AGAINST ALL ODDS:

THE LATE BUT RAPID DEVELOPMENT

OF THE GERMAN VENTURE CAPITAL INDUSTRY

Marc-Oliver Fiedler

Thomas Hellmann

Stanford Graduate School of Business

forthcoming in the Journal of Private Equity

May 2001

I. INTRODUCTION

For years it was claimed that the German economy is too conservative to develop a significant

venture capital industry. Yet, in a period of few years, German venture capital transformed itself

from a small, stagnant and obscure niche industry into one of the fastest growing and most

visible segments of the economy. What happened? Why did the reasons for Germany’s inability

to develop a venture capital industry suddenly vanish? What made the industry leap forward in a

space of two or three years? And are these changes only part of a bubble, or is the German

venture capital industry here to stay?

Historically, the overall market for private equity investments has been underdeveloped in

Germany. While the first investment funds date back to 1965, the number of private equity

funds remained small; approximately sixty funds were active in Germany in 1995. The gross

investment volume had stagnated at approximately DM 1 billion a year in the earlier nineties. In

1995, the volume of all private equity investments in Germany represented a mere 0.03% of the

gross domestic product, compared to 0.11% in the United States.i The private equity industry in

Germany seemed to be dormant.

Then something remarkable happened. In 1997, the private equity industry suddenly came to

life. The volume of gross private equity investment almost doubled year-on-year from DM 1,4

billion in 1996 to DM 2,6 billion in 1997. The industry association (Bundesverband Deutscher

Kapitalbeteiligungsgesellschaften or BVK) saw its membership jump by 20% per year. By 1999

the investment volume had expanded to DM 6,2 billion, representing more than a fourfold

increase over only four years (see Figure 1).

1

Figure 1: Private Equity Investments in Germany 1990-99 ii

Even more intriguing than the growth in overall investment activity was the source of that

growth. In Germany, the term “venture capital” is used loosely and includes a lot of LBOs,

MBO/MBIs, turnarounds and expansion investments, which in the U.S. would have been

classified as (non-venture) private equity. This kind of financing traditionally dominated the

German venture capital industry. The spectacular growth after 1997, however, was clearly

driven by “proper” venture capital investments. Seed and start-up investing experienced an

incredible explosion, growing by almost 1,300% between 1995 and 1999—three times faster

than the overall private equity investment volume (see Figure 2). In 1999, venture capital

investments had reached a level of DM 2,0 billion, almost 50% higher than the entire private

equity investments in 1996.

2

.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Gross Private Equity Investments (Billion DM)

+91%

+47%

+61%

941 995 1,229 1,112 1,449 1,141 1,367 2,6075

3,837 6,178 DM Million

(1)Other

Turnaround

LBO/MBO/MBI

Bridge

Expansion

Seed/Startup

Figure 2: Growth of Private Equity Investments by Type 1995-1999

Why this extraordinary boom? Most industry pundits have pointed to the March 1997

introduction of the Neuer Markt, the German stock market equivalent of the NASDAQ. They

argue that the Neuer Markt created a new exit channel that provided liquidity for venture

capitalists. The liquid stock market promised higher returns than trade sales or management

buy-outs could offer. With better return, investors became much more willing to make venture

capital investments. According to this “pull” theory, entrepreneurial activity was “pulled” or

triggered by changes in the financial market.

We argue that this “pull” theory is grossly oversimplified. It captures only a small part of the

real driving forces behind the dramatic industry developments. For one, it ignores the advent of

the Internet, which changed the nature of technological opportunities. Interestingly, however,

there appear to have been many other factors that, while they did not always make headline

news, nonetheless seemed to have been equally if not more important. In this paper, therefore,

we explore the more complex confluence of several factors that were necessary for the

spectacular boom. Indeed, we emphasize that there were a number of “push” factors that made

entrepreneurship and venture capital more attractive to Germans.

3

-100

100

300

500

700

900

1100

1300

1500

1995 1996 1997 1998 1999

Growth of Investment Volume by Type (Indexed)

Seed/Startup

Bridge

TOTAL

LBO/MBO/MBI

Expansion

Turnaround

+ 1,262%

+ 959%

+ 441%

+ 282%

+ 262%

-80%

Why should we care about what happened? The first reason is because this offers many lessons

for other countries developing their own venture capital industries. For the longest time there

was a belief that Germany would never be home to a vivid venture capital industry. Yet, against

all odds, it happened. If venture capital can flourish in Germany, perhaps there is hope for many

other countries as well. Second, a proper understanding of what happened is critical to scripting

a prognosis for the industry’s future. A simplified explanation that overemphasizes a single

factor would imply that as this factor changes, the industry would again recede. In particular,

with the recent bursting of the stock market and Internet bubble, it might seem that the time has

come to write a requiem for the German venture capital industry. Our analysis, however, allows

for a subtler, and interestingly more optimistic, prognosis.

The purpose of this study is to examine the underlying reasons for the sudden rise in German

venture capital. While it is difficult to draw an exact line between private equity and venture

capital activities in Europe – the distinction in Europe is not as clear-cut as it is in the United

States – we will focus primarily on the early stage venture capital market.

Our methodology involved an extensive study of available literature, such as business

magazines, newspapers and industry statistics. The core of the research was an extensive series

of interviews with a wide variety of key industry participants.iii The different perspectives

expressed allowed us to thoroughly develop our main argument. After offering a brief history of

German venture capital, we explore the central factors that explain the explosion of the industry

in the late nineties. We also evaluate the current state of the industry and conclude with

questions about the future.

