Venture Capital in Europe and the Financing of Innovative ...

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1. Venture Capital in Europe and the Financing of Innovative Companies Laura Bottazzi∗ Universit` Bocconi, IGIER, and CEPR a and Marco Da Rin Universit` di Torino and…
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  • 1. Venture Capital in Europe and the Financing of Innovative Companies Laura Bottazzi∗ Universit` Bocconi, IGIER, and CEPR a and Marco Da Rin Universit` di Torino and IGIER a July 2001 Abstract Venture capital is considered to be the most appropriate form of financing for innovative firms in high-tech sectors. Venture capital has greatly developed over the last three decades in the United States, but much less so in Europe, where policy makers are striving to help channel more funds into this form of financial intermediation. We provide the first assessment of venture capital in Europe. We document its development in the 1990s, also providing a conceptual framework for this analysis. Comparing the evolution and structure of European and American venture capital, we find the wedge between these two industries to be large and growing. We then look at the involvement of venture capital with some of Europe’s most innovative and successful companies: Those listed on Europe’s ’new’ stock markets. Venture capital is effective in helping these firms overcome credit constraints, and thus to be born in the first place. Using a unique, hand collected data set from the listing prospectuses and annual reports of these companies, we then find European venture capital to have a limited effect on their ability to raise funds, grow, and create jobs. We conclude that public support of the European venture capital industry should look at both its growth and at its maturation. Forthcoming, Economic Policy, v.34, 229-69, April 2002. ∗ We thank Erik Bergl¨f, Jean-Bernard Chatelain, Jan van Ours, Henri Pag`s, Guido Tabellini, and partic- o e ipants to the Economic Policy 33rd Panel Meeting for valuable comments. Detailed suggestions by Richard Baldwin (the editor) helped us improve the quality of the paper. Veronica Guerrieri, Giuseppe Maraffino, Gaia Narciso, and Battista Severgnini provided excellent research assistance. We also thank all the companies which provided us with data and prospectuses. Financial support from Fondation Banque de France and from Universit` Bocconi (Ricerca di Base) is gratefully acknowledged. All errors remain our own. a
  • 2. 1 Introduction The ability to encourage and sustain technological innovation is one of the main sources of economic growth. In the last decade, the increasingly rapid pace of innovation induced by en- trepreneurial firms has substantially contributed to the strong competitiveness and protracted growth of the US economy. Several studies have documented the ability of US venture capi- talists to select promising companies, provide adequate financing, and spur innovative firms to behave aggressively and emerge as market leaders (see Hellmann (2000) for an overview). A wide consensus among economists, business leaders, and policy-makers exists that a vibrant venture capital industry is a cornerstone of America’s leadership in the commercialization of technological innovation, and that the lack of venture capital hinders European firms from competing on an equal footing (European Commission (1994)). Several official documents of European governments and institutions suggest bolstering venture capital and revamping the regulation of stock markets as remedies to Europe’s eco- nomic slugginesh and dismal unemployment. For instance, the European Commission’s 1998 Risk Capital: A Key to Job Creation in the European Union Communication states as its main message that ‘[d]eveloping risk capital in the European Union, leading towards the development of pan-European risk capital markets is essential for major job creation in the EU’ (European Commission (1998) p.1). As the title of the Communication indicates, the creation of a pan-European equity market for innovative companies was identified by the Communication as a crucial step not only for providing risk capital to companies, but also for the creation of a substantial number of new jobs. More recently, the ’Final Report of the Committee of Wise Men on the Regulation of European Securities Markets,’ ’urges governments and the European institutions to pay par- ticular attention to ensuring that there is an appropriate environment for the development of the supply of risk capital for growing small and medium sized companies, given the cru- cial importance of this sector for job creation’ (Committee of Wise Men (2001) p.10). The Committee goes on to argue that ’[t]oday there is still an inadequate supply of risk capital in the EU with venture capital only one fifth of US per capita levels. However, if the Euro- pean Union’s financial markets can integrate (...) European venture capital financing will be encouraged from the bottom up’ (p.78). Other official documents and reports identify the immaturity of Europe’s venture capital industry and the hostility of its stock exchanges towards young firms as powerful obstacles to the growth of European entrepreneurial firms (see for instance Bank of England (2000)). In 1
