Young German companies

Sentiment for German venture has improved considerably in the last 18 months and confidence is returning to the market, according to the local VC firms that survived the post-bubble fall-out. “I am very positive about German venture. The market has improved greatly in the last two years and will continue to do so,” says Rolf Dienst, founding partner at German VC firm Wellington Partners.

Such optimism is due in part to the fact that many underlying portfolio companies are starting to perform well. Most VC firms have moved past the post-bubble restructuring phase and have been focusing on building up their investment companies, many of which are now starting to reap the rewards. “The economic outlook in Germany has improved in the last year and business confidence is returning, so large corporates are spending more on technology again. As a result, our portfolio companies’ product sales have risen faster than expected and their revenues are now increasing significantly,” says Friedrich Bornikoel, managing partner at German VC firm TVM Capital.

With portfolio companies performing well and many reaching critical mass, the exit climate has improved greatly in the last 18 months, providing a considerable boost to confidence. According to the BVK WHAT IS THE BVK?, German VC exits have risen from 479 companies in 2003 to 576 in 2004 and 659 in 2005.

Broad recovery elusive

While many venture firms report that the recovery from the tech and venture bust is well underway, others are less confident about the market at present. While the top venture firms have been able to raise new funds, for many other groups, fund raising remains extremely difficult. Although, with an increasing number of exits, future returns in many VC funds are likely to be far better than in the past, LPs focus on current and historic market averages, which are deeply uninspiring. As a result, most LPs are still steering clear of venture in Europe, saving most of their powder for buyouts and are likely to do so until aggregate venture returns have shown consistent improvement.

LPs looking to invest in venture are still heading for the US market, which, due to its longevity, boasts attractive historical returns for vintages before the 2000 tech market crash. “European venture capital, in general, suffers from under-funding by institutional investors and Germany is no exception. Many LPs are only investing in buyouts in Europe and go to the US to invest in venture. German venture is seriously under-funded and, although some firms have managed to fund raise, most are still finding it very difficult,” says Andreas Wilde, managing director at German-based fund-of-funds manager VCM.

To make matters worse, many institutional investors that are investing in venture funds in Europe tend to migrate towards the largest, most international funds, often based in the UK. “We are not investing much in German VC at the moment – although there are some good groups, we only carve out a moderate amount to invest in European venture and that is mostly going into the pan-European firms,” says VCM’s Wilde.

With even those firms that have successfully closed funds in the last year taking considerable time to do so – two years in some cases – the jury is still out as to whether all of the firms currently fund raising will be successful. Some fear that further rationalisation is likely over the next two years. “Fund raising will remain difficult until Germany sees some Skype-type exit successes. Not all the firms that are currently fund raising will make it and a further reduction in the number of players is likely,” adds Wilde.

To succeed, venture experts say, it is crucial for firms to have an international network and investment capability. “You need to be international to be successful these days. We are a German firm, but only 45% of our investments are in Germany and we have French, Dutch, Swiss and Austrian team-members. The international model is what LPs are looking for,” says Wellington’s Dienst. Purely local firms, which may be less equipped at helping portfolio companies achieve an international scale, are finding fund raising especially difficult. “German VC firms that think in global terms are finding it easier to fund raise than those more local in focus,” says TVM’s Bornikoel.

Before there can be any meaningful talk of a recovery, specialists say that, not only does there need to be a far broader return in LP interest, but also a number of other issues need to be addressed. Top of most VC firms’ wish-list is the development of a proper exit channel for small-cap venture-backed companies. Revenue level requirements for IPOs on the Frankfurt Stock Exchange remain an entry barrier for all but the largest companies, while despite its improving profile, many firms are still avoiding AIM.

Venture capital players are also calling for the Government to boost the industry by further modernising labour laws, to bring German start-ups the same hiring and firing flexibility as their peers elsewhere in Europe. Re-drafting legislation to help German early stage companies will allow them to remain competitive with those in the UK and elsewhere in Europe.

Venture capitalists also say that, to ensure a successful future for Germany’s venture market, the management of the country’s VC-backed companies need to become far more global in focus. “German technology is superb – better than in many countries. But many of the managers lack the successful US-style approach to venture. They need to adopt global ambitions and become far more aggressive in terms of rapid company development and then exit,” says VCM’s Wilde. Yet despite their market’s various ongoing difficulties and the progress still required, VC firms in Germany remain upbeat about the future of their industry. Institutions with an international network are expected to prosper over the next five years. “The outlook is good. There are many attractive investment opportunities in Germany, exits will keep rising and firms with an international focus will continue to fund raise successfully,” says Wellington’s Dienst.

In addition to the rise in sound investment propositions, the fact that the economy and industry dynamics are improving and that venture firms are syndicating deals and sharing their expertise are further causes for optimism. In addition, entry valuations are still low, while, with more exit opportunities opening abroad, exit valuations are rising. “Entry valuations are very low in Germany, but with more and more exit possibilities abroad, especially in the US, where valuations are much higher, there are opportunities to make a lot of money at present,” says VCM’s Wilde.