II. HISTORICAL DEVELOPMENT OF VENTURE CAPITAL IN GERMANY

Slow growth over the first thirty years

1965 probably marks the birth year of the German venture capital industry: the founding of the

first four organized venture capital funds. In the following years, more funds were started, but

most produced disappointing results and perished quickly. By 1975, the total investment volume

had reached DM 372 million.iv

4

In 1975, the industry witnessed its first significant event with the creation of the Deutsche

Wagnisfinanzierungsgesellschaft mbH (WFG). This was the first ambitious effort to create a

proper venture capital vehicle. It was founded by a consortium of all the leading German

financial institutions and supported by the federal government. The motivation was a belief that

Germany was in danger of falling behind the United States especially in terms of the

commercialization of new technologies and their importance for economic growth and

employment. However, the experiment of the WFG proved a complete failure. The majority of

investments made by the WFG resulted in a net loss, and the WFG soon abandoned its early

stage technology investment strategy (see Becker and Hellmann, 2000).

In the eighties, a number of venture capital firms followed the U.S. model and emerged with

moderate success. By 1985, the overall market portfolio had grown to DM1 billion. Despite

new federal initiatives to foster start-ups in high technology, such as the “Beteiligungskapital für

junge Technologieunternehmen” (BJTU), venture capital investments in the early nineties

remained stagnant at approximately DM1 billion a year. By 1996 the entire venture capital

portfolio reached DM7 billion and consisted mainly of mature private equity investments.

Overall, the growth of the venture capital industry before 1997 had been frustrating and slow.v

Entrepreneurship à la Germany: “Mittelstand”

A popular myth is that Germany has no entrepreneurial culture. There is a longstanding tradition

of entrepreneurship in Germany, but it follows a somewhat different pattern than the Anglo-

Saxon model of entrepreneurship. Entrepreneurship in Germany dates back to the second half of

the nineteenth century, the so-called “founding years” (Gründerjahre). At the end of the

nineteenth century and the beginning of the twentieth, we find the creation of some of the well-

known industrial empires, such as Siemens and Daimler-Benz. And while some of these

entrepreneurial start-ups grew into large conglomerates, most entrepreneurial activity centered

on the so-called “Mittelstand.” The term “Mittelstand” refers to medium-sized enterprises (up to

approximately 1,000 employees) that are usually regional, family-owned businesses. Typically

they specialize in specific industrial niche markets, especially manufacturing machinery and

automotive parts. After World War II, the “Mittelstand” fashioned an important engine for

Germany’s economic reconstruction. With more than 800,000 companies, the “Mittelstand”

remains an important force in the German economy today.vi

5

If an entrepreneurial spirit always existed in Germany, why did venture capital take so long to

develop? The answer lies in the types of entrepreneurial activities and the entrepreneurs behind

the ventures. A typical “Mittelstand” company generally was started and managed by a family.

Initially bootstrapped from family resources, with time it would secure loans from commercial

banks, with founders pledging both personal and company assets as collateral. Given the more

traditional, slow-moving industries in which these businesses competed (especially in machine

tool manufacturing, or “Maschinenbau”), there was no need for rapid growth. Instead, they grew

gradually, relying mostly on retained earnings rather than external equity. Many founders

wanted to make a good living with their enterprises, but few had the intention – or skills, for that

matter – to build large-scale businesses. The concept of sharing equity with outsiders was

foreign to these entrepreneurs. They viewed their family businesses with pride and put great

emphasis on retaining control. The business model pursued by a typical “Mittelstand” company,

while clearly entrepreneurial, was distinct from the business models that would attract venture

capital. Consequently, venture capitalists encountered considerable difficulty working with

traditional German entrepreneurs. The chairman of the venture capital industry association, Dr.

Holger Frommann, commented: “[German venture capitalists] had difficulty to build a positive

image and had to fight against the deep-rooted and widespread mentality of the German

‘Mittelstand’, the ‘King of the Castle’ mentality.”vii

Social norms as disincentives

Social norms embedded in German society prevented the widespread acceptance of venture

capital. Traditionally, the ideal job for a middle manager was a stable career position with good

compensation and status within an established company. Those with the skills to run a

successful start-up had little incentive to do so. Professional failure invited social stigma which a

failed founder would carry for a lifetime. Concurrently, financial success was not necessarily

viewed with admiration either, but with envy. In the rather egalitarian German society, a

successful entrepreneur could easily be admonished as a “capitalist pig.” From a social

perspective, it was relatively safe to start a family-oriented “Mittelstand” company; but there

were no social incentives to start a high-risk, large-scale business that would require venture

capital. Interestingly, these social norms created adverse selection among entrepreneurs.

Successful managers were less likely to give up the security of their current employment, and the

6

managers who were willing to take the risk were more likely those who had not achieved a high

level of success in the corporate world.

III. EXPLOSION OF VENTURE CAPITAL IN THE LATE NINETIES

This situation changed abruptly in 1997 when German venture capital exploded. Why? Clearly

the emergence of venture capital cannot be explained by a single factor, such as the introduction

of the Neuer Markt. We will show that there were multiple factors that complemented each

other. To structure the analysis, we group these multiple factors into four main groups.

1. A sharp rise in entrepreneurial opportunities and entrepreneurial activities, the Internet being

the most visible component.

