Smart Money: Influence of Venture Capitalists on High Potential Companies [1 ed.] 9783896449511, 9783896732606

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Entrepreneurial and Financial Studies Hrsg.: Prof. Dr. Dr. Ann-Kristin Achleitner Prof. Dr. Christoph Kaserer

Christian H. Fingerle

Smart Money – Influence of Venture Capitalists on High Potential Companies

Verlag Wissenschaft & Praxis

Smart Money – Influence of Venture Capitalists on High Potential Companies

Entrepreneurial and Financial Studies

Herausgegeben von Prof. Dr. Dr. Ann-Kristin Achleitner Prof. Dr. Christoph Kaserer

Band 7

Entrepreneurial and Financial Studies

Christian H. Fingerle

Smart Money – Influence of Venture Capitalists on High Potential Companies

Verlag Wissenschaft & Praxis

Bibliografische Information der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http://dnb.ddb.de abrufbar.

ISBN 3-89673-260-9 © Verlag Wissenschaft & Praxis Dr. Brauner GmbH 2005 D-75447 Sternenfels, Nußbaumweg 6 Tel. 07045/930093 Fax 07045/930094

Alle Rechte vorbehalten Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen. Printed in Germany

Foreword Across the globe, policymakers stress the importance of vibrant entrepreneurial activities in order to spur economic growth and innovation. Venture capitalists are commonly believed to contribute significantly to the rapid development of entrepreneurial firms. With the venture capital boom at the turn of the millennium being past, a sober assessment of the role of venture capitalists in the entrepreneurial process is now warranted. Christian H. Fingerle provides a comprehensive analysis of the influence of venture capitalists on their portfolio companies. He explores the areas of potential value-added and discusses adjacent topics such as the extent to which entrepreneurs give up part of their managerial autonomy. The theoretical core of the study is greatly enriched by the presentation and comparative analysis of three unique case studies on German venture capital-backed companies. I strongly believe that this work offers many valuable contributions for the venture capital industry and helps further professionalizing the entrepreneurial community. I am sure that it will find the broad audience it merits and will spark intensive discussions among scholars and practitioners.

Munich, 1 June 2005 Prof. Dr. Dr. Ann-Kristin Achleitner

Acknowledgments With the following lines, I want to express my sincere appreciation and gratitude to the many individuals whose cooperation and support were essential to the completion of this book that results from my work at KfW Endowed Chair in Entrepreneurial Finance, Munich University of Technology (TUM). First and foremost, I very much thank Professor Ann-Kristin Achleitner for giving me the exceptional opportunity of working together with her for three years. Her thoughtful guidance in pursuing my research agenda and her perpetual availability for discussion have been a tremendous help. Most importantly, I thank her for the trust and respect that I experienced right from the beginning and that made me enjoy every day of my work. I am indebted to several members of the faculty of TUM Business School. In particular, I very much would like to thank Professor Christoph Kaserer for acting as referee for my dissertation and for always supporting my projects as member of the Center for Entrepreneurial and Financial Studies. In addition, I would also like to thank Professor Wolfgang Lück for assuming the chair of my doctoral examination committee and giving me the opportunity to attend his doctoral seminars. This work benefited to a large degree from the extensive support of the following entrepreneurs and venture capitalists: • Dr. Mirko Scherer, Dr. Elmar Maier and Dr. Markus Maier (GPC Biotech AG), • Dr. Christian Friedemann and Dr. Karl-Heinz Pettinger (Bullith Batteries AG), • Günther Baierl (varetis AG) and Dr. Konstantin Becker, • Dr. Helmut Schühsler (Techno Venture Management), • Dr. Michael Steinmetz (MPM Capital), • Dr. Jürgen Diegruber and Tim Stemmer (Gi Ventures AG), as well as • Dr. Wolf-Rüdiger Willig (Bayerische Beteiligungsgesellschaft mbH). For their personal commitment and the many hours spent in interviews, discussions and proof-readings, I would like to express my sincere appreciation and deepest gratitude. The interaction with these outstanding individuals greatly enriched my scientific

analysis and extended my personal horizon. For their invaluable support and endurance in preparing the case studies, I would also like to thank Johanna Rüttinger, Dr. Monika Labes, and Sven Eppert. To my colleagues at TUM Business School I want to express my deepest gratitude for their intellectual and emotional support that went well beyond this book. Above all, I thank Dr. Simon J. Wahl and Dr. Eva Nathusius for the unique team spirit and the many memorable moments that we enjoyed together starting with the Founders’ Forum in Schloß Elmau. I am grateful to Kay Müller and Annabell Geidner for keeping up and broadening this team spirit besides their invaluable input to my work in numerous discussions. I would also like to thank Thorsten Groth, Martin Brixner, Benjamin Moldenhauer and Dr. Angela Poech for several significant contributions to my work. I’m also very grateful to Professor Alexander Bassen for his valuable advice and support over the years. Furthermore, I would like to thank Monika Paul and Evelin Winands for supporting me in many aspects of my daily work. For their excellence assistance in several projects, I am grateful to Michael Lutz and Elisabeth Tyroller. For his valuable comments on my manuscript, I am also indebted to Dominik Jais. I would very much like to thank Nicole Hinn for her love and moral support during the final phase of the completion of this work. Above all, I thank my parents, Ilse and Herbert Fingerle, for their love, encouragement and support over all the years.

Munich, 1 June 2005 Dr. Christian H. Fingerle

Table of Contents

IX

Table of Contents Table of Figures……………...…..………………………………………………......XV Table of Abbreviations……………………….…………..…………………………XIX Table of Interview Partners…...………………………………………….................XXI

1

Introduction ...........................................................................................................1 1.1 Relevance of Smart Money ..............................................................................1 1.2 Aims of Analysis ..............................................................................................4 1.3 Research Approach and Dataset .......................................................................6 1.4 Structure of Analysis ......................................................................................10

2

Characteristics of High Potential Companies...................................................13 2.1 Introductory Remarks .....................................................................................13 2.2 Fundamentals of the Resource-based View....................................................13 2.2.1 Resources in Strategic Management Research .......................................13 2.2.2 Resources and Competitive Advantage...................................................17 2.2.3 A Comprehensive Resource-based View................................................19 2.3 Resource Profile of High Potential Companies..............................................24 2.3.1 Resource Needs in Stage Models ............................................................24 2.3.2 Resource Categorization .........................................................................26 2.3.3 Technological Resources.........................................................................27 2.3.4 Financial Resources.................................................................................28 2.3.5 Managerial Resources .............................................................................31 2.3.6 Personnel Resources................................................................................33 2.3.7 Physical Resources ..................................................................................34 2.3.8 Organizational Resources........................................................................34 2.3.9 Reputational Resources ...........................................................................35 2.3.10 Social Resources......................................................................................37 2.4 Mechanisms to Fill the Resource Gap ............................................................38

X

Table of Contents

2.5 Return and Risks of Investments in High Potential Companies .................... 39 2.5.1 Investment Decision Trade-Off .............................................................. 39 2.5.2 High Expected Return............................................................................. 40 2.5.3 High Risks............................................................................................... 44 2.5.3.1 Liability of Newness........................................................................44 2.5.3.2 Liability of Smallness ......................................................................45 2.5.3.3 Uncertainty of Supply......................................................................45 2.5.3.4 Uncertainty of Demand ...................................................................46 2.5.3.5 Competitive Uncertainty..................................................................47 2.5.3.6 Dependency on Founders ................................................................47 3

Business Model of Venture Capital Firms ........................................................49 3.1 Introductory Remarks..................................................................................... 49 3.2 Definition of Business Model Concept .......................................................... 49 3.3 Customers of Venture Capital Firms.............................................................. 51 3.4 Value Creation Architecture of Venture Capital Firms.................................. 54 3.4.1 Organizational Structure ......................................................................... 54 3.4.2 Personnel Structure ................................................................................. 59 3.4.3 Refinancing Process................................................................................ 62 3.4.3.1 Overview..........................................................................................62 3.4.3.2 Fundraising Process .........................................................................63 3.4.3.3 Investor Relations Process...............................................................66 3.4.3.4 Distribution of Returns Process.......................................................68 3.4.4 Investment Process.................................................................................. 69 3.4.4.1 Overview..........................................................................................69 3.4.4.2 Investment Origination ....................................................................70 3.4.4.3 Investment Due Diligence ...............................................................73 3.4.4.4 Investment Structuring ....................................................................77 3.4.4.5 Investment Development .................................................................81 3.4.4.6 Investment Exit................................................................................82 3.5 Customer Value Proposition of Venture Capital Firms ................................. 87 3.5.1 Enhancement of Performance of Portfolio Companies .......................... 87 3.5.2 Enhancement of Asset Allocation of Investors....................................... 90

Table of Contents

XI

3.6 Profit Model of Venture Capital Firms...........................................................99 3.6.1 Management Fee .....................................................................................99 3.6.2 Participation in Value Creation .............................................................100 4

Venture Capitalists’ Influence through Contractual Agreements ...............103 4.1 Introductory Remarks ...................................................................................103 4.2 Deal-specific Risks for Venture Capital Firms.............................................103 4.2.1 Risk of False Investment Decision........................................................103 4.2.2 Risk of Managerial Opportunism..........................................................104 4.2.3 Risk of Competitive Opportunism ........................................................107 4.2.4 Risk of Unfavorable Decision-Taking ..................................................108 4.2.5 Risk of Exit Obstruction........................................................................109 4.3 Influence through Contractual Provisions ....................................................110 4.3.1 Information Rights ................................................................................110 4.3.2 Conversion Rights .................................................................................111 4.3.3 Control Rights .......................................................................................113 4.3.3.1 Voting Rights .................................................................................113 4.3.3.2 Veto Rights ....................................................................................114 4.3.3.3 Supervisory Board Representation Right ......................................115 4.3.4 Management Covenants ........................................................................117 4.3.4.1 Affirmative Covenants...................................................................117 4.3.4.2 Non-Compete Clause .....................................................................118 4.3.4.3 Vesting ...........................................................................................119 4.3.4.4 Representations and Warranties.....................................................120 4.3.5 Milestone Agreements...........................................................................121 4.3.5.1 Milestones ......................................................................................121 4.3.5.2 Earn-out..........................................................................................122 4.3.5.3 Ratchets..........................................................................................123 4.3.5.4 Management Dismissal..................................................................123 4.3.5.5 Staging ...........................................................................................124 4.3.6 Cash Flow Rights ..................................................................................126 4.3.6.1 Dividend Preference.......................................................................126 4.3.6.2 Liquidation Preference...................................................................127 4.3.6.3 Anti-Dilution Protection ................................................................128

XII

Table of Contents

4.3.7 Preemptive Rights ................................................................................. 130 4.3.7.1 Right of First Refusal.....................................................................130 4.3.7.2 Right of First Offer ........................................................................131 4.3.8 Disinvestment Rights ............................................................................ 132 4.3.8.1 Tag-Along Right............................................................................132 4.3.8.2 Drag-Along Right ..........................................................................133 4.3.8.3 Redemption Right..........................................................................133 4.3.8.4 Registration Rights ........................................................................134 4.3.8.5 Cancellation Right .........................................................................135 4.3.9 Summary ............................................................................................... 137 4.4 Loss of Formal Autonomy through Venture Capital Firms ......................... 138 5

Venture Capitalists’ Influence through Provision of Resources ..................141 5.1 Introductory Remarks................................................................................... 141 5.2 Content of Resource Provision..................................................................... 141 5.2.1 Activities of Venture Capital Firms ...................................................... 141 5.2.2 Certification through Venture Capital Firms ........................................ 144 5.2.3 Resource-Based View on Activities of Venture Capital Firms ............ 145 5.2.3.1 Redefining Activities as Resources ...............................................145 5.2.3.2 Direct vs. Indirect Resource Provision ..........................................147 5.3 Determinants of Resource Provision............................................................ 148 5.3.1 Differences in Intensity of Resource Provision .................................... 148 5.3.2 Size of Investment................................................................................. 151 5.3.3 Performance of Portfolio Company ...................................................... 153 5.3.4 Stage of Portfolio Company.................................................................. 156 5.3.5 Technology Intensity of Portfolio Company ........................................ 156 5.3.6 Venture Capitalists’ Incentives for Resource Provision ....................... 157 5.3.7 Syndication............................................................................................ 158 5.4 Loss of Real Autonomy through Venture Capital Firms ............................. 159 5.4.1 Sources of Venture Capital Firm’s Power ............................................ 159 5.4.2 Loss of Real Autonomy by Levels of Management ............................. 160 5.4.3 Loss of Real Autonomy by Levels of Decision-taking......................... 164 5.4.4 Benefit of a Loss of Autonomy............................................................. 167

Table of Contents

XIII

6

Case Study Bullith Batteries AG......................................................................169 6.1 Case Description...........................................................................................169 6.1.1 Preliminary Remark ..............................................................................169 6.1.2 Development before First Round Financing .........................................169 6.1.3 First Round Financing...........................................................................174 6.1.4 Further Development until Second Round Financing...........................176 6.1.5 Second Round Financing ......................................................................184 6.1.6 Further Development.............................................................................186 6.2 Case Analysis................................................................................................187 6.2.1 Gi Ventures’ Influence through Contracting.........................................187 6.2.1.1 Investment Agreement Structure ...................................................187 6.2.1.2 Influence on Deal-specific Risks ...................................................191 6.2.1.3 Influence on Management’s Formal Autonomy............................192 6.2.2 Gi Ventures’ Influence through Resource Provision ............................193 6.2.2.1 Influence on Resource Pool ...........................................................193 6.2.2.2 Influence on Management’s Real Autonomy ................................197

7

Case Study GPC Biotech AG ...........................................................................201 7.1 Case Description...........................................................................................201 7.1.1 Development before First Round Financing .........................................201 7.1.2 First Round Financing...........................................................................203 7.1.3 Development until Second Round Financing .......................................206 7.1.4 Second Round Financing ......................................................................213 7.1.5 Further Development and MPM Capital’s and TVM’s Exit.................215 7.2 Case Analysis................................................................................................219 7.2.1 MPM Capital’s and TVM’s Influence through Contracting .................219 7.2.1.1 Preliminary Remark .......................................................................219 7.2.1.2 Investment Agreement Structure ...................................................219 7.2.1.3 Influence on Deal-specific Risks ...................................................223 7.2.1.4 Influence on Management’s Formal Autonomy............................224 7.2.2 MPM Capital’s and TVM’s Influence through Resource Provision.....226 7.2.2.1 Influence on Resource Pool ...........................................................226 7.2.2.2 Influence on Management’s Real Autonomy ................................230

XIV

Table of Contents

8

Case Study varetis AG ......................................................................................235 8.1 Case Description........................................................................................... 235 8.1.1 Development before First Round Financing......................................... 235 8.1.2 First Round Financing........................................................................... 238 8.1.3 Development until Second Round Financing ....................................... 241 8.1.4 Second Round Financing ...................................................................... 245 8.1.5 Further Development and BayBG’s Exit .............................................. 247 8.2 Case Analysis ............................................................................................... 251 8.2.1 BayBG’s Influence through Contracting .............................................. 251 8.2.1.1 Investment Agreement Structure ...................................................251 8.2.1.2 Influence on Deal-specific Risks ...................................................256 8.2.1.3 Influence on Management’s Formal Autonomy............................258 8.2.2 BayBG’s Influence through Resource Provision.................................. 259 8.2.2.1 Influence on Resource Pool ...........................................................259 8.2.2.2 Influence on Management’s Real Autonomy................................263

9

Comparative Case Study Analysis...................................................................267 9.1 Venture Capitalists’ Influence through Contractual Agreements ................ 267 9.1.1 Contracting Negotiations ...................................................................... 267 9.1.2 Content of Investment Agreements....................................................... 268 9.1.3 Portfolio Companies’ Loss of Formal Autonomy ................................ 269 9.2 Venture Capitalists’ Influence through Resource Provision ........................ 271 9.2.1 Direct Resource Provision .................................................................... 271 9.2.2 Indirect Resource Provision .................................................................. 274 9.2.3 Dynamic Aspects of Resource Provision.............................................. 278 9.2.4 Venture Capitalists’ Influence on Competitive Advantage .................. 279 9.2.5 Portfolio Companies’ Loss of Real Autonomy..................................... 281

10

Conclusion and Further Implications .............................................................285 10.1 Conclusion.................................................................................................... 285 10.2 Implications for Researchers and Practitioners ............................................ 288

11

References ..........................................................................................................293

Table of Figures

XV

Table of Figures Figure 1: Figure 2: Figure 3: Figure 4: Figure 5: Figure 6: Figure 7: Figure 8: Figure 9: Figure 10: Figure 11: Figure 12: Figure 13: Figure 14: Figure 15: Figure 16: Figure 17: Figure 18: Figure 19: Figure 20: Figure 21: Figure 22: Figure 23: Figure 24: Figure 25: Figure 26: Figure 27: Figure 28: Figure 29: Figure 30: Figure 31:

Structure of analysis....................................................................................12 Interrelation between strategic management research streams...................17 Comprehensive resource-based view of the firm........................................23 Resource needs in stage models..................................................................25 Ten largest European venture capital deals (2Q03-1Q04)..........................29 Distribution of degrees of academic founders in Germany ........................32 Professional background of founders..........................................................33 Mechanisms to fill the resource gap of high potential companies..............39 Investment decision trade-off for high potential companies ......................40 Fluctuations in US market P/E ratio (1881-2003) ......................................42 Average P/E ratios for selected US industries ............................................43 Target IRR by country and type of investment...........................................44 Generic business model concept.................................................................50 Financing relationships of a venture capital firm .......................................52 Investors in German private equity funds (2003) .......................................53 Venture capital investments by industries (2003).......................................54 Private equity market share of investment companies (2003)....................55 Partnership structure of a venture capital firm............................................58 Number of professionals .............................................................................60 Educational background..............................................................................60 Professional background .............................................................................61 Specialization in teams................................................................................62 Refinancing process ....................................................................................63 Importance of investors’ investment criteria ..............................................64 Performance of European private equity (1980-2002) ...............................68 Typical structure of cash flows to investors ...............................................69 Investment process......................................................................................70 Importance of venture capitalists’ investment criteria................................76 Venture capital and private equity financial instruments (2003)................78 Exit channels of venture capitalists (2003).................................................83 Important international growth stock markets ............................................85

XVI

Figure 32: Figure 33: Figure 34: Figure 35: Figure 36: Figure 37: Figure 38: Figure 39: Figure 40: Figure 41: Figure 42: Figure 43: Figure 44: Figure 45: Figure 46: Figure 47: Figure 48: Figure 49: Figure 50: Figure 51: Figure 52: Figure 53: Figure 54: Figure 55: Figure 56: Figure 57: Figure 58: Figure 59: Figure 60: Figure 61: Figure 62: Figure 63: Figure 64: Figure 65:

Table of Figures

Reduction of number of transactions through intermediation ....................91 Return distributions of direct, fund, and fund-of-funds investments .........93 Risk/return measures for direct, fund, and fund-of-funds investments ......94 Performance data for several asset classes and benchmark indices ...........96 Impact of variations in private equity allocation on efficient frontier........98 Effects of information rights.....................................................................111 Effects of conversion rights ......................................................................112 Effects of control rights ............................................................................117 Effects of management covenants ............................................................121 Effects of milestone agreements...............................................................126 Effects of cash flow rights ........................................................................130 Effects of preemptive rights......................................................................132 Effects of disinvestment rights .................................................................136 Summary of effects of typical elements in venture capital contracts .......137 Importance of venture capitalists’ activities .............................................143 Resource provision table of venture capital firms ....................................146 Differences in intensity of venture capitalists’ activities..........................150 Differing perceptions of the extent of venture capitalists’ activities........151 Underinvolvement of venture capital firm ...............................................152 Prospect theory and its implications for venture capitalists .....................154 Performance, resource needs and extent of involvement .........................155 Levels of management ..............................................................................164 Degrees of influence and management’s autonomy.................................164 Selected data for comparing different accumulator technologies ............171 Profiles of Friedemann Stöckert and Dr. Karl-Heinz Pettinger................173 Organization chart of Bullith Batteries (2001) .........................................174 Profiles of Dr. Jürgen Diegruber and Tim Stemmer ................................175 Profiles of Peter Hertig and Janos Gönczöl..............................................177 Profile of Dr. Christian Friedemann .........................................................183 Contractual analysis of Bullith Batteries’ investment agreements...........191 Deal-specific risks between Gi Ventures and Bullith Batteries ...............192 Resource-based analysis of Bullith Batteries ...........................................196 Profiles of GPC Biotech’s founding team ................................................202 Profile of Dr. Helmut Schühsler ...............................................................203

Table of Figures

Figure 66: Figure 67: Figure 68: Figure 69: Figure 70: Figure 71: Figure 72: Figure 73: Figure 74: Figure 75: Figure 76: Figure 77: Figure 78: Figure 79: Figure 80: Figure 81: Figure 82: Figure 83: Figure 84: Figure 85:

XVII

Profile of Dr. Mirko Scherer .....................................................................204 Profile of Dr. Michael Steinmetz ..............................................................205 Profiles of additional members of GPC Biotech’s supervisory board......208 Profile of Dr. Bernd Seizinger ..................................................................212 Contractual analysis of GPC Biotech’s investment agreements...............223 Deal-specific risks between MPM Capital, TVM, and GPC Biotech ......224 Resource-based analysis of GPC Biotech.................................................230 Profit centers of varetis (1986) .................................................................237 History of BayBG (1972-2003) ................................................................239 Profile of Dr. Wolf Rüdiger Willig...........................................................241 Product groups of varetis (1999)...............................................................248 Contractual analysis of varetis’ first investment agreement .....................254 Contractual analysis of varetis’ second investment agreement ................256 Deal-specific risks between BayBG and varetis.......................................257 Resource-based analysis of varetis ...........................................................263 Comparison of number of contractual elements .......................................268 Comparison of risks addressed by investment agreements ......................269 Comparison of contractual elements restraining formal autonomy..........270 Comparison of direct resource provision by venture capital firms...........271 Comparison of indirect resource provision by venture capital firms........274

Table of Abbreviations

Table of Abbreviations 3C-market

Market for Computers, Camcorders and Communication

AIM

Alternative Investment Market

AktG

Aktiengesetz

BayBG

Bayerische Beteiligungsgesellschaft

BNP

Banque National Paribas

BVCA

British Venture Capital Association

BVK

German Venture Capital Association e.V.

CEO

Chief Executive Officer

CFO

Chief Financial Officer

COO

Chief Operating Officer

CTI

Computer Telephony Integration

CTO

Chief Technology Officer

DPI

Distribution to Paid-in

EBT

Earnings before Taxes

EVCA

European Venture Capital and Private Equity Association

FDA

U.S. Food and Drug Administration

IDIS

International Directory Inquiry System

HGB

Handelsgesetzbuch

HVB

HypoVereinsbank AG

IHK

Industrie- und Handelskammer (Bavarian Chamber of Industry and Commerce)

IPO

Initial Public Offering

IPR

Intellectual Property Rights

IRR

Internal Rate of Return

XIX

XX

Table of Abbreviations

ISiT

Institute for Silicon Technology

IT

Information Technology

KfW

Kreditanstalt für Wiederaufbau

LfA

Landesanstalt für Aufbaufinanzierung

M&A

Mergers & Acquisitions

NASDAQ

National Association of Securities Dealers Automated Quotation System

NDIS

National Directory Inquiry System

NiCd

Nickel-cadmium

NiMH

Nickel metal hydride

NVCA

National Venture Capital Association

OEM

Original Equipment Manufacturer

P/E

Price/Earnings

QST

Inquiry Support for Telecom Operators System

R&D

Research and Development

RVPI

Residual Value to Paid-in

SME

Small- and Medium-sized Enterprises

SWOT

Strengths, Weaknesses, Opportunities and Threats

S&P

Standard & Poor’s

tbg

Technologie-Beteiligungs-Gesellschaft

TVPI

Total Value to Paid-in

US

United States of America

WAP

Wireless Application Protocol

ZEW

Center for European Economic Research

Table of Interview Partners

XXI

Table of Interview Partners Günther Baierl

Chairman of the Supervisory Board, varetis AG

Dr. Konstantin Becker

Former CFO, varetis AG

Dr. Jürgen Diegruber

Founder and CEO, Gi Ventures AG

Dr. Christian Friedemann

Managing Director, Bullith Batteries AG

Dr. Elmar Maier

Founder and COO, GPC Biotech AG

Dr. Karl-Heinz Pettinger

Founder and Managing Director, Bullith Batteries AG

Dr. Mirko Scherer

Founder and CFO, GPC Biotech AG

Dr. Helmut Schühsler

Managing Partner, Techno Venture Management

Dr. Michael Steinmetz

General Partner, MPM Capital Management

Tim Stemmer

Investment Manager and CTO, Gi Ventures AG

Dr. Wolf Rüdiger Willig

Managing Director, BayBG mbH

Introduction

1

Introduction

1.1

Relevance of Smart Money

1

Entrepreneurship and innovation are more than ever essential for securing employment and economic prosperity of a country.1 The widely discussed finding from BIRCH that most new jobs emanated from entrepreneurial firms in the US market has been substantiated for many other countries.2 For Germany, AUDRETSCH/WEIGAND find that strong job growth is only exhibited among the group of small- and medium-sized technology-based firms.3 A better understanding of how this specific group of companies can realize its growth potential is therefore of prime interest. The bright brains of their founders are often the only assets, which newly founded companies operating at the frontiers of emerging technologies and markets have. This makes an investment in technology-based start-ups very risky. Consequently, many traditional sources of finance from public and private capital markets are not available to cover the financial needs of these companies. This is where venture capital firms come into play. Following BLACK/GILSON, this analysis defines venture capital as the investment by specialized venture capital firms in high-growth, high-risk, often high-technology firms, therefore called high potential companies, which need capital to finance product development or growth and must, by nature of their business, obtain this capital largely in the form of equity rather than debt.4 GIFFORD and SAHLMAN stress that venture capital is “a professionally managed

1

According to the GLOBAL ENTREPRENEURSHIP MONITOR, start-up firms provide a significant part, ranging from 2% to 15%, of the current jobs in most countries. This job creation is highly correlated with the level of entrepreneurial activity. See GEM (2003a), p. III. The role of innovation in enabling today’s economies to grow can not be valued high enough since it accounts for more than half of economic growth. See The Economist (2002).

2

See Birch (1987); Birch (1981). Several surveys provide an overview of this literature. See Audretsch (2002); Acs/Audretsch (1993); Eckart/von Einem/Stahl (1987); Fritsch/Hull (1987); Storey/Johnson (1987).

3

See Audretsch/Weigand (1999).

4

See Black/Gilson (1998), p. 245. This definition excludes later stage financing, which involves providing capital to companies that are already established. See Achleitner (2001), p. 516. Laterstage financing is often also called private equity financing. See EVCA (2004). It is not to be confused with the concept of private equity financing as opposed to public equity financing via organized capital markets.

2

Introduction

pool of capital invested in equity-linked private ventures”.5 Other authors add that venture capitalists expect to realize a capital gain by selling their shares after a certain time, which usually amounts to several years.6 However, high potential companies do not only lack financial resources. They also require support in several non-financial areas, which the following statement of a venture capitalist illustrates: “To quickly reach ‘critical mass’, young companies today need more than capital. They need access to people and companies who can accelerate their growth by helping them develop strategic partnerships, expand into new markets, raise international expansion financing, cut OEM deals, build distribution channels, secure purchase commitments, and get professional advice.”7 Usually, venture capital firms claim that they offer broad non-financial support to their portfolio companies as shown by the following marketing statements of leading venture capital firms: • Accel Partners: “Each of our portfolio companies benefits from the leverage of a deep team of professionals knowledgeable and active in their industry, as well as an extensive network of highly relevant executives and companies built through Accel's previous venture development activity.”8 • Apax Partners: “[Our portfolio companies can expect from us]9, frank, unbiased advice based on our shared financial objectives and over thirty years of experience, assistance with the formation of major advisory relationships, support in the recruitment of high caliber, influential non-executive and executive directors, support and guidance in international expansion through strategic alliances, acquisitions or other means, extensive global knowledge of their sector and technology, an experienced, well connected, international team committed to [the portfolio companies’] success.”10

5

See Gifford (1997), pp. 459 et seq.; Sahlman (1990), p. 473.

6

See Achleitner (2001), p. 514; Giudici/Paleari (2000), p. 154.

7

Target Partners (2004).

8

Accel Partners (2004). Accel Partners is based in London and Palo Alto.

9

Remarks in brackets are added by the author.

10

Apax Partners (2004). Apax Partners is based in Leeds, London, Madrid, Menlo Park, Milan, Munich, New York, Paris, Stockholm, Tel Aviv, Tokyo, and Zurich.

Introduction

3

• Atlas Venture: “Atlas Venture’s ongoing support helps companies reduce the trial and error inherent in moving from a startup to an established business. Our inside experts expand the reach of the already deep individual involvement of Atlas Venture principals who serve as board members. This program gives portfolio companies in both Europe and the US highly leveraged tools and hands-on assistance in the areas of recruitment, marketing, legal and finance.”11 • Kleiner Perkins Caufield & Byers: “Entrepreneurs gain access to our unmatched portfolio of companies and associations with global business leaders. These relationships are the foundations for strategic alliances, partnership opportunities, and the sharing of insights to help build new ventures faster, broader and with less risk.”12 The joint provision of capital and non-financial support from a venture capital firm is called “smart money”.13 Due to the many non-financial activities that venture capitalists are believed to provide, they are often esteemed to be “company builders rather than financiers”14 or “consultants with a financial interest”15. The US venture capital industry can exhibit an impressive track record in building companies that reach a global dimension. Famous names of formerly venture capital-backed companies are Amazon.com, America Online, Amgen, Apple Computer, Cisco Systems, Compaq, DEC, Federal Express, Genentech, Intel, Lotus, Netscape, Oracle, Seagate, Sun Microsystems, 3Com, and Yahoo.16 The much younger German venture capital industry yet has to prove that it is able to build companies of such global dimension. However, the “smartness” of the money provided by venture capital firms comes with costs. In fact, entrepreneurs have to accept significant reductions in the valuation of their company as venture capitalists add a smart money premium to their required in-

11

Atlas Venture (2004). Atlas Venture is based in Amsterdam, Boston, London, Munich, and Paris.

12

Kleiner Perkins Caufield & Byers (2004). Kleiner Perkins Caufield & Byers is based in Menlo Park and San Francisco.

13

Cf. Kreditanstalt für Wiederaufbau (2003), p. 18; Bascha/Walz (2002), p. 1; Lange et al. (2001); Baums/Möller (2000), p. 3.

14

Smart/Payne/Yuzaki (2000), p. 16.

15

Fried/Hisrich (1995), p. 102.

16

See Kenney (2000), p. 2.

4

Introduction

ternal rate of return (IRR) for the investment.17 ACHLEITNER ET AL. find that 28% of German, Austrian, and Swiss venture capitalists ask for such a smart money premium whereas this is done only by 4% of later stage buyout investors.18 This difference between venture capital firms and buyout investors is of particular interest, as there is no significant difference between the two groups with regard to their demand behavior concerning risk and illiquidity premiums.19 It appears that smart money plays a clear role in early-stage financing and a lesser role in later-stage financing. In addition to these financial costs, entrepreneurs receiving venture capital-backing often have to consider further non-financial costs such as losing some control over their company since venture capital firms tend to require a number of additional investor rights that give them a powerful position in their portfolio companies.

1.2

Aims of Analysis

A number of empirical studies compare the performance of venture capital-backed with non-venture capital-backed companies by: • IPO-related data. Examples are Tykvová/Walz (2004) (Germany)20, Jain/Kini (2000) (US), and Megginson/Weiss (1991) (US). • Growth-related data. Examples are BVCA (2003) (UK), Engel (2002) (Germany), and EVCA (1996) (Europe).

17

The higher the smart money premium is, the higher will be the discount rate which will be used to calculate the present value of the company’s expected cash flows and the lower will be the company’s valuation.

18

See Achleitner et al. (2004), p. 10. HSU confirms for the US market, that entrepreneurs of high potential companies are willing to accept a discount on their company’s valuation in order to get smart money from a venture capital firm that has an excellent reputation in the market. The magnitude of this discount ranges between 10% and 14% for a high reputation venture capital firm. See Hsu (2004).

19

A risk premium is required by investors due to the high risks involved in investment in high potential companies. See chapter 2.5. An illiquidity premium is required by investors due to the risk emanating from not being able to sell the investment instantly on the private market, as this would be possible on a public market. See Damodaran (1996), p. 495. Further references for illiquidity premiums are Brennan/Subrahmanyam (1996); Silber (1991); Amihud/Mendelson (1986). For a discussion in the German context, see Kaserer/Mohl (1998).

20

Brackets indicate to which countries the empirical findings relate.

Introduction

5

• Other data. Examples are Hellmann/Puri (2002) (US), Hellmann/Puri (2000) (US), Kortum/Lerner (2000) (US), and Cyr/Johnson/Welbourne (2000) (US). In general, these studies find a positive influence of venture capital-backing. However, they do not answer the question whether this superior performance is because of the financial resources being provided or because of the venture capitalists’ non-financial support. In this regard, another stream in venture capital research analyzes the performance effect of the non-financial support of venture capitalists mainly by carrying out studies based on questionnaires. The findings of these studies are based on assessments of venture capitalists’ non-financial contribution by: • Venture capital firms themselves. Examples are Cornelius/Naqi (2002) (Hong Kong, Singapore) and Schefczyk/Gerpott (1998) (Germany). • Venture capitalists’ portfolio companies. Examples are Brinkrolf (2002) (Germany) and Barney et al. (1996) (US). • Venture capitalists and their portfolio companies. Examples are Mitchell/Reid (1997) (UK) and Fredriksen/Olofsson/Wahlbin (1997) (Sweden). These studies show that venture capitalists and their portfolio companies believe that the non-financial support of venture capital firms has a positive effect on the development of their portfolio companies. Several studies try to gain a deeper understanding of how venture capitalists influence their portfolio companies: • One research stream focuses on the analysis of venture capital investment agreements. Examples are Kaplan/Strömberg (2003) (US) and Brinkrolf (2002) (Germany). • A second research stream focuses on the analysis of venture capitalists’ areas and intensities of non-financial support using questionnaire data. Examples are MacMillan/Kulow/Khoylian (1988) (US) and Brinkrolf (2002) (Germany). Whereas the analysis of venture capital investment agreements has a sound theoretical basis with applications of contract theory21, the analysis of the areas of venture capitalists’ involvement lacks a coherent theoretical framework. Therefore, the first aim of

21

See Salanié (1997) and Hart/Holmström (1987) for excellent overviews of this field.

6

Introduction

this analysis is to provide a theoretical framework for the role of venture capitalists as smart money investors. Most existing research concerning the influence of venture capitalists on their portfolio companies focuses on the question: What do venture capitalists do? These studies analyze the topic of the influence of venture capitalists from an investor perspective. In contrast, this analysis proposes a change of perspective towards the perspective of the portfolio company. In this respect, the second aim of this analysis is to give an answer to the question: What do high potential companies get from their venture capitalists? This moves the content of the “package” smart money from the entrepreneurs’ perspective in the center of the analysis. Against the background of this change in perspective of analysis, it becomes crucial to examine whether venture capitalists provide the kind of support that their portfolio companies actually need. Therefore, the third aim of this analysis is to give an answer to the question: Do high potential companies get what they need from their venture capitalists? Finally, it is interesting to note that there is yet no study that examines in detail what non-financial consequences entrepreneurs have to put up with due to the involvement of venture capitalists in the management of their companies.22 In particular, since entrepreneurs are said to be characterized by a high need for autonomy, problems can be expected with a strong involvement of venture capitalists in the management of their portfolio companies.23 Therefore, the fourth aim of this analysis is to give an answer to the question: To what extent do entrepreneurs lose their autonomy due to the involvement of venture capitalists?

1.3

Research Approach and Dataset

All these questions are of high practical relevance to every founder or manager of a high potential company as well as to venture capitalists. Consequently, this analysis

22

FLORIN studies the financial consequences that are associated with receiving venture capitalbacking. See Florin (2004).

23

See McClelland (1987); Hornaday/Aboud (1974).

Introduction

7

pursues an applied research approach in business administration.24 Accordingly, the practical relevance and applicability of the research findings is put in the center of this analysis. In order to achieve the first aim of this analysis, it becomes necessary to develop a theoretical framework, which allows explaining the role of venture capitalists as smart money investors. In the first part, this analysis develops a scientific toolkit based on contract theory and the resource-based view, which allows characterizing the influence of venture capitalists on their portfolio companies. In the second part, this toolkit is employed to check whether the developed theoretical constructs can be validated in practice. In order to achieve the second, third, and fourth research aim, it is highly necessary to have an unbiased and detailed insight into the development of portfolio companies and the associated activities of their venture capitalists. There are three important factors, which preclude conducting this analysis by using questionnaires: • Since questionnaires are in the best case filled out by those people who experienced the situation themselves, they are inherently subject to present a biased view.25 • The amount of data, which has to be gathered for this purpose, exceeds the scope of a questionnaire by far. • The venture capital market is generally a very intransparent market with market participants being very hesitant towards disclosing any information.26 In order to receive critical information from venture capital firms and their portfolio companies such as details of investment agreements and financial performance data, it requires a lot of convincing. Even more importantly, the researcher must 24

For a comparison of applied research and fundamental research in business administration, see Ulrich (1994); Heinen (1991); Ulrich (1981).

25

Furthermore, in many firms those questionnaires are given to interns or other less suitable persons to answer the questions. Certainly, data gathered this way will not help to provide an useful insight.

26

An example for this is the fact, that there has been an outcry in the venture capital industry, when venture capitalists were put under pressure to publicly disclose the performance of their portfolios. For a discussion of this case, see Chaplinsky/Perry (2004). EVCA (2003c) and Achleitner/Fingerle (2004b) call for further efforts to be undertaken by venture capitalists to improve the transparency of their industry.

8

Introduction

have the trust from both sides, the venture capitalists and the portfolio companies, which he is unlikely to obtain if he only sends a questionnaire. Therefore, this analysis employs the case study method for its empirical research. According to YIN, the case study method is the appropriate research method to understand complex social phenomena.27 There are five important characteristics of case study research:28 • The analysis is detailed and objective. • The analysis focuses on contemporary phenomena. • The analysis is embedded in a real-life context. • The researcher has no influence on events and organizations. • The aim of the analysis is a description of states and principles of cause and effect that match the reality. The major disadvantage of case study research is that findings from individual cases cannot be generalized. In order to mitigate this disadvantage, this analysis follows the suggestions of ROLL, who states, that multiple case studies enhance validity and reliability of the research findings.29 To improve the quality of the research findings further, this analysis follows EISENHARDT, who suggests undertaking a cross case study comparison by applying the same theoretical constructs to the cases and search for similarities and differences.30 According to the searchlight theory of POPPER, such findings potentially represent a leap forward in the search for knowledge.31 He suggests that knowledge creation happens by trial and error. A key feature of his “searchlight theory” is that problems or expectations take precedence over observations. These observations are always preceded by expectations, questions or problems, which, like a searchlight, illuminate a

27

See Yin (1994), p. 3.

28

See Roll (2003); Yin (1994); Eisenhardt (1989b).

29

See Roll (2003), p. 315.

30

See Eisenhardt (1991); Eisenhardt (1989b).

31

See Popper (1979); Popper (1949).

Introduction

9

certain area, thereby enabling the researcher to understand what he truly has to observe. The approach to gather the relevant data for the case studies is based on MINTZBERG.32 In a first step, all available written documentation was reviewed in order to obtain an understanding of the chronology of the portfolio companies’ development and the relevant players. In a second step, by conducting a number of interviews with the relevant decision makers, the influence of venture capitalists on their portfolio companies was reconstructed. To compile the datasets for each investee-investor dyad, the author had full access to important formal documents such as investment agreements, employment contracts, articles of association, bylaws for management and supervisory board, minutes of supervisory board meetings, business plans, budgets and forecasts, auditor reports as well as annual, quarterly and monthly reports, and financial statements. Moreover, the author had access to internal market studies and presentations as well as the correspondence between both parties. This information was supplemented by various publicly available information including the companies' websites, their press releases, internet databases, and press articles from third parties. For each case study, the author led talks and conducted in-depth interviews with the portfolio company’s management team and the corresponding venture capitalists, adding up to about ten hours per case study.33 The different investee-investor dyads were chosen to achieve significant variation between portfolio companies’ industries and type of venture capital firms. The dataset comprises three case studies on German high-tech start-ups. Bullith Batteries AG focuses on solid-state-based lithium-polymer accumulator technology and received its first financing round in 2002 by the small independent venture capital fund Gi Ventures AG. GPC Biotech AG focuses on genomic technology platforms as well as drug discovery and drug development. It received its first financing round in 1997 from the large and prominent independent venture capital funds of MPM Capital and TVM. The third, varetis AG, focuses on innovative software solutions in the market for directory

32

See Mintzberg (1979), p. 582.

33

See the Table of Interview Partners for more details.

10

Introduction

inquiry assistance. It received its first financing round in 1990 from the regional and government-friendly investment company BayBG.

1.4

Structure of Analysis

After the introduction of chapter 1, the subsequent chapter 2 deals with the characteristics of high potential companies. After introductory remarks in chapter 2.1, chapter 2.2 discusses the fundamentals of the resource-based view, which is presented as a suitable theoretical framework for understanding the problems of high potential companies in securing the resources they urgently need to pursue their entrepreneurial activities. The main research streams within the resource-based view are summarized and integrated into a comprehensive resource-based view. Chapter 2.3 elaborates on the resource profile of high potential companies by describing their resource base and their further resource needs. The here introduced resource categorization allows to systematically and comprehensively analyze start-ups. This approach will later be used to analyze and compare the cases. Chapter 2.4 briefly discusses other ways than venture capital financing to meet the resource demands of high potential companies. Chapter 2.5 discusses the implications of the typical resource profile of a high potential company for the risks and return of an investment in such a company. Chapter 3 introduces the business model concept to explain what venture capitalists are doing and why they are doing it. Subsequent chapters will frequently readdress the insights from this chapter. After introductory remarks in chapter 3.1, chapter 3.2 clarifies the components of the business model concept of venture capital firms since little conceptual research has been carried out in this area to date. Chapter 3.3 describes the investors and portfolio companies of venture capital firms as the two groups of customers that venture capital firms have to deal with in their function as intermediaries. The subsequent three chapters discuss in turn each of the three components of the business model concept. Chapter 3.4 provides an analysis of the value creation architecture of venture capital firms. This comprises a description of the organizational and personnel structures as well as the refinancing and investment process of venture capital firms, i.e. their institutional framework. Among other things, this chapter clarifies how venture capital firms deliver their value adding services to their investors and portfolio companies. Chapter 3.5 discusses the value propositions of venture capital firms towards their investors and portfolio companies. It provides several arguments

Introduction

11

why investors and portfolio companies benefit from using the services of venture capital firms. Chapter 3.6 analyzes the incentive structure of venture capitalists and explains how venture capitalists earn money with their activities. Chapter 4 analyzes how venture capitalists influence their portfolio companies through contractual agreements. After introductory remarks in chapter 4.1, chapter 4.2 explicates deal-specific risks that arise for venture capital firms when they invest in high potential companies. The analysis goes beyond most existing research on venture capital financing, which focuses solely on agency risks, and discusses additional risks that venture capital firms have to manage and control. Chapter 4.3 provides a comprehensive and detailed overview of contractual elements that are often used in the context of venture capital financing. Furthermore, their effects on the behavior of the managers and on the scope of the portfolio companies’ activities are described. This allows examining to what extent investment agreements provide venture capital firms with the possibility to manage and control the deal-specific risks of their investments. Chapter 4.4 introduces the concept of formal autonomy and discusses what implications the contractual agreements between high potential companies and venture capital firms have on the formal autonomy of the portfolio company and its managers. Chapter 5 examines how venture capitalists exert influence on their portfolio companies through the provision of resources. After introductory remarks in chapter 5.1, chapter 5.2 analyzes the existing literature on the value-adding activities of venture capitalists using the resource-based view. This allows ascertaining in which resource categories venture capitalists are commonly found to be active resource providers. Since several studies find that the involvement differs among venture capital firms, chapter 5.3 portrays various determinants of the intensity of venture capitalists’ resource provision to their portfolio companies. Chapter 5.4 introduces the concept of real autonomy and discusses to what extent venture capitalists can get involved into the management processes of a high potential company. The chapters 6, 7, and 8 present three in-depth case studies that illustrate to what extent various and in which ways venture capital firms influence high potential companies in practice. All case study chapters follow the same pattern of analysis. Chapters 6.1, 7.1, and 8.1 each describe the development of the case company and illustrate the role their venture capital firms played during this development. The influence that the venture capital firms exert during this time is analyzed in turn in chapters 6.2, 7.2, and

12

Introduction

8.2. These chapters deal with the questions what influence the venture capitalists gain over their portfolio company through the investment agreement and to what extent a portfolio company and its managers lose formal autonomy. Furthermore, these chapters also analyze the resource provision activities of venture capital firms and show to what extent portfolio companies lose real autonomy through venture capital firms getting involved into the management of their portfolio companies. Chapter 9 compares the results of the three case studies and puts them into context. Chapter 9.1 describes commonalities and differences of the venture capital firms’ influence on their portfolio companies through their investment agreements. In turn, chapter 9.2 focuses on the analysis of commonalities and differences of the venture capital firms’ influence on their portfolio companies through their resource provision activities. Chapter 10 concludes and discusses further implications for the research community as well as the management of high potential companies and venture capital firms. The following Figure 1 summarizes the structure of the analysis.

1

Introduction

2

Characteristics of High Potential Companies

3

Business Model of Venture Capital Firms

4

Venture Capitalists‘ Influence through Contractual Agreements

5

Venture Capitalists‘ Influence through Provision of Resources

6

Case Study Bullith Batteries AG

7

Case Study GPC Biotech AG

9

Comparative Case Study Analysis

10

Conclusion and Further Implications

Figure 1:

Structure of analysis

8

Case Study varetis AG

Characteristics of High Potential Companies

2

Characteristics of High Potential Companies

2.1

Introductory Remarks

13

It is widely believed that entrepreneurship and new firm creation are important for economic growth.34 There is also increasing perception that not all start-ups contribute equally to this growth. Rather, only few start-ups eventually achieve significant aboveaverage growth rates and therefore qualify for being called “high potential companies”.35 Even though there exists a well established understanding of the macroeconomic importance of the high growth performance of high potential companies, the questions of what are the characteristics of high potential companies and how their growth potential can be realized merit closer inspection. This chapter proceeds as follows. The resource-based view of strategic management research is discussed in the light of explaining the superior performance of companies in general. It contends that the competitive advantage of a firm is found in its resource base. The typical resource profile of a high potential venture is then discussed. It will be demonstrated that high potential companies typically show resource needs in every resource category. These resource needs can be covered through several mechanisms. Venture capital financing seems to be a promising way to do this. However, venture capital firms need to trade-off the high expected return against the high risks associated with an investment in a high potential company.

2.2

Fundamentals of the Resource-based View

2.2.1

Resources in Strategic Management Research

Strategic management research deals with understanding the sources of a firm’s competitive advantage.36 Several streams within strategic management research claim that the resources of a venture play a major role in explaining its competitive advantage. However, the importance of a firm’s resources for its competitive advantage differs across prominent research streams. 34

See Audretsch (2002); Wennekers/Thurik (1999); Westhead/Cowling (1995); Kirchhoff (1994); Storey (1994); Birch (1979).

35

See GEM (2003a); GEM (2003b); Autio/Yli-Renko (1998); Birch/Haggerty/Parsons (1997); Westhead/Cowling (1995); Birch (1979).

36

See Barney (1991), p. 99.

14

Characteristics of High Potential Companies

Early research in this field, the so-called design school 37, suggests that firms obtain competitive advantages by pursuing strategies that achieve a fit between internal strengths and weaknesses and external threats and opportunities.38 The design school explicitly includes firm-level resources as a driver for competitive advantage and suggests that firms need to differentiate themselves from competitors to build up a sustainable competitive advantage. Corporate success is dependent on designing a strategy that is best apt to make full use of the firm’s internal resources in a given setting of external factors. The design school analyzes sources of competitive advantage on an industry level as well as on a firm level. According to the design school, a high potential company realizes a competitive advantage through its unique strengths, i.e. resources, in markets offering great opportunities. Promising market opportunities can only be exploited if the company possesses the corresponding resources. If a high potential company lacks these resources to pursuit an opportunity, it has to find ways to build them up. However, the design school does not mention how high potential companies can build these strengths and avoid weaknesses. Subsequent development in strategic management research leads to the emergence of the market-based view39 that analyzes sources of competitive advantage mainly emanating from industry characteristics and largely ignores firm-level differences between individual companies within a certain industry.40 One of its underlying assumptions is that all firms within an industry dispose of the same resource basis and that resources are perfectly mobile across firms.41 Differences among firms are either transitory or

37

See von den Eichen (2002), p. 145; Mintzberg (1990).

38

See zu Knyphausen (1993); Andrews (1971); Ansoff (1965); Selznik (1957).

39

The term market-based view is first introduced by Rühli (1994), p. 39.

40

See Nelson (1991), pp. 64 et seq. The market-based view is largely based on insights of industrial organization research. See Rumelt/Schendel/Teece (1991). However, industrial organization and strategic management pursue diametrically opposed goals. See von den Eichen (2002), p. 146, footnote 1. Whereas, industrial organization research tries to find ways how to minimize rents of firms to achieve the first-best social optimum, strategic management research tries to find ways to maximize those rents in order to achieve maximum profitability for an individual firm.

41

See Hitt/Ireland/Hoskisson (2003), pp. 21 et seq.

Characteristics of High Potential Companies

15

unimportant.42 Industry characteristics and the firm’s position within the industry determine the firm’s profitability. This causal relationship is summarized in the famous and intensively discussed structure-conduct-performance paradigm, which draws most notably on the works of BAIN, CHAMBERLIN, CHANDLER, CLARK, and MASON.43 It states that basic demand and supply conditions determine the industry structure, which determines the conduct of buyers and sellers that in turn determines industry performance. Finally, industry performance determines firm performance. The basic assumption of the market-based view is the existence of systematic interindustrial differences in profits.44 This means that the attractiveness of industries differs and, depending on the individual industry, can be more or less favorable. In such a constellation, the firm’s main task is to pick the right industry and to understand its underlying mechanisms, which PORTER calls competitive forces.45 The market-based view assumes that even if resource heterogeneity develops within an industry, e.g. through a new entrant, this heterogeneity will be short lived since factor markets are efficient and resources are mobile.46 However, a fact that has been ignored in the academic discussion is that the market-based view implicitly allows for resource heterogeneity across firms in terms of managerial resources expressed in the firm’s competitive strategy. The relative position of a firm within its industry determines whether its profitability is above or below the industry average. A firm that understands the five forces better than its competitors can better position itself within the industry and has the chance to build up a sustainable competitive advantage.47 Therefore, it can be argued that managerial resources within firms might be unevenly distributed, as some 42

See Schmalensee (1985), p. 342. For example, BAIN finds no significant support for economies of scale to play an important role in determining a firm’s competitive position. See Bain (1954), p. 38.

43

See Teece (1984); Bain (1968); Chandler (1962); Bain (1954); Bain (1951); Bain (1950); Clark (1940); Mason (1939); Chamberlin (1933).

44

See zu Knyphausen (1993), p. 772. The market-based view largely draws on industrial organization literature and features four important assumptions. First, above-average performance is due to a firm‘s better adaptation to industry structure. Second, all firms within an industry dispose of the same resource basis. Third, employed resources are fully mobile. Fourth, managers act rational and according to the best interest of the company’s shareholders. See Hitt/Ireland/Hoskisson (2003), pp. 21 et seq.

45

See Porter (1985), pp. 4, 7.

46

See Barney (1986b); Hirshleifer (1980).

47

See Porter (1985), p. 7.

16

Characteristics of High Potential Companies

managers are able to better adapt the firm’s strategies to the requirements of an industry. In this respect, the market-based view allows for some resource heterogeneity but only with respect to firms’ managerial resources.48 Further development in strategic management research shows a shift towards a firm’s internal resources leading to the rise of the resource-based view.49 The main assumption of the resource-based view is that competitive advantage results from resource heterogeneity and resource immobility across firms within a certain industry.50 Whereas the market-based view takes an external view on a firm’s competitive advantage, the resource-based view takes an internal view. Its analysis focuses on the firm level and claims that competitive advantage results from firm-specific resources.51 PENROSE mentions in her seminal work that firms are both a pool of resources and an administrative entity.52 WERNERFELT picks up this concept and applies it to strategic management research.53 The resource-based view defines the concept of resources in a broad sense. A resource is everything that firms can use directly and indirectly to pursue wealth creation activities.54 BARNEY defines corporate resources to include “all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc”.55 The market-based view assumes that due to market failure in the form of monopolistic market structures, firms can earn monopoly rents, i.e. returns to market power. The resource-based view introduces the concept of Ricardian rents, which are returns to resources above their real costs.56 Firms with superior resources have either lower costs

48

Moreover, even though industry structure is relatively stable, there are continuous shifts in the overall and relative strength of the competitive forces. Firms can influence the competitive forces through their strategies and thereby shape an industry’s attractiveness. See Porter (1985), p. 7.

49

Wernerfelt (1984) first introduces the term resource-based view.

50

See Barney (1991), p. 101.

51

See Barney (1991); Dierickx/Cool (1989); Wernerfelt (1984).

52

See Penrose (1995), p. 31. PENROSE actually investigates the question what makes firm grow. RUBIN follows this line and derives a theoretical model that shows that firm growth is linked to the resource endowment of a firm. See Rubin (1973).

53

See Wernerfelt (1984).

54

See Wernerfelt (1984), p. 172.

55

Barney (1991), p. 101.

56

See Grant (1991), p. 117.

Characteristics of High Potential Companies

17

or show higher productivity than competitors that do not dispose of these resources.57 Consequently, the resource-conduct-performance paradigm emerges within strategic management. In contrast to the structure-conduct-performance paradigm of the market-based view, firm strategy and performance in the resource-based view are not dependent on industry structure, but on the resource endowment of the firm. Whereas the important task of the management to secure profitability is industry picking in the market-based view, it is resource picking in the resource-based view. Figure 2 shows the interrelation between the three discussed strategic management research streams. The design school covers both internal and external analysis and thus is the basis for the market-based view with its focus on external drivers (industry characteristics) of competitive advantage and the resource-based view with its focus on the firm’s internal drivers (resources) of competitive advantage.

Design school (internal and external analysis) Market-based view (external analysis)

Resource-based view (internal analysis)

Opportunities

Strenghts Fit

Threats

Figure 2:

2.2.2

Weaknesses

Interrelation between strategic management research streams

Resources and Competitive Advantage

Not all resources of a start-up hold the potential for competitive advantages. For resources to yield a competitive advantage, they must fulfill two different requirements:58

57

Cf. Peteraf (1993), p. 180.

58

See Barney (1991), pp. 105 et seq.

18

Characteristics of High Potential Companies

• A resource must be valuable in the sense that it helps either to exploit market opportunities or to neutralize threats in the company’s environment.59 This implies that the resource helps to increase corporate effectiveness or efficiency. • A resource must be rare in order to enable the company to follow a certain strategy that competitors cannot follow due to resource constraints.60 If a large number of competitors own a particular resource, then each of these competitors can exploit the resource and a common strategy emerges within the industry that gives no firm a competitive advantage. The resource-based view points towards four characteristics of resources that are likely to be particularly important determinants of the sustainability of competitive advantage:61 • The sustainability of a company’s competitive advantage depends on how durable its resources are, i.e. how long the resources are useful to the firm, even in the absence of competitive challenges.62 • Imperfectly transferable resources impair possibilities of competitors to acquire strategically critical resources and thereby increase the sustainability of the firm’s competitive advantage.63 • Imperfectly imitable64 resources make it possible for a company to maintain its competitive advantage as it is often not possible for competitors to build the same resources.65

59

See Barney (1991), p. 106.

60

See Barney (1991), pp. 106 et seq.

61

See Grant (1991), pp. 124 et seq.

62

See Grant (1991), pp. 124 et seq.

63

See Grant (1991), pp. 126 et seq. Imperfections in resource transferability arise from several sources. First, geographical immobility of resources might hamper their transferability as for example high relocation costs might deter competitors from acquiring certain resources. Second, information asymmetry between buyers and sellers regarding the effective value of a resource might lead to adverse selection along the lines of Akerlof (1970). Third, the specificity of a resource often causes its value to fall in transactions with competitors since performance-enhancing complementarities with other firm resources will not be present in the acquiring firm. See Klein/Crawford/Alchian (1978). Fourth, an even higher immobility of resource bundles is found to play a major role in impairing their transferability.

64

See Barney (1986a); Barney (1986b); Lippman/Rumelt (1982).

Characteristics of High Potential Companies

19

• Imperfectly substitutable resources positively influence the sustainability of a start-up’s competitive advantage.66 If there were strategically equivalent resources that could be exploited to follow the same strategy, a competitive advantage would not be sustainable. The traditional resource-based view67 understands the firm as a bundle of distinct resources that are unique to the firm and that other firms cannot acquire easily and most likely not at the same conditions. The resulting heterogeneity across firms allows for a sustained competitive advantage and economic profits of firms with superior resource basis.68

2.2.3

A Comprehensive Resource-based View

Few resources are productive on their own but rather require the cooperation and coordination of a bundle of resources, often called a competence or capability, to be productive.69 Building up a competence involves complex patterns of coordination between people (human resources) and (non-human) resources.70 A competence refers to a firm’s wealth creating ability to deploy these resources by using organizational rou65

Three different reasons for the existence of imperfectly imitable resources are advanced. First, unique historical conditions or path dependencies can lead to the possession of a resource that competitors do not possess. See Barney (1991), pp. 107 et seq. Second, the link between a resource and the associated competitive advantage is unclear to competitors and therefore subject to causal ambiguity. See Reed/DeFillippi (1990), pp. 90 et seq.; Lippman/Rumelt (1982), p. 420. Third, competitive advantages might be rooted in complex social phenomena that are beyond the ability of a competitor to imitate. See Hambrick (1987); Barney (1986a).

66

See Barney (1991), p. 111 et seq.; Dierickx/Cool (1989), p. 1509.

67

See von den Eichen (2002), p. 150.

68

For example, according to LIEBERMAN/MONTGOMERY, a first-mover advantage can arise among other reasons from a firm’s technological leadership and preemption of assets. See Lieberman/Montgomery (1988), pp. 41 et seq.

69

See Grant (1991), p. 118 et seq. A productive resource bundle is called a capability by the following authors. See Blyler/Coff (2003); Matsusaka (2001); Lee/Lee/Pennings (2001); Eisenhardt/Martin (2000); McEvily/Zaheer (1999); Chaston/Mangles (1997); Teece/Pisano/Shuen (1997); Madhok (1996); Teece/Pisano (1994); Chandler/Hanks (1993); Stalk (1992); Hamilton/Singh (1992); Grant (1991). A productive resource bundle is called a competency by the following authors. See Javidan (1998); Lei/Hitt/Bettis (1996); Henderson/Cockburn (1994); Prahalad/Hamel (1990); Stoner (1987).

70

Cf. Grant (1991), p. 122.

20

Characteristics of High Potential Companies

tines.71 In this way, the competence-based view of strategic management emerges as a refinement of the resource-based view.72 The seminal paper by PRAHALAD/HAMEL makes the point that among a firm’s competencies, only few might be core competencies that actually deliver a competitive advantage to the firm.73 The authors argue that there are three prerequisites for a competence to qualify as core competence:74 • The competence needs to provide potential access to a large number of markets, • the competence makes a significant contribution to the customer value proposition of the firm, • the competence must be hard to imitate. Consequently, the core competency concept directly builds on the assumptions of the resource-based view. Early proponents of the resource-based view already understand resources to include capabilities, organizational processes, firm attributes, information, knowledge, etc.75 BARNEY argues that this broad understanding of resources helps to ensure the wide applicability of the resource-based view.76 ALVAREZ/BUSENITZ contend therefore that the competence-based view can be seen as an extension of the traditional boundaries of the resource-based view.77 However, the focus of the competencebased view shifts away from Ricardian rents to Schumpeterian rents that result from creative entrepreneurial activities.78 As high potential companies are usually operating in dynamic fast-changing markets, it becomes crucial for them to adapt their resources and competencies continuously to preserve competitive advantages.79 In this regard, dynamic competencies of the firm, 71

Cf. Amit/Schoemaker (1993), p. 1137. The concept of organizational routines goes back to NELSee Nelson/Winter (1982), pp. 97 et seq.

SON/WINTER. 72

See Teece/Pisano/Shuen (1997); Amit/Schoemaker (1993); Dierickx/Cool (1989).

73

See Prahalad/Hamel (1990).

74

See Prahalad/Hamel (1990), pp. 83 et seq.

75

See Penrose (1995); Barney (1991), p. 101.

76

See Barney (2001), p. 51.

77

See Alvarez/Busenitz (2001), p. 772.

78

See Müller-Stewens/Lechner (2003b), p. 361.

79

Cf. Barney/Wright/Ketchen (2001), p. 630; Fiol (1991).

Characteristics of High Potential Companies

21

i.e. the ability to adapt the firm’s resource basis to current needs, gain importance.80 According to PRAHALAD/HAMEL, the sources of competitive advantage rest with the management team’s ability to enable a firm to quickly response to changing opportunities.81 Another research stream delves into the importance of knowledge as the key resource of firms. The fundamental assumption of the so-called knowledge-based view is that knowledge is the most important resource in a firm’s wealth creation activities.82 Thereby, the knowledge-based view links the resource-based view with epistemology.83 The knowledge-based view therefore is an extension of the resource-based view by deepening its explanatory power for proprietary knowledge as key driver for firm performance. Corresponding with the presumption of the traditional resource-based view, the knowledge-based view also assumes that not all knowledge resources yield a competitive advantage, but rather knowledge that cannot be appropriated by others easily. Whereas tacit knowledge is hard to codify and can only be acquired through observation and practice84, explicit knowledge is easy to transfer and contracts protecting knowledge are difficult to enforce85. A further research stream argues that the resource-based view focuses unnecessarily on internal resources as drivers of competitive advantage.86 The traditional resourcebased view assumes that resources providing a sustainable competitive advantage are exclusively under the firm’s control and permanently linked to it. However, a firm’s critical resources may extend beyond its boundaries.87 The so-called relational view

80

Cf. Eisenhardt/Martin (2000).

81

See Prahalad/Hamel (1990), p. 81.

82

Cf. Grant/Baden-Fuller (2000), p. 121. Important contributions to the knowledge-based view are Foss/Foss (1998); Conner/Prahalad (1996); Grant (1996); Krogh/Roos/Slocum (1994); Nonaka (1994); Kogut/Zander (1992); Cohen/Levinthal (1990); Polanyi (1958).

83

See Grant/Baden-Fuller (2000), p. 120.

84

See Grant (1996); Kogut/Zander (1992).

85

See Liebeskind (1966).

86

See Socher (2003); McEvily/Zaheer (1999); Dyer/Singh (1998).

87

See Dyer/Singh (1998), p. 660. PFEFFER/SALANCIK argue that “the organization ends and the environment begins at that point where the organization’s control over activities diminishes and the control of other organizations or individuals begins. At this point, [resource] exchanges with the environment begin […].” Pfeffer/Salancik (1978), p. 113.

22

Characteristics of High Potential Companies

argues that idiosyncratic linkages between firms can be a source of relational rents and competitive advantage.88 The process of founding and growing a company is embedded in a social, political, and cultural context.89 Entrepreneurs are thus not isolated and autonomous decision makers but are rather required to engage in social activities and interactions when gathering resources and coordinating resource allocation. Entrepreneurship is therefore inherently a networking activity.90 Empirical research shows that network resources, networking activities, and network support promote successful company foundations and future company development.91 In particular, personal contacts are in many areas crucial for a successful development of a high tech company as they often facilitate the access to important decision makers.92 In this regard, the relational view stresses the importance of social resources.93 The relational view further refines the traditional resource-based view by expanding its scope beyond internal resources and stressing the importance of access to external resources through relationships with third parties in order to achieve sustained competitive advantage. HOWARD STEVENSON makes the point: “When it comes to resources…all I need...is the ability to use [them]”.94 Not the possession of resources is relevant for achieving a competitive advantage, but rather the access to resources. Figure 3 shows how various research streams feed into a comprehensive resourcebased view of the firm and summarizes how resources, (core) competencies and competitive advantage are linked together.

88

See Dyer/Singh (1998), p. 661.

89

Cf. Brüderl/Preisendörfer (1998), p. 214.

90

See Dubini/Aldrich (1991), p. 306.

91

See Dubini/Aldrich (1991); Burt (1992), p. 36.

92

See Achleitner/Engel (2001), p. 16.

