Germany: Early stage hits a rough patch

Times are hard for fundraising and the series of high growth rates in German early stage investing has ground to a halt. Dr Holger Frommann, managing director of the BVK, Germany’s national venture capital association, predicts the volume of deals in the second half of the year will decrease. “Germany has moved on from the boom to a process of consolidation which usually means a stagnation in new investments,” he said.

While there are some good quality early stage deals around in the German market, they are not being funded, says Trevor Bayley, head of Hg Capital’s Frankfurt office, which focuses on both early and later stage investments. “There is more of a trend towards expansion rather than seed or start-up and investors are moving towards buyouts and later stage investments and away from traditional VC investments.”

For the first half of 2001, total seed investments reached E46.7 million in 66 companies, accounting for 6.6 per cent of the total private equity market. While start-up investments took a 35.8 per cent share with E440 million invested in 359 companies, according to the European Venture Capital Association.

“The government is the biggest early stage investor in Germany,” says Rolf Mathies of German firm EarlyBird. There are a number of soft money schemes which make it very attractive to invest in Germany and over the years have boosted Germany’s entrepreneurial spirit far beyond expectations. Germany’s soft money, or subsidy, schemes start at State Government level with funds allocated by Bonn-based Deutsche Ausgliechsbank and Frankfurt-based Kreditanstalt fur Wiederaufbau (KfW).

There is no shortage of funds for early stage investments, says Mathies. “Because you don’t need so much capital in early stage, finding funding is not a problem. It is pre-expansion that is lacking the phase between early stage and expansion that is the most critical phase right now.” He says, particularly in the healthcare sector, start-ups are having tremendous problems securing second round funding. “For this reason there will be a shake-out of companies in their second and third rounds. This will get rid of the bad companies, but it also means some good companies will miss out on funding.”

Earlybird announced the final closing of its German fund Earlybird III last August and the final closing of US Earlybird III took place in March this year, bringing the total size of Earlybird III to E243 million. Mathies says: “I’m glad we don’t have to fundraise right now. We have committed 30 per cent from the current fund so we should be alright for another year and a half. We are glad about this not only because the mood is bad, but also because allocations to early stage funds have dropped.”

Munich-based Techno Venture Management (TVM), a German/US focused firm is in the process of fundraising for an IT fund and its first life sciences fund see evcj June page 20. Both have a target of E250 million. TVM V Life Science Ventures is due to close this month, with TVM V Information Technology holding its first closing alongside it. Investment manager, John Chapman says it was interesting to compare the demand for these products in Germany. “There were very different responses to both funds. In life sciences, the interest and availability of funds has been very resilient. There has been a continued interest in life sciences and institutional investors still have a strong appetite for biotech funds.”

The IT fund has been more challenging, but the firm expects to meet its target of E250 million later next year. “Levels of allocations made to IT over the past year have been very high and many institutional investors have over-invested in IT, making it tough to fundraise in this sector right now,” says Chapman.

Investing with caution Looking at general investment trends Chapman says investors are cautious and rightly so. Events of September 11 have not changed the underlying trends, but have resulted in a break in decision making from anywhere between three weeks and three months, he said. “What we are seeing is a return to the old fashioned rules of investing in seed and early stage. There is renewed emphasis on long-established investment criteria such as markets with demonstrated demand, technologies with strong value-propositions, experienced, mature management teams, and modest valuations.” He adds: “Management teams are also placing greater emphasis on the ability of their investors to support company growth over time, both financially and in terms of professional support.”

The slump in technology stocks worldwide has led to the virtual closure of IPO and trade sales exits for such companies. This has led to a collapse in the valuation criteria for unquoted companies, particularly early stage technology investments. Faced with such conditions VCs have taken an increasingly defensive stance towards new investment opportunities. One such example is relative newcomer Target Partners, which last year only decided to make one investment. This year however the company has been more adventurous with four new deals to its name and one more in the pipeline.

The German venture capital market has recently seen a spate of problems among high tech investors. TFG Venture Capital, Germany’s second largest VC group, for example, recently cut the value of its funds by 25 per cent and is predicted to take a major loss this year.

Berlin-based bmp saw its first half results record a drop of 67 per cent in sales revenues. Cost reduction measures, including a refocusing on its core business through the sale of its two consultancy subsidiaries bmp telecommunications Consultants and ISBAC, mean the number of employees at the firm, which has fallen from 105 last year to the current number of 90, will be reduced to around 30 by year-end.

Another German early stage high tech investor, GUB Unternehmensbeteiligungen saw its fundraising efforts quashed by decreasing investor appetite for technology funds and the firm was forced to issue a warning of losses to the Frankfurt exchange.

“It has not been a good year for the German IT sector.

A lot of broken business models got funding that shouldn’t have,” says Trevor Bayley. “Now that the Neuer Markt has hit the floor and the Internet bubble has burst, many German VC funds will go out of fashion.”

Bayley says the implosion of the Neuer Markt is part of the reason for the recent lack of enthusiasm in early stage investments. The last few years have seen venture capital in Germany driven by the Neuer Markt to the extent that, like elsewhere, start-ups were listing as soon as possible to raise capital. Bayley says Hg Capital has managed to avoid being affected too much by the state of the Neuer Markt because the firm makes an investment with a view to a future trade sale, rather than IPO. “You should never make an investment with the expectation of floating in a short period of time,” he says.

