germany was in danger of falling behind the United States especially in terms of the commercialization of new technologies and their importance for economic growth and employment. However, the experiment of the WFG proved a complete failure. The majority of investments made by the WFG resulted in a net loss, and the WFG soon abandoned its early stage technology investment strategy (see Becker and Hellmann, 2000). In the eighties, a number of venture capital firms followed the U.S. model and emerged with moderate success. By 1985, the overall market portfolio had grown to DM1 billion. Despite new federal initiatives to foster start-ups in high technology, such as the “Beteiligungskapital für junge Technologieunternehmen” (BJTU), venture capital investments in the early nineties remained stagnant at approximately DM1 billion a year. By 1996 the entire venture capital portfolio reached DM7 billion and consisted mainly of mature private equity investments. Overall, the growth of the venture capital industry before 1997 had been frustrating and slow.v Entrepreneurship à la Germany: “Mittelstand” A popular myth is that Germany has no entrepreneurial culture. There is a longstanding tradition of entrepreneurship in Germany, but it follows a somewhat different pattern than the Anglo- Saxon model of entrepreneurship. Entrepreneurship in Germany dates back to the second half of the nineteenth century, the so-called “founding years” (Gründerjahre). At the end of the nineteenth century and the beginning of the twentieth, we find the creation of some of the well- known industrial empires, such as Siemens and Daimler-Benz. And while some of these entrepreneurial start-ups grew into large conglomerates, most entrepreneurial activity centered on the so-called “Mittelstand.” The term “Mittelstand” refers to medium-sized enterprises (up to approximately 1,000 employees) that are usually regional, family-owned businesses. Typically they specialize in specific industrial niche markets, especially manufacturing machinery and automotive parts. After World War II, the “Mittelstand” fashioned an important engine for 6
  7. 7. Germany’s economic reconstruction. With more than 800,000 companies, the “Mittelstand” remains an important force in the German economy If an entrepreneurial spirit always existed in Germany, why did venture capital take so long to develop? The answer lies in the types of entrepreneurial activities and the entrepreneurs behind the ventures. A typical “Mittelstand” company generally was started and managed by a family. Initially bootstrapped from family resources, with time it would secure loans from commercial banks, with founders pledging both personal and company assets as collateral. Given the more traditional, slow-moving industries in which these businesses competed (especially in machine tool manufacturing, or “Maschinenbau”), there was no need for rapid growth. Instead, they grew gradually, relying mostly on retained earnings rather than external equity. Many founders wanted to make a good living with their enterprises, but few had the intention – or skills, for that matter – to build large-scale businesses. The concept of sharing equity with outsiders was foreign to these entrepreneurs. They viewed their family businesses with pride and put great emphasis on retaining control. The business model pursued by a typical “Mittelstand” company, while clearly entrepreneurial, was distinct from the business models that would attract venture capital. Consequently, venture capitalists encountered considerable difficulty working with traditional German entrepreneurs. The chairman of the venture capital industry association, Dr. Holger Frommann, commented: “[German venture capitalists] had difficulty to build a positive image and had to fight against the deep-rooted and widespread mentality of the German ‘Mittelstand’, the ‘King of the Castle’ mentality.”vii Social norms as disincentives Social norms embedded in German society prevented the widespread acceptance of venture capital. Traditionally, the ideal job for a middle manager was a stable career position with good compensation and status within an established company. Those with the skills to run a successful start-up had little incentive to do so. Professional failure invited social stigma which a failed founder would carry for a lifetime. Concurrently, financial success was not necessarily viewed with admiration either, but with envy. In the rather egalitarian German society, a successful entrepreneur could easily be admonished as a “capitalist pig.” From a social perspective, it was relatively safe to start a family-oriented “Mittelstand” company; but there were no social incentives to start a high-risk, large-scale business that would require venture capital. Interestingly, these social norms created adverse selection among entrepreneurs. 7