2. A new breed of progressive, less risk-averse entrepreneurs with more affinity toward Anglo-

Saxon funding models.

3. Increased necessity to fund ventures through equity rather than debt or retained earnings.

4. Increased availability of funds for investing in start-ups and stock markets

A. The Internet and deregulation bring about new opportunities

The Internet opened a large number of new business opportunities promising to transform entire

industries. In the United States, public access to the Internet and commercial applications first

became prevalent around 1995. User-friendly browsers made the Internet accessible to anyone,

regardless of technical know-how. Once the general public started adopting the Internet as a new

communications medium, and the user group reached critical mass, the development of

commercial applications became economically viable.

Obstacles in infrastructure and more conservative consumer behavior, Europe’s adoption of the

Internet lagged behind the United States. Most industry experts estimate that this time lag

spanned one to two years, hence it was not until 1997 that Internet euphoria really spilled

eastward across the Atlantic Ocean. In 1997, 7% of the German population had access to the

7

Internet—approximately the same percentage as in the United States 1½ years earlier (see Figure

3). But once the euphoria swept across Europe, savvy entrepreneurs quickly realized the

opportunities to be harvested.

Figure 3: Internet User Penetration (in Percent of Total Population) viii

It is important to recognize that the Internet had some unique characteristics that made it a

relatively “safe” platform for new entrepreneurial activity in Germany. Earlier waves of

entrepreneurial innovation, such as the computer hardware and software revolution in the

eighties and early nineties, had thrived on technological breakthroughs and proprietary

developments. The Internet, on the other hand, was marked by the emergence of new business

models (such as reverse auctions, consumer-to-consumer transactions, communities, etc.) and the

application of old business models to a new medium. Business models were built on new, but

highly transparent business processes rather than proprietary technology. These could easily be

copied and applied to new target audiences. Not surprisingly, a majority of the Internet start-ups

springing up in Germany were essentially copycats of U.S. concepts (see Figure 4 for some

prominent examples). Taking proven business models that already had been scrutinized by U.S.

venture capitalists, and transplanting them into the German market, was perceived as an easy,

low-risk way to start a venture.

8

0%

10%

20%

30%

40%

50%

60%

1995 1996 1997 1998 1999 2000 2001 2002

1 ½ years

USA

Germany

Figure 4: Prominent Copycat Examples of German Internet Start-ups

In addition to the Internet, privatization and deregulation of the German telecom market created

further opportunities for entrepreneurs. Obviously telecommunication played an integral part in

the exploitation of the new Internet media, so deregulation created particularly exciting

opportunities in the German market. As network access became liberalized, and emancipated

customers demanded innovative new services, a broad spectrum of competitors emerged. While

some represented divisions or spin-offs of established industry conglomerates (e.g. Mannesmann

Arcor and VIAG Interkom), others were entirely independent ventures (e.g. Mobilcom, QSC,

Primacom, Strato Medien AG). Clearly the combination of a new technology and

communication platform(the Internet) alongside the deregulation of the telecommunications

market opened the door for tremendous entrepreneurial opportunities.

B. A new generation of entrepreneurs emerges

Who were the entrepreneurs who could take advantage of these new opportunities? The more

conservative Mittelstand mentality hardly lent itself to exploiting these technological

breakthroughs. A new generation of entrepreneurs needed to step up to the plate and take a

swing at the new economy.

And a new breed of entrepreneurs did emerge. Most were young, highly educated, and had been

exposed to a dynamic professional environment in their short previous careers. A fairly large

percentage had earned a business degree as part of their education. A study of one thousand

9

US Model

eBay

epinions

etoys

hotmail

Amazon

German Copycats

alando, ricardo

dooyoo, ciao

myToys.de

web.de

buecher.de

start-ups in the German Internet and e-commerce industry conducted at the European Business

School (EBS) illustrates this picture (see Figure 5).

10

Figure 5: Profile of New German Entrepreneurs ix

The background of these “new” entrepreneurs stands in sharp contrast to that of the traditional

“Mittelstand” entrepreneurs, who were usually older and more likely held engineering positions

in established industries. These differences in backgrounds appear to be particularly relevant as

data from the EBS study suggest that founders with business backgrounds show more affinity to

venture capital than founders with more technical backgrounds.x One German venture capitalist

noted: “Today, the typical entrepreneur is no longer the cigar-smoking middle-aged Mercedes

driver who would rather die than give up control over his company. Today’s entrepreneurs are

young, enthusiastic and don’t shy away from risk.” Another venture capitalist added: “Today’s

entrepreneurs are much more money-driven. They realize that equity funding is the only way

they can grow their start-up quickly and attain high personal returns.”

Many of the “new” founders have had significant exposure to American culture, having studied

or lived in the United States, or having worked for U.S. corporations in Europe. As a result,

these entrepreneurs are comfortable following the U.S. model of starting businesses, including

giving up equity in return for funding and managerial support.

11

24-

18%

25-2930%30-34 32%

35-39

40+

13%

7%High school

Col-lege

Graduate school

PhD

Research/University

Consulting

BankingServices

IT

Media

Industry

Age of Founders at Inception of Venture

Level of Education of Founders

Professional Back-ground of Founders

21%

13%52%

14%

18%

26%

5%13%

23%

12%

Educational Degree of Founders

Business/Economics34%

CS/Math25%

21%

SocialScience

Natural Science

10%11%

Engineering

Inspirational success stories

New entrepreneurs’ affinity towards venture capital was reinforced by inspirational success

stories spreading through business circles and universities. These inspired young professionals

to try their luck at a start-up and helped boost boost both the image and prominence of venture

capital.

