Early Stage Investments in New Technology Based Firms - Analyzing the Changing German Landscape of Venture Capital Finance in the Light of Capital Market Theory and New Institutional Economics

Diploma Thesis , 1998 , 184 Pages , Grade: 2

Economics - Finance

Gegenstand der Arbeit ist die Untersuchung der jüngsten Veränderungen in der institutionellen Mikrostruktur des deutschen Kapitalmarktes, die geeignet sind die Bedingungen für die Versorgung junger Technologieunternehmen mit Eigenkapital zu verbessern. Behandelt werden insbesondere die Funktionsweise und zunehmende Bedeutung professioneller Venture Capital-Intermediäre und die hierzu komplementäre Rolle des “Neuen Marktes” in Deutschland.

Der Autor zeigt, wie die Finanzierung junger Technologieunternehmen durch strukturelle Imperfektionen des Kapitalmarktes in besonderem Maße beeinträchtigt wird. Unter Berücksichtigung der fundamentalen Aussagen der neoklassischen Kapitalmarkttheorie und der Neuen Institutionenökonomik wird die Hypothese entwickelt, daß die durch die Unvollkommenheit der Märkte bedingten Risikoprämien und Transaktionskosten im Falle von Frühphaseninvestitionen in innovativen Unternehmen besonders hoch sind. Somit besteht im Falle dieser Investitionen eine erhebliche Spanne zwischen den vom Unternehmer zu tragenden Kapitalkosten und den vom Financier empfangenen Nettoerträgen.

Bestimmte Institutionen des Kapitalmarktes, d. h. spezialisierte Intermediäre und regulierte Marktsegmente sind geeignet diese Spanne zwischen Kapitalkosten und Nettoerträgen zu vermindern, indem nicht-projektinhärente Risiken oder Transaktionskosten reduziert werden. Das für die Investitionsentscheidung maßgebliche Risiko-Rendite-Verhältnis einer Investition wird somit durch institutionelle Rahmenbedingungen erheblich beeinflußt.

Der Autor diskutiert vor diesem theoretischen Hintergrund umfassend die konkreten Veränderungen des deutschen Venture-Capital-Marktes in der jüngsten Zeit und entwirft verschiedene Szenarien für dessen zukünftige Entwicklung.

Keywords: Venture Capital, Neuer Markt, Unternehmensgründung, Innovationsmanagement

Contents

1 Introduction

2 Venture Capital Finance and the New Technology Based Firm
2.1 Telling the difference: Venture Capital and Private Equity
2.1.1 What is Venture Capital?
2.1.2 Private Equity distinguished
2.2 Early Stage and other Venture Capital Investments
2.2.1 The Life-Cycle-Model: Early and other Stages of Venture Capital Finance
2.2.2 Divestments and Holding Periods
2.2.3 New Companies and Special Situations Segment
2.2.4 The Nature of Early Stage Investments
2.3 The New Technology Based Firm
2.3.1 What is a New Technology Based Firm?
2.3.2 The Life Cycle of a New Technology Based Firm
2.3.3 Strategic Idiosyncrasies of Technology Industries
2.3.4 Venture Capitalist and the New Technology Based Firm
2.3.5 RIGHT-ES ² : Early Stage Investments in New Technology Based Firms

3 The Landscape of Venture Capital Finance
3.1 Informal Investors
3.2 The Organized Venture Capital Market
3.2.1 Financial Investors
3.2.1.1 Private Investors
3.2.1.2 Institutional Investors
3.2.1.2.1 Financial Intermediaries
3.2.1.2.2 Specialized Added Value Intermediaries: Venture Capitalists
3.2.2 Strategic Investors: Corporate Venture Capitalists
3.2.3 Political Investors: Government and its Agencies
3.3 Institutional Venture Capital - How „hot” is it really?

4 Institutions of the Venture Capital Market in Germany
4.1 Venture Capital in Capital Market Theory and New Institutional Economics
4.2 Venture Capital as an Institution
4.2.1 Venture Capital as a Finance Technology
4.2.1.1 Equity
4.2.1.2 Visibility, Reputation and Trust
4.2.1.3 Selection and Assessment
4.2.1.4 Monitoring and Incentive Alignment
4.2.1.5 Management Support and Added Value
4.2.2 Which strategy is right? Diversification or specialization?
4.2.3 Venture Capitalist, its Network and Portfolio Companies as a governance structure
4.2.3.1 Comparing Venture Capital Firm, its Network and Portfolio Companies with Multidivisional Organizations - A Visual Stop-Over
4.2.3.2 The Discovery Part: V-CTORY - The Virtual Venture Capital Network Factory
4.3 The Role of the Neuer Markt
4.3.1 Why the Geregelter Markt failed
4.3.2 Why the Neuer Markt may succeed

5 Conclusion

Bibliography

Appendix I: Case Study Gulfstream Aerospace Corp.

Appendix II: The Changing German Landscape of Venture Capital Finance

Appendix III: The Financial Theorist’s Toolbox

Appendix IV: What’s next? - A comprehensive outlook and educated judgement

Appendix V: Gallery

"If you want to get rich, it might seem that you need only follow this simple formula. First, find a nerd with a garage and a good idea. Next, warm him up with visions of Gatesian glory, administer a heavy dose of management jargon, and add a million dollars. Then wait a decade and hope that you get lucky."

The quotation and the drawing on the front page are taken from the article "From labs to riches", The Economist, 1996, November 9th, p. 103 - 104

1 Introduction

In recent years the issue of early stage investment in new technology based firms has drawn considerable attention. Its relevance emerges from the rise of high technology industries in the global economy.

In a special issue on "The 21st Century Economy", "an economy that, driven by technological progress, can grow at a 3 % pace for years to come"¹, Business Week's Michael Mandel (1998, p. 28) notes:

"In the long run, the success of the 21st Century Economy will depend on whether techno- logical progress will continue to drive growth, as it has so far in this decade. That would be a big change from the 1970s and 1980s. In those decades of economic stagnation, technol- ogy contributed almost nothing to growth, ... in the 1990s, the innovations have been coming thick and fast The innovations wave has also being given more force by the globalization of the economy."

As competition in established, mature industries all over the world is ever increasing, the importance of keeping up and increasing the speed of innovation to ensure competitiveness of companies and national wealth is widely recognized.²

Innovation may concern products or processes. It refers to the development of new proprietary knowledge, i. e. technology, which is embodied in marketable products or services³. In as far as the added "private" knowledge increases the utility of a product to the customers, it adds value (Kim and Mauborgne 1998). Unless the new features of a product are matched by competitors, a company may earn innovation rents. Thus proprietary knowledge attained through innovation is an important source of strategic advantage.⁴

In a competitive, dynamic market, however innovation rents are not sustainable. Competitors will attempt to match and exceed the innovation advantage. This may be achieved by imitation or by adding other or more innovative features. Whereas following the product life cycle model initial growth may be steep and rents may be high for the first mover (Lieberman and Montgomery 1988), imitators competing on price and other rivals competing on innovations, may inflate the monopolistic power of the proprietary knowledge. Striving to maintain and increase market shares and profitability, companies thus have a strong incentive to keep innovating.⁵