  8. 8. Successful managers were less likely to give up the security of their current employment, and the managers who were willing to take the risk were more likely those who had not achieved a high level of success in the corporate world. III. EXPLOSION OF VENTURE CAPITAL IN THE LATE NINETIES This situation changed abruptly in 1997 when German venture capital exploded. Why? Clearly the emergence of venture capital cannot be explained by a single factor, such as the introduction of the Neuer Markt. We will show that there were multiple factors that complemented each other. To structure the analysis, we group these multiple factors into four main groups. 1. A sharp rise in entrepreneurial opportunities and entrepreneurial activities, the Internet being the most visible component. 2. A new breed of progressive, less risk-averse entrepreneurs with more affinity toward Anglo- Saxon funding models. 3. Increased necessity to fund ventures through equity rather than debt or retained earnings. 4. Increased availability of funds for investing in start-ups and stock markets A.The Internet and deregulation bring about new opportunities The Internet opened a large number of new business opportunities promising to transform entire industries. In the United States, public access to the Internet and commercial applications first became prevalent around 1995. User-friendly browsers made the Internet accessible to anyone, regardless of technical know-how. Once the general public started adopting the Internet as a new communications medium, and the user group reached critical mass, the development of commercial applications became economically viable. Obstacles in infrastructure and more conservative consumer behavior, Europe’s adoption of the Internet lagged behind the United States. Most industry experts estimate that this time lag spanned one to two years, hence it was not until 1997 that Internet euphoria really spilled 8
  9. 9. eastward across the Atlantic Ocean. In 1997, 7% of the German population had access to the Internet—approximately the same percentage as in the United States 1½ years earlier (see Figure 3). But once the euphoria swept across Europe, savvy entrepreneurs quickly realized the opportunities to be harvested. Figure 3: Internet User Penetration (in Percent of Total Population) viii 60% USA 50% 40% 1 ½ years 30% Germany 20% 10% 0% 1995 1996 1997 1998 1999 2000 2001 2002 It is important to recognize that the Internet had some unique characteristics that made it a relatively “safe” platform for new entrepreneurial activity in Germany. Earlier waves of entrepreneurial innovation, such as the computer hardware and software revolution in the eighties and early nineties, had thrived on technological breakthroughs and proprietary developments. The Internet, on the other hand, was marked by the emergence of new business models (such as reverse auctions, consumer-to-consumer transactions, communities, etc.) and the application of old business models to a new medium. Business models were built on new, but highly transparent business processes rather than proprietary technology. These could easily be copied and applied to new target audiences. Not surprisingly, a majority of the Internet start-ups springing up in Germany were essentially copycats of U.S. concepts (see Figure 4 for some prominent examples). Taking proven business models that already had been scrutinized by U.S. venture capitalists, and transplanting them into the German market, was perceived as an easy, low-risk way to start a venture. 9
  10. 10. Figure 4: Prominent Copycat Examples of German Internet Start-ups US Model German Copycats eBay alando, ricardo epinions dooyoo, ciao Amazon etoys hotmail In addition to the Internet, privatization and deregulation of the German telecom market created further opportunities for entrepreneurs. Obviously telecommunication played an integral part in the exploitation of the new Internet media, so deregulation created particularly exciting opportunities in the German market. As network access became liberalized, and emancipated customers demanded innovative new services, a broad spectrum of competitors emerged. While some represented divisions or spin-offs of established industry conglomerates (e.g. Mannesmann Arcor and VIAG Interkom), others were entirely independent ventures (e.g. Mobilcom, QSC, Primacom, Strato Medien AG). Clearly the combination of a new technology and communication platform(the Internet) alongside the deregulation of the telecommunications market opened the door for tremendous entrepreneurial opportunities. B.A new generation of entrepreneurs emerges Who were the entrepreneurs who could take advantage of these new opportunities? The more conservative Mittelstand mentality hardly lent itself to exploiting these technological breakthroughs. A new generation of entrepreneurs needed to step up to the plate and take a swing at the new economy. And a new breed of entrepreneurs did emerge. Most were young, highly educated, and had been exposed to a dynamic professional environment in their short previous careers. A fairly large percentage had earned a business degree as part of their education. A study of one thousand 10
  11. 11. start-ups in the German Internet and e-commerce industry conducted at the European Business School (EBS) illustrates this picture (see Figure 5). 11
  12. 12. Figure 5: Profile of New German Entrepreneurs ix Age of Founders at Level of Education of Inception of Venture Founders 40+ PhD 24- High 7% school 35-39 18% 14% 21% 13% Graduate 13% Col- 32% 30% 25-29 30-34 school 52% lege Educational Degree of Professional Back- Founders ground of Founders Natural Science Industry Research/ University Social 11% Media 12% Science 10% Business/ 26% 34% Economics IT 23% 21% 18% 13% 5% Consulting Engineering 25% CS/Math Services Banking The background of these “new” entrepreneurs stands in sharp contrast to that of the traditional “Mittelstand” entrepreneurs, who were usually older and more likely held engineering positions in established industries. These differences in backgrounds appear to be particularly relevant as data from the EBS study suggest that founders with business backgrounds show more affinity to venture capital than founders with more technical backgrounds.x One German venture capitalist noted: “Today, the typical entrepreneur is no longer the cigar-smoking middle-aged Mercedes driver who would rather die than give up control over his company. Today’s entrepreneurs are young, enthusiastic and don’t shy away from risk.” Another venture capitalist added: “Today’s entrepreneurs are much more money-driven. They realize that equity funding is the only way they can grow their start-up quickly and attain high personal returns.” Many of the “new” founders have had significant exposure to American culture, having studied or lived in the United States, or having worked for U.S. corporations in Europe. As a result, these entrepreneurs are comfortable following the U.S. model of starting businesses, including giving up equity in return for funding and managerial support. 12