Many looked in awe to Silicon Valley icons, such as Jerry Yang of Yahoo, Marc Andreesen of

Netscape, or Jeff Bezos of Amazon. The fascination over Silicon Valley spilled into Germany,

so that major business magazines (Wirtschaftswoche, Capital, DM) introduced Silicon Valley

columns and special reports providing current information about the Californian “field of

dreams.” Aspiring German entrepreneurs were eager to follow the path of these role models, and

since venture capital seemed to have played an important role in the success stories of Silicon

Valley, new German entrepreneurs were more favorably disposed towards venture capital.

The inspiration for a new generation of entrepreneurs became all the more vivid when high-

profile German success stories emerged: German entrepreneurs, too, could make it in the Internet

world. Some of the most talked about examples included Stephan Schambach, founder of

Intershop—a world leader in Internet shopping applications—or Stefan Röver, who started

Brokat, an online bank. In some instances, such as occurred with the Samwer brothers, founders

of alando (now eBay Germany), television and the boulevard press elevated entrepreneurs to a

status of pop icons.

A point of debate is whether these role models inspired awe or greed. One partner of a large

German VC firm asserted: “Greed has been the major driver for many entrepreneurs over here in

recent years. They watch how some kids make millions in Silicon Valley starting their own

company, and now they want to do it too.” Whatever the motivation may have been, these

entrepreneurial idols paved the way for fledging new founders in Germany. They created

awareness in the general public, they established credibility and legitimacy for entrepreneurs,

and they validated a business model where venture capital played a central role.

It is worth noting the extent to which established organizations changed their attitude towards

entrepreneurship. German universities are hardly known for institutional change, but almost

every major University began launching its own business plan competitions. Ironically, these

12

events were frequently co-sponsored by established companies such as BMW, Siemens,

Deutsche Bank, McKinsey, Deutsche Post, or the Frankfurter Allgemeine Zeitung.

Shifts in the labor market

Start-up fever also reached German employees, who historically showed little job mobility. For

the first time a large number of employees “jumped ship” from traditional jobs, especially in

banking and consulting firms. One former IT consultant who had joined an Internet start-up

noted: “People fleeing from consulting firms’ doors have worn out their hinges…. There were

probably only a few years of this madness left, so it was now or never.”xi

Other factors reinforced this movement. In the late nineties, Germany faced a grim labor market.

Unemployment rates, for example, had almost doubled since the beginning of the decade to more

than 10%. The unemployment figures partly reflected the stagnation in the traditional industries.

Those attracted to entrepreneurship often perceived traditional industry as lacking dynamism.

Closely related to this, the government supported venture capital as a means to reduce

unemployment. Initiatives such as the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW

(Kreditanstalt für Wiederaufbau) provided federal funds for new start-ups. Entrepreneurs and

venture capitalists gradually became recognized as leading facilitators in the creation of new

jobs. One VC partner commented on this new role of entrepreneurs and venture capitalists: “Just

five years ago, entrepreneurs and venture capitalist were seen as blood drinkers. Now, they are

seen as heroes creating new jobs. We don’t have yet the same go-for-broke culture as California,

but Germans really see the need for catalysts to pump up the economy here.”xii

C. New business models require equity financing

Traditionally, German business founders relied almost exclusively on personal wealth, retained

earnings, and bank loans to fund their new ventures. Few entrepreneurs knew about the

possibility of obtaining equity funding as a financing alternative, and in any case, German

founders resisted relinquishing control over their ventures. However, the late nineties brought a

clear change in attitude: new founders discovered and in many cases chose to rely on venture

capital. By 1999, the share of companies at the Neuer Markt that was venture capital financed

13

increased to almost 40%.xiii A central reason for this shift was that the new business models had

distinct financing requirements.

The models of the late nineties were capital-intensive, but not asset-intensive. This change

required a shift from bootstrapping and debt financing to equity financing. Traditional German

start-ups focused on the manufacturing industries. Besides the investment in property and

equipment, little additional capital was needed to start operations. Since the financing was used

mostly to acquire tangible assets, these assets could be pledged against the borrowed money as

collateral. In addition, these ventures operated in fairly stable market environments where rapid

growth was not critical to survival; and gradual growth, based on cash flow and borrowing

capacity—expanding in good years and consolidating in not so good years—was the norm.

Manufacturing operations were usually expected to turn profitable soon after the start-up so that

a gradual expansion could be financed from retained earnings.

The financing requirement for Internet companies was radically different. Internet business

models could not rely on gradual evolution but required aggressive expansion strategies. The

competitive challenge was to quickly acquire and then defend a market position. Capturing

market share early on, to dominate a segment, was deemed to be the key to success. The

performance of Internet start-ups was often measured in the “number of eyeballs,” i.e., the

number of users drawn to a company’s web site. Consequently companies tried to attract as

many users as possible, often by relying on free services. Internet start-ups anticipated losing

money for several years: their strategy was predicated on a willingness to sacrifice short-term

profits in the hopes of capturing a large user base in the longer run. These strategies required

extraordinarily large up-front investment. Bootstrapping was certainly not an option for these

companies.

At the same time, Internet start-ups possessed very few tangible assets against which to secure a

bank loan. This was especially true if companies invested heavily in marketing and customer

acquisition. Most traditional bank credit analysis was ill-suited to Internet start-ups; these

companies could never meet the standard criteria for credit approval, thus the banks considered

them too risky for loans.