For new technology-based firms the importance of proprietary knowledge is particularly pronounced. These start-ups operate in a hostile competitive environment, characterized by high uncertainty, offering the potential for rapid growth and high profits on the upside, but als the substantial threat of incurring deep losses on the downside.⁶ Whereas large companies generally possess a diversified product portfolio and a host of strategic assets, small compa- nies will need to compete on a single new product or service and the determination of its management team.⁷

Politicians, worried by high unemployment and budget deficits, lately fell in love with the high- technology start-ups for their ability to create jobs and ensure future tax revenues.⁸ New technology-based firms are drivers of structural change in the economy in that they are among the first to enter new high growth potential industries.⁹

For Germany it turns out however, that while it is easy to go out of business, proven by an ever rising insolvency rate, getting started is far more difficult. The major complaint is that it is troublesome to impossible to raise the needed funds.¹⁰ New technology-based firms for their high capital needs for research and development from an early stage are particularly impaired by the financing problem.¹¹

What is puzzling about the early stage segment of the capital market is, that while would-be entrepreneurs complain about the lack of capital supply, investor claim they have the money ready, but face problems to find enough "good" projects.¹² The contrasting statements may indicate in part a market failure situation in the German finance system.¹³

This paper will therefore examine the peculiarities of early stage investments in new technology-based firms, identify causes of financing problems and propose how recent changes in the microstructure of the German capital market may help to reduce or surpass imperfections, to increase the volume of early stage investments in technology start-ups.

Early stage investments in new technology-based firm are a subset of venture capital invest- ments. Venture Capital has been an often heard term in public discussion, however for lack of a common definition is often misunderstood. It will therefore be one aim of this paper to develop a useful definition for venture capital and to distinguish it in particular from the private equity term. This will be undertaken in the following section 2.1. An introduction to early stage investing 2.2 and the new technology-based firm 2.3 follows.

Section 3 maps out the landscape of venture capital finance in Germany with some reference to international developments.

Section 4 will analyze how venture capital and the Neuer Markt as secondary institutions of the German venture capital market economize on transaction and agency costs as well as on uncertainty involved with early stage investments in new technology based firms.

On the creative or discovery part of this paper I will introduce the model of a new governance structure - the V-CTORY.

Section 5 draws the conclusion on this paper and provides an outlook on the continuing development of the venture capital market in Germany and beyond.

The appendices contain additional information. Appendix I features a case study of Gulfstream Aerospace Corp.. Appendix II provides an update on recent important changes in the German venture capital and private equity market. Appendix III makes explicit the underlying neoclas- sical capital market -, transaction cost - and principal-agent-theory used in analyzes through- out the paper. Appendix IV contains a comprehensive outlook and educated judgment about the future development of the private equity and venture capital market in Germany.

2 Venture Capital Finance and the New Technology Based Firm NTBF

2.1 Telling the difference: Venture Capital and Private Equity

2.1.1 What is Venture Capital?

Various definitions of venture capital have emerged with time.¹⁴ They mainly differ in the broadness of their conceptual extent.

Liles (1974, p. 461) provides an overview of the "spectrum of definitions of venture capital investing”, including the following:

„1. Investing in any high-risk financial venture
2. Investing in unproven ideas, products or start-up situations; i. e. the provision of what is called ‘seed capital’
3. Investing in going concerns that are unable to raise funds from conventional public or commercial sources
4. Investing in large and - in some cases - controlling interests in publicly traded companies where there is a considerable degree of uncertainty."¹⁵

Pfirrmann, Wupperfeld and Lerner (1997, p. 10) note, in looking at the venture capital intermediating institutions that a current "comprehensive description of venture capital companies has to include the following activities:”

"PInvestment in the seed, start-up and other early stages

PInvestment in established companies that are unable to finance their expansion through banks or the stock exchange

PInvestment in management buyouts and leveraged buyouts

PInvestment on the stock exchange where patient, supportive investment can facilitate ongoing business development"

The broadness of these descriptions of venture capital finance, which basically refer to all sorts of non-publicly raised equity capital, may cause misunderstanding.¹⁶ A more narrow, precise definition of venture capital may facilitate communication. Therefore I suggest to depart from attempts to define venture capital as all sorts of money provided by presumable venture capitalists, to instead seek to capture the distinguishing, essential features of venture capital.

Since venture capital finance is usually most closely associated with the USA (Wrede 1987), home to more than 700 professional venture capital firms, with over 300 in the Silicon Valley area alone (Price Waterhouse 1998), the definition of the US American NVCA National Venture Capital Association may be considered to possess some authority (NVCA 1998, http://www.nvca.com/def.html, 02.08.1998):

"Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors."

It should be noticed that this definition requires the professional intermediation of funds and thus refers only to the organized or institutional part of the venture capital market. Since the NVCA represents the professional venture capital firms of the USA, it is understood, that it has an incentive to claim the concept of venture capital all for its members.

It has to be kept in mind however, that there is also an informal market for funds given to start-up companies by private investors. Rumors say that some professional venture capitalists refer to these as "dumb dentists". However as private investors or "business angels", as they are often called, may frequently have been business owners themselves, possessing manage- ment experience, industry expertise and access to a powerful private network, they might also be in a position to cover key features of the venture capital finance technology (see 4.2.1) to some extent.¹⁷ Therefore venture capital should not be defined investor bound.

MacMillan, Kulow and Khoylian (1988) describe the observable involvement of venture capitalists on a pragmatic level as reaching from nearly total hands-off, in particular during the growth phases of a business to every day active operative management support in particular during the seed and start-up stages of a company. Also the OECD points out that the "'handson' aspect of venture capital is a particularly characteristic of investments in earlydevelopment-stage companies".

I would like to stress the aspect of management support provided with equity funds as the distinctive feature of venture capital. If venture capitalists would provide purely passive equity capital on a regular basis, they would be indistinguishable from other financial intermediaries.¹⁸ I suggest however to slack the often heard narrowing requirement, that only equity finance plus management support provided to young companies should be considered venture capital.

Explaining how the conceptual content of the term venture capital changed with time S. E. Pratt (1985, p. 7) points out, that whereas the traditional understanding of venture capital refered to the provision of seed, start-up and first stage financing, venture capitalists broadened their activities to include the funding of the expansion of established businesses, which lack direct access to the public securities market or "credit-oriented institutional funding sources such as banks or insurance companies ... They also provide management/leveraged buyout financing to assist operating management's purchase and revitalize a division of a major corporation or an absentee-owned private company."

In addition, the US National Venture Capital Association (1998) acknowledges, that

"[n]ot all venture capitalists invest in 'start-ups' ... venture capitalists will also invest in companies at various stages of the business life cycle. A venture capitalist may invest in a company before there is a real product or company organized so called 'seed investing', or may provide capital to start up a company in its first or second stages of development known as 'early stage investing'. Also, the venture capitalist may provide needed financing to help a company grow beyond critical mass to become more successful ('expansion stage financing') At the other end of the spectrum, some venture funds specialize in the acqui- sition, turnaround or recapitalization of public and private companies that represent a favorable investment opportunity." NVCA (1998)

Therefore venture capital may not necessarily be associated with a certain stage of the business life cycle.

This is however not to say, that the stage model of venture capital, which is introduced below should be abandoned. It is useful to distinguish the changing finance needs and venture capital requirements of a business. I simply argue that the provision of venture capital is not limited to certain stages.