93

The “social capital” and “network” research streams analyze the effects of a firm’s social relations on its performance. Important works in this area are Blyler/Coff (2003); Yli-Renko/Autio/Tontti (2002); Varamäki/Pihkala (2002); Gulati/Nohria/Zaheer (2000); Hansen et al. (2000); Brüderl/Preisendörfer (1998); Portes (1998); Uzzi (1996).

94

Quoted in Timmons (1999), p. 321.

Characteristics of High Potential Companies

23

Competitive advantage (Core) competence-based view

(Core) competencies

Relational view

Resources

Dynamic capability-based view

Knowledge-based view

Traditional resource-based view

Figure 3:

Comprehensive resource-based view of the firm95

The resource-based view is certainly relevant to all firms but it is considered particularly suitable for high potential companies.96 However, relatively few authors establish a link between the resource-based view and entrepreneurship research.97 Early work acknowledges that entrepreneurial activities of firms are a fundamental part of the resource-based view.98 For example, DIERICKX/COOL argue that as new ventures only dispose of few resources, the important task of the management is to acquire, develop, and apply resources in order to achieve competitive advantage and superior firm performance.99 This chapter explained the important role of resources for the performance of firms. The next chapter provides an overview of important resource categories for start-ups and analyzes the typical resource profile of a high potential venture.

95

Cf. Brush/Greene/Hart (2001), p. 71.

96

Cf. Cooper/Gimeno-Gascon/Woo (1991).

97

Cf. Barney (2001), p. 53.

98

See Conner (1991); Rumelt/Schendel/Teece (1991).

99

See Cornelius/Naqi (2002), p. 255; Dierickx/Cool (1989).

24

Characteristics of High Potential Companies

2.3

Resource Profile of High Potential Companies

2.3.1

Resource Needs in Stage Models

Many scholars have engaged in extensive conceptualizations of stages of corporate development.100 According to this research, corporate development is not a linear and piecemeal process.101 Instead, stagnation in one stage, steps backwards to a previous stage, jumps to any previous or consecutive stage, and repeating a stage represent conceivable ways of corporate development. A major strength of the stage model research is that it enhances the understanding of the complex phenomenon of growth and its impact on firms.102 It provides valuable insights into what challenges companies are facing when they set out to realize their growth potential. A major weakness is that after several decades of research in that field, there is still not yet a commonly accepted model of corporate development and differing conceptualizations abound. The academic discussion lacks a link between the resource perspective and the stagemodels of corporate development. This analysis sets aside a detailed description of the many individual stage models. However, nine commonly used stage models are analyzed in terms of what resources are needed to further build up the organization. Figure 4 depicts the studies with authors, definition of the stages, and resource needs of growing companies.

100

Stages of corporate development are often categorized according to quantifiable measures such as size and age of a company. Firm size is a standard measure for a company’s stage of development. See Scott/Bruce (1987); Barrie (1974); Greiner (1972); Steinmetz (1969). It can be obtained both from input-oriented data, i.e. resources available to the company such as number of employees and assets, and from output-oriented data such as revenues, number of sold items, number of products, and number of markets. See Fingerle (2003), p. 725 and Kiriri (2002). Firm age is often believed to give a good indication of the company’s development stage. See Hanks et al. (1993); Scott/Bruce (1987); Miller/Friesen (1984); Churchill/Lewis (1983); Greiner (1972). However taking spin-offs into account, it follows that there is no clear-cut dependent relationship between a company’s age and its development stage. Cf. Churchill/Lewis (1983), p. 31; Kimberley/Miles (1980), p. 7. Moreover, entrepreneurs can deliberately choose to remain in one development stage. For example, managers might follow a lifestyle strategy of no-growth once they have established corporate viability at a relatively small company size or they follow a capped growth strategy after they have expanded the company to an intermediate size. See McMahon (1998), p. 7; Hanks et al. (1993), pp. 22 et seq.; Churchill/Lewis (1983), p. 31.

101

See Hanks et al. (1993); Scott/Bruce (1987); Miller/Friesen (1984); Churchill/Lewis (1983); Greiner (1972).

102

See Kazanjian (1988), p. 258.

Characteristics of High Potential Companies

25

Authors

Stages

Resource needs

Steinmetz (1969)

Direct supervision, supervised supervision, indirect control (divisional organization)

Managerial resources

Greiner (1972)

Creativity, direction, delegation, coordination, collaboration

Managerial and organizational resources

Galbraith (1982)

Proof of principal, model shop, start-up, natural growth, strategic maneuvering

Managerial and organizational resources

Churchill/Lewis (1983)

Existence, survival, success (disengagement, growth), take-off, resource maturity

Managerial and organizational resources

Miller/Friesen (1984)

Birth, growth, maturity, revival, decline

Managerial and organizational resources

Smith/Mitchell/ Summer (1985)

Inception, high-growth, maturity

Managerial and organizational resources

Scott/Bruce (1987)

Inception, survival, growth, expansion, maturity

Managerial, financial, and organizational resources

Kazanjian (1988/90)

Conception and development, commercialization, growth, stability

Organizational and social resources

Hanks et al. (1993)

Cluster A, B, C, D, (E, F)

Managerial and organizational resources

Figure 4:

Resource needs in stage models103

The analysis of commonly used stage models clearly shows that this research emanates from organization research and largely fails to include insights from many other disciplines such as finance and entrepreneurship.104 It demonstrates that growing companies have to acquire managerial and organizational as well as financial and social resources. However, as this analysis argues later, high potential companies have a resource need in further resource categories, which are not addressed by the stage model literature. Therefore, the next chapter provides a more complete categorization of resources.

103

See Hanks et al. (1993); Kazanjian/Drazin (1990); Kazanjian (1988); Scott/Bruce (1987); Smith/Mitchell/Summer (1985); Miller/Friesen (1984); Churchill/Lewis (1983); Galbraith (1982); Greiner (1972); Steinmetz (1969). These stage models describe actions or activities the company has to undertake to progress to the next stage. These activities and actions can also be interpreted as referring to resources the company has to acquire or to improve. An example would be that an author argues that the company has to overcome difficulties resulting from a lack of formal organization. This would be reinterpreted as the need of organizational resources.

104

It is astonishing that only one stage model mentions the domain of financial resources as important determinant in the development of a firm.

26

Characteristics of High Potential Companies

2.3.2

Resource Categorization

Leading scholars of the resource-based view attempt several categorizations of important resources. BARNEY only differentiates between three resource categories: physical, human, and organizational resources.105 GRANT uses the following six categories to describe important resource categories: Financial, physical, human, technological, reputation, and organizational resources.106 BRUSH/GREENE/HART propose a very similar categorization in organizational, human, technological, physical, financial, and social107 resources.108 This analysis splits human resources into managerial resources on the one hand and personnel resources on the other hand to gain a more detailed insight into the quality of the human resources of a high potential company. Furthermore, this analysis argues that social resources play an important role in the development of a high potential company.109 Consequently, this analysis employs eight resource categories to characterize the typical resource profile of a high potential start-up. According to this categorization, the following resources are differentiated, which are explained in more detail in the following chapters: • Technological resources, • financial resources, • managerial resources, • personnel resources, • physical resources, • organizational resources, • reputational resources, • social resources.

105

See Barney (1991), p. 101.

106

See Grant (1991), p. 119.

107

Following PORTES, who introduces the concept of social capital, this analysis employs the term social resources instead of the original term of networking resources. See Portes (1998).

108

See Brush/Greene/Hart (2001), p. 69.

109

This is supported by the relational view that stresses the importance of social resources. See chapter 2.2.3.

Characteristics of High Potential Companies

2.3.3

27

Technological Resources

High potential companies show a high degree of innovative activity.110 They create novel products or services through innovative combination of resources within existing industries or they even create new industries.111 These innovations are regularly technology-driven.112 Accordingly, ARTLEY ET AL. define an innovation as “a new technological idea clearly able to support one or more applications and provide commercial benefits”.113 Innovations are qualitatively different to existing products and services or processes.114 Technological resources comprise the knowledge behind inventions and innovations that the company can use to pursue its value creating activities. They are one of the main assets of high potential companies. The value of technological resources within a firm can be enhanced by protecting them with intellectual property rights (IPR).115 These are the “principal rights governing the ownership and disposition of technology”.116 Intellectual property rights can be classified in patents, copyrights, trademarks, design rights, and certain specialist rights.117

110

The degree of innovative activity of a company is typically measured according to the research and development (R&D) intensity, i.e. the relative importance of R&D expenditures compared to company sales. See Grupp/Legler (2001), p. 18. High technology is defined if the R&D intensity is above 3.5%. See Grupp/Legler (2001). Advanced technology is a sub-group of high technology that shows R&D intensities above 8.5%. Among today’s typical high technology industries biotechnology, information and communication technology as well as nanotechnology are often quoted. High potential companies regularly show considerable R&D intensities, which characterize them as high-tech companies. See Timmons/Bygrave (1986), pp. 163 et seq.; Gompers (1995), p. 1463. The determination of the degree of innovation is much more complicated with service companies as innovation in the service sector depends to a much lesser degree on R&D intensities. See Grupp/Legler (2001), p. 25. In this case, an alternative measurement option could be the use of the knowledge intensity, i.e. the relative importance of highly skilled personnel for the value creating activities of a company. See Grupp/Legler (2001), p. 26.

111

See Elfring/Baden-Fuller (2000), p. 9. Prominent examples for companies that created new products or industries mainly come from the US such as the internet auction company Ebay Inc. or the search engine company Yahoo Inc.

112

See Bank of England (1996), p. 10; Sweeting (1991), p. 602.

113

See Artley et al. (2003), p. 42.

114

See Aldrich (1979); Hauschildt (1997).

115

See Bank of England (2001b), p. 1. Patents are used not only to establish property rights but also to facilitate licensing and to be used to enhance bargaining power in negotiations. See Hippel (1988).

116

Artley et al. (2003), p. 247.

117

See Artley et al. (2003), p. 247.

28

Characteristics of High Potential Companies

The patent as a legal title is the strongest form of protecting technological resources, which grants its holder the exclusive right to exploit the economic potential of an invention for a limited geographic area and a limited time, usually 20 years or less.118

2.3.4

Financial Resources

High potential companies are active in innovative industries and require large amounts of capital to finance the introduction of new products or services in the markets. The prime example for this is the biotech respectively pharmaceutical industry, where average costs for the introduction of a new drug amount between $500m and $800m.119 This exemplifies that these newly founded ventures need large amounts of financial resources.120 As Figure 5 shows, nine out of ten largest European financings of high potential companies in the period of second quarter 2003 and first quarter 2004 involved biotech companies. For example, the Austrian vaccine company Intercell AG raised €44m in its second round financing in November 2003, the largest venture capital financing round until then in Europe.121 Financing possibilities for high-tech start-ups are usually very limited. Internal financing is in many cases not sufficient or even possible since high potential companies often show negative or only small positive cash flows.122 External financing via government funding schemes are available that help many start-ups to overcome initial financial gaps. However, they are by far not sufficient to cover the financial needs of high potential companies. External financing via organized public capital markets is not yet feasible due to the early stage of the companies’ development. In fact, they usually do not yet fulfill all requirements for accessing organized public capital markets.123 Consequently, high potential companies are dependent on external financing via private capital markets.

118

See Artley et al. (2003), p. 247.

119

See Kallmeyer/Canabou (2001), p. 8; Anonymous author (2003), p. 13.

120

See Tykvová (2000), p. 2.

121

See Intercell AG (2004).

122

See Gifford (1997), p. 459.

123

It can be distinguished between quantitative and qualitative criteria for being able to raise capital on organized public capital markets. Among the quantitative criteria are minimum company size,

Characteristics of High Potential Companies

Company name

Country

Intercell

Austria

44.0

Developer of chemically defined vaccines for the cancer and chronic infections

Lorantis

UK

36.1

Discoverer of a fundamental immune mechanism

Cyclacel

UK

30.9

Developer of biotechnology and therapeutics for treating cancer

Arrow Therapeutics

UK

30.5

Developer of patented anti-bacterial, anti-viral, and anti-fungal drugs with novel modes of action

Ardana Bioscience

UK

28.6

Developer of products to promote better reproductive health for men and women

Igeneon

Austria

26.7

Developer of unique cancer vaccines

Ablynx

Belgium

25.0

Developer of therapeutic drugs based on a single-domain antibody platform (nanobodies)

CareX

France

25.0

Discoverer of nuclear receptor modulators for the treatment of metabolic disease

BioVex

UK

24.4

Developer of treatments for cancer and chronic infectious diseases

esmertec

Switzerland

23.0

Provider of Java solutions and technologies for mass market devices

Figure 5:

Amount raised in €m

29

Company description

Ten largest European venture capital deals (2Q03-1Q04)124

External debt financing through bank loans is hard to get for early-stage high potential companies, as the risk associated with an investment in such companies is estimated very high resulting in a credit constraint.125 This is mainly due to the lack of tangible resources, which could be used as collateral.126 Frequently, high potential companies only have intangible technological resources such as intellectual property rights.127 However, the valuation of these assets is still controversial and consequently, their use

minimum sales, existence of a credit rating, adequate company growth and profitability, and a relatively large transaction size. Among the qualitative criteria, the most important one is a convincing investment story. Particularly for equity offerings, the criteria vary according to the targeted stock market segment. For further details see Achleitner (2003), pp. 260 et seq. Early-stage high potential companies do regularly not yet fulfill requirements of company and transaction size. In addition, for a successful long-term performance of the shares it is indispensable to keep stock market analysts interested in the company. However, satisfying analyst coverage is only possible if there is enough market liquidity, which is normally only true for larger companies. Cf. Brennan/Jegadeesh/Swaminathan (1993), pp. 820 et seq. 124

See VentureOne (2004).

125

See Christofidis/Debande (2001), p. 1.

126

See Amit/Glosten (1990), p. 102; Lerner (1995), p. 302; Giudici/Paleari (2000), p. 154; Bank of England (2001b), p. 1; Manigart/Baeyens/van Hyfte (2002), p. 103.

127

See chapter 2.3.3.

30

Characteristics of High Potential Companies

as collateral for bank financing is in most cases not accepted.128 The more a company’s asset base consists of intangible resources, the less likely it is to receive traditional bank financing.129 In addition, debt financing comes along with interest and principal payment obligations which most companies would not be able to fulfill or which would at least be an encumbrance to the rapid development of high potential companies.130 Since external debt financing is not a sufficient source of financial resources for high potential companies, they mainly have to rely on equity financing.131 External equity financing through further injections of the founders is in most cases not a realistic option because they are often not able or not willing to invest further personal assets in their companies.132 External equity financing through family and friends is also mentioned as another possibility to raise financial resources to set up a company.133 However, the company is unlikely to meet its full capital requirements via this way. Consequently, high potential companies often require external equity financing provided by third parties such as venture capital firms since these professional investment companies are also capable to cover the large financial need of high potential companies.134 Venture capital financial instruments differ from public equity financial instruments in three important dimensions:135 • They show a much higher specificity since they are not subject to the standardization pressure of public capital markets.

128

See Allee (2000), pp. 17 et seq.

129

See among others Friend/Lang (1988), pp. 271 et seq.; Titman/Wessels (1988), pp. 1 et seq.; Rajan/Zingales (1995), pp. 1421 et seq.; Giudici/Paleari (2000), p. 158.

130

Cf. Wright/Robbie (1998), p. 527; Tykvová (2000), pp. 7 et seq.

131

See Sahlman (1990), p. 473 and Schefczyk (2000), p. 37.

132

See Tykvová (2000), p. 7.

133

See Bygrave (2000), pp. 97 et seq.

134

Bootstrap finance is defined by FREEAR/SOHL/WETZEL as “highly creative ways of acquiring the use of financial resources without borrowing money or raising equity financing from traditional sources". See Freear/Sohl/Wetzel (1995), pp. 85 et seq. Bootstrap finance is not adequate to raise amounts large enough to cover the financing needs of high potential companies.

135

This argument follows Kaserer/Diller (2004c), who discuss characteristics of private debt financial instruments.

Characteristics of High Potential Companies

31

• They facilitate implementing a number of additional investor rights such as management covenants and veto rights. • They are characterized by a relatively low liquidity on secondary equity markets.

2.3.5

Managerial Resources

Managerial resources are defined as the skills, abilities and knowledge of managers.136 Especially in the context of high potential companies, entrepreneurial recognition, which is defined as the recognition of opportunities and the behavior of seeking opportunities, is an essential part of managerial resources.137 This analysis argues that not only executive managers, but also members of the supervisory board have to be included in the definition of managerial resources, since they are also involved in strategy formulation.138 High potential companies typically have a strong need to build up their managerial resources. According to the CENTER FOR ENTREPRENEURIAL AND FINANCIAL STUDIES, 70.8% of all German founders have an academic background.139 Among the founders with an academic background, 27.0% hold a PhD.140 Several empirical studies show that most academic founders have a technology background and outstanding capabili-

136

Cf. Castanias/Helfat (2001), p. 661. Managerial resources are an important part in building core competences that generate competitive advantage and above-average returns. These returns are called “managerial rents”. This rests on the assumption that managers differ in the type and quality of their skills. See Castanias/Helfat (2001), pp. 661 et seq.

137

Cf. Alvarez/Busenitz (2001), p. 756.

138

Fried/Bruton/Hisrich (1998) provides evidence that members of the supervisory board are engaged in strategy formulation. LÜCK describes the German supervisory board as crucial for securing the existence of a company. See Lück (2002a).

139

The sample of this study covers participants from the German Start-up Competition, which focuses on high potential companies. See Center for Entrepreneurial and Financial Studies (2004), p. 16. In the broader study of KULICKE/GÖRISCH, the share of academic founders is 71.6%. Their sample is based on all German founders without a focus on high potential companies. See Kulicke/Görisch (2002), p. 37.

140

See Center for Entrepreneurial and Financial Studies (2004), p. 16. The high number of founders holding a PhD is largely due to start-ups from the industries of biotechnology and medical technology where 71.1% respectively 52.9% of academic founders hold a PhD.

32

Characteristics of High Potential Companies

ties regarding technical development.141 At the same time, founders often lack profound business knowledge such as in the functional area of marketing and mostly lack the experience of setting up and growing a venture.142 Figure 6 shows the distribution of degrees among academic founders.

15.8% - Other degree 28.0% - Engineering science degree 2.8% - Law 7.0% - Humanities

23.1% - Natural science degree

Figure 6:

23.3% - Business/economics degree

Distribution of degrees of academic founders in Germany143

A lack of leadership abilities within the group of founders is often observed.144 According to the CENTER FOR ENTREPRENEURIAL AND FINANCIAL STUDIES, 26.9% of founders previously held an executive position before starting their company. In addition, founding teams are often incomplete meaning that senior management of the company does not yet make up a balanced combination of diverse personal and professional profiles.145

141

See Kulicke/Görisch (2002), p. 37; Schefczyk/Gerpott (2000), p. 148; Lessat et al. (1999), pp. 71 et seq.; Pleschak (1998), p. 67 and Pleschak (1997), p. 17.

142

See Sykes (1986), pp. 275 et seq.; Timmons/Bygrave (1986), pp. 161 et seq.; Perry/Young (1988), p. 205; Boekholt (1996), pp. 760 et seq.; Westhead/Storey (1997), p. 197; Forbes/Milliken (1999), pp. 489 et seq.; Achleitner/Engel (2001), p. 16; Gabrielsson/Huse (2002), p. 127.

143

See Center for Entrepreneurial and Financial Studies (2004), p. 16.

144

See Sapienza/Gupta (1994), p. 1622.

145

See Sapienza/Gupta (1994), p. 1622.

Characteristics of High Potential Companies

33

3.2% - Other 2.3% - Public servant 8.6% - Student/apprentice 28.7% - Company employee 9.4% - Unemployed

20.9% - Self-employed 26.9% - Executive employee

Figure 7:

Professional background of founders146

The lack of managerial resources entails several needs of a typical high potential company: • There is a need for further professionalizing the existing management team. • There is a need for attracting additional experienced managers to complete the management team. • There is a need for supervisory board members that are able to support the existing management team. • There is a need for further support from third parties such as accountants, attorneys, bankers, and consultants.

2.3.6

Personnel Resources

Along the lines of the definition of managerial resources, personnel resources are defined as the skills, abilities and knowledge of non-managerial employees. Personnel resources are required to carry out the operational value creation activities of a firm. Start-ups often begin their activities with having only few founders doing all the work to get the company going. Therefore, high potential companies quickly need further

146

See Center for Entrepreneurial and Financial Studies (2004), p. 20.

34

Characteristics of High Potential Companies

personnel to enable the founder-managers to concentrate on their strategic and entrepreneurial actions instead of administering the organization.

2.3.7

Physical Resources

Physical resources include a firm’s access to resources such as plants, machinery, equipment, and its geographic location.147 The availability of sufficient office space and infrastructure as well as the opportunity to reside in an incubation center or a science park do play a role in the development of a firm.148 High potential companies typically have a short company history and therefore have not yet build up significant physical resources. Moreover, start-ups have an incentive to rent or lease physical resources instead of buying them to keep cash outflows as low as possible.

2.3.8

Organizational Resources

The organization of a company aims at minimizing coordination and motivation problems resulting from economic activities.149 The degree of the organizational structure indicates therefore to what extent corporate structures and processes are established within a company to enable an efficient value creation. Due to their short time of existence, high potential companies usually exhibit a low degree of organizational structure.150 This can go as far as that not even a legal corporate shell exists, as this is usually the case in the seed phase, where only a project team is working together.151 Looking at the internal structure of the company, many new roles and simultaneously their mutual relationships need to be defined.152 Standardized routines and behaviors

147

See Barney (1991), p. 101.

148

See Clarysse et al. (2004).

149

See Picot/Reichwald/Wigand (2001), p. 29.

150

See Hellmann/Puri (2002), p. 170; Achleitner/Engel (2001), p. 16; Mitchell/Reid (1997), pp. 54 et seq.; Kazanjian (1988), pp. 270 et seq.

151

Cf. Artley et al. (2003), p. 40.

152

See Stinchcombe (1965), p. 148.

Characteristics of High Potential Companies

35

are not yet established that would help coordinating the many different roles within an organization. Moreover, a lack of clearly organized management structures is typical for those ventures.153 Management systems such as accounting, risk management and employee incentive schemes are far from being fully developed if existent at all.154 Similar problems emerge when looking at organizational interfaces that are required for efficient transactions between the company itself and external third parties. The venture has to set up organizational structures and processes with contact persons from third parties that are not yet acquainted with the venture. An example for that would be that customers do not yet know what steps are required to place an order.155 Initially, these organizational design processes are accompanied by a low level of trust and routine between the parties.156 This results in the need to build up organizational structures to enhance efficiency. This is in particular relevant considering the fact that high potential companies have to design their organizational structure in a way that the organization is capable of managing the challenges from rapid growth. However, the founders often lack the knowledge of how to implement such a structure in practice and are therefore dependent on external support.

2.3.9

Reputational Resources

Reputational resources are a collective construct describing aggregate perceptions of third parties about the performance of a venture157 and its reliability.158 Reputation is advantageous for transactions in uncertain environments where the firm frequently en-

153

See Brav/Gompers (1997), p. 1793.

154

See Mitchell/Reid (1997), pp. 45 et seq.; Kaplan/Strömberg (2001), p. 8; Kaplan/Strömberg (2002), p. 12.

155

See Stinchcombe (1965), pp. 148 et seq.

156

See Stinchcombe (1965), p. 149; Lindström/Olofsson (2001), p. 151.

157

See Fombrun/Gardberg/Sever (2000), p. 242.

158

The reputation of the company and the reputation of its products and services are strongly interconnected. See Bank of England (2001b), p. 1. As products and services are mostly new and innovative, customers lack handling experiences and reliable data concerning their quality. See Stinchcombe (1965), p. 149.

36

Characteristics of High Potential Companies

counters unforeseen events and a fair behavior is required.159 The impact of a positive corporate reputation on firm performance has received significant attention in the academic literature.160 However, notwithstanding its acknowledged high relevance as driver of company value, the concept of reputation is still in its infancy, probably due to the complexity of its measurement. Building a corporate reputation requires a significant amount of time.161 However, high potential companies lack the time required to build up their reputation with third parties and are often not even active on their markets.162 Third parties are just about to gain first experiences with the company and a corporate reputation will therefore only gradually build up. To speed up company development it becomes necessary to acquire a good reputation as quickly as possible since this largely facilitates corporate transactions.163 As high potential companies cannot achieve this instantly alone, they need the support of certifying third parties in this respect.164 This analysis shows that supervisory board members play an important role from a certification perspective in the beginning of the company. The further the company develops the less the supervisory board plays a role since the company acquires its own track record.

159

See Holmström/Tirole (1989), p. 76 et seq.

160

See Fombrun/Gardberg/Sever (2000); Dunbar/Schwalbach (2000); Fombrun (1996); Dowling (1994) and Hall (1992).

161

Cf. Marwick/Fill (1997), p. 398.

162

See Davis/Stetson (1985), p. 51; Tykvová (2000), p. 7. A stakeholder is any group or individual who can affect the development of the venture or is affected by the achievement of the venture. See Freeman (1984), p. 47.

163

In this context, NATHUSIUS speaks of the risk of market acceptance that high potential companies face. Whereas it might be a lesser problem to find customers as a start-up in the US, this turns out to be a significant problem for German start-ups. See Nathusius (2001), p. 11. A contributing factor for this finding might be the high risk aversion within the German society. See Sternberg/Bergmann/Lückgen (2004), pp. 18 et seq. This might also have consequences for the behavior of more established companies that are often important customers for high potential companies.

164

Booth/Smith (1986) provides an early analysis of the certification hypothesis. Certification in the context of financing high potential companies through venture capital is analyzed in Hsu (2004); Wang/Wang/Lu (2003); Schertler (2003); Da Silva Rosa/Velayuthen/Walter (2002); Kraus (2002); Lee/Wahal (2002); Francis/Hasan (2001); Hamao/Packer/Ritter (2000); Ljungqvist (1999); Lin/Smith (1998); Brav/Gompers (1997); Megginson/Weiss (1991).

Characteristics of High Potential Companies

37

2.3.10 Social Resources Social resources facilitate a firm’s access to resources of third parties.165 Early-stage high potential companies usually lack a widespread network of business contacts to all stakeholder groups.166 As BLEICHER points out, there is no commonly accepted segmentation for the stakeholders of a company.167 He lists employees, debt and equity holders, customers, suppliers, public, state and trade unions as relevant stakeholders.168 Within the context of start-ups, stakeholders such as trade unions are considered to play a lesser role due to their weak position in young start-ups.169 Stakeholders such as strategic alliance partners170 and M&A candidates171 are considered to play a more important role. Based on BLEICHER and RÜEGG-STÜRM, this analysis proposes that the following stakeholders are of high importance to high potential companies: Investors, founders/managers, employees, suppliers, customers, collaboration partners, M&A candidates, competitors, public, and state. High potential companies have only few links to these different stakeholders as it takes a significant amount of time to build relations. As a result, there is a strong need to strengthen the relations of a high potential company with its stakeholders. In particular, first introductions to third parties could be helpful for a more rapid company development. This chapter defined eight resource categories that are of importance to high potential companies. It has been demonstrated that a typical high potential venture shows a resource need in every defined resource category. This implies that there is an imbalance between resources at disposal and resources required to secure their existence and to exploit their growth potential.172 The following chapter discusses several mechanisms for high potential companies to fill this resource gap.

165

Cf. Portes (1998), p. 4.

166

See Davis/Stetson (1985), p. 51.

167

See Bleicher (1994), p. 161.

168

See Bleicher (1994), p. 162.

169

Cf. Paqué (2001).

170

See Forrest (1990), p. 38.

171

See Lindqvist/Ahsberg (2000), p. 2.

172

See Sapienza/Gupta (1994), p. 1622; Manigart/Baeyens/van Hyfte (2002), p. 103.

38

Characteristics of High Potential Companies

2.4

Mechanisms to Fill the Resource Gap

To cover the resource needs of high potential companies, there are three different mechanisms: • They can acquire the required resources through internal development. However, this is not possible for all kinds of resources. For example, high potential start-ups show large financial needs that they have to cover externally because they do not yet earn enough money. • They can acquire the required resources through a market purchase but often lack the money to pay for them. For example, they often have a strong need for support in questions of strategic direction or need contacts to potential customers, i.e. resources that are usually not offered for direct purchase on the market or that start-ups cannot afford to pay in cash.173 • They can obtain required resources through relational acquisition. In this case, the company enters into a relationship with third parties to gain access to further resources. Alliances with other firms174, universities and research institutes are one way to set up such a relationship.175 Another way would be to enter into a sponsorship-based relationship with government agencies or other organizations that provide resources without a quid pro quo.176 Finally, high potential companies might have the chance to enter into a relationship with venture capital firms to fill their resource gaps.

173

In recent years, there has been some discussion about consulting services offered to start-ups in exchange for an equity stake in the start-up. For example, in the Silicon Valley it has not been uncommon for consultants, headhunters, lawyers and even landlords to take a portion of their fees in options from start-ups. See Teece (2000), p. 43. However, it can be assumed that after the New Economy boom, many consultants do not pursue this more risky business model anymore. EHRMANN sees the applicability of the “consulting for equity” model rather problematic. He proposes that consulting for equity is mainly useful in the context of a corporate restructuring mandate and less in the context of a high potential company. See Ehrmann (2003), p. 2.

174

An important research stream in building alliances with its competitors is coopetition, which refers to a simultaneously cooperative and competitive behaviour of firms. See Tsai (2002), p. 180. For an application of this concept to German small- and medium-sized enterprises, see Lück/Henke (2003a); Lück/Henke (2003b); Henke (2003).

175

See Lee/Lee/Pennings (2001), p. 620.

176

See Lee/Lee/Pennings (2001), p. 622.

Characteristics of High Potential Companies

39

Figure 8 shows different ways for high potential companies to acquire resources to meet their resource needs.

Ways to fill the resource gap

Internal development

Market purchase

Relational acquisition

Alliances

Figure 8:

Sponsorships

Venture capital firms

Mechanisms to fill the resource gap of high potential companies

LEE/LEE/PENNINGS show that venture capital firms have a clearly positive effect on the resource acquisition and subsequent performance of a high potential company.177 In fact, as this analysis will show later, venture capital firms are well positioned to fill the resource gaps of high potential companies. However, financing a high potential company is a complex task. From the perspective of an investor, this involves diligently weighing advantages and disadvantages when considering an investment. The next chapter sheds some light on the returns and risks associated with an investment in a high potential venture.

2.5

Return and Risks of Investments in High Potential Companies

2.5.1

Investment Decision Trade-Off

Investors in high potential companies are confronted with the problem of extreme values of the parameters of their investment decision. On the one hand, such an investment promises a large upside potential with exceptionally high returns on investment. On the other hand, the investors have to consider a range of high risks that are associ177

See Lee/Lee/Pennings (2001).

40

Characteristics of High Potential Companies

ated with an investment in a high potential company. Figure 9 shows the trade-off between the return and the risks of investing in high potential companies.

Return

High expected return

Figure 9:

2.5.2

Risks

Investment decision trade-off

• • • • • •

Liability of newness Liability of smallness Uncertainty of supply Uncertainty of demand Competitive uncertainty Dependency on founders

Investment decision trade-off for high potential companies

High Expected Return

High potential companies are believed to yield an above-average return on investment for their investors.178 Several factors drive the value creation of high potential companies and simultaneously drive the returns that can be expected from investments in such companies by equity investors:179 • Revenue growth and margin improvement, • multiple expansion, • liquidity or strategic premium. Revenue growth and margin improvement both increase the value of a firm on an operational basis. These improvements directly lead to higher cash flows and thereby to a higher firm value since third parties will be inclined to pay a higher price for the com178

See Achleitner (2002), p. 143.

179

Cf. European Venture Capital Journal (2004). Two drivers of value creation in private equity investments are not covered in the following analysis, as they are rather applicable to investments in later stage companies. An increase in the leverage of the company potentially increases the value of the equity investment. See Becker (2000), p. 11. The leverage effect is mainly used in later stage deals. In particular buyouts often appear in the form of leveraged buyouts. See Achleitner/Fingerle (2003). Exploiting arbitrage opportunities between capital markets is another way of increasing the value of an equity investment. Theoretically, this plays an important role in later stage deals, when there are pricing differentials between public and private or national and international markets. However, in early stage deals this does not seem to play a significant role.

Characteristics of High Potential Companies

41

pany’s shares. This mainly becomes possible due to the possession of unique technological resources, i.e. product, service or process innovations.180 Innovative companies realize new factor combinations and generate new products or services. LINDSTRÖM provides empirical evidence for a positive relation between technology orientation and company growth.181 Technology-intensive companies are likely to exhibit an aboveaverage growth potential.182 Among technology-based companies, spin-offs from universities and research institutions show an even higher degree of technology orientation and consequently an even higher growth potential.183 Growth potential is the key determinant for the value of high potential companies.184 A multiple expansion implies that third parties are willing to pay a higher price for the shares of the company and the investor receives a higher return on his investment. Multiple expansions can be due to a promising fundamental performance, which makes investors believe in a generally higher level of company growth and profitability than the company had before. Multiple expansions can also be attributed to the fact that the overall level of stock market valuations at the time of exit is higher than at the time of investment.185 However, the opposite effect of falling stock market multiples can also lead to a decrease in value creation of a high potential company. The continuous change in the price/earnings (P/E) ratio for the US market is shown in Figure 10.

180

See among others Fingerle (2003), p. 725; Elango et al. (1995), p. 167; Fenn/Liang/Prowse (1995), p. 22; Gompers (1995), p. 1463; Autio (1997), p. 196; Black/Gilson (1998), p. 245; Christofidis/Debande (2001); p. 40; Lockett/Wright (2001), p. 375; Robinson/van Osnabrugge (2001) p. 38; Smith (2002), p. 71.

181

See Lindström/Olofsson (2001), p. 166.

182

See Westhead/Cowling (1995), p. Lindström/Olofsson (2001), p. 166.

183

See Lindström/Olofsson (2001), p. 166.

184

See Cornell/Shapiro (1988); Cyr/Johnson/Welbourne (2000), p. 79; Manigart/Baeyens/van Hyfte (2002), p. 103.

185

GOMPERS shows that a 100% increase on stock markets leads to a 15%-35% increase of valuations in venture capital deals. See Gompers (1996), p. 283.

111

et

seq.;

Westhead/Storey

(1997),

p.

197;

42

Characteristics of High Potential Companies

50

US market P/E ratio

40

30

20

10

1881

Figure 10:

1900

1920

1940

1960

1980

2003

Fluctuations in US market P/E ratio (1881-2003)186

Even when stock market multiples are unchanged, P/E ratios still differ within industries as Figure 11 shows. A high potential company can try to profit on these interindustry valuation differentials. A multiple expansion can be realized if the company manages to be perceived by investors at the time of exit to belong to a higher-P/E industry than initially at the time of investment.187 A multiple expansion can potentially also be realized, when the company has an improved corporate governance structure at the time of exit.188 As the company is easier to understand and investor rights’ are firmly established, the company attracts more investors. At the time of selling the company’s shares to third parties, a premium might be added to the selling price. Such a premium might be a liquidity premium in case the company realizes an IPO and as the company’s shares are now floated on the stock market. Risks resulting from illiquidity of the shares are then eliminated.189 It also can be a

186

See Anonymous author (2004b), p. 37.

187

This is rather applicable in later stage deals than in early stage deals. Start-ups usually dispose of one technology in a certain industry. Later stage companies might already have a portfolio of technologies. Therefore, it is less clear in which industry a later stage company is actually active.

188

GOMPERS/ISHII/METRICK show that good corporate governance has a positive impact on company valuations. See Gompers/Ishii/Metrick (2003).

189

Cf. Achleitner (2003), pp. 627 et seq.; Damodaran (1996), p. 495; Elton/Gruber (1995), p. 20.

Characteristics of High Potential Companies

43

strategic or control premium in case the company is sold via a trade-sale to a strategic investor that is willing to pay a higher price in order to acquire a controlling stake in the company.190

Banks Insurance Telecommunications & services

14 19 20

Media Software & services Pharmaceuticals & biotech

Figure 11:

26 38 54

Average P/E ratios for selected US industries191

High potential companies face very high expectations from equity investors regarding their performance. The survey data in Figure 12 show that target internal rates of return (IRR) are in Germany for early stage investments above 55% and for expansion investment between 30% and 35%, which is at the upper end in an international comparison.

190

Cf. Damodaran (2004), p. 35.

191

See Anonymous author (2004a). P/E ratios base on latest twelve months’ earnings and stock prices of February 27, 2004.

44

Characteristics of High Potential Companies

Country

Early stage

Expansion stage

Later stage

Germany

> 55%

30% - 35%

20% - 25%

US

45% - 55%

30% - 35%

25% - 30%

UK

45% - 55%

30% - 35%

30% - 35%

France

35% - 45%

20% - 25%

25% - 30%

Figure 12:

Target IRR by country and type of investment192

These high required IRRs could be explained with the high risks that are characteristic for high potential companies. The following chapter discusses several risk categories that are relevant for high potential companies.

2.5.3

High Risks

2.5.3.1 Liability of Newness Most high potential companies are young companies and only have a short corporate history.193 Consequently, these companies lack a significant performance record as well as an experience base with their products and services.194 This increases the risk for third parties intending to engage in business activities with the start-up, as they cannot base their decision on former experiences with the company. On relative terms, new organizations fail more often than old organizations.195 STINCHCOMBE calls this the “liability of newness”.196 The fact that young companies exhibit statistically significant higher mortality rates than older companies implies a high degree of uncertainty concerning the present and future capabilities of a start-up and possibly deters third parties from doing business with it. 192

Wright (2003), p. 19. The presented IRRs are expected and not realized. Further research is required to explain the remarkable differences in return expectations across countries.

193

See Gompers (1995), p. 1463 and Tykvová (2000), p. 10.

194

See Tyebjee/Bruno (1984a), p. 1051 and Davis/Stetson (1985), p. 51.

195

See Brüderl/Schüssler (1990); Freeman/Carroll/Hannan (1983); Stinchcombe (1965).

196

See Stinchcombe (1965), p. 148.

Characteristics of High Potential Companies

45

2.5.3.2 Liability of Smallness A further characteristic of high potential companies is their small size.197 In theory and practice, one encounters many different definitions of company size. Most of them use sales and employee numbers, more seldom market share and balance sheet total as threshold levels.198 In 2003, more than 96% of new investments in German high potential companies were companies with fewer than 500 employees.199 BRÜDERL/SCHÜSSLER argue that a company’s small size comes along with a “liability of smallness”.200 They argue that larger firms have more resources to withstand difficult periods. The small asset base of a start-up increases the mortality risk of a company. For example, the impact on the company of an employee leaving is different in a ten people business compared to a multinational corporation. Similarly, failing in the acquisition of a single customer when the company has none is a different story compared to when the company already has a large customer base. In general, small companies are therefore much more vulnerable to shocks. Even though third parties might believe in the capabilities of a company, they still might refrain from doing business with the venture because of the relatively high probability that some external event that cannot be controlled by the company makes it fail.

2.5.3.3 Uncertainty of Supply The high degree of innovative activity of high potential companies implies that there is a high degree of supply uncertainty, meaning that it is yet unclear whether R&D efforts will finally result in marketable products or services.201 This is especially relevant for companies that are in the seed phase. Reasons for the company not managing to develop and deliver its products or services can be found in internal and external conditions. Internally, the company might simply

197

See Gompers/Lerner (2001), p. 145. Stage models of company growth postulate a strong correlation between a company’s age and its size. See chapter 2.1 for a review of stage models.

198

See Behringer (1999), p. 8.

199

See BVK (2004a), p. 17.

200

See Brüderl/Schüssler (1990), p. 532.

201

Cf. Sapienza/Gupta (1994), p. 1622; Elango et al. (1995), p. 159; Fenn/Liang/Prowse (1995), p. 17; Westhead/Storey (1997), p. 197; Tykvová (2000), p. 7.

46

Characteristics of High Potential Companies

encounter development problems it did not expect. The biotechnology industry is a prime example proving the considerable uncertainty that surrounds R&D efforts in high-tech industries. Studies show that only five out of 5,000 leads result in drug candidates that make it to the final phase of clinical trials and only one of them finally receives the approval of the FDA.202 In addition, external factors, such as a change in the legal regulations can potentially result in the company having to abandon its activities.203 An example for this might be a ban for the use of stem cells in biotechnology research. Early-stage high potential companies do not yet have a broad and diversified range of products and services.204 This aggravates the uncertainty of supply surrounding these companies, as they are often dependent on the success of one product or service. If this one fails to be a success on the market, the company might fail already.

2.5.3.4 Uncertainty of Demand The high degree of innovative activity of high potential companies implies that there is a high degree of demand uncertainty, meaning there is little information available whether the expected demand of customers can actually be realized.205 The preferences of their customers are not yet well known since these companies create new products and services. This makes it complicated to develop an appropriate marketing and sales strategy and increases the uncertainty of a marketing success.206 In addition, lifecycles of innovative products and services tend to shorten, causing dynamic uncertainty regarding the continued success of a product.207

202

See Kallmeyer/Canabou (2001), p. 7.

203

See Gabrielsson/Huse (2002); Davila/Foster/Gupta (2003), p. 691.

204

See Lehmann/Weigand (2000), p. 173; Kraus (2002), p. 14.

205

Cf. Amit/Glosten (1990), p. 103; Sapienza/Gupta (1994), p. 1622; Elango et al. (1995), p. 159; Westhead/Storey (1997), p. 197.

206

See Fenn/Liang/Prowse (1995), p. 17.

207

See Bank of England (2001b), p. 1; Westhead/Storey (1997), p. 197.

Characteristics of High Potential Companies

47

2.5.3.5 Competitive Uncertainty The high degree of innovative activity that is characteristic for the new markets in which high potential companies are active implies that there is a high degree of competitive uncertainty. This means that there is little information available regarding the activities of their competitors.208 Because of the intransparent market situation, a venture is unlikely to know who its relevant national and international competitors are and whether a competitor is already offering or developing similar products and services and what kind of strategies they pursue.209 However, competitors might know about the venture’s products and services and could be attracted by expected high returns that these innovations promise and potentially engage in imitation strategies.210 A dominant design for innovative products and services in an industry is often not yet existent.211 This is on the one hand positive as it presents a chance for the company to become the standard setter but on the other hand implies a high degree of uncertainty concerning future developments and standards in the industry.212

2.5.3.6 Dependency on Founders Unity of ownership and management is often a characteristic for high potential companies.213 The founders in their role as owner-managers largely shape corporate strategy and culture and exert thereby a material influence on the development of the venture.214 High-tech start-ups show a strong dependency on their founders, as the success potential of the company is based both on managerial and technological resources,

208

See Barney et al. (1996), p. 262; Bottazzi/Da Rin (2002a), p. 3; Elfring/Baden-Fuller (2000), p. 9; Thornhill/Amit (2000), p. 36; Lindström/Olofsson (2001), p. 154; Cumming (2002), p. 11.

209

See Tykvová (2000), p. 7; Sapienza/Gupta (1994), p. 1622; Amit/Glosten (1990), p. 103; Zaltman/Duncan/Holbeck (1973).

210

See Amit/Glosten (1990), p. 103.

211

See Jain/Kini (2000), p. 1159.

212

For further details see the discussion about first mover advantages as in Jensen (2003); Arnold/Quelch (1998); Patterson (1993); Lieberman/Montgomery (1988); Glazer (1985); Gal-Or (1985).

213

See among others Kulicke (1987), p. 118; Westhead/Cowling (1995), p. 111; Westhead/Wright (1998), p. 175; Roper (1999), p. 235; Tykvová (2000), p. 7; Bank of England (2001a), p. 44; Gabrielsson/Huse (2002), p. 125.

214

See Behringer (1999), p. 14.

48

Characteristics of High Potential Companies

which are linked in the early development of a company. In this respect, high potential companies typically show a distinctive specificity215 of their resource basis as this can easily become worthless when the founding team is not available anymore.216 Consequently, without the founders the companies only have a low liquidation and respectively going-concern value.217 Chapter 2 explained the fundamentals of the resource-based view, which allows understanding how firms can gain a sustained competitive advantage. Assuming a resourcebased perspective on high potential companies led to a categorization of resources that seems very apt to grasp the specifics of high potential companies. It was shown that these companies are characterized by pronounced resource needs. Several ways to close the resource gap were outlined and venture capital was presented as a very suitable possibility to do this. Finally, this chapter showed that venture capitalists have to trade-off the benefits from a high expected return on their investment with the high risks that are inherent in a high potential company. To cope with the sophistication and complexity of investing in high potential companies, they have developed a wellelaborated business model, which is explained in the next chapter.

215

A resource is specific, when its second-best use yields a much lower utility to the user than its first-best use. See Picot/Reichwald/Wigand (2001).

216

Cf. Gompers (1995), pp. 1461 et seq.; Wright/Robbie (1998), p. 525.

217

See Triantis (2001), p. 2.

Business Model of Venture Capital Firms

3

Business Model of Venture Capital Firms

3.1

Introductory Remarks

49

Research on venture capital financing lacks a comprehensive framework, which explains characteristics, activities, and behaviors of venture capital firms. The business model concept seems to be a useful tool to capture these aspects of the venture capital industry. A sound understanding of the business model of a venture capital firm helps to grasp why venture capitalists might want to exert influence on portfolio companies and how they can do it. This chapter proceeds as follows. As the term “business model” still lacks a commonly accepted definition, its concept is at first clarified. A business model builds on three main components: Value creation architecture, customer value proposition, and profit model. Each component is explained in turn for a typical venture capital firm in the following.

3.2

Definition of Business Model Concept

Even though the term “business model” is widely used in practice, it still lacks a generic and widely accepted definition. The first appearance of the term is associated with commercial activities in e-business.218 The internet context still stamps many academic definitions of the term.219 According to TIMMERS, a business model is “an architecture for the product, service and information flows, including a description of the various business actors and their roles; and a description of the potential benefits for the various business actors; and a description of the sources of revenues.”220 Consequently, three important components of a business model can be identified, which are: • Value creation architecture,

218

See Stähler (2001), p. 38.

219

Several authors try to classify internet-based business models. See among others Timmers (1998); Tapscott/Ticoll/Lowy (1999); Pigneur (2000); Amit/Zott (2001); DubossonTorbay/Osterwalder/Pigneur (2002).

220

Timmers (1998), p. 2. Similar definitions are provided by Selz (1999), p. 106; Stähler (2001), pp. 41 et seq. It is important to note, that a business model can always only be an abstract description. See Stähler (2001), p. 42.

50

Business Model of Venture Capital Firms

• customer value proposition, • profit model. The value creation architecture describes processes and structures within the value creation activities of a company.221 This architecture is the basis for the customer value proposition, which in turn describes the utility increase that a company can promise its customers with its products and services. The value that the products and services deliver to the customer is the basis for the profit model of the company, i.e. the way and the sources by which the company can harvest the returns from the value it provided to its customers.222 Figure 13 summarizes the business model concept.

Profit model

Customer‘s value delivers returns to the company

Customer value proposition

Value creation architecture

Figure 13:

Product/service delivers value to the customer

Company delivers product/service to the customer

Generic business model concept

Real-world business models of companies will always differ because of unequal resource sets and varying historic development between companies.223 TIMMONS/BYGRAVE point to the fact that the venture capital industry is not an agglomeration of homogenous firms, but rather a quite diverse group of firms that differ in terms of strategies, goals, resources and organizational forms.224 This fact must be accommodated by acknowledging that every business model is integrated in a specific economic and social context. For instance, the legal framework can have a strong in-

221

See Chesbrough/Rosenbloom (2002), p. 7.

222

See Stähler (2001), p. 47.

223

Several authors argue that the development of individual companies is path-dependent. See among others Penrose (1995); Richardson (1972); Teece (1980). SCHERTLER explicitly shows that path dependencies exist in venture capital markets. See Schertler (2002).

224

See Timmons/Bygrave (1986), p. 163.

Business Model of Venture Capital Firms

51

fluence on the actual design of a venture capitalist’s business model.225 In the next chapters, the concept of business model will be applied to the activities of venture capital firms.

3.3

Customers of Venture Capital Firms

Financing relationships between companies searching for capital and investors providing the required capital can be arranged in three different institutional forms.226 The first is a direct financing relationship between the company and an investor without the involvement of another institution, such as is the case in business angel financing.227 The second is a direct financing relationship using the stock market as the institution to match capital demand and capital supply.228 The third is an indirect financing relationship using an intermediary such as a venture capital firm to bring together capital demand and capital supply.229 The venture capital firm splits the original direct financing relationship between ventures and investors in two separate financing relationships. In the refinancing relationship, the venture capital firm raises money from investors who will later receive returns on their provided capital. In the financing relationship, the venture capital firm invests (smart) money into ventures and participates in their success. Due to its role as intermediary, the venture capital firm has two distinct customer groups: investors and portfolio companies.230 Figure 14 illustrates the two financing relationships of a venture capital firm.

225

See Möller (2003).

226

See Engel (2003), pp. 185 et seq.

227

For a definition of business angels see Nathusius (2004a), p. 115.

228

See Achleitner (2003), pp. 239 et seq.

229

See Leland/Pyle (1977), pp. 382 et seq. Most of the existing research dealing with financial intermediation is focused on banks. See among others Leland/Pyle (1977); Diamond (1984); Ramakrishnan/Thakor (1984); Greenbaum/Thakor (1995); Allen/Santomero (1997); Allen/Santomero (2001). Only few have examined the role of venture capital firms as financial intermediaries in more detail. See Chan (1983); Peeters (1999), p. 122.

230

Cf. Robbie/Wright/Chiplin (1997), p. 9.

52

Business Model of Venture Capital Firms

Return on investment

Investors

Refinancing relationship

Equity participation

Venture capital firm

Money

Figure 14:

Financing relationship

High potential companies

(Smart) money

Financing relationships of a venture capital firm

The investors in venture capital firms are primarily institutional investors such as pension funds, banks, and insurance companies.231 Fund of funds232 continue to grow in importance as capital providers for venture capital firms on a European level.233 However, according to statistics of the BVK, they still play a minor role in Germany.234 Private, public, corporate investors and charitable foundations are as well investors in venture capital firms. In addition, some academic institutions play a significant role as private equity investors in the US.235 Figure 15 shows the distribution of different types of investors in German private equity funds 2003.236 The type of investor that is backing a venture capital firm has potential ramifications on all processes and structures within a venture capital firm and so potentially impacts the behavior, strategies and performance of venture capitalists.237

231

See BVK (2004a), p. 3; EVCA (2003a), p. 3.

232

Fund of funds are specialized in investing in other venture capital funds instead of directly investing in high potential companies. An investment advisor or an investment bank usually organizes them. See Christofidis/Debande (2001), p. 74.

233

See Goldman Sachs & Co./Frank Russell Company (2003), p. 29.

234

See BVK (2004a), p. 3.

235

Among the most important institutions are Harvard University, Yale University, and Princeton University. See Fenn/Liang/Prowse (1995), p. 46.

236

Unfortunately, specific data for venture capital funds are not available in the statistics of the BVK.

237

See van Osnabrugge/Robinson (2001), p. 37; Barry (1994), p. 13.

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53

24.1% - Pension funds

43.2% - Others

11.1% - Banks 1.1% - Corporate investors 1.2% - Fund of funds 4.1% - Public investors

Figure 15:

10.1% - Insurance companies 5.1% - Private investors

Investors in German private equity funds (2003)238

The second customer group of venture capital firms are their portfolio companies, which are due to the strong selection of venture capital firms only high potential companies.239 As already discussed in chapters 2.3 and 2.5, these companies share certain characteristics regarding their growth potential, risk profile and resource needs. In 2003, venture capital-backed companies are active in all kinds of industries such as information technology, biotechnology, medical applications, mechanical engineering, communication technology, trading, electrical engineering, chemicals, new materials, and others. Figure 16 presents the distribution of venture capital investments by BVK members in 2003 according to these industries.

238

See BVK (2004a), p. 3.

239

There is broad literature examining the selection criteria used by venture capitalists to ensure that they only invest in high potential companies. See chapter 3.4.4.3 and Baum/Silverman (2004); Brettel (2002); Zutshi et al. (1999); Zacharakis/Meyer (1998); Muzyka/Birley/Leleux (1996); Bacher/Guild (1996); Hall/Hofer (1993); MacMillan/Zemann/Subbanarasimha (1987); MacMillan/Siegel/Subbanarasimha (1985).

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Business Model of Venture Capital Firms

19.5% - Others

19.6% - Information technology

4.9% - Chemicals and materials 15.0% - Biotechnology

5.4% - Electrical engineering 5.5% - Trading 7.7% - Communication technology

12.8% - Medical applications

9.6% - Mechanical engineering

Figure 16:

Venture capital investments by industries (2003)240

3.4

Value Creation Architecture of Venture Capital Firms

3.4.1

Organizational Structure

Venture capital firms can be classified according to the influence investors have on its investment policy in independent, semi-dependent and dependent funds.241 Figure 17 shows the relative importance of these fund types according to their gross investments in Germany in 2003. Independent funds are dominant in the German private equity industry accounting for 77.1% of gross investments. These funds are backed by many different investors and are organizationally not linked to one of their investors.242 A single investor does not control more than 20% of the shares of an independent venture capital firm.243 Few independent public funds exist that are stock market-listed such as bmp AG, Deutsche Beteiligungs AG and Deutsche Effecten- und Wechsel-Beteiligungsgesellschaft AG in Germany as well as 3i Group plc in the UK.

240

See BVK (2004b), p. 3.

241

Cf. BVK (2004b), p. 3.

242

See Bader (1996), p. 154.

243

See BVK (2004a), p. 35.

Business Model of Venture Capital Firms

4.6% - Government-dependent funds

55

2.0% - Semi-dependent funds

16.3% - Dependent funds

77.1% - Independent funds

Figure 17:

Private equity market share of investment companies (2003)244

Dependent funds account for 16.3% of gross investments in the German private equity industry. A dependent fund is characterized by the fact that one of its investors holds more than 50% of its shares.245 If an investor fully controls the venture capital firm, one speaks of a captive fund in case the investor is a financial institution or of a corporate venture capital fund in case the investor is an industrial company.246 Whereas the vast majority of venture capital firms only pursue financial goals247, corporate venture capital funds also pursue strategic goals.248 Examples for strategic goals are access to new technologies, often called “window on technology”249, access to new products/services and processes as well as access to potential M&A candidates.250 Due to the fact that corporate venture capital represents a very different stance towards invest-

244

Unfortunately, these data do not distinguish between venture capital and private equity (buyout) funds. See BVK (2004a), pp. 14, 35.

245

See BVK (2004a), p. 35.

246

Cf. Achleitner/Müller (2004), p. 15.

247

See van Osnabrugge/Robinson (2001), p. 25.

248

See Working Council for Chief Financial Officers (2000).

249

See Abell (1978).

250

See Working Council for Chief Financial Officers (2000). RÖPER provides a detailed overview over corporate venture capital activities in Germany and the US. See Röper (2003).

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Business Model of Venture Capital Firms

ing in high potential companies, this analysis does not consider corporate venture capital firms.251 Government-dependent funds account for 4.6% of gross investments in the German private equity industry. They include the activities of fully state-backed investment companies such as KfW Mittelstandsbank with its public support schemes. Additionally, the activities of so-called “Mittelständische Beteiligungsgesellschaften”, i.e. regional investment companies with strong financial backing from governmentinfluenced investors, are also included. The establishment of these investment companies has been supported by the German federal states. Their investors are institutions from the respective federal state, the local banking community and often the respective regional chambers of industry and commerce. Semi-dependent funds play a minor role in Germany accounting for only 2% of gross investments in the German private equity industry. These funds are backed by several investors with one investor owning between 20% and 50% of the shares of the venture capital firm.252 They often evolve from captive funds, after these have proven their capability of generating attractive returns. Following a cross-selling approach, the parent company might then invite other institutional and private investors to co-invest into the fund.253 Besides the influence of their investors, venture capital funds can also be classified according to their lifetime. The typical venture capital firm is structured as a closed-end fund.254 The lifetime of a closed-end fund varies between seven and ten years.255 An option to extend the fund’s life for up to three years can often be observed in practice.256 These funds usually apply an upper limit to the fundraising volume within a specified subscription period. Contributions by investors after the end of the subscription period 251

POSER conducts a study that is in some aspects closely linked with this analysis. However, he employs the resource-based view to explain the potential of competitive advantages for the parent company through corporate venture capital programs. See Poser (2003).

252

See BVK (2004a), p. 35.

253

See Bader (1996), p. 154.

254

See Feinendegen/Schmidt/Wahrenburg (2003), p. 4.

255

See Kenney (2000), p. 3 and Lin/Smith (1998), p. 244. In the early 1990s, most private equity funds did not specify a lifetime, whereas in the late 1990s, more than 60% of new funds raised were closed-end funds. See Schertler (2001), p. 55.

256

See Barry (1994), p. 4.

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57

are not possible.257 Returns from its investments are distributed to the investors at the latest at the end of the fund’s lifetime. Open-end funds258 have no pre-defined liquidation date. Investors can usually make subscriptions to the fund at any time, as there is no upper limit to the managed volume of the fund. Returns from its investments are usually reinvested in the fund.259 In general, open-end funds play a less important role than closed-end funds in the venture capital market.260 However, two organizational forms of venture capital firms are important that share similar characteristics to open-end funds: • Independent public funds do not define a liquidation date and allow further contributions of investors by resolution of the general meeting. • Many government-dependent funds have an infinite lifetime and their investors can contribute further by resolution of the general meeting. Furthermore, venture capital firms can be classified according to their legal structure. Since the emergence of venture capital, there has been significant institutional experimentation with the legal structure of venture capital firms.261 In practice, there are two important types of legal structure: A partnership structure and a corporate holding structure. The partnership structure in the form of a limited partnership is the dominant organizational form of independent venture capital firms.262 According to this structure, a venture capital firm consists of a management company and one or more investment funds.263 The management company is responsible for administering the investment fund and its investments whereas the investment fund is constrained to the role of holding the shares of the portfolio companies.264 The management company itself is

257

See Zemke (1995), pp. 25 et seq.

258

Another common expression is evergreen fund. See Christofidis/Debande (2001), p. 10

259

See Christofidis/Debande (2001), p. 10

260

See Wahl (2004), p. 56, footnote 222.

261

See Kenney (2000), p. 3.

262

See Achleitner/Müller (2004), p. 13; Kenney (2000), p. 3; Bader (1996), p. 155; Barry (1994), p. 4; Sahlman (1990), pp. 473, 489 et seq.

263

See Fenn/Liang/Prowse (1995), p. 416.

264

See Zemke (1995), p. 114.

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Business Model of Venture Capital Firms

either a limited liability corporation or a stock corporation and functions as the general partner of the investment fund partnership.265 The general partners usually invest personal assets in the investment fund. Typically, this capital commitment amounts to 1% of the total fund volume.266 The investors act as limited partners of the investment fund and provide the remaining 99% of the total committed capital of the fund. Figure 18 shows the standard partnership structure of a venture capital firm.

General partner: management company

Money and operational management

Limited partners: investors

Figure 18:

Money Return on investment

Return on investment, management fee, carried interest

Limited partnership: investment fund

Money Portfolio companies Equity participation

Partnership structure of a venture capital firm267

Besides the partnership structure, a second organizational structure of venture capital firms is important. The corporate holding structure is an organizational form of a venture capital firm in which management company and investment fund form a single organizational entity with infinite lifetime. Actually, the latter is in many aspects very similar to a financial holding, which holds and manages majority and minority interests in other companies.268 However, there are two major differences of a venture capital firm in comparison with a financial holding:269

265

Thereby, it becomes possible to avoid a personal liability of the venture capitalists.

266

See Hagenmüller (2004), p. 18 and Bader (1996), p. 156.

267

Based on Hagenmüller (2004), p. 18 and Bader (1996), p. 156.

268

See Achleitner/Müller (2004), p. 11.

269

See Achleitner/Müller (2004), p. 21.

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59

• Whereas a financial holding usually does not have an interest in influencing its portfolio companies, a venture capital firm might well exert some influence on its portfolio companies, • Whereas a financial holding has a long-term interest in holding stakes in its portfolio companies, a venture capital firm is actually exit-oriented right from the beginning.

3.4.2

Personnel Structure

Venture capital firms are flat organizations and their managerial resources are limited.270 Among the professional staff, there are often only three hierarchical levels such as Managing Directors, Investment Managers and Analysts. THE GERMAN VENTURE CAPITAL ASSOCIATION analyzes the personnel structure of German investment companies.271 Unfortunately, this study does not differentiate between venture capital and private equity firms. Therefore, this analysis presents the study’s results under reserve since no research has yet been undertaken that discusses differences in organizational structure between venture capital and private equity firms.272 In general, venture capital and private equity firms are also small organizations as Figure 19 demonstrates. About 83% of German venture capital and private equity firms employ only up to ten professionals.

270

See Fried/Bruton/Hisrich (1998), p. 496.

271

See BVK (2003).

272

However, differences are assumed minor since many investment companies pursue a generalist approach, meaning that they not only invest in start-ups but also in more established companies and could therefore be classified as venture capital and private equity firm.

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Business Model of Venture Capital Firms

5% - more than 25 professionals 12% - up to 25 professionals

52% - up to 5 professionals

31% - up to 10 professionals

Figure 19:

Number of professionals273

The educational background of venture capitalists and private equity investors is shown in Figure 20. Academics dominate the industry, mainly from the fields of business/economics, natural science, and engineering science. Among venture capitalists and private equity investors, 16% hold a MBA degree and 22% a PhD degree.

Business administration/economics

50%

Natural/engineering science Law MBA

39% 10% 16%

PhD Other

Figure 20:

22% 15%

Educational background274

Managing Directors have typically over ten years of relevant professional experience, whereas Investment Managers have more than six years.275 Analysts are sometimes hired without any previous professional experience. Most venture capitalists and pri273

See BVK (2003), p. 6.

274

See BVK (2003), p. 14.

275

See BVK (2003), p. 14.

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61

vate equity investors collected their professional experience in industrial corporations, financial institutions and auditing and consulting firms as is shown in Figure 21.

Industrial corporations

70%

Financial institutions

66%

Auditing and consulting firms

38%

Research institutes

26%

Government institutions Law firms

23% 8%

Other

Figure 21:

45%

Professional background276

Venture capital and private equity firms are often organized in separate teams that specialize on certain industry sectors or regions. However, this is rather relevant for larger investment companies. Techno Venture Management (TVM), a typical example and a leading transatlantic venture capital firm, has a life science and an information and communication technology team.277 Figure 22 shows that 34% of venture capital and private equity firms have teams specialized on industries whereas only 9% have teams specialized on certain regions.

276

See BVK (2003), p. 15.

277

See Techno Venture Management (2004).

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Business Model of Venture Capital Firms

20% - not specified

37% - teams are not specialized

9% - teams are specialized on regions

34% - teams are specialized on industry sectors

Figure 22:

Specialization in teams278

To complement missing specialist knowledge within venture capital firms, a scientific advisory board is often present. These advisors can be consulted when venture capitalists need specific advice on key areas of technology.

3.4.3

Refinancing Process

3.4.3.1 Overview A venture capital firm usually manages several closed-end investment funds. For each fund, the venture capitalists have to manage a refinancing process, which consists of three sub-processes as shown in Figure 23: • The first is the fundraising process, which means that venture capital firms raise money from investors. • In the second process, venture capitalists engage in investor relations. • Parallel to this process, venture capitalists also start the process of distributing returns from investments back to their investors.

278

See BVK (2003), p. 8.

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63

Investor relations process

Fundraising process Fund pre-marketing

Figure 23:

Fund due diligence

Fund structuring

Fund closing

Distribution of of Distribution returns process returns

Refinancing process

3.4.3.2 Fundraising Process The fundraising process can be classified in four consecutive phases.279 The time required to raise a venture capital fund in the European market amounts on average 14 months with a standard deviation of 8 months.280 Success in fundraising efforts is strongly dependent on public capital market conditions, as in times of good performance of public markets more capital and at better conditions can be raised.281 The first phase of the fundraising process is fund pre-marketing. This comprises rather informal announcements and talks of venture capitalists to potential investors. These early contacts with investors are important to gauge overall interest and trends in the venture capital market from an investor’s perspective.282 The gathered information feed in the private placement memorandum, which principally serves a similar function as the offering prospectus for public capital markets. This document essentially contains all information needed by the investor to make an investment decision.283 It also includes an analysis of the targeted venture market and a clearly defined investment strategy. The memorandum conveys the composition and reputation of the fund management team.284 In addition, it also presents the envisaged legal fund structure with

279

This is a condensed description of the fundraising process, which is sufficient for the present purpose. Other authors segment the fundraising process in a more detailed way. HAGENMÜLLER proposes six phases whereas the EVCA even suggests eight phases. See Hagenmüller (2004), p. 72; EVCA (2000), p. 7.

280

See Hagenmüller (2004), p. 84. A study undertaken by EVCA states that general partners require about 15 months to raise a new fund. See EVCA (2000), pp. 7 et seq. BROOKS states that fundraising usually takes between 12 and 18 months. See Brooks (1999), p. 112.