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Equity financing naturally became the only viable financing alternative for these kinds of start-

ups, providing the necessary cash to fund rapid expansion plans. Entrepreneurs had to give up

sizable stakes in their companies, something that the “Mittelstand” firms traditionally had

resisted. But the new entrepreneurs were more willing to accept this, in part because it relieved

them of the financial liabilities that could cripple a founder’s professional and personal life.

Given the high risk of the Internet, it was not surprising that the new generation of entrepreneurs

readily opted to finance their ventures by sharing ownership with their financial backers.

D. Equity funding becomes readily available

With more and more entrepreneurs looking to fund their businesses through equity, one could

wonder whether the supply of funds would be sufficient to meet the growing demand. Supply

depended heavily on investors’ perception of how attractive VC returns would be, as well as any

other investment incentives.

Creation of new exit options

A prerequisite for an attractive venture capital market is the existence of highly liquid exit

options enabling investors to cash out. In Germany, the March 1997 introduction of the Neuer

Markt (NEMAX) significantly improved the options. Previously, investors were likely to sell

their shareholdings in trade sales to strategic investors or in buybacks to the original founders.

Neither option yielded a reliable source of liquidity, and in addition, given the limited number of

buyers, trade sales were likely to result in a lower valuation than a stock exchange. Most

interviewees agreed that an initial public offering (IPO) at a stock exchange is unquestionably

the “Königsweg” (literally translated as “kings route”) for an exit.

One may ask why German venture capitalists did not exit through placing their companies on the

NASDAQ. Most interviewees pointed to the extreme difficulty of listing a German company.

Indeed, they claimed that it was almost impossible to attract the interest of U.S. investors in a

German high-growth stock. Most U.S. investors found it cumbersome to evaluate the German

market, and investment banks were unwilling to provide analyst coverage for comparatively

small companies outside the U.S. Hence, NASDAQ placement was a viable exit option for only

a very select number of ventures that had attained global leadership in a significant market

15

segment. Since the inception of the NASDAQ only a few German companies (such as Rofin-

Sinar or Digital Telekabel) had pursued a listing on the world’s largest high-growth stock

exchange.

Investors therefore welcomed the introduction of the Neuer Markt, and it quickly developed

beyond the wildest expectations. From 1997 to 1998, IPOs went from 4% to 16% of venture

capital divestments, a fourfold increase (see Figure 6). The number of listed companies on the

Neuer Markt more than tripled to 202 over a period of thirteen months spanning late 1998 and

early 2000. Its total market capitalization zoomed to $140 billion by early 2000, doubling in size

over just a few months,xiv though this growth turned out to be short-lived. At its peak, the Neuer

Markt’s NEMAX50 index had climbed above 9000; but it declined to under 3000 by the end of

2000. If the Neuer Markt were the extent of the German venture capital market, it would clearly

be in trouble. Our analysis, however, emphasizes that while the Neuer Markt is an important exit

option, it is not the only factor determining the viability and growth of the German venture

capital market.

i Source: Bundesverband Deutscher Kapialbeteiligungsgesellschaften (BVK), Statistisches Bundesamt, US Department of Commerceii Source: Bundesverband Deutscher Kapialbeteiligungsgesellschaften (BVK)iii Interviewees include Sebastian Blum (T-Venture), Max Burger-Calderon, Christian Reiberger and Christian Stahl (Apax Partners), Werner Dreesbach and Wilken Engelbracht (Atlas Partners), Martin Linkemann (TFG Venture Capital), Detlef Mackewicz (Mackewicz & Partner), Alexander Meyer (Wellington Partners), Dr. Hendrik Brandis and Dr. Oliver Thum (Earlybird Venture Capital) and Guiseppe Zocco (Index Ventures).iv Dr. Frommann, Holger. Speech at the Fourth German Private Equity Symposium: “Zehn Jahre BVK: Der Verband gestern und heute.” August 1998.v Bundesverband Deutscher Kapitalbeteiligungsgesellschaften (BVK). Jahrbuch 1998. p. 74.vi Business Week e.biz. “Net Fever Is Rocketing the Neuer Markt.” January 31, 2000.vii Dr. Frommann, Holger. Speech at the Fourth German Private Equity Symposium: “Zehn Jahre BVK: Der Verband gestern und heute.” August 1998.viii Source: International Data Corporation, Statistisches Bundesamtix Prof. Dr. Heinz Klandt and Lutz Krafft. “Die Bedeutung von Venture Capital für die Entwicklung von Internet/E-Commerce-Gründungen in Deutschland.” September 2000: p. 22-24.x Prof. Dr. Heinz Klandt and Lutz Krafft. “Die Bedeutung von Venture Capital für die Entwicklung von Internet/E-Commerce-Gründungen in Deutschland.” September 2000: p. 23.xi “Europe’s Great Leap Forward.” Tornado-Insider. Issue 13, May 2000. xii “The Smartest Money in Europe.” Tornado-Insider. Issue 1, April 1999.xiii Venture Capital Panel 1999, Mackwicz & Partner and VDI Nachrichtenxiv Business Week e.biz. “Net Fever Is Rocketing the Neuer Markt.” January 31, 2000.