Also established businesses may face special situations such as a management/leveraged buy-out/buy-in MBO/MBI/LBO/LBI or turnaround situations after undergoing crisis, which may require the infusion of equity funds for recapitalization from an active investor (Crawford 1987).

There may, as with Gulfstream Aerospace Corp. (Appendix I), be special situations in the life of an established company, where equity infusion plus management support becomes necessary again. Thus venture capital cannot be defined stage bound.

With a different emphasize Reinhard. H. Schmidt (1985, p. 421) defines venture capital as a possible solution for the finance problem of young, risky and in particular technologically innovative businesses. Schmidt (p. 431) identifies three characteristic features of venture capital as associated with the US American practice:

P "real" equity capital with unlimited risk exposure and opportunity participation

P the investor assumes an active role in the management of the company

P investors divest by taking the company public and selling their shares in an organized market.

In Schmidt's definition exiting the investment through an initial public offering is considered a typical feature. As will be pointed out in 2.2.2 Divestments and Holding Periods, in discussing exit opportunities for venture capital investors, company shares are not always sold through IPOs. In fact, public sales account for a smaller share of venture capital divestments and therefore may not be considered a distinctive feature.¹⁹

Thus I suggest to define venture capital as active investment from a source outside the members of the owner-managers team, distinguished by involving the provision of some sort of equity capital alongside with hands-on management support from an active investor.

Abbildung in dieser Leseprobe nicht enthalten

Box 2.1.1 Definition of Venture Capital (Source: Holger Ludewig)

Some may find it necessary to explicitly refer to the long-term orientation or high-risk- highyield potential of venture capital.²⁰

However, the intention for longer holding periods may be considered as typically implied by the provision of equity capital already. Moreover if it would be just for the long-term orientation, long-term debt capital could be sufficient to cover the typical venture capital investment period of 5 to 12 years (Yago 1991).

Regarding the requirement of high-risk/high-yield, it may also be considered an implicit element of the active management feature. The owner of a business would not accept the intervention of an active investor, if it was not for the high risk nature and value additivity of the external investor's involvement.²¹

If the nature of the business and capital requirements would allow it, entrepreneurs would rather choose to stay single in the "driver's seat", without having to share earnings symmetrically. Thus most initiators of a business use their own money complemented by debt to finance their start-ups (Bhide 1992, also 3.3).

External equity is the most expensive form of financing. The advantage it offers is, that its ultimate costs are contingent upon the success of the business. Thus as opposed to a debt investor, an equity investor shares the risk of the business.²²

Because of its costs, equity will only be taken on if self-financing is not possible and business projects are too risky to be financed with debt capital.²³ Passive investors will be preferred to active investors unless the later are expected to add value to the business as a whole by adding skills or strategic assets, or to allow for the ultimate reduction of capital costs, i. e. the required risk premium by eliminating uncertainty.

Active investing causes high transaction costs, which eat into the net return of the investors. From a financial perspective investors will only have an incentive to get "hands-on", if they expect their active involvement to add value in that risks are reduced or higher returns become attainable. Therefore active external investment will always be associated with relatively high risk/high yield investments, whereas for lower risk investments passive provision of capital will do the job. With lower risk investments expected returns in a competitive market would not even be high enough to pay for the afforded "hands-on" support (e. g. Grossman and Stiglitz 1976 and 1980).

With professional venture capitalists it might still be relatively easy to distinguish an active external investor from the original management team seeking support. In general however the venture capital investor may be distinguished from the owner-manager team, who's members are obviously also equity holders, in that he typically intents to provide capital and manage- ment services only for a limited period of time and strives to divest from the business as soon as possible (see 3.2.1.2.2 Specialized Added Value Intermediaries: Venture Capitalists, see also Hamel and Prahalad 1989).

It should be noticed so that the difference between active external investor and active internal investor, i. e. owner-manager may not always be that clearly cut. Difficulties might become apparent by looking at cases, where the venture capitalist is forced to replace the initial founders team by outside managers or venture capitalists, who move as far up-stream in the deal-flow, as to initiate the set up of a business themselves by hiring a brain to think about a new product, find someone to develop it and than assemble the management team to usher it into the market (Himelstein, Burrows, Reinhard 1997).

In a paper that looks at the changing landscape of venture capital finance in Germany it seems reasonable to discuss the German language definition of Wagniskapital, Chancenkapital and Risikokapital. They are all used and often misunderstood as alternative terms for venture capital. But how would the German translations of venture capital be precise, if as was pointed out not even a common English definition exist.

From my point of view, venture capital was most successfully applied and as a term is associated with the USA. It is rooted in the market-oriented finance system of the USA (Allen and Gale 1994), thus I believe it is appropriate to keep using the English term instead of trying to translate it and cause evenmore confusion. An own German term offers too much of an invitation to find more similarities of venture capital with traditional German finance technologies than actually exist (Schmidt 1985).

2.1.2 Private Equity distinguished

Zemke (1998, p. 212 - 215) points out that venture capital was originally used as a generic term including early and later stage funding, characterized by the key features of long-term nevertheless limited provision of equity capital or equity surrogates accompanied by active management support. With time venture capital was frequently understood more narrowly as referring just to the funding of the early stages of a business, Zemke says. He suggests to use private equity²⁴ as a new generic term as opposed to public equity raised in an IPO.²⁵

On the other hand Frommann (1992) explicitly states that the term venture capital first refered to the risky provision of equity funds to start-ups and young technology-oriented businesses. Whereas today the venture capital concept is sometimes understood more broadly to include the equity funding of established small and medium sized enterprises SMEs. Thus in everyday use the focus on 'venture' had to step back, Frommann says.²⁶

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.1.2: Private Equity and Venture Capital (Source: Holger Ludewig)

From the statements above it may not be told whether venture capital was first used as a specific or a generic term. I will not attempt to find out whether the venture capital term acutally went from broad to narrow (Zemke) or narrow to broad (Frommann).

In focusing on the nature of venture capital investments, using my definition above, the situa- tion may be resolved. In refraining from the stage -, investor -, exit mode -, etc. - bound definitions, narrowing venture capital down to investments involving the provision of equity funds plus management support, private equity may be used as a generic term for all kinds of non-publicly offered equity investments. Venture capital would therefore be a subset of private equity.

2.2 Early Stage Investments and other Venture Capital Investments

2.2.1 The Life-Cycle-Model: Early and other Stages of Venture Capital Finance

The varying funding needs of young firms addressed by venture capital finance are often presented in association with the stages of the product- or company-life-cyle.²⁷ Product-life- cycle and company-life-cycle may be regarded as being the same, in cases where a company offers just one product, as will usually be the case with young technology based businesses. The company-life-cyle may be detached from the single product-life-cycle and perpetuated by adding further products and therefore product-life-cycles.

The following stages are distinguished (e. g. Bruno and Tyebjee 1985, OECD 1996, BVK 1998, Pfirrmann, Wupperfeld and Lerner 1997, Posner 1996, Pichotta 1990, Breuel 1988, Nathusius 1985, Lorenz 1985).

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.2.1 a: Business-Life-Cycle and Investment Stages

(Source: Holger Ludewig)²⁸

A. Early stage investments

The early stage of the business-life-cycle spans from the development of a prototype, to the start of the company to the set up of production facilities and distribution system. Early stage investments fund the first three stages of the company-life-cycle: Seed, start-up and first stage.