  13. 13. Inspirational success stories New entrepreneurs’ affinity towards venture capital was reinforced by inspirational success stories spreading through business circles and universities. These inspired young professionals to try their luck at a start-up and helped boost boost both the image and prominence of venture capital. Many looked in awe to Silicon Valley icons, such as Jerry Yang of Yahoo, Marc Andreesen of Netscape, or Jeff Bezos of Amazon. The fascination over Silicon Valley spilled into Germany, so that major business magazines (Wirtschaftswoche, Capital, DM) introduced Silicon Valley columns and special reports providing current information about the Californian “field of dreams.” Aspiring German entrepreneurs were eager to follow the path of these role models, and since venture capital seemed to have played an important role in the success stories of Silicon Valley, new German entrepreneurs were more favorably disposed towards venture capital. The inspiration for a new generation of entrepreneurs became all the more vivid when high- profile German success stories emerged: German entrepreneurs, too, could make it in the Internet world. Some of the most talked about examples included Stephan Schambach, founder of Intershop—a world leader in Internet shopping applications—or Stefan Röver, who started Brokat, an online bank. In some instances, such as occurred with the Samwer brothers, founders of alando (now eBay Germany), television and the boulevard press elevated entrepreneurs to a status of pop icons. A point of debate is whether these role models inspired awe or greed. One partner of a large German VC firm asserted: “Greed has been the major driver for many entrepreneurs over here in recent years. They watch how some kids make millions in Silicon Valley starting their own company, and now they want to do it too.” Whatever the motivation may have been, these entrepreneurial idols paved the way for fledging new founders in Germany. They created awareness in the general public, they established credibility and legitimacy for entrepreneurs, and they validated a business model where venture capital played a central role. It is worth noting the extent to which established organizations changed their attitude towards entrepreneurship. German universities are hardly known for institutional change, but almost every major University began launching its own business plan competitions. Ironically, these 13
  14. 14. events were frequently co-sponsored by established companies such as BMW, Siemens, Deutsche Bank, McKinsey, Deutsche Post, or the Frankfurter Allgemeine Zeitung. Shifts in the labor market Start-up fever also reached German employees, who historically showed little job mobility. For the first time a large number of employees “jumped ship” from traditional jobs, especially in banking and consulting firms. One former IT consultant who had joined an Internet start-up noted: “People fleeing from consulting firms’ doors have worn out their hinges…. There were probably only a few years of this madness left, so it was now or never.”xi Other factors reinforced this movement. In the late nineties, Germany faced a grim labor market. Unemployment rates, for example, had almost doubled since the beginning of the decade to more than 10%. The unemployment figures partly reflected the stagnation in the traditional industries. Those attracted to entrepreneurship often perceived traditional industry as lacking dynamism. Closely related to this, the government supported venture capital as a means to reduce unemployment. Initiatives such as the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW (Kreditanstalt für Wiederaufbau) provided federal funds for new start-ups. Entrepreneurs and venture capitalists gradually became recognized as leading facilitators in the creation of new jobs. One VC partner commented on this new role of entrepreneurs and venture capitalists: “Just five years ago, entrepreneurs and venture capitalist were seen as blood drinkers. Now, they are seen as heroes creating new jobs. We don’t have yet the same go-for-broke culture as California, but Germans really see the need for catalysts to pump up the economy here.”xii C.New business models require equity financing Traditionally, German business founders relied almost exclusively on personal wealth, retained earnings, and bank loans to fund their new ventures. Few entrepreneurs knew about the possibility of obtaining equity funding as a financing alternative, and in any case, German founders resisted relinquishing control over their ventures. However, the late nineties brought a clear change in attitude: new founders discovered and in many cases chose to rely on venture capital. By 1999, the share of companies at the Neuer Markt that was venture capital financed 14