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Figure 6: Divestments by exit channel

Rising popularity of stock market investments

After the economic struggles following reunification in the early nineties, the German economy

enjoyed a period of prolonged prosperity. Between 1996 and 2000, the gross domestic product

(GDP) grew consistently, increasing overall by 8.3%. This provided start-up businesses with a

healthy environment in which to flourish and take advantage of the generally strong buying

behavior of consumers and corporate customers. National spending increased by 2.7% and

2.9%, respectively, in 1998 and 1999.xv

Economic prosperity was reflected in the performance of the stock markets, which witnessed

abundant value growth and overall stability. In this economic uptake, investors became less risk-

averse and more willing to invest in high-risk projects. Both institutional and private investors

increasingly sought the market’s high-growth segment, and with more money chasing high-risk

projects, market valuations for start-ups exploded. Ironically, the high valuations attracted

further investments, leading to a self-reinforcing growth cycle and the creation of an economic

bubble.

xv Statistische Bundesamt Deutschland. “Volkswirtschaftliche Gesamtrechnung.” http://www.statistik-bund.de/basis/d/vgr/vgrtab1.htm. January 20, 2001.

17

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1998

Gross Divestments by Exit Channel

Trade Sales

IPO

Other

Buy back

1998 IPOs

Int'l. Capital Markets

Other DomesticCapital Markets

Neuer Markt

IPO Placement

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1997 1998

Gross Divestments by Exit Channel

Trade Sales

IPO

Other

Buy back

1998 IPOs

Int'l. Capital Markets

Other DomesticCapital Markets

Neuer Markt

IPO Placement

Historically, Germany’s capital markets failed to attract the attention of the broad public. Capital

markets were tainted with an image of imprudent gambling. Unlike in the U.S., making money

by investing was not considered “serious business for honest people.” In the late nineties,

however, the public attitude towards stocks market investing changed dramatically. About the

time of the privatization of Deutsche Telekom in 1996 (the largest IPO in German history),

Germans seem to have adopted stock market investing as a new “hobby.” Between 1996 and

1998 the volume of stocks traded more than doubled, surging from DM2378 billion to DM5238

billion (see Figure 7). Throughout all segments of the population, the number of stockholders

increased rapidly, with more Germans invested their savings in the stock market (see Figure 8).

DM, a business magazine, enticed its readers: “Make your first million! Start getting rich today.”

Another leading newspaper, Die Welt, declared: “People have succumbed to a stock market

frenzy.”

Figure 7: Volume of Stocks Traded xvi Figure 8: Growth of Shareholders xvii

Silicon Valley start-ups became a source of revelation to many entrepreneurs. Witnessing how

U.S. entrepreneurs grew their companies with equity investments opened the eyes of German

entrepreneurs, particularly the younger ones. Capital markets became a more common source of

funding for the newly invigorated entrepreneurial sector. The change in sentiment regarding xvi Source: Der Spiegel, Issue 11, March 2000xvii Source: Der Spiegel, Issue 11, March 2000

18

0

1.000

2.000

3.000

4.000

5.000

6.000

1992

1993

1994

1995

1996

1997

1998

1999

Total Value of Stocks Traded (Billion DM)

157%

93%

40%

37%

10%

2%

Growth of Shareholders Since 1988

Blue-collar workers

Office employees

Professionals

Managers

Homemakers

Students

capital markets – by the public in general and by entrepreneurs specifically – thus also

contributed to the German venture capital boom.

Another related factor pushing money into high risk capital was the abolition of preferential tax

treatment for other forms of investment. In the past, many German investors reaped tax benefits

by investing in real estate funds or economic projects in former East Germany. In the late

nineties, however, many of these benefits were abolished and people sought new investment

alternatives, some turning to venture capital as a high-return opportunity. Yet another factor

was the trend away from the public pension system toward private provisions. Historically,

German society relied almost exclusively on an extensive public pension system. By the late

nineties, however, it was clear that public funds would not provide adequate support for retirees.

New government programs placed more emphasis on private pension provision (e.g.

Altersvorsorge-Sondervermögen-Fonds), and a public discussion ensued about liberalizing

regulations pertaining to the investment of pension funds.

High leverage through government programs

A peculiarity of the German venture capital market is the existence of various government

programs that foster investment in high-growth companies. The two main sponsors of the

subsidy initiatives are the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW

(Kreditanstalt für Wiederaufbau).

The tbg is part of the Deutsche Ausgleichsbank (DtA) and supports start-ups through a number

of different subsidy programs, e.g. “Beteiligungskapital für kleine Technologieunternehmen”

(BTU), “DtA-Technologie-Beteiligungsprogramm,” “Förderung und Unterstützung von

technologieorientierten Unternehmensgründungen.” The various programs are tailored toward

companies in different financing cycles (from seed funding to mezzanine financing) and in

different locations (e.g., special programs for former East Germany). All programs have some

fundamental investment principles in common. The tbg requires an outside lead investor in all

investments. It co-invests as a silent partner in portfolio companies, matching the funds of the

lead investor. The tbg itself plays a rather passive role in the investment, performing little of its

own due diligence, relying instead on the lead investor’s analysis. Most importantly, the tbg

funds are treated like a loan: there is a fixed payback rate associated with the tbg investment, part

of which is tied to the profits of the portfolio company. Hence, the VC firms use these programs

19

to leverage their own investments, and in case of a venture’s failure the tbg assumes half the

losses of the private investors.

The KfW has its roots in the post-war Marshall plan for restructuring the German economy.