Posner (1996, p. 10 f.) notes that there are no really clear cut boundaries to distinguish the single stages, he suggests however, to consider investments in a venture before the actual formation of the business as seed investments and funds provided during the period from company formation to market introduction of the product as start-up investments.

I. Seed-money stage.

The seed-money-stage parallels the founding phase of the company preceding the formal foundation of the company. During this phase relatively little capital is needed to cover first research and development expenses to create the prototype of a product or prove the concept of a business in market research (Schween 1996, p. 98 f.).

This period lasts usually less than one year (Kelly 1989). The seed stage offers the highest positive (chance) and negative risk for the investor (Nathusius 1985). At this stage, Schween (1996, p. 98) says, public support programs in the form of loans, equity capital or publicly supported technology centers are of some importance (Cox 1986, also 3.2.3).

Seed-stage investments are characterized by very high assessment costs and high management support intensity, coupled with low absolute capital requirements. Thus the relative transaction costs are substantial. The gap between gross and net return for the investor would therefore be particularly wide. In addition, longer time span till divestment greatly increases the uncertainty involved with the assessment of product market chances and capability of the management as compared to later stage investments.²⁹

II. Start-up stage.

The start-up phase may take six months to five years. Capital is needed to cover the set up costs of the enterprise and initial marketing. At this stage companies may be in the process of being organized or have been in business for a short time, but have not sold their products commercially. Generally, a firm in start-up phase will have assembled the key management, prepared a business plan, and made market studies. A basically marketable product is at hand. Nathusius (1985) calls this stage the "classical venture capital case". In this state the risk is already lower than during the seed stage, however capital requirements generally increase. 10 - 20 % of cost of the early stages accrue during the start-up stage (Schween 1996, Hielscher, Dorn and Lampe 1982).

III. First round financing.

The capital provided in the first round following the start-up investment is needed to cover the high capital requirements of the market introduction of a product and perhaps the set up and operation of manufacturing facilities. 45 - 75 % of the cost from invention to market introduc- tion of a product accrue during the first stage (Schween 1996, Hielscher, Dorn and Lampe 1982).

B. Expansion or later stage investments

IV. Second round financing

Funds are provided to support working capital for a firm that is generating cash-flows by selling its product successfully, but still not enough to ensure liquidity. Additional capital is needed to allow for further exploitation and penetration of markets.

V. Third round financing

Capital is raised to fund further growth of a company that broke even. Intermediated external equity capital of the venture capitalist is still needed at this point to pay for the expansion of production and distribution systems, to enter new markets or develop a new product, in as far as the company cannot yet access the organized capital markets directly to cover its financing needs.

VI. Fourth round financing also known as bridge or mezzanine financing (Volkart and Lautenschlager 1998, p. 155, Jury 1997) provides money in the specific case for a firm likely to go public within the following six months.³⁰

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.2.1 b: Stage Structure of BVK Members' Investments 1997 (Sources: BVK 1998)

In 1997 the aggregate investment portfolio of BVK member funds, accounting for DM 7.1 billion invested in 3496 companies (EVCA 1998), was made up of 9 % start-up-, 4 % seed-,55 % expansion-, 2 % turnaround-, 18 % MBO/MBI- and 10 % bridge investments.

Early stage investments thus added up to 13 % of the portfolio in terms of invested funds (BVK 1998)³¹.

In 1997 the amount of seed capital newly invested in Germany grew by 23 %, start-up invest- ments by 67 %. Since investments as a whole grew by 42 %, the money share of seed capital in relative terms declined. The start-up share however grew faster than the average. It has to be kept in mind so, that due to the fast growth of funds, it is unlikely, that the money share of seed investments would grow as fast as that of later stages, since the necessary number of transactions, because of the low capital volumes involved, would be far higher. Thus early stage investmentsaccounted for 25 % of newly funded companies, but a money share of only 7,4 %(EVCA and Appendix II).

The Price Waterhouse Venture Capital Survey (Price Waterhouse 1998) found that in the US formative stage (start-up and other early stages) companies received the largest share of investments. US$ 1.28 billion or 35 % of the total were given to 317 seed and start-up compa- nies within the first three months of 1998. Early stage companies received on average US$ 4 million, compared to an average of US$ 3.3 million one year earlier. In addition212 companies in expansion stages received US$ 1.14 billion. Average investment was US$ 5.2 million versus US$ 4.8 million one year ago.

2.2.2 Divestements and Holding Periods

C. Divestment stage

VII. Exit

For the investor the cycle ends with the divestement stage, when a venture capital investment is exited.

Venture capitalists exit successful investments by trade sales, repurchase or buy-back, private placements or secondary purchase, and most favorably by IPOs. In a trade sale the shares of a portfolio company of the venture capitalist will be sold to an industrial or service company. Private placement refers to the sale to other financial investors, in particular other venture capitalists, i. e. a venture capitalist specialized in early stage investments exits a project by selling the shares to a later stage specialist. In a buy-back or repurchase the owner-manager acquires the shares of his company owned by the venture capitalist. Involuntary exits result when a failing business has to file for bankruptcy and is liquidated.

The independent Munich based early stage technology fund TVC says companies need on average DM 15 to 40 million before divestment, 20 -30 % fail. (HB 27.10.1997)

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.2.2: Exit Channels for BVK Members' Investments 1997 (Sources: BVK 1998)

The BVK (1998) notes that 57 member organizations provided information on chosen exit modes for 1997. Divestments from 322 companies amounted to DM 936 million. 27,5 % of the exit volume was attained from repurchases, 60 % from trade sales, 5,8 % from secondary purchase, 3,3 % from going public.

The holding periods of venture capital investments will differ depending on the entrance stage, industry specific characteristics, company specific factors and the overall macroeconomic situation, in particular as impacting the stock market climate.

"One of the most decisive determinants of returns on venture capital investments is the health of the IPO market. In establishing a price for an acquisition, reference is made to the valuation of similar companies in recent public offerings. IPOs therefore play an important role in the functioning of all venture capital exits." (OECD 1996, p. 28)

Regarding the stock market development during the last couple of years³², return of venture capitalists have greatly gained from an overall high demand for shares.³³

Early stage investments may take 5 to 12 years till divestment, later stage investment may vary between a couple of months up to eight years. The field of biotechnology is known to take a particularily long-term investment orientation since product development will typically require long time and much capital. In addition to industry specific differences, country specific differences prevail.

The holding period in the US is about 8 to 10 years, while European venture capitalists need to hold on to their investments longer. This is a result of the better synchronization of venture capital finance and stock markets, as institutions of the venture capital market, in the USA. In particular the NASDAQ proved to be quite absorptive for young high growth companies, granting US venture capitalists to exit earlier than their German and European colleagues. In Europe venture capitalists may be forced to hold on to companies, despite they can no longer add value, because a suitable buyer could not be found without offering steep discounts on company value. Return prospects of European venture capital funds are thus impaired by prolonged holding periods or by sales discounts.

