Venture capital Fueling innovation and economic growth 3 Ulrike Hinrichs Executive Member of the BVK Board Venture capital is much more than a funding instrument or an asset class. It is a central tool for fueling enterprise, sparking innovation in future technologies and powering growth and an elementary factor in our economys efforts to attract tech firms. Germanys ability to leverage the potential of the digital economy and to remain an attractive and prosperous place to live and do business depends partly on our ability to mobilize venture capital as well as other nations economies do. It is no coincidence that the dominance of US and Chinese digital champions is mirrored in the financial endowment of the ecosystems within which they operate: Asia, which was Europes equal in funding terms in 2012, has since steamed ahead of the European tech eco- system and with annual investments approaching EUR 62 billion has almost caught up with the United States. Clearly, we have no time to lose. Undeniably, Germanys venture capital market has picked up significantly in recent years thanks in part to the creation of new government incentives and the modifica- tion of existing programs. But there is still a long way to go to provide innovative new companies with all the capital they need, especially when theyre in the later stage of the startup lifecycle. The availability of sufficient capital plays a large part in de- termining whether or not todays startups will eventually become the mid-market champions or even the global trailblazers of tomorrow. The Internet Economy Foundation (IE.F) and the German Private Equity and Venture Capital Association (BVK) shine a light on the German venture capital sector in this study, which was conducted in conjunction with Roland Berger. The study identifies the key barriers to investment and highlights ways of overcoming them. At its heart stands the question of what to do to mobilize more private capital to drive innovation and growth within our economy. Creating a vibrant venture capital market and building a full-fledged digital economy in Germany will require a bold and determined effort on all sides. Our aim in produc- ing this study is to contribute toward this collective undertaking, and we sincerely invite you, too, to do what you can. Prof. Dr. Friedbert Pflüger Chairman of the Internet Economy Foundation Preface4 WHAT NEEDS TO BE DONE NOW: Six steps to turn Germany into a venture capital champion Create major leverage for later stage investments Establish a German “Fund for the Future” Actively communicate success stories Enable the people to share in venture capital growth Have a legal framework in place that drives venture capital mobilization Launch a “Science, Startups and Growth” excellence initiative5 1 The missing billions: Why Germany must mobilize more venture capital 6 2 Fueling innovation and growth: The importance of venture capital for the economy 10 3 Growth and investment backlog: The German market for venture capital 18 4 Catch-22: The vicious cycles of insufficient venture capital in Germany 26 5 What needs to be done now: Six steps to turn Germany into a venture capital champion 32 Contents1 The missing billions: Why Germany must mobilize more venture capital 7 1 The missing billions The seven most valuable companies in the world Apple, Amazon, Microsoft, Alphabet (Google), Facebook, Alibaba and Tencent have two key things in common. One: As powerful digital platforms, they control the in- ternet. And two: They would never have come into ex- istence and enjoyed the level of growth they have with- out venture capital (VC). Germany trails the United States in venture capital funding It is no coincidence that five of these seven companies are based in the United States, where there is a long tradition of funding startups with venture capital. While it is true that venture capital investments in Eu- rope have more than tripled in the past five years, our continent still invests EUR 48 billion less in VC funding than the United States. In 2017, the US saw venture cap- ital investments of EUR 63.8 billion pour into startups in contrast to Europes total of just EUR 15.6 billion. Germany is by no means a special case among Euro- pean nations. Venture capital companies invested just over EUR 1.1 billion in Germany in 2017. This equals 0.035% of German GDP, whereas the EUR 63.8 billion invested in the US is equivalent to 0.371% of that countrys GDP. Asia, too, is catching up in the VC in- vestment stakes, with countries like China pumping huge amounts of government money into new com- panies working to develop future technologies like artificial intelligence. “From an economic perspective, venture capital is more than just an asset class it is actually the fuel for innovation, growth and jobs.” René Obermann, Warburg Pincus8 “If European nations had blown EUR 60 billion on VC investments but had ended up with a Google, a Facebook and an Amazon, there would be no ques- tion over whether or not it had been worthwhile.” Klaus Hommels, Lakestar“Good German tech firms with an interna- tional outlook do find investors but they are principally from overseas and less likely to be from Germany.” Gert Köhler, Creathor Ventures “For a business, you need an idea, a founder and capital. You cant replace a lack of capital with a better idea.” Oliver Samwer, Rocket Internet9 1 The missing billions Particular investment backlog in the later stage The funding gap is particularly wide in whats known as the later stage, the time when companies are financing their market entry and their growth. This is the phase in which they need a lot of capital to build up a profession- al organization, to establish distribution structures and to get their product or service known in the market. An American firm benefits on average from almost EUR 10 million more in later stage venture capital than its Eu- ropean counterpart. Germany suffers from a particular lack of funding for later stage startups. The average Ger- man growth company in the later stage receives just under EUR 3.3 million from VC firms. Innovation and growth require venture capital This dearth of venture capital diminishes the innovation capacity of the German economy as a whole and throws up barriers to the growth of innovative young compa- nies. If Germany is to secure its prosperity long term, the country needs to mobilize more venture capital. Only then will the nation succeed in turning great ideas into great business models and great companies. Huge amounts of assets lying dormant There is no lack of suitable assets in Europe and Ger- many that could be diverted into venture capital funds. Europes thousand biggest pension funds alone had over EUR 7 trillion in capital in 2017. Taking just 0.7% of these “dormant” private assets and putting them into funding the future through VC would be sufficient to bring Europe up to the level of the United States in the venture capital stakes, adding a whole EUR 48 billion to our continents VC funding! Vicious cycles need to be broken This study shines a light on the German venture capi- tal market and explains why venture capital is elemen- tary to an economy. It analyzes the barriers standing in the way of mobilizing venture capital in Germany, especially later