Generally it does not invest directly in the portfolio companies, but instead offers refinancing for

VC funds at very attractive conditions. The most popular program, the “ERP-

Beteiligungsprogramm,” offers refinancing of up to 75% (85% in Berlin and former East

Germany) of the VC fund’s investment—though generally not more than EUR 500,000 per

company. The interest rates on the loans are set at the lower end of market rates and are fixed

over the duration of the loan. The KfW also covers part of the investment losses in case of a

venture’s failure. Its investments are capped at EUR 1.5 million per portfolio company. Overall,

the funds available through co-investment from the tbg and through refinancing from the KfW

can increase the leverage of the VC investment significantly.

The preferential treatment of start-up investments made Germany’s venture capital market highly

attractive. Most interview partners believed that these programs played an important role in

jump-starting the German venture capital market. However, some industry experts also

expressed concerns about relying on these programs in the future, particularly since they

engendered less scrutiny on the part of the investors.

IV. THE CURRENT STATE OF THE GERMAN VENTURE CAPITAL MARKET

The confluence of all the factors described above fed the German venture capital boom. Against

all odds, Germany developed a thriving venture capital market. This, however, does not mean

that German VC is identical to Silicon Valley VC. Next we examine some of the distinct

features of today’s German venture capital market.

A. Managerial and entrepreneurial labor markets

Despite recent monumental changes, German entrepreneurs still struggle more for legitimacy

than do their U.S. counterparts. Given the rich entrepreneurial tradition in the United States, a

significant number of high-technology entrepreneurs are former employees of large technology

companies such as IBM, HP or Cisco. Others leave one start-up company to found another. In

20

Silicon Valley, employees are exposed to the technology, the markets and the culture that propel

them to become successful company founders. Venture capitalists draw on a large pool of

management talent for starting and staffing their portfolio companies. In contrast, several

German venture capitalists noted that the majority of business plans they received came from ex-

consultants and recent technical school graduates. One VC noted: “Most of the business plans I

see are really nothing more than hot air. The founders have no experience and it really shows in

the business plans they put together.” This person also commented that a smaller, but growing,

percentage of the business plans were from more experienced managers with industry

experience. Not surprisingly, these plans tended to be stronger. He expected to see more such

offerings in the future.

Founder replacement is a frequent occurrence in the U.S., but German VCs have limited ability

to reconstruct their portfolio companies’ management teams. This is not only because German

founders resist such transitions, but also because it is difficult to recruit experienced managers

who enjoy their stable, high-status positions. Ten years ago the idea of leaving a good

management position at a prestigious company (e.g., Siemens) to join a start-up would have been

thought absurd. In recent years this has changed, but only slightly. Some venture capitalists

commented that the success of companies such as Intershop and Mobilcom, and the

extraordinary value of management stock options at those companies, made recruiting

experienced managers somewhat easier. One VC argued, “You can make a case for many

factors having contributed to the increase in entrepreneurial activity, but it really comes down to

one thing: greed. Potential entrepreneurs read about the huge sums of money made by the

success stories and that is the reason for the surge in entrepreneurial activity.” Nonetheless,

there is still no comparison between the U.S. and Germany in terms if the liquidity of managerial

labor markets.

B. Sources of funding

In the United States, pension funds are the largest source of VC funds; but in Germany, banks

are the largest source (see Figure 9). (German pension funds seem likely to gain in importance

as the federal government contemplates legal changes allowing them to invest more significantly

in private equity.) German banks have tended to view venture capital as a solution to the equity

gap (i.e., excessive leverage of bank-dependent private companies). They usually wanted funds

to go toward more established companies, which explains why expansion stage investments and

21

buyouts traditionally accounted for the majority of investments. This changed in the late

nineties, when seed and start-up stage investments began to boom. A related shift is also

apparent in the mix of companies receiving venture capital funding. Traditional areas such as

machine tool manufacturing declined in importance (from 16% in 1997 to 12% in 1998),

whereas investments in biotechnology and the Internet increased (IT investments increased from

7% in 1997 to 17% in 1998).

Figure 9: Source of funds

C. Quality of venture capital

Several trends have become apparent for the structure of venture capital firms. With the

explosion in investment volume, there has been a rapid increase in the number of German

venture capital funds. In the years since 1996, close to forty new funds were founded each year,

approximately three times the rate of previous years (see Figure 10). By 2000, the German

Venture Capital Association totaled 178 members.

22

0%

20%

40%

60%

80%

100%

1996 1997 1998

Sources of Venture Capital in Germany

Banks

Endowments

Federal Funds

1998

Comparison USA

Banks/Ins. Co.

Pension Funds

Corporate

Private

Foreign

InsuranceCompanies

Pension Funds

Corporate

Private

0%

20%

40%

60%

80%

100%

1996 1997 1998

Sources of Venture Capital in Germany

Banks

Endowments

Federal Funds

1998

Comparison USA

Banks/Ins. Co.

Pension Funds

Corporate

Private

Foreign

InsuranceCompanies

Pension Funds

Corporate

Private

Figure 10: Number of New VC Funds by Year of Founding

This growth came from two sources: a plethora of local funds were founded by venture

capitalists with little entrepreneurial experience. At the other extreme, foreign funds decided to

enter the Germany market. Many venture capitalists worry about too much competition, and

there is a belief that a shakeout and consolidation lies ahead.