In as far as IPOs generally yield higher returns than a trade sale as most common in Europe, US venture capitalist are likely to earn a higher capital gain in a shorter time, thus effectively attaining much higher returns.³⁴

2.2.3 New Companies and Special Situations Segment

Based on the former discussion I suggest to distinguish two basic investment segments of the venture capital market:

Abbildung in dieser Leseprobe nicht enthalten

Plate 2.2.3: Two Basic Segments of the Venture Capital Market (Source: Holger Ludewig)

The Special Situations Segment (VC-SSS) would be made up of investments in established companies facing a buy-out or turnaround situation.

The New Companies Segment (VC-NCS) in turn would be separated into an early stage segment (VC-NC-ESS) and later stage segment (VC-NC-LSS) as discussed above.

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.2.3: Venture Capital Market Segments - The Investment Side (Source: Holger Ludewig)

The new company segment thus would account for 68 % of the venture capital and private equity market as traced by the BVK (see 2.2.1). Special situations would make up 20 % of the organized market. Bridge finance 10 % according to my definition would be pure private equity. It may for statistical purposes as a pragmatic solution be included in the new compa- nies segment, since it is provided only briefly by the venture capital or private equity firm on its way out.

The further theoretical discussion of this paper will be limited to considerations concerning early stage investments.

2.2.4 The Nature of Early Stage Investments

According to Posner (1996, p. 11) early stage investments are not just distinguished by phase of the company-life-cycle during which they occur, but also include a risk tolerance of the investors which is higher than that of providers of debt capital or equity capital to established enterprises.

Risk (Appendix III 6) occurs from the fact that, e. g. in case of seed capital investments, the development of a prototype, of which it is not known beforehand whether it will justify the actual formation of a new business, may demand high expenditure and still may end up as an instant failure. In particular in the field of technology, like biotechnology, etc. the development of a prototype may take very long and require lots of capital from an early state.³⁵ Research and market tests to estimate the potential of a new product or business concept may afford additional funding.

Thus early stage investments are also distinguished from later stage investments by the level of risk they involve. The company has no track record yet, from which many finance experts use to derive prognoses about cash-flow, turnover, profit and market share, by using some more or less sophisticated form of extrapolation.³⁶ Posner (1996) says that even for a young company, which exists for only two or three years, the quality of the prognosability compared to an early-stage investments increases by a multiple.

Posner (1996) points out that it is the characteristic relation of risk and return in early stage investments, which affords the investment of equity capital. Equity participates symmetrically in risk and return (Ewert 1993). Returns adequately matching the risk of an investment may be attained by full participation in the increase of the value of a company. The asymmetric return participation characteristic of debt capital would necessitate prohibitive risk premiums on the interest rate of debt capital (Stiglitz and Weiss 1981).³⁷

Posner (1996) mentions that bank credits are usually only provided if the default risk is at maximum 1 - 1,5 %. In addition typical debt finance with periodic interest payment would withdraw liquidity from the company, whereas for equity in all cases but for repurchases the investor will be paid in terms of capital gains by a third party (Kaminski 1988), leaving the cash money in the company.

With the exception of equity-kickers, a subsidiary form of debt, foreign capital is thus generally not used in early stage investment.

Early stage investors are therefore equity investors which are aware and tolerant of the risk involved with investments at particular stages they provide the funds. Whereas later stage investments may allow for more of a hands off approach, early stage investors may be consid- ered as typical venture capital investors, in that they typically assume the role of an active investor, making up for company founders knowledge deficits in the field of finance, controlling and marketing (Posner 1996, Nathusius 1986).³⁸

This characteristic strongly influences the number of investments a single venture capital manager may take care of. An early stage venture capitalist may work on five to six projects simultaneously, while with passive equity investments managers may administer up to 100 (Murray 1991, Nathusius 1991).

Early stage projects are rarely syndicated, thus diversification advantages are foregone. This may be explained however by the high transaction costs of syndication, as compared to the low investment volume. Because of the relatively small amounts invested, early stage funds may attain a high level of diversification within their own portfolios already (Nathusius 1991, Fama 1976).

2.3 The New Technology Based Firm NTBF

2.3.1 What is a New Technology Based Firm?

At first sight the term new technology based firm NTBF seems to leave it to individual disposition whether it requires the firm itself to be new or the technology it is based on. In regard of venture capital investments in these enterprises I suggest to hold on to this uncertainty to understand it in both senses.

The company should be new, since after having matured it will typically need no more venture capital, but will be fine with passive equity investments. Moreover it should be based on new technology, understood as innovative proprietary knowledge, since this will be its source of competitive advantage and the basis of the enormous potential for rapid growth and profitability. NTBFs may therefore be able to attain the benefits which occur to an innovator in the form of unique selling arguments for its products and innovation rents (e. g. Bower and Christensen 1995, Hitt, Ireland and Hoskisson 1995, Kim and Mauborgne 1998).

Pfirrmann, Wupperfeld and Lerner (1997, p. 11) describe the new technology based firm as a business start-up not more than five years old with a yearly R & D expenditure of at least DM 100000."³⁹ The "new technology based firms can be seen as important vehicles in the commercialization of technological innovations" (Pfirrmann et. al 1997, p. 12).

Abbildung in dieser Leseprobe nicht enthalten

Box 2.3.1 The New Technology Based Firm

(Source: Pfirrmann, Wupperfeld and Lerner 1997, p. 14)

2.3.2 The Business Life Cycle of a New Technology Based Firm

Whereas NTBFs pass through similar stages as ordinary companies, certain differences apply. Pfirrmann, Wupperfeld and Lerner (1996, p. 12) distinguish five stages of the NTBF's life cycle: founding phase, R &D-phase, market introduction, growth, stabilization and maturity phase.

Abbildung in dieser Leseprobe nicht enthalten

Graph 2.3.2 Business-Life-Cycles of the New Technology Based Firm Source: Holger Ludewig

The foundation phase precedes the formal foundation of the firm and involves basic decision making about products and markets, etc.. The need for capital at this point is small and can be covered without external financing.

The Pfirrmann, Wupperfeld, Lerner scheme adds an own R & D stage, to account for the great importance in terms of time and capital afforded for the development of the innovative, technology-intensive product of the NTBF. Capital requirements may run up to several million US$. Pfirrmann et al.(p. 12) stress that because of the "high degree of innovation risk, these capital requirements should be largely covered by equity and promotion funding." (p. 12) High risks and capital requirements involved in addition to the long time that still has to elapse before the NTBF will begin to make a profit, make the financing of an NTBF particularly difficult. A lack of finance may mean that the development of a new product is not possible and therefore the start-up of an NTBF is void. Even the mere shortage of capital will pose a threat to the entire project, since it is likely to slow down the development process, so that the company looses its competitive edge as a first mover (Lieberman and Montgomery 1988) against its rivals. (Pfirrmann, Wupperfeld, Lerner 1997, p. 12 - 13).

As with other businesses the market introduction phase is critical, since "with market entry the economic viability of the product, and thus also the firm's prospects of success become appar- ent." (Pfirrmann et al. 1997, p. 13). Because of the innovativeness and complexity of the NTBFs' products, customers have no experience in using it, thus it will typically take longer for a buyer to make a decision. There may even be a need for a pilot phase, sometimes involv- ing the distribution of incomplete beta releases (which at times seem to be never ending, HL) (Iansiti and MacCormack 1997). Thus for a NTBF the market introduction phase "last consid- erably longer in NTBFs than in other types of newly-founded enterprises." (Pfirrmann et al. 1997, p. 13).