  15. 15. increased to almost 40%.xiii A central reason for this shift was that the new business models had distinct financing requirements. The models of the late nineties were capital-intensive, but not asset-intensive. This change required a shift from bootstrapping and debt financing to equity financing. Traditional German start-ups focused on the manufacturing industries. Besides the investment in property and equipment, little additional capital was needed to start operations. Since the financing was used mostly to acquire tangible assets, these assets could be pledged against the borrowed money as collateral. In addition, these ventures operated in fairly stable market environments where rapid growth was not critical to survival; and gradual growth, based on cash flow and borrowing capacity—expanding in good years and consolidating in not so good years—was the norm. Manufacturing operations were usually expected to turn profitable soon after the start-up so that a gradual expansion could be financed from retained earnings. The financing requirement for Internet companies was radically different. Internet business models could not rely on gradual evolution but required aggressive expansion strategies. The competitive challenge was to quickly acquire and then defend a market position. Capturing market share early on, to dominate a segment, was deemed to be the key to success. The performance of Internet start-ups was often measured in the “number of eyeballs,” i.e., the number of users drawn to a company’s web site. Consequently companies tried to attract as many users as possible, often by relying on free services. Internet start-ups anticipated losing money for several years: their strategy was predicated on a willingness to sacrifice short-term profits in the hopes of capturing a large user base in the longer run. These strategies required extraordinarily large up-front investment. Bootstrapping was certainly not an option for these companies. At the same time, Internet start-ups possessed very few tangible assets against which to secure a bank loan. This was especially true if companies invested heavily in marketing and customer acquisition. Most traditional bank credit analysis was ill-suited to Internet start-ups; these companies could never meet the standard criteria for credit approval, thus the banks considered them too risky for loans. 15
  16. 16. Equity financing naturally became the only viable financing alternative for these kinds of start- ups, providing the necessary cash to fund rapid expansion plans. Entrepreneurs had to give up sizable stakes in their companies, something that the “Mittelstand” firms traditionally had resisted. But the new entrepreneurs were more willing to accept this, in part because it relieved them of the financial liabilities that could cripple a founder’s professional and personal life. Given the high risk of the Internet, it was not surprising that the new generation of entrepreneurs readily opted to finance their ventures by sharing ownership with their financial backers. D.Equity funding becomes readily available With more and more entrepreneurs looking to fund their businesses through equity, one could wonder whether the supply of funds would be sufficient to meet the growing demand. Supply depended heavily on investors’ perception of how attractive VC returns would be, as well as any other investment incentives. Creation of new exit options A prerequisite for an attractive venture capital market is the existence of highly liquid exit options enabling investors to cash out. In Germany, the March 1997 introduction of the Neuer Markt (NEMAX) significantly improved the options. Previously, investors were likely to sell their shareholdings in trade sales to strategic investors or in buybacks to the original founders. Neither option yielded a reliable source of liquidity, and in addition, given the limited number of buyers, trade sales were likely to result in a lower valuation than a stock exchange. Most interviewees agreed that an initial public offering (IPO) at a stock exchange is unquestionably the “Königsweg” (literally translated as “kings route”) for an exit. One may ask why German venture capitalists did not exit through placing their companies on the NASDAQ. Most interviewees pointed to the extreme difficulty of listing a German company. Indeed, they claimed that it was almost impossible to attract the interest of U.S. investors in a German high-growth stock. Most U.S. investors found it cumbersome to evaluate the German market, and investment banks were unwilling to provide analyst coverage for comparatively small companies outside the U.S. Hence, NASDAQ placement was a viable exit option for only a very select number of ventures that had attained global leadership in a significant market 16
  17. 17. segment. Since the inception of the NASDAQ only a few German companies (such as Rofin- Sinar or Digital Telekabel) had pursued a listing on the world’s largest high-growth stock exchange. Investors therefore welcomed the introduction of the Neuer Markt, and it quickly developed beyond the wildest expectations. From 1997 to 1998, IPOs went from 4% to 16% of venture capital divestments, a fourfold increase (see Figure 6). The number of listed companies on the Neuer Markt more than tripled to 202 over a period of thirteen months spanning late 1998 and early 2000. Its total market capitalization zoomed to $140 billion by early 2000, doubling in size over just a few months,xiv though this growth turned out to be short-lived. At its peak, the Neuer Markt’s NEMAX50 index had climbed above 9000; but it declined to under 3000 by the end of 2000. If the Neuer Markt were the extent of the German venture capital market, it would clearly be in trouble. Our analysis, however, emphasizes that while the Neuer Markt is an important exit option, it is not the only factor determining the viability and growth of the German venture capital market. 17