281

See Gompers/Lerner (2001), p. 153.

282

See Brooks (1999), p. 112.

283

See Brooks (1999), p. 102.

284

See Brooks (1999), p. 102.

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Business Model of Venture Capital Firms

detailed terms and conditions. The distribution of the private placement memorandum to potential investors marks the end of the pre-marketing phase.285 The second phase of the fundraising process is fund due diligence. In this phase, investors might require further documents from the venture capitalists to carry out a detailed due diligence.286 Figure 24 lists investment criteria of investors according to their importance regarding their investment decision. It reveals that the investment process and the track record of the venture capitalists are the most important criteria for investors when deciding to invest in a specific fund.

Investment process

78%

Track record

75%

Quality of internal organization

72%

Fit with asset allocation strategy

69%

Perceived deal flow

66%

Recommendation of third parties

61%

Name recognition of general partners Comfort level with other investors Name recognition of sponsors

Figure 24:

42% 26% 24%

Importance of investors’ investment criteria287

Personal meetings between venture capitalists and individual investors take place to discuss further details of a potential investment. Early on, venture capitalists seek a commitment from a sponsor, i.e. a reputable investor that is willing to commit himself

285

See Hagenmüller (2004), p. 72.

286

See Hagenmüller (2004), p. 73.

287

See Goldman Sachs & Co./Frank Russell Company (2001), p. 42. Numbers indicate the degree of importance according to a scale with 0 being least important and 100 being most important.

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65

to invest prior to other investors.288 This facilitates the acquisition of additional investors, in particular for first-time funds. The third phase of the fundraising process is fund structuring. In this phase, venture capitalists and investors refine the terms for the partnership agreement, which is a legal document that essentially specifies the compensation structure for the fund management, the distribution scheme of costs and profits, and covenants.289 Three classes of covenants can be differentiated290: • Covenants relating to overall fund management, • covenants relating to the activities of the general partner, • covenants restricting the type of investment. In the fund structuring phase, the final commitment, which is the total amount that is to be contributed to the limited partnership by each limited partner, is defined. The most important terms that investors look at are the compensation of the general partner, the preferred rate of return291 and the capital commitment by the general partner.292 The fourth and final phase of the fundraising process is fund closing. An upper and a lower capital size limit are usually applied to a venture capital fund. The first closing of the fund is realized when sufficient investors commit to invest the required minimum aggregate amount for the fund to be established.293 The venture capital firm then can start to invest in promising start-ups. A final second closing or additional closings usually take place several months later.294

288

See Hagenmüller (2004), p. 81.

289

See Feinendegen/Schmidt/Wahrenburg (2003); Gompers/Lerner (1996).

290

See for further details regarding the legal structure of a partnership Feinendegen/Schmidt/Wahrenburg (2003); Möller (2003); Gompers/Lerner (1996).

291

Feinendegen/Schmidt/Wahrenburg (2003), p. 1170. The preferred return is calculated by a hurdle rate that is specified in the partnership agreement. The hurdle rate is a minimum annual rate of return that has to be achieved on the investors’ commitment before any profit participation of the general partner is payable.

292

See Goldman Sachs & Co./Frank Russell Company (2001), p. 43.

293

See BVCA (2002), p. 7.

294

See Hagenmüller (2004), p. 73.

agreement

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Business Model of Venture Capital Firms

3.4.3.3 Investor Relations Process After the fundraising process is completed, the venture capital firm has to initiate the investor relations process.295 Investor relations are the strategic and continuous management of the relationship between a venture capital firm, its investors and the private equity investor community.296 The primary addressees of investor relations are the limited partners. The private equity investor community as a source of potential future investors and opinion leaders such as placement agents, investment advisors, and journalists can be seen as secondary addressees.297 On the one hand, investor relations are a requirement of the partnership agreement. On the other hand, through investor relations, venture capital firms maintain good relations to the investors for future fundraising aspirations. In fact, investor loyalty is a valuable asset for a venture capital firm.298 Instruments of investor relations can be classified in personal and impersonal instruments.299 Among personal instruments is the general investors’ meeting of limited partners, which follows a standard format and leaves little space for direct interaction. Therefore, one-on-one meetings, i.e. direct talks between general partner and limited partners, are led frequently. One-on-ones are widely used as they allow satisfying the individual information needs of limited partners and the limited group of investors allows doing it.300 General partners from large funds often go on a road show, which is a business trip involving many one-on-one meetings with limited partners. Investors’ committees, advisory or supervisory boards are increasingly common in venture capital funds.301 Limited partner send representatives to such an institution to meet once or

295

For a detailed description of the investor relations process see Hagenmüller (2004), pp. 109 et seq.

296

Cf. Hagenmüller (2004), p. 24 and Achleitner/Bassen (2001), p. 7. A broader definition of the term investor relations is proposed by Lindner in the context of public companies, who also includes the IPO process into the definition. See Lindner (1999), pp. 18 et seq. The National Investor Relations Institute proposes a very broad understanding of the term by stating that investor relations is relevant to every firm. According to this definition, “investor relations is a strategic, executive function of corporate management. It combines the disciplines of marketing, finance, and communications to provide present and potential investors with an accurate portrayal of the company’s performance and prospects.” National Investor Relations Institute (1994), p. 2.

297

See Hagenmüller (2004), p. 107.

298

See Brooks (1999), p. 114.

299

See Hagenmüller (2004), p. 114.

300

See Hagenmüller (2004), p. 116.

301

See EVCA (2000), p. 13.

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67

twice a year in order to discuss issues concerning the fund, to resolve conflicts of interest between general and limited partners and to provide guidance regarding reporting standards.302 Impersonal instruments are another important way of communicating with investors. Press releases allow addressing a broad investor community. Typically, a successful closing of a fund or a new investment is announced via a press release.303 Venture capital firms report to their investors on a regular basis, usually quarterly, about the development of the fund.304 Reports include the highlights of the period, updates on each portfolio company, explanations of any changes in progress or valuation, an account of fund performance and a capital account, which details the change in an investor’s equity and capital contributions over the reporting period.305 It is important to provide investors with consistent information to allow an accurate assessment of fund performance over time and against other funds and other assets classes.306 Venture capitalists need to provide this information timely, as investors are used to public market investments where valuation data is almost instantaneously available.307 Several different metrics exist to measure the performance of a fund.308 The standard measure of return on a fund is the internal rate of return (IRR). The IRR is the net return earned by limited partners in a certain period. It is calculated as an annualized effective compounded rate of return using monthly cash flows to and from limited partners, together with the residual value of the fund as a terminal cash flow to limited partners. The distribution to paid-in (DPI) measures the cash-on-cash return of a fund. It is calculated as the proportion of cumulative net distributions returned to limited partners to cumulative paid-in capital. The residual value to paid-in (RVPI) measures a fund’s unrealized return on investment. It is calculated as the limited partners’ interest held with the fund, relative to the cumulative paid-in capital and is net of payments to the general partner. Finally, the total value to paid-in (TVPI) measures the multiple by 302

See EVCA (2000), p. 13; Brooks (1999), p. 116.

303

See Hagenmüller (2004), p. 115.

304

See Hagenmüller (2004), p. 114.

305

See Brooks (1999), p. 115.

306

See Brooks (1999), p. 115.

307

See Brooks (1999), p. 115.

308

For the following description of performance metrics, see EVCA (2003b).

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Business Model of Venture Capital Firms

which net distribution to limited partners exceeds their paid-in capital. The TVPI is calculated as the sum of DPI and RVPI. Figure 25 shows these performance measures for the long-term return on European venture capital and private equity funds.

Type of investment

Number of funds

Pooled IRR

DPI

RVPI

TVPI

Early stage

187

5.1

0.47

0.70

1.17

Development

137

10.6

0.87

0.78

1.65

Balanced

113

11.4

0.70

0.70

1.40

437

10.4

0.73

0.70

1.43

265

14.2

0.70

0.68

1.38

Generalists

63

10.4

0.94

0.50

1.44

All private equity

765

11.5

0.74

0.65

1.39

All venture capital Buyouts

Figure 25:

Performance of European private equity (1980-2002)309

3.4.3.4 Distribution of Returns Process Closed-end funds usually work on the basis that capital is called for or drawn down in stages or tranches.310 In closed-end funds, investors are usually opposed to the reinvestment of capital.311 Therefore, they ask for the distribution of returns as soon as the fund’s first investment has been liquidated, which is usually after a few years of the fund’s existence. Consequently, it is common to see investors never reach the position of having invested the entirety of its total commitment in the partnership at any one time, due to the investment phase overlapping with the liquidation phase.312 Figure 26 illustrates the typical structure of cash flows to investors from a closed-end fund.

309

See EVCA (2003b).

310

See BVCA (2002), p. 7.

311

See Brooks (1999), p. 111. However, some exceptions might apply, see BVCA (2002), p. 8.

312

See BVCA (2002), p. 8.

Business Model of Venture Capital Firms

69

250 225 200

in % of committed capital

175 150 125 100 75 50 25 0 -25 -50 -75 1

2

3

4

5

6

7

8

9

10

Year

Investment phase Liquidation phase Distributions

Figure 26:

Draw-downs

Cumulated cash flow to investors

Typical structure of cash flows to investors313

This chapter explained how venture capitalists interact with their investors to raise money. The next chapter discusses how venture capital firms invest this money in high potential companies.

3.4.4

Investment Process

3.4.4.1 Overview Each investment of a venture capital firm has to pass through the investment process of a venture capital firm. There are several approaches to conceptualize this investment process.314 The standard model is developed by BRUNO/TYEBEE, who differentiate between the phases deal origination, deal screening, deal evaluation, deal structuring, and post-investment activities.315 The present analysis largely follows ACHLEIT-

313

Based on Hagenmüller (2004), p. 21.

314

The earliest version of a venture capital investment process is found in Wells (1974).

315

See Tyebjee/Bruno (1984a), p. 1051. This is further refined by FRIED/HISRICH in the phases origination, venture capital firm-specific screen, generic screen, first-phase evaluation, second-phase evaluation, and closing.

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Business Model of Venture Capital Firms

in decomposing the investment process in five distinct phases316: investment origination, investment due diligence, investment structuring, investment development, and investment exit. Figure 27 shows a schematic investment process of a venture capital firm.317 NER

Investment origination

Figure 27:

Investment due diligence

Investment structuring

Investment development

Investment exit

Investment process

It usually takes several months to go to through the process from investment origination to the closing of the deal in the investment structuring phase. However, the actual duration of this pre-contractual investment process varies with the complexity of the due diligence, the urgency of the financial need of the venture and the number of parties involved in the transaction.318 FRIED/HISRICH show that venture capitalists usually dedicate about 130 hours of their time until the closing of a deal.319 The subsequent post-contractual investment process, including investment development and investment exit, is of long-term nature and typically spans several years.320

3.4.4.2 Investment Origination To be a successful venture capital firm, it is decisive to attract an attractive dealflow.321 In quantitative terms, this means having a large number of potential deals from

316

See Achleitner (2001), p. 527.

317

This investment process does not include the syndication process of venture capital investments since this is not the focus of the present analysis. Syndication is the joint and simultaneous investment of venture capitalists in their portfolio companies. For a thorough discussion of the specifics of syndicated venture capital deals, see Nathusius (2004b).

318

See Vogel (2001), p. 1053.

319

See Fried/Hisrich (1994), p. 31.

320

See Stolpe (2003), p. 61.

321

Deal-flow is an expression for all investment opportunities of a venture capital firm. See Dotzler (2001), p. 6; DRI-WEFA (2002), p. 7.

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71

which to choose. 322 In qualitative terms, this requires finding companies with an outstanding growth potential and investing in them at financial terms that still allow for extraordinary capital gains.323 The continuity and sustainability of the deal-flow is highly important when it comes to secure the long-term existence of a venture capital firm.324 The investment process begins with the first contact to a (high potential) venture. This contact can be established either directly between the company and the venture capital firm or indirectly by third parties. Frequently, venture capital firms receive a business plan directly from a venture without any prior contact. However, these so-called “cold calls”325 are usually not successful in raising capital from venture capital firms.326 In contrast to this reactive approach of venture capitalists waiting for deals to come to their desk, they can also try to establish contacts to high potential companies themselves.327 For instance, venture capital firms can attempt to meet potentially interesting candidates on fairs and conferences.328 Another opportunity is a “technology scan”, i.e. a sort of dragnet investigation for companies with a certain technology.329 Similarly, this can also be done for companies of a certain industry in the form of a “sector scan”. In general, the active search of a venture capital firm for potential investees is rather unusual.330 Ultimately, the competitive situation between venture capital companies determines the extent of an active search for investees.331 For the most part, promising deals come through recommendation from third parties.332 Several professional intermediaries and service providers such as banks, lawyers, accountants, and consultants play an important role in matching companies seeking fi322

See Lockett/Wright (1999), p. 307.

323

See Wright/Robbie (1998), p. 536.

324

See Lockett/Wright (1999), p. 308.

325

See Tyebjee/Bruno (1984a), p. 1053.

326

See Fried/Hisrich (1994), p. 31.

327

See Wright/Robbie (1998), p. 536.

328

See Tyebjee/Bruno (1984a), p. 1055.

329

See Tyebjee/Bruno (1984a), p. 1053.

330

See Sweeting (1991), p. 603.

331

See Wright/Robbie (1998), p. 536.

332

See Sweeting (1991), p. 603.

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nancial resources with venture capital firms.333 Recommendations from other venture capital firms play a particularly important role in realizing an attractive deal-flow. This happens often because of considerations to syndicate a deal.334 A motivation for syndicating venture capital deals is the anticipation of future reciprocal behavior.335 It is assumed that today’s invitation to a promising deal entails a return invitation in the future. Recommendations by managers or employees of former portfolio companies are also an attractive source of promising deals.336 There are also consultants that specialize on supporting start-ups in their fundraising efforts and go with the ventures all the way to the final closing of the deal.337 These socalled gatekeepers increase competition between venture capital firms, but their involvement is certainly also associated with additional costs, which makes a potential deal opportunity less interesting for venture capitalists.338 The recommendation of a company through professional third parties is generally perceived to be a signal of quality.339 Often, venture capitalists do not attach a great deal of importance to the business plan but rather rate personal recommendations as being more important.340 Even with international venture capital firms, a fine-spun local network is of prominent importance in attracting a promising deal-flow.341 Reputation and public perceptions determine the number of deals that come to the attention of a venture capital firm.342 The public visibility of a venture capital firm can be leveraged through membership in industry associations such as the German BVK or the European EVCA. Besides, a series of marketing tools is available to increase name

333

See Tyebjee/Bruno (1984a), p. 1055; Fenn/Liang/Prowse (1995), p. 29; Dotzler (2001), p. 7.

334

See Dotzler (2001), p. 7

335

See among others Nathusius (2004b); Manigart et al. (2002), p. 3 and Lockett/Wright (1999), pp. 307 et seq.

336

See Fenn/Liang/Prowse (1995), p. 29; Wright/Robbie/Ennew (1997), p. 228; Dotzler (2001), p. 7.

337

See Fenn/Liang/Prowse (1995), pp. 51 et seq.

338

See Fenn/Liang/Prowse (1995), pp. 29 et seq.

339

See Tyebjee/Bruno (1984a), p. 1065.

340

See Steier/Greenwood (1995), p. 337.

341

See Dixit/Jayaraman (2001), p. 43.

342

See Smart/Payne/Yuzaki (2000), p. 18; Manigart et al. (2002), p. 7.

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recognition, such as sponsoring, organization of special events, internet presence, publications, and interviews.343

3.4.4.3 Investment Due Diligence Venture capital firms receive a large number of offers in the investment origination phase. Ultimately, they only invest in very few selected companies, usually between 1% and 2% of the total deal-flow.344 Venture capital firms only dispose of limited financial resources and need to invest them carefully to achieve the ambitious performance goals set by their investors. During the investment due diligence phase, venture capitalists act as scouts trying to find the most promising investments on the market.345 Venture capitalists first check whether the company fits to the overall portfolio strategy and whether the venture capital firm brings along the required competencies for the post-investment support activities.346 This takes normally only about 15 minutes.347 Typically, the investment volume in a portfolio company is subject to a lower and upper limit. The lower limit is determined by the fact that venture capital firms are run by few people that have limited time resources.348 Venture capitalists cannot afford to spread the fund’s capital over too many portfolio companies since the time effort in supporting the ventures during the investment development phase is independent of the amount invested.349 The upper limit is determined by the fund’s overall capital base and its intended degree of diversification across a number of investments.350 Syndication allows investing in deals that would be too big if the venture capital firm invested alone.351

343

See Peeters (1999), pp. 124-129; Dotzler (2001), p. 6.

344

See Fenn/Liang/Prowse (1995), p. 30; Anonymous author (1999), pp. 13 et seq.

345

See Baum/Silverman (2004), p. 413.

346

See Tyebjee/Bruno (1984a), p. 1053.

347

See Sweeting (1991), p. 610.

348

See Robinson (1987), p. 69; Gorman/Sahlman (1989), p. 235; Sapienza/Manigart/Vermeir (1996), p. 444; Gifford (1997), p. 474; Giudici/Paleari (2000), p. 155.

349

See Manigart/Baeyens/van Hyfte (2002), p. 106.

350

See Tyebjee/Bruno (1984a), p. 1056.

351

See Tyebjee/Bruno (1984a), p. 1056.

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Business Model of Venture Capital Firms

In addition to the limited investment volume, the investment strategy of a venture capital firm is often characterized by a focus on certain financing phases of their portfolio companies as capital and support needs can largely differ. It is also common investment policy of venture capitalists not to invest in direct competitors of portfolio companies.352 Geographical proximity is often quoted as another prerequisite to be a potential target for the venture capital firm.353 Finally, venture capitalists only invest in independent companies, as conflicts of interests would be foreseeable in case another company could block major strategic decisions.354 Venture capitalists are generalists and cannot build up expert knowledge in every technology or industry they invest in, but specialize on few of them.355 BYGRAVE points to the fact that venture capital firms have to specialize to profit on learning effects, networks, and reputation.356 This becomes particularly important during the investment development phase. In general, venture capital firms try to reduce their risk exposure by specialization.357 After this short initial screening of potential candidates, the venture capital firm starts the actual due diligence process that usually takes three months.358 The main areas covered in this process are human resources due diligence, market due diligence, technical due diligence, financial due diligence, legal and tax due diligence, organizational, and information technology due diligence.359

352

See Tyebjee/Bruno (1984a), pp. 1056 et seq.

353

See Fenn/Liang/Prowse (1995), p. 34; Bank of England (2000), p. 68; Fuchs (2001), p. 2; Gompers/Lerner (2001), p. 156; Krauss/Stahlecker (2001), p. 148; Shepherd/Zacharakis (2001), p. 144; Carlsson (2002), p. 118.

354

Independent start-ups are companies where the founders act on their own account. The European Commission defines independence by the fact that no other organization holds 25% or more of the shares of a company. Exceptions to this rule are stakes of investment companies that regularly invest in other companies. See European Commission (2002b), pp. 2 et seq.

355

See Tyebjee/Bruno (1984a), p. 1057; Norton/Tenenbaum (1993), pp. 431 et seq.

356

See Bygrave (1987); Bygrave (1988).

357

See Norton/Tenenbaum (1993), pp. 431 et seq.; Brettel/Thust/Witt (2001), pp. 13 et seq.

358

See Fried/Hisrich (1994), p. 31.

359

See Natusch (2002).

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A full due diligence involves a deeper analysis of the business plan, talks with the management and visits to the company’s premises.360 Venture capitalists often involve outside experts in the evaluation of the company. Technology experts from university departments, technology consultants, patent advisors, and market research consultants are hired on a project basis to support the due diligence process.361 In addition, venture capitalists also involve persons from the direct environment of the potential portfolio company, such as suppliers, customers, and competitors as they usually offer very valuable insights due to their continuous interaction with the company.362 Within this process, the venture capital firm intensively checks on four important dimensions of the potential portfolio company: management, market, product/service and financials. Venture capitalists check on these dimensions to ensure that they are actually financing a high potential company. If the due diligence shows that a company does not have the required growth potential, the investment process is ended at that point. Figure 28 gives an overview of the literature regarding the importance of these investment criteria and shows a meta ranking across all studies. The most important decision criterion is the management team. There is broad consensus in the literature regarding the prime importance of the top-management team for the success of a venture.363 Excellence in leadership, industry expertise, track record, and management capabilities of the founding team are highly important to venture capitalists.364 The second most important decision criterion is the company’s target market. A significant size365 coupled with a significant market growth rate and large entry barriers are factors that positively affect the venture capitalist’s decision to in-

360

See Heyning (1999), pp. 157 et seq.

361

See Heyning (1999), p. 160.

362

See Natusch (2002), p. 542.

363

See Baum/Silverman (2004); Franke et al. (2003); Brettel (2002); Smart (1999); Fried/Hisrich (1994); Hall/Hofer (1993); Lant/Milliken/B. (1992); Hambrick/D'Aveni (1992); Finkelstein/Hambrick (1990); MacMillan/Zemann/Subbanarasimha (1987); MacMillan/Siegel/Subbanarasimha (1985); Hambrick/Mason (1984).

364

See Muzyka/Birley/Leleux (1996), p. 281.

365

SAHLMAN states that a company that cannot reach annual revenues about $50m in five years will have a hard time finding venture capitalists willing to invest in the company. See Sahlman (1997), p. 101.

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vest.366 The third most important decision criterion is the company’s products and services. They should be unique and proprietary and it should be possible to protect them with IPR. In general, the company’s products and services must feature a sustainable competitive advantage.367 The financials are the fourth most important decision criterion. Venture capitalists look for example for a short time to break-even and a good opportunity to exit the investment with high rates of return.368

Study

Management

Market

Product/service

Financials

Tyebjee/Bruno (1984)

1

3

—

2

MacMillan/Siegel/Subbanarasimha (1985)

1

2

4

3

Carter/van Auken (1994)

1

2

3

4

Bacher/Guild (1996)

1

2

3

4

Muzyka/Birley/Leleux (1996)

1

4

2

3

Zutshi et al. (1999)

1

2

3

4

Pries/Guild (2001)

1

2

3

4

Brettel (2002)

1

3

2

4

Meta ranking

1

2

3

4

Figure 28:

Importance of venture capitalists’ investment criteria369

However, there is some discussion about the reliability of the results mentioned in Figure 28. Most studies in this area rely on post-hoc methodologies which typically suffer from problems of recalling past information.370 Furthermore, there are indications that venture capitalists might be biased in their evaluations.371 In particular, FRANKE ET AL. show with regard to the management team criterion that venture capi366

Cf. MacMillan/Siegel/Subbanarasimha (1985), p. 121; Muzyka/Birley/Leleux (1996), p. 281.

367

Cf. MacMillan/Siegel/Subbanarasimha (1985), p. 121; Muzyka/Birley/Leleux (1996), p. 281.

368

See Carter/van Auken (1994), p. 66.

369

See Brettel (2002); Pries/Guild (2001); Zutshi et al. (1999); Muzyka/Birley/Leleux (1996); Bacher/Guild (1996); Carter/van Auken (1994); MacMillan/Siegel/Subbanarasimha (1985); Tyebjee/Bruno (1984b). The meta ranking was derived by calculating the average rank across all studies. Some studies did not feature ranks for the given criteria.

370

See Shepherd (1999); Zacharakis/Meyer (2000).

371

See Franke et al. (2003); Shepherd/Zacharakis/Baron (2003); Zacharakis/Meyer (2000).

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talists prefer founding teams that share major characteristics with themselves.372 Due to the limited amount of data that is available for basing the venture capitalist’s decision on and the apparent inappropriateness of over-sophisticated analytical techniques, evaluations during the due diligence phase therefore often involve much subjectivity. Consequently, mutual trust and a smooth information exchange are required to pass successfully the investment due diligence phase.373

3.4.4.4 Investment Structuring After the investment due diligence, the venture capital firm enters into negotiations about contractual agreements with the potential portfolio company, which cover mainly the financial instruments and additional investor rights that will define the formal relationship between the two parties. The outcome of these negotiations is highly dependent on the distribution of bargaining power between the venture capital firm and the potential portfolio company. The actual financial and legal terms related to a transaction are summarized in a legally non-binding term sheet.374 These terms are negotiated during the investment structuring phase and are finally included in various legal documents such as the shareholders’ agreement, the articles of association, the bylaws of the management and supervisory board, and the employment contracts of the management team. Venture capital firms invest in high potential companies primarily using equity and equity-linked financial instruments. Figure 29 shows the importance of various classes of financial instruments in the German venture capital and private equity industry in 2003.

372

See Franke et al. (2003), p. 4. Similarity biases have also been found in other research fields such as personnel management and marketing. See Franke et al. (2003), p. 5.

373

See Sweeting (1991), p. 604.

374

See Wilmerding (2003), p. 31.

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Used financial instrument Straight and preferred equity Quasi equity and silent partnerships Mezzanine Shareholder loans Total

Figure 29:

Volume in €m

Relative frequency

1,887.31

78.1%

299.52

12.4%

77.50

3.2%

151.07

6.3%

2,415.40

100.0%

Venture capital and private equity financial instruments (2003)375

Straight and preferred equity are the important financial instruments in the German private equity industry: 78.1% of the investment volume of BVK-listed investment companies is done with equity. The remaining 22.9% of the investment volume are structured in the forms of quasi equity, silent partnerships, mezzanine capital, and shareholder loans.376 Common stock (straight equity) is created when a company is incorporated. All common stockholders share the same level of risk and return. In Germany, the typical way of investing in high potential companies is that the venture capital firm holds common stock.377 Additional investor rights can be given to the investment company by the shareholders’ agreement.378 Shareholders’ agreements are contracts entered into between company shareholders, which can enable a minority shareholder such as a venture capital firm to exercise disproportionate control over a company.379

375

Unfortunately, the BVK does not disclose the statistics only for venture capital firms. Consequently, these numbers have to be interpreted with caution, as there are many later stage investment companies included in the BVK dataset that potentially distort the statistic results. See BVK (2004a), p. 14.

376

For a detailed analysis and classification of different financial instruments see Wahl (2004), pp. 140 et seq.

377

See Engel (2003), p. 281.

378

See Hale/Besner/Ayres (2002).

379

See Richardson (2004).

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Preferred stock (preferred equity) is issued when additional investor rights should be directly linked to the ownership of the stock.380 The typical way of structuring venture capital deals in the US is by issuing convertible preferred stock.381 With an investment company joining the shareholder group, a new series of preference shares is issued, typically in alphabetical order (e.g. series A, series B, etc.). The further in the alphabet, the more recent the venture capital firm invested into the company and the more preferred its financial position influence is. Normally, the most recent series has more influence, or at least, shares all the rights of previous series of stock.382 KAPLAN/STRÖMBERG show that convertible preferred stocks account for more than 90% of all US-financing rounds.383 However, one of the principal reasons for using preferred stock in the US is absent in Germany. When stock options are granted to the management at a valuation below the price that venture capitalists pay for preferred stock, the US tax authorities accept the differential in valuation placed on common and preferred stock only if extensive additional investor rights for preferred stockholder are present. The German tax authorities generally do not challenge the valuation placed on any shares at all within this context.384 Hybrid financial instruments such as convertible bonds and warrant bonds are another possibility to finance high potential companies. In practice, they do not play an important role in venture capital financing, neither in Germany nor in the US.385 This is astonishing, as theoretical work has demonstrated the superiority of convertible bonds

380

It is important to differentiate between private and public preference shares. Public preference shares regularly carry dividend and liquidation preferences (see chapter 4) but no voting rights and therefore show debt characteristics. See Wahl (2004), p. 162 and Bagley/Dauchy (1999), p. 272. Private preference shares however, usually carry many additional investor rights, which give their holders a more powerful position in comparison to common stock holders. In the present context, speaking of preferred stock or preference shares always means speaking of private preferred stock or private preference shares.

381

See Kaplan/Strömberg (2003), p. 286.

382

See Wilmerding (2003), p. 36.

383

Similar results are found by Sahlman (1990) and Gompers (1997). Notably, banks or other passive outside equity holders rarely use convertible securities in the US. See Schmidt (2003), p. 1147.

384

See Hale/Besner/Ayres (2002).

385

See Kaplan/Strömberg (2003), p. 284 for the US market and Figure 29 for the German market.

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over other financial instruments in venture capital financing.386 Further research is required to explain this phenomenon. Silent partnerships are a widely used financial instrument in German small- and medium-sized enterprises (SME) financing.387 The portfolios of government-dependent venture capital firms typically contain many investments in the form of silent partnerships.388 For example, via the public funding scheme “Beteiligungskapital für kleine Technologieunternehmen” early-stage high-tech companies receive financing predominantly in the form of silent partnerships.389 The silent partner participates in profits and losses (maximally with the amount of his investment). It is possible to exclude the loss participation. The silent partner can claim the repayment of his investment. As the silent partnership is a private contractual relationship between the company and the silent partner the freedom of contract allows various specifications. The German tax law differentiates between a typical silent partnership and an atypical silent partnership according to the degree of entrepreneurial risk, return and participation rights that are attributable to the silent partner. One speaks of an atypical silent partnership in cases where the silent partner’s position is rather comparable to an equity investor.390 The silent partnership leaves the shareholder structure untouched. However, additional rights of the silent partner can be quite substantial.391 The negotiations about the valuation of the company between the two parties are often long-winded.392 The uncertainty regarding the future development of the company combined with long horizons of product and market development393 complicates the valuation process and leads to substantial differentials between the value estimated by the founding team and the value estimated by the venture capital firm.

386

See chapter 4.3.2.

387

See Achleitner/Fingerle (2004a), p. 25. The silent partnership is legally codified in §§ 230-236 HGB.

388

See Leopold/Frommann/Kühr (2003), p. 142.

389

See KfW Mittelstandsbank (2003), p. 2.

390

See Leopold/Frommann/Kühr (2003), p. 142.

391

See Leopold/Frommann/Kühr (2003), p. 142.

392

See Achleitner/Nathusius (2004) for methods used in venture capital financing.

393

See Tyebjee/Bruno (1984a), p. 1052.

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The manner in which the investment structure is negotiated has an impact on the relationship between the management team and the venture capitalists, as this is the first impression both parties get from each other.394 The way in which the management team negotiates gives a useful insight to the venture capitalists of how well the management will pay attention to the interests of the venture capital firm in the postcontractual investment development phase.395

3.4.4.5 Investment Development With a successful closing of the venture capital deal, the post-contractual investment development phase begins. In this phase, venture capitalists assume two roles with regard to their portfolio company that are closely linked together: • A venture capital firm acts as monitor for the management team of the portfolio company.396 • A venture capital firms assumes the role of a coach.397 The two roles of monitor and coach complement one another.398 The basic assumption underlying the involvement of venture capitalists is that by assuming the two roles an increase in the value of the portfolio company can be achieved.399 The monitoring function of a venture capitalist primarily pursues the goal of protecting the value of the investment, whereas the coaching function primarily pursues the goal of enhancing the value of the investment.400 All actions of venture capitalists during the investment development phase are therefore directed towards minimizing risks and maximizing returns of their investment.401

394

Cf. Sherling (1999), p. 181.

395

See Sherling (1999), p. 181.

396

See Barry et al. (1990), p. 448.

397

See Baum/Silverman (2004), p. 414.

398

See Schmidt (1999), p. 12.

399

See Gifford (1997), p. 473.

400

Cf. Gorman/Sahlman (1989), p. 241.

401

See Nagtegaal (1999), pp. 185 et seq. MANIGART/SAPIENZA claim that venture capitalists focus more on maximizing returns instead of minimizing risks due to the high growth environment. See

82

Business Model of Venture Capital Firms

Along the lines of MANIGART/BAEYENS/VAN HYFTE, one can argue that the intensity of involvement of the venture capital firm depends on the venture capitalists’ perception what the return on its involvement will be.402 “Time is the binding constraint” for a venture capital firm regarding its efforts during the investment development phase.403 A venture capitalist tries to maximize the return of his financial investment as well as the return on his time investments.404 Therefore, he has to allocate his time to the activities that yield the highest return.

3.4.4.6 Investment Exit With the portfolio company further developing over time, venture capitalists and the portfolio company’s management team start preparations for the exit of the venture capital firm. The basic idea of the investment exit phase is to enable the venture capitalists to sell their stake in the company to third parties. A well-established stock market with an active IPO405 and M&A market are prerequisites for a successful exit of the venture capitalists. During the investment exit phase it is important to consider the interests of all involved parties.406 In particular, the issues of which exit channel to choose and when to exit are issues that contain a high conflict potential between the venture capital firm and its investees.407 Therefore, it is important to discuss the exit strategy right from the beginning. There are four regular exit channels for the investments of venture capitalists:408 • IPO,

Manigart/Sapienza (1999). Chapter 5 gives a more detailed overview of the resource provision activities of venture capitalists. 402

See Manigart/Baeyens/van Hyfte (2002).

403

Gifford (1997), p. 474.

404

See Manigart/Baeyens/van Hyfte (2002), p. 106.

405

See Franzke/Grohs/Laux (2002), p. 16; Jain/Kini (2000), p. 1139; Black/Gilson (1998), p. 245; Jeng/Wells (2000).

406

See Wright/Robbie (1998), p. 549.

407

See Fried/Hisrich (1995), p. 110.

408

See Achleitner (2001), p. 527.

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83

• trade sale to a strategic buyer, • secondary sale to a financial investor, • buyback through the portfolio company’s management team. Every exit channel has its advantages and disadvantages that differ depending whether viewed from the perspective of the entrepreneurs or from the venture capital firm. The actual choice of an exit channel often depends on the overall sentiment on capital markets.409 In addition to the four regular exit channels, the liquidation of a company is another exit way, where the investment is written off in the books of the venture capital firm. Figure 30 shows actually observed exit channels chosen for German venture capital investments in 2003.

17.9% - Other

8.1% - Initial public offering

42.7% - Liquidation

14.2% - Secondary sale

17.1% - Trade sale

Figure 30:

Exit channels of venture capitalists (2003)410

The most frequently chosen exit channel for venture capital investments in 2003 is the liquidation. Liquidations are due to the high uncertainty of venture capital investment inevitable. However, the extent of liquidations in 2003 shows that excesses from the high-tech bubble from the late 1990s still burden venture capital portfolios. The second most important exit channel in 2003 is the trade sale. Typically, a portfolio company is sold either to a competitor for the purpose of horizontal integration or 409

See Achleitner (2001), p. 527.

410

See BVK (2004b), p. 7. The category “other exits” comprises repayments of silent partnerships, shareholder loans, and buybacks.

84

Business Model of Venture Capital Firms

to suppliers respectively customers for the purpose of vertical integration.411 A portfolio company that goes for a trade sale does not have to be a complete firm and may lack entire functions since the purchaser may only be interested in one specific capability of the firm. As the buyer in a trade sale has a strategic interest in the firm, usually all shares of the company have to be sold, i.e. the entrepreneurs have to sell their shares alongside the other financial investors. The acquirer probably prefers a complete sale since he then has much greater freedom to use the company’s assets and technology without being hindered by legal obligations to other owners.412 Certainly, this often provokes conflicts of interests413 as the current management team of the portfolio company might have a strong interest to resist a trade sale as their jobs will be in danger or at least they might have to work under the management of the acquiring company. A complete sale of the company is not necessary in cases where the strategic acquirer is only looking for a window on technology. The third most important exit channel in 2003 is the secondary sale. A secondary sale differs from a trade sale since only the venture capital firm sells its shares to a financial investor such as another venture capital firm. The entrepreneur and other investors can keep their shares.414 Venture capitalists choose the secondary sale as exit channel mainly in portfolio restructuring efforts and when there are no possibilities to realize an exit via IPO or trade sale. This might for example occur when a venture capital firm nears the end of the fund’s term and investments must be liquidated in an orderly fashion. A venture capital firm clearly wants to avoid such a scenario.415 The valuation in a forced sale is probably much lower in comparison to a regular trade sale or IPO. Nonetheless, there may be portfolio companies that, as the end of the fund’s term approaches, are ready neither for an IPO nor for a trade sale. In this situation, a secondary sale is the best that can be achieved from the perspective of a venture capital firm. The fourth most important exit channel in 2003 is the IPO. Actually, the IPO is the most preferred exit channel since it allows generating on average the highest rates of

411

See Achleitner (2001), p. 528.

412

See Cumming/MacIntosh (2003), p. 522.

413

Cf. Wright/Robbie (1998), p. 551.

414

See Cumming/MacIntosh (2000), p. 5.

415

See Cumming/MacIntosh (2000), p. 5.

Business Model of Venture Capital Firms

85

return for venture capitalists.416 However, the slump of high-tech stock markets during the years 2000 until 2003 led to a deeply rooted risk aversion of public market investors towards growth stocks. Therefore, demand for venture capital-backed IPOs has diminished drastically. In addition, since the termination of the famous German growth stock market “Neuer Markt” at the Frankfurt Stock Exchange a German IPO platform that provides IPO candidates with the required public visibility is missing. These facts explain the subordinate role of the IPO as exit channel in 2003. Internationally, there are several major markets for growth stocks as is depicted in Figure 31. Among them are the US-based NASDAQ, the UK-based AIM and techMARK, the EURO.NM network of stock markets from France, Portugal, Netherlands, and Belgium on Euronext, and finally the Japan-based Mother’s Market on the Tokyo Stock Exchange.

London SE (AIM, techMARK)

Nasdaq

Euronext (Euro.NM)

Figure 31:

Tokyo SE (Mother‘s)

Important international growth stock markets

The IPO offers the opportunity for the venture capitalists to exit at high valuations without requiring the management team to exit as well. In addition, due to the dis-

416

See Achleitner (2001), p. 527; Gompers (1995), p. 1462; Barry (1994), p. 12.

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Business Model of Venture Capital Firms

persed free float of the shares after an IPO, it is unlikely that another shareholder group gains strong influence over the management and the company right at the beginning.417 However, the IPO might not be the adequate exit for every portfolio company. A company ready to go for an IPO needs to be built up in all aspects of its organization and must be capable of thriving as an independent entity. In addition, the company must be able to deliver quarterly budgets and forecasts, to fulfill accounting and disclosure standards for public companies and to work continually on its public and investor relations. A full exit for the venture capital firm is usually not possible on the day of the IPO.418 The main reason for this is the lock-up period for shares of insiders such as venture capitalists. A lock-up is an agreement between underwriters and existing shareholders not allowing the existing shareholder to sell any shares for a certain specified period of time, typically six months, but sometimes up to two years after the offering.419 In Germany, about 80% of lock-up agreements imply a six months lock-up period.420 The timing of the IPO is a critical issue in the investment exit phase. Seasoned venture capitalists are well apt to spot public stock market peaks for bringing their portfolio companies public.421 However, newly founded and inexperienced venture capital firms might have an incentive to “grandstand” their portfolio companies, i.e. to bring them public earlier than they would normally do. The reason for this might be that new venture capital firms are under pressure to generate a track record to be able to raise a new fund from investors.422 Another exit channel is the buyback through the management team. This is an indication for an unsatisfying performance of the portfolio company from the perspective of a venture capital firm.423 In many cases, the company probably lacks a significant growth and capital gain potential. The proceeds from such an exit are usually modest

417

See Achleitner (2001), p. 527.

418

See Lin/Smith (1998), p. 244.

419

See Lin/Smith (1998), p. 245.

420

See Bessler/Kurth/Thies (2001), p. 257.

421

See Lerner (1994).

422

See Gompers (1996), p. 133. Cf. chapter 3.4.3.

423

See Brinkrolf (2002), p. 33.

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as the management team is unlikely to bring up enough financial means. Leveraging the buyout with debt is not yet possible, as venture capital-backed companies usually do not show large and predictable cash flows that debt investors would require in such a transaction.424 This chapter discussed the value creation architecture of venture capital firms, the basis of their business model. It showed how venture capital firms deliver their services to their portfolio companies and investors. The next chapter explains the value proposition of venture capital firms towards their portfolio companies and investors, i.e. the second part of their business model.

3.5

Customer Value Proposition of Venture Capital Firms

3.5.1

Enhancement of Performance of Portfolio Companies

Chapter 2.3.4 already mentioned that high potential companies lack significant alternatives as sources of capital. For many early-stage high potential companies, venture capital firms are the only capital providers they can address in their stage of development. The important role of venture capital firms in providing a vital capital base for promising start-ups is confirmed by EVCA, since 55% of European managers of venture capital-backed start-ups stated that their company would not exist at all if they had not received venture capital.425 The same study also examines growth rates of venture capital-backed companies with those of more established public companies. The study finds that European venture capital-backed companies grow twice as fast in terms of revenues and seven times as fast in terms of number of employees than their more established counterparts.426 A similar study for the US market by NVCA finds that venture capital-backed companies are relative to their resources almost two thirds more efficient, export twice as much and invest almost three times as much in R&D than more established public companies.427 The results for the UK market confirm these results. British venture capital-

424

See Achleitner/Fingerle (2003), pp. 14 et seq.

425

See EVCA (1996), p. 7.

426

See EVCA (1996), p. 5.

427

See NVCA (2002), pp. 12 et seq.

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backed companies increase revenues and number of employees more than three times as fast as their more established counterparts do.428 However, the results of these studies have to be interpreted with caution. These studies cannot explain whether the outstanding performance of venture capital-backed companies derives from the superior selection ability429 of venture capital firms in the investment due diligence phase or from their monitoring and coaching efforts in the investment development phase. Furthermore, the control companies with which venture capital-backed companies are compared are only limited comparable as these companies are much more developed. Actually, these studies should compare early-stage companies that received venture capital financing with similar companies that did not receive venture capital financing. BRAV/GOMPERS follow this research strand and examine the performance differential between comparable venture capital-backed and non-venture capital-backed companies on the basis of their post-IPO performance in the period 1972-1992 for the US market. They find a higher survival probability for venture capital-backed companies: 23.3% of non-venture capital-backed companies do not survive a five-year period after the IPO whereas only 18.7% of venture capital-backed companies file for bankruptcy in the same time.430 The authors also state that venture capital-backed companies have a lower delisting probability: Within a five-year time span, 13.3% of non-venture capital-backed companies delisted in comparison to only 7.5% of venture capital-backed companies. Finally, their study also shows a better post-IPO stock price performance for venture capital-backed companies. The average performance of the stock price within a five-year time span is 22.5% with non-venture capital-backed companies and 44.6% with venture capital-backed companies.431 MAYER examines the performance differential in the development of the stock price after the IPO in the period March

428

See BVCA (2003), p. 2.

429

Cf. Casamatta/Haritchabalet (2003), p. 1; Brettel/Thust/Witt (2001), pp. 13 et seq.; Norton/Tenenbaum (1993), pp. 431 et seq.

430

See Brav/Gompers (1997), p. 1796. The higher survival probability for venture capital-backed companies is also confirmed by JAIN/KINI in the period 1977-1990 for the US market. See Jain/Kini (2000). MANIGART/BAEYENS/HYFTE find this positive effect of venture capital financing in their sample of Belgian companies only within the group of companies that has been financed by the most seasoned venture capital firms. See Manigart/Baeyens/van Hyfte (2002).

431

See Brav/Gompers (1997), p. 1800.

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1997 until February 2000 for the German market based on companies from the former stock market segment Neuer Markt.432 The average percentage capital gain within the first year after the IPO amounts to 301% in the case of venture capital-backed companies whereas former non-venture capital-backed companies realized 177% in the same period.433 A closely related research strand compares corporate growth rates of venture capitalbacked companies with those of non-venture capital-backed companies. BAMFORD/DOUTHETT state that revenue growth is much higher for venture capital-backed companies in the period 1991-1994 for the US market.434 Looking at the German market in the period 1997-2002, AUDRETSCH/LEHMANN find that employment growth is significantly higher for venture capital-backed companies.435 The study of ENGEL controls for the selection bias that results from the screening activities of venture capitalists during the investment due diligence phase.436 Based on the German dataset of the ZEW founding panel, this study finds that venture capital-backed companies show an employment growth rate that is about 165% as large as with non-venture capitalbacked companies even after controlling for the selection bias.437 KORTUM/LERNER show that venture capital-backed companies are much more productive in R&D activities: They generate on average three times as many patents as R&D departments of large corporations with the same amount of funding.438 Indirectly, venture capitalbacking seems to have a positive impact on corporate growth, as there is a positive correlation between a firm’s intangible resources and its employment growth.439

432

See Mayer (2001).

433

The data is to be interpreted with caution as the sample period matches the time of the worldwide high-tech bubble on the stock markets. Results might be different in less turbulent times.

434

See Bamford/Douthett (2000), p. 6.

435

See Audretsch/Lehmann (2002), p. 19.

436

See Engel (2002).

437

See Engel (2002), p. 16.

438

See Kortum/Lerner (2000), p. 689.

439

See Audretsch/Lehmann (2002), p. 20. Innovative companies also show a significantly higher corporate growth rate. See Audretsch (1995), p. 441.

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Business Model of Venture Capital Firms

Taking the different aspects of the quoted studies together, there is broad empirical evidence that venture capital-backed companies exhibit an articulate better performance in comparison to non-venture capital-backed companies.

3.5.2

Enhancement of Asset Allocation of Investors

Venture capitalists are specialized institutions to reduce participation barriers for investors in the venture capital market. Among important participation barriers are high transaction costs, high minimum investment volumes and risk considerations. If participation barriers are too high, investors might not invest in the venture capital asset class.440 Venture capitalists reduce transaction costs441, which can be broken down in initiation, contracting, execution, adjustment, control, and information costs.442 In a perfect capital market with no frictions, transaction costs do not exist. All n investors would invest in all m companies and the total number of transactions would be n*m. In reality however, transaction costs do play a very important role.443 Under these circumstances, interposing one intermediary such as a venture capital firm can help reduce the number of transactions to n+m.444 The following Figure 32 shows that already with relatively few investors and investees the number of transactions can be widely reduced.

440

Cf. Allen/Santomero (1997); Allen/Gale (1994); Merton (1987).

441

See Gurley/Shaw (1960).

442

See Picot (1991), p. 147.

443

The share of transaction costs in the gross domestic product of an economy amounts to more than 50%. See Wallis/North (1986), p. 121.

444

The assumption that there is only one intermediary in the market is not realistic since alone in Germany there are more than one hundred listed BVK members. Hence, the given numbers for the potential reductions due to the existence of venture capital firms overestimate their beneficial effect on transaction costs.

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91

Number of investors (n)

2

10

100

1,000

Number of investees (m)

2

10

100

1,000

Number of transactions without intermediary (n*m)

4

100

10,000

1,000,000

Number of transactions with intermediary (n+m)

4

20

200

2,000

0.0

80.0

98.0

99.8

Reduction of number of transactions in %

Figure 32:

Reduction of number of transactions through intermediation

Venture capital firms are specialized in investing in high potential companies and can therefore profit on economies of scale and scope.445 Based on their long-term sector and management experience, venture capitalists can judge on the value of an investment proposal much quicker than a “normal” investor could do and thereby reduce initiation costs. With recourse to their contracting experience from previous deals, venture capitalists can save on contracting, execution, and adjustment expenses in the investment structuring phase. Through delegated investment decisions and venture management, venture capitalists can reduce control costs in the investment development and investment exit phase.446 Institutional and private investors find it much more difficult to invest on their own in promising early-stage high potential companies than for example in public stocks as they usually only have incomplete information regarding all investment opportunities on the market. To gather the relevant information to understand a biotech investment proposal in every important aspect is extremely costly if at all possible for laymen. The information processing capacity of investors is limited and therefore bounded rationality drives the behavior of investors.447 This leads to a situation where investors will only achieve a sub-optimal allocation of their money if they invest on their own. Venture capital companies do neither have full information, but they are specialized on investments in certain companies and dispose of an established network of contacts

445

Cf. Sahlman (1990), p. 475; Wright/Robbie (1998), p. 521; Strzelczyk/Shanley (1999), p. 65; Tsuru (2000), p. 31.

446

Cf. Diamond (1984), pp. 393 et seq.

447

See Simon (1955), pp. 99 et seq. for a discussion of rational behavior. Conlisk (1996) provides an overview of research on bounded rationality.

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Business Model of Venture Capital Firms

they can ask for advice on a potential deal thus keeping information costs low.448 Therefore, they dispose of superior information regarding possible investment opportunities and are consequently able to take better investment decisions. Venture capitalists also cut down on minimum investment volumes in the venture capital market. The required size of investments often exceeds financing possibilities of single investors.449 Through their transformation function as intermediaries, venture capital firms make smaller contributions from investors to the venture capital asset class possible.450 The minimum commitment in a venture capital firm organized as limited partnership is typically €1m, but those that also invite wealthy private individuals may have a lower minimum.451 Listed venture capital funds such as those from 3i Group plc do not have minimum commitments and thus enable private investors to invest also small amounts into venture capital and private equity.452 Risk considerations can also keep investors away from investing in venture capital. Venture capitalists reduce unsystematic risks in venture capital investments. Figure 33 demonstrates that the risk/return profile of a direct venture capital investment is highly skewed with around 30% being a total loss and a fat slowly thinning tail of extremely high returns, amounting to investment multiples up to 100.453 This fits well to previous studies that find venture capital returns to exhibit a lognormal distribution with a very high standard deviation.454 As WEIDIG/MATHONET point out, it does not make sense for inexperienced investors to engage in direct venture capital investments, as the involved risks are too high. In turn, they recommend investing in professionally managed venture capital funds.455 By 448

Cf. Peeters (1999), p. 103 for an overview of specialization strategies of venture capital firms.

449

See Figure 5 for the ten largest European venture capital deals and associated investment volumes in the period between the second quarter 2003 and the first quarter 2004.

450

Cf. Greenbaum/Thakor (1995), p. 53 for a description of the transformation function of an intermediary. However, not all of the there mentioned functions can be directly applied to venture capital firms.

451

See Fenn/Liang/Prowse (1995), p. 29. Larger partnerships may require a €10m to €20m minimum commitment.

452

See 3i (2003).

453

See Weidig/Mathonet (2004), p. 9.

454

See Cochrane (2001), p. 1.

455

See Weidig/Mathonet (2004), p. 9.

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pooling several investments in funds, venture capitalists are able to reduce unsystematic risks associated with stand-alone investments.456 Fund-of-fund investors can further reduce the risks involved with investing in only a single fund. The changes in return distributions through the activities of venture capitalists and fund-of-funds investors are shown in Figure 33.

Probability

30 30%

Direct investment

25 25% 20 20%

15% 15 10 10% 5 5% 0 0%

0

1

2

3

4

5

6

7

8

9

10 and more

6

7

8

9

10 and more

6

7

8

9

10 and more

Probability

30 30%

Fund investment

25% 25 20% 20 15% 15 10% 10 5% 5 0% 0

0

1

2

3

4

5

Probability

30 30%

Fund-of-funds investment

25 25%

20% 20 15% 15 10 10% 5 5% 0 0%

0

1

2

3

4

5

Investment multiple (TVPI)

Figure 33:

Return distributions of direct, fund, and fund-of-funds investments457

Pooling individual investments in a fund and pooling individual funds in fund-of-funds vehicles eliminate extreme returns and greatly diminish return variance. Figure 34 gives various measures of risk and return for direct, fund, and fund-of-funds investments in venture capital.

456

See Markowitz (1952), pp. 77 et seq.

457

See Weidig/Mathonet (2004), pp. 10, 14, 17. Data are based on US and European venture capital investments as well as on simulation calculations for fund-of-funds investments.

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Business Model of Venture Capital Firms

Risk/return measure

Direct investment

Fund investment

Fund-of-funds investment

Average TVPI

6.2

1.7

1.8

Median TVPI

1.5

1.3

1.7

Standard deviation of TVPI

53.8

1.9

0.5

Risk/return ratio

10.3

2.7

0.6

Probability of a loss (in %)

42.0

30.0

1.0

Average loss given a loss (in %)

-85.0

-29.0

-4.0

Probability of a total loss (in %)

30.0

1.0

0.0

Figure 34:

Risk/return measures for direct, fund, and fund-of-funds investments458

The risk/return ratio is calculated as standard deviation divided by average multiple minus one. It gives a measure of how much risk the investor has to bear for a unit return. The risk/return ratio is reduced from 10.3 in a direct venture capital investment to 2.7 in a venture capital fund investment. In addition, the probability of any loss is reduced from 42% to 30%, the level of a potential loss falls from -85% to -29%, and the probability of a total loss is almost eliminated as it falls from 30% to 1%. The risk characteristics of venture capital investments can be enhanced further when looking at simulated fund-of-funds data. Both, average multiple and risk/return ratio indicate that fund-of-funds investments dominate single fund investments from a risk/return perspective. By opening up the venture capital asset class for investments, venture capitalists provide the possibility to enhance the investors’ asset allocation. SHARPE defines asset allocation “as the allocation of an investor’s portfolio across a number of ‘major’ asset classes”.459 Traditional asset classes are public equity, fixed income, real estate, and natural resources. Whereas for private investors private equity is not yet a fully established asset class460, institutional investors perceive venture capital and private equity 458

See Weidig/Mathonet (2004), pp. 11, 15, 18. TVPI is total value to paid in capital. See chapter 3.4.3.3.

459

See Sharpe (1992), p. 7.

460

In general, 17.9% of the total German population holds equity interests in their portfolios. See Deutsches Aktieninstitut (2003). A more detailed breakdown in individual asset classes is not available, but it can be conjectured that only few private investors are invested in venture capital as the asset class is mainly open for institutional investors.

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as an important asset class. According to ADVEQ, 40% of German insurance companies are invested in private equity.461 However, investors’ target allocation to venture capital and private equity is only 2.2% of the total portfolio, but with rising tendency.462 Earlier studies show institutional investors’ target allocations ranging from 2% to 10%.463 The current low target allocation rate is probably a consequence of the high-tech bubble from the late 1990s since many investors lost a lot of money with early-stage investments. The development of the asset allocation rate of institutional investors in venture capital is assumed to outperform most other asset classes with a CAGR of 9% in the period 2000-2005.464 For the addition of private equity and venture capital to the available set of asset classes to have a positive impact on the investors’ asset allocation it is crucial, that private equity and venture capital show capital market characteristics that differ from other asset classes. Asset classes should be mutually exclusive and exhaustive and at the same show a risk/return profile that differs among the classes.465 The risk/return profile and correlation with other asset classes is of particular importance in this regard. The venture capital and private equity industry still lacks transparency since limited partnerships are not obliged by law to publish their performance.466 Due to the resulting limited availability of risk/return data on venture capital as an asset class there is

461

See Adveq (2003), p. 7.

462

See Adveq (2003), p. 8 and CAPENAgroup (2002), p. 8.

463

See Bader (1996), pp. 199 et seq.

464

See CAPENAgroup (2002), p. 7. Only private equity with a CAGR of 12% CAGR and hedge funds with a CAGR of 10% are predicted to gain even more importance in institutional investors’ asset allocations.

465

See Sharpe (1992), p. 8.

466

There are some exceptions in the US as institutions under public law such as public pension schemes and foundations of state universities might be required by state law to publish the returns on their investments. See Hagenmüller (2004), p. 153. Listed venture capital firms are in general obliged by terms of stock markets to publish their performance.

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only few empirical research dealing with its risk and return characteristics.467 However, this problem is recognized by the industry and improvements are under way.468 There is some empirical evidence that the venture capital and private equity asset class offers higher returns but also higher risks in comparison to other asset classes.469 Figure 35 shows internal rates of return for various asset classes. Over a ten year time period, venture capital clearly outperforms public asset classes whereby return is measured on the basis of disclosed net asset values.

Asset classes and benchmarks a

Net IRR per 31.12.2002 1 year

3 years

5 years

10 years

-30.7

0.6

7.9

12.1

European buyouts a

-3.2

6.0

12.0

13.5

European private equity a

-9.2

4.1

10.1

13.6

-37.4

-24.7

-12.4

-4.1

-15.5

19.1

-12.5

-6.1

12.6

3.4

7.9

8.2

European venture capital

Morgan Stanley European Equity Index b HSBC Small European Equity Index b JP Morgan Euro Bond Index b

Figure 35:

Performance data for several asset classes and benchmark indices470

LJUNGQVIST/RICHARDSON propose a cash flow based approach in calculating the return on venture capital and private equity investments. They show that investors in US private equity could expect a return premium to the S&P 500 stock index of five to eight percent per year over the period 1981-1993.471 KASERER/DILLER calculate cash flow based returns for European venture capital and private equity investments for the

467

See Kaserer/Diller (2004b); Ljungqvist/Richardson (2003).

468

50% of general partners plan to publish their performance data voluntarily. See Hagenmüller (2004), p. 158. EVCA tries to improve industry reporting standards by setting harmonization and transparency guidelines. See EVCA (2003c).

469

However, not all studies find a higher return for venture capital and private equity investments in comparison to other asset classes. KAPLAN/SCHOAR demonstrate that average returns are equal to that of the S&P 500 stock index for US private equity in the period 1980-2001. See Kaplan/Schoar (2003).

470

See a: EVCA (2003b), p. 7; b: Hagenmüller (2004), p. 14.

471

See Ljungqvist/Richardson (2003), p. 28.

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period 1980-2003.472 Due to the shortcomings of the IRR approach, they calculate a relative performance measure for European private equity funds, which assumes that returns to investors are reinvested in a public market index. This facilitates an ex-post comparison of private and public equity returns. They show that the returns to private equity investments are equal to the MSCI Europe Equity Index in the period of 19802003, but show a strong outperformance in the period of 1989-2003, which the authors explain with the professionalization of the industry during this time. The correlation of returns between venture capital and other asset classes is an important factor in determining to what extent the portfolio risk can be reduced by including venture capital in the investor’s asset allocation.473 With correlation coefficients below one, it becomes possible to reduce the overall portfolio risk. According to DILLER/KASERER, correlations of European venture capital investments with fixed income are 0.77 and 0.80 with public equity.474 These are higher correlations as indicated by BADER for private equity, who states the correlation coefficient with fixed income to be 0.10 and 0.20 and the correlation coefficient with public equity to be between 0.40 and 0.60.475 In simulation calculations, it can be shown that the efficient frontier of a portfolio can be shifted outwards if investors add venture capital to their asset allocation. The efficient frontier is the subset of all possible portfolios that is preferred by rational investors that are risk-averse and prefer more return to less.476 Figure 36 shows how the efficient frontier changes depending on the maximum share of private equity in the investor’s asset allocation based on simulations.

472

See Kaserer/Diller (2004a).

473

See Elton/Gruber (1995), p. 79.

474

See Diller/Kaserer (2004), p. 43.

475

See Bader (1996), p. 199. Whereas BADER assumes that returns are reinvested in private equity, DILLER/KASERER assume that returns are invested in a public market index. This is one explanation for their higher calculated correlations between private and public equity. See Diller/Kaserer (2004).

476

See Elton/Gruber (1995), p. 70.

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Business Model of Venture Capital Firms

16 16 Up to 100%

Expected portfolio return in %

15 15 14 14

Up to 10% Up to 5%

13 13

0%

12 12 11 11 10 10

99 4

6

8

10

12

Portfolio risk in %

Figure 36:

Impact of variations in private equity allocation on efficient frontier477

Prerequisite for the validity of these results is the applicability of the portfolio selection theory in the context of venture capital and private equity. HEIM argues that not all assumptions of the portfolio selection theory are fulfilled, but important conclusions regarding venture capital as an asset class can still be drawn from these results.478 KASERER/DILLER use a dataset of returns from private equity for the period 1972-2003 and calculate an optimal allocation of different asset classes according to the maximum Sharpe ratio portfolio, which includes 5% venture capital and 3% buyouts.479 To conclude, venture capital is an interesting asset class for investors. Venture capitalists make it much easier for investors to put money in this asset class. Venture capital investments improve the overall risk/return profile of the investor’s asset allocation. Through the activities of venture capitalists, it becomes possible for investors to earn a higher return on their capital without increasing their associated risk position or to reduce the risk of their portfolio without earning fewer returns. This chapter discussed the value propositions of venture capital firms towards portfolio companies and investors, i.e. it discussed the second part of their business model. It

477

See Heim (2001), p. 493.

478

See Heim (2001), p. 493.

479

See Kaserer/Diller (2004b), p. 70.

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showed that both, the performance of the portfolio companies as well as the asset allocation of the investors is enhanced through their services. The next chapter discusses the profit model of venture capital firms, i.e. the third part of their business model.

3.6

Profit Model of Venture Capital Firms

3.6.1

Management Fee

Contracts between venture capitalists and investors usually provide for a management fee serving as a basic salary for venture capitalists and their support staff.480 In addition, it covers establishment and transaction costs. Establishment costs arise in establishing the limited partnership and include legal and accounting advisers' fees.481 They are normally borne by the investment fund, perhaps up to a capped level, with establishment costs above a cap being borne by the management company. Establishment costs arising from the involvement of third party placement agents are commonly borne by the general partners. Transaction costs incurred by the general partner in connection with proposed investments are borne by the management company.482 If a deal cannot be closed successfully, the general partner seeks to charge such costs to the target company by agreeing a break-up fee for the transaction. In case the target company does not meet transaction costs, they will be borne either by the general partner himself or by the partnership, or split between them. The management fee is independent of the performance of the fund and is usually paid in advance on a monthly or quarterly basis.483 The management fee arrangements vary according to the size or scope of the fund, the track record or experience of the general partners, whether a sponsor, i.e. the first lead-investor, is investing in the fund and other factors which affect the attractiveness of the fund.484 In most cases, it is either 2.0% or 2.5% of the committed capital of a fund per annum.485 The management fee

480

See Bader (1996), p. 157.

481

See BVCA (2002), p. 12.

482

See BVCA (2002), p. 12.

483

See Christofidis/Debande (2001), p. 11; Post (2001), p. 2.

484

See BVCA (2002), p. 1.

485

See Feinendegen/Schmidt/Wahrenburg (2003), p. 1176.

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Business Model of Venture Capital Firms

normally reduces after the investment phase486 and tapers with the progress of a fund's life as investments are realized and distributed to the investors and as it is assumed that General Partners spend less time on the fund.487 FEINENDEGEN/SCHMIDT/WAHRENBURG calculate the present value of the management fee payments of a fund: On average, investors pay management fees amounting to 14.7% of their invested capital.488

3.6.2

Participation in Value Creation

The main incentive for venture capitalists to achieve high returns with their funds and their primary source of profit lies in the carried interest.489 In contrast to the management fee, which is not related to the performance of the fund, the carried interest scheme directly links remuneration for venture capitalists to the fund’s performance.490 Potentially diverging interests between investors and venture capitalists are aligned through this incentive scheme.491 The carried interest is typically 20%492 of the fund’s profits after commitments and preferred return of limited partners have been paid off.493 According to the BVCA, a typical scheme for the order of cash distribution is the following:494 (1) The payment of the management fee495 to the general partner is due. (2) Draw-downs of limited partners are paid back.

486

See Figure 26.

487

See Brooks (1999), p. 109.

488

See Feinendegen/Schmidt/Wahrenburg (2003), p. 1177.

489

See Brooks (1999), p. 110.

490

See Sahlman (1990), p. 491.

491

See Gifford (1997), p. 460.

492

In more than 90% of European partnership agreements, the carried interest is 20%. See Feinendegen/Schmidt/Wahrenburg (2003), p. 1177.

493

Similar schemes can be found in funds devoted to leveraged buyout, mezzanine, real estate, and oil-and-gas investments, as well as hedge funds. See Gompers/Lerner (1999), p. 4.

494

See BVCA (2002), p. 9.

495

See chapter 3.6.

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(3) Where agreed, limited partners receive a return on their investment that is often referred to as preferred return. (4) Remaining profits are shared between the limited partners and the general partner in accordance with the carried interest496 provisions. A second incentive for venture capitalists to achieve high returns with their funds lies in the fact that they also invest personal assets in the fund. Usually this amounts to 1% of the total capital commitment of the fund.497 Thereby, venture capitalists personally act as limited partners in the fund. In this role, venture capitalists also participate directly in the fund’s performance.498 Chapter 3 explained the activities of venture capital firms using the business model concept. It clarified under which conditions venture capitalists operate and set a framework to explain how their influence on portfolio companies fits into their overall activities. The next chapter analyzes the influence venture capitalists gain on their portfolio companies through the investment agreement. Subsequently, chapter 5 discusses the influence venture capitalists have on their portfolio companies through their resource provision activities.

496

See chapter 3.6.

497

See chapter 3.4.3.

498

This role must be seen separate from the general partner role of the management company, which they assume in parallel.