Regarding the financing needs of NTBFs during this stage, some income accrues from turnover activity. However, the capacity for self-financing to cover the costs of expanding production and sales organization will generally be still insufficient. "[L]arge amounts of capital, far exceeding the requirements in the R&D phase" (Pfirrmann et al. 1997, p. 13), are needed and may again lead to considerable financing difficulties. Pfirrmann et al. (p. 13) note however, that "[f]rom market introduction onwards,.., NTBFs also increasingly finance themselves with debt capital."

In the growth stage the client scope of the product is broadened, other market segments or additional channels of distribution may be entered, the product may be further developed or diversified, marketing effort may be intensified, manufacturing facilities may be improved to provide a higher operational leverage. At this stage additional equity and debt capital inflows are needed, however, difficulties in procuring capital are decreasing, since the investment risk has become more "calculable" (Pfirrmann et al. 1997, p. 13).

The stabilization and maturity phase of a NTBF does not necessarily imply a decrease of the growth rate of the turnover. Stabilization, according to Pfirrmann et. al (1997, p. 14), is rather meant to refer to the organizational processes and structures, customer-, supplier- and investor relations of the firm. As a company builds strategic assets formerly complemented by the venture capitalist, such as experienced management, reputation and its own network, there is not much opportunity left for the venture capitalist to add value. The NTBF becomes an established high-technology firm.

Overall the intensity of competition NTBFs face throughout its life and from an early stage, make speed a factor of strategic importance for the success of the product. NTBF's are also distinguished from e. g. "Lifestyle-Enterprises" (Bhide 1996) in that their initiator intents to develop a "high-technology enterprise, which is economically viable and capable of surviving in the long term" (Pfirrmann, Wupperfeld and Lerner 1996, p. 13, Collins and Porras 1995, Kim and Mauborgne 1997, Hamel and Prahalad 1989).

Scheduled R&D expenditure of new technology-based firms is sharply increasing. For 1998 NTBFs surveyed by the Technologiebeteiligungsgesellschaft of the Deutsche Ausgleichsbank had scheduled an average R&D expenditure of DM 1.1 million , up form DM 850000 in 1997, four times the average amount of a survey for 1994. 50 % of the surveyed NTBF were found to plan an IPO during the first five years after set up. In biotechnology it was even 80 % (FAZ 30.12.97).

2.3.3 Strategic Idiosyncrasies of Technology Industries

Technology is an intermediate intangible asset, which use is non-rivalous in nature, thus it can be embodied in any number of products without further increasing the costs of its creation or reducing its utility (Dunning 1993). The intermediate intangible nature becomes obvious, if one thinks for example of a person who walks into a pharmacy with a headache, but instead of the fast working tiny little pain-killer pill, she receives the research and development documentation along with all you need to know about the processing of pharmaceuticals. Utility is therefore not derived directly from the technology, but from what it does.

The best example is offered by software products since they are entirely immaterial. One cannot even be sure whether it is not rather a service stored on a disk. Once programmed as for example a computer game or word processor, it can be multiplied at almost no cost. The R&D costs may be substantial and result almost entirely from the salary of the programmers plus perhaps some computer equipment and the rent for some sort of an office.⁴⁰

If development costs are US$ 300 million for the software and it would be sold once, the price would have to be US$ 300 million, sold twice however the price would have to be US$ 150 million. If it is sold 10 million times all over the world a price of US$ 30 would cover the development costs, add US$ 15 for marketing, taxes, distribution, packaging and overhead and the price would have to be 45 US$ to make no loss. If the company can sell the product at 60 US$ it would make a profit of US$ 150 million. If the company sells only one million copies at 60 US$, because perhaps its rival offered a new better program or introduced it three weeks early with a big "media blitz", the company would make a loss of US$ 240 million. This feature of knowledge driven competition on intangible non-rivalously useable intermediary assets, may be considered a key characteristic of technology based companies. The proximity of high risk and great opportunity is its signature.

With software it is most obviously the case, however other knowledge driven industries offer similar features. In biotechnology or information technology hardware a tangible product might be sold, however the utility that the customer accepts to pay a premium for, is not derived from the material parts of a pill or liquid, otherwise discount priced aspirin or some kind of sweet would do, or from a gray plastic box with some wires in it, but from the superior intangible impact or capabilities they mediate and render.

An Intel CPU for example ten years ago, did not really look much different from today's latest model, however today's processors offered at the same price offer several times faster process- ing (Moore’s law; Gates et. al. 1996, Sherman 1993). Thus what customers are willing to pay for is processing power not the piece of silicon (Kim and Mauborgne 1997). The improved processing power represents the utility from the knowledge embodied in the innovative chip design. Much as a disk carries the software, the chip carries the processor design. As a differ- ence, the chip as other hardware parts too carries a higher share of production costs, since the production of computer chips requires very sophisticated equipment and processing capabili- ties. Thus however, the product processing know-how, may become another important source of intangible strategic assets.

With high fixed costs for R&D or R&D and set up of production plus marketing costs, the business is characterized by an enormous natural operational leverage⁴¹. Powerful economies of scale may be achieved. Each product sold, diminishes the share of fixed costs per unit and increases profits. Fast generation of high volume to attain large fix cost degression is the key to success.⁴² High volume is important to allow to offer a product at low, competitive prices. Low prices are required to attain high sales volume. However prices are determined in competitive markets, meaning a company is either able to generate high volume and enjoy the benefits of mass production or it is out of business.⁴³

2.3.4 Venture Capitalist and the New Technology Based Firm

NTBFs offer the high growth potential and opportunity for hugh profits to pay for the venture capital services. This potential results from the major strategic asset of the NTBF, its proprie- tary knowledge advantage (Kim and Mauborgne 1997, Hitt, Ireland and Hoskisson 1995). It is based on the initial idea of the founder and is further developed in the costly R&D process.

Abbildung in dieser Leseprobe nicht enthalten

Box 2.3.4 a: Characteristcs of Investments in New Technology Based Firm (Source: Pfirrmann, Wupperfeld and Lerner 1997, p. 14)

Pfirrmann, Wupperfeld and Lerner (1997, p. 3) note that the "financing of new technology based firms (NTBFs) is easier in one respect, but in others it is more difficult than is generally the case with smaller firms." It is easier, because "the large amounts of capital frequently required, and the shorter time window available for exploitation of new technological develop- ments mean that entrepreneurs are more willing to seek external equity finance." Bhide (1992, p. 110) points out, that "[s]ignificant initial capital is indeed a must in industries such as biotechnology or supercomputers where tens of millions of dollars have to be spent on R & D before any revenue is realized."

Greater difficulties in assessing the risk of a project result however from "the nature of innova- tive technologies and the typical pressing need of NTBFs to compete on a global scale" (Pfirr- mann et al. 1997, p. 3). Investments in NTBF are also more risky for a "long period of time may .. pass between the research and development phase and the prospect of a positive cash flow" in particular in "certain fields of specialized technology, such as biotechnology." (Pfirr- mann et al. 1997, p. 3).

The higher the technology intensity of the projects applying for funding, the more difficult and costly will be their assessment. The more innovative the new technology at hand, the higher will generally be the involved complexity⁴⁴, uncertainty and cost of information acquisition.