  • 3. turn, entrepreneurial firms are viewed as major contributors to economic growth and to the creation of new jobs (see German Federal Ministry of Economic and Technology (1999a,b)), and venture capital as an important tool for job creation, technological innovation, export growth, and regional development (European Investment Bank (2001)). There is a growing perception that Europe’s growth problems may be caused not as much by rigidities in labour markets, as by weakensses in capital markets, and in particular in the access to risk capital. These documents raise important policy issues. In particular, it is crucial to understand how policy can actually contribute to the growth of a dynamic venture capital industry in Europe. European official documents, but also industry reports like the White Paper of the European Venture Capital Association (EVCA (1998)), tend to focus on the supply of funds and on the creation of favorable structural conditions for entrepreneurship. However, it is far from evident which policy measures would be most appropriate to nurture venture capital in Europe. Here the lack of rigorous investigation is felt most. In this paper we provide a contribution in this direction by developing the first systematic analysis (to the best of our knowledge) of venture capital in Europe. To get around the dearth of firm-level data on European venture capital, we exploit the unique opportunity offered by the opening in 1997 of Euro.nm, the alliance of Europe’s ’new’ stock markets for innovative companies in high-growth industries–along the lines of America’s Nasdaq. Euro.nm brought under its wings the ’new’ markets of Amsterdam, Brussels, Frankfurt, Paris, and (since June 1999) Milan. Euro.nm ceased to exist as an alliance in December 2000, but its five members have continued to operate independently. Over its life span, Euro.nm has allowed nearly 600 companies to list and raise over 40 billion euros of equity capital. We collect a unique data set from issuing prospectuses and annual reports of more than 500 Euro.nm listed companies. These data provide an excellent opportunity to study the effects of venture capital on Europe’s innovative companies, given the wealth of information which they are required to disclose in order to go public. We focus on three key issues. First, we develop a conceptual framework for appraising the role of venture capital in the financing of innovative companies. Second, we document the development of venture capital in Europe, compare it to that of US venture capital, and assess the extent and determinants of venture financing to companies listed on Euro.nm. Third, we study the effect of venture capital on the ability of these companies to raise funds, grow, and create jobs. The evidence we provide is useful in assessing the extent to which European venture capital helps create and nurture innovative companies. We challenge several common beliefs on the role of venture capital in Europe, and question its ability to make a difference for economic 2
  • 4. growth and job creation. In particular, we argue that venture-backed companies do not grow and create jobs faster than non venture-backed companies. Whether this is due to a lack of ’stars’ among European firms or to the immaturity of European venture capital is not possible to tell apart, but several pieces of evidence make the latter possibility more than likely. We also have good news. We find that venture capital does help European innovative companies by providing them with financing crucial for their creation and development. This also means that an increasing number of (venture-backed) companies benefits from the possibility to go public on Euro.nm, with a positive effect on the growth of Europe’s ’new’ stock markets. Since venture capitalists benefit, in turn, of the possibility to exit their investments through a listing on a stock market, this may have triggered a self-reinforcing virtuous circle. These findings provide support for the European Commission’s stated policy of promot- ing European venture capital. The major action of Commission in this respect has been transformation of the European Investment Fund (EIF) into a major investor in venture cap- ital funds. Our findings suggest that the ’quality’ of European venture capital should be as urgent a concern for the EIF as its sheer ’quantity,’ so as to advance both the size and the maturation of the industry. The rest of the paper is organised as follows: Section 2 provides a primer on venture capital based on the extant economics literature and on the available empirical evidence. Section 3 develops a statistical portrait of the European venture capital industry, comparing it to its American counterpart and assessing its involvement in financing Euro.nm listed companies. Section 4 evaluates the role of European venture capital in the companies it finances. Section 5 concludes. A Data Appendix contains a detailed description of our data collection, and a Web Appendix provides additional tables and material. 