Venture Capitalists’ Influence through Contractual Agreements

4

Venture Capitalists’ Influence through Contractual Agreements

4.1

Introductory Remarks

103

The contractual agreements between the venture capital firm and the high potential company result from the negotiations during the investment structuring phase. The investment agreement provides the formal framework within the relationship between venture capital firm and its portfolio company can unfold in the ensuing investment development and investment exit phases. The main purpose of these legal documents is to enable the venture capital firm to interfere with the development of the portfolio company in case the company’s development contravenes its interests. In this respect, the venture capital firm receives formal influence in many areas over its portfolio company. This chapter proceeds as follows. The existence of a relationship between a venture capital firm and its portfolio company causes additional deal-specific risks, which increase the risk position of the venture capital firm. In order to reduce these emerging risks, the venture capital firm asks for various contractual elements in the investment agreement. These contractual elements can be classified in the following eight categories: Information rights, conversion rights, control rights, management covenants, milestone agreements, cash flow rights, preemptive rights, and disinvestment rights. Simultaneously with enabling venture capitalists to manage their risks better, these contractual rights also grant significant influence over the portfolio company to the venture capital firm. The growing influence of venture capitalists comes along with a decreasing formal autonomy of the managers of the portfolio company, which might ultimately deter them from using venture capital financing.

4.2

Deal-specific Risks for Venture Capital Firms

4.2.1

Risk of False Investment Decision

One of the most obvious deal-specific risks for venture capital firms is the risk of a false investment decision. Following the “lemons” argument of AKERLOF, the market for equity stakes in start-ups could break down because of the problem of adverse se-

104

Venture Capitalists’ Influence through Contractual Agreements

lection.499 This problem arises as venture capitalists have less information regarding the true potential of the start-up than the entrepreneurs. The venture capital firm runs the risk that after some time the value increase potential of the investment reveals not to be as promising as expected. Before venture capital firms enter into an investment agreement with a company, they use several pre-contractual instruments to address the adverse selection problem.500 By screening the venture during the investment due diligence phase, they undertake a detailed check on the company’s assets and its market environment to gain a better understanding of the risks of the investment.501 Moreover, they use a self-selection mechanism to deter unpromising investment proposals by offering a certain contractual structure in the investment structuring phase that punishes adverse performance of the management team.502 Nevertheless, pre-contractual instruments cannot fully eliminate the risk of investing in a company that reveals to have no significant potential for capital gains.

4.2.2

Risk of Managerial Opportunism

Agency theory deals with the analysis of relationships between principals and agents.503 In a principal-agent relationship, the agent takes decisions that not only affect his utility level but also that of the principal.504 Although agency theory has been developed in the context of publicly listed firms with dispersed ownership structures and managers with little stakes in their companies, it is frequently applied in the entrepreneurial context of venture capital financing with the venture capital firm being the

499

See Akerlof (1970), pp. 488 et seq. AKERLOF uses the term “lemons” to describe used cars of bad quality. In the present context, the term is used to describe portfolio companies that turn out to have no potential for significant capital gains.

500

See Picot/Reichwald/Wigand (2001), p. 58 et seq. The entrepreneur can also engage in actions that reduce the problem of adverse selection. Particularly, he can signal the quality of his investment proposal by delivering a detailed business plan or refer to his track record.

501

See Arthurs/Busenitz (2003), p. 150. See chapter 3.4.4.3 for details regarding the investment due diligence phase.

502

See chapter 3.4.4.4.

503

See Fama/Jensen (1983); Jensen/Meckling (1976); Ross (1973).

504

See Picot/Reichwald/Wigand (2001), p. 56.

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principal and the management team of the portfolio company being the agent.505 There are several important assumptions of the agency theory.506 First, the principal is expected to have less information than the agent does, i.e. there is an information asymmetry between both parties. Second, agents and principals are supposed to act purely in their self-interest. Third, agency theory presumes a goal conflict between the two parties. Fourth, bounded rationality507 is assumed to characterize the decision taking of both parties. These circumstances allow the agent to take advantage of this discretionary scope508 and engage in actions that may reduce the wealth of the principal. After signing the investment agreement, the problem of moral hazard arises in the relationship between the management of the portfolio company and the venture capital firm.509 The venture capital investment brings along a separation of ownership and management as the venture capital firm acquires a significant stake in the company, which entails diverging interests and goals between the venture capital firm and the management team of its portfolio company.510 The actions of the management cannot be observed by the venture capitalists and cannot be inferred from the outcome of the management’s actions since the outcome is largely dependent on the random occurrence of external conditions.511 Under such circumstances, the management of a portfolio company might take advantage of its discretionary scope and engage in actions that potentially reduce the wealth of the venture capital firm. BARNEY ET AL. call this behavior of a portfolio company’s management team “managerial opportunism”.512 The major risk for venture capitalists is that managers pursue their own interests rather than maximize shareholder value as soon as they received the money from the venture capital firm.

505

See Sapienza/Gupta (1994); Sahlman (1990); Barney et al. (1989).

506

See Eisenhardt (1989a), p. 63. Further assumptions that are not treated in detail in this analysis are preeminence of efficiency, risk aversion, and information as a commodity.

507

See Conlisk (1996) for more information on the concept of bounded rationality.

508

See Picot (1991), p. 150.

509

See Picot/Reichwald/Wigand (2001), p. 59.

510

See Jensen/Meckling (1976).

511

See Picot (1991), p. 151.

512

BARNEY ET AL. call this behavior of a portfolio company’s management team “managerial opportunism”. See Barney et al. (1994), p. 20.

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Venture Capitalists’ Influence through Contractual Agreements

Several examples can be found for actions of managers of portfolio companies that deviate from the best interest of the venture capitalist. For instance, the venture capital firm is exposed to the risk of perk consumption by the management of its portfolio companies.513 If the venture capitalist holds x percent of all shares of the venture, the managers can still enjoy full marginal benefit of a further unit of perk consumption whereas their marginal costs in terms of reduced firm value are only 100-x percent. Utility maximization of the managers leads to an increased consumption of perks. The venture capital firm can also be exposed to the risk of shirking by the management of its portfolio companies. If the venture capitalist holds x percent of all shares of the venture, the managers have still full marginal costs of their efforts but receive only 100-x percent of marginal profits. Utility maximization of the managers leads to less effort devoted to the venture. The underlying assumption in this respect is that managers favor leisure to effort and are thus predisposed to shirking. Another risk for the venture capital firm may be that managers of portfolio companies engage in actions of empire building to increase their own prestige or span of control.514 Moreover, these managers might want to protect their specific human capital and engage in actions that decrease the risk but also the potential for capital gains of the portfolio company since they suffer from a largely non-diversifiable employment risk.515 Managers of portfolio companies might also try to engage in actions of managerial entrenchment by making manager-specific investments that make it costly for venture capitalists to replace them.516 Furthermore, they might also run pet projects that give them personal satisfaction but do not contribute to the value maximization of the portfolio company.517 In all cases, a misalignment of incentives between venture capitalists and managers of portfolio companies leads to sub-optimal results for both parties. Proper incentive518

513

See Jensen/Meckling (1976), p. 312.

514

See Klein (1998), p. 25; Baumol (1967).

515

See Amihud/Lev (1981).

516

See Shleifer/Vishny (1989).

517

See Lehmann/Weigand (2000), p. 159; Clayton/Gambill/Harned (1999), p. 51.

518

See Prendergast (1999), p. 7.

Venture Capitalists’ Influence through Contractual Agreements

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and governance structures are required to reduce the risk of moral hazard and to ensure management’s actions are directed towards maximizing shareholder value.519

4.2.3

Risk of Competitive Opportunism

There a further deal-specifics risks that emanate directly from the management of the portfolio company. BARNEY ET AL. suggest that managers may engage in “competitive opportunism”, i.e. actions that increase the level of competition faced by the portfolio company.520 Examples for such a behavior would be disclosing the firm’s proprietary technology to competitors, acting as advisors for competing firms, and leaving the portfolio company and starting a new competing firm. Managers of portfolio companies might have an incentive to engage in these actions if they had to give up a large equity stake in their original company for further developing their products. If they are able to manage to transfer their knowledge and skills to a newly formed company in which they still hold 100 percent of the shares, they might try to do so. As indicated in chapter 2.5.3.6, the original portfolio company would lose a large part of its value. This also puts the venture capital firm in danger of suffering from a hold-up521 strategy of the management team. As human capital is “inalienable”522, the entrepreneur is in a strong bargaining position after the venture capital firm has made its investment.523 The investment of the venture capital firm in its portfolio company represents sunk costs and is such a specific investment that is not recoverable. The venture capital firm becomes dependent on the actions of the portfolio company and its management team. The management team could take advantage of this situation, force the venture capital firm into a renegotiation of the investment agreement, and ask for terms that are more favorable. However, the scope for undertaking a hold-up with a venture capital firm

519

By personally investing a significant amount of money in the venture, the management can bond itself, thus committing credibly to not engage in behaviors that would be detrimental to the company’s success. See Arthurs/Busenitz (2003), p. 150.

520

See Barney et al. (1994), p. 20.

521

See Picot/Reichwald/Wigand (2001), p. 60; Hart/Moore (1994).

522

See Hart/Moore (1994).

523

See Neher (1999), p. 256.

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Venture Capitalists’ Influence through Contractual Agreements

has severe repercussions for the management team. In fact, the community of venture capitalists is sufficiently small to allow such news to spread quickly. Therefore, the management team will find it hard in the future to convince other venture capitalists to invest again.

4.2.4

Risk of Unfavorable Decision-Taking

Once the venture capital firm has invested in the portfolio company, it is subject to the risk that the portfolio company takes decisions, which are not anymore in its interests. Common shareholders have the power to decide over fundamental issues regarding the company such as electing non-executive directors and proposals for mergers or liquidation of the business. To effect decisions in shareholders’ meetings, usually simple, two-thirds or three-fourths majorities are required. In turn, to block decisions a corresponding stake in the company is required. Venture capital firms invest in their portfolio companies under certain premises regarding for example the strategic direction of the firm. If they do not own a controlling stake, they are at risk of the portfolio company changing important aspects of its business model since management and other shareholders might well have different goals with the direction of the company. However, these measures could adversely affect the value of the investment of the venture capital firm. Venture capitalists therefore need to be on the qui vive concerning the shareholder structure of their portfolio company. Two issues are of importance in this regard: First, the composition of the group of shareholders and second, the relative power between shareholders. In particular, entries of new shareholders pose a threat to venture capitalists to enforce their interests as they might pursue a different agenda with their investment in the venture. Conversely, the venture capital firm is also at risk of existing shareholders leaving the firm. Adverse effects on the portfolio firm’s outlook can be expected in case a shareholder leaves the firm, who provided critical resources such as reputational or networking resources. Several events change the relative power within the group of shareholders and potentially lead to a situation in which the venture capital firm runs the risk to lose control over its portfolio company. Conversely, the venture capital firm also faces the risk that third parties gain control over its portfolio company. An example for such a situation would be a capital increase in which the stake of the venture capital firm is diluted

Venture Capitalists’ Influence through Contractual Agreements

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since it cannot participate anymore as its fund is already fully invested or it already invested the maximum amount its fund statutes allow it to commit to a single portfolio company. Other parties might in such a scenario acquire a larger stake in the company and move themselves in a position to block or enforce certain decisions that are not in the interest of the venture capital firm.

4.2.5

Risk of Exit Obstruction

A further deal-specific risk that venture capital firms face when entering into a financing relationship with a portfolio company is that the sale of its stake in the company turns out to be problematic. The exit is the mechanism for a venture capital firm to realize capital gains of its investments. However, venture capitalists might face several problems with the management team and other shareholders when trying to realize an exit. First, the management of the portfolio company or other shareholders can oppose any exit of the venture capital firm. Many reasons can be the cause for this behavior such as the unwillingness to find a buyer for the shares of the venture capital firm. This might be less a problem with serial entrepreneurs that have an exit orientation right from the beginning.524 They only want to accompany the company to a certain stage of development, sell it and subsequently start a new company. Second, managers and other shareholders might refuse an exit via a certain exit channel. There might be different preferences among managers and venture capitalists concerning the choice of the exit channel.525 For instance, a reason for the managers to resist a trade sale might be that they do not want to sell “their baby” to a competitor. Another example might be that managers dislike the idea of a secondary sale to another venture capital firm that is well known for putting high pressure on the management of its portfolio companies. Third, managers and other shareholders might object a certain timing of the exit. A venture capital firm might be in the situation to be obliged according to its fund statutes to liquidate all its investments quickly when the end of the fund term approaches. However, in the view of the management team their company might not yet be ready to go public or to be acquired by a strategic buyer. 524

See Wright/Robbie/Ennew (1997).

525

See chapter 3.4.4.6 for further details.

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Venture Capitalists’ Influence through Contractual Agreements

Fourth, managers and other shareholders might reject the company’s valuation associated with a certain exit. In case a strategic buyer acquires the company, other shareholders might argue that they believe that this offer does not yet match the real value of the company and thus protract the exit of the venture capital firm. This chapter showed that venture capitalists face several deal-specific risks when they enter into a financing relationship with a portfolio company. In order to reduce their exposure to these risks, they ask for several contractual provisions in the investment agreement that are explained in detail in the next chapter.

4.3

Influence through Contractual Provisions

4.3.1

Information Rights

A common contractual provision in venture capital financing agreements is that the venture capital firm receives information rights. These rights define the extent to which venture capitalists have access to information regarding their portfolio company.526 Many of those rights are already provided by statutory regulation.527 The statutory information rights of investors in an AG are reduced to a limited right to inquire whereas investors in a GmbH dispose of comprehensive information rights. Consequently, in particular for investors in an AG, it becomes necessary to require their investees to grant comprehensive information rights, like the right to ask for information and the right to visit company premises at any time.528 Moreover, venture capital firms usually define a catalogue of information, like financial statements and budgets but also non-financial information regarding company development that their portfolio companies are required to deliver in regular intervals, usually monthly.529 The demands that they place on their investees require a minimum

526

Wilmerding (2003), p. 62.

527

For shareholders in a limited liability corporation (GmbH) they are set out in § 51a GmbHG and for shareholders of a stock corporation (AG) they are defined in § 131 AktG.

528

See Heitzer (2002), p. 473. A detailed description of information rights required by investors can be found in Von Einem/Tränkle (2003).

529

Cf. Sahlman (1990), p. 505.

Venture Capitalists’ Influence through Contractual Agreements

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standard of systematic accounting information and the establishment of an appropriate system to ensure compliance.530 To fulfill its monitoring role and to be able to react quickly on events within the company, the venture capital firm requires more detailed and more frequent information flows than statutory requirements stipulate. Information rights provide the basis for any measures that venture capitalists intend to take. They reduce post-contractual information asymmetries between management and venture capital firm, since they enable the venture capitalists to watch over management’s activities and thereby help to reduce management’s scope for engaging in managerial opportunism.531 Figure 37 shows the effects of information rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

Information rights

9





 9 Applicable

Figure 37:

4.3.2

 Not applicable

Effects of information rights

Conversion Rights

Securities employed for financing high potential companies often include conversion provisions in which the security held by the venture capital firm converts into common stock at the option of the holder. The most common convertible securities are preferred stock and debentures. Most convertible securities also carry an automatic conversion right, which, in case an exit event occurs, triggers the convertible securities to convert automatically into common stock.532 Conversion provisions give the venture capital firm a preferred position when it comes to liquidating the company. If the company turns out to be a “lemon”, the venture capital firm can make use of its preferred position and receive his payments before any of 530

See Mitchell/Reid (1997), p. 50.

531

See Wright/Robbie (1998), p. 544.

532

See Kaplan/Strömberg (2003), p. 291.

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Venture Capitalists’ Influence through Contractual Agreements

the founders receives any payments. This way, the founders have an incentive to unveil the true character of their company ex ante, since they will probably receive nothing in case of liquidation. There are several arguments, why convertible debt financial instruments are an efficient form of investing in early-stage high-tech companies from the perspective of a venture capital firm. Since the development of a portfolio company is very uncertain, conversion rights give the venture capital firm the opportunity to choose the cash flow profile that is better for it in a given state of the world. If the company turns out to be a lemon, a venture capital firm holding convertible debt can forego its conversion rights and remain in the preferred liquidation position as debt holder. In such a case, the entrepreneurs are likely to receive no liquidation payments since the venture capital firm will collect them all. However, entrepreneurs can anticipate the venture capital firm’s behavior and will consequently not enter into a contract with the venture capital firm. This implies that conversion rights help the venture capital firm to reduce the risk of taking a false investment decision. Based on a similar argument, one can show that conversion rights also induce the management to refrain from managerial opportunism.533 Figure 38 summarizes the effects of conversion rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

Conversion rights

9





 9 Applicable

Figure 38:

533

Effects of conversion rights

See Schmidt (2003); Cornelli/Yosha (2003).

 Not applicable

Venture Capitalists’ Influence through Contractual Agreements

4.3.3

113

Control Rights

4.3.3.1 Voting Rights Voting rights define the extent to which a shareholder has the possibility to effect corporate decisions.534 In general, voting rights of venture capital firms do not depend on the type of stock issued.535 For example, venture capitalists as holders of convertible preferred stock or even convertible bonds can cast their vote on an as-converted basis. Venture capitalists usually try to hold a minority stake in early-stage portfolio companies. Nevertheless, even if the venture capital firm lacks voting control, it is generally the largest non-management shareholder.536 Still, it runs the risk to be overruled in shareholders’ resolutions concerning important topics, such as amendments to the articles of association.537 One way to deal with this is simply to increase requirements for majorities needed to effect important changes in the company. However, these rights only allow preventing decisions to be taken from the majority of the shareholders. In case, the venture capitalist wishes that the majority of shareholders agrees on certain measures to be taken, a pooling agreement among the major shareholders, e.g. the venture capital firm and the management, is most appropriate.538 It is important to note that pooling agreements are private contracts among the involved parties, which have no legal implications for the venture itself.539 Venture capital firms usually hold a certain class of preferred stock and ask for a class voting right, which essentially means that only the holders of this class of preferred stock are allowed to vote on changes regarding the status of their class of stock without other investors having the right to intervene.540 The economic rationale behind class voting is that holders of preferred shares want to protect themselves against decisions of the majority of all shareholders that could have a negative effect on their posi534

See Kaplan/Strömberg (2003), p. 290.

535

See Baums/Möller (2000), p. 40 and Fenn/Liang/Prowse (1995), p. 33.

536

See Fenn/Liang/Prowse (1995), p. 33.

537

In Germany, decisions of the shareholders’ meeting in a stock corporation require according to §133 II AktG a simple majority of cast votes. Amendments to the articles of association of a stock corporation require according to §179 II (1) AktG a majority of 75% of cast votes.

538

See Baums/Möller (2000), pp. 43 et seq.

539

See Müller (2004), p. 2.

540

See Baums/Möller (2000), p. 40.

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Venture Capitalists’ Influence through Contractual Agreements

tion within the company. For example, recapitalization transactions could require dramatic changes in both the legal documents of the company and in the investment documents governing the rights of the investment company. Class voting ensures that amendments to these documents will require the affirmative vote of at least a majority of the adversely affected investors voting separately as a class.541 The venture capitalist will use this “holdout” to negotiate better conditions for him.542 By declining to accept proposed terms, the venture capital firm could potentially bring down negotiations about a recapitalization proposal.

4.3.3.2 Veto Rights Venture capitalists generally ask for a catalogue of actions requiring approval also called veto rights.543 Typically, various corporate decisions call for the direct approval of the venture capital firm in case a supervisory board is not existent. In case a supervisory board exists, the management requires the approval of the supervisory board in which venture capitalists usually play a decisive role.544 In general, veto rights are structured in a way to enable the venture capitalist to prevent its portfolio company from changing the nature and the value of its operations without his consent.545 HOMMEL/RITTER/WRIGHT and DELOITTE & TOUCHE show that veto rights are among the most important contractual relations for financing early-stage high-tech companies in Germany.546 Among the most important veto rights is the approval of the annual budget. Through participation in the budgeting process, the venture capital firm can ensure that the company is following the agreed strategy and is not taking on excessive risks.547 Simi541

See Jaffe (2002), pp. 30 et seq.

542

See Jaffe (2002), pp. 31 et seq.

543

See Wilmerding (2003), pp. 61 et seq.; Heitzer (2002), p. 473. These rights are sometimes also called supermajority rights, as they give majority power to the venture capital firm even though it only holds a minority stake in the company. See for example Vinturella (2004); Deloitte & Touche (2002); Hale/Besner/Ayres (2002).

544

Investment companies usually exert strong control over the composition of the supervisory board of a venture. See chapter 4.3.3.3.

545

See Leopold/Frommann/Kühr (2003), p. 141.

546

See Hommel/Ritter/Wright (2003), p. 328; Deloitte & Touche (2002), p. 10.

547

See Sherling (1999), p. 179.

Venture Capitalists’ Influence through Contractual Agreements

115

larly important is the consent to the appointment of senior management, as this determines in which persons the venture capital firm invests and eventually how well the company performs. Several veto rights refer to important financial aspects such as changes in the shareholder structure, capital increases, taking on additional debt, issue of charges over the company’s assets and introduction of corporate pension schemes.548 These veto rights allow venture capitalists to a large degree to shape the shareholder and financial structure of the venture. Investment and respectively disinvestment aspects can also be subject of veto rights, like the merger with or acquisition of companies or the sale of a business division. These veto rights provide the venture capital firm with the power to prevent undesired changes in the business structure of the venture.549 The management becomes dependent on the approval of the venture capital firm when it comes to pursue an external growth strategy. Organizational aspects are also considered in venture capitalists’ veto rights such as the creation or closing of subsidiaries or the alteration of the company’s statutes. By these veto rights, it is ensured that valuable assets cannot be transferred to subsidiaries and then sold without any control of the venture capitalists.550 In addition, the venture capital firm secures its influence onto the corporate governance structure of its portfolio company. Other veto rights refer to contracts of material influence onto the future development of the company, such as senior management employment contracts, contracts with other shareholders and other major related party transactions. Venture capitalists require these veto rights to prevent major conflicts of interests and to control for large individual risk exposures. Particularly, they try to reduce their risk exposure to managerial opportunism and to unfavorable decisions by both management and other shareholders, simply by not allowing them.

4.3.3.3 Supervisory Board Representation Right Investment companies generally call for the right of representation on the company’s supervisory board through one or two members or confidants of the investment com548

See Engel (2003), p. 290; Sherling (1999), p. 178; Barney et al. (1994), p. 28.

549

See Manigart et al. (2002), p. 18.

550

See Sherling (1999), p. 179.

116

Venture Capitalists’ Influence through Contractual Agreements

pany.551 Of somewhat less importance are the even stronger voting shift provisions under which the venture capital firm may elect additional directors or a majority of the supervisory board in the event of poor performance.552 In a US survey, BARTLETT finds that board rights are the most important contractual element in venture capital financing agreements.553 WEITNAUER states for the German market, that in almost all cases, venture capital firms receive board rights or at least the right to join a council that assumes a consulting role within the company.554 Most of the board-related venture capital research focuses on the Anglo-Saxon one-tier model of the board of directors, which is elected by the shareholders and consists of two types of representatives.555 Inside directors come from within the company and are usually referred to as executive directors if they are part of the company's management team. Outside directors are not directly part of the management team and are supposed to be independent from the company. In Germany, a two-tier board model is legally codified for stock corporations since 1937.556 Its central feature is the organizational and personal division of management and control. Shareholders elect the representatives of the supervisory board557, who in 551

See Leopold/Frommann/Kühr (2003), p. 140; Kaplan/Strömberg (2003), p. 287; Engel (2003), p. 290; Brettel/Thust/Witt (2001), p. 29; Busenitz et al. (1997), p. 9; Barney et al. (1994), p. 28; Rosenstein et al. (1993), p. 99; Sahlman (1990), p. 506; Rosenstein (1988), p. 160; Hoffman/Blakey (1987), p. 23.

552

This is the case in 18% of US financing rounds. See Kaplan/Strömberg (2003), p. 290.

553

See Bartlett (1999), p. 9.

554

See Weitnauer (2001), p. 283.

555

See HAWRYLYSHYN for a discussion of the historic origins and developments of three intensively discussed board models: the Anglo-Saxon one-tier model, the German two-tier model, and the Japanese model. See Hawrylyshyn (2002), pp. 315 et seq. There is a broad discussion about the differences between international board models. See Hopt/Leyens (2004); Hawrylyshyn (2002); Gros (2002); Wulfetange (2002); Shleifer/Vishny (1997). A German peculiarity is the strong labor co-determination. Companies with 2,000 or more employees must have half their supervisory board composed of workers’ representatives. Only the casting vote of the chairman of the supervisory board, who is elected by the shareholders, gives some more influence on corporate decisions to the shareholders. For a detailed analysis, see Hopt/Leyens (2004), pp. 6 et seq. However, labor co-determination within the supervisory board does not play an important role in the context of venture capital-backed companies, as this is only relevant for companies with 500 and more employees. See Sadowski/Junkes/Lindenthal (2000), p. 2.

556

See Behr/Schäfer (2003), p. 6.

557

LÜCK provides an extensive catalogue on personal requirements of members of the supervisory board and on principles of their activity. See Lück (2002b), p. 24; Lück (2001b), p. 130.

Venture Capitalists’ Influence through Contractual Agreements

117

turn elect the members of the management board. Whereas the management board is responsible for running the company, the supervisory board’s duties are the appointment, supervision, and removal of members of the management board.558 It usually also assumes the role of the top management’s advisor on issues such as corporate strategies and often even has to ratify important corporate decisions.559 The supervisory board acts as the institution that allows formal and regular interactions between the venture capital firm and its portfolio company. It serves a crucial function in mitigating risks of managerial opportunism as supervisory board members have the right to fire the management in case it does not serve the interests of the shareholders. Moreover, as the supervisory board has to consent to important firm-related issues such as amending the corporate strategy, it serves as a mechanism to control for the risk of unfavorable decision taking. Figure 39 summarizes the effects of control rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

9



9



Control rights

9 Applicable

Figure 39:

4.3.4

 Not applicable

Effects of control rights

Management Covenants

4.3.4.1 Affirmative Covenants Venture capital firms require the management of their portfolio companies to adhere to affirmative covenants, which define correct behavior on the part of the company’s management.560 For example, the management promises to maintain adequate insurance, to pay corporate debts and taxes in accordance with normal terms, to comply 558

See Hopt/Leyens (2004), p. 5. The German statutory requirements on the supervisory board are formally defined in §§ 95-116 AktG.

559

See Kaplan/Strömberg (2003), p. 287. Several managerial decisions require the consent of the supervisory board. See chapter 4.3.3.2 for a more detailed discussion.

560

Cf. Richardson (2004).

118

Venture Capitalists’ Influence through Contractual Agreements

with all laws applicable and to perform its obligations under its agreements. Furthermore, the company can assure to take reasonable steps to protect its patents, trade secrets and copyrights as well as to use the funds provided by the venture capital firm in the agreed manner. Affirmative covenants are a legal basis for the venture capitalist to sue managers that act negligently or even illegally. By building up the threat of a costly and unpleasing lawsuit, venture capital firms raise the costs for managers to pursue any unwanted actions. Therefore, affirmative covenants help venture capitalists to reduce the risk of managerial opportunism.

4.3.4.2 Non-Compete Clause Venture capitalists require the management to enter into agreements with the company that require their full time attention to the company’s business, protect its trade secrets and prevent the founders and managers from going into competition with the company.561 A non-compete clause specifies that if an employee leaves a firm, he cannot work in the same profession for a couple of years and geographical location.562 KAPLAN/STRÖMBERG show that non-compete clauses are used in approximately 70% of US venture capital financing rounds.563 For the German market HOMMEL/RITTER/WRIGHT and DELOITTE & TOUCHE indicate that non-compete clauses are a standard contractual element in early-stage financings by venture capital firms.564 BARNEY ET AL. developed the concept of competitive opportunism, which states that managers might engage in actions increasing the level of competition faced by the venture capital firm’s portfolio company, such as disclosing proprietary technology to competitors, acting as advisors to them or even starting a new competing firm.565 Management could for example push forward the development of a production process technique with the money provided by venture capital firm A. Many of the results of these development efforts are useful only in combination with the knowledge of the 561

See Richardson (2004).

562

See Levin/Tadelis (2002), p. 22.

563

See Kaplan/Strömberg (2003), p. 292.

564

See Hommel/Ritter/Wright (2003), p. 328; Deloitte & Touche (2002), p. 11.

565

See Barney et al. (1994), p. 20.

Venture Capitalists’ Influence through Contractual Agreements

119

management team. In such a case, management might have an incentive to leave the initial company, where venture capital firm A already holds a major stake and start a new company, in which A does not hold a stake. As this new company has now a better starting position to the readily available production process technique, it could enter into negotiations with the venture capital firm B and negotiate a much better deal than initially with A. The non-compete clause forbids the managers to engage in any of these actions. The venture capital firm can sue the management if it breaches this agreement.566 Generally, its reputation in the market is usually forfeit as such events spread quickly within the small community of investment companies. With contractual sanctions and penalties anchored with the non-compete clause in the labor contract of the company’s management, the incentive to follow a hold-up strategy is diminished drastically. The non-compete clause is the venture capitalist’s prime contractual clause to reduce the risk he faces from management’s competitive opportunism.

4.3.4.3 Vesting Venture capital firms often negotiate to make entrepreneurs subject to future vesting so that they will forfeit granted shares or options if they leave the employment of the company before the vesting periods expire (time vesting) or if certain milestones are not met (performance vesting).567 They usually ask for a time vesting period spanning several years.568 KAPLAN/STRÖMBERG show that founders’ vesting schedules are used in more than 40% of US venture capital financing rounds.569 For the German market, HOMMEL/RITTER/WRIGHT and DELOITTE & TOUCHE indicate that vesting provisions play an important role in early-stage financings through venture capital companies.570

566

See Hoffman/Blakey (1987), p. 18.

567

See Richardson (2004); Kaplan/Strömberg (2003), p. 287; Bottazzi/Da Rin (2002b), p. 235; Manigart et al. (2002), p. 18; Hoffman/Blakey (1987), p. 18.

568

See Gompers/Lerner (2001), p. 157.

569

See Kaplan/Strömberg (2003), p. 292.

570

See Hommel/Ritter/Wright (2003), p. 328; Deloitte & Touche (2002), p. 11.

120

Venture Capitalists’ Influence through Contractual Agreements

Vesting provisions are contractual provisions for venture capital firms to cope with problems arising from information asymmetries. With performance vesting provisions in place, the venture capital firm can punish the management if the portfolio company misses performance targets. In such a case, founders’ shares or options are transferred back to the venture capitalists respectively not transferred to the founders from the venture capital firm. In case the company misses its targets, the management loses its vested shares and options. In order not to let this happen, the management will exert more effort to reach the set milestones. Thereby, performance vesting agreements reduce the risk of managerial opportunism. Time vesting agreements reduce the risk of the management to engage in actions of competitive opportunism. By making it more costly for a founder to leave the firm before the shares have fully vested, venture capital firms increase the incentives of the founder to stay with the firm.571

4.3.4.4 Representations and Warranties Venture capital firms require the company to make representations concerning among others its good standing, the ownership of its technology and other assets, full disclosure of all material information needed to make an informed investment decision, the accuracy of the company's financial statements and the absence of litigation, i.e. known or probable claims against the company.572 The economic rationale for the venture capital firm to include representations and warranties in the investment agreement with portfolio companies is to provide for a legal basis to sue managers in case of an infringement.573 By building up this threat, venture capitalists induce managers to unveil all negative information regarding the company before both parties sign the final investment agreement. The risk of a false investment decision can thereby be reduced as the problem of hidden characteristics of the portfolio company becomes less pronounced due to the improved information basis of the venture capital firm. Figure 40 summarizes the effects of management covenants from the perspective of a venture capital firm. 571

See Kaplan/Strömberg (2002), p. 19.

572

See White (2004).

573

Cf. Brettel/Thust/Witt (2001), p. 17.

Venture Capitalists’ Influence through Contractual Agreements

Reduce risk of…

Effects Contractual rights Management covenants

121

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

9

9



 9 Applicable

Figure 40:

4.3.5

 Not applicable

Effects of management covenants

Milestone Agreements

4.3.5.1 Milestones Venture capitalists typically negotiate contracts that specify measures to be taken contingent on the incidence of certain predefined events.574 These so-called milestones define important steps in the planned development of the company.575 This chapter defines what common milestones are and the next chapters discuss the applications of milestones in several contractual elements between venture capital firms and their portfolio companies. Milestone agreements can be of financial nature, such as reaching certain sales and profitability numbers or registration for an initial public offering.576 They can also be of technical nature, such as completion of design, pilot production or introduction of a second product.577 Often this is combined with a patent application or registration of a trademark. Finally, milestone agreements can as well be linked to the conclusion of contracts that are considered decisive for the future corporate development, such as the acquisition of a key customer or the conclusion of licensing and R&D contracts.578 Contingent on attaining milestones these agreements provide for taking measures that can affect various investor rights as KAPLAN/STRÖMBERG show.579 The freedom of contract actually allows for a plethora of milestone agreements, to present would go 574

Cf. Kaplan/Strömberg (2003), p. 292.

575

Cf. Hoffmann/Hölzle (2004), p. 233.

576

See Sahlman (1990), p. 475; Hoffmann/Hölzle (2004), p. 233.

577

See Hoffmann/Hölzle (2004), p. 233.

578

See Hoffmann/Hölzle (2004), p. 233.

579

See Kaplan/Strömberg (2003), pp. 292 et seq.

122

Venture Capitalists’ Influence through Contractual Agreements

beyond the scope of this analysis. Therefore, the following chapters will discuss the most relevant contractual milestone agreements.

4.3.5.2 Earn-out An earn-out is an agreement obliging the venture capital firm to pay a certain amount on top of the price it initially paid for its stake in the company after some time.580 The venture capitalist firm commits itself to pay a higher price for the contracted stake if the portfolio company manages to achieve pre-specified mostly financial criteria like profit, cash flow or sales within a certain period. In case such a milestone is achieved, the amount that goes beyond the initial price has to be transferred to the entrepreneurs. Whereas the earn-out is a common contractual agreement in buyout and acquisition financing581, it is still used infrequently in early-stage financing, even though it theoretically offers a remedy to the uncertainty in company valuations.582 The earn-out is a contractual agreement targeted at solving valuation problems resulting from the extensive uncertainty rooted in early-stage high-tech companies. Most of the value of early-stage high-tech companies lies in intangible assets and uncertain future developments. The perceptions of the true value of the company can therefore differ substantially between venture capitalists and entrepreneurs.583 Time has to pass until these uncertainties are resolved and the “real” value can be observed. The earn-out clause reduces the risk of a false investment decision in the beginning as it reduces the amount committed to a venture. The full price has to be paid only in case the venture turns out to be performing according to expectations, i.e. the uncertainty regarding its true value increase potential has been revealed. Thereby, the earn-out clause helps the venture capital firm to mitigate the risk associated with a false investment decision. In addition, the earn-out agreement also serves to reduce the risk of managerial opportunism, since entrepreneurs have a higher incentive to achieve those milestones, as they will receive an additional payment for their shares.

580

See Schnetzer (2002) for further details.

581

See Richardson (2004).

582

See Hommel/Ritter/Wright (2003), p. 328; Tyebjee/Bruno (1984a), p. 1064.

583

See Bartlett (1999), pp. 11 et seq.

Venture Capitalists’ Influence through Contractual Agreements

123

4.3.5.3 Ratchets Venture capitalists often ask for ratchet agreements that are contingent on the company’s performance.584 A ratchet-down agreement specifies that in case the management fails to meet a performance target within a specified period of time a reduction in the management’s equity share is effected by transferring shares from the management to the venture capital firm. Conversely, a ratchet-up agreement envisages that if management timely meets a performance target it will receive shares from the venture capital firm. The economic rationale behind ratchet agreements is a straightforward incentive consideration on the part of the venture capitalists. To motivate the management team to perform up to its promises, it offers financial rewards in form of shares in their company. Thus, the use of ratchets mitigates the risk of managerial opportunism.

4.3.5.4 Management Dismissal Even though venture capitalists usually are represented on the supervisory board585 and exert influence on senior management, they still might ask for explicit milestone agreements defining under which circumstances the venture capital firm has the right to exchange senior management.586 By securing its influence onto the decision which person runs the company, the venture capital firm simultaneously secures its influence onto the general development of the company. The right to dismiss the management of a portfolio company represents a strong contractual device that enables the venture capital firm to reduce the risk associated with managerial opportunism. Managers that shirk or excessively consume perquisites are very likely to be dismissed by the venture capital firm. Thereby, the problem of moral hazard can be reduced.

584

See Manigart et al. (2002), p. 18.

585

See chapter 4.3.3.3.

586

See Barney et al. (1994), p. 28.

124

Venture Capitalists’ Influence through Contractual Agreements

4.3.5.5 Staging Typically, venture capitalists provide capital through staged financing587, which means that the company only receives additional financing if it achieves pre-specified milestones.588 In case the company fails to reach its milestones, the venture capital firm is typically released from its contractual obligation to provide further finance.589 SAHLMAN states for the US market: “The most important mechanism for controlling the venture is staging the infusion of capital”.590 The studies of HOMMEL/RITTER/WRIGHT and DELOITTE & TOUCHE find strong support for an important role of staging investments in early-stage high-tech companies in Germany as well.591 The staging of investments allows the venture capital firm to verify the company’s situation recurrently. Each time a capital infusion takes place, the company needs to generate reports and to update business plans allowing the investment company to gather new information regarding the development of the portfolio firm. Staging lowers the amount of capital at risk by only paying out a fraction of the total required investment. After some time, the uncertainty concerning the company’s true characteristics resolves and the next stage can be financed under less information asymmetries. Thereby, staging reduces the risk of a false investment decision by limiting potential losses. However, the infusion of capital in stages can induce a myopic behavior of the company’s management.592 CORNELLI/YOSHA show that an entrepreneur has incentives for window-dressing when capital is invested in stages.593 An example for this would be to

587

According to CUNY/TALMOR, staging can be arranged for with two different methods. The first is milestone financing, which includes both an immediate funding by the investment company and a commitment for a subsequent additional investment. The second arrangement is round financing, in which there is no pre-commitment to invest beyond the current funding needs. See Cuny/Talmor (2004), pp. 1 et seq.

588

See Gompers/Lerner (1996), p. 465.

589

See Hoffmann/Hölzle (2004), p. 233.

590

See Sahlman (1990), p. 506.

591

See Hommel/Ritter/Wright (2003), p. 328; Deloitte & Touche (2002), p. 10.

592

See Wright/Robbie (1998), p. 542.

593

This problem can be mitigated through the use of convertible securities. See Cornelli/Yosha (2003).

Venture Capitalists’ Influence through Contractual Agreements

125

come up with a prototype designed in a rough-and-ready way, simply to meet the milestone, but which would hamper long-term performance of the company. Staging reduces problems arising from moral hazard considerations. Infusing capital in distinct stages offers the venture capital firm the option to abandon594 its investment in the venture after each capital infusion in case milestones are not met. Venture capital firms use staging as an important monitoring device.595 Consequently, the entrepreneur is kept on a “tight leash” by staging the financing rounds.596 The threat to halt financing the company even if it would be economically viable is credible, as it is rational for the venture capital firm to only provide money and support for portfolio companies where an adequate return on invested capital and spent time can be expected.597 It sends a very strong negative signal to the market if a venture capital firm is not willing to continue financing its portfolio company.598 The associated loss of reputation for the company leads to the danger of putting off other investment companies. This has a strong motivational effect on the company’s management, as the managers will be dedicated to prevent this from happening599. Strong incentives for entrepreneurs to exert high effort and to avoid high risks are thus implemented.600 Therefore, staging serves as an instrument to reduce managerial opportunism. Staging of capital infusions also mitigates a potential hold-up problem from the side of the entrepreneur, who could threaten the venture capital firm with him leaving the company and taking all his human capital with him.601 Over time, the inalienable human capital of the entrepreneurs becomes embodied in the physical capital, structures and processes of the company and consequently becomes alienable.602 By keeping the initial financing rounds as small as possible, the potential payoff of a hold-up strategy for the entrepreneur is reduced. Consequently, the venture capital firm also faces a 594

See Sahlman (1990), p. 473; Gompers (1995), p. 1461.

595

See Sahlman (1990), p. 506.

596

Gompers (1995), p. 1462.

597

See Sahlman (1990), p. 507.

598

See Sahlman (1990), p. 507.

599

See Hoffmann/Hölzle (2004), p. 233.

600

See Schertler (2001), p. 9.

601

See Neher (1999), p. 256.

602

See Neher (1999), p. 256.

126

Venture Capitalists’ Influence through Contractual Agreements

lower risk of competitive opportunism. Figure 41 summarizes the effects of milestone agreements from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

9

9





Milestone agreements

9 Applicable

Figure 41:

4.3.6

 Not applicable

Effects of milestone agreements

Cash Flow Rights

4.3.6.1 Dividend Preference Venture capital companies sometimes negotiate a preferred dividend payment for their preferred stock.603 The dividend will be of some specified percent that will be accrued on the preferred stock and paid before any dividend is paid to holders of common stock. The common type of this preference is a mandatory and cumulative dividend604, which acts as an interest payment on the nominal investment. It accrues at fixed dates, typically annually and cumulates until fully paid.605 As they do not have to be paid out during normal business operations and as they are normally added to the liquidation claim of the venture capital firm, a clear-cut dividing line cannot be drawn between the dividend preference and the liquidation preference discussed in chapter 4.3.6.2. In view of the cash needs and anticipated losses of most start-ups, venture capitalists usually prefer to have their portfolio companies retain any profits to fund operations. In practice, a dividend preference is seldom included in investment agreements in the US as well as in Germany.606

603

See Richardson (2004).

604

In case the dividend is non-mandatory and non-cumulative, which is the standard case in public markets, the company can take the decision not to issue a dividend. Under such circumstances, the investment company will receive no dividend payment at all. See Wilmerding (2003), p. 40.

605

See Beavers/Brownlee (2001).

606

See Hale/Besner/Ayres (2002).

Venture Capitalists’ Influence through Contractual Agreements

127

The dividend preference can be used within the US context to support the argument in front of tax authorities that preferred stock is more valuable than common stock, and to allow the founders to purchase common stock at a lower price than venture capital firms purchase the preferred stock at. If the portfolio company performs poorly, the required dividend payments could devour all capital gains of the company from the position of an entrepreneur. This leads to two effects from the perspective of a venture capital firm. First, the entrepreneurs can anticipate that they only will benefit from venture capital financing if their company performs well. Only when the company achieves a high enough value increase, there will be payments left that can go to the entrepreneurs. Therefore, only companies that truly see the potential to achieve this will go for venture capital financing. Thereby, the venture capital firm’s risk of a false investment decision is reduced. Second, based on the same argument, the dividend preference gives the entrepreneur more incentives to exert more effort and reduces the risk of managerial opportunism.

4.3.6.2 Liquidation Preference Venture capitalists usually ask for liquidation preferences that entitle them to receive a predetermined amount before other shareholders in the event the company is sold or liquidated.607 Liquidation preferences specify the amount and the order in which holders of different classes of securities are paid.608 The basic structure of a liquidation preference is that the venture capital firm receives its initial investment back before other investors receive any payments. If the venture capital firm asks for example for the repayment of double of its initial investment, one speaks of a double liquidation preference. In practice, even triple liquidation preferences have been negotiated.609 As already indicated in chapter 4.3.6.1, the liquidation preference can be closely linked with cumulative dividend payments and thus increases the payments that only go to the venture capital company.610 A so-called participating preferred stock adds another strong element as this involves not only the payback of the investment plus accumu-

607

See Richardson (2004); Hale/Besner/Ayres (2002).

608

See Hoffman/Blakey (1987), p. 24.

609

See Hoffmann/Hölzle (2003), p. 113.

610

See Kaplan/Strömberg (2003), p. 290.

128

Venture Capitalists’ Influence through Contractual Agreements

lated dividends but also lets the preferred stock holders participate in the remaining payments with common stock holders as if they had converted.611 For the US market, the liquidation preference is a standard contractual element, as it is used in 98% of financings rounds.612 The same is true for the German market.613 From an economic point of view, the liquidation preference works as a similar incentive mechanism as the dividend preference. If the portfolio company develops poorly, only little or nothing will be available for distribution to the entrepreneurs after senior claims of the venture capital firm have been paid off. Only in good states of company performance, the entrepreneur will receive a significant amount after selling the company, as the liquidation preference of the venture capital firm is then only a rather small fraction of total returns from the exit. Consequently, the liquidation preference is an instrument to reduce the risk of a false investment decision and the risk of managerial opportunism.

4.3.6.3 Anti-Dilution Protection Venture capital firms typically protect their shareholdings against both share dilution and price dilution.614 Recently, a pay-to-play clause is also often included in antidilution provisions. Under this provision, only those investors who make pro rata investments in future financings will receive anti-dilution protection.615 Share dilution or percentage-based dilution616 provisions protect the shareholdings of the venture capital firm against dilution from events such as capital increases, stock dividends and stock splits. These provisions keep the percentage of the venture capital firm’s shareholding constant. The German Stock Corporation Act (AktG) grants a statutory preemptive right for all shareholders, which can be waived by a 75% majority of the shareholders. In case, the venture capital firm holds less than 25% of the

611

See Beavers/Brownlee (2001).

612

See Kaplan/Strömberg (2003), p. 290. The liquidation preference in form of a participating preferred stock is present in 48% of US financing rounds.

613

See Hoffmann/Hölzle (2003), p. 113.

614

See Beavers/Brownlee (2001).

615

See Womble Carlyle Sandridge & Rice (2003), p. 5; Sokol et al. (2001), p. 2.

616

See Harris (2002), p. 35.

Venture Capitalists’ Influence through Contractual Agreements

129

company’s shares, it will normally ensure that the shareholder agreement prohibits waiver of the preemptive right without the consent of the venture capitalist.617 Price dilution or price-based dilution provisions protect the shares of the venture capital company against dilution from sales of shares at lower valuations in downrounds.618 These provisions adjust the price per share paid by the venture capitalist or the conversion price of convertible securities to a lower level.619 In all cases, the portfolio company would have to issue new shares or the entrepreneurs have to transfer their personal shares to compensate the venture capital firm for the dilutive effect.620 In practice, two different forms of a price-based anti-dilution clause can be distinguished. The full ratchet anti-dilution protection allows a venture capital firm having invested in earlier rounds at a higher price than new investors in later rounds to receive as many additional shares as to make its average purchase price for its entire shareholding equal to the share price the new investor paid in the down-round.621 This clause can have drastic effects on a company’s shareholder structure as the sale of a single share at a lower valuation requires the full investment of a venture capital company being priced at the new low price by transferring shares for free. The full ratchet provision is therefore widely viewed as unfair and is consequently used rarely. The more common and equitable approach to implement a price protection is the weighted average ratchet. In this case, the conversion rate for the venture capital firm’s shares is adjusted down to the weighted average share price of all outstanding common shares after the down-round. The venture capital firm‘s average cost per share will then equal the average price per share given to all investors. For the US market, anti-dilution provisions are standard contractual elements and are implemented in 95% of financings

617

See Hale/Besner/Ayres (2002).

618

See Möller (2003), p. 38; Kaplan/Strömberg (2003), p. 291; Harris (2002), p. 35. Down-rounds are financing rounds where additional capital is raised at a company valuation significantly below that at which it has been previously raised. See Harris (2002), p. 37.

619

As long as any new common stock is sold at a price equal or higher than the rate at which the investment company bought its shareholdings or at which the investment company can convert its convertible securities into common stock, its investment will not be diluted economically. Although its slice of the pie shrinks, the pie itself will at least grow commensurately. Only if common stock is sold for less than the initial price, the pie will not grow enough to compensate for the shrinking size of the slice. See Hoffman/Blakey (1987), p. 17.

620

See Hale/Besner/Ayres (2002).

621

See Hoffman/Blakey (1987), p. 17.

130

Venture Capitalists’ Influence through Contractual Agreements

rounds, whereby 78% are weighted average ratchets and 22% full ratchets.622 According to HOMMEL/RITTER/WRIGHT and DELOITTE & TOUCHE, anti-dilution provisions are also extensively used in the German market.623 Whereas the percentage-based anti-dilution clause only aims for maintaining the status quo within the shareholders’ structure and thereby helps to reduce the risk of unfavorable decision-taking, the economic effect of a price-based anti-dilution clause onto the company’s management and employees who are not price protected can be tremendous.624 The dilutive cost of raising additional capital rises the lower the valuation in the next financing round. This imposes a strong incentive for the company’s management to avoid a down-round and motivates to strive for delivering excellent performance. Thereby, the anti-dilution clause helps to reduce the risk of managerial opportunism. Figure 42 summarizes the effects of cash flow rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

9



9



Cash flow rights

9 Applicable

Figure 42:

4.3.7

 Not applicable

Effects of cash flow rights

Preemptive Rights

4.3.7.1 Right of First Refusal Venture capital firms typically seek the right to control the transfer of shares to third parties. The right of first refusal requires the portfolio company’s management to offer the stock for sale to the venture capital company at the same price and terms negotiated with a third party.625

622

See Kaplan/Strömberg (2003), p. 292.

623

See Hommel/Ritter/Wright (2003), p. 328; Deloitte & Touche (2002), p. 11.

624

See Harris (2002), p. 37.

625

See Greenberger (2001), p. 47.

Venture Capitalists’ Influence through Contractual Agreements

131

Whether the venture capital firm is required to purchase all the stocks offered or only part of them is subject to negotiations. Certainly, from the viewpoint of the management an “all or nothing” option is favored, as many institutions active in secondary transactions626 may desire to acquire only blocks of shares of certain sizes.627 A venture capital company that is able to exercise its first refusal right as to only part of the offered stock can be in a position to block an entire secondary transaction. In fact, the management might find it hard to enter at all into promising negotiations with third parties due to the presence of a first refusal clause. The interested party might be unwilling to put up with the effort of lengthy negotiations of the terms of a stock purchase when it knows that the venture capital firm might well be exercising its right of first refusal. Consequently, rights of first refusal are considered to substantially limit the liquidity of shares of the management. The company’s management can thus become strongly dependent on the actions of the venture capital firm underlining the importance of keeping good relations between the two parties. The venture capital firm pursues two goals with share transfer restrictions.628 First, it retains the option to increase its stake in the company. Second, it allows controlling the composition of the shareholder group and thereby reduces its risk of unfavorable decisions been taken against its will.

4.3.7.2 Right of First Offer The right of first offer is a weaker version of the right of first refusal. In the presence of a venture capital firm’s right of first offer, the management must merely define the minimum price and terms it will accept for the sale of stock to third parties.629 The venture capital firm then has the option to purchase the stock at these minimum terms for a designated period. If the venture capital firm declines to purchase the stock at these terms, the management can sell the stock to a third party that is willing to accept these terms. Clearly, the right of first offer puts the management in a stronger position than the right of first refusal. From the perspective of the venture capitalist, the right of first 626

See Smith (2001) for more information regarding secondary transactions.

627

See Greenberger (2001), p. 49.

628

See Greenberger (2001), p. 47.

629

See Greenberger (2001), p. 49.

132

Venture Capitalists’ Influence through Contractual Agreements

offer is less attractive as it does not permit to control the shareholder structure as effectively as does the right of first refusal.630 The economic purpose for the venture capital firm to include a right of first offer in the investment agreement is the same as with the right of first refusal: To reduce the risk of an unfavorable decision-taking by others. Figure 43 summarizes the effects of preemptive rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

Preemptive rights





9

 9 Applicable

Figure 43:

4.3.8

 Not applicable

Effects of preemptive rights

Disinvestment Rights

4.3.8.1 Tag-Along Right Venture capital firms usually ask for specific disinvestment rights, which aim for facilitating their exit. Among the important disinvestment rights is the so-called tagalong right, which is the right of the venture capital firm to participate in any sale of stock by the management, usually on a pro-rata basis.631 The purpose of the tag-along right is to provide the venture capital firm with a protection against a sell-out by the company’s management. The management of a company is generally considered the most critical success factor for a company.632 Consequently, the venture capital firm has an interest in keeping the entrepreneurs in the venture as they often provide resources that are critical to the success of the portfolio company. The exit of the entrepreneurs could have a strong adverse effect on valuations by third parties and make it much harder for the venture capital firm to find a buyer for its 630

See Greenberger (2001), p. 49.

631

See Greenberger (2001), p. 49. Go-along right, take-along right, and co-sale right are synonyms for the tag-along right.

632

See chapter 3.4.4.3.

Venture Capitalists’ Influence through Contractual Agreements

133

shares. As a result, tag-along rights from the perspective of a venture capital firm mainly reduce the risk of exit obstruction by third parties.

4.3.8.2 Drag-Along Right Venture capitalists often negotiate a drag-along right, which requires the management to sell their shares to a third party if the venture capital firm itself sells its interest.633 The management can do this at the same price and terms as the venture capital firm. The drag-along right is important if an exit via trade sale becomes possible. Normally, an investor is interested in acquiring at least a majority in the company if he is not going for a complete (100%) acquisition. In such a case, the venture capital firm, even if it is only a minority investor can require the other shareholders to sell their stock to the acquirer.634 The venture capitalist ensures this way that the management is not capable of blocking an exit possibility by not participating in a trade sale.

4.3.8.3 Redemption Right To facilitate disinvestment in rather poor performing ventures, venture capital firms negotiate a redemption right, which entitles the venture capitalist to sell the stock to the company.635 The company is usually required to repay the initial investment plus a minimum interest rate to the venture capital firm.636 In reality, the company regularly lacks the capital to comply with the payback demands of venture capitalists.637 The re-

633

See Greenberger (2001), p. 51.

634

A major consideration in a drag-along transaction is to ensure the fairness of the deal terms for the management. Problematic are transactions where the buyer is an entity in which the investment company holds an economic interest. Normally, interests are aligned between investment company and management concerning the price at which shares are sold, i.e. both parties strive to realize the maximum possible valuation. See Greenberger (2001), p. 52.

635

If redemption rights are given to the investment company, they are economically similar to a protective put option. However, redemption rights can also be given to the company. In such a case, it requires the investment company to redeem its stock at the will of the management, which corresponds to a call option for the company’s management.

636

See Heitzer (2002), p. 476. Sometimes repayment is asked for at terms of fair market value. See Kaplan/Strömberg (2003), p. 291.

637

See Baums/Möller (2000), p. 34.

134

Venture Capitalists’ Influence through Contractual Agreements

demption right is observed in the US in 79% of financing rounds, but is less common in the German market.638 The redemption right mainly aims at building up a credible threat potential against the management of a laggard developing company.639 A management that is confronted with repayment demands of venture capitalists is thought to step up its efforts to find another exit opportunity for the venture capital firm. In this context, the redemption right enhances the incentives of the management to work together with the venture capital firm in searching for an adequate exit opportunity. It also serves as a mechanism to reduce the venture capitalists’ risk of facing barriers to exit from its investment by third parties.

4.3.8.4 Registration Rights Venture capitalists typically negotiate contractual agreements that entitle them to require their portfolio company to register its shares for sale to the public.640 In case the portfolio company is not structured as a stock corporation (AG), the venture capital firm requires in addition the right to prompt the conversion of the legal form of the company.641 They usually require two types of registrations rights. Demand rights entitle venture capitalists to force their portfolio company to register its shares on a stock exchange. This is necessary, as under the applicable German law, the issuer itself has the sole discretion to choose which shares it lists on a stock exchange.642 Piggy-back rights entitle venture capitalists to include their shares in a stock registration initiated by the portfolio company.643 The venture capital company can negotiate the right to sell its shares with other investors on a pro rata, a disproportionate and a secondary ba-

638

See Kaplan/Strömberg (2003), p. 291; Brettel/Thust/Witt (2001), p. 23.

639

See Brettel/Thust/Witt (2001), p. 23.

640

See Richardson (2004); Sahlman (1990), p. 504.

641

See Heitzer (2002), p. 476.

642

See Hale/Besner/Ayres (2002).

643

See Richardson (2004). The associated costs with registration at a stock market are normally borne by the portfolio company, whereas each shareholder pays the underwriting fee of the investment bank pro rata. See Beavers/Brownlee (2001).

Venture Capitalists’ Influence through Contractual Agreements

135

sis.644 The actual allocation will be determined, partly dependent on marketing considerations, in negotiations with investment banks. The purpose of registration rights is to provide the investment company with a mechanism to exit from its investment. Venture capitalists and management potentially have different time horizons regarding the exit of the venture capital firm.645 The management of an early-stage company usually follows a long-term build-up strategy regarding the development of its company. The venture capitalist pursues a mid-term investment strategy, which implies that an exit is aimed for after some years of investment.646 As the performance of a venture capital firm is, among others, dependent on the time it holds each investment, it has an incentive to realize capital gains from its investments rather sooner than later. Registration rights help the venture capital firm to realize an exit when the management still hesitates to undertake an IPO. Certainly, in cases where the management absolutely declines to go for an IPO, the enforcement of registration rights does not make sense. An IPO will only be successful, if the majority of all involved parties supports this decision.647

4.3.8.5 Cancellation Right Investment companies holding a (silent) partnership have a contractual right to cancel the partnership after a certain period.648 To avoid discussions about the adequate amount of repayment, in particular about the development of profits and undisclosed

644

See Beavers/Brownlee (2001).

645

Cf. Brettel/Thust/Witt (2001), p. 11.

646

GOMPERS argues that among venture capital firms, young venture capitalists have incentives to grandstand. This means that they have an interest to take their portfolio companies public earlier than more established venture capital firms do. Thereby, they hope to establish a reputation and to facilitate fund raising for the next fund. See Gompers (1996), p. 134.

647

See Baums/Möller (2000), pp. 58 et seq.

648

See Leopold/Frommann/Kühr (2003), pp. 142 et seq. It is important to note, that both, the investment company and the portfolio company have the right to cancel the partnership. This is contrary to a straight or preferred equity investor, who cannot be made to leave the company involuntarily. Usually, there is a certain minimum term for a silent partnership. After this minimum term, cancellation is possible from both parties according to the cancellation period that is specified in the investment contract.

136

Venture Capitalists’ Influence through Contractual Agreements

reserves, a fixed value increase premium is often negotiated.649 This instrument has been quite popular among government-backed investment companies, since it is easy to implement. The drawback is that the contractually fixed value increase premium does not reflect the real increase in the company’s value. Apart from a partnership, only shareholders in a limited liability corporation (GmbH) have the possibility to cancel their investment. However, this is only possible if the investment company can prove a good reason why it is not possible anymore to continue being a shareholder in the company.650 The potential economic effect of an investment company’s cancellation right on its portfolio company is massive. By depriving the company of parts of its equity base, a financial situation of the portfolio company can be provoked which could endanger the survival of the company. This effect is reinforced through the negative signal that is sent to the market when an investment company cancels its investment. Other investors will be wary of investing in the company due to the uncertainty surrounding the reasons that made the other investment company exit the investment. Thus, the threat that is linked to the cancellation right reduces potential moral hazard problems and pushes the management to perform strongly according to the wishes of the investment company thereby aligning the interests between both parties. In this respect, it not only reduces the risk of exit obstruction by third parties but also reduces the risk of managerial opportunism. Figure 44 summarizes the effects of disinvestment rights from the perspective of a venture capital firm.

Reduce risk of…

Effects Contractual rights Disinvestment rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

9





9 9 Applicable

Figure 44:

 Not applicable

Effects of disinvestment rights

649

The value increase premium is usually an additional annual interest payment on the nominal investment amount. See Leopold/Frommann/Kühr (2003), pp. 142 et seq.

650

See Heitzer (2002), footnote 26.

Venture Capitalists’ Influence through Contractual Agreements

4.3.9

137

Summary

Figure 45 provides an overview of the effects of typical elements in venture capital contracts from the perspective of a venture capitalist.

Reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

unfavorable decision taking

exit obstruction

Information rights

9







Conversion rights

9







Control rights

9



9



Management covenants

9

9





Milestone agreements

9

9





Cash flow rights

9



9



Preemptive rights





9



Disinvestment rights

9





9 9 Applicable

Figure 45:

 Not applicable

Summary of effects of typical elements in venture capital contracts

Venture capitalists ask for these contractual elements in the investment agreement with their portfolio companies directly to protect the value of their investment. However, this contractual structure also works indirectly to reduce the risk of the venture capital firm of taking a false investment decision beforehand. Many entrepreneurs will be deterred from financing their venture with the help of venture capitalists in view of the strong pressure that venture capitalists can exert on them with the help of these contractual rights. In general, venture capital contracts are designed in a way to give more control and financial rights to the entrepreneurs when they show good performance and to take these rights away from entrepreneurs when they miss their performance targets. Hence, a venture capital contract acts as a self-selection mechanism that leads to a situation where only really promising deals will actually be brought to the attendance of venture capitalists. Entrepreneurs can expect that they benefit from venture capital financing only in case the company is successful, those of them that cannot offer such a deal will refrain from going after venture capital. This mechanism reduces the venture capitalists’ risk of taking a false investment decision.

138

Venture Capitalists’ Influence through Contractual Agreements

Whereas this extensive catalogue of additional investor rights is perceived to be necessary from the perspective of the venture capital firm, entrepreneurs might well have a different stand towards including them into the investment agreement since venture capital firms can directly interfere with their activities. The next chapter addresses the problem of a loss of formal autonomy of the portfolio company’s management team following venture capital financing.

4.4

Loss of Formal Autonomy through Venture Capital Firms

According to HORNADAY/ABOUD and MCCLELLAND, a high need for autonomy and independence is said to characterize entrepreneurs.651 With respect to this fact, one could expect problems to arise in the relationship between venture capitalists and entrepreneurs, as the latter could conjecture that the multitude of contractual rights that venture capitalists claim for themselves will impair their autonomy and be associated with a loss of authority within their own company. This seems to be a valid argument for the reservation of managers of more established German Mittelstand companies652, towards including the possibilities of investment companies in the financing strategy of the firm.653 In can well be assumed that this problem also plays a role in venture capital financing albeit the financing possibilities of start-ups are more limited than in more established companies and therefore most start-ups do have less a choice from where to raise their capital.654 SIMON defines power within an organization as the right to select actions that will influence the organization.655 An autonomous organization has the power to decide on its actions by itself. One can distinguish between two forms of autonomy in a portfolio

651

See McClelland (1987); Hornaday/Aboud (1974).

652

Typically, these companies are small- and medium-sized enterprises that in most cases are run by owner-managers. See Achleitner/Fingerle (2004a).

653

This negative attitude of Mittelstand companies towards investment companies is mentioned in Achleitner/Fingerle (2004a), p. 29; Achleitner/Fingerle (2004b), p. 183; Reimers (2003), p. 32; Hommel/Schneider (2003), p. 70; Ahrweiler/Börner (2003), p. 60.

654

Cf. chapter 2.3.4.

655

See Simon (1951), p. 294. WEBER defines power as the ability to impose one's will on others, even if those others resist in some way. See Weber (1980).

Venture Capitalists’ Influence through Contractual Agreements

139

company: formal and real autonomy.656 Formal autonomy is defined as the legal ability of the management team to make decisions independent of other parties. Real autonomy is the management team’s factual ability to take decisions independently of third parties. The above analysis of contractual agreements in venture capital contracts shows that venture capital firms using all described contractual provisions can massively influence and even direct the development of their portfolio companies.657 Clearly, by signing the investment contract, the management team of a venture capital-backed company loses formal autonomy in every important aspect of the company. Control rights are a prime example for the loss of formal authority from the management team’s perspective, as usually every important corporate decision requires the consent of the venture capital firm. In practice, an investment agreement between the two parties normally contains only a selection of the described contractual provisions. How many and which contractual provisions are actually agreed on depends on the relative bargaining power of the two parties and the individual situation.658 Usually, there is an imbalance of bargaining power between the two parties, as the venture capital firm has large financial resources at its disposal that the management painfully lacks.659 Bargaining power also depends on the venture capital firm’s reputation in the market. Reputable fund managers such as TECHNO VENTURE MANAGEMENT or KLEINER, PERKINS, CAUFIELD & BYERS can ask for more rights in contractual negotiations than competitors. The bargaining power of the venture capital firm is also dependent on the size of its capital commitment. The higher the investment amount, the higher will be its bargaining power to demand more scope for control.660 As many venture capital firms can potentially be interested in financing a start-up, entrepreneurs might be in some instances in a better bargaining position.661 However, 656

Cf. Aghion/Tirole (1997), p. 2.

657

See also Fried/Hisrich (1995), p. 107.

658

Cf. Cornelli/Yosha (2003), fn. 28; Wright/Robbie (1998), p. 550.

659

See Bartlett (1999), p. 12. ADMATI/PFLEIDERER support the notion that investment companies are in a better bargaining position than entrepreneurs. See Admati/Pfleiderer (1994), p. 389.

660

See Cumming (2001), footnote 10.

661

See Lerner (1998), p. 736.