Expert knowledge is expensive, the more advanced a technology is, the smaller will be the number of experts and the higher will be their ranking and price (Posner 1996).

Since potential target companies for venture capital funds need to be "young" and in particular "rapidly growing", offering "the potential to develop into significant economic contributors", the group of businesses in question for professional venture capital support is clearly narrowed down (NVCA 1998, also Sahlman 1997).

As The Economist (1997, January 25th, p. 19) pointed out: "Corner groceries may technically be start-ups, but they do not need venture capital".

Timmons (1990, p. 100 f.) distinguishes "high-potential firms" and "foundation firms" also called "mid-market companies" as primarily relevant targets for venture capital.

High-potential firms are businesses which grow rapidly, i. e. over 30 % per year and are likely to exceed US$ 20 million in sales. Foundation firms are defined as businesses which grow more slowly at a rate of 10 to 20 % a year with sales exceeding US$ 2 million.

"Lifestyle firms" (Bhide 1992, Bhide 1996) may rely entirely on personal savings of the owner-manager.

Bhide (1992, p. 111) explains that 7 % of venture capital investments account for 60 % of the profits, while one third result in a partial or total loss. Therefore "each project must .. represent a potential home run."

Moreover, since venture capitalists are usually highly skilled professionals, which in economic terms incur substantial opportunity costs by choosing to work as an venture capitalist instead of taking on other occupations, their intermediation services are expensive.

In addition John Doerr of Kleiner Perkins Caufiel Byers (http://www.kpcb.com) likens the training of a professional venture capitalists to crashing a jet fighter: "It's probably going to cost you US$ 20 - 30 million." (The Economist 1997, p. 21)

Thus it is only worthwhile to demand their services in fields, where their portfolio of strategic assets like management and industry expertise, superior access to and processing capability of information will have a significant impact.

[...]

---

¹ Business Week (August 31st, 1998), p. 24

² e. g. Smith (1776), Schumpeter (1912 and 1961), Porter (1990), Vernon (1966 and 1980), Acs and Audretsch (1991), Hitt, Ireland and Hoskisson (1995), Evans and Wurster (1997), Iansiti and MacCormack (1997), Eisenhardt and Brown (1998)

³ e. g. Albach, Hunsdiek and Kokalj (1986), Albach (1989), Dunning (1993)

⁴ Process innovation may yield similar benefits, in that production costs may be diminished by the application of innovative, proprietary production technologies or in that unique features, formerly not realizable may be added to a product. In case of process innovation, rents may thus be earned by broadening the span between production cost and market price or by allowing for new valued product features. e. g. Porter (1980 and 1985), Lengnick-Hall (1992), Lieberman and Montgomery (1988), Prahalad and Hamel (1990), Dunning (1993), Hitt, Ireland and Hoskisson (1995)

⁵ Mandel (1998, p. 28) reminds, that "[i]n part, the sudden re-emergence of technological progress is the culmination of years of research in disparate fields that are finally reaching critical mass." Business Week (1998, p. 24) holds however, that "[t]he innovation pipeline is fuller than it has ever been in decades." The magazin also expects (p. 29), that "[i]ncreasing globalization will simultaneously provide much larger markets and tough foreign competitors. The result: Companies will have even more incentive to innovate while cutting costs."

⁶ Firms entering industries characterized by a high degree of innovative activity face a greater prospect of growth, but they are also burdened with a lower likelihood of survival. e. g. Audretsch (1995), Audretsch and Mahmood (1995), Mahmood (1992), see also Pfirrmann, Wupperfeld and Lerner 1997, Gross and Port 1998

⁷ Schumpeter (1942 p. 134 - 175), for all his appreciation of the entrepreneur, thought, that large companies have a stronger incentive and are better suited to innovate, since they may exploit monopolistic advantages to a greater extent. Scherer (1984, p. 224) holds however, that "smaller firms are disproportionally prolific contributors to the generation of important technological innovations" whereas "[l]arge corporations barely pull their weight." see also Scherer (1988) on innovation advantages of small firms and Röpke (1977, p. 150 f. ) Acs and Audretsch (1990) support Scherer's argument, saying that small firms have innovative advantages in a number of industries, particularly in high technology industries. see also Williamson (1975, p. 205 f.) and 3.2.2 Strategic Investors: Corporate Venture Capitalists

⁸ According to a survey of the tbg 400 new technology-based firms are started each year. NTBFs according to the survey create four times more jobs than average founders. Three years after formation they employ an average of 18 people, in the fourth year 23. (FAZ 31.12.97). Business Week (1998, August 31st, p. 26) expects that "[t]he innovation boom, and the faster growth rate it could ignite, could make it much easier to address some of the vexing social and environmental problems of the 21st century." e. g. expenditure for social insurances, retirement, protection of the environment, employment, etc.. see also Porter (1990) Looking at new technology industries and small business formation's role for job creation in the US, Brock (1997, p. 9) points out, that "[i]n 1980, we had 101 million workers in the U.S.. If I had known that 42 million would lose their jobs over the next 16 years, I would have predicted that when I wake up in 1996, the unemployment rate would be 15 percent. But it was 4.9 percent because 72 million new jobs in fact were created in 17 years, with a net gain of 30 million jobs How did the nation that fired everybody hire everybody?" Because of the regained public awareness of economic dynamics and the role of the entrepreneur, as Bös and Stolper (1984) comparing Keynes and Schumpeter foresaw, Schumpeter experiences a revival as the "political economist of the 1990s" (Stopler 1984, p. 1).

⁹ e. g. Giersch (1984), Hax (1989), Gahlen, Meyer, Schumann (1989), Birch (1984), Audretsch and Fritsch (1994), Scherer (1984 and 1988), Acs and Audretsch (1990), Pfirrmann, Wupperfeld and Lerner (1997), Wissenschaftlicher Beirat beim Bundesministerium für Wirtschaft (1997)

¹⁰ "It is well known, that small companies have few opportunities to gain access to stock markets." (Pfirrmann, Wupperfeld and Lerner, 1997, p. 3) Discriminatory capital market acces may act as an entry barrier to products and service market (Hitt, Ireland and Hoskisson, 1995, p. 49). see also Appendix II

¹¹ "The birth of new firms depends upon the availability of venture capital." (Cooper 1970, p. 75). Under 3.3 How "hot" is it really?, I will argue, that Cooper's statement perhaps over-emphasizes the importance of venture capital. Looking at the big picture however it may nevertheless hold true. see also e. g. Pfirrmann, Wupperfeld and Lerner (1997), Laub (1991), Stedler (1996), Wossidlo (1985)

¹² see Appendix II 1 The German Capital Market so far

¹³ "These imperfections in the capital market with respect to supplying finance to smaller firms are primarily seen in the ability of external investors to evaluate the quality of investment opportunities." (Pfirrmann, Wupperfeld and Lerner 1997, p. 3) see also Allen and Gayle (1994)

¹⁴ Pfirrmann, Wupperfeld and Lerner (1997, p. 9)

¹⁵ Liles (1974, p. 461) also points out, that "[i]nterestingly enough, seed capital situations are considered by some individuals or firms as too risky to be described as suitable for venture capital and by others as the only form of "pure" venture capital investment opportunity."