Fund Raising

Firms that have successfully raised funds since the start of 2005 include the Government initiative High-Tech Gründerfonds’ €262m tech fund, TVM Capital’s €240m Life Science VI fund, Wellington’s €150m tech fund, Baytech’s €86m tech fund, Ventizz’s €60m tech fund and Hasso Plattner Ventures’ second closing of its tech fund at €50m.

Many more firms are currently in the process of fund raising or pre-marketing. According to market rumours, these include Earlybird, Wellington’s €100-120m Life Science Fund, Target Partners, Dr Neuhaus’ Techno Nord VC group, Heidelberg Innovation, Target Partners, Global Life Science Ventures and PolyTechnos Venture-Partners, as well as a host of smaller firms. With fund raising rising from the post-crash desert, the volume of new investments has also risen since 2004. According to EVCA, the volume of German VC investments rose from €1bn in 2004 to €1.3bn in 2005. Investments in 2006 have stayed the same as last year’s first half levels, remaining flat at €364.4m in 422 firms, compared to €366.4m in 419 firms in the first half of 2005 (BVK).

Among this year’s high-profile new deals are the US$50.8m investment in antibiotics researcher Nabriva Therapeutics GmbH in January by a group including Life Science Ventures and HBM BioVentures AG; the US$31.6m investment in Dialog Imaging Systems in February by a group including 3i, GIMV and Doughty Hanson; and the US$28.78m investment in CoreOptics GmbH by a group including TVM Capital, Quest Management and GIMV (Thomson Financial).

Even so, many firms are still doing fewer deals than before the crash, as despite the rise in fund raising, many firms have yet to raise follow-on funds. “We have done more deals this year than last, but overall investment numbers are still falling as many VC firms have only a limited amount of cash left and are restricted in their investment activity,” says Wellington’s Dienst.

Expansion stage still preferred

By far the bulk of today’s venture capital in Germany is going to expansion and later stage companies. While some firms, such as Wellington and Atlas, are investing in early stage, in general interest in this space remains relatively sparse among venture firms active in Germany.

Lessons learnt from the 1999-2000 tech bubble have imposed an enduringly cautious attitude towards new investments on most venture firms. Those early stage deals that are being done differ greatly from those seen before the tech crash. Venture firms tend to insist on some proper substance and experience today, before they will write any cheques. “In many cases, early stage no longer means just a business plan and two people. Now, some kind of technology or prototype and at least 6 months’ experience is required before VC firms will invest,” says Atlas’ Bruehl.

Many firms now require venture prospects to fulfil strict criteria and also prefer companies to be international in scope. “We still invest in early stage companies, but we are looking for those with an international focus,” says TVM’s Bornikoel.

Detailed due diligence and really getting to know management before investing are viewed as crucial today. Some specialists see all this as a positive – VC firms are picking their investments carefully, doing fewer, but higher quality deals and really preparing the groundwork beforehand.

Equally positive is the fact that, when venture firms are investing now, they are ploughing far more capital into portfolio companies than before. “The number of investments remains low, but when VC firms are investing, they are putting much more money into companies. This is a lesson learnt from the last cycle – in the past, European companies were under-funded compared to those in the US. Most VC firms now acknowledge that, for companies to deliver expected returns, you need to inject more capital in the first round,” says TVM’s Bornikoel.

Elsewhere, in addition to the rise in exits, investments and fund raising since 2004, another cause for optimism is that market professionals say the quality of investment opportunity in Germany is improving. “We get fewer than 1,000 business plans a year now, compared to many 1,000s back in 1999, but the quality of the plans that we do see is far higher,” says Atlas’ Bruehl.

Not only are more entrepreneurs emanating from big corporates and willing to risk start-up initiatives again, but repeat entrepreneurs are an emerging phenomenon in Germany. In addition, top executives from corporates are joining existing portfolio companies as board members and advisers. “There are a number of repeat entrepreneurs in Germany now. For example, the CEO of new start-up Collax, Olaf Jacobi, was involved in two of our other portfolio companies – Cobion AG and ACG AG,” says Wellington’s Dienst.

Technology continues to attract the bulk of investment, accounting for an estimated 70% of deals, compared to 20% to 25% in life sciences. German firms are particularly innovative in the clean technology and renewable energy sectors – as seen with the landmark deals for solar energy companies Q-Cells and Conergy. Government subsidies have driven demand and interest in this space, resulting in perhaps the highest amount of innovation and activity in this field in Europe. Other notable sectors include open-source software, such as SUSE Linux, which was acquired by Novell in early 2004.

With this new cycle, VC firms have made other changes to the way they do business. Not only have firms got much more circumspect about the type of companies they invest in, but they have embraced the syndication approach to investing.