140

Venture Capitalists’ Influence through Contractual Agreements

syndication of investments could again reduce the number of potential competing venture capitalists and thus reduce the entrepreneur’s bargaining power.662 If entrepreneurs are inexperienced in negotiations with venture capitalists, this might again reduce their relative bargaining power.663 Bargaining power of entrepreneurs might increase over time, as the company is growing successfully and the entrepreneurs get used to negotiations with venture capital firms.664 In turn, bargaining power of entrepreneurs can also decrease over time if the company fails to meet performance milestones. Chapter 4 showed that venture capitalists not only face the idiosyncratic risks inherent in the portfolio company itself, but are also exposed to several deal-specific risks that emerge with the venture capital firm financing the portfolio company. To reduce its risk exposure, the venture capital firm asks for several contractual elements to be included in the investment agreement, which simultaneously give the venture capital firm strong influence over its portfolio company. This influence can potentially deter entrepreneurs from using venture capital financing. However, this chapter only described the formal influence of the venture capital firm on its portfolio companies. The next chapter analyzes the real influence that venture capital firms exert on their portfolio companies through provision of resources.

662

See Brander/Amit/Antweiler (2002), p. 427.

663

Cf. Wright/Robbie (1998), p. 560.

664

See Wright/Robbie (1998), p. 561.

Venture Capitalists’ Influence through Provision of Resources

5

Venture Capitalists’ Influence through Provision of Resources

5.1

Introductory Remarks

141

The investment development phase is the period within the investment process of a venture capital firm in which the venture capitalists provide monitoring and coaching to their portfolio companies.665 This is the time, where contractual agreements come to play and influence the venture capital firm’s actual activities. In terms of resources, this is the time where venture capitalists provide besides financial also non-financial resources, which earned them their reputation as smart money providers. This chapter proceeds as follows. Previous research on venture management activities of venture capital firms is reviewed. These insights are then analyzed from a resourcebased perspective using the resource categorization of chapter 2.3. This allows structuring the venture capitalists’ provision of resources to their portfolio companies in an innovative and intuitive way. In the following, several determinants of the intensity of the venture capitalists’ resource provision activities are discussed. Finally, the chapter ends with an analysis to which extent the involvement of venture capital firms is associated with a loss of real autonomy for the entrepreneurs.

5.2

Content of Resource Provision

5.2.1

Activities of Venture Capital Firms

The involvement of venture capital firms in terms of its content is dependent on the firm’s specific situation and therefore comes in various forms.666 Several studies examine the importance of different activities of venture capitalists and come up with a ranking of these activities according to their importance.667 Unfortunately, all studies employ different definitions of venture capitalists’ activities making a direct comparison of the rankings impossible. To make such a direct comparison possible, this analy-

665

See chapter 3.4.4.5.

666

See Kenney (2000), p. 6.

667

See Deloitte & Touche (2002); Dotzler (2001); Feinendegen/Hommel/Wright (2001); Morris/Watling/Schindehutte (2000); Deakins/O'Neill/Mileham (2000); Coopers & Lybrand (1998); Ehrlich et al. (1994); Gorman/Sahlman (1989).

142

Venture Capitalists’ Influence through Provision of Resources

sis clusters in a first step more than fifty different activities mentioned in these studies in the following nine categories: • Providing financial support, • serving as a sounding board to the management, • supporting in strategy development, • providing feedback to the management, • helping the management in operational aspects, • providing contacts to third parties, • recruiting management, • providing ethical support to the management, • supporting in organizational planning. In a second step, the individual rankings of each study are aggregated to fit these nine categories of activities of venture capitalists. Figure 46 shows a comparison for eight international and German studies. Providing financial support, acting as a sounding board to the management team, and supporting in developing the corporate strategy are ranked relatively consistently among the top three important activities of venture capital firms.

Venture Capitalists’ Influence through Provision of Resources

Gorman/ Sahlman

Ehrlich et al.

Deakins et al.

Morris et al.

(1994)

Coopers & Lybrand (1998)

(1989)

(2000)

Financial support

1

1

2

Sounding board

—

2

Strategy development

2

Provision of feedback

143

Dotzler

(2000)

Feinendegen et al. (2001)

(2001)

Deloitte & Touche (2002)

6

1

1

1

2

1

1

3

2

4

1

3

4

2

4

2

2

—

—

—

—

3

—

4

7

1

Operational support

4

2

6

7

2

3

5

—

Provision of contacts

5

—

3

—

—

3

8

3

Management recruiting

3

—

5

8

—

5

3

—

Ethical support

6

—

—

4

—

—

—

—

Organizational planning

—

—

—

5

—

—

6

—

Activities of venture capitalists

Figure 46:

Importance of venture capitalists’ activities668

These rankings have several weaknesses: • Most of them lack a clear structure within the individual activities that allow grasping the complexity of the venture capital firms’ involvement in their portfolio companies. • In many of these studies the opinion about the involvement of the venture capital firm of only one party has been analyzed, i.e. either the venture capitalists or the entrepreneurs. Figure 49 shows that this is a problematic methodology since perceptions between venture capital firms and entrepreneurs regarding the involvement of the venture capital firm can differ significantly. • These studies completely omit the important contribution to the portfolio companies’ development through certification by venture capitalists.

668

Different activities within a study can have the same ranking. See Deloitte & Touche (2002); Dotzler (2001); Feinendegen/Hommel/Wright (2001); Morris/Watling/Schindehutte (2000); Deakins/O'Neill/Mileham (2000); Coopers & Lybrand (1998); Ehrlich et al. (1994); Gorman/Sahlman (1989).

144

Venture Capitalists’ Influence through Provision of Resources

5.2.2

Certification through Venture Capital Firms

Several studies propose that venture capital-backed companies benefit from the reputation of their venture capital firms in the resource acquisition process. This has been suggested for various groups, such as customers669, suppliers670, investors671, personnel and management672 as well as investment banks and accountants673. Along the lines of KLEIN/LEFFLER and DIAMOND, the reputation of a venture capital firm can transmit valuable signals about a portfolio company to third parties and thereby reduce transaction barriers because of asymmetric information.674 According to SAHLMAN, venture capitalists bring an instant credibility to their portfolio firms.675 The transmission of a positive signal about a portfolio company is called “certification”.676 Through certification, the portfolio company is provided with a reputational resource, which facilitates resource acquisition processes with regard to many other required resources. This is particularly true for venture capital firms that have an excellent reputation.677 Consequently, the venture capitalists’ reputation plays an important role for a high potential company to choose a venture capital firm. HSU finds for the US market there is an almost three times higher probability that offers of venture capital firms with high reputation will be accepted by a potential portfolio company in comparison to a venture capital firm without significant reputation.678

669

See Fried/Hisrich (1995), p. 104.

670

See Timmons/Bygrave (1986), p. 169.

671

See Schertler (2003); Lee/Wahal (2002); Kraus (2002); Da Silva Rosa/Velayuthen/Walter (2002); Francis/Hasan (2001); Hamao/Packer/Ritter (2000); Ljungqvist (1999); Lin/Smith (1998); Brav/Gompers (1997); Megginson/Weiss (1991).

672

See Bottazzi/Da Rin (2002b), p. 236; Fried/Hisrich (1995), p. 104.

673

See Tykvová (2000), p. 10; Davis/Stetson (1985), p. 56.

674

See Diamond (1991); Klein/Leffler (1981). Transaction barriers could for example arise as suppliers are uncertain, whether the portfolio company can pay its bills or customers are uncertain, whether they will still receive support services from the portfolio company in the future, as many new firms do not survive the first years of their existence.

675

See Sahlman (1990).

676

See Megginson/Weiss (1991); Booth/Smith (1986), p. 261.

677

See Fried/Hisrich (1995), p. 104.

678

See Hsu (2004), p. 17.

Venture Capitalists’ Influence through Provision of Resources

5.2.3

145

Resource-Based View on Activities of Venture Capital Firms

5.2.3.1 Redefining Activities as Resources Previous research on the influence of venture capital firms was directed primarily towards clarifying in which areas venture capitalists actually supported their portfolio companies. The present analysis takes a different stand and analyzes the activities of venture capital firms in terms of the resources they provide to the portfolio company. The advantage of this approach is that the resource-based view is widely accepted within strategic management research in explaining performance differentials between firms and is assumed particularly suited for new ventures. As already discussed earlier, the high growth potential of venture capital-backed companies stems mainly from their technological resources. However, a stand-alone resource such as a patent on a certain technological process does not yet form a competence. Several resources from different categories are required to build a competence. Some of a company’s competences need to be core competences, which allow gaining competitive advantage and generating above-average returns for the investors. This analysis argues that venture capital firms contribute resources to their portfolio companies and thereby enable building competences that ultimately lead to economic success. Two important research contributions explicitly establish a link between venture capital financing and the resource-based view.679 LEE/LEE/PENNINGS employ the resourcebased view to assess the development of high potential companies dependent on resource provision through external parties such as alliances, sponsorships and venture capital firms.680 They show that venture capital firms play an important role in providing their portfolio companies with access to further resources whereas other external parties play a much lesser role.681 CORNELIUS/NAQI assume that provision of resources depends on the fit between resource needs of portfolio companies and resources avail-

679

Several studies use the term “resources” for activities of venture capital firms, but do not establish an explicit link between their findings and the resource-based view. In the related field of corporate venture capital, POSER also introduces the link between the resource-based view and corporate venture capital firms. However, his work investigates sources of competitive advantage from the perspective of the investing firm. See Poser (2003).

680

See Lee/Lee/Pennings (2001).

681

See Lee/Lee/Pennings (2001), p. 634.

146

Venture Capitalists’ Influence through Provision of Resources

able through venture capital firms.682 They analyze the Hong Kong and Singapore venture capital market by sending out a questionnaire to senior venture capitalists asking about their activities on behalf of their portfolio companies.683 In general, they find that perceived high resource needs of portfolio companies result in venture capitalists providing more resources to the firm.684 This analysis follows CORNELIUS/NAQI in redefining activities as resources. However, their resource categories are incomplete and partially overlapping.685 Therefore, this analysis uses the resource categorization proposed in chapter 2.3. Translating the activities, which are described in chapters 5.2.1 and 5.2.2, into resources provided, makes it possible to develop the resource provision table in Figure 47 that shows in which resource categories venture capitalists support their portfolio companies.

Resource categories

Resource provision by venture capital firms

Technological resources



Financial resources

9

Managerial resources

9

Personnel resources



Physical resources



Organizational resources

9

Reputational resources

9

Social resources

9 9 Some resources provided

Figure 47:

 No resources provided

Resource provision table of venture capital firms

682

See Cornelius/Naqi (2002), pp. 253 et seq.

683

See Cornelius/Naqi (2002), p. 256.

684

See Cornelius/Naqi (2002), p. 262.

685

They establish the following resource categories: Portfolio company industry contacts, personnel management, other industry contacts, project/idea evaluation, strategic planning, crisis management, operational planning, financial expertise, financial contacts, and monitoring performance. See Cornelius/Naqi (2002), p. 257.

Venture Capitalists’ Influence through Provision of Resources

147

According to the resource provision table, venture capitalists can support their portfolio companies in the acquisition of managerial, financial, organizational, reputational, and social resources. The surveyed studies from chapters 5.2.1 and 5.2.2 do not find a significant contribution from venture capitalists in terms of technological, personnel and physical resources. Business incubators are a special kind of venture capital firm that also provide physical resources to their portfolio companies. ALLEN/RAHMAN define a business incubator as “a facility that aids the early-stage growth of companies by providing rental space, shared office services, and business consulting assistance”.686 Even though it is often contended from policy makers that incubators are a truly fruitful way of developing start-ups, their development in Germany lags behind expectations. The reason for this is probably that in most cases existing business incubators offer little more than a place to set up a company physically and thus is in fact only a real-estate business.687

5.2.3.2 Direct vs. Indirect Resource Provision It is necessary to distinguish between a direct and an indirect resource provision of venture capital firms. Direct resource provision means that the provided resources come directly from the venture capital firm. For instance, a direct resource provision would be a venture capitalist taking over a seat on the supervisory board of a portfolio company, thereby offering his own managerial resources. In contrast, indirect resource provision means that the venture capital firm only acts as facilitator between the port-

686

See Allen/Rahman (1985), p. 12. According to ACHLEITNER/ENGEL, there are four forms of business incubators where each pursues different goals. First, non-profit incubators backed by government or other institutions are primarily interested in the economic development of a region and aim for creating employment. Second, for-profit incubators look for attractive financial returns. Third, hybrid incubators are backed by non-profit and for-profit-organizations and will probably look for a financial return as otherwise the for-profit organization might not have an interest to join in. Fourth, research-oriented incubators backed by universities and research institutions want to foster entrepreneurial activities primarily to open up new sources of finance. See Achleitner/Engel (2001), pp. 9 et seq. Important contributions to the research on business incubators are Clarysse et al. (2004); Rice (2002); European Commission (2002a); Achleitner/Engel (2001); Hansen et al. (2000); Rice/Abetti (1993); Feeser/Willard (1989); Campbell (1989); Merrifield (1987); Cooper (1985); Allen/Rahman (1985).

687

See Hansen et al. (2000), p. 75. See Artley et al. (2003) for details regarding best practice in incubating new ventures.

148

Venture Capitalists’ Influence through Provision of Resources

folio company and third parties. This essentially means that the resources do not come directly from the venture capital firm, but from third parties. The venture capital firm only facilitates the resource transfer between the portfolio company and the third parties. For example, establishing a contact between future members of the management team of a portfolio company is a direct provision of social resources and at the same time an indirect resource provision of managerial resources. This chapter provided an overview of the activities of venture capital firms as documented in the literature. The task-driven definitions of the areas of involvement of venture capital firms were translated into the provision of eight different resources. However, this chapter only showed the content of the resource provision of venture capital firms. Therefore, the next chapter discusses what determines the intensity of the resource provision by venture capital firms.

5.3

Determinants of Resource Provision

5.3.1

Differences in Intensity of Resource Provision

Smart money from venture capital firms is far from being a homogenous good. In fact, several factors determine the “smartness” of the money provided by venture capital firms. Venture capital firms can largely differ with respect to the intensity of their involvement and resource provision during the investment development phase.688 One can differentiate between two fundamental approaches towards the post-contractual coaching function of venture capitalists.689 The first approach is “hands-on”, i.e. venture capitalists are actively influencing the management of a portfolio company.690 The second approach is “hands-off” which means that venture capitalists do not interfere with the decisions of the management of a portfolio company but follow a laissezfaire691 policy.692 Venture capital firms operating in established venture capital markets

688

See Wright/Robbie (1998); Elango et al. (1995); Sweeting (1991); MacMillan/Kulow/Khoylian (1988); Perry/Young (1988); Tyebjee/Bruno (1984a).

689

See Sapienza/Manigart/Vermeir (1996), p. 439.

690

See Kreditanstalt für Wiederaufbau (2003), p. 19.

691

See MacMillan/Kulow/Khoylian (1988).

692

See Brettel/Thust/Witt (2001), p. 27.

Venture Capitalists’ Influence through Provision of Resources

149

such as the US and the UK generally seem to show higher levels of involvement than do venture capital firms from less established venture capital markets.693 An important measure of the venture capital firm’s inclination towards providing nonfinancial resources to its portfolio companies is the relation of the number of monitored investments to the number of investment managers within a fund.694 To follow its investments closely, an investment manager should not be responsible for more than three portfolio companies whereas this can be more on the partner level. Time is the limiting factor for venture capitalists in coaching their portfolio companies.695 ROBINSON states that the average venture capitalist spends about 35%696 of his time with activities in the investment development phase, whereas in the samples of GORMAN/SAHLMAN697 and FRIED/HISRICH698 this even amounts to 60%. The time that venture capital firms actually invest in their portfolio companies varies widely and is situation-specific.699 If the amount invested in a portfolio company only represents a minor stake within the portfolio of the venture capital firm, the company will receive on average less coaching from the venture capitalists.700 The studies of MACMILLAN/KULOW/KHOYLIAN and ELANGO ET AL. identify three types of venture capital firms according to the perceived intensity of their coaching function in the investment development phase. Figure 48 shows how the intensity of venture capitalists’ activities increases in general701 from low involvement (laissezfaire) over medium involvement (moderately involved) to high involvement (close trackers). The values in the column “moderately involved” indicate by how much the

693

See Sapienza/Manigart/Vermeir (1996), pp. 441, 464.

694

See Deloitte & Touche (2002), p. 11.

695

See Giudici/Paleari (2000), p. 155; Gifford (1997), p. 474; Sapienza/Manigart/Vermeir (1996), p. 444.

696

See Robinson (1987), p. 69.

697

See Gorman/Sahlman (1989), p. 235.

698

See Fried/Hisrich (1994).

699

Cf. Robinson (1987), p. 68.

700

See Gifford (1997), p. 474.

701

The only exceptions are that in the sample of ELANGO ET AL., management recruiting and ethical support seem to be less intensive in the high involvement group in comparison to the medium involvement group but still higher than in the low involvement group.

150

Venture Capitalists’ Influence through Provision of Resources

intensity is higher within the group of “moderately involved” venture capitalists in comparison to “laissez faire” venture capitalists. Similarly, the values in the column “close trackers” indicate by how much the intensity of involvement of venture capitalists of this group is higher than that of “moderately involved” venture capitalists.

MacMillan/Kulow/Khoylian (1988)

Elango et al. (1995)

Activities of venture capitalists

Laissez faire

Moderately involved

Close trackers

Low involvement

Medium involvement

High involvement

Financial support

2.82

+0.74

+0.97

4.39

+0.39

+0.02

Sounding board

3.17

+0.60

+0.64

—

—

—

Strategy development

1.83

+0.98

+0.63

4.07

+0.21

+0.25

Provision of feedback

1.33

+0.30

+0.37

4.31

+0.31

+0.01

Operational support

2.16

+0.65

+0.72

2.98

+0.10

+0.57

Provision of contacts

1.11

+1.11

+0.38

2.98

+0.23

+0.31

Management recruiting

0.94

+1.76

+1.36

3.89

+0.51

-0.20

Ethical support

1.39

+0.80

+0.57

3.73

+0.81

-0.21

Responses indicate the importance of the activities of venture capital firms by using a five-point scale, with one being unimportant and five being very important. This table reads as follows. In the MacMillan/Kulow/Khoylian study, the financial support of venture capital firms is ranked with 2.82 in the laissez-faire group, increases by 0.74 ranking points in the moderately involved group, and increases again by 0.97 ranking points in the group of close trackers. Thus, a plus always indicates an increase in importance, measured by ranking points, of the activity in comparison to the less involved group of venture capital firms.

Figure 48:

Differences in intensity of venture capitalists’ activities702

PERRY also finds differences between venture capital firms and distinguishes between investors, builders and partners.703 He mentions that not only the intensity of support between these types of venture capitalists but also the content of their activities is different. Interestingly, there are clear differences between the impact of venture capitalists’ activities in the perception of entrepreneurs and venture capitalists themselves.704 Generally, the entrepreneurs’ estimate of the extent of support by venture capitalists is lower

702

See Elango et al. (1995); MacMillan/Kulow/Khoylian (1988).

703

See Perry/Young (1988), p. 211.

704

See VDI Verlag (2000).

Venture Capitalists’ Influence through Provision of Resources

151

than the venture capitalists’ estimate. Figure 49 shows this for several venture management categories.

Financial support Business planning Management accounting Business development Provision of consultants Marketing Management recruiting Provision of contacts Introduction to customers 0 (no support)

1

2

3

4

5 (high support)

Venture capitalists’ perception Entrepreneurs’ perception

Figure 49:

5.3.2

Differing perceptions of the extent of venture capitalists’ activities705

Size of Investment

Differences in the intensity of resource provision of venture capitalists can be due to varying sizes of investments.706 On the level of the venture capital fund, the relative investment size within the venture capital fund plays an important role in determining the importance the venture capitalists will attach to a certain portfolio company. The more fund capital is invested into a single portfolio company, the more the fund’s performance will be driven by the performance of that portfolio company and the higher the venture capitalists’ incentives will be to provide resources to that portfolio com-

705

See VDI Verlag (2000), p. 35.

706

The average venture capital investment size in US early stage deals was $4.6m in the first quarter 2004, whereas for expansion stage deals it amounted to $8.7m. See PricewaterhouseCoopers (2004), p. 7. Generally, average deal sizes are lower in Europe. Cf. BVK (2004a), p. 15; EVCA (2003a), p. 3.

152

Venture Capitalists’ Influence through Provision of Resources

pany.707 However, it should be noted that usually a covenant in the fund’s statues applies which limits the relative share of a single investment in a venture capital fund.708

Marginal costs, marginal value increase

On the level of the individual portfolio company, the equity share that the venture capital firm holds plays an important role in determining the intensity of its involvement in the portfolio company.709 Whereas the venture capital firm has to bear the full costs of its venture management activities, it only participates partially in the resulting increase of the portfolio company’s equity value according to its stake. This results in a lower level of resource provision than would be socially optimal. This “underinvolvement” of the venture capital firm is depicted in Figure 50.

Marginal costs of resource provision

Social optimum Venture capital firm‘s optimum

Marginal value increase through resource provision Venture capital firm’s share x marginal value increase through resource provision Extent of resource provision

Underinvolvement

Figure 50:

Underinvolvement of venture capital firm710

The higher the share of the venture capitalist, the higher will be his incentive to provide further resources. It is important to note, that this analysis is only valid ceteris paribus. As detailed in chapter 4.2.2, the more the stake of the venture capital firm rises, the higher will be problems of managerial opportunism, which potentially reduce the value of the portfolio company. 707

Cf. Gifford (1997), p. 474.

708

See chapter 3.4.3.2.

709

See Gifford (1997), p. 461.

710

This graphical analysis does not take into account endogenous effects such as agency costs that would rise with the venture capital firm’s share increasing in the company. These costs would potentially reduce the total marginal value increase in the company’s value. See Jensen/Meckling (1976) and chapter 4.2.2.

Venture Capitalists’ Influence through Provision of Resources

5.3.3

153

Performance of Portfolio Company

The actual performance of a portfolio company might also be a determining factor of the intensity of resource provision of the venture capitalists. A portfolio of a venture capital firm can be presented in a simplified way as containing four different types of portfolio companies. First, a potential write-off is a company that is obviously miscarried and it is highly probable that the venture capital firm loses its investment completely. Second, a living dead is a company that is surviving but stalling in revenues and profits and therefore unable to produce satisfactory returns to the venture capitalists.711 Third, an on-track is a company that is well performing and promising to yield adequate returns on the venture capitalists’ investment. Fourth, a high-flyer is a company that obviously outperforms normal expectations and promises to yield extraordinary returns to the venture capital firm. Often, a single investment can determine the ultimate fund performance.712 The upper part of Figure 33 confirms that venture capital portfolios show an extreme variance of returns on investment. Total write-offs account for 30% and high-flyers account for more than 10% on average. The other two types account for the remaining part of venture capital portfolios. There are contrary opinions regarding the link between a portfolio company’s performance and the intensity of the involvement of venture capitalists. SAPIENZA/MANIGART/VERMEIR argue that venture capital firms might follow “homerun strategies”, i.e. the better the portfolio company performs, the more they become involved.713 According to this hypothesis, high-flyers would receive most attention of venture capitalists, and potential write-offs would be neglected. To explain this phenomenon they put forward prospect theory.714 According to this theory, the utility of venture capitalists is evaluated to a reference point and defined in terms of gains and losses. This means that only deviations from that reference point matter. The utility function is concave with regard to gains, convex with regard to losses, and steeper in the area of losses, which implies that value decreases entail larger utility losses than value increase entail utility gains. This implies that a high-flying company that be-

711

See Manigart/Baeyens/van Hyfte (2002), p. 106; Ruhnka/Feldman/Dean (1992), p. 138.

712

For example, fund performance of Techno Venture Management’s first fund TVM I is driven mainly by its investment in Qiagen. See Techno Venture Management (2004).

713

See Sapienza/Manigart/Vermeir (1996), pp. 447 et seq.

714

See List (2004); Sitkin/Pablo (1992); Kahneman/Tversky (1979).

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Venture Capitalists’ Influence through Provision of Resources

comes an on-track company entails a huge utility loss for the venture capitalists, whereas a potential write-off portfolio company that manages to become selfsustaining in the sense of a living dead company only entails a lesser utility gain for the venture capitalists. Therefore, venture capitalists have a much stronger incentive to work for their well performing companies in order to prevent a deterioration of their status quo. Figure 51 shows the utility gain and loss for venture capitalists that are associated with, in absolute terms identical, value increases and decreases of the portfolio company’s value.

Utility gain of venture capitalist

Reference point

Utility gain

Value decrease of portfolio company

Value increase of portfolio company

Utility loss

Utility loss of venture capitalist

Figure 51:

Prospect theory and its implications for venture capitalists715

However, along the lines of LIST, one could argue that this might be true rather for inexperienced private investors than for professional venture capitalists.716 Obviously, there is need for further research.717

715

Based on Kahneman/Tversky (1979), p. 279.

716

See List (2004).

717

The proposed argument could be one building block of a yet to develop more general theory of entrepreneurial behavioral finance that analyzes deviations in behaviors of economic agents from neoclassical assumptions. Along the lines of ACHLEITNER, entrepreneurial behavioral finance should analyze the behavior of portfolio companies, intermediaries such as venture capital firms and investors. See Achleitner (2002).

Venture Capitalists’ Influence through Provision of Resources

155

Contrary to the approach of prospect theory, LERNER argues that the venture capitalists’ “involvement as directors should be more intense when the need for oversight is greater”.718 Therewith, he proposes that high-flyers should receive least attention and potential write-offs should be in the center of the efforts of the venture capital firm. Figure 52 summarizes the two arguments regarding which portfolio company receives the most attention of the venture capitalists.

low

Extent of venture capitalists’ involvement depending on performance (prospect theory argument)

Potential write-off

high

Figure 52:

Living dead

high

On-track

(need for oversight argument) Extent of venture capitalists’ involvement depending on performance

High-flyer

low

Performance, resource needs and extent of involvement

An alternative explanation that has not yet been mentioned in the relevant literature takes a reputational approach. Reputation is one of the key resources a venture capital firm possesses. One could argue that shifts in the reputation of a venture capital firm can be provoked by extreme events within its portfolio. Write-offs are a threat for the reputation of a venture capital firm, as it makes obvious that the venture capital firm took the wrong investment decision. On the contrary, high-flyers might contribute positively to a venture capital firm’s reputation. This is for example the case with the leading venture capital firm KLEINER, PERKINS, CAUFIELD & BYERS that is often mentioned as the firm that built blue chip companies such as Amazon.com, Sun Microsystems, and Genentech. Taking such a reputational perspective on the intensity of involvement implies that both high-flyers and potential write-offs receive most attention of venture capitalists.719

718

Lerner (1995), p. 301.

719

Ultimately, reputation of a venture capital firm should be exclusively determined by the performance of its funds and not by single investments within its portfolio.

156

Venture Capitalists’ Influence through Provision of Resources

5.3.4

Stage of Portfolio Company

Differences in the intensity of resource provision of venture capitalists can also be determined by characteristics of the portfolio company. There is ample evidence that the coaching function becomes less important, the more established a portfolio company is.720 According to SAPIENZA/AMASON/MANIGART, early-stage investments receive 47% more attention in terms of hours invested by the venture capitalists than laterstage investments in Europe.721 A study by KFW MITTELSTANDSBANK shows for the German market that early-stage investment companies are much more inclined (65%) to follow a “hands-on” approach than later-stage investment companies are (35%).722 A related fact is that inexperienced CEOs receive more support from venture capitalists than experienced CEOs.723 This fact strongly supports the applicability of the resource-based view on the relationship between venture capital firms and their portfolio companies. The more firms develop over time, the more resources they have at their disposal and their urgent resource needs become less. Accordingly, the role of venture capitalists in providing critical resources beyond capital declines. This would also explain, why buyout investors, i.e. investors in later-stage companies, usually do not ask for a smart money premium on their required IRR.724

5.3.5

Technology Intensity of Portfolio Company

The degree of technological sophistication of a portfolio company is another determinant that influences the level of intensity of resource provision by venture capital

720

See Kreditanstalt für Wiederaufbau (2003), p. 19; Cornelius/Naqi (2002), p. 255; Engel (2002), p. 244; Nagtegaal (1999), p. 185; Wright/Robbie (1998), p. 526; Sapienza/Gupta (1994), p. 1630; Sapienza/Amason (1993), p. 47.

721

See Sapienza/Amason/Manigart (1994), p. 9.

722

See Kreditanstalt für Wiederaufbau (2003), p. 19.

723

See Sapienza/Amason/Manigart (1994), p. 10.

724

See chapter 1.1 and footnote 18. However, buyout investors spend a significant amount of time, up to a third of their time, with coaching their portfolio companies. See Fenn/Liang/Prowse (1995), p. 34.

Venture Capitalists’ Influence through Provision of Resources

157

firms.725 In fact, high-tech investments exhibit greater involvement of their venture capitalists than low-tech investments.726 There are several arguments from a resource-based perspective why this is to be expected. First, pursuing high technology strategies places heavy demands on all kinds of resources of a portfolio company.727 Second, entrepreneurs that have extensive technical skills and knowledge but lack managerial skills and knowledge often manage high technology ventures.728 Third, these companies require timely feedback due to their fast changing environment and therefore require close attendance by venture capitalists.729

5.3.6

Venture Capitalists’ Incentives for Resource Provision

Differences in the intensity of resource provision might also rest with differences in the incentives of venture capitalists that result from differing business models of their organizations. In fact, venture capitalists of independent funds seem to be much more inclined to pursue a “hands-on” approach in managing their portfolio than venture capitalists of government-dependent funds.730 Interestingly, existing literature has not yet examined differences between the venture capitalists’ incentives depending on whether they are working for an independent fund or a captive fund. However, it can be conjectured that differences are not pronounced since both organizational forms pursue exclusively financial goals. A venture capitalist from an independent fund is trying to maximize the rate of return of its investment since his remuneration directly depends on the fund’s performance.731 Through the carried interest scheme, there is no limit to the upside potential for the venture capitalists. Therewith, the venture capitalist has a strong interest that the portfolio company performs well. Hence, he will contribute to the venture’s performance 725

See Giudici/Paleari (2000), p. 158.

726

See Sapienza/Gupta (1994), p. 1622; Sapienza/Amason/Manigart (1994), p. 13.

727

See Pisano (1994).

728

See chapter 2.3.5.

729

See Wright/Robbie (1998), p. 526.

730

See Kreditanstalt für Wiederaufbau (2003), p. 19; Zemke (1995).

731

See chapter 3.6.

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Venture Capitalists’ Influence through Provision of Resources

according to his entire means. The remuneration scheme in government-backed funds is different to that of independent funds. Due to these funds’ linkages to governmental institutions, remuneration of venture capitalists of government-backed funds are linked to collective wage agreements of the public service and do not provide the upside potential comparable to a carried interest scheme. This implies that their remuneration is much more independent of venture performance and therefore, there are fewer incentives to support portfolio companies in a government-backed fund. Another argument for differences in the extent of involvement of venture capitalists in their portfolio companies could be differences in their ability to provide valuable resources. Unfortunately, there is not yet a study analyzing differences in skills and knowledge of different types of venture capitalists. However, the remuneration of venture capitalists might be a proxy for their ability. If the job market for venture capitalists works efficiently, then the best venture capitalists will also earn the most since they will be able to select better deals and to provide better resources to their portfolio firms, which leads to an above-average performance of their administered venture capital funds. Following this argument, it could be expected that venture capitalists of government-backed funds are on average less able to provide valuable resources to portfolio companies, since they normally earn less than their counterparts in independent funds do.732

5.3.7

Syndication

Syndication is the joint and simultaneous investment of venture capitalists in their portfolio companies.733 When analyzing the intensity of resource provision through venture capital firms, it is important to note that due to syndication large differences might arise between lead and non-lead venture capitalists.734 TIMMONS claims that lead venture capitalists assume the main role in the post-contractual venture management.735 Other studies state that in several cases, the lead investor completely assumes the 732

This statement is based on several talks the author led with industry experts. Certainly, a further empirical study is required to confirm this statement.

733

For a thorough discussion of syndicated venture capital deals and the effect of syndication on the post-contractual activities of venture capitalists, see Nathusius (2004b).

734

See Deloitte & Touche (2002); Fenn/Liang/Prowse (1995); Timmons/Bygrave (1986).

735

See Timmons/Bygrave (1986), p. 168.

Venture Capitalists’ Influence through Provision of Resources

159

coaching role whereas the non-lead investors only loosely monitor the investment.736 According to ELANGO ET AL., the average time that lead investors commit to their portfolio companies is three times as large as that of non-lead investors.737 GORMAN/SAHLMAN state that this factor is ten in their sample.738 This provides evidence for the fact that not all venture capitalists in a deal have to show the same level of involvement intensity. In many cases, lead investors provide the smart money whereas co-investors simply provide “pure” money. This could be particularly expected with high potential companies such as biotech companies that show a disproportionate need of financial resources in comparison to resources of other categories. In general, syndication mitigates the problem of limited time resources on the side of venture capitalists to some degree as several venture capitalists are usually involved in the venture management process.739 However, a free rider problem between syndicate members might arise as each venture capital firm might hope that the other venture capitalists will provide the required resources. This chapter showed that there are differences in the “smartness” of the money provided by venture capital firms. These differences can be due to different characteristics of the portfolio companies, the deal parameters and the business model of venture capital firms. However, as chapter 4.4 has shown, smart money usually comes along with venture capitalists taking over formal power in their portfolio company. The next chapter discusses to what extent venture capitalists also take over actual power in their portfolio companies.

5.4

Loss of Real Autonomy through Venture Capital Firms

5.4.1

Sources of Venture Capital Firm’s Power

In chapter 4, it has been shown that venture capitalists typically dispose of various possibilities to block decisions both of other shareholders and of the management.

736

Cf. Deloitte & Touche (2002), p. 20; Fenn/Liang/Prowse (1995), p. 34.

737

See Elango et al. (1995), p. 165.

738

See Gorman/Sahlman (1989), p. 235.

739

See Gifford (1997), p. 474.

160

Venture Capitalists’ Influence through Provision of Resources

Contractual agreements mainly provide the venture capital firm with the formal power to prevent actions that would decrease the value of its investment. Besides its formal power, the two important sources of the venture capital firm’s actual power to initiate changes that are conducive to an increase of the value of its investment are money that will be required in the future and personal relationships. Chapter 2.3.4 shows that high potential companies have few other possibilities of raising money besides venture capital firms. Therefore, a prime source of the actual power of a venture capital firm is its money and most importantly the money, the portfolio company is to receive in future financing rounds. With this respect, staging the financing of portfolio companies provides the venture capital firm with a large degree of authority. Even, if the portfolio company tries to raise money from other investors, the success of its efforts will still be largely dependent on the behavior of its present venture capital firm. Since new investors will usually refrain from investing in a company, where there are problems with an existing venture capital firm, there is a strong need for the portfolio company to maintain good relations with its venture capitalists. Another source of the actual power of a venture capital firm lies within its personal relationships with the managers of the portfolio company.740 This power develops over time and results mainly from the venture capitalists’ individual charisma, expertise and effort devoted to the portfolio company.741 The actual power of a venture capital firm potentially leads to a loss of autonomy on the side of the portfolio company’s management team. Two different approaches are proposed to describe the loss of autonomy by the management team.

5.4.2

Loss of Real Autonomy by Levels of Management

A widely accepted management approach within the German-speaking world is the socalled “St. Gallen Management Concept”.742 This approach is firmly rooted in systems

740

See Fried/Hisrich (1995), pp. 105 et seq. The question of power in the relationship between investment companies and their portfolio companies has been widely neglected in venture capital research. However, linking sociological theories of power with economic research on venture capital financing seems to be a promising avenue for further research.

741

Cf. Sapienza (1992).

742

The name derives from the fact that several generations of scholars from the St. Gallen University have been working and refining this concept over time. See Müller-Stewens/Lechner (2003a);

Venture Capitalists’ Influence through Provision of Resources

161

theory743 and is valuable for understanding firms in an integrative way.744 One of the core elements of this approach is the distinction between normative, strategic and operational management levels. Applying this model to the relationship between venture capital firm and its portfolio company allows understanding in which management dimensions venture capitalists make use of their actual power to influence the development of the portfolio company. It clarifies to which extent the management of a portfolio company suffers from a loss of real autonomy. Normative management defines goals and principles of a firm.745 Decisions taken on a normative management level shape the vision and mission of a firm and result in a certain corporate governance structure and corporate culture.746 The vision represents the company’s orientation on its own future and should have a sense-making, motivational, guiding character for all members of the organization.747 In contrast to the future-oriented vision, the mission is directed rather towards the present tasks of a company.748 It comprises the object of a firm and its goals, which clarify why the firm exists at all as well as the values and behavioral standards of a firm, which shed light on what behavior is adequate and accepted. Furthermore, the mission explicitly includes strategies that are directed towards securing the ability of the firm to live and develop.749 The corporate governance structure defines how a firm is managed and controlled and how the relationships between its main institutions750 are related with each other and with the firm’s stakeholders751.752 The corporate culture comprises all values Rüegg-Stürm (2002); Bleicher (2001); Gomez (1998); Bleicher (1994); Bleicher (1991); Ulrich/Krieg (1974). 743

For a discussion of systems theory and its application in management science see Staehle (1999); Schwaninger (1994); Gälweiler (1986); Ulrich/Krieg (1974); Ackoff (1970).

744

See Bleicher (2001).

745

See Bleicher (2001), p. 74.

746

The concepts of vision, mission, corporate governance structure and corporate culture are linked together and partially overlapping. Nevertheless, they are widely used to describe the normative management of firms.

747

See Müller-Stewens/Lechner (2003b), p. 235.

748

See Müller-Stewens/Lechner (2003b), p. 236.

749

See Bleicher (1994), p. 44.

750

The main institutions of a firm are the shareholders’ meeting, the supervisory board and the executive board.

751

A definition of important stakeholders of a high potential company is given in chapter 2.3.10.

162

Venture Capitalists’ Influence through Provision of Resources

and norms that have been developed in the past and which are typical for the members of a firm.753 Venture capitalists usually exert quite some influence on the normative management of a portfolio company. By assuming the role of long-term advisors to the portfolio company’s management, venture capital firms are likely to influence the company’s vision and mission.754 The corporate governance structure of a portfolio company is largely shaped by its contractual agreements with the venture capital firm.755 The least influence of venture capitalists is expected to be within the domain of the corporate culture of the portfolio company as this largely arises from the daily life within the company that is usually not directly altered by venture capital firms. In summary, venture capital financing entails a loss of real autonomy on a normative level for the part of the portfolio company’s management since many decisions cannot be taken independently of the venture capital firm anymore. Strategic management has to lay the foundations for the company to fulfill its normative requirements on a sustainable basis.756 This requires developing strategies that provide the company a competitive advantage through both its market position and its resource basis.757 The implementation of these strategies is supported by management systems and organizational structures.758 Thus, strategic management creates a framework within individual actions can take place. Many studies on the activities of venture capitalists stress the key role that venture capitalists play in acting as a sounding board and in strategy development of their port-

752

This broad definition of corporate governance is based on definitions by OECD (2004); Regierungskommission Deutscher Corporate Governance Kodex (2003); Ruppen (2002); Bleicher (2001); Lück (2001a); Cadbury (1992). Other studies take a rather narrow view on the definition of corporate governance by focusing on the relationship between a firm, its managers and its investors. See Gompers/Ishii/Metrick (2003); Shleifer/Vishny (1997).

753

See Bleicher (2001), p. 93.

754

See Higashide/Birley (2002), p. 73; Sapienza/Manigart/Vermeir (1996), p. 439.

755

See chapter 4.3.

756

See Hungenberg (2001), p. 20.

757

See chapter 2.2.

758

See Bleicher (2001), pp. 76 et seq.

Venture Capitalists’ Influence through Provision of Resources

163

folio companies.759 The design of the company’s organizational structures and the implementation of advanced management systems are clearly among the core activities of venture capital firms.760 Therefore, the management team of a portfolio company loses a large part of its real autonomy on a strategic level due to the involvement of venture capitalists. Operational management has to decide about concrete actions on the market or within the company.761 For this purpose, goals and measures have to be worked out for functional areas and are to be implemented according to normative and strategic guidelines. Venture capital firms intend to play a lesser role in operational management and leave setting operational goals and defining operational measures solely to the portfolio company’s management.762 However, in individual cases, they can be very active in operational management by even assuming interim senior management positions.763 This implies that the management team of a portfolio is generally autonomous with respect to operational management issues. Figure 53 shows the management levels according to the St. Gallen Management Concept. It assumes that normative decisions largely determine and limit the scope for strategic management, which in turn again determines and limits operational management. Nevertheless, it is important to note that there are feedback loops as well. This means, operational management might still influence decisions on a strategic and normative level.

759

See Kaplan/Strömberg (2002), p. 12; Brinkrolf (2002), p. 141; Cornelius/Naqi (2002), p. 257; Gabrielsson/Huse (2002), p. 126; Higashide/Birley (2002), p. 73; Dotzler (2001), p. 9; Morris/Watling/Schindehutte (2000), p. 73; Deakins/O'Neill/Mileham (2000), p. 116; Smart/Payne/Yuzaki (2000), p. 14; Smith (1999), p. 953; Fried/Bruton/Hisrich (1998), p. 498; EVCA (1996), p. 6; Sapienza/Manigart/Vermeir (1996), p. 439; Steier/Greenwood (1995), p. 340; Fenn/Liang/Prowse (1995), p. 34; Lerner (1995), p. 302; Ehrlich et al. (1994), p. 69; Rosenstein et al. (1993), p. 105; Ruhnka/Feldman/Dean (1992), p. 138; Gorman/Sahlman (1989), p. 237; Timmons/Bygrave (1986), p. 161.

760

See Kaplan/Strömberg (2002), p. 12; Lockett/Wright (2001), p. 378.

761

See Hungenberg (2001), p. 21.

762

See Kaplan/Strömberg (2001), p. 8; Davis/Stetson (1985), p. 51.

763

See Fried/Hisrich (1995), p. 103; Sahlman (1990), p. 508.

164

Venture Capitalists’ Influence through Provision of Resources

Normative management (vision, mission, corporate governance structure, corporate culture)

Strategic management (strategies, structures, systems) Operational management (goals, measures)

Figure 53:

5.4.3

Levels of management

Loss of Real Autonomy by Levels of Decision-taking

BRINKROLF distinguishes six different levels of venture capitalists’ influence on the management of a portfolio company ranging from a fully passive behavior towards the management, i.e. no activities at all, to a fully active behavior, which involves taking over corporate leadership.764 Figure 54 shows the degree of influence on a portfolio company and the resulting degree of autonomy of the portfolio company’s management.

Influence on portfolio company low

No activity

high

Monitoring

Consulting

Participation in decision-taking

high

Taking decisions

Corporate leadership

low Autonomy of portfolio company‘s management

Figure 54:

Degrees of influence and management’s autonomy765

Monitoring requires that the management of the portfolio company reacts to information requests on an ad-hoc basis as well as to provide the venture capital firm with

764

See Brinkrolf (2002), p. 94.

765

Based on Brinkrolf (2002), p. 94.

Venture Capitalists’ Influence through Provision of Resources

165

regular reports regarding the company’s development. To ensure this degree of influence, investment agreements between venture capital firms and portfolio companies provide for certain information rights.766 Monitoring its portfolio companies belongs to the basic tasks of a venture capital firm, even if it pursues only a hands-off venture management approach. Therefore, studies on venture capital unanimously confirm the monitoring role of venture capitalists.767 Since monitoring is an ex-post activity, i.e. decisions of the management team are examined after they are executed, the management retains a large part of its autonomy in decision making. However, because of the long-term relationship between venture capital firm and its portfolio companies, there is a dynamic aspect to be considered. If the monitoring efforts in the first period show managerial misconduct, the management has to be aware of consequences in the following period. Consulting requires that the venture capital firm is involved in discussions about the future development of the company. Thereby, the venture capitalists might indirectly influence the development of a portfolio company. Almost every study on the activities of hands-on venture capitalists mentions the advisory role of venture capitalists as a key element.768 If the venture capital firm engages in consulting activities besides its monitoring activities, a further loss of the management’s autonomy can be conjectured since due to the important role of personal relationships, the management cannot easily dismiss any suggestions made by the venture capitalists since this would harm the long-term relationship between the two parties. By participation in decision taking, venture capitalists can directly influence the development of a portfolio company, but decisions are still taken together with others. Chapter 4.3.3 details the voting and supervisory board rights of venture capitalists. By making use of these control and decision rights, venture capitalists regularly participate in the decision taking within the portfolio company. Whereas the loss of autonomy through monitoring and consulting activities of venture capitalists rather comes

766

See chapter 4.3.1.

767

Some examples are Davila/Foster/Gupta (2003), p. 691; Deloitte & Touche (2002), p. 11; Cornelius/Naqi (2002), p. 257; Brettel/Thust/Witt (2001), p. 27; Morris/Watling/Schindehutte (2000), p. 73; Gompers/Lerner (1996), p. 465; Ehrlich et al. (1994), p. 76; Rosenstein et al. (1993), p. 100; Gorman/Sahlman (1989), p. 236; MacMillan/Kulow/Khoylian (1988), p. 33.

768

See footnote 759.

166

Venture Capitalists’ Influence through Provision of Resources

subliminally, by participation in decision taking, venture capitalists openly curtail the autonomy of the management team. Taking decisions implies that venture capitalists actually take some decisions themselves without requiring the consent of other parties. Usually, this is only observed in cases where the portfolio company misses pre-defined milestones and the venture capital firm obtains rights such as exchanging the management or registration of the company’s shares on a stock market.769 This comes along with a total loss of the management team’s autonomy in individual issues. However, several studies note the importance of a co-operative relationship between venture capitalists and entrepreneurs for the success of the portfolio firm and correspondingly for the investment of the venture capital firm.770 Therefore, venture capitalists need very good reasons to take decisions alone. Corporate leadership is the highest degree of influence, venture capitalists can exert on their portfolio companies. It implies that the venture capital firm takes over senior management positions on an operational basis. This actually happens in some instances, but usually only on an interim basis.771 The loss of autonomy is most marked with venture capitalists taking over corporate leadership, since this involves not only a total loss in autonomy regarding individual issues, but rather gives the venture capitalists a blanked control of the firm. Managers of venture capital-backed companies need to be aware that they lose a large part of their autonomy because of the involvement of venture capital firms. Considering the entrepreneurs’ need for autonomy, one might take the bait to conclude that entrepreneurs should try to avoid a loss of autonomy to the largest degree possible. However, the next chapter argues that a loss of autonomy can also be beneficial for entrepreneurs.

769

See chapter 4.3.5 and 4.3.8.4.

770

See Shepherd/Zacharakis Steier/Greenwood (1995).

771

See Fried/Hisrich (1995), p. 103; Sahlman (1990), p. 508.

(2001);

Cable/Shane

(1997);

Sapienza/Korsgaard

(1996);

Venture Capitalists’ Influence through Provision of Resources

5.4.4

167

Benefit of a Loss of Autonomy

The extensive catalogue of additional investor rights is necessary to control the management of the portfolio company from the perspective of a venture capital firm. From the perspective of the portfolio company’s management, this extensive catalogue of additional investor rights must be perceived negatively, since it reduces their autonomy. In particular, supervisory board representation rights enable the venture capital firm to dismiss management and therefore pose a threat to the existing management team. However, resource dependence theory can shed a different light on the provision of these rights to the venture capital firm. Resource dependence theory argues from the perspective of the portfolio company and claims that firms that are not self-sufficient should bind crucial resource providers to the firm by having them sit on their supervisory board.772 PFEFFER/SALANCIK argue that firms “use their board of directors as vehicles for co-opting important external organizations with which they are interdependent.”773 The supervisory board plays a crucial role in providing essential resources and securing those resources through linkages to the external environment.774 Thus, it is a mechanism to manage high external uncertainty.775 As has been shown above, venture capitalists play an important role in providing their portfolio companies with a wide array of resources. Resource dependence theory therefore suggests giving venture capitalists a seat on the supervisory board of their portfolio companies in order to secure provision of resources to the portfolio company. Therefore, it can be argued that through the management loosing autonomy to the venture capital firm, a better resource provision by the venture capital firm is made sure. This chapter demonstrated that venture capitalists influence their portfolio companies by providing a broad set of resources that are needed by the portfolio companies. Consequently, the entrepreneurs have to face a significant loss of autonomy, which usually is perceived negatively by them. However, there is some theoretical evidence that this 772

See Hillman/Dalziel (2003); Hillman/Cannella/Paetzold (2000); Johnson/Daily (1996); Daily/Dalton (1994a); Daily/Dalton (1994b); Gales/Kesner (1994); Pearce/Zahra (1992); Boyd (1990); Zahra/Pearce (1989); Pfeffer/Salancik (1978); Pfeffer (1972); Thompson (1967).

773

Pfeffer/Salancik (1978), p. 167.

774

See Hillman/Cannella/Paetzold (2000), p. 236.

775

See Boyd (1990), p. 427.

168

Venture Capitalists’ Influence through Provision of Resources

loss of autonomy is inevitable and even beneficial for firms that are strongly dependent on external resources like venture capital-backed companies. The next chapters present three case studies from venture capital investments in Germany that shed some light on how the influence of various venture capital firms on their portfolio companies turns out to be in practice. In order to do this, the analysis draws on the theoretical constructs that have been developed in the previous chapters.

Case Study Bullith Batteries AG

6

Case Study Bullith Batteries AG

6.1

Case Description

6.1.1

Preliminary Remark

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Due to a confidentiality agreement between the author and the involved case companies, the description of the case study on Bullith Batteries AG must disguise financial and several personal information since it is still an active investment. Therefore, the given financial numbers are altered in a way that prevents inferring the original data. However, the economic sense of the financial information has been preserved.

6.1.2

Development before First Round Financing

In 1998, the Munich start-up Implex GmbH is searching for a power supply for its full implantable hearing aid. In October 1998, Friedemann Stöckert, its founder and Chairman of the supervisory board, encounters the technology of the solid-state-based lithium-polymer accumulator developed by Prof. Dr. Anton Heuberger and Dr. Thomas Muster776 and their team at the Fraunhofer Institute for Silicon Technology (ISiT)777. This technology seems to be far superior to existing accumulator technologies. The rising global demand for mobile energy solutions provides huge market opportunities. Current accumulator technologies are based on nickel cadmium (NiCd), nickelmetal hydride (NiMH), lithium-ion and most recently lithium-polymer technology. Most of these technologies still suffer from low energy density and low form flexibility and require extensive precautions. Any accumulator consists of three layers: the negative electrode (anode), the positive electrode (cathode) and in between the electrolyte layer. First generations of lithiumpolymer accumulators are based on a liquid electrolyte technology, which has several disadvantages: • Its high danger of an explosion requires a hermetic metal encasement, which in turn reduces its effective energy density and increases its weight.

776

Name has been changed by the author.

777

ISiT is based in Itzehoe in Germany. It is one of the many institutes of the FraunhoferGesellschaft, which in turn is one of Europe’s leading organizations for technical and organizational innovations.

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• The metal encasement offers only limited possibilities to adapt its shape to fit the requirements of products. • The service life of the accumulators is rather short because the connection with the electrodes and the conductors undermines the electrolyte's chemical stability. • The liquid electrolyte is also very sensitive to any humidity requiring a complex and expensive production in dry-rooms. • The resulting high production costs of accumulators based on liquid electrolyte technology restrict their use to mass markets, such as the mobile communications or automotive industry. Research institutions and corporate R&D departments worldwide have made great efforts to reduce the above mentioned problems. However, all existing technologies do not fully solve the problems arising from the use of liquid electrolytes. Anton Heuberger and his team at the Fraunhofer Institute for Silicon Technology (ISiT) have achieved a major technological breakthrough by developing an accumulator based on a solid-state electrolyte technology. These accumulators consist of three layers: • The anode, which consists of graphite or lithium-titanate and stores the lithiumions in a lattice, • the cathode, which consists of solid lithium-cobalt dioxide, • the solid-state electrolyte layer separates both electrodes and consists of a special paste with added lithium salts to improve conductivity. In the process of discharging the accumulator, electrons move from the anode to the cathode via the external power circuit. The positive loaded lithium-ions detach from the graphite or lithium-titanate lattice of the anode and migrate through the solid-state electrolyte to the cathode, which absorbs the lithium-ions as well as the electrons. The process is reversed when charging the accumulator. The accumulators consist of several foils, which are produced through lamination under heat and pressure. Before the lamination of the electrolyte foil with the electrode foils, the conductor grids are impressed separately in the electrode foils. The compound is sealed in an aluminum foil casing. Several foil compounds can be stacked up on top of each other to increase energy capacity. Thereby it is also possible to adjust

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the design of the accumulator to a variety of forms. Most production steps are carried out on relatively simple machines in a normal working environment. One production step has to be performed under dried air but a sophisticated dry-room is not required. The accumulators based on this technology offer several advantages: • They do not require any metal encasements since neither overloading nor shortcircuiting can induce critical conditions or an explosion, • they provide nearly unlimited design and customization possibilities, • they have a higher energy density, • they exhibit by far the highest cycle stability reflecting the long service life, • they operate in a wider temperature range, • they are environmentally safe, • they are 30% to 50% lighter than comparable NiCd or NiMH-accumulators, • their required production investments are smaller, which allows an easier and more flexible production. This implies that even small production lots can be profitable. This opens up the opportunity to serve not only mass markets but also market niches with customized accumulators. Figure 55 compares different accumulator technologies by various technical data.

Characteristics

NiCd

NiMH

Lithium-ion

Lithium-polymer

Average operation voltage (V)

1.2

1.25

3.7

3.7

3.7 (graphite)/ 2.3 (titanate)

Energy density (Wh/dm3)

90

200

230-350

230-300

250-385/ 140-180

Cycle stability

N/A

N/A

80% of normal capacity after 300 cycles

80% of normal capacity after 300 cycles

Min. 80% of normal capacity after 500/3,000 cycles

Memory effect

Yes

No

No

No

No

25

20-25

1-2

1-2

1-2

Temperature range (°C)

-30 to +50

-10 to +50

-10 to +60

-10 to +60

-20 to +60/ -20 to +80

Environmental concerns

Yes

No

No

No

No

Self discharge rate (%/month)

Figure 55:

Selected data for comparing different accumulator technologies

Solid-state lithium-polymer

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There are several global players in the accumulator market from Asia, US, and Europe such as Sanyo, Matsushita, Sony, Ultralife Batteries, Valence Technology, Duracell, Saft, and VARTA. They all focus on mass markets and operate large-scale production lines for lithium-polymer accumulators with typical investment requirements of €100m. In Germany, several start-ups emerge which focus on innovative accumulator technology. Examples are GAIA Akkumulatorenwerke GmbH focusing on the automotive mass market and Ionity AG targeting niche markets. Friedemann Stöckert enters into licensing negotiations with the FraunhoferGesellschaft, the research institution that governs the ISiT, and Dr. Karl-Heinz Pettinger778 supports him. However, the technology is already partially licensed to Solid Energy GmbH, a spin-off that is founded in Itzehoe in May 1999 and managed by Thomas Muster. Solid Energy’s license for the technology covers the so-called 3Cmarket, which is the mass market for computers, camcorders and communication. In July 2000, Friedemann Stöckert manages to receive a license for the technology covering the use of the technology for all markets except the 3C-market, as well as the smart cards/smart labels and the automotive/traction sector, which were reserved under authority of ISiT. Essentially, it is a worldwide, temporally unlimited exclusive license, which can also be assigned to third parties. Besides, also all further patents of Fraunhofer-Gesellschaft in this area will be automatically included in this license agreement. Moreover, the license holder will receive technical support and both parties will inform each other about any new developments. The Fraunhofer-Gesellschaft will benefit by means of royalty fees. Based on this license, Friedemann Stöckert and several other people set up Bullith Batteries AG in November 2000. Friedemann Stöckert is designated chairman of Bullith Batteries’ supervisory board and holds 30% of the company. Karl-Heinz Pettinger joins the founding team as the company’s designated Managing Director and holds 14%. The attorney Dr. Dieter Pracht joins the founding team of Bullith Batteries through his long-term contact to Friedemann Stöckert. He is a designated member of the supervisory board and holds 15% of the company. A further member of the founding group holds 15%. The group of founders holds 74% of the shares of Bullith Batteries.

778

The electric chemist of Implex establishes the contact to Karl-Heinz Pettinger.

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Furthermore, Anton Heuberger joins the co-founding team as designated member of the supervisory board and holds 4% of the company. The Fraunhofer-Gesellschaft and an affiliated co-founder hold 9% together. Consequently, the group of shareholders from the Fraunhofer-Gesellschaft holds 13% of the shares of Bullith Batteries. Furthermore, the Managing Directors of Solid Energy, Thomas Muster and Michael Müller779, are personally invested in Bullith Batteries as well as the company Solid Energy itself. The group of shareholders affiliated with Solid Energy holds 13% of the shares of Bullith Batteries. The Fraunhofer-Gesellschaft intends to strengthen the links between the two companies with Solid Energy’s investment in Bullith Batteries. According to the articles of association of Bullith Batteries, the FraunhoferGesellschaft reserves the right to send one member to the supervisory board that comprises at that time three persons. The first shareholder meeting appoints Friedemann Stöckert as Chairman of the supervisory board and Anton Heuberger and Dieter Pracht as additional members of the supervisory board. Figure 56 shows the background of Bullith Batteries’ key people.

Friedemann Stöckert (Chairman of the supervisory board) Friedemann Stöckert, born in 1941, has extensive entrepreneurial experience and industry experience, especially in the field of medical technology. In the beginning of the 1970s, he started Stöckert Instruments GmbH, later a world market leader for heart and lung machines. After the trade sale to Pfizer Inc. he assumed management positions within Pfizer for several years. In the early 1990s, he founded a trading company with focus on Russia, and simultaneously started Implex GmbH. Dr. Karl-Heinz Pettinger (Managing Director) Karl-Heinz Pettinger, born in 1962, holds a PhD in electrochemistry from Munich University of Technology (TUM). In 1992, he joined Bayer Diagnostics where he was responsible for the know-how transfer within the Bayer Group. Furthermore, he set up a development department for electrochemical components and developed and initiated production of electrochemical and physical sensors. He gained management responsibility from 1994 onward as Head of Development in COMPUR Monitors after its spin-off from Bayer AG.

Figure 56:

Profiles of Friedemann Stöckert and Dr. Karl-Heinz Pettinger

Right from the beginning, Bullith Batteries forms a strategic alliance with ISiT aiming at a very intense knowledge exchange in research and development. Actually, ISiT covers the fundamental research, whereas Bullith Batteries concentrates on the further development and adaptation of the technology to customer's needs. In his function of a non-executive director, Anton Heuberger actively provides advice in technological is-

779

Name has been changed by the author.

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sues. In the first year of Bullith Batteries’ operations, the company only employs three people in addition to Karl-Heinz Pettinger. The organization chart of the company is depicted in Figure 57.

Karl-Heinz Pettinger Managing Director

Karl-Heinz Pettinger Technology/R&D

Figure 57:

Employee B Production

Employee C Marketing and Sales

Employee A Assistant

N.A. Administration and Finance

Organization chart of Bullith Batteries (2001)

The initial sales and marketing strategy aims at positioning Bullith Batteries in attractive niche markets that require its technological advantages. The FraunhoferGesellschaft refers many first contacts to potential customers to Bullith Batteries. In addition, Bullith Batteries manages to sign a research contract with ISiT to develop a power supply for hearing aids. The European Union subsidizes this so-called “HARPOS” project. Several promising negotiations with a worldwide leading manufacturer of hearing aids are initiated. Within the first year, Karl-Heinz Pettinger successfully develops the prototype technology, builds up a laboratory and starts designing a flexible, semi-automated production line, while hiring only three additional employees. Moreover, Bullith Batteries moves to its current location in Ismaning near Munich where it takes over the existing infrastructure of a former medical technology company.

6.1.3

First Round Financing

In order to build up the production line and to begin production, it becomes necessary to search for additional financial resources. In October 2001, Bullith Batteries concludes a comprehensive consulting agreement with an incubator to write the business plan and to source potential investors. Besides, the incubator should also provide support in further professionalizing the company in areas such as strategy development, designing the controlling system and management recruiting. The company intends to raise capital via issuing common stocks and silent partnerships. Preferably, the silent

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partnerships should come from KfW-Mittelstandsbank through its subsidiary Technologie-Beteiligungs-Gesellschaft (tbg) and from LfA Förderbank through its subsidiary Bayern Kapital. However, times for raising money from investors are tough in 2001 as stock markets have been plummeting for some time and investors have become more cautious. Venture Partners780 is interested but does not want to take the role of a lead investor since the amount of €1m is a too small investment regarding its large fund size, but would be willing to do a co-investment. In December 2001, after having approached more than 30 investors, Friedemann Stöckert talks about his capital raising efforts with his neighbor Janos Gönczöl, who is an industrial partner with Munich-based Gi Ventures AG, an independent venture capital firm providing equity finance to early- and expansion-stage companies in the German-speaking Europe. A few days later, Bullith Batteries enters into talks with Dr. Jürgen Diegruber, CEO of Gi Ventures, and Tim Stemmer, investment manager and CTO of Gi Ventures. Figure 58 shows the background of Gi Ventures’ key people.

Dr. Jürgen Diegruber (Co-founder, Partner and CEO, Gi Ventures) Dr. Jürgen Diegruber holds a master and PhD in business administration from the University St. Gallen, Switzerland. He is co-founder of Bossard Consultants GmbH, where he works between 1990 and 1995 as well as co-founder of ACADEMY AG, the German market leader of driving schools. In 1995, he founds Ahorn-Grieneisen AG, the leading industry holding in the considerably fragmented German market for funeral services, and serves as member of the Management Board until 2000. Since then, he is co-founder, partner and CEO of Gi Ventures AG. Tim Stemmer (Investment Manager and CTO, Gi Ventures) Tim Stemmer holds a master degree in industrial engineering and management from the Technische Hochschule Karlsruhe, Germany. From 1985 until 1991 he is a free-lance management consultant in the IT industry. Subsequently, he works as Project Manager at Bossard Consultants GmbH from 1992 until 1996. From 1996 until 2000, he gains line management experience as head of the Group Organization and Information Management department (CIO) of Knorr-Bremse AG. Since 2000, he is investment manager and CTO with Gi Ventures AG.

Figure 58:

Profiles of Dr. Jürgen Diegruber and Tim Stemmer

According to Gi Ventures’ marketing statement for their closed-end fund “GermanIncubator” with a volume of €10m781, top priority is to realize sustained and above average returns for its fund investors. Gi Ventures aims to realize this capital gain by get-

780

Name has been changed by the author.

781

HypoVereinsbank AG is the main sponsor of the fund.

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Case Study Bullith Batteries AG

ting actively involved in its portfolio companies by using its own management team and international network. The venture capitalists regard themselves as mentors and sparring partners to the company. However, they do not intend to get actively involved in the daily business of their portfolio companies. Instead, Gi Ventures wants to contribute its management experience in building up and managing the companies as well as providing active management support. The shareholders of Bullith Batteries elect Friedemann Stöckert to represent their interests in negotiations with Gi Ventures. However, the group of shareholders is quite heterogeneous with founders, members of the ISiT, and Solid Energy having several differing interest in the future of the company. In total, negotiations take about eight months time. During this time, many discussions take place between Gi Ventures and Bullith Batteries thereby creating a clear commercial awareness within Bullith Batteries’ management team. These discussions also reveal that both parties believe that the profile and needs of Bullith Batteries fit with Gi Ventures' investment principles. Finally, both parties agree on a term sheet in February 2002 and Gi Ventures commits to invest €1m for a 33.3% stake in the company and receives in turn Series A preferred shares.782 Accordingly, the group of founders holds 46.0%, the group of shareholders from the Fraunhofer-Gesellschaft and the group of shareholders from Solid Energy each holds 10.3% of the shares of Bullith Batteries. The resulting investment agreement is analyzed in detail in chapter 6.2.1.1. Gi Ventures takes the first round alone since it does not perceive a necessity to join forces with Venture Partners in a syndicated financing round.

6.1.4

Further Development until Second Round Financing

The investment contract requires Bullith Batteries to find a sales manager as this is a precondition for Gi Ventures to invest into the company. The search turns out to be quite complicated. At the end of July 2002, finally an appropriate candidate is found and accepted by Gi Ventures. Consequently, the investment of Gi Ventures is realized.

782

In fact, several new documents are drafted after the negotiations: the shareholder pool agreement, the founder's vesting contract, and the articles of association as well as the bylaws for both the management and the supervisory board.

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In August 2002, the shareholders' meeting decides to extend the supervisory board to six members. Dieter Hermann, a banker and manager from Friedemann Stöckert's network, joins the supervisory board, whereas Dieter Pracht resigns. From Gi Ventures, Jürgen Diegruber, Tim Stemmer and Peter Hertig, another partner of Gi Ventures join the supervisory board. Even though, Gi Ventures does not have the formal right to send the Chairman of the supervisory board, Jürgen Diegruber is appointed Chairman of the supervisory board. Changes in the supervisory board’s composition take place already at the second supervisory board meeting in late 2002, when Dieter Hermann resigns and is replaced by Janos Gönczöl. This fourth representative from Gi Ventures on the supervisory board is explicitly requested from Bullith Batteries’ management, even though Gi Ventures only has the contractual right to send three delegates. Figure 59 shows the professional background of Gi Ventures’ additional delegates to the Bullith Batteries’ supervisory board. Over the course of the subsequent months, the work of the supervisory board becomes more professional due to Gi Ventures’ presence.