  18. 18. Figure 6: Divestments by exit channel Gross Divestments by Exit Channel IPO Placement 100% Other 90% Int'l. Capital Markets 80% Trade Other Domestic 70% Sales Capital Markets 60% 50% Buy 40% back 30% Neuer Markt 20% 10% IPO 0% 1997 1998 1998 IPOs Rising popularity of stock market investments After the economic struggles following reunification in the early nineties, the German economy enjoyed a period of prolonged prosperity. Between 1996 and 2000, the gross domestic product (GDP) grew consistently, increasing overall by 8.3%. This provided start-up businesses with a healthy environment in which to flourish and take advantage of the generally strong buying behavior of consumers and corporate customers. National spending increased by 2.7% and 2.9%, respectively, in 1998 and 1999.xv Economic prosperity was reflected in the performance of the stock markets, which witnessed abundant value growth and overall stability. In this economic uptake, investors became less risk- averse and more willing to invest in high-risk projects. Both institutional and private investors increasingly sought the market’s high-growth segment, and with more money chasing high-risk projects, market valuations for start-ups exploded. Ironically, the high valuations attracted further investments, leading to a self-reinforcing growth cycle and the creation of an economic bubble. Historically, Germany’s capital markets failed to attract the attention of the broad public. Capital markets were tainted with an image of imprudent gambling. Unlike in the U.S., making money by investing was not considered “serious business for honest people.” In the late nineties, 18
  19. 19. however, the public attitude towards stocks market investing changed dramatically. About the time of the privatization of Deutsche Telekom in 1996 (the largest IPO in German history), Germans seem to have adopted stock market investing as a new “hobby.” Between 1996 and 1998 the volume of stocks traded more than doubled, surging from DM2378 billion to DM5238 billion (see Figure 7). Throughout all segments of the population, the number of stockholders increased rapidly, with more Germans invested their savings in the stock market (see Figure 8). DM, a business magazine, enticed its readers: “Make your first million! Start getting rich today.” Another leading newspaper, Die Welt, declared: “People have succumbed to a stock market frenzy.” Figure 7: Volume of Stocks Traded xvi Figure 8: Growth of Shareholders xvii Total Value of Stocks Traded (Billion DM) Growth of Shareholders Since 1988 6.000 Blue-collar workers 157% 5.000 Office employees 93% 4.000 3.000 Professionals 40% 2.000 Managers 37% 1.000 Homemakers 10% 0 Students 2% 92 93 95 96 97 94 98 99 19 19 19 19 19 19 19 19 Silicon Valley start-ups became a source of revelation to many entrepreneurs. Witnessing how U.S. entrepreneurs grew their companies with equity investments opened the eyes of German entrepreneurs, particularly the younger ones. Capital markets became a more common source of funding for the newly invigorated entrepreneurial sector. The change in sentiment regarding capital markets – by the public in general and by entrepreneurs specifically – thus also contributed to the German venture capital boom. 19
  20. 20. Another related factor pushing money into high risk capital was the abolition of preferential tax treatment for other forms of investment. In the past, many German investors reaped tax benefits by investing in real estate funds or economic projects in former East Germany. In the late nineties, however, many of these benefits were abolished and people sought new investment alternatives, some turning to venture capital as a high-return opportunity. Yet another factor was the trend away from the public pension system toward private provisions. Historically, German society relied almost exclusively on an extensive public pension system. By the late nineties, however, it was clear that public funds would not provide adequate support for retirees. New government programs placed more emphasis on private pension provision (e.g. Altersvorsorge-Sondervermögen-Fonds), and a public discussion ensued about liberalizing regulations pertaining to the investment of pension funds. High leverage through government programs A peculiarity of the German venture capital market is the existence of various government programs that foster investment in high-growth companies. The two main sponsors of the subsidy initiatives are the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW (Kreditanstalt für Wiederaufbau). The tbg is part of the Deutsche Ausgleichsbank (DtA) and supports start-ups through a number of different subsidy programs, e.g. “Beteiligungskapital für kleine Technologieunternehmen” (BTU), “DtA-Technologie-Beteiligungsprogramm,” “Förderung und Unterstützung von technologieorientierten Unternehmensgründungen.” The various programs are tailored toward companies in different financing cycles (from seed funding to mezzanine financing) and in different locations (e.g., special programs for former East Germany). All programs have some fundamental investment principles in common. The tbg requires an outside lead investor in all investments. It co-invests as a silent partner in portfolio companies, matching the funds of the lead investor. The tbg itself plays a rather passive role in the investment, performing little of its own due diligence, relying instead on the lead investor’s analysis. Most importantly, the tbg funds are treated like a loan: there is a fixed payback rate associated with the tbg investment, part of which is tied to the profits of the portfolio company. Hence, the VC firms use these programs to leverage their own investments, and in case of a venture’s failure the tbg assumes half the losses of the private investors. 20