stage VC. One of the studys key findings is that the relative weakness of the German venture capital market compared to the US market in particular can be traced back to a number of interlinked causali- ties repeating vicious cycles of insufficient venture capital. The study therefore makes suggestions as to how to overcome the barriers and how the vicious cy- cles that are currently impeding venture capital can be transformed into virtuous cycles that continually mo- bilize more venture capital. The studys key messages and all of the highlighted quotes are drawn from the numerous interviews we held with VC fund man- agers, investors and other stakeholders in the venture capital market. Extensive sets of data and other pub- lished material were also analyzed for the study.10 2 Fueling innovation and growth: The importance of venture capital for the economy11 2 Fueling innovation and growth Venture capital falls under the private equity asset class. Corresponding investments are frequently made by venture capital funds. These are funds that aggregate capital from numerous different investors and invest it in newly founded companies displaying strong growth potential. Parties that invest in venture capital funds include institutional investors like banks and insurance companies, operative companies, govern- ment funding agencies such as the KfW , and wealthy private individuals. Given the uncertainty over the suc- cess of growth companies and the high failure rate among startups, venture capital investments are always relatively high risk hence the common synonym for venture capital, risk capital . At the same time, the cap- ital gives young companies new chances for develop- ment and growth, which is why it is also known in some cultures as opportunity capital . From seed to exit: The typical phases of venture capital funding The term venture capital specifically describes the eq- uity and equity-like investments that flow into new companies in the early stage, startup stage and later stage of their development. Companies in the early phase of their lifecycle need seed funding to get their products and services ready for market. Then in the ac- tual startup stage, the point of market entry, companies plan the (mass) production and distribution of their market offering and initiate their marketing activities. In the later stage, venture capital is mainly needed for startups to be able to scale their business model scale meaning to elevate the quantitative parameters within which the company operates (employee numbers, rev- enues, customer base and so on) to a new level. It financ- es the actions the company has to take to get itself es- tablished in the market (such as expanding production, distribution and marketing). New business ventures are funded in a number of different rounds. The seed round is followed by the series A and B rounds, when the com- pany is typically in the startup phase. Further funding rounds (from series C onwards) mostly happen in the later stage. It is in this final phase that successful start- ups normally enter the profit zone, where the risk of failure is low because the business model has already been proven. Venture capitalists often divest their holding following successful later stage funding, or sometimes before. Their exit can be effected by means of a trade sale (selling to a strategic investor), an IPO (listing the company on the stock market) or a secondary purchase (selling to anoth- er private equity firm). A Capital and knowledge: The economic benefits of venture capital From an economic perspective, venture capital is crucial for the funding of startups. These types of companies can promise investors neither security nor profits, putting debt financing firmly out of reach for most of them be- sides the lack of collateral they have to offer, the need to make capital and interest repayments would stretch a startups liquidity situation beyond breaking point. 12 A Years of rapid expansion: New startups go through several phases, each involving different sources of funding Source: BVK, IE.F, Roland Berger Seed Startup Later Stage Maturity, possibly exit Phases of startup development and where their funding comes from Friends & family Seed investors Local incubators Awards/grants Venture capitalists Capital-intensive phase with limited offers of funding Lower risk proven business model High risk IPO, trade sale, secondary purchase Bank loans Time Profit Loss 13 2 Fueling innovation and growth What venture capitalists bring to the table is not just their capital, but their knowledge and also their exper- tise when it comes to starting a business. They are in a position to advise the founders on strategic aspects of their nascent company, such as the best structure for the organization or how to develop new markets. They can also give founders the benefit of their own experi- ence and networking skills to help them build up distri- bution networks and acquire cooperation partners. Innovation and growth: The economic importance of venture capital Venture capitalists take a considerable risk when they invest in a company that is not yet turning a profit. To ensure that the risk translates into an appropriate return, VC investors must be very careful about selecting which companies to finance. The fact that it is in their own interests to select the startups with the highest potential therefore ensures the efficient allocation of resources: Venture capital flows into startups with the best pros- pects for growth given limited access to resources. As such, venture capital drives the productivity and com- petitiveness of the economy as a whole. Studies have shown that VC-funded companies grow much faster than other comparable firms and not just in terms of revenues and profits, but in the number of jobs they create, too. Moreover, venture capital princi- pally goes into companies with digital and research- intensive business models. So risk capital is being used to fund innovation and new market development. According to a study by Stanford University, 17% of all listed companies in the United States were funded by venture capital in the seed stage. What these compa- nies spend on research and development makes up 44% of the total R&D spending of all listed companies in the US, which serves to illustrate that most risk cap- ital is funneled into companies that have innovative business models. These innovations are what open up new opportunities for customers, develop new mar- kets, create future-proof jobs, reinforce competitive- ness and safeguard economic prosperity. Disruption: Venture capital can jump-start the superstars of the internet age A look at the worlds seven most valuable companies by market capitalization proves the point B: Apple, Amazon, Alphabet (Google), Microsoft, Facebook, Ali- baba and Tencent are all digital behemoths that re- ceived seed funding from venture capitalists Face- book alone benefited from over USD 600 million in venture capital in the first five years of its life. The combined market cap of the worlds seven most valu- able firms is now more than three times higher than that of all DAX-30 companies put together. These seven firms jointly bring in more than EUR 0.5 trillion in rev- enues and employ over a million people. They have