Most firms are now looking to co-invest with their peers, rather than to go it alone as they did in the heady years leading up to the tech crash. Local players such as Earlybird, TVM Capital, Wellington Partners, Baytech and Hannover Finanz now join forces to co-invest with the large US and European VC firms active in Germany, such as Axcel Partners, 3i, Apax, Benchmark and Atlas Ventures. “There is less competition for assets than before. Whereas in the last cycle, VC firms would try and sole lead deals, now the trend is to co-invest,” says Atlas’ Bruehl.

Corporates are also jumping on the co-investment bandwagon. “Corporates are increasingly willing to co-invest and not just at the expansion stage – for example, Intel co-invested with us in Collax,” says Atlas’ Bruehl.

Your nearest exit may be behind you

The year 2005 proved to be the best year for exits since the tech bust and venture market downturn, with Germany delivering some of the best realisations in Europe after the landmark US$4.1bn sale of UK Voice-over IP software provider Skype to eBay in September 2005. Solar energy company Q-Cells, which listed on the Frankfurt Stock Exchange (FSE) in October 2005, remains top of Germany’s venture exit hall of fame. With a market cap of about €2.5bn and raising €313.2m on IPO, Q-Cells gave investor Apax a return of 27x its €11.5m investment. Together with Skype, the deal was lauded as proof that Europe was capable of delivering US-style venture homeruns.

Lower down the scale but also among Europe’s most high-profile VC exits in 2005 were the US$103.4m FSE IPO of German online mortgage broker Interhyp – which has enjoyed strong post-IPO performance – and the IPO of ErSol, which raised about €153.7m, both last September. 2005 also saw the IPO of online betting company Tipp24 in October and the sale of Munich-based online survey provider Ciao to the US’s Greenfield for US$154m in April.

Although anecdotal evidence suggests 2006’s exits have dropped a little from 2005, there have still been some notable realisations this year, including the circa US$100m acquisition of mapping and satnav software company Gate5 by Nokia in August, the FSE IPO of international multimedia software provider MAGIX in April, which raised €75.3m and the €94.9m IPO of solar module maker Aleo Solar in July.

Most VC experts say the exit environment is still favourable and expectations are that 2007’s exits will exceed those in 2005 and 2006, as more and more corporates are looking to buy venture-backed companies again. Indeed, sales to corporates are providing by far the most exits, accounting for an estimated 70% of deals. Increasingly, international corporates are hunting in Germany, with US companies in particular snapping up German venture-backed assets in the last two years.

Other nationalities are also shopping in Germany – as seen with Nokia’s August acquisition of Gate5 AG, which listed Target Partners and Innoven Partenaires among its VC backers. “There have been fewer big exits this year compared to 2005, but the general trend is still up and the outlook for exits is encouraging. Most exits are through sales to corporates, with US firms in particular showing a lot of interest in Germany at the moment,” says Alexander Bruehl, senior partner at Atlas Venture.

Corporate sales may provide the bulk of exits, but IPOs are also rising, however. Despite the demise of Frankfurt’s Neuer Markt in 2002, larger companies still have the option of the Frankfurt Stock Exchange, while there are several smaller exchanges across the country. In addition, the perception of AIM as a mere funding tool is gradually starting to change in Germany, with some firms now seeing it as a viable exit channel too. “There have been about 10 VC-backed IPO exits in Germany this year – mostly on the Frankfurt SE. We are about to do our second – following our IPO of SAF AG, we are now planning to list eCircle,” says Wellington’s Dienst.

The rise in exits has meant that, following the near-dearth of fund raising since the tech crash, a few firms have been able to raise new funds in the last 18 months. VC fund raising in Germany rose to €1.63bn in 2005, up from €610m in 2004, €609.5m in 2003 and €1.01bn in 2002. However, it is still well below the €2.46bn raised in 2001, €4.6bn in 2000 and the €2.2bn raised in 1999 (EVCA/BVK).

Germany has also seen a rise in start-up investments in Q2 of 2006, when the number of financed seed companies doubled to 28 from Q1. This rise is largely attributed to the creation in 2005 of the €262m High-Tech Gründerfonds (high tech start-up fund), by the federal government, KfW, BASF, Siemens and Deutsche Telekom. Recognising the ongoing difficulties in accessing capital for most German start-ups, the German Government contributed €240m to the fund, which provides seed capital and secondary loans to seed and early stage companies. For example, in September 2006, High-Tech Gründerfonds is said to have invested €600,000 in eWave Interactive, an eight-month-old start-up that sells enabling software for hosting massive multiplayer online games on mobile phones.

In addition to the High-Tech Gründerfonds, a few other VC firms are also now supporting seed and early stage deals once again though. “We have done several early stage deals in the last year, including Collax and Safe-ID. More VC firms and entrepreneurs have started to consider start-ups again recently, encouraged by the more favourable economic conditions,” says Atlas’ Bruehl.