  21. 21. The KfW has its roots in the post-war Marshall plan for restructuring the German economy. Generally it does not invest directly in the portfolio companies, but instead offers refinancing for VC funds at very attractive conditions. The most popular program, the “ERP- Beteiligungsprogramm,” offers refinancing of up to 75% (85% in Berlin and former East Germany) of the VC fund’s investment—though generally not more than EUR 500,000 per company. The interest rates on the loans are set at the lower end of market rates and are fixed over the duration of the loan. The KfW also covers part of the investment losses in case of a venture’s failure. Its investments are capped at EUR 1.5 million per portfolio company. Overall, the funds available through co-investment from the tbg and through refinancing from the KfW can increase the leverage of the VC investment significantly. The preferential treatment of start-up investments made Germany’s venture capital market highly attractive. Most interview partners believed that these programs played an important role in jump-starting the German venture capital market. However, some industry experts also expressed concerns about relying on these programs in the future, particularly since they engendered less scrutiny on the part of the investors. IV. THE CURRENT STATE OF THE GERMAN VENTURE CAPITAL MARKET The confluence of all the factors described above fed the German venture capital boom. Against all odds, Germany developed a thriving venture capital market. This, however, does not mean that German VC is identical to Silicon Valley VC. Next we examine some of the distinct features of today’s German venture capital market. A.Managerial and entrepreneurial labor markets Despite recent monumental changes, German entrepreneurs still struggle more for legitimacy than do their U.S. counterparts. Given the rich entrepreneurial tradition in the United States, a significant number of high-technology entrepreneurs are former employees of large technology companies such as IBM, HP or Cisco. Others leave one start-up company to found another. In Silicon Valley, employees are exposed to the technology, the markets and the culture that propel them to become successful company founders. Venture capitalists draw on a large pool of management talent for starting and staffing their portfolio companies. In contrast, several 21
  22. 22. German venture capitalists noted that the majority of business plans they received came from ex- consultants and recent technical school graduates. One VC noted: “Most of the business plans I see are really nothing more than hot air. The founders have no experience and it really shows in the business plans they put together.” This person also commented that a smaller, but growing, percentage of the business plans were from more experienced managers with industry experience. Not surprisingly, these plans tended to be stronger. He expected to see more such offerings in the future. Founder replacement is a frequent occurrence in the U.S., but German VCs have limited ability to reconstruct their portfolio companies’ management teams. This is not only because German founders resist such transitions, but also because it is difficult to recruit experienced managers who enjoy their stable, high-status positions. Ten years ago the idea of leaving a good management position at a prestigious company (e.g., Siemens) to join a start-up would have been thought absurd. In recent years this has changed, but only slightly. Some venture capitalists commented that the success of companies such as Intershop and Mobilcom, and the extraordinary value of management stock options at those companies, made recruiting experienced managers somewhat easier. One VC argued, “You can make a case for many factors having contributed to the increase in entrepreneurial activity, but it really comes down to one thing: greed. Potential entrepreneurs read about the huge sums of money made by the success stories and that is the reason for the surge in entrepreneurial activity.” Nonetheless, there is still no comparison between the U.S. and Germany in terms if the liquidity of managerial labor markets. B.Sources of funding In the United States, pension funds are the largest source of VC funds; but in Germany, banks are the largest source (see Figure 9). (German pension funds seem likely to gain in importance as the federal government contemplates legal changes allowing them to invest more significantly in private equity.) German banks have tended to view venture capital as a solution to the equity gap (i.e., excessive leverage of bank-dependent private companies). They usually wanted funds to go toward more established companies, which explains why expansion stage investments and buyouts traditionally accounted for the majority of investments. This changed in the late nineties, when seed and start-up stage investments began to boom. A related shift is also apparent in the mix of companies receiving venture capital funding. Traditional areas such as 22