Peter Hertig (Partner, Gi Ventures) Peter Hertig accomplished Senior Executive Management University Programs at University St.Gallen, IMD Lausanne and Harvard Business School. He is founder of the automobile supplier TOGO in Switzerland. In 1986, he sells the company to the Swiss EMS Chemie Holding and subsequently serves as member of the board of directors of EMS group, a company with 2,500 employees and revenues of €1bn. Since 1987 he is an active investor and consultant in the fields of automobile ancillary industry, metal products and chemical products. Moreover, he is co-founder of B.Com International AG, a service provider in the IT/TC environment. He is with Gi Ventures AG since 2000. Janos Gönczöl (Industrial Partner, Gi Ventures) Janos Gönczöl holds a law degree (assessor jur.) from universities in Paris, London and Munich. He is admitted to the Munich bar as a lawyer. He is founder and co-owner of MPC Agentur für Unternehmenskommunikation GmbH, the fifth largest independent PR agency in Germany from 1984 until 1999. In 1999, he sells the company to BSMG Worldwide, Chicago, USA, a leading global PR agency. He serves as a member of the Management Board of BSMG Worldwide from 2000 until 2001. From 2001 until 2002 he serves as a member of the Executive Board of Weber Shandwick, the world-wide largest PR agency, responsible for building up and expanding operations within Europe. He is with Gi Ventures AG since 2003 as industrial partner.

Figure 59:

Profiles of Peter Hertig and Janos Gönczöl

Early on, the organizational structure of Bullith Batteries is adapted to the monitoring needs of Gi Ventures and thus becomes more formalized. Gi Ventures helps to reengineer the internal accounting and reporting system and provides the contact to a service provider that overtakes the external reporting for Bullith Batteries. Furthermore, the

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management and Gi Ventures meet at least monthly to discuss the budget and important events. In September 2002, the supervisory board reviews the status quo of Bullith Batteries. Gi Ventures plays an important role in the ensuing improvements of the marketing and sales strategy. Bullith Batteries decides to pursue a specialization strategy focusing on niche markets, where its products not only satisfy the requirements of the market, but also provide a further advantage through the form flexibility. The market requirements are further miniaturization of applications while ensuring an effective energy density, greater cycle stability for special applications such as in medical implants, environmental friendliness, and safety. As there seems to be no direct competitor on the market yet, Bullith Batteries hopes to earn far higher margins due to lower price sensitivity in niche markets in comparison to mass markets. Moreover, the company also sets out to benefit from its first mover advantage. By establishing a standard, Bullith Batteries would make it harder for prospective competitors to catch up. Bullith Batteries’ technology does not only optimize existing applications, but allows developing new applications. As a result, the markets for medical equipment and explosion-proof applications are identified as key markets.783 Both can be addressed with a clear focus and require the unique selling points of Bullith Batteries’ technology. The company already disposes of extensive expertise and contacts in the field of medical devices, especially through the network of Friedemann Stöckert. By focusing on the two key markets, Bullith Batteries benefits from synergies between the two production lines since they pose largely similar demands on the production process. A further crucial question remains of how to access these markets and how to overcome entry barriers. Bullith Batteries’ management and the supervisory board agree on pursuing a new way of selling batteries. Traditionally, battery manufacturers produce batteries in pre-defined forms and follow a “product-out” approach. Device manufacturers have to adapt the design of their products to the form of the battery. Contrary to this, Bullith Batteries pursues a "market-in" approach, where batteries are developed jointly with the device manufacturer, who then markets both the device and the battery.

783

Other interesting market segments are optical devices, sensor technology, military equipment, specialist clothing, and sporting equipment.

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This sales process has two major phases. First, in a "development project" prototypes of the customer-specific battery are developed and tested in cooperation with the device manufacturer. Second, a successfully customized battery enters the "series delivery". This approach keeps the risks low for both the device manufacturer and Bullith Batteries since initial investments for the first development phase are small and both parties can get to know each other. Bullith Batteries can present itself as a reliable and trustworthy manufacturer of customized batteries. Once the customer is convinced by the quality of Bullith Batteries’ products, it might be easier to convince him to conclude a series delivery contract involving much higher costs. The supervisory board advises the management to implement a key account management system to enhance the customer contact. The key account manager is responsible for coordinating the internal and external activities in the project development and for assuring the customer-specific adaptation of the battery, both in technical and quality terms. Management and supervisory board decide on a focused communication policy that should support the implementation of the marketing and sales strategy. This communication policy includes building up a unique corporate identity and design that conveys Bullith as a brand for innovative accumulator technology ("Bullith – tailor made energy"). Therefore, the name "Bullith" is registered as a brand. Gi Ventures supports the management in finding an appropriate public relations agency for realizing their corporate design and negotiates better terms and conditions. To implement the proposed marketing and sales strategy, a detailed business planning is required. In this regard, the financial and business expertise of Gi Ventures is of great help to the management of Bullith Batteries since Gi Ventures initially develops the whole business planning for the company. Moreover, an enterprise resource planning software is implemented at the end of 2002 to better control the different processes of the company. In its selection and during the purchase negotiations, Bullith Batteries receives significant support from Gi Ventures. Furthermore, production facilities are acquired to complete the planned production line. About half of these facilities are financed through a leasing package. Special guarantees from all shareholders and the participation of especially Anton Heuberger, Jürgen Diegruber, Karl-Heinz Pettinger and Friedemann Stöckert are important success factors.

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After first presentations of Bullith Batteries' technology on trade fairs and in newspaper articles lots of requests have come up. To cope with the expected rising demand for Bullith Batteries’ products, the company hires additional personnel for the sales and production departments as well as an assistant for the company’s management. However, the sales manager is rather unsuccessful in conveying the unique selling points of Bullith Batteries’ technology to potential customers and works on many more market segments than has been agreed by the management and supervisory board. Until March 2003, he only delivers a few smaller orders. Consequently, the supervisory board suggests dismissing him still within his qualifying period. Until another sales manager joins the company, Friedemann Stöckert assumes the position through a consulting agreement in addition to his membership in the supervisory board. In March 2003, the financial situation comes to the fore again since additional financing in the form of silent partnerships is not yet raised. However, after long-winded negotiations led by Gi Ventures through its own contacts with several governmentdependent funds such as tbg, Bayern Kapital, and Bayerische Beteiligungsgesellschaft (BayBG), none of them actually invests due to various reasons. Bayern Kapital and BayBG refuse to invest because the market concept is not yet proven by a received series of orders and the management team is not yet complete since a manager with business background is still missing. The reason for tbg not to invest is that it is already invested in a competing company. Against the background of this development, the supervisory board meeting regards the requirements for a capital increase to be fulfilled as defined in the investment agreement because also the liquidity forecast shows a capital need exceeding €50k for the next three months. First, to overcome short-term cash need Gi Ventures provides a loan of €50k. Second, a capital increase amounting to €1m to be paid out in two stages is decided. The first tranche is paid out in May 2003, thereby increasing the stake of Gi Ventures in Bullith Batteries to 41.3%. In August 2003, a further loan is granted by Gi Ventures to bridge an acute liquidity shortage. In September 2003, Gi Ventures subscribes to the second tranche and then holds 50% of Bullith Batteries. Accordingly, the group of founders holds 34.5%, the group of shareholders from the FraunhoferGesellschaft and the group of shareholders from Solid Energy each holds 7.7% of the shares of Bullith Batteries.

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In May 2003, on the initiative of Gi Ventures, the management, Tim Stemmer and Friedrich Stöckert review the sales and marketing strategy in a workshop with an external consultancy that is specialized on the electronic industry. The workshop comes up with an idea of how to identify a customer with promising potential by defining the following four critical criteria a customer has to fulfill to be of interest to Bullith Batteries: • Customer needs at least one of Bullith Batteries’ unique selling points, • customer is willing to adopt a new technology, • customer produces capital-intensive products with final selling prices above €500, • innovation rate of the customer's industry is high. To support the marketing efforts of Friedemann Stöckert, the Bullith Batteries hires a key account manager. Due to the strategic importance of this position, Gi Ventures also approves him. The key account manager acts as the link between Bullith Batteries’ internal R&D department and the customer in order to streamline the development and production process. In addition, the management comes up with the idea of introducing a reseller system in order to enlarge sales capacities and is supported strongly by Gi Ventures during the implementation. Furthermore, two cooperation agreements are signed with sales representatives, so-called technology scouts, who refer potential customers to Bullith Batteries. Management and supervisory board also discuss a solution for sub-licensing Bullith Batteries’ technology. The company would provide the licensee with a complete service package or preferably refer the licensee to another existing licensee in order to avoid the complex process of knowledge transfer. This would enable the company to participate through royalty fees in markets with annual production volumes well over 200,000 units without having to invest in production facilities and bearing any risks. The enforced sales efforts pay off and the company acquires major customers in the market for medical devices. Besides HARPOS, the already existing large development project for hearing aids, Bullith Batteries initiates other projects with leading companies for cochlear implants. In September 2003, the company successfully completes a development project for the global market leader for prosthetics. Subsequently, the project is extended to the series delivery phase, the first in the company’s history. Fur-

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thermore, the company also receives a larger order from a major manufacturer of implantable blood pumps. During a review of Bullith Batteries’ value chain, some proposals for improvements in the value chain come from Gi Ventures. Both management and supervisory board conclude that additional expertise and resources in some parts of the production process are required to achieve the aimed for high quality level. Consequently, the management starts to search for new cooperation partners and Gi Ventures refers some interesting contacts from its network to Bullith Batteries. In March 2003, the management initiates a contact with a Swiss battery manufacturer with expertise in plastics casing technology. Bullith Batteries strives to develop a better casing, especially for its cochlear implant batteries, and to share production facilities. During the subsequent negotiations, Gi Ventures becomes deeply involved. However, after three months of intensive negotiations a cooperation agreement cannot be found due to conflicting financial expectations. Nevertheless, both companies still work together for particular projects. In June 2003, the quality of the externally purchased foils fluctuates too much, leading to delays in the processing of existing orders.784 Initially, the foil production has been outsourced due to the few numbers that were required, even though it is a core competency in the battery production process. However, Bullith Batteries’ requested amount of foil is too little to change the production process at the supplier. The management and supervisory board search for ways to fill this critical resource gap in the supply chain of Bullith Batteries. Among other options, negotiations with the insolvent EMTEC Magnetics GmbH785 based in Willstätt/Germany to purchase two coating machines are initiated. Gi Ventures is also involved in the negotiation process, which turns out to be a long haul and finalized after the second financing round. The close cooperation with Solid Energy is also subject of discussion between management and supervisory board. Both companies have been deeply interconnected, but expectations of mutual benefits have not been fulfilled. Gi Ventures induces Bullith Batteries to become operationally independent of Solid Energy, which later proves to 784

The accumulators of Bullith Batteries consist of several foils, which are composed through lamination and application of heat and pressure.

785

EMTEC Magnetics GmbH is a 100% subsidiary of EMTEC International Holding GmbH, which in turn is a spin-off from BASF AG.

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be very helpful. Solid Energy and its Managing Directors keep their shares of Bullith Batteries and both companies continue jointly sourcing many raw materials. An open issue in the company is the still missing sales manager. For this search, KarlHeinz Pettinger, Friedemann Stöckert and Gi Ventures compile the required job profile and engage executive search agencies to find an adequate person. However, the search turns out to be rather complicated. In December 2003, Gi Ventures finds through its network Dr. Christian Friedemann, a promising candidate, and does the first interviews with him. Figure 60 shows the profile of Christian Friedemann. Intensive talks with Bullith Batteries’ management follow to assure not only the professional, but also the personal fit. Finally, all parties agree and Christian Friedemann assumes the position of the Managing Director for Finance and Sales, which allows Friedemann Stöckert to give up his operational role and to concentrate again on his function as member of the supervisory board.

Dr. Christian Friedemann (Managing Director) Christian Friedemann, born in 1966, holds a master and a PhD in business administration from Universities in Saarbrücken and Lyon. He starts his professional career with Roland Berger Strategy Consultants. Thereafter he joins Siemens Management Consulting. After five years of experience as consultant for strategic and organizational projects in the technological industry, he manages the sales organization of the Siemens Mobile Network Division for Europe and Africa. In addition, he receives responsibility for the key account management for a global customer several years later. Before joining Bullith Batteries, he is Managing Director of the telecommunication company Tenovis Comergo. There he is responsible for business operations, finance and controlling.

Figure 60:

Profile of Dr. Christian Friedemann

Together with the new management team, the supervisory board reviews the marketing and sales strategy. The company decides to focus its sales efforts on "quick-win" segments, in which revenues can be generated in relatively short time. One of these segments is the market for acoustic consumer products, which comprises among others headphones and microphones and allows the company to use its expertise gained in hearing aids. Bullith Batteries soon attracts several development projects in these markets. In April 2004, Bullith Batteries realizes its first master agreement over five years with a major cochlear implant manufacturer. Bullith Batteries further improves and professionalizes its organizational structure with the help of Gi Ventures. Since Bullith Batteries is quickly growing, the company needs an organization structure that makes it less dependent on the Managing Directors. The

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management takes care of personnel development and the design of an employee incentive plan and only receives some suggestions in this regard from Gi Ventures. However, Gi Ventures designs a bonus program to incentivize the management and to set ambitious goals. In November 2003, Bullith receives the certification for ISO 9001 and ISO 14001 documenting its quality and environmental management systems. Finally, with Christian Friedemann now filling the long open management position besides Karl-Heinz Pettinger, the company is ready for further expansion.

6.1.5

Second Round Financing

Starting in September 2003, Bullith Batteries tries to raise additional capital to expand production facilities in order to cope with increasing serial productions. The amount of €2m to €3m is required to set up a solid financial base for realizing Bullith Batteries’ further growth strategy. At the beginning, Gi Ventures decides on the terms and conditions of initiating negotiations so that its position and interests in Bullith Batteries are not harmed. Gi Ventures searches systematically its network and mandates a consultancy to establish first contacts to potential investors. Soon, Bullith Batteries’ management and Gi Ventures find out that other venture capital organizations are currently not willing to accept the valuation proposed by Gi Ventures. Therefore, both parties agree to address other types of investors, who might be willing to accept the proposed valuation: Strategic investors, who can potentially contribute in terms of technology development and sales and private investors, who mainly provide capital and support the vision of Bullith Batteries. However, the search for a new investor takes longer than expected and a liquidity shortage can be anticipated. To bridge the liquidity need of the company, Gi Ventures proposes to issue a convertible bond with the conversion price set to the price of Bullith Batteries’ shares in the second financing round. The management agrees and subscribes to a significant part of the bond proving its commitment to the company. Two promising investors enter into negotiations with Gi Ventures to discuss a potential investment in Bullith Batteries. CaseTube AG786, an established Mittelstand com-

786

Name has been changed by the author.

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pany shows interest in acquiring Bullith Batteries. It has a long-term experience of producing titanium housings for medical applications, hearing aids among them. Currently, CaseTube also expands its activities to other high-precision metal housings in areas such as mobile computing, telecommunications, automotive and other consumer applications. In addition, the company is also active in the development and mass production of essential components in a picture tube such as inner magnetic shields, rim bands, mask frames, diaphragm parts and mask pins. In particular, CaseTube’s expertise in designing high-precision metal housings and Bullith Batteries’ expertise in producing high-end batteries seem to be a promising combination. A private investor, who is referred to Bullith Batteries and Gi Ventures by HypoVereinsbank, which was mandated by Bullith Batteries to find interested private investors, shows a strong interest to invest in Bullith Batteries. He had built a textile business, which he subsequently sold to METRO AG. He focuses now on making selected private investments. Negotiations with CaseTube drag on since the company has never invested before in a cash flow negative start-up. Since time is running out for Bullith Batteries, management and supervisory board decide to intensify the talks with the private investor. The actual negotiations, in which Gi Ventures plays a leading role, are completed within few weeks. The second financing round is structured as a simple capital increase of €2.5m with only the private investor subscribing to the new shares. Both financial measures, the issue of the convertible bond in February 2004 and the capital increase in June 2004, change the shareholder structure, which is approximately as follows: Founders and managers of Bullith Batteries hold 26.7%, the shareholder groups from Fraunhofer-Gesellschaft and Solid Energy each hold 5.3%. Gi Ventures is diluted to 38.9% and the new private investor holds 23.8%. The private investor agrees to join the existing pooling agreement and only asks for a seat on the supervisory board. In addition, the private investor proposes to set up an advisory council that supports the company’s management in important decisions. The private investor and a former production manager from Siemens, who supported him during the due diligence, join the advisory council.

186

6.1.6

Case Study Bullith Batteries AG

Further Development

Parallel to the financing negotiations, a unique opportunity arises to acquire the production equipment of Solid Energy, which files for insolvency at that time. The production equipment of Solid Energy is one of the most modern, but it is designed specifically to the mass production of lithium-polymer accumulators based on the technology developed by the ISiT. Therefore, the production equipment is only valuable to holders of the license from the Fraunhofer-Gesellschaft, i.e. Solid Energy and Bullith Batteries. Consequently, the creditors of Solid Energy find it hard to liquidate the production equipment to another party. Gi Ventures leads the negotiations for the purchase of the production equipment and closes the deal in July 2004. The actual deal terms are that Bullith Batteries founds the 100% subsidiary Solith Batteries, which purchases the production equipment for a fraction of its costs. In return, Bullith Batteries promises to preserve the production site in Itzehoe with its seven employees as long as Bullith Batteries produces in Germany, which also allows Bullith Batteries benefiting from its proximity to the ISiT. Furthermore, Bullith Batteries acquires the full license of Solid Energy and receives the licenses for the smart cards/smart labels and the automotive/traction sector from the Fraunhofer-Gesellschaft, which provides Bullith Batteries with the full license for the lithium-polymer accumulator. Together with the acquisition of the production equipment, this opens up the possibility for Bullith Batteries to enter the mass market for accumulators. The foil production is a crucial capability in the process of producing the accumulators. Since June 2003, the company has been trying to find another way to produce these foils since the quality delivered by the current supplier is unsatisfying. In July 2004, the negotiations concerning the purchase of two foil production machines from the insolvency proceedings of EMTEC Magnetics finally end and Bullith Batteries purchases both machines and thus acquires a new location in Willstätt, where these machines are located. With the foil production now fully internalized, Bullith Batteries covers an additional important part of the accumulator value production chain. Hence, two years after signing the first investment agreement with Gi Ventures, Bullith Batteries seems well positioned for its future growth. The purchase of the production facilities is an unexpected but promising turn in the company’s development. However, it is also associated with risks as it comes along with an accelerated growth

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strategy. Therefore, the company sees itself in front of many new but exciting challenges.

6.2

Case Analysis

6.2.1

Gi Ventures’ Influence through Contracting

6.2.1.1 Investment Agreement Structure The investment agreements between Gi Ventures and Bullith Batteries contain a range of contractual elements that are detailed in the following. Information rights are fully implemented in the first investment agreement. Accordingly, Gi Ventures has the right to ask for information and to visit Bullith Batteries’ premises at any time. Furthermore, Gi Ventures requires audited annual financial statements, quarterly and monthly reports as well as annual budgets until certain pre-defined dates. Conversion rights are fully implemented in the first investment agreement. Gi Ventures holds preferred shares of the series A, which can be converted at any time into common shares. Control rights are fully implemented in the first investment agreement. In line with its shareholdings in Bullith Batteries, Gi Ventures receives 33.3% of all voting rights in the shareholders’ meeting. Furthermore, Gi Ventures has the right to nominate half of the supervisory board's members and the auditor. According to its bylaws, the supervisory board has veto rights for a range of actions: • Request of capital increases and shareholders' disposition of shares, • granting pension commitments, • conclusion of control agreements, profit and loss transfer agreements, and company liquidation agreements, • appointment of top level managers with full power of attorney, • foundation or dissolution of companies, acquisition and sale of them, or any other participation in such activities, • foundation, acquisition or sale of subsidiaries, • acquisition or sale of properties,

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• disposal of intellectual property rights and conclusion of patents, licenses, know-how and cooperation agreements, • conclusion of agreements with an annual volume exceeding €100k concerning supply contracts and €50k respectively in continuing obligations, • execution of investments not included in the budget or exceeding the budgeted value by more than 20%, • conclusion of employment contracts not cancelable within six months or exceeding an annual compensation of €50k including changing existing contracts, • providing securities in form of the company's assets beyond the regular business, • initialization of legal and arbitral procedures of any kind beyond the regular business, • conclusion of changes in contracts with shareholders or their family members, • all other management actions beyond regular business. Management covenants are fully implemented in the first investment agreement. Concerning affirmative covenants, there is a contractual obligation for Bullith Batteries to hire a sales manager to complete the management team. Gi Ventures only invests if this condition is fulfilled. A major issue when discussing management’s representations and warranties is the extent of the personal liability of the founders. However, the different shareholder groups within Bullith Batteries strongly wanted to avoid being jointly and severally liable for the whole guarantee catalogue. This catalogue includes among others the legitimacy of the company, its financial and proprietary situation, the existence of contracts and technological expertise as stated in the business plan, as well as the granted license. In the end, the liability is personalized and limited to a certain amount. Furthermore, a non-compete clause exists for all pool members787, except Gi Ventures, members of the Fraunhofer-Gesellschaft and Solid Energy. This clause forbids acquiring a competitor of Bullith Batteries, to participate in a competitor or to support it in any other way. After leaving Bullith Batteries, pool members are committed to this 787

Gi Ventures and all other shareholders join the pooling agreement.

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clause for another three years. In addition, the employment contract of the Managing Director also includes a non-compete clause, which forbids taking up any work at a competing company for two years after the end of his employment contract at Bullith Batteries. In case of breaching this agreement, the Managing Director has to sell his shares for €1 per share to Gi Ventures. Moreover, the Managing Director is subject to a vesting schedule whereby the amount of entitled shares depends on the time he has worked for the company and increases every month from July 2002 until June 2006. Milestone agreements are only partially included in the first investment agreement since Gi Ventures does negotiate neither an earn-out clause nor the right to dismiss the management. The investment agreement also lacks any ratchets. However, staging is implemented in the investment agreement. The investment of Gi Ventures only takes place in case a sales manager is hired. Simultaneously, tbg and/or Bayern Kapital are expected to provide additional €1m preferably as silent partnerships. Gi Ventures requires the right of enforcing a further capital increase, if until the end of 2003, the target amount of at least €1m is not raised and the liquidity forecast reveals a not covered capital need of at least €50k for the next three months. Furthermore, Gi Ventures commits an option amounting to at least €400k on demand of Bullith Batteries, if certain milestones are met. The strike price is the share price of the first financing round. This option is limited to the period from December 2002 to December 2003. The required milestones for the execution of this option are: • Sum of revenues in the last 90 days and order backlog exceed €1m, • revenues and order backlog are generated from at least three unrelated customers, • gross profit of the batteries sold during the last 90 days amounts to at least 50%. Cash flow rights are partially implemented in the first investment agreement. In case of Bullith Batteries' liquidation, Gi Ventures receives twice its invested capital and any agreed, but not distributed cumulated dividends before other shareholders receive any payments. The anti-dilution protection is designed as a weighted average ratchet. A dividend preference is not implemented in the investment agreement. Preemptive rights are fully implemented in the first investment agreement. In case, other shareholders want to sell their shares to a third party, Gi Ventures has the right of first refusal for a period of six weeks. In addition, only Gi Ventures or a co-investor

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proposed by Gi Ventures has the right of first offer regarding the subscription to the capital increase, which is conditional on Bullith Batteries not managing to raise the target amount of further €1m and the liquidity forecast revealing a not covered capital need of at least €50k for the next three months. The issue price is fixed and the amount of the capital increase is determined by the difference of the target amount and the actual raised capital. Disinvestment rights are partially implemented in the first investment agreement. A drag-along right provides Gi Ventures with the opportunity to force other shareholders to sell their shares as well, if a binding offer from a third party to buy these shares exists and the other shareholders are not willing to buy Gi Ventures' stake for the same conditions than the third party would. As a requirement to enforce this right, an annually increasing valuation of the whole company acts as a benchmark indicating the minimum value to which a sale can be carried out. This valuation increases every year until 2006, whereas from 2007 on this valuation remains constant. After the sale, Gi Ventures can also require a six-month long founders' lock-up from the shareholders. Other disinvestment rights such as a tag-along right, registration rights, cancellation rights, and redemptions rights are not included in the first investment agreement. The second financing round only entails minor changes in the pooling agreement. A change in the drag-along clause is required since the valuation of Bullith Batteries is now more than double the valuation at the time of Gi Ventures’ entry. Under the existing contractual agreement, this provides Gi Ventures with the right to force all shareholders to sell their shares along with Gi Ventures any time at the price of the second financing round. Therefore, the minimum performance goal concerning the company’s valuation at which the drag-along right can be exercised is set higher. These changes have no significant effect on Gi Ventures’ influence onto Bullith Batteries. Figure 61 summarizes the contractual elements that are included in both investment agreements between Gi Ventures and Bullith Batteries.

Case Study Bullith Batteries AG

Categories of venture capital firms‘ rights

Information rights

Conversion rights

Control rights

Management covenants

Milestone agreements

Cash flow rights

Preemptive rights

Disinvestment rights

Figure 61:

191

Investment agreements between Gi Ventures and Bullith Batteries

; Right to ask for information

; Regular reporting

; Right to visit company premises ; Conversion on option of the holder ; Voting rights

; Supervisory board representation right

; Veto rights ; Affirmative covenants

; Non-compete clause

; Representations and Warranties

; Vesting

… Earn-out

… Ratchets

… Management dismissal

; Staging

… Dividend preference

; Anti-dilution protection

; Liquidation preference ; Right of first refusal ; Right of first offer … Tag-along right

… Registration rights

; Drag-along right

… Cancellation right

… Redemption rights

Contractual analysis of Bullith Batteries’ investment agreements

6.2.1.2 Influence on Deal-specific Risks Gi Ventures uses a broad range of contractual elements to reduce several deal-specific risks in both investment agreements. Figure 61 shows that the investment agreements fully implement information rights, conversion rights, control rights, management covenants, and preemptive rights and partially implement milestone agreements, cash flow rights, and disinvestment rights. Along the lines of chapter 4.3, Figure 62 shows in detail, which deal-specific risks are addressed with the investment agreements between Gi Ventures and Bullith Batteries.

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Investment agreements between Gi Ventures and Bullith Batteries reduce risk of…

Effects Contractual rights

managerial opportunism

competitive opportunism

Information rights

x

Conversion rights

x

Control rights

x

Management covenants

x

x

Milestone agreements

x

x

Cash flow rights

x

unfavorable decision taking

x

 x

Preemptive rights



Disinvestment rights

x Figure 62:

exit obstruction

Risk addressed in both investment agreements

x 

Risk not addressed in both investment agreements

Risk not addressable by this category of contractual rights

Deal-specific risks between Gi Ventures and Bullith Batteries

Both investment agreements between Gi Ventures and Bullith Batteries address all deal-specific risk categories. Merely, the theoretical intensity of the effectiveness of the implemented contractual elements can be assumed lower than in the case of an investment agreement using all contractual elements since for instance several incentive mechanisms such as earn-outs, ratchets, and dividend preferences are not included.

6.2.1.3 Influence on Management’s Formal Autonomy The investment agreement with Gi Ventures includes several contractual elements that constrain the formal autonomy788 of the management team. In the following, the important possibilities of Gi Ventures to interfere with management decisions are described. Control rights are the most powerful contractual provisions in the investment agreement between the two parties. The voting rights of Gi Ventures reach their peak of 50% before the second financing round. This gives Gi Ventures the strongest position among the shareholders of Bullith Batteries. Gi Ventures can block any decision in the shareholder meeting. However, since Gi Ventures does not hold the majority of the shares of Bullith Batteries, it is not in the position to take decisions for the company on its own and still requires the support of other shareholders to effect changes. Through

788

See chapter 4.4.

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its strong supervisory board representation rights, Gi Ventures can block all major decisions of the management board that require the consent of the supervisory board. These contractual provisions drastically limit the scope of independent actions of Bullith Batteries’ management team. In particular, the management cannot conclude a single contract of some importance with third parties without the consent of Gi Ventures. In case, Gi Ventures does not approve any proposal of the management team, Bullith Batteries cannot pursue any significant activities. Management covenants also provide Gi Ventures with some influence on managerial decisions. The inclusion of the affirmative covenant to hire a sales manager forces the company to find a suitable candidate. Furthermore, the non-compete clause excludes Karl-Heinz Pettinger to engage in any competitive actions thereby reducing the scope of his activities not only during the time of his employment at Bullith Batteries but also for two more years after his employment contract ended. Considering the fact that this probably entails a wage loss in the future since he cannot benefit from his specific knowledge about the battery industry, the non-compete clause represents a major interference with his personal autonomy. Moreover, the drag-along right gives Gi Ventures the power to sell Bullith Batteries to another company in case the existing shareholders are not willing to purchase the shares of Gi Ventures at the same conditions. In such a case, Bullith Batteries would fully lose its autonomy and independence.

6.2.2

Gi Ventures’ Influence through Resource Provision

6.2.2.1 Influence on Resource Pool Besides the formal influence through the investment agreement, Gi Ventures also exerts significant influence onto Bullith Batteries by providing resources directly or indirectly and thereby influencing the company’s resource pool.789 In terms of technological resources, at the time of Gi Ventures’ first investment, Bullith Batteries holds a license for the commercial exploitation of a technology to develop solid-state-based lithium-polymer accumulators. The license covers all markets with the exception of the 3C-market, as well as the smart cards/smart labels and the automotive/traction sec-

789

See chapter 5.2.3.

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tor. Furthermore, the license agreement between Bullith Batteries and FraunhoferGesellschaft provides for a continued technology transfer between the ISiT and Bullith Batteries. With regard to intellectual property rights, the company does not show a critical need of further technological resources. Due to the unforeseen situation in 2004, where Solid Energy files for insolvency, Gi Ventures helps Bullith Batteries to receive the full license for the Fraunhofer technology by leading the negotiations with the Fraunhofer-Gesellschaft. In this regard, Gi Ventures indirectly provides technological resources to Bullith Batteries. Bullith Batteries urgently needs financial resources to pursue its wealth creation activities since the money provided by the founders is running out. Gi Ventures plays the dominant role as Bullith Batteries’ most important source of financial resources until the second financing round by subscribing to several capital increases and a major part of the convertible bond. The venture capitalists also support Bullith Batteries when liquidity problems are incurring. Furthermore, Gi Ventures also indirectly helps the company to acquire further financial resources. By providing guarantees, Gi Ventures enables Bullith Batteries to realize a favorable leasing package that prevents further dilution of the founders. Gi Ventures is strongly involved in the management of the second financing round. Since it does not accept the lower valuation offered by other venture capital firms and finally closes the deal with the private investor, it enables Bullith Batteries to raise additional money at lower capital costs. Further managerial resources are required, since the management team is lacking a sales manager. Through Jürgen Diegruber, Tim Stemmer, Peter Hertig, and shortly after Janos Gönczöl joining the supervisory board of Bullith Batteries, Gi Ventures offers significant managerial resources to the company. This becomes apparent in the close cooperation of supervisory and executive board regarding strategy development. The deep involvement of Tim Stemmer in setting up Bullith Batteries’ first business planning represents an important contribution to the company’s managerial resources. By leading the negotiations for the second financing round and the purchase of the production facilities, Jürgen Diegruber also actively supports the company in managing these processes and contributes his managerial resources to the company. Since Gi Ventures establishes the initial contact to Christian Friedemann, the venture capitalists also indirectly enable Bullith Batteries to access additional managerial resources.

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Further personnel resources are also required since Bullith Batteries only has very few employees at the time of the first financing round. The company therefore urgently needs some more employees to build up a small sample production line. However, in this regard, Gi Ventures does not support the company. In terms of physical resources, the company benefits from its close links to the ISiT. Nevertheless, Bullith Batteries lacks its own comprehensive production facilities to be able to deliver higher amounts of its accumulators. Gi Ventures does not provide direct access to physical resources. However, indirectly, through the extensive involvement of Gi Ventures in the negotiations to purchase the production equipment from the insolvencies of Solid Energy and EMTEC Magnetics, it contributes to the build up of important physical resources of Bullith Batteries. Organizational resources such as clear structures and processes within the company are under development since the company is already active since one year. There is still a need for further organizational resources. In this area, Gi Ventures supports Bullith Batteries in several ways by transferring its knowledge to the company. The venture capitalists mainly help Bullith Batteries in setting up management systems such as internal accounting, reporting, key account management and management incentive programs. Furthermore, they advise the management on possible improvements in the company’s wealth creation structures and processes. In terms of reputational resources, the company enjoys the benefits of its close links with the Fraunhofer-Gesellschaft and the ISiT within the scientific community. Regarding its commercial activities, the company lacks reputational resources since it has not yet established a track record with major partners. However, Gi Ventures does not play an important role in this respect. Some customers are easier to convince to enter into a relationship with Bullith Batteries because a venture capital firm backs the company. Another example is Christian Friedemann, who, signs the employment contract with Bullith Batteries because of the same reason among others. The founding team disposes of some social resources mainly in the scientific community but also in the field of medical devices, especially through the network of Friedemann Stöckert. Still, there is a strong need of establishing further social contacts to potential customers. Gi Ventures provides Bullith Batteries with important social resources. With Jürgen Diegruber, Tim Stemmer, Peter Hertig and Janos Gönczöl joining the supervisory, up to four members of Gi Ventures offer their network to Bullith

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Batteries. The company is referred to service providers that are trusted by Gi Ventures such as the agency supporting the management in its public relations efforts, the consultancy helping the management to review its sales and marketing strategy as well as the company that initially overtakes the external reporting for the company. Gi Ventures provides the important contact to Christian Friedemann and to several other parties such as potential collaboration partners, government-dependent funds, and potential investors for the second financing round, but they do not contribute significantly to Bullith Batteries’ development. It follows from the above analysis that Bullith Batteries has an initial resource need in all resource categories except for technological resources at the time of the first investment of Gi Ventures. This initial resource need is depicted in the second column in Figure 63. The analysis of the resource contribution of Gi Ventures shows that the venture capital firm directly and indirectly provides several important resources to Bullith Batteries as shown in the third and fourth column of Figure 63. However, the analysis also shows that relying exclusively on the resource provision activities of Gi Ventures would not be enough for Bullith Batteries since several resources are not provided at all by Gi Ventures.

Resource categories

Critical resource need of Bullith Batteries

Resource contribution by Gi Ventures Direct

Indirect

Technological resources





x

Financial resources

9

x

x

Managerial resources

9

x

x

Personnel resources

9





Physical resources

9



x

Organizational resources

9

x



Reputational resources

9

x



Social resources

9

x



9 Critical resource need

 No critical resource need Figure 63:

Resource-based analysis of Bullith Batteries

x Resources provided  No resources provided

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6.2.2.2 Influence on Management’s Real Autonomy The influence of Gi Ventures onto Bullith Batteries can be shown by analyzing its involvement in the company’s management processes. Along the lines of chapter 5.4.2, the levels of normative, strategic and operational management can be differentiated. On the normative management level, Gi Ventures’ influence is moderate. An important contribution to the company’s vision is the fact that even before Gi Ventures has invested in the company, the mindset of the management is directed towards a commercial awareness, replacing the still prevalent technical orientation. Bullith Batteries is positioned as a company that follows the shareholder value principle. Through the many discussions regarding Bullith Batteries’ long-term goals, Gi Ventures also plays a role in the definition of the company’s mission. A further contribution of Gi Ventures concerns the company’s corporate governance. Through the investment agreement and Jürgen Diegruber, Tim Stemmer, Peter Hertig and Janos Gönczöl joining the supervisory board the corporate governance structure of Bullith Batteries is completely revised. In particular, a professionalization of the corporate governance can be noted due to the strong influence of Gi Ventures on the formal processes within Bullith Batteries as a stock corporation. In addition, Gi Ventures introduces a management bonus program. Regarding the corporate culture, no significant influence of Gi Ventures can be found. On the strategic management level, Gi Ventures plays an important role. Above all, Gi Ventures shapes the financial strategy of the company. Examples for this are the fact that Gi Ventures decides on the terms and conditions for the negotiations in the second financing round and that Gi Ventures proposes to issue a convertible bond shortly before the second financing round to overcome the liquidity shortage. Furthermore, Gi Ventures also influences the sales and marketing strategy by participating in many discussions and the workshop with an external consultancy. Examples for this are the involvement in the decisions on which niche markets to focus, to switch from a “product-out” to a “market-in” approach, and to focus marketing efforts on quick-win segments. A further input from Gi Ventures is the fact that it pushes the management to become independent of Solid Energy, which proves to be very beneficial in view of Solid Energy’s later insolvency. Gi Ventures also introduces several management systems such as internal accounting and reporting. It helps the management in the implementation of a key account man-

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agement system. Moreover, Gi Ventures becomes deeply involved in the selection of the enterprise resource planning software. Regarding organizational structures, there is also some important support from Gi Ventures. Right from the beginning, Gi Ventures asks for an adaptation of Bullith Batteries’ organizational structure to comply with its monitoring needs and introduces structures that are more formal. Later, this becomes important again in the restructuring efforts of the company to become less dependent on the two Managing Directors. On the operational management level, Gi Ventures proves to be a hands-on venture capital firm. This becomes most obvious regarding the fact that Gi Ventures initially assumes the role of developing the whole business planning for Bullith Batteries. Within this function, Gi Ventures is clearly involved in defining operational goals for the company. Additionally, Gi Ventures is deeply involved in most negotiation processes that are of high importance to Bullith Batteries. These negotiations are with • Leasing companies to secure the leasing package, • tbg, Bayern Kapital, and BayBG to raise silent partnerships, • software companies to purchase the enterprise resource planning software, • Swiss battery manufacturer as potential collaboration partner, • Christian Friedemann as second Managing Director, • EMTEC Magnetics to purchase the two foil coating machines, • investors of the second financing round, • Solid Energy and its stakeholders to organize the purchase of the production equipment. In addition to these negotiations, Gi Ventures takes several other measures that are on an operational management level. It supports in the implementation of the reseller system and the compilation of the job profile of the second Managing Director. Furthermore, it actively provides contacts to potential second round investors. Finally, Gi Ventures also makes some proposals for improvements in Bullith Batteries’ value chain. By summarizing the influence of Gi Ventures onto Bullith Batteries, it becomes clear that the actual influence exertion conveys a clearly different picture in comparison to the formal influence possibilities that are granted to Gi Ventures by the means of the

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investment agreement. Except a few issues, such as how the internal accounting and reporting system has to be designed and that a second Managing Director has to be hired, Gi Ventures avoids to directly interfere with managerial decisions, but seeks to achieve a mutually accepted solution. There is no evidence of any event in which Gi Ventures directly blocks a decision of the management. Consequently, the influence of Gi Ventures does not come through open pressure or simple use of contractual rights but rather through a continued and ongoing discussion process with the management, in which new ideas and possible changes are discussed. The management of Bullith Batteries obviously loses real autonomy, but rather on a deliberate and voluntary basis since it perceives the contribution of Gi Ventures as very valuable to pursue its own goals.

Case Study GPC Biotech AG

7

Case Study GPC Biotech AG

7.1

Case Description

7.1.1

Development before First Round Financing

201

Prof. Dr. Hans Lehrach, one of Europe’s leading researchers in the field of genomics, and his research team have developed several innovative technologies in genomic research and automated molecular biology at the Imperial Cancer Research Fund in London/UK and subsequently at the Max-Planck-Institute for Molecular Genetics in Berlin. Moreover, they have been very successful in setting up several scientific collaborations with a number of pharmaceutical and biotech companies. Dr. Elmar Maier, Dr. Sebastian Meier-Ewert, Dr. David Bancroft, and Hans Lehrach decide to set up the Genome Pharmaceuticals Corporation (GPC Biotech) AG in 1997. Most of them have been working together since 1991. In addition, Prof. Dr. Annemarie Poustka, who holds a position at the German Cancer Research Center in Heidelberg, also joins the founding team. Previously, she has been working with Hans Lehrach for several years on a number of projects. Figure 64 shows the professional background of the founding team. Based on the many years of experience in cancer research and more precisely on specific target molecules, a sound knowledge about gene and protein function is available in the founding team that could help to develop new drug targets and therapeutics successfully. The members of the founding team possess unique platform technologies for areas such as identifying gene expression patterns, protein-protein interactions, assays that use living cells to test the effect of specific molecules on their behavior, and the automation of exact pipetting or spotting of samples.

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Dr. David Bancroft David Bancroft holds a degree in Biology and a PhD in molecular population genetics from the University of Cambridge, UK. His previous research positions include those at the Imperial Cancer Research Fund in London and at the Trinity College in Dublin as a Royal Society European Visiting Fellow. Later he was responsible for development and implementation of new automated technologies at the Max-Planck-Institute for Molecular Genetics in Berlin. In addition, he has several pending patent applications in the fields of molecular biology and automation. Prof. Dr. Hans Lehrach Hans Lehrach holds a degree in chemistry from the University of Vienna and a PhD from the Max-Planck-Institute for Experimental Medicine and Biophysical Chemistry in Göttingen. He worked as scientist in several laboratories at Harvard University in Boston, MA. For several years he led a team of scientists at the European Molecular Biology Laboratory in Heidelberg. Subsequently, he became director of the genomics department at the Imperial Cancer Research Fund in London. Thereafter, he is appointed Director and Head of Department at the Max-Planck-Institute for Molecular Genetics in Berlin. In addition, he became Director of the Resource Center within the German Human Genome Project in Berlin. He is a member of the International Council of the Human Genome Organization and author of several hundred papers and abstracts. He was a key member on the Scientific Advisory Board of Sequana Therapeutics Inc., a genomics company in San Diego from 1993 to April 1997. Hans Lehrach pioneered the automated mapping of very large regions of DNA. Dr. Elmar Maier Elmar Maier holds a degree in chemistry and a PhD in biology from the University of Konstanz. He has received numerous awards, including fellowships for his research in the field of genomics technologies at the Imperial Cancer Research Fund in London. As a Group Leader and Project Manager at the Max-Planck-Institute for Molecular Genetics in Berlin, he arranged collaborations with pharmaceutical and biotech companies. In addition, he co-founded a consulting firm commercializing biotech know-how. Dr. Sebastian Meier-Ewert Sebastian Meier-Ewert holds a degree in biochemistry from the University College in London and a PhD from the University of London. After his time at the Imperial Cancer Research Fund in London, he led a team of scientists working on gene expression analysis and bioinformatics at the Max-Planck-Institute for Molecular Genetics in Berlin. In addition, he co-founded a consulting firm commercializing biotech know-how. Prof. Dr. Annemarie Poustka Annemarie Poustka holds a degree in medicine from the University of Vienna and holds a PhD from the University of London. She is the head of the Division of Molecular Genome Analysis at the German Cancer Research Centre in Heidelberg and is a Professor at the University of Heidelberg. As one of the pioneers of positional cloning technology, her major research interest is the cloning, characterization and functional analysis of disease genes. She is a member of the International Council of the Human Genome Organization and author of a number of patents and a few hundred papers and abstracts.

Figure 64:

Profiles of GPC Biotech’s founding team

Over a five-year period, the founders aim for expanding the company’s technology base to become an integrated drug discovery and development company. This technology base shall also be used in collaborations with major life science and pharmaceutical companies to support their drug discovery and development programs. Several companies already show interest in collaborations with the founding team. The company will focus on the areas of immunology, infectious diseases, and oncology, which are large markets with significant unmet medical needs that are not addressed by currently available drugs. Furthermore, the predictability of disease models is high and the costs of clinical development are relatively moderate.

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7.1.2

203

First Round Financing

Before setting up the company, the scientists search for financial investors that would provide the required financial resources. Elmar Maier and Sebastian Meier-Ewert have consulted the biotech company Qiagen N.V. on several specific technological developments for a number of years and have built up good relations with the management team. Therefore, Dr. Metin Colpan, CEO of Qiagen and Peer Schatz, CFO of Qiagen, introduce the founding team to Dr. Helmut Schühsler, Managing Partner at Techno Venture Management (TVM), which formerly was lead investor in Qiagen. Figure 65 shows the professional background of Helmut Schühsler.

Dr. Helmut Schühsler (Managing Partner, TVM) Helmut Schühsler holds a master degree and a PhD in business administration from the Economics University of Vienna. He was an Investment Manager at the venture capital firm Horizonte Venture Management in Vienna. Since 1990 he served on various committees, among others as a member of the senate of the Helmholtz Association of National Research Centers, which is with its 15 research centers and an annual budget of €2bn one of Germany’s largest research institution. He serves on the board of several life science companies. He is with TVM since 1991.

Figure 65:

Profile of Dr. Helmut Schühsler

TVM started its operations in Munich in 1983. The opening of its Boston office followed in 1986. TVM invests in information technology and life science, which is also reflected in its internal organization with one team specializing on information technology and the other team focusing on life sciences. In addition, a corporate finance team assists investment managers and the management of portfolio companies in various financial issues. Furthermore, the investment managers are supported by a research team, which for instance provides information on competitors and general trends in the biotech and pharmaceutical industry. Until 1997, TVM has raised three funds: TVM I in 1984 with €87m, TVM II in 1987 with €90m, and TVM III in 1997 with €93m. A major objective of TVM’s investment strategy is to create transnational businesses that thrive for access to science, management talent and capital on both sides of the Atlantic, thereby increasing their opportunity to develop into dominant players in their markets. Right from the start, Helmut Schühsler is interested in the founding team, but advises to search for an additional member of the founding team with a business background. At this time, Dr. Mirko Scherer, who has just completed his MBA at Harvard Business

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School, is looking for a management position and contacts Helmut Schühsler, who directly refers him to the founding team. Soon, all parties agree to work together and Mirko Scherer joins the founding team. Figure 66 shows his professional background.

Dr. Mirko Scherer Mirko Scherer holds a degree in business administration from the University of Mannheim, a PhD in Finance from the European Business School in Oestrich-Winkel and a MBA from Harvard University. Before joining GPC Biotech, he worked for The Boston Consulting Group in Munich.

Figure 66:

Profile of Dr. Mirko Scherer

Various parties support the founding team in its efforts to set up GPC Biotech in Martinsried/Munich, which is one of the largest biotech clusters in Europe. Even before investing in the company, Helmut Schühsler supports the team of founders through several discussions about business and financing strategies and technology transfer issues. Essential support in a number of strategic and operational questions comes from Metin Colpan and Peer Schatz, not only in the first months, but also in the subsequent years. The team receives further valuable support from Prof. Dr. Horst Domdey, probably the most prominent single person in the German biotechnology industry. The Bavarian Ministry of Economics also supports the founding team in its effort to set up operations in Martinsried. Furthermore, the founders are supported by a leading German law firm in preparing basic legal documents such as the articles of association, which already meet the requirements of a professional venture capital firm. In May 1997, a term sheet is negotiated between TVM and the founding team. TVM agrees to invest as lead investor in a yet to be founded company together with Qiagen as co-investor. Parallel to these negotiations, Hans Lehrach and Dr. Michael Steinmetz, who did research in the same field a long time ago and know each other for more than 20 years, discuss another financing opportunity with the US venture capital firm Medical Portfolio Management (MPM) Capital, which Michael Steinmetz joins as General Partner in the beginning of 1997. The discussions with MPM open up a further interesting opportunity for the founding team. Dr. Ansbert Gädicke founded MPM Capital in 1996 as an independent venture capital firm. Subsequently, MPM Capital raises $230m for its MPM BioVentures I fund, which will be committed with 75% in biotechnology and 25% in medical devices and

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other healthcare related fields. The investment decisions are taken exclusively by the General Partners and monitored every six months by an investor committee. Right from the beginning, MPM Capital is set to be one of the most prominent venture capital firms in this field due to Ansbert Gädicke and Michael Steinmetz, who both possess excellent reputation within the industry.790 Figure 67 shows the professional background of Michael Steinmetz.

Dr. Michael Steinmetz (General Partner, MPM Capital) Michael Steinmetz holds a degree and PhD in molecular biology from Munich University. He held research positions at the California Institute of Technology and the Basel Institute for Immunology. Later, he joined Hoffmann-La Roche for ten years, where he headed the company’s biology department in Basel and the preclinical research and development department in Nutley, New Jersey. As Vice President of Preclinical Research and Development, Michael Steinmetz directed the research efforts of over 800 scientists. Multiple drug candidates, including recombinant proteins, antibodies and small molecules were discovered under his leadership and moved into clinical trials. He also conceptualized and managed many of Roche’s research-stage alliances including the company’s first investment in genomics (Millennium) as well as collaborations with Incyte and Caliper. He joined MPM Capital as General Partner in 1997.

Figure 67:

Profile of Dr. Michael Steinmetz

MPM Capital is only willing to invest in GPC Biotech if it can take the lead investor role. Simultaneously, Michael Steinmetz offers to act as interim CEO until a qualified person is found that can assume the role of GPC Biotech’s permanent CEO. The founders strive to achieve a syndicated investment since they are convinced that the combination of both venture capital firms would present a unique opportunity for their company. TVM offers the expertise and the reputation of a number of very successful investments in the biotech industry. MPM Capital offers better access to the US market, offers the backing of a large fund, an excellent interim CEO with sound expertise in the pharmaceutical industry, and the reputation of one of the world’s premier venture capital teams in the area of life sciences. After several discussions, all parties see the benefit of joining forces and agree to do the deal together with MPM Capital as lead investor and TVM and Qiagen as coinvestors. Right from the beginning, the venture capital firms agree on a clear distribution of roles. MPM Capital with Michael Steinmetz focuses on pharmaceutical collaborations and operational aspects of the company. TVM with Helmut Schühsler ad790

This proved to be true. In 2004, MPM Capital is the world’s largest biotech venture capital firm having $2.1bn committed capital under active management.

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vises the company on financial and legal matters. MPM Capital clearly wants to syndicate the deal with TVM since it lacks at that time a long-time experience of doing venture capital investments. In July 1997, all parties sign the new term sheet, which has less favorable conditions for the founders regarding the company’s pre-money valuation and implemented investors’ rights in comparison to the term sheet offered before by TVM and Qiagen alone. The founders accept the new conditions for the benefit of having both venture capital firms backing the company. In August 1997, Elmar Maier, Sebastian Meier-Ewert, David Bancroft, Hans Lehrach, Annemarie Poustka, and Mirko Scherer found GPC Biotech through a corporate shell purchase and provide the company with an initial capital base of €34k. In October 1997, all parties sign the final investment agreement. All investors acquire common stocks of GPC Biotech through a capital increase. After the capital increase, the approximate shareholder structure is as follows: The founders hold 39% of all common shares. MPM holds 32% and as a fiduciary another 9% that are reserved for the future CEO of the company.791 TVM and Alpinvest, a Dutch venture capital fund that TVM also advises, hold 16%. Qiagen holds 4% of the company. In the first financing round, GPC Biotech raises €3m from both venture capital firms: €2m from MPM Capital and €1m from TVM. Qiagen provides further €0.3m. At this time, GPC Biotech’s post-money valuation is €6.4m.

7.1.3

Development until Second Round Financing

The investment agreement with the independent venture capital firms MPM Capital and TVM enables GPC Biotech to apply for silent partnerships provided by government-dependent funds of tbg and Bayern Kapital Risikokapitalbeteiligungs GmbH (Bayern Kapital). Because tbg and Bayern Kapital have made good experiences with investments in former TVM portfolio companies, GPC Biotech quickly gets the approval for the additional financing. In January 1998, GPC Biotech and tbg sign three silent partnership contracts with a total volume of €2.5m, which is the maximum funding that can be obtained from tbg. The term of the partnership agreement is ten years

791

However, the company later redeems these shares.

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and GPC Biotech has the right to cancel the partnership within three months’ notice. tbg is compensated in three different ways: • tbg receives interest payments on the nominal value of the silent partnership with the interest rate varying between 6% and 7% p.a., • tbg participates in the company’s success with 9% of potential profits, • if GPC Biotech terminates the silent partnership before the end of the fifth full year, tbg's contribution has to be repaid together with a premium of 30% on the nominal value. A few weeks later, GPC Biotech and Bayern Kapital sign a silent partnership contract with a volume of €2.5m, which is also the maximum funding that can be obtained from Bayern Kapital. Bayern Kapital is compensated in three different ways: • Bayern Kapital receives interest payments on the nominal value of the silent partnership with an interest rate of 6.75% p.a., • Bayern Kapital participates in the company’s success with 9% of potential profits, • at the end of the silent partnership, Bayern Kapital’s contribution has to be repaid together with a premium of 35% on the nominal value and 9% p.a. of the nominal value for each year after the end of the fifth full year. The founders, MPM Capital, TVM and Qiagen discuss intensively the adequate composition of GPC Biotech’s supervisory board. MPM Capital appoints Ansbert Gädicke as its delegate to the supervisory board, whereas Helmut Schühsler takes over TVM’s mandate and becomes Vice Chairman of the supervisory board. The founders appoint Metin Colpan as their representative. Furthermore, two industry experts join the supervisory board of GPC Biotech. Michael Steinmetz convinces Prof. Dr. Jürgen Drews, former President of Global Research at Hoffmann-La Roche, to join the supervisory board of GPC Biotech. Prof. Dr. Ernst-Ludwig Winnacker, President of the German Research Foundation (DFG), also joins the supervisory board of GPC Biotech. He already supported Helmut Schühsler during the investment due diligence phase in his function as a member of TVM’s scientific advisory council. Figure 68 shows the professional background of GPC Biotech’s supervisory board members.

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Dr. Metin Colpan (Co-founder, CEO and President, Qiagen) Metin Colpan holds a master degree and PhD in chemical engineering from the Darmstadt Institute of Technology. He held a research position at the Institute for Biophysics at the University of Düsseldorf. He has a wide range of experience in separation techniques, particularly in the separation and purification of nucleic acids, and filed many patents in the field. In 1984, he co-founded Qiagen and since then served as its CEO and President. In addition, he is active as a consultant for the federal and state governments of Germany. Prof. Dr. Jürgen Drews (President of Global Research, Hoffmann-La Roche) Jürgen Drews holds a MD and PhD in medicine from University of Innsbruck and the FU Berlin. He held several research positions at Yale University and University of Heidelberg, where he was appointed as Extraordinary Professor in 1973. From 1970 he has served at the Sandoz Research Institute (today: Novartis), first as director and since 1979 as President. From 1982 to 1985 he has been Head of International Pharmaceutical Research and Development for Sandoz. Since 1985 he serves as President of Global Research at Hoffmann-La Roche. From 1991 until 1995 he has been a member of the Executive Committee for the Roche Group. In addition, he serves as the Chairman of EuropaBio, the European Association for Bioindustries, which has more than 500 individual member companies. Moreover, he also serves on the boards of several biotech companies worldwide. Dr. Ansbert Gädicke (Founding General Partner, MPM Capital) Ansbert Gädicke holds a MD and PhD from Johann Wolfgang Goethe University in Frankfurt. After practicing medicine in Germany, he subsequently held research positions in biochemistry and molecular biology at the Whitehead Institute at MIT, Harvard University and the German Cancer Research Center. He published in leading scientific publications including Nature and Cell. Later, he consulted pharmaceutical and other health care companies for The Boston Consulting Group. In 1996, he founds MPM Capital and becomes its President and Chairman. Prof. Dr. Ernst-Ludwig Winnacker (President, German Research Foundation) Ernst-Ludwig Winnacker holds a master degree and PhD in chemistry from the Swiss Federal Institute of Technology, Zurich. He subsequently held research positions at the University of California in Berkeley, the Nobel Institute of Medicine, Stockholm, and the Institute for Genetics at the University of Cologne, where he became Visiting Professor in 1974. He became Associate Professor with the Institute of Biochemistry at the University of Munich in 1977. In 1984, he is appointed as Director of the Laboratory of Molecular Biology of University of Munich’s Gene Centre. From 1992 until 1995, he is Dean of Faculty of Chemistry and Pharmacy at the University of Munich. Since 1990, he is Visiting Professor at Harvard Medical School. From 1987 until 1993 he has been Vice President and since 1998 he is President of the German Research Foundation.

Figure 68:

Profiles of additional members of GPC Biotech’s supervisory board

GPC Biotech also sets up a scientific advisory board, with Hans Lehrach and Annemarie Poustka and five additional members. Once formally established, GPC Biotech inspires several employees from the Max-Planck-Institute for Molecular Genetics in Berlin to join the company. In addition, Michael Steinmetz convinces Dr. Zoltan Nagy, a former member of his research team at Hoffmann-La Roche and an expert with more than 20 years of experience in autoimmunity research and drug discovery, to join GPC Biotech as Vice President for Immunology. Helmut Schühsler and Dr. Bernd Seibel, CFO at TVM, support Mirko Scherer in defining an appropriate accounting and reporting system. Initially, the accounting is done through an external partner, who is suggested by TVM. Right from the beginning, GPC Biotech does its accounting according to US-GAAP, which later proves to be very helpful. In addition, Peer Schatz, CFO of Qiagen, proves to be a very helpful source of advice in financial issues. A stock option plan for the employees and some

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consultants of GPC Biotech is set up with the help of Helmut Schühsler and a leading lawyer, who also consults MPM Capital and TVM. Mirko Scherer manages to negotiate extraordinarily favorable leasing contracts mainly for robots and office equipment with leasing subsidiaries of Deutsche Bank, Dresdner Bank, and IKB. In total the leasing package amounts to more than €1.5m. MPM Capital and TVM do not play a role in these negotiations. At the end of 1997, GPC Biotech has licensed three patent applications for specific methods to identify molecules and pathways associated with diseases that the Lehrach team had filed during their time at the Max-Planck-Institute for Molecular Genetics in Berlin. Several molecules, which play a key role in the disease mechanisms, which GPC Biotech is pursuing, will soon be filed at the patent office as well. In addition, the company protects four of its technology platforms with trademarks. GPC Biotech receives some advice from the venture capitalists on issues of protecting its technology with intellectual property rights. MPM Capital and TVM, both convey several basic business principles to the founders. In the beginning of GPC Biotech’s operations, most of the founders are still very much into research and lack a mindset that is fully oriented towards commercial markets’ needs. In this regard, the venture capitalists exert a strong influence on the mindset of the founders by making them think more in commercial terms. Furthermore, in discussions about the business development of GPC Biotech, the venture capitalists make it clear that the company must think in big and global terms. In particular, MPM Capital with its strong position in the US market drives the global approach within GPC Biotech. Initially, GPC Biotech is positioned as a provider of platform technologies for companies engaging in drug discovery and development. The company envisions a dual business model, which implies that GPC Biotech further develops its technology platforms to support the efforts of third parties such as biotech and pharmaceutical companies. With the revenues from these collaborations, the company simultaneously engages in own efforts in drug discovery and development using its technology platforms. The founders had this vision early on in their mind. Michael Steinmetz also wants to position the company in this direction and takes several measures to implement this vision.

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However, drug discovery and development is a very complex and lengthy process. In particular, there are several regulatory hurdles imposed by either the European Medicines Evaluation Agency (EMEA) or the United States Food and Drug Administration (FDA) depending for which market the drug is developed. A drug development process begins with the identification of the drug target, i.e. the protein that is the root cause for a disease. Once the target is validated, the development of therapeutic compounds is initiated. In the preclinical phase, the compound is tested on animals. In the clinical phase one, the compound is tested on healthy individuals only. In the clinical phase two, the compound is tested on a small sample of patients and control groups. In the final clinical phase three, the compound is tested on a large number of patients and control groups. However, the odds to pass the third clinical phase successfully are only about 0.3% for any compound.792 The key hurdle for most drug development companies are the associated costs, which are between $500m and $800m, including the costs for failed R&D projects.793 The time horizon for the development of a drug is between 10 and 16 years.794 GPC Biotech faces strong international competition, mainly from the US. Main competitors in the genomics area are Millennium Pharmaceuticals, CuraGen, Human Genome Sciences, and Axys Pharmaceuticals. Competitors that are active in drug discovery and development based on cell cycle technologies, a core competency of GPC Biotech, are Onyx, Cyclacel, and Profilix. They also compete with GPC Biotech for deals with big pharmaceutical companies. Other companies competing in the wider field of drug discovery are public companies such as Genome Therapeutics, Genset, Affymetrix, Incyte Pharmaceuticals, Lynx Therapeutics, and Myriad Genetics as well as private companies and major pharmaceutical companies. The research team of TVM provides additional information on these competing companies to GPC Biotech’s management. Furthermore, because both venture capital firms receive a number of new business plans weekly, they are also very well informed about current trends in the industry.

792

See Boston Consulting Group (2001).

793

See Kallmeyer/Canabou (2001), p. 8; Anonymous author (2003), p. 13.

794

See Ernst & Young (2000).

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Michael Steinmetz is well informed about the research directions of many of these companies. Therefore, he plays an important role in defining the areas of internal research of GPC Biotech. In particular, he supports the company in developing a midterm research agenda that directly works towards commercialization. GPC Biotech also tries to match its internal research efforts with the envisioned external research collaborations. From his former responsibilities, Michael Steinmetz knows which strategy is the most promising to follow. At the beginning of GPC Biotech’s operations, internal research primarily focuses on immunology and antibacterial research. The immunology research program concentrates on therapeutics for autoimmune diseases like multiple sclerosis and rheumatoid arthritis. These are diseases associated with the class II major histocompatibility complex (MHC II). A possible treatment is envisioned with specific monoclonal antibodies, which can also be used within GPC Biotech’s efforts in oncology research such as targeting diseases like myeloma, lymphoma and lymphocytic leukemia. GPC Biotech’s infectious diseases research focuses on the development of antibiotics. Resistance to antibiotics of an increasing number of bacterial pathogens is rapidly spreading, and the demand for new drugs is foreseeable. Because of Michael Steinmetz’ background from his position as Vice President of Preclinical Research and Development at Hoffmann-La Roche, he fully understands how GPC Biotech has to position itself to be of interest to large pharmaceutical companies and how to approach them to negotiate a deal. Because of his excellent reputation within the pharmaceutical industry, Michael Steinmetz can convince potential partners to join forces with GPC Biotech. At the end of 1998, GPC Biotech acquires its first research collaboration with a major pharmaceutical company, a very important milestone in the history of the company. Together with Altana Pharma795 a close collaboration on the identification and validation of new genomic targets for the control of infections caused by Helicobacter pylori796 and Chlamydia pneumonia797 is negotiated for a five-year period. GPC Biotech receives an upfront payment and additional milestone payments for all accepted targets. If drugs will be launched based on these targets, royalties are payable to GPC Biotech. 795

The original name of the company has been Byk Gulden, which later has been acquired by Altana Pharma AG.

796

Helicobacter pylori is a bacterium that plays a key role in inducing stomach ulcers.

797

Chlamydia pneumonia causes lung infections and is strongly linked to arteriosclerosis and heart disease.

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In the first year, Michael Steinmetz works for a couple of days every two to three weeks in Martinsried. From the beginning on, it has been clear that he only assumes the role of an interim CEO until a permanent CEO can replace him. Since its foundation, GPC Biotech is seeking a senior person with expertise in the pharmaceutical industry and an international background and has interviewed many candidates, but none of them has been selected. In 1998, Michael Steinmetz makes a contact to Dr. Bernd Seizinger, a very promising candidate with prominent expertise in cancer research. Soon, the existing management team and Bernd Seizinger agree on working together. Michael Steinmetz and Helmut Schühsler negotiate the employment contract. Among others, the international orientation of the company that has been strongly fostered by MPM Capital is one reason that convinces Bernd Steinmetz to join GPC Biotech. Figure 69 shows his professional background.

Dr. Bernd Seizinger Bernd Seizinger holds a MD and PhD from Munich University. From 1984 to 1992, Bernd Seizinger served both as Associate Professor of Neuroscience at Harvard Medical School and Associate Geneticist and Director of the Molecular NeuroOncology Laboratory at Massachusetts General Hospital. He also held a visiting professorship at the Department of Molecular Biology at Princeton University. From 1992 to 1996, Bernd Seizinger was at Bristol-Myers Squibb, Pharmaceutical Research Institute, where he held the posts of Vice President of Oncology Drug Discovery and, in parallel, Vice President of Corporate and Academic Alliances. From 1996 to 1998 he was Executive Vice President and Chief Scientific Officer of the biotech company Genome Therapeutics Corporation of Waltham/Boston, MA. He is the recipient of a number of scientific awards and has authored over 100 publications. In 1999, he joins GPC Biotech as President and CEO.

Figure 69:

Profile of Dr. Bernd Seizinger

In January 1999, Bernd Seizinger becomes CEO of GPC Biotech. Subsequently, Michael Steinmetz concentrates on his duty as Chairman of the supervisory board. In the following months, the previous efforts of Michael Steinmetz, Elmar Maier and Sebastian Meier-Ewert pay off and with the final support of Bernd Seizinger, several research alliances can be signed. In May 1999, Aventis Pharma and GPC Biotech agree to collaborate on the identification of novel anti-fungal targets. In June 1999, Boehringer Ingelheim Austria GmbH and GPC Biotech agree to collaborate on the identification of genes and proteins involved in the development of cancer. In July 1999, Aventis Pharma and GPC Biotech agree on a second collaboration, now in the field of osteoarthritis, which has a term of three years. GPC Biotech will receive up to €20m plus royalties for this three-year research alliance.