2 Venture capital and the creation of innovative companies 2.1 History, definitions and jargon In 1946 Georges Doriot, a professor at Harvard University, created American Research and Development (ARD) together with Karl Compton, president of the Massachusetts Institute of Technology, Merrill Griswold, chairman of Massachusetts Investors Trusts, and Ralph Flan- ders, president of the Federal Reserve Bank of Boston. ARD was created to raise funds from wealthy individuals and college endowments and invest them in entrepreneurial start- ups in technology-based manufacturing: Modern venture capital was born. Half a century 3
  • 5. later venture capital has become the form of financial intermediation most closely associated with dynamic entrepreneurial start-ups, especially–though not exclusively–in high-tech in- dustries like biotechnologies, computer hardware and software, information technology (IT), e-commerce, medical equipment, and telecommunications.1 Many of today’s most dynamic and successful corporations received venture capital at the initial stages of their lives: Ama- zon, Apple, Cisco, e-Bay, Genentech, Genetic Systems, Intel, Microsoft, Netscape, and Sun Microsystem, to name just a few. As a result, venture capital has developed into an impor- tant, established form of financial intermediation (see Gompers and Lerner (2001)). The maturation was not smooth, though (see Gompers (1994)). Until the 1980s, ven- ture capital firms were in large part publicly funded Small Business Investment Companies (SBICs). While SBICs trained many venture capitalists and helped the industry reach a critical mass by channeling large sums to start-ups, their ability to perform was limited by bureaucratic constraints, lack of professional expertise, and a faulty design of capital structure and incentives (Lerner (1994a)). Their investment record was in fact mixed, and spurred a fall in investor confidence and in committed funds around the late 1980s. Also, many venture firms, including ARD, were organized as closed-end funds, but this attracted retail investors with short-term horizons, whose needs clashed with the long-term returns of venture capital. Only in the late 1980s were SBICs and closed-end funds superseded by the limited partner- ship as the dominant organizational form of American venture capital firms. Another major contribution to the adoption of a more efficient organizational form was the clarification, in 1979, of the Employment Retirement Income Stabilization Act, which allowed pension funds to invest in venture capital. This resulted in a staggering increase of funds invested, and in a faster professionalization of the industry. Until the early 1990s, venture capital remained essentially an American phenomenon. Its success in supporting dynamic companies which create jobs and wealth brought many governments to look for ways to nurture a national venture capital industry. At the same time, the high returns enjoyed by US venture capital firms induced venture capitalists to become active also in other countries. Venture capital is by now a sizeable industry also in Europe and Asia. While no standard definition of venture capital exists, there is wide consensus that it corresponds to the professional financing of young, unlisted dynamic ventures through equity or equity-like instruments like convertible securities. Unlike wealthy individuals who occa- 1 Dynamic firms in traditional services, like Federal Express, Staples, or Starbucks, also received a sizeable share of venture finance. 4
  • 6. sionally invest in start-ups (’business angels’), venture capitalists are professional investors, organised in small limited partnerships, who raise funds from wealthy individuals and in- stitutional investors and invest on their behalf. They specialise in financing young firms which typically have not yet produced any sales, but which have high growth and earnings potential–many investees are ’start-ups’ which come into life through venture financing. Box 1 provides an explanation of some common terms of the venture capital jargon. 2.2 Financing an innovative company: The alternatives 2.2.1 How to start a start-up Why do innovative companies in high-tech industries get financed primarily by venture capi- talists? To set the stage for our empirical investigation, it is useful to consider what we know about this question, and therefore what one would expect to find from companies backed by a venture capitalist. Consider the hypothetical case of a brilliant academic engineer who has just discovered in his lab a technology to produce a new type of circuit for mobile phones. He believes his product would make an important breakthrough by opening a market for three-dimensional messaging. He thinks he could get rich and famous by creating a start-up which could hope- fully go public. However, the industrial implementation of his product requires an investment in the order of three million euros. This sum far exceeds his personal wealth and that of his family and friends. He asks his bank for a loan, but is told that the bank does not lend to start-ups–unless enough collateral is pledged to cover the full value of the loan. The same disappointing answer comes from several other banks he then contacts. 