  23. 23. machine tool manufacturing declined in importance (from 16% in 1997 to 12% in 1998), whereas investments in biotechnology and the Internet increased (IT investments increased from 7% in 1997 to 17% in 1998). Figure 9: Source of funds Sources of Venture Capital in Germany Comparison USA 100% Federal Funds Foreign Private Endowments Corporate Private 80% Pension Funds Corporate 60% Insurance Companies 40% Pension Funds Banks 20% Banks/ Ins. Co. 0% 1996 1997 1998 1998 C.Quality of venture capital Several trends have become apparent for the structure of venture capital firms. With the explosion in investment volume, there has been a rapid increase in the number of German venture capital funds. In the years since 1996, close to forty new funds were founded each year, approximately three times the rate of previous years (see Figure 10). By 2000, the German Venture Capital Association totaled 178 members. 23
  24. 24. Figure 10: Number of New VC Funds by Year of Founding Number of New VC Funds 80 26 39 38 35 14 12 13 11 11 1992 1993 1994 1995 1996 1997 1998 1999 2000 Founding and earlier year This growth came from two sources: a plethora of local funds were founded by venture capitalists with little entrepreneurial experience. At the other extreme, foreign funds decided to enter the Germany market. Many venture capitalists worry about too much competition, and there is a belief that a shakeout and consolidation lies ahead. Interestingly, while many German venture capitalists commented about the inexperience of most entrepreneurs, the same comment may apply to the VCs themselves. German venture capitalists very often come from a consulting or investment banking background. They tend to have little entrepreneurial experience and their business networks are not always relevant for start-ups. Another concern is that as the size of German VC funds grows, new gaps may emerge. One venture capitalist remarked that as the average deal size rose, a new equity gap was emerging in the DM 1-5 million range. One response to this concern is an increasing number of incubators. There are also signs that a more lively angel community is emerging in Germany, although this segment is still much less developed than in the U.S. (see Cadenhead et. al., 2000). V.OUTLOOK FOR FUTURE DEVELOPMENTS After our detailed analysis of the history and current state of the German venture capital market, we now consider the future prospects of the industry. With the Internet bubble now burst, the 24
  25. 25. German venture capital has entered a make-or-break phase that ultimately will show whether the recent boom was merely a fad, or the beginning of a thriving industry. While there may be some difficulty in the near future, we believe that the medium to long-term outlook of the industry is actually very solid. Our analysis shows that the market’s growth was based on a number of drivers. The current lull in the stock market should therefore not choke off this more fundamental momentum in the German economy. However, in order to thrive three important issues will have to be resolved: Will consolidation help the long-term survival of the industry? Can Germany produce its own breed of real entrepreneurs? And will the industry generate true innovation? A.Is consolidation a good or a bad thing? The rise in venture capital in tandem with the booming capital markets led to the creation of many new venture capital funds. In these exceptional times, attractive investment opportunities seemed abundant, and the number of start-ups promising outstanding investment returns appeared almost unlimited. There was money to be made for everyone—until the market downturn in the spring of 2000. Not every deal is a winner anymore, and obtaining a good exit event no longer seems a “sure thing.” In this environment, a natural selection takes place. The best funds with the best skills and the best reputation attract the best deals. And the less reputable funds are likely to end up with much less attractive deals. The likely result will be a consolidation of venture capital funds, with the top-performing funds outlasting and taking over the rest. While most industry experts expect such a consolidation to take place over the next year, the real question remains what the more fundamental effects of this consolidation will be. Some industry participants paint a more somber picture: the consolidation may lead to a stall in the development of venture capital in Germany. As public investors lose confidence in the high-growth market and less experienced funds start to crumble, more start-ups will find themselves searching for continued financial support. Ultimately, failed start-ups and drained funds may cause such deep scars with investors and entrepreneurs that the momentum could grind to a halt. Yet there is also a more optimistic outlook, anticipating the consolidation will have an overdue cleansing effect, separating the “serious” investors from the unprofessional “cowboys.” This view holds that the industry will emerge healthier and fundamentally stronger than before. 25