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Bernd Seizinger integrates himself smoothly into the existing management team and the founders accept him right from the beginning as the new CEO of their company. GPC Biotech manages very well to overcome this critical phase since on the one hand, the existing management team does not start to engage in internal power struggles and on the other hand, Bernd Seizinger can deal very well with the corporate culture of a young and dynamic start-up. Since its foundation, GPC Biotech has shown a rapid growth. According to its business plan, GPC Biotech will employ 70 people at the end of 1999 and 100 at the end of 2000. Since the average monthly cash burn rate strongly increases, the management team starts to prepare a second round financing.

7.1.4

Second Round Financing

Initially, the management team presents its proposal for the second financing round to Helmut Schühsler, who gives his approval very early. In an ensuing supervisory meeting, both venture capital firms agree to invest as much as to maintain their stakes in the company and in case no further investors are found they are also willing to finance the full second round. With this strong backing from their existing investors, the management team searches for new investors. The strategy is to find investors that are willing to accept the current strategy of GPC Biotech. In particular, MPM Capital/TVM and the management team do not see the necessity to raise smart money from another venture capital firm since they believe that two strong players are already enough for the company. Therefore, they concentrate on finding new investors that do not want to influence the direction of the company. A further aspect in selecting co-investors is the fact that GPC Biotech intends to do an IPO within the next one to two years. Consequently, the management team also approaches several banks to join the syndicate. The management team takes the process of finding new investors in its own hands, and MPM Capital and TVM assume a passive role in this regard. During the negotiation phase, they are available for talks with potential new investors, who approach existing shareholders within the scope of their due diligence. Furthermore, MPM Capital and TVM also give feedback to the management team on every potential investor, thereby supporting the actual selection process.

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Since GPC Biotech is already backed by two heavyweight venture capitalists, the company relatively quickly attracts many potential new investors. In this regard, a further important contribution comes from Mirko Scherer, who started early to give numerous presentations on venture capital related conferences and thus established the name GPC Biotech in the minds of a number of important venture capitalists and also made many personal contacts to them. In July 1999, all parties sign the new investment agreement. All investors acquire common stocks of GPC Biotech through a capital increase. Lead investor of the second financing round is the Beteiligungsgesellschaft für die deutsche Wirtschaft (BdW), an affiliate of Dresdner Bank, which purchases a stake of about 9% in the company. Furthermore, two banks, Deutsche Bank and Kredietbank Luxembourgeoise, several investment companies such as tbg, Deutsche Venture Capital Gesellschaft, IKB Beteiligungsgesellschaft, LG Venture Capital, and two private investors join the syndicate. After the second financing round, the approximate shareholder structure is as follows: The founders’ stake is diluted to 26% and Qiagen’s stake is diluted to 2%. MPM Capital and TVM with Alpinvest fully subscribe to the capital increase and hold 32% and 18%798, respectively. In sum, all new investors hold 22%. GPC Biotech raises €6.1m from MPM Capital and TVM and further €7.2m from new investors. In total, the company raises €13.3m from all investors resulting in a post-money valuation of €33.5m. Besides, the company also raises a convertible loan of €2.3m from tbg, which is repayable in 2009 as well as a loan of €1m from IKB Deutsche Industriebank AG. The new investors join the pool agreement, and only minor elements are altered in comparison to the 1997 investment and pool contracts. The veto rights and supervisory board representation rights regarding MPM Capital and TVM are extended to the new investors as long as they hold more than 10% of the company’s shares. However, none of them reaches this limit at that time. An exception is granted to BdW, GPC Biotech’s third largest external investor holding more than 9%, by receiving the right to nominate one board member as long as it holds more than 5%. The group of founders may nominate two members of the supervisory board as long as they hold more than 20% of the company’s shares. All other rights remain unchanged.

798

TVM and Alpinvest slightly increase their stake in GPC Biotech.

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7.1.5

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Further Development and MPM Capital’s and TVM’s Exit

GPC Biotech has developed very positively and always stayed below its approved budget. Consequently, from the perspective of MPM Capital and TVM, the management team has built a reputation of being very reliable and trustworthy. Therefore, the venture capital firms refrain from a deep involvement in the company’s operations. From its research programs in immunology and cancer, GPC Biotech hopes to generate three candidates for its product pipeline within the next three years. The first candidate is a peptidomimetic antagonist of antigen presentation for treatment of rheumatoid arthritis and multiple sclerosis. The second candidate is a class II specific immunosuppressive human monoclonal antibody for indications of transplant rejection and graft versus host disease. The third candidate is an MHC II specific human monoclonal antibody that is cytotoxic to malignant lymphoid cells. The second and the third candidate will be developed in research collaborations with MorphoSys AG, another portfolio company of TVM. GPC Biotech pursues two goals with its antibacterial research. The first goal is to integrate comparative genomics and bacterial genetics to identify and validate novel targets for future broad-spectrum antibiotics. The second goal is to develop assay strategies for the translation of these targets into high-throughput screening. Within this field, GPC enters in a research collaboration with Evotec OAI AG799 to further characterize and screen for ligands, i.e. small compounds that bind to targets. Evotec OAI is another portfolio company of TVM. The compounds in GPC Biotech’s product pipeline are still in the early stages of the drug development process. GPC Biotech needs drug candidates that are already in the clinical trial phase of the drug development process to generate revenues earlier and to increase its attractiveness for potential research alliance partners. There are two options to achieve this goal, either by acquiring a company, which has later stage drug candidates or by in-licensing later stage drug candidates. In mid 1999, the management decides with the support of the supervisory board to search for a suitable merger candidate and screens the US market. To be present on the US market has two important advantages. First, the US market is by far the largest drug market worldwide. Second, even though competition in the biotech sector is 799

At that time, the name of the company was Evotec Biosystems AG.

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fiercer than in Europe, the chances to initiate alliances with pharmaceutical companies are also much higher since many large US pharmaceutical companies are already used to enter into research collaborations with young biotech companies. Consequently, the management of GPC Biotech compiles a long list of more than 50 potential candidates. Finally, the management proposes to the supervisory board to buy a California-based biotech company, but fails to get the approval for the proposed deal since MPM Capital and TVM are not convinced that this company will be the best choice for GPC Biotech. One of the reasons is that there is a too large time difference between a US west coast based company and GPC Biotech based in Germany, which would complicate even more coordinating transatlantic activities than with a US company based on the east coast. Shortly after, due to personal contacts of Bernd Seizinger, the management comes up with a new proposal for an acquisition candidate. Mitotix Inc., based in Cambridge, MA, is a mechanism-based drug discovery and development company focused on treatments for cancer and fungal infections. Founded in 1992, Mitotix employs 49 people with significant experience in drug discovery and disposes of an interesting internal product pipeline. Furthermore, the company has research collaborations in oncology with BASF Bioresearch Corporation, DuPont Pharmaceuticals Company, and Genetica Inc. The combined entity allows leveraging GPC Biotech’s technology platforms. Furthermore, the entity is well positioned with its laboratories in two leading biotech clusters and access to the European and the US market. Both companies view a merger as an important step in realizing the common vision of an integrated genomics- and proteomics-based drug discovery from target identification to the clinic. In February 2000, all parties sign the merger agreement. The merger is structured as a share deal with the former Mitotix shareholders being exclusively allowed to subscribe to a new capital increase of GPC Biotech. After the merger, the approximate shareholder structure of GPC Biotech is as follows: The founders of GPC Biotech are diluted to 17%, MPM and TVM with Alpinvest are diluted to 21% and 12% respectively, Qiagen holds about 2%, and the investors of GPC Biotech’s second round financing are diluted to 16%. The former shareholders of Mitotix, among them 25 additional investment companies, hold about 32% of GPC Biotech, which is valued at that time at €101.3m. After the merger, GPC Biotech has 94 employees.

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Through the acquisition of Mitotix, three candidates enter GPC Biotech’s oncology product pipeline: • A gene therapy approach, which allows delivering intact p16 and p27 tumor suppressor proteins to the patient’s cells, is in preclinical research in collaboration with Cell Genesys, a US-based gene therapy company. • Cyclin dependent protein kinase (CDK) inhibitors, which selectively stop cancer cells from dividing, are in preclinical research in collaboration with DuPont. • Angiogenesis inhibitors, which stop the formation of new blood vessels within a tumor, are in the target validation phase. In addition, GPC Biotech’s product pipeline now also covers two anti-fungal compounds: • Geranylgeranyl transferase type I (GGTase) inhibitors are in preclinical research. • CAK1 inhibitors enter the lead optimization and selection phase. At this time, 13 patents are issued to GPC Biotech and 27 licenses for diseaseassociated molecules have been purchased. Additional trademarks for genomics, proteomics and drug discovery technologies are registered. GPC Biotech has at this time 13 pharmaceutical and biotech partners and is the leading German biotech company in terms of numbers of alliances. Already in mid 1999, the management and the supervisory board decide to undertake an IPO to finance further research activities. The preparations for the IPO start in parallel with the search for an appropriate merger target. Peer Schatz is designated as GPC Biotech’s IPO consultant. The company chooses May 31, 2000 as the offering date and the stock market segment Neuer Markt at the Frankfurt Stock Exchange as the IPO platform. TVM supports the company in finding reputable investment banks. The management decides to choose Credit Suisse First Boston as Lead Manager. Colead Managers are SG Cowen and Robertson Stephens International. Sal. Oppenheim Jr. & Cie is Co-manager. During the time of the preparations for the IPO, Helmut Schühsler advises the management team on specific issues, but he is not involved on an operational basis. Through his extensive experience in taking companies public, he brings more serenity in the IPO process. One aspect that both venture capitalists monitor closely is GPC Biotech’s positioning in the public. Since the company’s founda-

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tion, all press releases are discussed and approved by Michael Steinmetz or Helmut Schühsler. The company cancels all silent partnership contracts and the convertible loan with tbg and converts the claims into loans, equity stakes, or options. Before the IPO, the number of outstanding non-par bearer shares is 12,619,420. The company intends a capital increase of 4,300,000 new shares and a conditional capital increase of 645,000 shares as a greenshoe option to meet excessive demand for its shares. The book building range is set at €20.5 to €25 and the final issue price is €24. The valuation of GPC Biotech on the basis of the offering price is €421.6m. The gross proceeds to GPC Biotech amount to €118.7m. On its first trading day, the price of GPC Biotech’s shares closes at €31.5. After the IPO, the approximate shareholder structure is as follows. The founders are diluted to 12%. MPM Capital and TVM with Alpinvest are diluted to 15% and 9% respectively. Qiagen holds about 1%. The investors of GPC Biotech’s second round financing are diluted to 12%. The former Mitotix shareholders are diluted to 23%. Consequently, the old shareholders of GPC Biotech together hold 72% of the company and the free float is 28%. Due to the obligatory six-month lock-up period at the Neuer Markt, none of the existing shareholders can sell his shares until the beginning of December 2000. At first, the stock price soars and reaches its peak at €69 in July 2000. At the end of the lock-up period however, the stock price is again at around €30 and trading volumes are low. Most of the former Mitotix investors and TVM sell their shares subsequently and contribute thereby to a bad stock performance. MPM Capital does not see a possibility to sell its shares via the stock market since this would further drag down the stock price. Consequently, MPM Capital tries to initiate block trades, but this does not work out either. MPM Capital maintains its holdings in GPC Biotech for a relative long period and finally sells its shares when the stock price climbs again back to around €12. Notwithstanding the exit problem, the GPC Biotech investment is a big success for the venture capital firms, yielding an IRR well beyond 50% p.a. Michael Steinmetz resigns from his position as Chairman of the supervisory board in June 2001 handing over this position to Jürgen Drews. Helmut Schühsler resigns from his position as Vice Chairman of the supervisory board at the end of 2003.

Case Study GPC Biotech AG

7.2

Case Analysis

7.2.1

MPM Capital’s and TVM’s Influence through Contracting

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7.2.1.1 Preliminary Remark The analysis of the case of GPC Biotech concentrates on MPM Capital’s and TVM’s influence onto the company and does not further analyze potential contributions of the second round investors. All interview partners from GPC Biotech, MPM Capital, and TVM confirmed that the second round investors did not play an important role in the development of GPC Biotech besides the provision of financial resources. Therefore, it seems justified to pursue the following analysis with a focus on the activities of MPM Capital and TVM.

7.2.1.2 Investment Agreement Structure The first investment agreement between MPM Capital, TVM and GPC Biotech contains a range of contractual elements that are analyzed in the following. Information rights are fully implemented in the first investment agreement between MPM Capital, TVM, and GPC Biotech. The investors require a regular reporting from the company’s management comprising non-audited as well as audited financial statements as well as annual budgets, as long as 10% of the common stock continues to be held by the investor and the company remains privately held. In addition, the investment agreement gives members of the supervisory board the right to ask for information and the right to visit company premises at any time. Conversion rights are not implemented in the first investment agreement. Control rights are fully implemented in the first investment agreement. Both venture capital firms receive voting rights according to their respective shareholdings. The supervisory board of GPC Biotech consists of six members, whereby MPM Capital and TVM are entitled to send one delegate each, the founders send two delegates and two industry experts assume the remaining two board seats. As soon as a permanent CEO is hired, Michael Steinmetz will be elected Chairman of the supervisory board. The articles of association contain an extensive catalogue of actions and decisions that require the consent of the supervisory board including as follows:

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• Appointment and removal of statutory authorized officers and mercantile agents, • changing the company's bankers, • foundation, dissolution, acquisition and sale of companies, • establishment, acquisition, closure or sale of plants, parts of establishments or branches, • acquisition, sale or encumbrance of real estate or rights equivalent to real estate, • mortgaging or charging or permitting the creation of any mortgage or charge over the whole or any part of the assets of the company, • disposal of industrial property rights as well as conclusion or termination of patent-, license-, know-how-, and cooperation agreements, • entering into conclusion and termination of distribution agreements and entering into contractual delivery obligations, • borrowing other than normal trade credit, • granting of loans to firms which are not related with the company or to third parties, • conclusion of other agreements, which will lead to the company incurring expenses or liabilities exceeding €30k, • arranging for development projects exceeding a volume of €25k, • incurring any capital expenditure exceeding €15k, • engaging any employee, whose employment cannot be terminated by three months' notice or less or whose remunerations will or may exceed €45k p.a., • increasing the remuneration of any existing employee by more than €5k p.a., • entering into or varying any agreements or arrangements with or for the benefit of any of the company's directors or shareholders, • agreeing to any material amendment to the terms of any substantial agreement to which the company is a party or waiving its rights under any such agreement,

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• conducting any litigation material to the company, other than for the collection of debts arising in the ordinary course of business, • provisions of security, furnishing of bonds or guarantees, entering into liabilities on bills, except for the usual warranty for products of the company, • charges of substantial importance in the internal organization, • every other extraordinary management operation or expenditure, • exercising of shareholder rights in subsidiary companies and in the advisory councils of subsidiary companies, as far as these are of substantial importance. In addition, several veto rights are given exclusively to MPM Capital and TVM concerning: • Any measures to raise capital or to decrease capital, • capital increases for the creation of conditional and authorized capital, • issue of preferred stocks, stock options, convertible bonds, • changes in the legal form of the company, • changes of the articles of association (with due reason), • control agreements, profit transfer agreements, • any payouts or withdrawals of agios of the non-founders, • sale of 75% or more of the company’s assets, • trade sale of the company, • liquidation of the company. Management covenants are fully implemented in the first investment agreement. The management’s representations and warranties comprise standard elements such as that the given information is correct. However, a contractual penalty is included that states that any breach can lead to a contractual penalty for the founders. Standard affirmative covenants such as maintaining facilities, rights and insurances, paying taxes, maintaining and providing records and adequate internal accounting controls, complying with articles of association, and conducting business in compliance with the applicable law are included in the investment agreement. There are three further affirmative covenants:

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• There is a contractual obligation for all employees of GPC Biotech to enter into a proprietary information and invention agreement, which states that all patents and patent applications made while being with GPC Biotech are assigned to the company, even for a period of six months after leaving the company. • GPC Biotech promises to establish a stock option plan as an incentive system for the employees of GPC Biotech. • GPC Biotech has to change its legal form to a stock corporation until the end of 1997. The managers of GPC Biotech are subject to a non-compete clause, which states that they are not allowed to work for a company that is in direct or indirect competition with GPC Biotech for two years after their employment at GPC Biotech. In case of an infringement, the manager has to pay a contractual penalty. All founders are subject to a vesting schedule that requires all shares to be held for three years before they can be sold. In case, a founder or a stock option holder leaves the company before the end of the vesting period, he is obliged to transfer his shares to the company. Milestone agreements are not implemented in the first investment agreement. Cash flow rights are partially implemented in the first investment agreement. The antidilution protection is designed as a weighted average ratchet. A dividend preference and a liquidation preference are not implemented in the investment agreement. Preemptive rights are partially implemented in the first investment agreement. All existing shareholders receive a pro rata right of first refusal. A right of first offer is not included in the investment agreement. Disinvestment rights are partially implemented in the first investment agreement. A pro rata tag-along right is included for MPM Capital, TVM and Qiagen. The dragalong right specifies that if a 75% majority of the combined votes of these three investors decides to sell shares to a third party, all other pool members have to sell their shares at the same conditions. In addition, a 75% majority of the three investors has the right to demand the registration of the company’s shares at a national, European or transatlantic stock exchange. For the case of an IPO, all pool members are obliged to agree on a restructuring of the company if necessary. Redemption rights and cancellation rights are not included in the investment agreement.

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In general, the second investment agreement between MPM Capital, TVM, and GPC Biotech does not change the contractual structure in comparison to the first investment agreement. Figure 70 summarizes the important contractual elements that are included in both investment agreements between MPM Capital, TVM, and GPC Biotech.

Categories of venture capital firms‘ rights

Information rights

Conversion rights

Control rights

Management covenants

Milestone agreements

Cash flow rights

Preemptive rights

Disinvestment rights

Figure 70:

Investment agreements between MPM Capital, TVM, and GPC Biotech

; Right to ask for information

; Regular reporting

; Right to visit company premises … Conversion on option of the holder ; Voting rights

; Supervisory board representation right

; Veto rights ; Affirmative covenants

; Non-compete clause

; Representations and Warranties

; Vesting

… Earn-out

… Ratchets

… Management dismissal

… Staging

… Dividend preference

; Anti-dilution protection

… Liquidation preference ; Right of first refusal … Right of first offer ; Tag-along right

; Registration rights

; Drag-along right

… Cancellation right

… Redemption rights

Contractual analysis of GPC Biotech’s investment agreements

7.2.1.3 Influence on Deal-specific Risks MPM Capital and TVM use a broad range of contractual elements in both investment agreements. Figure 70 shows that the investment agreements fully implement information rights, control rights, and management covenants and partially implement cash flow rights, preemptive rights, and disinvestment rights. Conversion rights and milestones agreements are not included in the investment agreements. Figure 71 visualizes in detail which deal-specific risks are addressed with the investment agreements between MPM Capital, TVM, and GPC Biotech.

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Investment agreements between MPM Capital, TVM, and GPC Biotech reduce risk of…

Effects Contractual rights

managerial opportunism

Information rights

x

Conversion rights



competitive opportunism

Control rights

x

Management covenants

x

x





Milestone agreements

unfavorable decision taking

x

x

Cash flow rights

x x

Preemptive rights

x

Disinvestment rights

x Figure 71:

exit obstruction

Risk addressed in both investment agreements

x 

Risk not addressed in both investment agreements

Risk not addressable by this category of contractual rights

Deal-specific risks between MPM Capital, TVM, and GPC Biotech

The investment agreements between MPM Capital, TVM, and GPC Biotech address all deal-specific risk categories. Merely, the theoretical intensity of the effectiveness of the implemented contractual elements can be assumed lower than in the case of an investment agreement using all contractual elements since several strong incentive mechanisms such as milestone agreements as well as conversion rights are not included.

7.2.1.4 Influence on Management’s Formal Autonomy The investment agreement with MPM Capital and TVM includes several contractual elements that constrain the formal autonomy800 of GPC Biotech’s management team. In the following, the important possibilities of the venture capital firms to interfere with managerial decisions are described. The voting rights for their initial 48% stake in GPC Biotech give MPM Capital and TVM the strongest position among the shareholders of GPC Biotech. In fact, since MPM Capital additionally holds 9% as a fiduciary, the venture capital firms jointly hold a majority position of 57% within GPC Biotech. This allows them not only to block many decisions in the shareholders meeting but also to take decisions for the

800

See chapter 4.4.

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company on their own. Consequently, the management team loses a large part of its formal autonomy. Using their supervisory representation rights, MPM Capital and TVM each have the right to send one delegate to the six-persons comprising supervisory board. Since both investors do not hold a majority on the supervisory board, they are not in the position to block major decisions of the management board that require the consent of the supervisory board. Since MPM Capital and TVM jointly hold two seats, they still have a strong influence on the decisions of the supervisory board. The veto rights of the supervisory board drastically limit the scope of independent actions of GPC Biotech’s management team. Almost every contract with third parties of some importance requires the consent of the supervisory board. In case the supervisory board does not approve any proposal of the management team, GPC Biotech cannot pursue any significant activities. However, both venture capital firms receive exclusive veto rights regarding important financial decisions for the company. Consequently, the management loses a large part of its formal autonomy in the financial domain. Beyond the standard affirmative covenants that ask for management’s conduct to be in line with contracts and laws, the venture capital firms also require all employees to sign a proprietary information and invention agreement with GPC Biotech that helps to retain all newly developed technological resources within the company. The management team therefore loses all personal rights on any of their developments while being with GPC Biotech and even six months after leaving the company. A further covenant is that the management team establishes a stock option plan for GPC Biotech’s employees. This potentially affects the future shareholder structure of the company. Employees become shareholders and receive some control rights over the management, which reduces the formal autonomy of the management team. The investment agreement also requires a change in the legal form to a stock corporation. This implies that the management has to accept operating under a legal form that is subject to many legal requirements leading to a more formal control of the management and the company. A non-compete clause combined with a contractual penalty in case of an infringement excludes the managers to engage in any competitive actions thereby reducing the scope of their activities not only during the time of their employment at GPC Biotech but also for two more years after their employment contract ends. Considering the fact

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that this probably entails a wage loss in the future since the managers cannot benefit from their specific knowledge about drug discovery and development, the noncompete clause represents a major interference with their personal autonomy. The drag-along right enables MPM Capital and TVM to sell GPC Biotech to another company. If existing shareholders are not willing or able to purchase the investor’s shares at the conditions that the acquiring company offers, the management would fully lose its autonomy since GPC Biotech would become a subsidiary of the acquiring company. The stock registration rights allow MPM Capital and TVM to initiate an IPO for GPC Biotech without requiring the approval of other shareholders or the management team. This severely curtails the autonomy of the management team since for the managers it is a great difference whether they are managing a private or a public company. The main difference being that in a private company they are accountable to a number of personally known, long-term investors whereas in a public company they are accountable to a large number of mostly anonymous investors, of which many might also have a short-term investment horizon. Furthermore, as managers of a listed company, they also have to face the risk of a hostile takeover leading to a subsequent loss of autonomy. To summarize, the investment agreement between GPC Biotech, MPM Capital, and TVM gives the venture capitalists a strong formal position within the company and the management team loses its formal autonomy with regard to almost every important decision that affects the company.

7.2.2

MPM Capital’s and TVM’s Influence through Resource Provision

7.2.2.1 Influence on Resource Pool Besides the formal influence through the investment agreement, MPM Capital and TVM also exert significant influence on GPC Biotech by providing resources directly or indirectly and thereby affecting the company’s resource pool. In terms of technological resources, GPC Biotech disposes of several unique innovative technologies in genomic research and automated molecular biology, but initially none of these technologies is protected by intellectual property rights. MPM Capital and TVM strongly favor protecting GPC Biotech’s technologies and give advice on

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patenting issues, thereby indirectly contributing to GPC Biotech’s increasing technological resources. The company urgently needs financial resources to start operations since the founders provided the company with an initial capital base of only €34k. MPM Capital and TVM play an important role as source of financial resources. In the first financing round, they provide GPC Biotech with €3m. TVM’s excellent track record indirectly helps the company to raise further €5m as silent partnerships from the governmentdependent venture capital firms tbg and Bayern Kapital. In his role as acting CEO, Michael Steinmetz plays a key role in preparing collaborations with pharmaceutical companies, most importantly with Altana, that generate significant financial resources for the company. In the second financing round, MPM Capital and TVM subscribe to the capital increase according to their stake and provide GPC Biotech with further €6.1m. Early on, both venture capitalists declare their willingness to subscribe to the full second financing round, even in case no new investors will be found. This strong commitment from both venture capital firms facilitates the task of GPC Biotech’s management team to convince new investors in joining the syndicate of the second financing round. The initial founding team lacks some managerial resources since it comprises three young talented and two senior researchers that dispose of a deep technological understanding but clearly lack business expertise. Even before the venture capitalists invest in the company, TVM offers some managerial resources since Helmut Schühsler advises the founding team on important strategic and technology transfer issues. He also establishes the contact to Mirko Scherer thereby indirectly providing GPC Biotech with managerial resources. Michael Steinmetz assumes the position as interim CEO working for a couple of days every two to three weeks in Martinsried. His involvement fills a critical resource gap in the company’s management team since the founding team has some experience in working with pharmaceutical companies but only from the perspective of a research organization and not from a commercial perspective. Due to his background as Vice President of Global Research at Hoffmann-La Roche, Michael Steinmetz brings in the full industry knowledge regarding drug discovery and development. Furthermore, he also convinces Zoltan Nagy, who has more than 20 years of relevant experience, to join GPC Biotech as Vice President for Immunology. Once the company is formally established, Helmut Schühsler and Ansbert Gädicke join the supervisory board and offer their managerial resources to the company as ac-

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tive board members. MPM Capital convinces Jürgen Drews, former President of Global Research at Hoffmann-La Roche, and TVM convinces Ernst-Ludwig Winnacker, one of Europe’s most prominent researchers in genomics, to assume a seat on GPC Biotech’s supervisory board, thereby offering their unique expertise to the young start-up. Michael Steinmetz provides the contact to the future CEO Bernd Seizinger, who brings along a sound expertise in cancer research and drug discovery and development and who integrates well into the existing management team. After the IPO, Michael Steinmetz continues to serve on GPC Biotech’s supervisory board for one more year and Helmut Schühsler for two and a half years, thereby providing the company with managerial resources even when GPC Biotech is a public company. Personnel resources are a further bottleneck in the development of the company, since initially there is only a management team. However, in this regard, both venture capital firms do not support the company. In terms of physical resources, the company actually does not dispose of more than some laboratory equipment and an excellent geographic location being based in Martinsried/Munich, which offers a vibrant biotech start-up scene with many service providers such as the German and European patent office, venture capital firms and lawyers. Office and laboratory equipment are therefore also major resource needs in the beginning of GPC Biotech. Both venture capital companies do not support GPC Biotech in its efforts to acquire further physical resources. In the beginning, organizational resources such as clear structures and processes within the company are virtually non-existent. Since Michael Steinmetz initially assumes the role of acting CEO, he is also involved in defining the organizational structure of GPC Biotech. Further valuable input comes from TVM in this regard, which helps in defining an appropriate accounting and reporting system and a stock option plan for the company’s employees. Initially, GPC Biotech shows a critical need in terms of reputational resources. Hans Lehrach has a good reputation within the scientific community and within the pharmaceutical industry since he is one of Europe’s leading researchers in the field of genomics. However, in the beginning, the company GPC Biotech and its management team do not have a commercial track record. Michael Steinmetz as well as Helmut Schühsler and Ansbert Gädicke all have an excellent reputation with the biotech industry and convey this to GPC Biotech by joining its executive and supervisory board re-

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spectively. An example for this is that potential collaboration partners from the pharmaceutical industry fear the risk of collaborating with a small start-up since it is unclear if the start-up will be still around in one year. With Michael Steinmetz leading the negotiations for GPC Biotech, the company gains credibility from the perspective of large pharmaceutical companies. Through the establishment of the contact to Bernd Seizinger, who has an excellent reputation as well, MPM Capital provides indirectly some reputational resources to GPC Biotech. Furthermore, the venture capital firms also contribute indirectly to an increased reputation of GPC Biotech by convincing Jürgen Drews and Ernst-Ludwig Winnacker, who are both leading personalities in the biotech community, to join the supervisory board. TVM’s reputation as a very successful venture capital firm plays a clear role in facilitating GPC Biotech’s efforts to raise additional financial resources from tbg and Bayern Kapital. Furthermore, MPM Capital’s and TVM’s reputation among financial investors helps the company in its efforts to find new investors for the second financing round. TVM also helps the management to find reputable investment banks, which in turn facilitates the IPO. The founding team disposes of some social resources such as good contacts to the managers of Qiagen, to the research community and to some pharmaceutical companies such as Altana Pharma. To speed up corporate development, GPC Biotech needs further social resources. As already mentioned, Helmut Schühsler provides GPC Biotech with the contact to Mirko Scherer even before TVM is invested. MPM Capital provides the contact to Zoltan Nagy and Bernd Seizinger. By convincing Jürgen Drews and Ernst-Ludwig Winnacker to join the supervisory board, the venture capital firms indirectly provide GPC Biotech with two personalities, each having an extensive social network in the biotech industry and research community. The venture capital firms do not provide contacts to large pharmaceutical companies that ultimately lead to a collaboration agreement. However, GPC Biotech enters into biotech-biotech collaboration agreements with Evotec OAI, a portfolio company of TVM. In the beginning, TVM provides a contact to an external partner, who overtakes the accounting for the company. Furthermore, TVM provides some contacts to tbg, Bayern Kapital and later to reputable investment banks to facilitate raising additional financial resources. It follows from the above analysis that GPC Biotech has a critical resource need in all resource categories, which is depicted in the second column in Figure 72. The analysis of the resource contribution of MPM Capital and TVM shows that the venture capital firm directly and indirectly provides several important resources to GPC Biotech as

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shown in the third and fourth column of Figure 72. However, the analysis also shows that in several aspects, the company has to rely on its own resource acquisition power since there is no input coming from the venture capital firms.

Resource categories

Critical resource need of GPC Biotech

Resource contribution by MPM Capital and TVM Direct

Indirect

Technological resources

9



x

Financial resources

9

x

x

Managerial resources

9

x

x

Personnel resources

9





Physical resources

9





Organizational resources

9

x



Reputational resources

9

x

x

Social resources

9

x

x

9 Critical resource need

 No critical resource need Figure 72:

x Resources provided  No resources provided

Resource-based analysis of GPC Biotech

7.2.2.2 Influence on Management’s Real Autonomy The influence of MPM Capital and TVM on GPC Biotech can be shown by analyzing its involvement in the company’s management processes. On the normative management level, the venture capital firms play a crucial role. Both venture capital firms set ambitious goals for GPC Biotech envisioning a company that is able to compete in global competition. From the beginning, Michael Steinmetz supports the mission of the founders, who perceive GPC Biotech not only as a company that provides platform technologies to the Biotech industry but which also employs its technological base to pursue its own drug discovery and development efforts. An important contribution of both venture capital firms to the company’s mission is the influence on the mindset of the founders. Initially, the founders rather think in a research-oriented way. MPM Capital and TVM clearly change this by inducing them to think more in commercial terms. Furthermore, MPM Capital and TVM support and reinforce underlying corpo-

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rate values. A prime example for this is the fact that both venture capital firms put great emphasis on winning only excellent people for the company, even if this proves to be much more expensive. A further contribution of MPM Capital and TVM concerns the build up of the company’s corporate governance structure. The founders develop the articles of association, which already comply with the requirements of the venture capital firms, even before the company is founded at all. The expectation to be financed with venture capital leads the founders to prepare a governance structure that will fulfill the requirements of professional venture capital firms. The investment agreement further specifies how the various parties are related to each other and which rights and duties every party has. MPM Capital, TVM, and the founders jointly discuss the composition of the supervisory board. Helmut Schühsler and Ansbert Gädicke join the supervisory board, and after resigning from the position as interim CEO, Michael Steinmetz becomes Chairman of the supervisory board thereby assuming the role as monitors of GPC Biotech’s management. With regard to the corporate culture, there is some influence of Michael Steinmetz since as interim CEO he is leading the founding team during their first year of GPC Biotech’s operations, thereby assuming sort of a role model function. On the strategic management level, MPM Capital and TVM play an important role. This influence is already visible before the venture capital firms are invested. Early on, Helmut Schühsler supports the founding team through discussions regarding business and financial strategies. During the time of Michael Steinmetz assuming the position as interim CEO, he supports the company in developing a mid-term research strategy, thereby laying the foundations for GPC Biotech, to switch from a pure technology platform provider to become an integrated drug discovery and development company. In their role as members of the supervisory board, the venture capitalists intensively discuss strategic plans of the company. Only in one instance, the venture capitalists make use of their veto rights thereby blocking a strategic decision of GPC Biotech’s management team to acquire a California-based biotech company since they are not convinced that this will be the best option available to GPC Biotech. With regard to the financial strategy of the company, the venture capitalists contribute relatively little and let the management team come up with proposals how they want to do the next financing round, which are then jointly discussed. TVM proves to be a valuable source of support for establishing several management systems within the company. It helps with defining an internal accounting and reporting system and with the establishment

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Case Study GPC Biotech AG

of a stock option plan for the employees and some consultants of GPC Biotech. With the exception of the time of Michael Steinmetz serving as interim CEO, the venture capitalists do not take any significant influence on the organizational structures of the company. On the operational management level, it is important to differentiate between the operational tasks that Michael Steinmetz assumes during his role as interim CEO such as leading the collaboration negotiations with pharmaceutical companies, and the remaining operational involvement of the venture capitalists. Clearly, the first year of GPC Biotech’s existence is characterized by a strong involvement in operational issues from the side of MPM Capital. After this time, both venture capital firms are already very confident in GPC Biotech’s management capabilities and rather pursue a hands-off venture management approach leading to only selected interfere in operational issues. An important task of the venture capitalists is to check on every press release the company intends to publish since this shapes the public perception of the company to a significant extent. Both venture capitalists advise the management team on protecting the company’s technologies with intellectual property rights. The research team of TVM provides the company with further background information on its competitive environment. During the second financing round, the venture capitalists discuss each potential new investor with the management team thereby helping them to put together the optimal syndicate. In the preparations of the IPO, both investors remain largely passive. TVM supports the company by establishing some links with reputable investment banks. Summarizing the influence of MPM Capital and TVM on GPC Biotech, it becomes clear that the actual influence exertion conveys a clearly different picture in comparison to the formal influence possibilities that are granted to the investors by the means of the investment agreement. Only one time, the venture capitalists make use of their contractual veto rights to block a decision of the management. The extensive catalogue of veto rights that would enable them to interfere with many operational issues is not used in practice since the venture capitalists largely refrain from interfering on an operational basis. However, on the normative and strategic management level MPM Capital and TVM have a strong influence on the development of the company. The founders obviously lose real autonomy with appointing Michael Steinmetz as interim CEO. However, they are willingly giving away this power and even pay for this in

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terms of a reduced company valuation assuming that they will benefit from the associated professionalization of the company in the long-term.

Case Study varetis AG

8

Case Study varetis AG

8.1

Case Description

8.1.1

Development before First Round Financing

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Until the early 1980s, mainframe computers have dominated the IT industry. In 1982, IBM launches its first personal computer in the US and announces the launch in Germany for 1983. These personal computers offer little functionality because they lack the processing power and memory capacity of mainframe computers. A promising way to enhance their performance is to link them with mainframe computers via a network. The necessary network cards are already produced in the US, however adequate software for the data transfer is missing. Observing the developments in the US market, Dr. Martin Henk, CEO and owner of Munich-based DataProcess GmbH801, anticipates a promising opportunity. He develops the vision of a company that programs standard and customized network software for IBM mainframe and personal computers and imports network cards from the US. Driven by this vision, Martin Henk approaches several people from his network to set up varetis GmbH802. Finally, in January 1983, five more people join the founding team of varetis: • Günther Baierl, Peter Wünsch, and Thomas Franke, all have been working as consultants with DataProcess and previously studied computer science at the Munich University of Applied Sciences, • Dr. Christian Schneider has been working as external consultant on several projects with DataProcess, • Joachim Stieda has been running his own company specializing on process computers. The first shareholder meeting appoints Martin Henk, Günther Baierl, and Peter Wünsch as Managing Directors. Initially, Christian Schneider and Joachim Stieda only intend to assume a consulting role with varetis.

801

Name has been changed by the author.

802

The original name of the company is “pc-plus Gesellschaft für Planung und Systementwicklung mbH”. In this analysis, the company will always be called varetis, the name currently is use.

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After two years of operations, it becomes obvious that varetis is too early on the market for network software. The company switches to managing a variety of software and consulting projects, which the founders acquire through their networks. In the beginning of 1985, Martin Henk decides to withdraw from the company and sells his shares to the remaining founding team and to Jakob Schwerdt, who joins varetis through the contact of Christian Schneider. Shortly after, Joachim Stieda also leaves the company and sells his shares to the original founders. In 1986, the shareholders of varetis decide to introduce a profit center concept to improve the incentive structure. According to this, the Director directly retains 40% of his profit center’s earnings and contributes the remaining 60% to a corporate pool. The shareholder meeting then decides whether the money from the corporate pool is reinvested or distributed among the shareholders. Since the shareholders try to maintain an equal position within varetis, each of them receives responsibility for one of the six profit centers as follows: • Peter Wünsch is responsible for the Real-time profit center, which focuses on process computers and designs real-time systems. • Günther Baierl is responsible for the Database profit center, which focuses on mainframe computers and database solutions. • Christian Schneider is responsible for the Security profit center, which develops security software to protect personal computers from unauthorized access. • Thomas Franke is responsible for Custom Projects profit center, which focuses on customized software. • Jakob Schwerdt is responsible for the Retail profit center, which imports softand hardware from the US and resells these to local customers. • An external manager is responsible for the Training profit center, which offers training for several applications running on personal computers. Figure 73 summarizes the profit center structure of varetis in 1986.

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Profit centers of varetis

Real-time

Database

Security

Custom Projects

Retail

Training

Wünsch

Baierl

Schneider

Franke

Schwerdt

External director

Figure 73: Profit centers of varetis (1986)

In the years 1988 and 1989 the sales and profit situation in several profit centers deteriorates and leads to significant financial pressure on the company. Retail and Training face increased competition due to new market entrants. Prices and margins fall, both putting pressure on sales and profits. Security struggles with extensive technical challenges like developing an online encryption technology and stays unprofitable. The volatile nature of Custom Projects’ activities leads to increasing working capital requirements. Additional cash needs arise to cover the costs incurred by the company moving to a new and larger location. Peter Wünsch has contacts to the German telecommunications industry and perceives an opportunity in the directory assistance market that varetis can address with its accumulated knowledge in software development. His profit center Real-time invests heavily in the development of a new product, the International Directory Inquiry System (IDIS). Peter Wünsch hopes to achieve a unique selling position since IDIS would be the first and only software solution for international directory assistance in the still highly regulated telecommunications market. An operator in an international directory assistance call center still has to leaf through huge international phone directories to search for the number the customer is asking for. This process is time consuming and therefore inefficient. IDIS improves efficiency since it greatly reduces the search time for an international telephone number by using an electronic database with a computer terminal. In June 1989, the company shows a minimum capital need of €500k. Until this time, varetis has financed its growth mainly through retained profits and bank loans, which have been secured with the private property of the shareholders since the company does not own any significant tangible assets. In 1989, the personal financial involvement of the shareholders is already far stretched and most of them reject to provide further personal assets in exchange for further credit lines. Peter Wünsch is the only

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one willing to provide additional personal guarantees. All shareholders finally agree to contribute to a minor capital increase. On this basis, the company manages to raise a €250k803 bank loan to cover short-term financial needs and to finalize the development of IDIS. At this time, the shareholder structure is as follows: Jakob Schwerdt holds 26.5%, Peter Wünsch holds 25.0%, Günther Baierl holds 20.5%, Thomas Franke holds 15.5% and Christian Schneider holds 12.5%.

8.1.2

First Round Financing

To cover its long-term financial need, varetis also starts to talk to private investors and professional investment companies. International Ventures804, a well-known international independent private equity firm, refuses to finance varetis stating that although it likes the product portfolio as well as the management team, the required investment would be too small for its fund size. Both parties agree to stay in contact and to talk again, when the company has progressed and shows greater financing needs. After intensive discussions within the shareholder group, the company enters into negotiations with two further investment companies. The contact to National Ventures805, a well-known German captive venture capital fund, is established directly by the management of varetis. National Ventures proposes to buy 25% of the company’s common shares via a capital increase at an attractive equity valuation. However, National Ventures asks for strong investor rights. In particular, a negative earn-out806 is included in the term sheet, which reduces the company’s valuation ex post if the management fails to achieve predefined milestones. Furthermore, National Ventures demands the right to dismiss senior management in case it fails to achieve these milestones. The negative earn-out is perceived unfair by the management team. National Ventures’ right to dismiss the management team strongly deters the managers of varetis since they do not want to risk replacement due to the in-

803

All financial data in this case study have been slightly altered to enhance readability.

804

Name has been changed by the author.

805

Name has been changed by the author.

806

A negative earn-out implies an ex-post reduction of the company’s valuation, in case its management fails to achieve certain pre-defined milestones.

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tervention of National Ventures. In general, they perceive the investment terms as a threat to their coherence and their pursuit of autonomy. The second investment company that varetis enters into negotiations with is Bayerische Beteiligungsgesellschaft (BayBG), which is a government-friendly investment company with the mission to support small- and medium sized enterprises, the socalled Mittelstand, in Bavaria. Figure 74 shows the development of BayBG from 1972 until the end of 2003.

History of BayBG (1972-2003) In 1972, the investment company Kapitalbeteiligungsgesellschaft (KBG) for the Bavarian Mittelstand and the bank Bayerische Garantiegesellschaft (BGG) are both founded in Munich and associated through an agency contract with the government bank Landesanstalt für Aufbaufinanzierung (LfA). KBG invests in Bavarian Mittelstand companies mainly using silent partnerships that are guaranteed up to 70% through the BGG. In the 1980s, the venture capital idea comes from the US to Europe. In the following years, more than 20 German venture capital firms are founded. In 1985, the investment company Bayerische Wagnisbeteiligungsgesellschaft (BWB) is founded by private and public banks and insurance companies, industry associations and the Bavarian Chamber of Industry and Commerce (IHK) in Grünwald/Munich. BWB invests in innovative Mittelstand companies also mainly using silent partnerships. In 1987, the German government passes the Gesetz über Unternehmensbeteiligungsgesellschaften (UBGG), a federal law that aims for improving the conditions to set up investment companies. On that legal basis, the investment company Bayerische Unternehmensbeteiligungs-Aktiengesellschaft (BUB) is founded in Munich in the same year. BUB intends to invest in larger Mittelstand companies. Its shareholder group is nearly identical to BWB. In 1994, the management holding Bayerische Beteiligungsgesellschaft (BayBG) is founded as a 100% subsidiary of LfA. BayBG enters into agency contracts with KBG, BGG, BWB and BUB. In the same year, the investment company Beteiligungsgesellschaft der Bayerischen Wirtschaft (BBW) is founded with the aim to engage in turnaround investments. BayBG also enters into an agency contract with BBW. In 1998, BWB and BUB are merged to the new investment company Bayerische Unternehmens- und Wagnisbeteiligungsgesellschaft (BUWB). In 2000, all investment companies are merged into the BayBG to achieve a coherent corporate identity, an integrated controlling of the business divisions and an uniform senior management team. In 2003, the portfolio of BayBG looks as follows: 77% are expansion stage deals, 8% turn-around deals, 8% venture capital deals, and 7% company succession deals.

Figure 74:

History of BayBG (1972-2003)

BayBG finances small- and medium-sized enterprises with equity or equity-linked financial instruments. Its business model deviates from that of independent venture capital firms, which chapter 3 explains, in three important aspects: (1) BayBG’s value creation architecture is different to that of a standard venture capital firm. In terms of organizational structure, BayBG can be classified as a semi-government-dependent and open-end fund with a corporate holding structure. In terms of its refinancing process, BayBG does not have to work continuously on raising new funds since it can reinvest its profits. There is no predefined date at which BayBG has to liquidate all its investments and pay out its investors.

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(2) BayBG’s customer value proposition is different to that of a standard venture capital firm. BayBG’s investors are Bavarian private and public banks and insurances, industry associations and the Bavarian Chamber of Industry and Commerce (IHK). These investors follow a financial interest with their investment in BayBG, but they are also interested in a positive economic development of the state of Bavaria. They hope to achieve that aim by investing in companies that cannot raise equity otherwise. In addition, banks look for future business opportunities with the funded companies. A strictly IRR-oriented investment policy is therefore not required from the perspective of BayBG’s investors. (3) BayBG’s profit model also differs from the one of a standard venture capital firm. Through its financing operations, BayBG receives interest payments, profit participations and benefits from capital gains of its shareholdings. The compensation for BayBG’s investment managers follows a completely different approach than typical venture capital funds. In 1990, investment managers' salaries contain a 10% variable component that is the result of an employee appraisal system.807 An incentive mechanism similar to a carried interest does not exist. The contact to BayBG is established through one of varetis’ main banks.808 Dr. Wolf Rüdiger Willig, Managing Director of BayBG, leads the negotiations with varetis. Figure 75 shows the background of Wolf Rüdiger Willig.

807

This is true for BWB, the part of the latter BayBG that is responsible for the investment in varetis. Variable payment components are introduced fully to BayBG in 1999.

808

Actually, varetis has been negotiating with BWB and BUB. To simplify matters in the following analysis, the author subsumes BWB and BUB under the single entity of BayBG even before it actually existed. This seems justified since Wolf Rüdiger Willig has already been Managing Director of BWB at the time of the investment in varetis.

Case Study varetis AG

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Dr. Wolf Rüdiger Willig (Managing Director, BayBG) Wolf Rüdiger Willig, born 1941, holds a master degree and PhD in physics and process engineering. After his studies he joins the semiconductor R&D department of Siemens AG. At Leybold Heraeus GmbH, a vacuum process technology company, he joins the sales department. Thereafter, he collects experience in innovation, marketing and consulting with Bergmann AG, an electrical engineering company. In 1986, he is appointed as Managing Director of BWB. After the merger with BUB, he becomes Managing Director of BUWB. Since 1994, he is Managing Director of BayBG.

Figure 75:

Profile of Dr. Wolf Rüdiger Willig

Wolf Rüdiger Willig suggests a financial structure based on three pillars: • The first pillar is an atypical silent partnership of €250k provided by BayBG. With this come relatively weak investor rights and most importantly there are no milestone agreements involving a negative earn-out or the right to dismiss the management. The money from BayBG is meant exclusively to support the further development and marketing of IDIS. • The second pillar is a capital increase of €200k raised exclusively from existing shareholders. • The third pillar is an extension of existing credit lines by €1m from the local banks Dresdner Bank809 and Bayerische Vereinsbank810, which BayBG negotiates. After intensive discussions, the shareholders sign the investment agreement with BayBG in July 1990, which is analyzed in detail in chapter 8.2.1.1.

8.1.3

Development until Second Round Financing

A monthly reporting fosters a good working relationship between the management and BayBG. Both meet every month and discuss the company's status quo. In addition, Wolf Rüdiger Willig or an investment manager talks to the company's management at least every second week to monitor the company's development. Within the regular meetings, the company's strategy and operational events of major importance are discussed. In addition, strategy workshops are done on a yearly basis. BayBG also helps

809

Dresdner Bank AG is acquired by Allianz AG in 2000 but still operates under its previous name.

810

Bayerische Vereinsbank AG merges with Bayerische Hypotheken- und Wechselbank AG in 1998 to form today's HypoVereinsbank AG.

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Case Study varetis AG

to identify potential areas of cost savings. Wolf Rüdiger Willig is the main discussion partner from the side of BayBG in all these discussions. IDIS proves to be a successful product and can be placed in five countries in 1990 and in three more countries in 1991. In addition, test installations can be placed in Australia and New Zealand. When it comes to convince British Telecom to mandate varetis with the installation of its directory assistance system, BayBG comes into play. Managers of British Telecom hesitate to purchase the system of a still small German software company. They are unsure whether varetis will be able to continue offering their services in the following years. Wolf Rüdiger Willig joins the management team in the negotiations and assures British Telecom that BayBG is dedicated to its investment and will continue backing varetis. Finally, British Telecom signs the contract with varetis. Financial results are rather disappointing in the first years after the first financing round. In 1991, the management team begins to restructure the company’s activities. BayBG also recommends shutting down unprofitable activities. Since the security profit center still fails to show a satisfying performance, it is sold to a competitor at the end of the year. Christian Schneider, its Director, leaves varetis and sells his shares to Peter Wünsch. In general, the activities of the company are more and more directed towards realizing the potential of IDIS and putting less emphasis on the company’s various previous activities. In 1992, varetis changes its legal form to a limited partnership due to tax reasons. BayBG does not interfere in this respect even though this entails a less transparent organizational structure. However, BayBG initiates a broad analysis of business processes within varetis and advises the management on possible improvements. The company further tries to acquire international customers. BayBG assists varetis by acting as a reference for international customers, who want to check on the company’s credibility. Due to the intense work of Jakob Schwerdt, varetis manages to acquire a mandate from AT&T to install IDIS with a sales volume amounting to several million € for the first two years. The AT&T contract requires varetis to build up a local support organization. After consultations with BayBG, the management decides to start a sales organization for the North American market in the beginning of 1993. The company also acquires a mandate from Swisscom, Switzerland’s telecommunication company, and decides to set up a representative sales office in Bern, Switzerland.

Case Study varetis AG

243

In the same year, a resolution of the European Council of Ministers for Telecommunications states the need for further deregulation in the telecommunications market and requires liberalizing the market for voice telephony. Monopolists still dominate the European market for telecommunications, which limits the number of varetis’ potential customers in many countries. The fall of telephony monopolies in Europe promises new telecommunication companies entering the lucrative market. In a competitive environment, telecommunication companies need to differentiate themselves from their competitors. One possibility to do this is by offering directory assistance to their customers. varetis can benefit from these companies through license and maintenance fees for the provision of the directory assistance system. However, several new telecommunication companies might be too small to set up their own call center and want to outsource the directory assistance service completely. Peter Wünsch perceives this opportunity and convinces the other shareholders to start a new business division, which builds up a full-scale call center. Soon, varetis acquires Deutsche Telekom AG as its first call center customer offering directory assistance for cell phone networks, which proves to be a very profitable activity. An additional benefit of the call center division is that it provides varetis with the possibility to gain more experience with its own software products. In 1994, the organizational structure of varetis and its business operations become again subject to reorganization efforts. The operating performance of the retail and training divisions is still disappointing. In discussions between BayBG and the management of varetis, both parties do not perceive any strategic potential for the company and agree on a smooth exit. The company merges both divisions into a separate company and sells 51% of that company’s shares to the existing management and external managers and retains a stake of 49%, which is subsequently reduced to 44.5%. varetis is now positioned as both a system provider, who provides soft- and hardware for directory assistance operations, and a service provider, who provides services in the directory assistance market through its own call center. The company also looks for potential alliance partners. BayBG identifies several potential candidates. BayBG joins the management team in talks with potential partners a few times. However, they all belong to the German Mittelstand and lack the international network that varetis is looking for. In general, the efforts to establish partnerships with other innovative software companies remain unsuccessful.

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Case Study varetis AG

In 1996, varetis pushes forward its internationalization efforts. Since the management perceives a good chance to win large mandates by British Telecom and Vodafone, a local subsidiary is set up in Shipley, UK to be already present in the market when it comes to the bid invitations. BayBG advises the management on this decision. This strategy proves to be successful and the company wins the mandate from British Telecom. However, in the same year the company has to suffer a major setback as the Managing Director Peter Wünsch leaves varetis. He founds the telecommunication company telegate AG with Dr. Klaus Harisch and Dr. Christian Schwarz-Schilling, the former German Secretary of Communications. BayBG perceives this as a painful loss for varetis since Peter Wünsch assumed the role of the visionary within the company. Günther Baierl remains as the only Managing Director of varetis and has to cope with a number of additional tasks. varetis carries out a broad market study to understand the future dynamics of the directory assistance market. The study’s forecast shows that the market demand for IDIS and its complementary products will rise especially in the period from 1997 until 1999 since the old directory assistance systems from IBM will need replacement. To be able to serve these market needs in the future, the management decides to invest in the further improvement of the search engine and in a broad range of additional system features like a proprietary database, a statistical analysis, and a security package. A new feature, the Inquiry Support for Telecom Operators System (QST), complements IDIS. QST enables the operators to get hold of hard to find numbers, like chalets in Austria's Alps, and provides further information like time zones, price tables, country and city codes. Furthermore, the National Directory Inquiry System (NDIS) is developed and the functionality of Computer Telephony Integration (CTI) is added. Since 1990, BayBG works together with the management team in refining the internal accounting and reporting system. BayBG also supports the company in establishing a key account and customer relationship management system. Furthermore, BayBG induces the company continually to improve its project management. Concerning the establishment of an employee incentive scheme, BayBG supports the management team through several discussions. The first signs of additional financial needs appear as early as in 1994. The company tries to obtain financial support from other government-dependent funds like tbg with

Case Study varetis AG

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the help of BayBG, but being a software company seems to be a great disadvantage in attracting public funds. Even if public funds are available, they are still paid out via local banks, which in turn approach varetis’ shareholders asking for collateral. Finally, the management ceases these efforts without any success. varetis still manages to continue its growth path by reinvesting a significant part of its profits and making full use of its credit lines by assigning receivables to banks and by shareholders providing additional personal collateral. In 1996, varetis is again at the limit of its internal and debt financing facilities. The shareholders decide that varetis should go public within a few years to raise enough equity to finance the further growth of the company. To cover financing needs until an IPO becomes possible, the shareholders decide to approach private equity investors.

8.1.4

Second Round Financing

During the negotiations for the second external financing round, talks to International Ventures are resumed as the company now shows strongly improved sales. Being a project-based company with extremely volatile sales, International Ventures argues that varetis will face difficulties in realizing an IPO. As International Ventures is afraid of not being able to exit from its investment, it refrains from making an investment offer to varetis. Another venture capital firm, Global Ventures811, shows interest in investing in varetis. Basis of the negotiations between the two parties is the current business plan, which already states ambitious growth goals for varetis. Global Ventures argues however, that the growth story is still too small to guarantee a successful exit via an IPO and asks the management to work again on its business plan. At the same time, Software Inc.812 approaches varetis with an offer for a share deal at an attractive company valuation. Software Inc. is a US-based software company active in the field of voice automation. The products of varetis would fit well to its product portfolio. Software Inc. lists at NASDAQ stock exchange and shows an excellent development of its stock price. varetis assumes that the management of Software Inc. has a strong interest in its share price performance and only looks for an exciting growth

811

Name has been changed by the author.

812

Name has been changed by the author.

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Case Study varetis AG

story by purchasing a leading European software company in an attractive niche market. varetis also enters again into negotiations with BayBG. At first, BayBG offers a similar financing solution to the 1990 financing round. However, an important contractual agreement between the existing shareholders receives BayBG’s closer attention since it perceives an interesting opportunity for itself. One of the shareholders has the right to sell 20% of the company's shares before any other shareholder can sell shares. Without solving this problem within varetis’ shareholder structure, an IPO is not conceivable. After long-winded negotiations between all involved parties, BayBG comes up with a new financing proposal that offers a solution to this problem. According to this new proposal, the existing atypical silent partnership is cancelled and BayBG invests €1m with a typical silent partnership. In addition, BayBG purchases 33% of the existing shares from the shareholders in turn for €3.3m, which implies a total equity value of varetis of €10m, which is significantly lower than the one Software Inc. offers. BayBG supports varetis in raising further €1m from banks as it has done in the first financing round. Half of this new debt is an extended credit line, the other half is a loan secured by personal assets of the shareholders using the proceeds from the partial sale of their shares to BayBG. Since BayBG does not want to co-invest with other investors, it remains the only external equity investor in the company. Due to the good relationship that has grown during the years of BayBG's investment, the management shows a tendency towards the proposal of BayBG. Whereas in the 1990 financing round, the smartness of the money provided did not play a role, in 1997, the management thinks a lot more about what each investor can bring in besides cash. Both, Global Ventures and Software Inc. dispose of broad international contacts, whereas BayBG offers mostly national contacts. The shareholders discuss the different financing options intensively. Finally, they decide that the offer of Global Ventures should be declined since they are not willing to take on the high risk associated with the rapid expansion of business activities. The shareholders also feel that the company lacks management capacities necessary to handle the growth. varetis also rejects the share deal offer of Software Inc., one reason being that a share deal does not solve the financing problems of varetis since no fresh money comes into the company. In October 1997, more than one year after talks with

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private equity investors have been initiated, varetis and BayBG sign the second investment agreement, which includes a number of additional investor rights in comparison to the first investment agreement. An important change initiated through the second investment agreement is the establishment of a supervisory board. The second investment agreement is analyzed in detail in chapter 8.2.1.1.

8.1.5

Further Development and BayBG’s Exit

In 1999, the call center division of varetis that has always been profitable gets into trouble as its largest customer Deutsche Telekom is not willing to renew its contract. Management and supervisory board decide to sell this division, as this measure will improve chances for a successful IPO. A formal trade sale process is initiated with the support of BayBG and several potential acquirers are found. Finally, the company is sold to a private investor. At this time, the product portfolio of varetis mainly consists of extremely fast search engines, call center technology and solutions to converge and consolidate data from different sources. Software components can be combined and customized and varetis is able to offer complete solutions including hardware components. varetis' sources of income mainly stem from sales of software licenses, followed by service and maintenance fees. The company continues product development and reorganizes itself into four different product groups that are depicted in Figure 76: (1) Directory Assistance Solutions comprises varetis' core products NDIS and IDIS. (2) Customer Care Solutions comprises software to support customer service in call centers. (3) Internet Solutions comprises applications to access directories via Internet or WAP.

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(4) Subscriber Data Funnel comprises applications that enable to merge and synchronize customer data from different telecommunication companies to build up a complete directory.813

Product groups of varetis

Directory Assistance Solutions

Figure 76:

Customer Care Solutions

Internet Solutions

Subscriber Data Funnel

Product groups of varetis (1999)

In particular, the standardization of the software is pushed forward, to enable the company to acquire business not only from large customers as before, but also from smaller customers. Standardized software would also make it possible to establish a reseller system with IT consultants offering varetis’ products to their customers. It is expected that the standardization efforts could also help to improve US sales since customers there are seeking a relatively simple directory assistance solution. The company further pushes its internationalization and sets up representative offices in Paris, France and Belo Horizonte, Brazil. The successful start of the German high-tech stock market segment Neuer Markt in March 1997 further motivates the parties to aim for a stock market listing. The further development of varetis is characterized by preparations to fulfill stock market requirements. A series of measures is taken to achieve that goal. With the existing legal form of a limited partnership, which was originally set up for tax reasons, an IPO at the Neuer Markt is not possible. The company therefore switches from its current legal form of a limited partnership to the legal form of a stock corporation. BayBG and external consultants advise the management team on ways to implement that change. At this time, the company also changes to the firm name varetis, since its old name pcplus might induce investors to think of a hardware manufacturing company.

813

§ 12, II TKG requires telecom companies to provide customer data on demand, e.g. for building up a directory assistance service.

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The supervisory board begins its operations with Wolf Rüdiger Willig taking on one seat to represent BayBG. In particular, with the impending IPO, Wolf Rüdiger Willig personally attends almost every meeting in that context. As a problem arises between varetis and its large customer Deutsche Telekom AG, Wolf Rüdiger Willig personally interferes to improve business relations. On initiative of the supervisory board, the software development process is reviewed together with companies out of BayBG's network. The supervisory board also pushes the management to be more active in patenting the company’s technology and advises on improvements in the marketing strategy. In detail, product sales and customer structures are analyzed. By discussing the results, the management gathers additional knowledge in e.g. how to generate cash cows out of existing products. The IPO is a clearly stated goal in the investment agreement with BayBG. Nevertheless, the company is confronted with several acquisition offers during the years before the IPO. For example, a UK-based software company offers to buy varetis. Günther Baierl and Wolf Rüdiger Willig fly over to discuss deal terms. A Swiss private investor also shows interest in buying BayBG’s stake in varetis. However, both Günther Baierl and Wolf Rüdiger Willig conclude that an IPO is the far more attractive option for varetis and BayBG. In 1999, varetis has a strong market position according to an internally conducted market analysis. Its market share in the European market for directory services accounts for 40%. Its world market share of currently 8% is increasing as it delivers 16% of all new installations. Among its customers are Deutsche Telekom, Mannesmann Mobilfunk, telegate, Mobilcom, Telekom Austria, Swisscom, British Telecom, Vodafone, Orange, France Telecom, kpn telecom, Cable & Wireless, AT&T, MCI, and Telecom New Zealand. The standardization efforts already pay off as smaller Czech and Portuguese telecom companies can be acquired as new customers with sales volumes below €500k. Before, the company mainly worked on projects with a budget over €1.5m. The company also thinks about acquiring other businesses to complement its product portfolio and speed up corporate growth. To negotiate a potential acquisition, an investment manager from BayBG joins the varetis management team on a trip to the USA. The management intensively analyzes several options, but many of them seem to be overpriced and none of them is finally realized.

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To position itself for the IPO, the company needs to hire several employees. In particular, a new CFO has to be found to manage the IPO process. To do this, BayBG's contacts to the industry and recruiting organizations are used. BayBG searches for the candidate only by stating that the position is with one of its portfolio companies. The fact that BayBG backs the company helps during negotiations with potential candidates, since this conveys a more long-term credibility to the job offer. After interviewing with management and BayBG, Dr. Konstantin Becker joins the company as new CFO. During the preparation of the IPO, an investment manager of BayBG supports him in budgeting and compiling the selling prospectus. To do this, he spends about one day per week at varetis. Besides, varetis urgently needs at this time further software developers. During the peak time of the New Economy Boom, IT experts are difficult to hire in the Munich area. BayBG supports the company in finding the urgently needed software developers by addressing its network. BayBG also establishes contacts to professional development institutions to train the varetis employees in various aspects. Management and supervisory board decide to involve a professional consultant for the IPO process. In a beauty contest, they jointly choose HypoVereinsbank (HVB) as lead manager and Banque National Paribas (BNP) as co-lead manager for the IPO. All involved parties agree to go for an IPO in the first quarter 2000. This requires canceling the silent partnership agreement with BayBG with effect of December 31, 1999. The definite IPO date is set according to the proposals of HVB and Wolf Rüdiger Willig to February 7, 2000. Timing could not be better since on that day German stock market indices are at their all-time high. Demand for the varetis share exceeds the IPO offer volume by 52 times. The selling price is set to the upper limit of the book building range at €32 and the greenshoe option is executed. The company’s market capitalization based on the selling price amounts to €121.6m. The first quotation at the Frankfurt Stock Exchange is an impressive €100. At the end of the first trading day, the share closes at €80. The IPO of varetis comprises selling 650,000 old shares including 250,000 shares from the greenshoe option and via a capital increase another 1,250,000 new shares. In total 1,900,000 shares are placed at the stock market with 3,800,000 shares outstanding. varetis receives €40m fresh money of which it has to deduct IPO flotation costs of

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around €4m.814 Due to its contractual preferred position, BayBG can provide two thirds of the old shares sold to the public, which represents more than 50% of its holdings in varetis. After deducting costs, BayBG obtains €13.3m and still has 10.3% of all outstanding shares in its portfolio. Those shares as well as the remaining shares of the other old shareholders are subject to a lock-up agreement of one year. After the burst of the high-tech bubble on stock markets beginning mid of 2000, selling the remaining shares of varetis becomes a difficult task, since BayBG does not want to drag the share price down by selling all shares at once. Therefore, BayBG continuously reduces its stake in varetis by selling shares on the market or in block trades. By June 2004, BayBG has sold all its shares and Wolf Rüdiger Willig resigns from his seat in varetis’ supervisory board.

8.2

Case Analysis

8.2.1

BayBG’s Influence through Contracting

8.2.1.1 Investment Agreement Structure The first investment agreement between BayBG and varetis is based solely on an atypical silent partnership. It contains several contractual elements that are detailed in the following. Information rights are fully implemented in the first investment agreement between varetis and BayBG. Accordingly, BayBG has the right to ask for information and to visit varetis’ premises at any time. Furthermore, BayBG requires a monthly direct costing analysis, a monthly cash budget, a quarterly profit and loss statement and complete audited annual financial statements with the auditor's report. Conversion rights are not implemented in the first investment agreement. Control rights are partially implemented in the first investment agreement. Since BayBG only holds an atypical silent partnership, it does not have any voting rights. However, BayBG receives veto rights regarding the following cases: • Changes in the articles of incorporation and bylaws, • capital increases and reductions,

814

With approximately 10% this number is slightly higher than the average IPO flotation costs of 7.77% in the German market. See Kaserer/Kraft (2003), p. 507.