Interestingly, while many German venture capitalists commented about the inexperience of most

entrepreneurs, the same comment may apply to the VCs themselves. German venture capitalists

very often come from a consulting or investment banking background. They tend to have little

entrepreneurial experience and their business networks are not always relevant for start-ups.

Another concern is that as the size of German VC funds grows, new gaps may emerge. One

venture capitalist remarked that as the average deal size rose, a new equity gap was emerging in

the DM 1-5 million range. One response to this concern is an increasing number of incubators.

There are also signs that a more lively angel community is emerging in Germany, although this

segment is still much less developed than in the U.S. (see Cadenhead et. al., 2000).

V. OUTLOOK FOR FUTURE DEVELOPMENTS

After our detailed analysis of the history and current state of the German venture capital market,

we now consider the future prospects of the industry. With the Internet bubble now burst, the

23

80

14

38 35

11

2639

131211

1992 1993 1994 1995 1996 1997 1998 1999 2000Founding

year

Number of New VC Funds

and earlier

German venture capital has entered a make-or-break phase that ultimately will show whether the

recent boom was merely a fad, or the beginning of a thriving industry. While there may be some

difficulty in the near future, we believe that the medium to long-term outlook of the industry is

actually very solid. Our analysis shows that the market’s growth was based on a number of

drivers. The current lull in the stock market should therefore not choke off this more

fundamental momentum in the German economy. However, in order to thrive three important

issues will have to be resolved: Will consolidation help the long-term survival of the industry?

Can Germany produce its own breed of real entrepreneurs? And will the industry generate true

innovation?

A. Is consolidation a good or a bad thing?

The rise in venture capital in tandem with the booming capital markets led to the creation of

many new venture capital funds. In these exceptional times, attractive investment opportunities

seemed abundant, and the number of start-ups promising outstanding investment returns

appeared almost unlimited. There was money to be made for everyone—until the market

downturn in the spring of 2000. Not every deal is a winner anymore, and obtaining a good exit

event no longer seems a “sure thing.” In this environment, a natural selection takes place. The

best funds with the best skills and the best reputation attract the best deals. And the less

reputable funds are likely to end up with much less attractive deals. The likely result will be a

consolidation of venture capital funds, with the top-performing funds outlasting and taking over

the rest.

While most industry experts expect such a consolidation to take place over the next year, the real

question remains what the more fundamental effects of this consolidation will be. Some industry

participants paint a more somber picture: the consolidation may lead to a stall in the development

of venture capital in Germany. As public investors lose confidence in the high-growth market

and less experienced funds start to crumble, more start-ups will find themselves searching for

continued financial support. Ultimately, failed start-ups and drained funds may cause such deep

scars with investors and entrepreneurs that the momentum could grind to a halt. Yet there is also

a more optimistic outlook, anticipating the consolidation will have an overdue cleansing effect,

separating the “serious” investors from the unprofessional “cowboys.” This view holds that the

industry will emerge healthier and fundamentally stronger than before.

24

B. Where are the “real” entrepreneurs?

The recent boom attracted many to start-ups with the prospect of enormous financial gain.

Witnessing entrepreneurial success, others compounded the snowball effect, leaving established

jobs to found yet more start-ups. It was hip and fashionable to be part of this booming sector.

However, with the market downturn the picture has lost its sharp focus, and new economy start-

ups are again viewed with skepticism. With the most opportunistic entrepreneurs fleeing the

scene, it remains to be seen how strong the “real” entrepreneurial movement is. How many

entrepreneurs are actually willing to build enterprises for the long term? Will the most talented

or the less talented people remain in the entrepreneurial sector? In this context, it will be

important for Germany’s start-up scene to nurture serial entrepreneurs who can contribute to the

maturation of the entrepreneurial culture. In the United States, serial entrepreneurs have become

an important stabilizing element in the entrepreneurial environment.

C. Do we have innovators or imitators?

To date, a significant amount of the entrepreneurial activity in Germany, particularly in the

Internet, has consisted of copycat models. It was relatively easy to take successful business

models from the United States and transplant them to Germany, but this is hardly innovative.

Copying successful business models may have been a convenient jump-start for entrepreneurial

activity in Germany, this cannot replace true innovation as the basis for entrepreneurship. The

window of opportunity for copying U.S. Internet business models was a passing phenomenon,

and with so many Internet models proving to be more difficult than anticipated, the wave of new

Internet start-ups has ceased in the United States. Copycat entrepreneurs may now have run out

of business models to copy, and this will force German entrepreneurs to become more innovative

in their business ideas.

Will German entrepreneurs will live up to this new challenge and build a culture of true

innovation? Experience over the last few years has shown that Germany is capable of

developing an entrepreneurial spirit. We believe that after the dust has settled on Internet and

stock market booms and busts, it is likely that Germany will sustain a lively venture capital

industry.

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VI. REFERENCES AND FURTHER BIBLIOGRAPHY

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Cadenhead, G., J. Weber, M. Brettel, C. Jaugey and C. Rost, “Business Angels in Germany: How Business Angels in Germany Help New Entrepreneurs,” Journal of Private Equity, Winter 2000, 50-58

Cooter, Maxwell. “European Startups Never Fail.” Tornado-Insider. Issue 11, March 2000. Retrieved at: http://www.tornado-insider.com/magazines/1999/11/coverstory2.asp

Cukier, Kenneth Neil. “Europe Imports Internet Euphoria.” Red Herring. December 1, 1999. Retrieved at: http://www.redherring.com/mag/issue73/feature/news-fea-trends-9europe.html

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