  26. 26. B.Where are the “real” entrepreneurs? The recent boom attracted many to start-ups with the prospect of enormous financial gain. Witnessing entrepreneurial success, others compounded the snowball effect, leaving established jobs to found yet more start-ups. It was hip and fashionable to be part of this booming sector. However, with the market downturn the picture has lost its sharp focus, and new economy start- ups are again viewed with skepticism. With the most opportunistic entrepreneurs fleeing the scene, it remains to be seen how strong the “real” entrepreneurial movement is. How many entrepreneurs are actually willing to build enterprises for the long term? Will the most talented or the less talented people remain in the entrepreneurial sector? In this context, it will be important for Germany’s start-up scene to nurture serial entrepreneurs who can contribute to the maturation of the entrepreneurial culture. In the United States, serial entrepreneurs have become an important stabilizing element in the entrepreneurial environment. C.Do we have innovators or imitators? To date, a significant amount of the entrepreneurial activity in Germany, particularly in the Internet, has consisted of copycat models. It was relatively easy to take successful business models from the United States and transplant them to Germany, but this is hardly innovative. Copying successful business models may have been a convenient jump-start for entrepreneurial activity in Germany, this cannot replace true innovation as the basis for entrepreneurship. The window of opportunity for copying U.S. Internet business models was a passing phenomenon, and with so many Internet models proving to be more difficult than anticipated, the wave of new Internet start-ups has ceased in the United States. Copycat entrepreneurs may now have run out of business models to copy, and this will force German entrepreneurs to become more innovative in their business ideas. Will German entrepreneurs will live up to this new challenge and build a culture of true innovation? Experience over the last few years has shown that Germany is capable of developing an entrepreneurial spirit. We believe that after the dust has settled on Internet and stock market booms and busts, it is likely that Germany will sustain a lively venture capital industry. 26
  27. 27. VI. REFERENCES AND FURTHER BIBLIOGRAPHY Becker, Ralf, and Thomas Hellmann. “The Genesis of Venture Capital: Lessons from the German Experience” Graduate School of Business, Stanford University. Working Paper, July 2000. Brant, Ives. “New Economy Stocks in Europe.” Tornado-Insider. Issue 12, April 2000. Retrieved at: Bundesverband Deutscher Kapitalbeteiligungsgesellschaften e.V.(BVK). Various documents available at URL: Cadenhead, G., J. Weber, M. Brettel, C. Jaugey and C. Rost, “Business Angels in Germany: How Business Angels in Germany Help New Entrepreneurs,” Journal of Private Equity, Winter 2000, 50-58 Cooter, Maxwell. “European Startups Never Fail.” Tornado-Insider. Issue 11, March 2000. Retrieved at: Cukier, Kenneth Neil. “Europe Imports Internet Euphoria.” Red Herring. December 1, 1999. Retrieved at: trends-9europe.html D’Amico, Mary Lisbeth. “Leveling the Field.” Tornado-Insider. Issue 13, May 2000. Retrieved at: Dunn, John. “Making it Happen.” Tornado-Insider. Issue 13, May 2000. Retrieved at: Econy. February 1999. “Das Silicon Valley ist uns drei Generationen voraus.” Retrieved at: Essick, Kristi. “Are Entrepreneurs Here to Stay?” Tornado-Insider. Issue 8, December 1999. Retrieved at: Essick, Kristi. “Europe’s Great Leap Forward.” Tornado-Insider. Issue 13, May 2000. Retrieved at: European Venture Capital Association (EVCA) and Coopers & Lybrand Corp. Finance. The Economic Impact of Venture Capital in Europe.. 1999. European Venture Capital Association (EVCA). Priorities for Private Equity. White paper. 1999. Freeman, John. “Venture Capital and Growth Businesses in Germany.” University of California, Berkeley. Research paper, November 3, 1999. Frommann, Holger. “Venture Capital in Deutschland – Rückblick auf ein Vierteljahr-hundert.” BVK Jahrbuch, December 1992. 27
  28. 28. Hirsch, Sascha. “Möglichkeit und Grenzen der Nutzung neuer Börsensegmente… in Europa.” Fachhochschule Ludwigshafen, Diplomarbeit. October 1998. Kuemmerle, Walter, Frederick M. Paul and Henrik Freye. “Survey of Private Equity in Germany – Summary of Results and Analysis.” Harvard Business School. Working paper 98-112. Mackewicz & Partner, and VDI Nachrichten. Venture Capital Panel. 1999. Manager Magazin. October 17, 1999. “Grossunternehmen als Venture-Capitalists?” Retrieved at:,1153,44934,00.html Manager Magazin. October 7, 1999. “Just Do It” Retrieved at: venture/artikel/fs/0,1153,45591,00.html Pfirrmann, Oliver, Udo Wupperfeld, and Joshua Lerner. Venture Capital and New Technology Based Firms: An US-German Comparison. Heidelberg: Physica-Verlag, 1997. Raik-Allen, Georgie. “Venture-backed Internet Companies Take Off in Europe.” Red Herring. June 3, 1999. Retrieved at: Red Herring. March 15, 2000. “’Social Concensus’ Slows Progress.” Retrieved at: Red Herring. March 15, 2000. “VCs in Europe.” Retrieved at: Red Herring. March 15, 2000. “Risk Reaps Rewards in Germany.” Retrieved at: Riekert, Philipp. “The Evolution of Venture Capital in the United States and Germany and its Role in Economic Growth.” Stanford University, Department of Economics. Term paper, March 1999. Riesenhuber, Heinz. “Beteiligungsmodelle für Junge Technologieunternehmen.” Bundesministerium für Forschung und Entwicklung. December 1994. Schefczyk, Michael. “Management Support for Portfolio Companies of Venture Capital Firms.” Booz-Allen & Hamilton, Presentation. January 1999. Straunik, Aleksander. “Europe’s Bright Spots.” Tornado-Insider. Issue 13, May 2000. Retrieved at: Venture One. Various documents available at URL: Waesche, Niko. “Privates Eigentum – Öffentliches Eigentum.” Jahrbuch für Wirtschaftsgeschichte, 1999/1. 28
  29. 29. Waesche, Niko. “Global Presence, Home Resources – Surveying the German Internet Start-up.” London School of Economics and Political Science. Draft version, August 19, 1998. Waesche, Niko. “Tough Balancing Act for German Internet Startups.” Tornado-Insider. May 1999: pp. 24. 29
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