Early Stage Investments in New Technology Based Firms

Diplomarbeit von Holger Ludewig

Abstract:

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.

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.

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 services. In as far as the added „private“ knowledge increases the utility of a product to the customers, it adds value. 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.

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, 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.

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 also the substantial threat of incurring deep losses on the downside. Whereas large companies generally possess a diversified product portfolio and a host of strategic assets, small companies will need to compete on a single new product or service and the determination of its management team.

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. 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.

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. New technology-based firms for their high capital needs for research and development from an early stage are particularly impaired by the financing problem.

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. The contrasting statements may indicate in part a market failure situation in the German finance system.

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 investments. 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 neoclassical capital market -, transaction cost - and principal-agent-theory used in analyzes throughout 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.

Einleitung:

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.

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