2.2.2 Why banks won’t do Why do banks typically refrain from investing in start-ups? The reason is that they are not a suitable financier for this type of projects. Banks specialize in raising deposits from the public, lending these sums to businesses, and earning an interest margin in the process. The high liquidity of deposits requires that loans be made only to businesses likely to repay within a relatively short period and with high probability. Banks also rely heavily on a firm’s tangible assets for collateral, but the assets of entrepreneurial start-ups are in large part intangible, like marketing knowledge or technology. In other words, the very nature of banks makes them suitable to lend to firms in established industries, with reasonably predictable cash flows. 5
  • 7. Box 1: The jargon of venture capital Start-up: a new company which is created by an entrepreneur in a high-tech industry, often with the goal of going public within a few years. Limited partnership: the typical form of organization of a venture capital firm. Its ’general partners’ (venture capitalists) manage the firm and assume full liability, while ’limited partners’ (investors) provide funds and assume no liability beyond the contributed capital. Captive: a venture capital firm which is owned by an industrial company or a finan- cial intermediary. Captives are common in Europe, whereas in the US ’independent’ venture firms, which raise money from institutional investors, are the norm. Convertible securities: equity-like financial instruments which offer venture capi- talists strong protection in case of liquidation, while ensuring participation in the upside should the project succeed. Vesting: a legal term which indicates the process by which a person comes into possession of corporate stock. It usually applies to entrepreneurs or employees whose right of possession over their stocks is contractually deferred until a certain date or until certain targets are met. ’Exit’ : the mode of exit from an investment. Venture capitalists typically exit their investee companies through an IPO, a trade sale, or by writing-off (liquidating) a non-performing company. Initial Public Offering (IPO): the offering of corporate stock to the public through which a company ’goes public’. It is the most sought after way of cashing in their investment by venture capitalists and entrepreneurs, since it allows the highest val- uation. Trade sale: sale of a start-up to another company, typically a large competitor. It is a common way for venture capitalists to liquidate their investment when a company is not growing enough for an IPO or the stock market is experiencing a downturn. Write-off: the disaster scenario. When a funded company fails, the venture capital writes off the investment from its assets. Most venture investments end up as write- offs. 6
  • 8. A start-up, on the contrary, is an utterly risky business: Most start-ups go bust but are extremely profitable if eventually successful. Another reason for banks’ reluctance to finance start-ups is their being heavily regulated intermediaries which face severe limits to holding equity. 2.2.3 Some possible alternatives... What other options could our engineer consider? The embryonic form of his project rules out direct access to capital markets, which is feasible only for firms with a proven business model, a solid organization, and a clear earning potential. Moreover, the capital needed by a start-up (three million euros in our example) is far below the minimal threshold for an Initial Public Offering (IPO). Government grants are also unsuited for such a project, since they are typically targeted at very small firms, and often require a proven track record which no high-tech start-up may provide (see Gordon (1998) and Lerner (1999)). Four practicable options remain: convincing a ’business angel’ or a financial company to invest in the start-up, finding an established industrial company interested in supporting the project (a ’corporate venture capitalist’), or going for a venture capitalist. A business angel is a wealthy individual who invests directly in a private company (see Benjamin and Sandles (1998) and Prowse (1998)). In some countries associations or groups of business angels provide some legal and organizational support, but these individuals largely invest based on personal relationships. In some cases they also provided expert knowledge of an industry, since many of them are (or have been) executives. A financial company is a holding company which invests in industrial companies. Finan- cial companies rarely invest in start-ups. They prefer more mature firms which are close to going public, to which they often p
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