¹⁶ See also 2.1.2 Private equity distinguished

¹⁷ The importance of private investors in particular during the early stages of a newly started businesses will be discussed under 3.1 Informal Investors.

¹⁸ For further arguments emphasizing the importance of the hands-on aspect of venture capital, e. g. added value, monitoring and reduction of uncertainty supported by the prinicpal-agent- theory see 4.2.1 Venture Capital as a Finance Technology and Appendix III.

¹⁹ Schmidt explicitly emphasizes the divestment by going public to contrast it as the US-American finance practice against the „traditional” German practice of the Kapitalbeteiligunggesellschaften KBGs. Schmidt (1985, p. 431) points out that the German funding practice of the KBGs differs from US-style venture capital in that 1) profit participation of the KBG is limited, so that compensation for high risk is impaired, 2) the KBGs take a passive approach to investing, which does neither allow for close control of management, nor for provision of value adding management support, 3) repurchase options granted to the portfolio companies may cause liquidity problems for the investee, trigger conflict about the valuation of shares and lead to adverse selection in the KBGs portfolio, since successful companies will leave while under-performers remain. see also 4.2.1 and Appendix III

²⁰ The OECD (1996, p. 15) defines venture capital as "a financing technique .. in the form of equity or an instrument, which can be converted into equity. The essence of venture capital is the provision of high-risk and high-reward finance to fast growing businesses."

²¹ 4.2.1 Venture Capital as an Institution and Appendix III

²² It has to be noticed so, that debt and equity mark only two extreme points on a continuum of funding forms, with mixed structures, such as subordinated debt or preferred stock in between (Ewert 1993).

²³ This assumption builds on Myers' (1984) pecking order theory of the capital structure. "Firms are said to prefer retained earnings (available liquid assets) as their main source of funds for investment. Next in order of preference is debt, and last comes external equity financing." Copeland and Weston (1988, p. 507) see also Stiglitz and Weiss (1981), 4.2.1 Venture Capital as an Institution and Appendix III

²⁴ "...private in the sense that it is not raised from the general public, or listed at a recognized stock exchange." Hindle (1997, p. 150)

²⁵ This point of view is also supported in the article "Time to stop calling it 'venture capital'" by Anslow (1992, p. 2 f.). The NVCA (1998) reports that "[r]ecently, some investors have been referring to venture investing and buyout investing as 'private equity investing'." The association fears that the term "private equity" may cause confusion, since the term is used in the investment industry to refer to buyout fund investing.

²⁶ See also Pratt (1985, p. 7) as cite 2.1.1 What is Venture Capital?

²⁷ With regard to the practical use of the model, the Bundesverband Deutscher Kapitalbeteiligungsgesellschaften German Venture Capital Association e. V. (BVK) (http://www.bvk-ev.de) provides its annual statistics on the investments of its member companies distinguishing seed-, start-up-, expansion stage-, MBO/MBI -, turnaround and other projects. A similar pattern is used by the NVCA of the USA, as well as in the national venture capital survey of Price Waterhouse for the USA (http://www.pw.com/vc/) and the annual statistics of the European Venture Capital Association EVCA (http://www.evca.com and press release of May 28th, 1998). In as far as leading venture capitalist like Draper Fisher Jurvetson (http://www.drapervc.com) and KPCB Kleiner Perkins Caufield Byers (http://www.kpcb.com) use the structure to describe their activities and invite business plan applications, the venture capital scheme structured in association with the stages of the business- life-cylce may be regarded as broadly accepted in practice.

²⁸ Product-Life-Cycle idea found in various sources e. g. Schween (1996, p. 95), Information content: Posner (1996), Bruno and Tyebjee (1985), NVCA (1998), OECD (1996)

²⁹ Schween 1996, p. 98, see also 2.3 The New Technology Based Firm, 4.2.1 Venture Capital as a Finance Technology and Appendix III

³⁰ According to my definition of venture capital 2.1.1, bridge finance would generally be pure private equity or even debt capital, since external management support from an investor is usually no longer needed. In as far as bridge finance is often provided by the venture capitalists on their way out it is nevertheless often considered venture capital, see e. g. BVK statistics for 1997.

³¹ First stages are not considered separately and merged into the expansion segment.

³² see e. g. DAX, Dow Jones or S & P 500 Indices

³³ Under 4.3 it will be pointed out how certain segment designs of the stock market may impact the price a venture capital as an issuer of stock may attain.

³⁴ see e. g. Pfirrmann, Wupperfeld, Lerner 1997, Nathusius 1985, Wrede 1987

³⁵ Eilenberger (1994, p. 104) points to the importance of time as a determinant of uncertainty in explaining, that uncertainty results from unforeseeable changes in the environment, as well as from the time it takes to implement a decision and to reach the intended final state. The more time it takes, the higher the threat of failure and negative interferences.

³⁶ Discounted cash flow (DCF) methods building on historic Capital Asset Pricing Model CAPM betas 1964) are widely used among accountants and investment bankers, see e. g. Drukarczyk and Schwetzler (1996), Ross, Westerfield and Jaffee (1993), Copeland and Weston (1988). Dietl (1993, p. 15 - 20) howeveer points out problems of deterministic perception of the future as implied by the CAPM (also Appendix III).

³⁷ Since as will be pointed out a negative selection process would be triggered, since only entrepreneurs with a risk above the calculated average would apply for debt capital, market failure would result ("market for lemons"-problem ; Akerlof 1970, Stiglitz and Weiss 1981).

³⁸ Nathusius (1986) notes that for a later stage investors the monthly controlling of the portfolio company will generally be enough.

³⁹ As with venture capital "a broad variety of definitions" for new technology based firms exists. Pfirrmann et. al (1997)

⁴⁰ e. g. Brock 1997, Pfirrmann, Wupperfeld and Lerner 1997, Ostermann and Sietmann 1983

⁴¹ Operational leverage refers to "the relation of fixed costs to total costs... Other thins being the same, the higher ratio of fixed costs to total costs, the greater the business risk." (D'Ambrosio 1976, p. 179), see 4.1.3.2 and Appendix III 6

⁴² Vessey (1991), Eisenhardt (1988), Eisenhardt (1989 speed), Iansiti and MacCormack (1997) For a discussion of threats from accelerated economic dynamics, see Backhaus and Bonus (1994)

⁴³ Hitt, Ireland and Hoskisson (1995, p. XVIII) claim that "[b]ecause of the conditions in the global economy, some believe the 1990s may be remembered as a time of 'competitive hell' for many Western companies - a time during which many firms will struggle to continously improve to meet customers' demands for high quality products at low prices In the opinion of General Electric's chairman, Jack Welch, firms that cannot sell a top-quality product at the world's lowest price will soon be out of business." see also Fortune, January 25th, 1993, Obloj, Cushman and Kozminski (1995), Eisenhardt and Brown (1998), Evans and Wurster (1997)

⁴⁴ On strategy and complexity see Stacey (1995) and Malik (1993)

• College: University of Paderborn
• Grade: 2
• Author: Fritz Holger Ludewig (Author)
• Publication Year: 1998
• Pages: 184
• Catalog Number: V185244
• ISBN (eBook): 9783656997993
• ISBN (Book): 9783867461504
• Language: English
• Tags: early, stage, investments, technology, based, firms, analyzing, changing, german, landscape, venture, capital, finance, light, market, theory, institutional, economics