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• company liquidation, • conclusion of control, profit and loss transfer, and company surrender agreements, • acquisitions of companies, mergers with companies, trade sale of the company, • foundation of subsidiaries, • appointment and dismissal of senior managers, • appointment of auditor, • conclusions or changes in contracts with shareholders or their family members, • disposition of company’s shares. In addition, BayBG has the right to send one member to the advisory council, in case one will be established in the future. However, BayBG does not have the right to ask for the establishment of such a council. Management covenants are partially implemented in the first investment agreement. Concerning affirmative covenants, the company promises to use the fresh capital for the further development and marketing of IDIS. Furthermore, the company is working towards implementing an equity participation program for its employees. The management’s representations and warranties section only contains standard statements such as that the data provided to BayBG is correct. Non-compete clauses and vesting provisions are not implemented in the first investment agreement. Milestone agreements are not implemented in the first investment agreement. Cash flow rights are partially implemented in the first investment agreement. The atypical silent partnership provides for BayBG’s compensation in three different ways:815 • BayBG receives interest payments on the nominal value of the silent partnership. The interest rate is 10% if EBT is below €250k and amounts to 15% if EBT is above that threshold level. • BayBG receives a dividend preference. According to this, BayBG is entitled to receive dividend payments before any other shareholders can claim any pay815

These investment terms have been slightly changed by the author.

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ments. The level of the dividend payment is 9% of EBT if EBT is below €250k and amounts to 4% if EBT is above that threshold level. • varetis is also obliged to pay a value increase premium of at least 5%816 on BayBG’s €250k investment for every profitable year. The value increase premium is capped at €250k until the end of 1996. Furthermore, the first investment agreement also provides for a liquidation preference, as BayBG is entitled to receive all payments before other shareholders can claim any payments. An anti-dilution clause is not applicable in a silent partnership agreement. Preemptive rights are not implemented in the first investment agreement. Disinvestment rights are partially implemented in the first investment agreement. BayBG receives the right to cancel its investment at the earliest at the end of 1996 with a cancellation period of one year. An extraordinary cancellation is possible in several instances: • varetis’ statements on which BayBG bases its investment decision are incorrect, • varetis’ financial situation deteriorates materially, • investment conditions change like varetis is liquidated or sold or relocated away from Bavaria, • varetis’ delays its payments for more than two months, • varetis breaches any obligations resulting from the investment agreement, • management endangers the goals of varetis. Tag-along rights, drag-along rights, registration rights and redemption rights are not included in the first investment agreement. Figure 77 summarizes the important contractual elements that are included in the first investment agreement between varetis and BayBG.

816

This rate can be higher in case varetis exceeds gross profits of €6m.

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Case Study varetis AG

Categories of venture capital firms‘ rights

Information rights

Conversion rights

Control rights

Management covenants

Milestone agreements

Cash flow rights

Preemptive rights

Disinvestment rights

Figure 77:

First investment agreement between BayBG and varetis

; Right to ask for information

; Regular reporting

; Right to visit company premises … Conversion on option of the holder … Voting rights

… Supervisory board representation right

; Veto rights ; Affirmative covenants

… Non-compete clause

; Representations and Warranties

… Vesting

… Earn-out

… Ratchets

… Management dismissal

… Staging

; Dividend preference

… Anti-dilution protection

; Liquidation preference … Right of first refusal … Right of first offer … Tag-along right

… Registration rights

… Drag-along right

; Cancellation right

… Redemption rights

Contractual analysis of varetis’ first investment agreement

This contractual structure changes in several aspects with the second financing agreement, in which BayBG not only enters into a typical silent partnership but also directly purchases a stake of 33% of varetis. Information rights are still fully implemented in the second investment agreement between varetis and BayBG. The only change that takes place is that BayBG requires varetis to provide financial statements in line with US-GAAP. Conversion rights are still not implemented in the second investment agreement. Control rights are now fully implemented in the second investment agreement. BayBG is now the largest single shareholder in the company and holds according to its stake 33% of all votes in the shareholders’ meeting. In addition, BayBG receives the right to send one delegate to the supervisory board that consists of three members. The existing shareholders also have the right to send one delegate to the supervisory board. The Chairman of the supervisory board should be independent of both parties. The veto rights are now given to the supervisory board instead of BayBG alone. The catalogue of veto rights remains largely the same as in the first investment agreement. The only

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important addition to the catalogue is that for all investments and loan contracts, which exceed a volume of €125k, the consent of the supervisory board is required. Management covenants are still partially implemented in the second investment agreement. Concerning affirmative covenants, the company promises to hire a CFO, to work towards an IPO in 1999 and to change its legal form to a stock corporation (AG) until the end of 1997. The latter is required for an IPO at the Neuer Markt, a new market segment at the Frankfurt Stock Exchange. The management’s representations and warranties section only contains standard statements such as that the data provided to BayBG is correct. Non-compete clauses and vesting provisions are still not implemented. Milestone agreements are now partially implemented in the second investment agreement. An earn-out clause states that in case the company develops well and exceeds certain sales and profit levels, BayBG will pay additional money to the former shareholders for their shares. Other contractual elements, such as the right for management dismissal, ratchets, and staging are not included. Cash flow rights are again partially implemented in the second investment agreement. The typical silent partnership agreement provides for BayBG’s compensation in three different ways: • BayBG receives interest payments of 8% on the nominal value of the silent partnership, • BayBG receives a dividend preference. According to this, BayBG is entitled to receive dividend payments before any other shareholders can claim any payments. The dividend payments amount to 3% of EBT and are capped at €40k annually. • varetis has to pay cumulated interest payments on the nominal value of the silent partnership with an interest rate of 4% for every year that profit exceeds €250k. The second investment agreement also provides for a liquidation preference concerning the typical silent partnership, as BayBG is entitled to receive all payments before other shareholders can claim any payments. The stock purchase agreement includes a liquidation preference for BayBG, stating that BayBG has a preferred position in selling shares in the IPO. An anti-dilution clause is not included.

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Preemptive rights are still not implemented in the second investment agreement. Disinvestment rights are strengthened in the second investment agreement. BayBG receives the right to cancel its silent partnership at the earliest at the end of 2004 with a cancellation period of one year. Concerning the stock purchase agreement, BayBG receives a tag-along right. Other disinvestment rights such as drag-along rights, registration rights and redemption rights are not included in the second investment agreement. Figure 78 summarizes the important contractual elements that are included in the investment agreement for the second financing round between varetis and BayBG.

Categories of venture capital firms‘ rights

Information rights

Conversion rights

Control rights

Management covenants

Milestone agreements

Cash flow rights

Preemptive rights

Disinvestment rights

Figure 78:

Second investment agreement between BayBG and varetis

; Right to ask for information

; Regular reporting

; Right to visit company premises … Conversion on option of the holder ; Voting rights

; Supervisory board representation right

; Veto rights ; Affirmative covenants

… Non-compete clause

; Representations and Warranties

… Vesting

; Earn-out

… Ratchets

… Management dismissal

… Staging

; Dividend preference

… Anti-dilution protection

; Liquidation preference … Right of first refusal … Right of first offer ; Tag-along right

… Registration rights

… Drag-along right

; Cancellation right

… Redemption rights

Contractual analysis of varetis’ second investment agreement

8.2.1.2 Influence on Deal-specific Risks BayBG uses a selection of contractual elements to reduce several deal-specific risks. Figure 77 and Figure 78 show that both investment agreements fully implement information rights but do not include any conversion rights or preemptive rights. The second investment agreement strengthens the control rights of BayBG through the inclu-

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257

sion of voting rights and the supervisory board representation right. Whereas the first investment agreement does not make use of any milestone agreements, the second investment agreement includes an earn-out clause. Furthermore, the second investment agreement also implements a tag-alone right. Figure 79 shows in detail the dealspecific risks are addressed with the two investment agreements between BayBG and varetis.

Investment agreements between BayBG and varetis reduce risk of…

Effects Contractual rights

managerial opportunism

Information rights

x

Conversion rights



competitive opportunism

Control rights

x

Management covenants

x



Milestone agreements

x



Cash flow rights

x

 

x

Disinvestment rights Risk addressed only in second investment agreement

Figure 79:

exit obstruction

x

Preemptive rights

x

unfavorable decision taking

x

Risk addressed in both investment agreements

x 

Risk not addressed in both investment agreements

Risk not addressable by this category of contractual rights

Deal-specific risks between BayBG and varetis

There is no difference between both investment agreements in terms which risk categories are addressed. Both investment agreements between BayBG and varetis do not address the risk of competitive opportunism. Merely, the intensity of the effectiveness of the implemented contractual elements and thereby BayBG’s influence on dealspecific risks in the second investment agreement can be assumed higher than in the first investment agreement due to the increased number of contractual elements. Still, the second investment agreement is a relatively weak version from the perspective of a venture capital firm since strong contractual elements such as staging, vesting, and anti-dilution are not included.

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Case Study varetis AG

8.2.1.3 Influence on Management’s Formal Autonomy The efforts to find an investor for the first financing round are characterized by the management team trying to prevent a strong external influence onto the company. Therefore, the management team decides against the financing proposal of National Ventures even though an attractive company valuation is envisioned since this proposal also includes strong investor rights such as milestone agreements that endanger the autonomy of the management team. The investor rights, which BayBG requires, are much weaker. Nevertheless, several contractual elements in the first investment agreement between BayBG and varetis constrain the formal autonomy of the management team. BayBG has several veto rights that grant influence on the company’s decisions, mainly regarding fundamentally important issues, but also on a more detailed level within the financial and managerial domain. In case BayBG does not approve any of the actions included in the catalogue of actions requiring the consent, the company is severely hindered in its future development and consequently, the management suffers a significant loss of formal autonomy in important decisions. BayBG formally has the right to send one delegate to an advisory council in case such a council is established. However, BayBG does not have the right to establish the advisory council and during the validity of the first investment agreement, varetis does not establish such a council. The cancellation right potentially reduces the formal autonomy of the management since BayBG can always threaten with canceling its silent partnership and thereby depriving varetis of an important part of its capital base. Furthermore, the support of BayBG in securing the loans of the banks would also be lost. However, BayBG can cancel its investment only with the end of 1996, i.e. six years after its investment. Especially during the first years, this threat is therefore not very strong. During the search for the second financing round, the management’s initial fear of losing autonomy is less pronounced. Therefore, several venture capital firms are approached again. However, because BayBG is already a trusted partner and the cooperation has been very smooth since the first financing round, the management decides again for the proposal of BayBG. The second investment agreement between BayBG and varetis increases BayBG’s formal influence on the company and thereby reduces further the formal autonomy of the management team.

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The establishment of the supervisory board introduces an institution, which largely reduces the management’s formal autonomy. Through BayBG’s right to send one delegate to the three-member supervisory board of varetis, BayBG gains strong influence on the company’s management and its decisions since the supervisory board receives slightly extended veto rights than BayBG alone held before. The catalogue of veto rights now also includes all investments and loan contracts, which exceed a volume of €125k. This implies that additionally to BayBG’s former veto rights that potentially block the company in major strategic decisions within the financial and managerial domain, this new veto right essentially also allows a more operational interference of the supervisory board with the management’s decisions. Furthermore, BayBG becomes varetis’ largest shareholder holding 33% of all shares. However, since BayBG does not hold the majority of varetis’ shares, it is not in the position to take decisions for the company on its own and still requires the support of other shareholders to effect changes. Nevertheless, BayBG significantly reduces the formal autonomy of varetis’ management team.

8.2.2

BayBG’s Influence through Resource Provision

8.2.2.1 Influence on Resource Pool Besides the formal influence through the investment agreements, BayBG also exerts influence on varetis by providing resources directly or indirectly and thereby influencing the company’s resource pool. At the time of BayBG’s first investment, varetis is already active on its markets since seven years and disposes of unique technological resources. The company has been able to develop a unique search engine and database technology that represents the basis of its core product IDIS. Therefore, the company does not show a critical need of further technological resources. During the whole investment development phase, BayBG does not provide varetis with any technological resources. The company urgently needs financial resources due to extensive investments in IDIS, increased working capital requirements, and profitability problems in several profit centers. In this situation, banks are not extending varetis’ credit lines without receiving further personal collateral, but most members of the management team are not willing to provide any further personal collateral. According to the three-pillar concept,

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Case Study varetis AG

BayBG is an important source of financial resources in the first financing round by directly providing €250k through a silent partnership. BayBG makes it indirectly possible to raise further €1m through bank debt, which has not been available to the company without BayBG’s involvement. In the second financing round, BayBG plays an even more important role as a provider of financial resources. Through the buyout of the shareholder with the right to sell 20% of varetis’ shares before any other shareholder can sell shares, BayBG enables to solve the blockage within the company’s shareholder structure, which ultimately makes the company again attractive to potential outside investors and increases its chances to raise further financial resources in the future. Furthermore, through the provision of €1m in the form of a typical silent partnership the equity base of the company is further strengthened. BayBG indirectly helps varetis to raise further €1m trough bank financing similar to the first financing round. In terms of managerial resources, varetis initially does not show a critical need. The existing management team with Günther Baierl and Peter Wünsch as Managing Directors and Jakob Schwerdt, Thomas Franke, and Christian Schneider as Directors of their respective profit centers dispose of broad technological expertise and management experience. BayBG perceives a gap in the management team after the time Peter Wünsch, who held the function of a CTO, leaves the company. Günther Baierl has to manage the company alone and faces many additional tasks. However, BayBG does not undertake any actions to find a new manager assuming the position of Peter Wünsch. BayBG supports the company in terms of managerial resources through Wolf Rüdiger Willig acting as the main discussion partner for varetis’ management team. This role is formalized through the establishment of the supervisory board in 1997. He joins the management in almost every meeting with third parties concerning the IPO. Due to the close relationship that he develops with varetis over the long investment development phase, he fulfills this function even long after the IPO, even though BayBG does not hold any special investor rights anymore. Furthermore, BayBG provides managerial resources with an investment manager joining the management team to negotiate an acquisition in the USA and supporting Konstantin Becker on site in the preparations for the IPO. Indirectly, BayBG supports varetis in acquiring managerial resources by establishing the contact to Konstantin Becker. Shortly before the IPO, varetis requires further personnel resources since it is growing quickly. Due to the overheated situation on the market for IT personnel in the Munich

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261

area, it is hard to find any further employees. In this respect, BayBG indirectly supports the company in its efforts to hire additional staff by addressing its network of portfolio companies and establishing the link between some potential candidates and varetis. Being a software company, varetis does not need many physical resources except for office space and IT equipment. Since the company operates since several years, it already disposes of full office equipment. Furthermore, varetis has just moved to new premises, which offer enough space to accommodate an expanding company. Besides that, Munich is an excellent location since many other software companies are also located in this area, which for instance makes it easier for the company to enter alliances or to find qualified employees. During the whole investment development phase, BayBG does not provide varetis with any physical resources. The company has already established some organizational resources over the course of its first six years of its operation. The introduction of the profit center concept in 1986 contributes positively to a clear role allocation within the management team. However, there is still a need for further organizational resources when the company starts to market IDIS, expands internationally, and works on its internal structures and processes. BayBG provides some organizational resources by defining the reporting system the company has to follow. BayBG also supports the company when it comes to implement a key account and customer relationship management system, and to design an employee incentive scheme. In the discussion and implementation of many organizational issues, BayBG plays an important role as discussion partner and advisor. An important contribution of BayBG is its continued work towards consolidating varetis’ business activities such as selling the unprofitable security division and the later merger and spin-off of the trading and training divisions. Moreover, BayBG also advises the management team when it comes to setting up subsidiaries in the UK and the US. BayBG helps the management to implement the change in the legal form from a limited partnership to a stock corporation. Furthermore, BayBG advises on possible improvements regarding important business processes, the software development process, and the internal project management. The company clearly requires reputational resources. Its customers are mainly foreign telecommunication companies because most countries only have a state-owned telecommunication company and consequently the only potential customer in Germany is

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Deutsche Telekom. However, the company has no track record in the German telecommunication market let alone in foreign markets. Furthermore, being a small software start-up makes it hard for the company to raise further debt financing or to hire managerial staff. BayBG provides varetis with reputational resources in various ways. Most importantly, since BayBG is backing varetis the local banks are willing to continue their financial backing of the company in both financing rounds. In addition, the closure of the important deal with British Telecom becomes only possible because British Telecom perceives it as a positive signal for the quality and continuity of varetis that a financial investor such as BayBG is invested. During the search for a CFO, the backing of BayBG also proves helpful since this conveys a more long-term credibility to the job offer. The founding team disposes of some social resources in the German market, but initially has no contacts to international telecommunication companies, which entails a strong need of establishing international social contacts. This need cannot be covered by BayBG since its network mainly comprises national contacts. BayBG provides varetis with some social resources by offering access to its network through Wolf Rüdiger Willig as a discussion partner and later as a member of the supervisory board. Once, Wolf Rüdiger Willig can help the company to ameliorate the relations with its main customer Deutsche Telekom. From BayBG’s network, several contacts to potential collaboration partners are established, but the scope for mutual benefits is limited and ultimately the company ceases these efforts. Contacts to government-dependent funds are established with the help of BayBG, but negotiations to raise additional financial resources finally break down because local banks require again personal collateral. BayBG refers service providers to varetis such as recruiting agencies and professional development institutions. It follows from the above analysis that varetis exhibits in all resource categories except for technological and physical a critical resource need, which is depicted in the second column in Figure 80. The analysis of the resource provision by BayBG shows that the venture capital firm directly and indirectly provides varetis with resources as illustrated in the third and fourth column of Figure 80.

Case Study varetis AG

Resource categories

263

Critical resource need of varetis

Resource provision by BayBG Direct

Indirect

Technological resources







Financial resources

9

x

x

Managerial resources

9

x

x

Personnel resources

9



x

Physical resources







Organizational resources

9

x



Reputational resources

9

x



Social resources

9

x



9 Critical resource need

 No critical resource need Figure 80:

x Resources provided  No resources provided

Resource-based analysis of varetis

The extent to which BayBG covers the resource need of varetis differs greatly between resource categories. varetis receives support from BayBG in all resource categories where it shows a critical resource need, but mainly in terms of financial, managerial and organizational resources.

8.2.2.2 Influence on Management’s Real Autonomy The influence of BayBG on varetis can be shown by analyzing its involvement in the company’s management processes. On the normative management level, BayBG’s plays a significant role. An important contribution to the company’s mission is the fact that varetis only receives the backing of BayBG because of its unique product IDIS. By providing financial resources only for the further development and marketing of IDIS, BayBG indirectly pushes varetis further in the direction of the directory assistance market. The other activities of varetis continually lose significance. A further important contribution of BayBG on the normative management level concerns the company’s corporate governance structure. Before BayBG’s investment, varetis’ management team has only been accountable to themselves. This changes with the first silent partnership being provided by BayBG since varetis’ management team then reports monthly in front of BayBG. With the establishment of the supervisory board sub-

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sequent to the second financing round, the accountability of the management team towards outsiders becomes even more institutionalized. Regarding the company’s vision and the corporate culture, no significant influence of BayBG can be found. On the strategic management level, BayBG’s activities in shaping the financial strategy of varetis are its most important influence. In the first financing round, BayBG develops the three-pillar financial strategy, which is then accepted by varetis. In the second financing round, BayBG comes up with the proposal to buy out the shareholder with the right to sell his shares before other investors can sell their shares and thus opens up the way to an IPO. An inquiry of the management team to syndicate the second financing round is declined by BayBG since it does not want to co-invest with other venture capital firms. This potentially limits the further development of varetis since other venture capital firms might be better able to support the company in its internationalization efforts. BayBG plays an important role in supporting the management team in discussions regarding the company’s strategic options but does not force the company to follow a certain strategy. This becomes evident in the example of varetis’ other business divisions. BayBG has no interest in them but still does not force the management to shut down these operations and agrees with a smooth exit. It takes the company several years until all these operations are sold, spun-off, or ceased. Regarding the establishment of subsidiaries in UK and US, BayBG advises the management team. Furthermore, BayBG also suggests several improvements in the company’s marketing strategy. BayBG also helps the company to improve its management systems such as internal accounting and reporting, key account management, customer relationship, and its employee incentive scheme. The project management of varetis is also subject to discussions and BayBG suggests several potential improvements. On the operational management level, BayBG gets involved occasionally. This involvement is most obvious with BayBG negotiating the bank loans for varetis and supporting the company in its negotiations with government-dependent funds. It also advises the company on implementing the change of the legal form. Before the IPO, an investment manager joins the CFO on site and supports with budgeting and compiling the listing prospectus. Wolf Rüdiger Willig almost joins every meeting with third parties concerning the IPO. A few times, BayBG participates in other negotiations such as with British Telecom, potential collaboration partners, and before the IPO with a UKbased software company discussion a merger and a potential acquisition target in the US. Once, Wolf Rüdiger Willig personally gets involved to improve business relations

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with Deutsche Telekom. BayBG also supports varetis to improve operational management processes such as the software development process and other business processes. Furthermore, BayBG engages actively in searching for a new CFO and even addresses its network to find additional non-managerial personnel for the company. In conclusion, it becomes clear that BayBG fits well to the preferences of the management team. In the years after the 1990 financing round, a close relationship develops between varetis' management and BayBG. As varetis is active in a very specialized market niche, it is not surprising that initially BayBG does not dispose of detailed industry expertise. After some time, BayBG and in particular Wolf Rüdiger Willig gain a broad knowledge to support the management in its decision-making. In the first financing round, the management team clearly states that varetis is looking for an investor that does not interfere with managerial decisions. Nevertheless, the management team loses formal autonomy since BayBG receives veto rights that give it considerable power in blocking important decisions, but these rights are never used. BayBG does not interfere with managerial decisions, but offers a sounding board to the company’s management. The influence of BayBG happens through the regular discussion process with the management, in which new ideas and possible changes are discussed. The management of varetis also loses some real autonomy, since it becomes accountable to BayBG and cannot make its decisions completely ignoring BayBG’s interests.

Comparative Case Study Analysis

9

Comparative Case Study Analysis

9.1

Venture Capitalists’ Influence through Contractual Agreements

9.1.1

Contracting Negotiations

267

During the investment structuring phase, all founding teams are confronted with venture capital firms asking for a number of additional investor rights. These investor rights reduce the prospective payoff for the founders mainly because of the venture capital firm‘s preferred cash flow rights. Venture capitalists gain a strong position within a portfolio company particularly through control rights, which curtail the formal autonomy of the portfolio company’s management team. In all cases, the demands of venture capitalists for additional rights lead to intense discussions between founders and venture capital firms. Ex post, all founders perceive the contracting negotiations with venture capitalists as very hard. In the case of varetis, the management team does not pursue the negotiations with National Ventures due to the demands for a negative earn-out clause and the right to dismiss the management team when pre-defined milestones are not achieved. Instead, the varetis management team decides to search for a “soft” venture capital firm, i.e. a venture capitalist, who asks for less additional investor rights. Even though GPC Biotech has already secured the first financing round with a fully negotiated term sheet with TVM as lead investor, its management team accepts a new term sheet with MPM Capital as new lead investor that offers a lower valuation and even stronger investor rights. The founding team expects that the benefits of MPM Capital’s contribution to the performance of the company will more than offset these drawbacks. This behavior is in line with the argument of BYGRAVE/TIMMONS, who state that “it is far more important whose money you get [as an entrepreneur]817 than how much you get or how much you pay for it”.818 It also gives support to the argument of SAHLMAN, who suggests that “from whom you raise capital is often more important than the terms”.819

817

Text in brackets is added by the author.

818

Bygrave/Timmons (1992), p. 208.

819

Sahlman (1997), p. 107.

268

9.1.2

Comparative Case Study Analysis

Content of Investment Agreements

The comparison of the investment agreements between Bullith Batteries and Gi Ventures as well as GPC Biotech and MPM Capital/TVM does not reveal pronounced differences. The three venture capital firms gain a very strong position in their respective portfolio companies and if they wanted to, they could completely block the development of their portfolio companies, mainly through their control rights. In this regard, the comparison with the investment agreement of the first financing round between varetis and BayBG is interesting since the negotiated terms should give BayBG a weaker control over the company. Figure 81 shows the number of the finally negotiated contractual elements that strengthen the venture capital firm’s positions in their respective portfolio companies.

Category of venture capital firm’s rights

Number of contractual elements in the investment agreements Gi Ventures

MPM Capital/TVM

BayBG 1st financing round

BayBG 2nd financing round

Information rights

3

3

3

3

Conversion rights

1







Control rights

3

3

1

3

Management covenants

4

4

2

2

Milestone agreements

1





1

Cash flow rights

2

1

2

2

Preemptive rights

2

1





Disinvestment rights

1

3

1

2

Total number

17

15

9

13

 No contractual elements included in investment agreements Figure 81:

Comparison of number of contractual elements

The mere number of contractual elements that strengthen the position of venture capital firms shows that BayBG with 9 investor rights in the first financing round but also with 13 investor rights in the second financing round has the weakest investor position in comparison to the other venture capital firms. The analysis of deal-specific risk categories that are addressed by the investment agreements demonstrates that BayBG takes a slightly less controlling stance towards varetis in comparison to the other venture capital firms. Figure 82 shows that Gi Ven-

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269

tures and MPM Capital/TVM use contractual elements to address all four postcontractual deal-specific risks whereas BayBG renounces in both investment agreements to address the risk of competitive opportunism.

Risk category

Risk addressed by both investment agreements Gi Ventures

MPM Capital/TVM

BayBG

Managerial opportunism

x

x

x

Competitive opportunism

x

x



Unfavorable decision taking

x

x

x

Exit obstruction

x

x

x

x

Figure 82:

9.1.3

Risk addressed in both investment agreements



Risk not addressed in both investment agreements

Comparison of risks addressed by investment agreements

Portfolio Companies’ Loss of Formal Autonomy

Figure 81 shows that the actual number of contractual elements used in varetis’ second financing round with BayBG does not differ much from the number MPM Capital/TVM use in their investment agreements with GPC Biotech. Filtering for contractual elements that reduce the formal autonomy of the portfolio company allows a better comparison of the three case studies with regard to the implied loss of formal autonomy. Figure 83 compares all investment agreements depicting only contractual elements that restrain the portfolio company’s formal autonomy. Comparing BayBG’s first financing agreement with those of Gi Ventures and MPM Capital/TVM it becomes obvious that varetis achieves its goal in the first financing round to grant its external investor less formal influence than Bullith Batteries and GPC Biotech do. Even when purchasing a 33% stake of varetis in the second financing round, BayBG continues to take a weaker stance towards restraining the portfolio company’s formal autonomy than the other venture capital firms do. Between the investment agreement of Gi Ventures and MPM Capital/TVM there is only little difference in this regard.

270

Comparative Case Study Analysis

Category of venture capital firm’s rights

Used contractual elements that restrain the portfolio company’s formal autonomy Gi Ventures

MPM Capital/TVM

BayBG 1st financing round

BayBG 2nd financing round

Voting rights

x

x



x

Supervisory board representation right

x

x



x

Veto rights

x

x

x

x

Affirmative covenants

x

x





Non-compete clause

x

x





Drag-along right

x

x





Registration right



x





Cancellation right





x

x

x Contractual element included in investment agreement(s)  Contractual element not included in investment agreement(s) Figure 83:

Comparison of contractual elements restraining formal autonomy

There are also great variations concerning the intensity of influence that is granted to the venture capitalists by the contractual elements as can be shown by the following two examples: • BayBG and MPM Capital/TVM hold only a third of the voting rights in the supervisory board and therefore run the risk to be overruled by other board members. In contrast, Gi Ventures holds half of the board seats and since it also nominates the chairman it can control any decision of the supervisory board. • The veto rights of BayBG are fewer and less restrictive than those negotiated by Gi Ventures and MPM Capital/TVM. For instance, whereas the supervisory board of varetis has a veto right regarding all investments and loan contracts over €125k, the supervisory board of GPC Biotech has a veto right for all capital expenditures exceeding €15k. This may allow MPM Capital/TVM to interfere with GPC Biotech’s corporate decisions on a more detailed level than BayBG is allowed to interfere with varetis’ decisions. It can be summarized that BayBG takes a pronounced weaker stance towards restraining the formal autonomy of its portfolio company than Gi Ventures and MPM Capital/TVM do. This contributes to the understanding, why BayBG is in practice often called a “soft venture capital firm”.

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271

9.2

Venture Capitalists’ Influence through Resource Provision

9.2.1

Direct Resource Provision

The comparison of resource provisions of Gi Ventures, MPM Capital/TVM, and BayBG results in a clear picture what kind of resources the portfolio companies receive directly from their venture capitalists. All venture capital firms directly provide financial, managerial, organizational, reputational, and social resources and do not directly provide technological, personnel, and physical resources. Figure 84 shows the comparison of direct resource provisions across the three case studies.

Resource category

Direct resource provision by venture capital firms Gi Ventures

MPM Capital/TVM

BayBG







Financial resources

x

x

x

Managerial resources

x

x

x

Personnel resources







Physical resources

Technological resources







Organizational resources

x

x

x

Reputational resources

x

x

x

Social resources

x

x

x

x Resources provided  No resources provided Figure 84:

Comparison of direct resource provision by venture capital firms

Comparing Figure 84 with Figure 47 shows that the results for the three German case studies are fully in line with the results of the, mainly US-based, literature on activities of venture capital firms. It also demonstrates that the analyzed venture capital firms do not follow an incubator business model since none of them actually provides its portfolio company directly with physical resources such as office space, which is a defining characteristic of incubator organizations.820 Figure 84 also shows that the analyzed venture capital firms do not directly contribute technological, personnel and physical

820

For more information and further references on incubator organizations, see chapter 5.2.3 and in particular footnote 686.

272

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resources, which corporate venture capitalists are believed to offer their portfolio companies.821 Figure 84 easily conveys the impression that all venture capital firms add to the resource base of their portfolio companies to the same extent. However, large differences in the resource provision activities of venture capital firms can be found in some resource categories. An example for this is GPC Biotech’s financial need. As already discussed in chapter 2.3.4 and as can be seen in Figure 5, biotech start-ups generally show the highest financial resource need in comparison to start-ups from other industries. This would explain, why GPC Biotech receives more financial resources in its first financing round than Bullith Batteries and varetis.822 All analyzed venture capital firms provide own managerial resources to their portfolio companies. The strongest commitment comes from MPM Capital, which provides Michael Steinmetz as an interim CEO for GPC Biotech for one year. This is possible at that time, since MPM Capital just started to invest and consequently had more time resources than it has a few years later. No venture capitalists from Gi Ventures or BayBG are officially nominated as members of the executive board of their portfolio companies. Nevertheless, Gi Ventures provides important managerial resources to Bullith Batteries by carrying out the first business planning and by leading many important negotiations with third parties. BayBG also sends an investment manager to support varetis on site during its preparations for the IPO. Four venture capitalists from Gi Ventures, for some time three from MPM Capital/TVM, and one from BayBG join the supervisory board of the respective portfolio companies. The venture capitalists of MPM Capital and TVM bring in more specific industry experience than the venture capitalists from Gi Ventures and BayBG since they have been working respectively investing in GPC Biotech’s industry for many years. With respect to filling managerial gaps in their portfolio companies, Gi Ventures and MPM Capital/TVM exert a strong influence. Gi Ventures even makes its investment conditional on Bullith Batteries hiring a sales manager. In contrast, BayBG does not

821

For more information and further references on corporate venture capital firms, see chapter 3.4.1 and footnote 250.

822

However, comparing the investment volumes of the first financing round for these portfolio companies is problematic, since substantial time has passed between varetis’ (1990), GPC Biotech’s (1997), and Bullith Batteries’ (2002) first financing rounds.

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273

push varetis to hire a new Managing Director to support Günther Baierl, when Peter Wünsch leaves the company. All venture capital firms provide their portfolio companies with organizational resources. In this category, the variance between the resource provisions of the analyzed venture capital firms seems to be the lowest. All venture capital firms support their portfolio companies in setting up an internal accounting and reporting system, which best meets their own controlling requirements. In addition, they are also involved in setting up a stock option, management incentive or employee incentive plan. All analyzed venture capital firms transfer some reputation to their portfolio companies. The fact that Bullith Batteries, GPC Biotech, and varetis are venture capitalbacked companies is generally perceived as a positive signal by third parties. However, the fact that “Gi Ventures” finances Bullith Batteries or that “BayBG” finances varetis does not play a further role. This is different in the case of GPC Biotech, where the name “TVM” plays an important role for example in facilitating raising the silent partnerships from tbg and Bayern Kapital. Therefore, the effect of reputational resources can be split into two components. Firstly, all portfolio companies gain reputation by receiving venture capital. This supports the results of the certification hypothesis, which has been discussed in chapter 5.2.2. Secondly, if they are backed by venture capital firms with a long-term track record such as TVM, the positive reputational effect is reinforced. This finding fits well to the argument of FRIED/HISRICH, who state that especially successful venture capital firms can transfer their positive reputation to their portfolio companies.823 The provision of reputational resources cannot be valued high enough in the context of GPC Biotech. A pharmaceutical company such as Altana Pharma needs to believe strongly in the continuity of GPC Biotech, since parallel to the investment on GPC Biotech’s side, Altana Pharma has to invest itself to be able to absorb the knowledge that is created through the alliance. Few industries show such a long planning horizon as the pharmaceutical industry. Therefore, continuity is a key success factor in this industry. All venture capital firms provide their portfolio companies with social resources, which mainly allow their portfolio companies to access further financial and manage823

See Fried/Hisrich (1995), p. 104.

274

Comparative Case Study Analysis

rial resources. However, there is one pronounced difference between the social network offered by MPM Capital/TVM and those offered by Gi Ventures and BayBG. MPM Capital and TVM establish contacts to highly regarded experts within the biotech industry such as Bernd Seizinger, who becomes CEO of GPC Biotech, as well as Jürgen Drews and Ernst-Ludwig Winnacker, who both join GPC Biotech’s supervisory board. This is mainly because Michael Steinmetz from MPM Capital has been working for many years in the pharmaceutical industry and Helmut Schühsler from TVM has been investing since many years in life science companies. This enables them to access a large network of contacts, which they have built over time. Gi Ventures and BayBG can offer a broad network as well, but it is less tailored to the specific needs of Bullith Batteries and varetis. Therefore, they do not provide their portfolio companies with contacts to internationally well-known industry experts.

9.2.2

Indirect Resource Provision

Whereas all venture capital firms directly provide resources from the same resource categories, a less clear picture emerges when comparing their indirect resource provisions as shown in Figure 85. The literature review that is summarized in Figure 47 indicates that existing research on venture capitalists’ activities does not mention any contributions in terms of technological, personnel, and physical resources. However, according to Figure 85, the analyzed venture capital firms do play a role in facilitating their portfolio companies’ access to these resources.

Resource category

Indirect resource provision by venture capital firms Gi Ventures

MPM Capital/TVM

BayBG

Technological resources

x

x



Financial resources

x

x

x

Managerial resources

x

x

x

Personnel resources





x

x





Organizational resources







Reputational resources



x



Social resources



x



Physical resources

x Resources provided  No resources provided Figure 85:

Comparison of indirect resource provision by venture capital firms

Comparative Case Study Analysis

275

The unique technological resources of their portfolio companies are one of the main reasons why the analyzed venture capital firms invest in these companies. This makes clear why all venture capital firms push the managers of their portfolio companies to protect their technologies with intellectual property rights. The build-up of further technological resources is clearly the task of the entrepreneurs since the venture capital firms only rarely get involved in this resource category. However, the case of Bullith Batteries shows that Gi Ventures facilitates the acquisition of the full license of the solid-state-based lithium-polymer accumulator technology through its lead in the negotiations with the Fraunhofer-Gesellschaft. In the case of GPC Biotech, TVM advises the founding team on technology transfer issues, thereby indirectly facilitating the acquisition of the licenses from Max-Planck-Institute for Molecular Genetics in Berlin, even before TVM is invested in the company. All analyzed venture capital firms facilitate the acquisition of additional financial resources for their portfolio companies. They regularly interact with other financial investors to help their portfolio companies to raise further financial resources. This is of high importance to the venture capitalists since this allows them to better diversify their portfolio, as they do not have to meet the full financial resource need of each of their portfolio companies. Venture capital firms can spread their investors’ money across more portfolio companies and are thus more likely to enhance the returns to their investors.824 In the case of varetis, BayBG directly provides only 20% of the total volume of the first financing round and indirectly facilitates to raise the remaining 80% in bank loans since it leads the negotiations with the local banks. MPM Capital/TVM directly contribute 38% of the volume of the first financing round and facilitate to raise the other 62% in form of silent partnerships from tbg and Bayern Kapital. Gi Ventures helps Bullith Batteries to secure a leasing package by providing a guarantee for the company after the conclusion of the first financing round, which it finances alone. From the perspective of venture capital firms and founders, it is very important that the company can raise financial resources from third parties through financial instruments such as silent partnerships, leasing, and bank loans, which do not dilute the equity stakes of the various shareholders within the company. This argument is of particular

824

See chapter 3.5.2.

276

Comparative Case Study Analysis

relevance for the case of GPC Biotech. MPM Capital and TVM already receive together 48% of the shares of the company in turn for providing the company with €3m. If the founders rose the additional €5m from tbg and Bayern Kapital also by selling common stock, they would have to sell all their shares of their company at the first financing round. In turn, this implies that the founders’ incentive to work hard for their company would be largely reduced. A further advantage of raising financial resources through non-dilutive financial instruments such as bank loans, leasing, or through public subsidized financial instruments such as the silent partnerships of tbg and Bayern Kapital is that the associated costs of capital are relatively low. Therefore, these instruments make it possible for entrepreneurs and venture capitalists to benefit from a potential leverage effect. A further argument for venture capital firms to help their portfolio companies raise financial resources from third parties is that they regularly report the performance of their investments to their investors.825 According to the conservative value and fair market value method of the EVCA Valuation Guidelines, an investment of a venture capital firm in a portfolio company should be valued on the transaction price of “a new financing round or partial sale, involving a material investment by a third party at arm’s length”.826 This implies that a venture capital firm can only report a value increase of its portfolio company to its investors when third parties invest into the portfolio company with financial instruments that require a valuation of the company such as common or preferred shares and convertible debt. In this regard, a new investment with silent partnerships or bank loans in a portfolio company does not allow the venture capital firm to report a higher value to its investors. Gi Ventures, MPM Capital, and TVM are organized as independent partnerships.827 They continually have to raise new funds since they are required to liquidate the fund at the end of its term and distribute the returns to their investors. This gives them an

825

See chapter 3.4.3.3.

826

EVCA (2001), p. 22. According to ACHLEITNER ET AL., 62.7% of investment companies of the German-speaking market state that they adhere to these guidelines. In particular, investment companies that manage medium- and large-sized funds follow these rules. See Achleitner et al. (2004), pp. 22 et seq. However, it has to be noted that their study does not differentiate between venture capital and private equity firms.

827

Chapter 3.4.1 discusses the partnership structure and the corporate holding structure, the two generic legal structures of venture capital firms.

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277

incentive to let third parties contribute to e.g. a second financing round of their portfolio companies since this allows them to report a value increase to their investors. As Gi Ventures and MPM Capital are relatively newly founded and consequently have not yet established a track record showing their investment selection and investment development expertise, this might be a further explanation for their efforts to provide their portfolio companies indirectly with additional financial resources. This logic does not apply to BayBG, which is organized according to a corporate holding structure and usually can reinvest the proceeds from its investments.828 All venture capital firms facilitate the acquisition of managerial resources. They use their social network to find suitable candidates for the executive board and the supervisory board of their portfolio companies. In the case of GPC Biotech, these individuals bring along an excellent reputation and an extensive social network within the biotech industry, which they contribute to the resource base of GPC Biotech. Thus, MPM Capital and TVM also indirectly provide GPC Biotech with additional reputational and social resources. Two examples show that the support from the analyzed venture capital firms is highly dependent on the needs and the particularities of the situation of their portfolio companies: • In a time of a severe shortage of software developers in the Munich area, BayBG supports varetis to find additional software developers by addressing its network. MPM Capital/TVM and Gi Ventures do not provide any contacts to non-managerial staff, but it has to be noted that their portfolio companies do not come into a comparable situation as varetis. • As Bullith Batteries is confronted with the unique opportunity to buy the production plants and machinery of the insolvent companies Solid Energy and EMTEC Magnetics, Gi Ventures takes over the lead in the purchasing negotiations and thereby indirectly facilitates the acquisition of physical resources. MPM Capital/TVM and BayBG do not support their portfolio companies in securing physical resources. However, it has to be noted that their portfolio com-

828

Nevertheless, the management of BayBG has to report to its the owners of BayBG and faces some pressure to show a good interim performance as well since otherwise it will eventually be dismissed by BayBG’s owners.

278

Comparative Case Study Analysis

panies do not have an opportunity comparable to the acquisition of Solid Energy’s production plants.

9.2.3

Dynamic Aspects of Resource Provision

Chapter 3.4.4 defines the investment process as a sequence of consecutive and independent phases of the venture capital firms’ activities. According to this scheme, the actual influence of venture capital firms is expected to begin with the signing of the investment agreement. However, the cases of Bullith Batteries and GPC Biotech show that venture capitalists already influence potential portfolio companies during the investment due diligence and the investment structuring phase, i.e. even before an investment agreement has been signed and a financial interest in such a company has been established. In the case of GPC Biotech, TVM provides the founding team with some resources before the investment agreement is signed, since Helmut Schühsler establishes the contact to Mirko Scherer and supports the foundation process of the company by discussing business model and technology transfer issues as well as the financing strategy. An important pre-contractual influence of Gi Ventures on Bullith Batteries is the induced change of the management team’s mindset towards a more commercial orientation. TVM and Gi Ventures stress the importance of building a well-rounded management team by having a person with business background joining the management team before any financial resources are committed. In the case study on varetis AG, there is no significant pre-contractual influence of BayBG found. However, this might be due to the more developed state of varetis since its management team has already proven itself and varetis has been profitable for several years at the time of BayBG’s first investment. All case studies reveal that the examined venture capital firms do not influence their portfolio companies over time with the same intensity. In the case of GPC Biotech, there is a strong influence in the first year after the first financing round, especially from MPM Capital since Michael Steinmetz assumes the position of an interim CEO thereby getting deeply involved in the operational management of the company. In the beginning, TVM also assumes a more hands-on role by helping to establish management systems and organizational structures. After the management team is completed with Bernd Seizinger joining the company as permanent CEO, the involvement of both

Comparative Case Study Analysis

279

venture capital firms, and mainly that of MPM Capital, is significantly reduced. Over time, the management team gains the trust of the venture capitalists and consequently the venture capitalists pursue a relatively hands-off approach towards their investment in GPC Biotech. This becomes evident in the subsequent important events such as the second financing round and the IPO, where both venture capital firms remain largely passive and only give advice if the management team asks them to do. In the case of Bullith Batteries, Gi Ventures is initially deeply involved in the operational management of the company by taking over the whole business planning. After the company established several organizational routines and hired Christian Friedemann as second Managing Director, the involvement of Gi Ventures in routine operations is greatly reduced. However, Gi Ventures continues to play a leading role in negotiations with third parties such as prospective investors for the second financing round as well as Solid Energy and EMTEC Magnetics. Negotiations with potential customers remain solely the task of the company’s management. In the case of BayBG’s investment in varetis, the dynamics of BayBG’s resource provision follow a different pattern. During the time, when BayBG is invested only with an atypical silent partnership, its support activities mainly center on monthly meetings with the varetis management. This changes after the second financing round, when BayBG acquires an equity stake in the company and assumes a seat on varetis’ supervisory board. BayBG’s support peaks during the time of varetis’ IPO, i.e. shortly before its exit. After the IPO of GPC Biotech and varetis, the role of the venture capital firms is reduced to that of a passive financial investor. The venture capitalists Michael Steinmetz, Helmut Schühsler, and Wolf Rüdiger Willig keep their personal appointments to the supervisory boards of their portfolio companies and thereby continue to support the companies for quite some time after the IPO.

9.2.4

Venture Capitalists’ Influence on Competitive Advantage

The comprehensive resource-based view discussed in chapter 2.2.3 argues that for companies to achieve a sustained competitive advantage they must have resources that fulfill the following characteristics: • Valuable,

280

Comparative Case Study Analysis

• rare, • durable, • imperfectly transferable, • imperfectly imitable, • imperfectly substitutable. Intellectual property rights are prime examples for resources that fulfill the above requirements. Gi Ventures plays a crucial role in the negotiations for the full license of the Fraunhofer technology. TVM also helps the founding team of GPC Biotech to acquire the licenses for several technologies from the Max-Planck-Institute for Molecular Genetics in Berlin. In terms of managerial resources, Gi Ventures provides with Jürgen Diegruber someone, who has experienced on its own what it requires to build a company from scratch several times. MPM Capital and TVM play an important role in providing GPC Biotech with managerial resources that largely fulfill the above requirements. There are very few venture capitalists active in Germany that have such a broad experience in terms of the biotech industry such as Michael Steinmetz and Ansbert Gädicke.829 Moreover, there is probably no other venture capitalist in Germany that can show such a successful track record in investing in biotech start-ups as Helmut Schühsler.830 BayBG also provides with Wolf Rüdiger Willig a venture capitalist, who has been responsible for numerous investments in small- and medium-sized companies from all industries and consequently brings in a very broad management expertise. BayBG helps to find software developers, i.e. personnel resources, for varetis during the peak of the worldwide IT boom in the years 1999 and 2000831 thereby enabling the company to stay on track with its software development projects. Gi Ventures helps Bullith Batteries to realize the unique opportunity to acquire the production facilities

829

See Christopher (2002).

830

See Gilmore (2004).

831

This even induces the Bavarian government to allow the temporary employment of skilled foreigners in the area of computing and information technology, which requires changes in the immigration law and leads to the introduction of the so-called “Blue Card”.

Comparative Case Study Analysis

281

of Solid Energy, i.e. physical resources, which promise a true competitive advantage for Bullith Batteries. Due to the long innovation cycles and large capital requirements in the biotech industry, the reputation of biotech start-ups plays a crucial role in their development. By transferring the excellent reputation of TVM and MPM Capital to GPC Biotech, the venture capital firms help the company to gain the trust of third parties more easily. In addition, by providing GPC Biotech with the contacts to two highly respected industry experts that eventually join the supervisory board, the venture capital firms help GPC Biotech to further increase its reputation and certify the company to third parties thereby facilitating to conclude important collaboration agreements with large pharmaceutical companies. The comprehensive resource-based view claims that few resources are productive on their own and rather need to be bundled to competencies. Some of them will be core competencies, which ultimately allow achieving a true competitive advantage. The analyzed venture capital firms not only provide their portfolio companies with important resource contributions for the development of their core competencies, but also support in the creation of non-core competencies that are required to harvest successfully the returns from the core competencies. A prime example for the latter is the provision of organizational resources such helping in building internal accounting and reporting systems, key account management systems, and incentive schemes that are required for a smooth operation of the portfolio companies.

9.2.5

Portfolio Companies’ Loss of Real Autonomy

All analyzed venture capital firms get involved in their portfolio companies at the normative, strategic, and operational management level.832 Consequently, all portfolio companies lose some real autonomy. On the normative management level, the venture capital firms to some extent influence the vision, the mission, and the values of their portfolio companies. This becomes most apparent with BayBG providing its financing only for varetis’ new product IDIS, for which a promising market can be expected. Thereby, BayBG sets the focus of varetis

832

See chapter 5.4.2.

282

Comparative Case Study Analysis

on marketing IDIS and the other products of varetis lose importance over time. MPM Capital and TVM require the GPC Biotech management to “think big and global” and to position the company accordingly. After two and a half years, the company already manages to accomplish a transatlantic merger, which also reflects the venture capital firms stance towards building a global business. Furthermore, Gi Ventures and MPM Capital/TVM induce the founders to think more in commercial terms and less in technological-oriented terms. All venture capital firms exert a strong influence onto their portfolio companies’ corporate governance structure. One of their major contributions is to determine who manages the portfolio company. This regularly implies that the venture capitalists get deeply involved in the search and selection for management candidates. In the case of GPC Biotech, MPM Capital even takes over the CEO position for the first year until the right permanent CEO is found. The venture capital firms also play an important role in determining who controls the management of the portfolio companies. This is mainly done via the investment agreements that specify in detail what the rights and duties of all parties are. The supervisory board representation rights in conjunction with the veto rights play the key role in allowing the venture capital firms to control the management of their portfolio companies. None of the venture capital firms gets involved into shaping the corporate culture of their portfolio companies. The only exception is MPM Capital that affects the corporate culture of GPC Biotech through Michael Steinmetz’ leadership in the first year. On the strategic management level, the venture capitalists consistently exert a strong influence on their portfolio companies across the three case studies. MPM Capital shapes the mid-term research agenda of GPC Biotech during the time of Michael Steinmetz being the interim CEO. In terms of the financing strategy, MPM Capital/TVM get less involved whereas Gi Ventures and BayBG determine the financing strategy of their portfolio companies to a large degree. Gi Ventures plays an important role in continually discussing the sales and marketing strategy with Bullith Batteries. The venture capitalists all help their portfolio companies to build organizational structures and management systems that are required for a smooth operation. On the operational management level, the involvement varies greatly between the analyzed venture capital firms. MPM Capital and Gi Ventures are strongly involved in operational issues at the beginning of their investment in the portfolio companies.

Comparative Case Study Analysis

283

Whereas MPM Capital’s operational involvement recedes with Michael Steinmetz handing over the CEO position to Bernd Seizinger, the operational involvement of Gi Ventures at the time of the second financing round is still very high since Jürgen Diegruber still leads every important negotiation for Bullith Batteries. BayBG’s operational involvement has been relatively hands-off between the first and the second financing round, but peaks during the IPO of varetis, which is contrary to the involvement of MPM Capital/TVM, who get barely involved during the IPO of GPC Biotech. As the above analysis has shown, the three portfolio companies lose a significant amount of real autonomy through their venture capitalists’ involvement. However, in most cases this involvement comes along with venture capitalists providing resources that help to build the company and improve its prospects. A clear-cut distinction between the monitoring and the resource provision role is therefore often not possible. This supports the argument of HELLMANN/PURI, who state that venture capital firms “may gather information not merely about firms, but also for firms.”833 The analyzed relations between the portfolio company managers and the venture capitalists are characterized by personal and mutual trust. Without the trust of the portfolio companies’ managers, Michael Steinmetz could not effectively assume the position as interim CEO and Jürgen Diegruber as well as Wolf Rüdiger Willig would not contribute their experience by leading the negotiations with financial investors on behalf of their portfolio companies. In this regard, the case studies provide strong support for the argument of SHEPHERD/ZACHARAKIS, who contend that trust plays a very important role for an effective cooperation between entrepreneurs and venture capitalists.834 The case studies show that making decisions against the declared intention of the management team is not what the venture capitalists are aiming for. To preserve the trust between the parties, the venture capitalists usually do not tell the managers what to do or what not to do but rather try to convince them that in their opinion there is a more clever way to achieve a goal. This could be a possible explanation for the fact that among all three case studies there is only one event, MPM Capital and TVM declining the acquisition of a US west coast-based biotech company, that actually shows that the

833

Hellmann/Puri (2002), p. 195.

834

See Shepherd/Zacharakis (2001).

284

Comparative Case Study Analysis

analyzed venture capital firms do not consent to a proposal of the management team of their portfolio companies.

Conclusion and Further Implications

10

Conclusion and Further Implications

10.1

Conclusion

285

High potential companies are expected to be one of the main drivers of innovation and economic growth. Venture capitalists are traditionally assumed to play a key role in their development.835 How these companies are influenced by venture capitalists’ provision of smart money is therefore of high interest to business people and policy makers.836 This concluding chapter presents a number of insights that can be learnt from the preceding analysis. The first aim of this analysis has been to provide a theoretical framework for the role of venture capitalists as smart money investors. The resource-based view has been suggested as a useful concept to shed light on the particular challenges of high potential companies on their way to building a thriving and growing company. In order to be able to apply the theoretical construct of the resource-based view in the present context, a categorization of resources has been elaborated that fits particularly well to high potential companies. Existing literature provides evidence that these companies in general only dispose of a small resource base and that they are characterized by pronounced resource needs in all relevant resource categories. Nevertheless, the existing resource base potentially allows extracting a high economic value. Starting from this assumption, the role of venture capitalists is to provide high potential companies with smart money, i.e. financial and non-financial resources that help to create core and non-core competencies. Ultimately, this bundle of core and non-core competencies allows high potential companies to achieve a sustained competitive advantage. The role of the smart money provided by venture capitalists is thus to help high potential companies to complement existing resources and competences in order to extract their full economic value. An examination of the existing literature from a resource-based perspective has demonstrated that venture capitalists can be expected to contribute finan-

835

See Achleitner (2001); Bygrave/Timmons (1992); Sahlman (1990).

836

The high interest of policy makers in this area manifests itself with the “High-tech Masterplan” of the German Federal Government. A new government-backed venture capital fund will be initiated, which will invest in early- and expansion-stage high potential companies. The fund’s volume amounts to impressive €500m. Since all investments will have to be syndicated with independent venture capital funds, the government hopes to raise in total €1.7bn for these companies. See Bundesministerium für Wirtschaft und Arbeit/Bundesministerium für Bildung und Forschung (2004), p. 7.

286

Conclusion and Further Implications

cial, managerial, organizational, reputational, and social resources to their portfolio companies’ resource base. Along with the provision of smart money comes the involvement of venture capitalists with the management of their portfolio companies. In this context, this analysis has introduced the concepts of formal autonomy and real autonomy. Whereas formal autonomy has been defined as the legal ability of the portfolio company’s managers to make decisions independent of the venture capitalists, real autonomy has been defined as their factual ability to take decisions independently of venture capitalists. A review of the literature has shown that venture capitalists restrain the portfolio company’s managers formal autonomy with a number of contractual elements. It has been demonstrated that venture capitalists mainly require these additional investor rights to protect the value of their investment and to mitigate several deal-specific risks that arise with the financing relationship between the venture capital firm and the portfolio company. In order to assess the extent of the venture capitalists’ involvement into the management of their portfolio companies, the present analysis has suggested applying the St. Gallen Management Concept. This allows judging to what extent the portfolio company’s managers lose real autonomy because of the venture capitalists’ involvement. The examination of the existing venture capital literature from this perspective has indicated that venture capitalists potentially get involved mainly on a normative and strategic, and less on an operational management level. To gain a detailed insight into the influence of venture capitalists on their portfolio companies, the author has conducted three case studies on German high potential companies. The second aim of this analysis has been to provide an answer to the question: What do high potential companies get from their venture capitalists? For the three analyzed cases, the findings from the existing literature that venture capitalists provide financial, managerial, organizational, reputational, and social resources have been confirmed. However, this analysis has shown that it is important to differentiate between a direct and an indirect resource provision. Whereas direct resource provision means that portfolio companies receive resources directly from their venture capitalists, indirect resource provision means that the portfolio companies acquire resources from third parties with the help of venture capitalists. Examining the indirect resource provision in the cases yields the interesting result that venture capitalists occasionally also provide technological, personnel, and physical resources.

Conclusion and Further Implications

287

The third aim of this analysis has been to provide an answer to the question: Do high potential companies get what they need from their venture capitalists? For the three analyzed cases, the answer is: Partly yes, partly no. Concerning the coverage of their financial and managerial resource needs, all analyzed portfolio companies received very important support. In other resource categories, there has been significant variation between the abilities of the analyzed venture capital firms to provide their portfolio companies with the relevant resources. An example for this is the provision of social resources, which has been demonstrated to be strongly dependent on the professional background of the analyzed venture capitalists. The three cases show that smart money from venture capitalists is an important but not the exclusive source of resources for high potential companies. In several instances, the analyzed venture capitalists make the first step for their portfolio companies but then the management team has to go the rest of the way on its own. The analyzed venture capitalists deploy their resources carefully. In most cases, they only provide as much resources as are obviously needed by their portfolio companies. Tasks that the entrepreneurs can do on their own are usually also left to be done by them. The fourth aim of this analysis has been to provide an answer to the question: To what extent do entrepreneurs lose their autonomy due to the involvement of venture capitalists? It has been shown that the management teams of the three case studies lose their formal autonomy to a large extent. Even the least strict among the analyzed investment agreements, which only formalizes a financing relationship based on a silent partnership – a financial instrument that generally allows for less influence of the investor on the investee than common or preferred stocks – provides the venture capital firm with several rights that potentially allow the venture capital firm to block every important action of the portfolio company. For all three cases an interesting observation can be made that during the deal negotiation and deal structuring, a lot of additional investor rights for venture capitalists are included in the investment agreement but no “entrepreneur” rights. Even though entrepreneurs are paying a premium837 when “purchasing” smart money by accepting a lower company valuation, they do not receive any additional rights that would for in-

837

See Achleitner et al. (2004); Hsu (2004).

288

Conclusion and Further Implications

stance define which kind of support the entrepreneurs could expect to receive from their venture capitalists. One reason for this could be that the venture capitalists do have a stronger bargaining position since the entrepreneurs are not experienced in dealing with venture capitalists. A second reason could be that it might be hard to write contracts that specify exactly what the venture capitalists are to deliver since the cases have shown that many of the venture capitalists’ provided support activities could not have been planned. The examined entrepreneurs lose their real autonomy to a significant degree. All venture capital firms get involved in the normative, strategic, and operational management of their portfolio companies. However, the degree of this involvement varies between the cases and changes over time. The three analyzed cases show that it is important to differentiate between formal and real autonomy. There is only one incident among the three cases in which the venture capitalists have actually used their veto rights to stop the entrepreneurs from pursuing a certain strategy. Apart from that unique instance, the venture capitalists and the entrepreneurs have agreed beforehand on how to proceed in a certain situation. Therefore, willingness to cooperate and mutual trust are found to be important prerequisites for a successful joint effort to realize the high potential of the venture capitalists’ portfolio companies. Reflecting again on the transition from the investment structuring phase to the investment development phase, the mutual relationship between the entrepreneurs and the venture capitalists in the analyzed cases seems to change. To speak in a metaphor, the behavior of the parties during the investment structuring phase conveys the impression that both parties sit in their own boats, whereas this changes in the investment development phase where one gets the impression that both parties sit in the same boat. Harming the interests of the other party in such a situation is likely to create a suboptimal result for both parties. This metaphor might explain why the analyzed venture capitalists put quite a lot of effort in convincing the entrepreneurs of doing something instead of simply forcing them to do it on the basis of their contractual rights.

10.2

Implications for Researchers and Practitioners

This analysis allows setting forth several implications for researchers. The resourcebased perspective as well as the autonomy perspective on the influence of venture capitalists on high potential companies have proven to be capable of producing results

Conclusion and Further Implications

289

that are worth to be further pursued by the research community. In this regard, a number of extensions of the research design are conceivable. It would be highly interesting to compare the influence of different investors over the “investor lifecycle” of a high potential company. As ARTLEY ET AL. point out, venture capitalists only accompany a high potential company for a limited time implying that the equity investors of a high potential company change over time.838 In this regard, one could examine and compare the influence of equity investors through resource provision and on the entrepreneurs’ autonomy across different investor types such as family and friends, business angels, research organizations, government institutions, and venture capitalists. This research design takes the perspective of the investors. However, the analysis of why companies in different stages of their development choose different investors seems also to be a promising field of research. The focus of analysis in this area would be to compare the resource needs of early-stage companies with later-stage companies and to compare the resource provision activities of venture capital firms with those of private equity firms. Furthermore, the extent to what these investors get involved in the management of their portfolio companies merits close attention. In addition, the influence of debt and mezzanine investors could also be analyzed according to the same scheme. ENGEL discusses “smart debt” as a conceivable financial innovation, but draws the conclusion that mainly practical circumstances hinder its establishment.839 WAHL adds to this discussion that private debt features similarities to the concept of smart debt.840 The case study by FINGERLE/SCHOELLER/WAHL demonstrates that private debt investors could get deeply involved in the financial and organizational restructuring efforts of firms.841 The analysis could lead to a more general theory of the influence of investors on firms that enable companies and their managers to select the financial investor that is most suitable to their current situation. Another interesting research direction is the analysis of the effect that different business models of venture capital firms have on the venture capitalists’ influence on high 838

See Artley et al. (2003), p. 103.

839

See Engel (2003), pp. 197 et seq.

840

See Wahl (2004), p. 289, footnote 909.

841

For a definition of the concepts of financial and organizational restructuring, see Achleitner/Wahl (2003), p. 10; Bowman/Singh (1993), p. 16.

290

Conclusion and Further Implications

potential companies. In this respect, a comparison between independent venture capital firms and dependent capital firms such as corporate venture capital firms and fully government-backed venture capital firms. A first step in this direction has already been taken by including BayBG as a government-friendly venture capital firm in the present dataset. It has been shown that there are some differences between BayBG on the one hand and MPM Capital/TVM and Gi Ventures as independent venture capital firms on the other hand. The present case study research is subject to a survivor bias and the findings are likely to exhibit a bias since the cases only present deals that have been successful. Therefore, a further research direction is the analysis of the influence of venture capitalists on portfolio companies that have ultimately been unsuccessful. It will be particularly interesting to compare the use of contractual rights by venture capitalists and their involvement in the management of their portfolio companies in circumstances where the interests between entrepreneurs and venture capitalists diverge. In view of the limitations of the case study research approach in terms of the ability to generalize the research findings, the adoption of other empirical methods of research is required in future research. A more quantitative research design will clearly reduce the contextual richness and the detail level of the research findings, but in return allows drawing conclusions that will be more generalizable than the case study research findings. In addition to the implication for researchers, the present analysis allows outlining several implications for practitioners. Entrepreneurs should have a clear perception of what their resource needs are when seeking external financing. Only by knowing what they actually need, entrepreneurs can make an informed decision for a certain investor. The research findings of this study allow entrepreneurs to better understand what smart money can do for them and what it likely cannot do. Entrepreneurs should not only let venture capitalists perform an investment due diligence but they should engage themselves in a detailed “investor due diligence”. A promising way to do this would be to enter into talks with other entrepreneurs that already have some experience in working together with the respective venture capital firm and can tell what kind of support they have received. Furthermore, these peers often have a much better insight into the industry and the relevant venture capital firms and might thereby be able to tell which venture capital firm respectively which venture capitalists should be addressed at all.

Conclusion and Further Implications

291

Entrepreneurs should have a clear understanding of what the financial and nonfinancial consequences of an involvement of venture capitalists are for the management of their company. Such an expectations management is likely to improve the ensuing cooperation between both parties since entrepreneurs then are consciously willing to accept the interference of venture capitalists. The issue of what influence should be granted to external investors should have been clarified among the founding team before any external investor is addressed since this also affects the choice of the most suitable investor. Venture capitalists themselves should assess their resource base in order to gain a clear understanding of their strengths and weaknesses. One possibility to engage in such an assessment would be to analyze their previously managed deals and elucidate to which extent they have been capable of providing adequate resources. This will help venture capitalists to more clearly define an investment strategy that promises to make the best use of their strengths. Furthermore, such an assessment allows them to identify their own weaknesses in order to identify areas in which they still need to improve their customer value proposition towards their portfolio companies. In conclusion, by illuminating several key aspects of the relationship between high potential companies and venture capitalists, the present analysis contributes to a deeper and wider knowledge of how venture capitalists influence high potential companies. The case studies play a key role in conveying a comprehensive picture of the activities of venture capitalists and thereby do not only address the scientific community but also every current and prospective entrepreneur. Based on an improved understanding of the relationship between high potential companies and venture capitalists both parties can make an effort towards further professionalizing their activities. In view of the crucial role of high potential companies in creating employment and prosperity, this professionalization can be expected to have a significant positive impact on the performance of a country’s economy.

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Entrepreneurial and Financial Studies Herausgegeben von: Prof. Dr. Dr. Ann-Kristin Achleitner, Prof. Dr. Christoph Kaserer Band

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Ronald Engel: Seed-Finanzierung wachstumsorientierter Unternehmensgründungen, 2003. Ann-Kristin Achleitner, Simon Wahl: Corporate Restructuring in Deutschland, 2003. Tobias Popović: Customer Capital – Die Wertschöpfung von E-Commerce-Unternehmen und ihre zweckadäquate Bewertung aus Perspektive des Aktienresearch, 2004. Simon J. Wahl: Private Debt – Private Fremdkapital- und MezzanineKapital-Platzierungen bei institutionellen Investoren, 2004. Moritz Hagenmüller: Investor Relations von Private-Equity-Partnerships, 2004. Eva Nathusius: Syndizierte Venture-Capital-Finanzierung, 2005. Christian H. Fingerle: Smart Money ─ Influence of Venture Capitalists on High Potential Companies, 2005.