In spite of well-publicised collapses, there is hope for maturing Internet investments in Germany. Around 66 per cent of German Internet companies say they are profitable, according to a survey by PricewaterhouseCoopers (PwC). While there has been much noise surrounding the companies going bust, PwC discovered how many of the companies from its first study could still be contacted. In Europe, the figure was 90 per cent and in Germany it was even higher at 95 per cent. On the other hand, a recent PwC survey with the title “The Internet segment of the Neuer Markt risk or opportunity?” came to the conclusion that every seventh company was threatened by insolvency.

The reality of the situation is that companies are consolidating. In the face of existing demand for Internet services and applications, it seems that at least some companies are succeeding in following a slow but healthy path towards growth. This also means that a broad base of companies is being formed in the middle ground and aggressive risk-laden growth from the era is now passe, cites the report.

How are the VCs adapting to this changed situation? Portfolio companies have to be financed for a longer period and this has resulted in fewer new investments in early stage companies. Also, with the recent Neuer Markt delistings rules, companies hoping to IPO would have to be in a more advanced stage before floatation than was the case in 2000.

Some players note that German VCs have been warming to US investments. US-based technology companies in particular have been attracting increasing interest. For example, earlier this year Siemens Venture Capital participated in a funding round for Digital Envoyan Atlanta-based producer of Internet mapping technology, and TVM co-lead a $12.9 million third round funding for Interactive Silicon, which is based in Austin, Texas. Siemens Venture Capital also co-invested in the deal, as did Austin Ventures, Band of Angels Fund, Convergent Investors and Dell. In September, TFG Venture Capital also ventured across the Atlantic committing E2.34 million to the second round funding of US biotechnology company, MERIX Bioscience Inc. Other investors in the round included Sofinov and TVM.

Waldemar Jantz of Target Partners however is cautious of investing Stateside. “We wouldn’t just jump into a venture deal in the US and we certainly wouldn’t lead a deal out there. It doesn’t make sense to start to lead deals in a market you don’t have a base in.”

Jantz worked for TVM in the US between 1988 and 1993 and is surprised that German investors are looking at US deals: “To be honest I’m not sure whether it is the right strategy to take. I think there are plenty of good deals in Germany. The grass is not always greener on the other side. You experience the same difficulties in the US as over here. I know the Neuer Markt is a problem, but so is the Nasdaq. Before the market matured there used to be problems with finding a good management team in Germany, but this has changed. We have some extremely strong companies in Germany.” He cites TVM-backed company Qiagen as an example which is still quoted on both Nasdaq and the Neuer Markt.

There is hope for the future, according to Juergen Diegruber of German Incubator. It is a good time to be in the market if you are a VC firm focusing on seed investments. “There isn’t so much competition. It is actually the best time to be in the market, but you have to look carefully for your investments.” One thing is certain, German VCs will have to adopt more of a long term approach if they are to survive in the current climate. Says Rolf Mathies of EarlyBird: “It is very important that venture capital gets good press right now. We have to prove that we are long-term investors, helping to grow companies and not just looking for a quick exit.”

But there remains a strong relationship in the minds of investors between successful venture capital investments and the stock markets. Players in Germany are confident that the venture capital market will bounce back, but not before public markets recover.

Incubators a dying breed The incubator scene in Germany has withered down to about 10 per cent of what it once was at its peak in the Internet boom. In the last two years, around 90 incubators cropped up in the German market. Now only about 10 remain and even these are struggling to make the grade. Recent casualties include Venturelab in Frankfurt: it’s Internet-focused business model folded earlier this year; and Berlin-based Venture Park, which in June returned its remaining funds of around E20 million to investors and ceased operations.

Rolf Mathies of EarlyBird says: “Most incubators have disappeared, as 90 per cent which were active in the German market were focused on the Internet and no more financing of Internet businesses is needed in Germany right now.” The failure of incubators has led to a reassessment of their investment models and some of them have attempted to reinvent themselves as venture capitalists with limited partnership structures.

One such example is German Incubator which from the onset distinguished itself from most incubators that had raised funds for investment from large corporates and institutions or raised via stock market listings. Founder and partner Juergen Diegruber felt the right approach was to use a traditional VC framework and so he raised a E15 million fund last year, to which HypoVereinsbank committed E7.5 million.

So far the fund is 20 per cent invested in five companies of which two already have a positive cash flow. Last year, German Incubator received over 300 business plans, but in Diegruber’s opinion, a venture focusing on seed investments should only be coaching a maximum of six companies a year. The problem with the incubators, he says, is that they started with a pan-European structure with funds that were too big. Investments were therefore scattered and too far to keep an eye on companies. “You need proximity to coach the company. A seed investor must assume a co-founder role,” says Diegruber. As a co-founder of the company, Diegruber says it is not capital that is the key.

You must have the entrepreneurial experience and management resources. “You need over a year to build up a company to start generating cash flow to turn it into a sustainable business. This is the reason a lot of these models didn’t work. They wanted to make a fast buck and promised their investors they would have an exit in a short time.”

The issue with most incubators, he says was most were start-up models having problems with their own funding. How then can they nurture companies if they are having trouble holding their own model?

Wolfgang Essler, managing director of corporate finance at Linklaters in Munich, says: “Corporate incubators such as the Siemens model are the only ones with a secure future. They have the brief to survive access to funds from their mother company and a strategic decision to invest in technologies that are beneficial to the corporation.”