Invest locally, exit globally

At last, it's dawn. After three years of misery caused by one of the most severe downturns in the history of financial markets, the recovery that technology companies, entrepreneurs, venture capitalists and investors have all been longing for seems finally underway.

Anecdotal evidence is plentiful. Visitors to California report that over the past quarter, positive sentiment has been sweeping across Silicon Valley, the centre of the technology universe. Corporate leaders may be careful not to show too much public enthusiasm for the turnaround at this point ? Cisco's CEO John Chambers made headlines recently after refusing to call the bottom of the market at a high-powered industry gathering in Geneva – but there is a consensus now among most commentators that the outlook for the technology sector is set to get better, not worse.

Capital expenditure is showing signs of a recovery, while liquidity is staging a return to stock markets. Around the world, the prospect of a multi-billion dollar IPO of ?awesome? internet search engine Google (Financial Times, 24 October 2003) has sent journalists spinning with enthusiasm as if the dotcom crash had never happened. Google's backers, including Silicon Valley venture capital heavyweights Kleiner Perkins and Sequoia Capital, will be chuckling with delight.

Even in the UK, institutions have started to look at domestic growth investment propositions again: in October, Edinburgh-based Wolfson Microelectronics became the first technology company in 18 months to successfully float on the London Stock Exchange. Later that month IP2IPO, an Oxford-based seed investment group, listed on London's Alternative Investment Market (AIM), achieving an initial market capitalisation of £110m ? no mean feat for a company that describes its own business model of commercialising the intellectual property of UK universities as ?unproven?.

Private Equity Performance Benchmarks – Returns Net to Investors (31 Dec 2002)

5 Year 10 year Inception vs US 10 year
Over/ Over/ Over/
(Under) (Under) Euro 1st (Under)
Europe US Perform Europe US Perform Quartile US Perform
Venture Capital
Early 1.0 51.0 (50.0) 5.5 34.8 (29.3) 8.0 34.8 (26.8)
Development 8.0 15.0 (7.0) 12.9 22.8 (9.9) 10.0 22.8 (12.8)
Balanced 17.5 20.2 (2.7) 16.1 21.0 (4.9) 12.8 21.0 (8.2)
All Venture Capital 7.9 28.4 (20.5) 12.1 26.4 (14.3) 9.5 26.4 (16.9)
Buyouts 12.0 8.3 3.7 13.5 14.9 (1.4) 17.8 14.9 2.9
Source: EVCA / Thomson Venture Economics

Assets and liabilities
Europe's struggle to produce US-style returns on tech investment is indeed puzzling because many of the necessary ingredients are actually in place. ?There is world-class technology in Europe, we're well positioned to compete internationally,? says Jean-Bernard Schmidt, managing partner of Paris-based Sofinnova Partners and incumbent chairman of the European Private Equity & Venture Capital Association (EVCA). Even the doomsayers can't seem to disagree with Schmidt's view.

Intellectual muscle is in strong supply, too: in 2002, the continent accounted for over 50 per cent of the world's holders of doctoral degrees in natural science, mathematics, engineering and computer science, against 23 per cent in the US and 21 per cent in Asia, according to the National Science Foundation in the US.

Neither do European venture capitalists complain much about a lack of capable entrepreneurs: most general partners now accept that there is a decent stock of individuals who have demonstrated a willingness to commercialise ideas. Co-join these factors with the fact that dealflow across Europe is described as strong and current valuations are seen as both realistic and attractive and there seems good cause for optimism. ?The land is fertile?, declared Charles Irving of UK early stage investors Pond Venture Partners at EVCA's recent technology conference in Amsterdam. (Pond also has an office in San Jose, California.)

So what has held Europe's venture capital community back from fulfilling a potential that most observers agree is definitely there? Several factors play a role. Practitioners with experience of investing on either side of the Atlantic say that while there is no shortage of European technology entrepreneurs, good managers of growth companies who are willing to take the inevitable risk are still hard to find. Also, Europe's continued political and cultural fragmentation, regardless of the European Union, the trade agreements and the single currency, is seen as a hindrance to rolling out new technologies across borders, and hence to maximising their commercial exploitation.

There are also concerns that European VCs as well as their investors, having lost their nerve during the market downturn, have shifted from an early to a later stage investment strategy in an attempt to reduce risk. The result, critics argue, is the opening up of a funding gap between seed and later stage companies. As a result, projects worth funding are not being funded. This ?underhang? of capital ? in stark contrast to the overhang regularly referenced in connection with the amount of buyout capital looking to be invested in Europe – has the potential to do lasting damage to Europe's growth company pipeline, and to undermine the venture industry's prospects going forward. (It should be noted that US venture capitalists also acknowledge that there has been a partial retreat from the early stage end of the market.)

Another perceived weakness concerns European companies and their appetite for IT. According to a recent study from the University of Groningen in the Netherlands, European service sector companies in particular are not investing in information technology to boost efficiency as effectively as their US counterparts. On the macro level, this is inhibiting Europe's economic growth. In the context of venture capital, it means portfolio companies have a less extensive, and it seems less receptive, prospective customer base to sell to.

Also relevant in this regard are the respective roles played by public sector institutions on either side of the Atlantic. In the US, government agencies are an important constituency for venture-backed early companies to market their products to. By contrast, venture capitalists in the UK for example frequently complain that public sector institutions are expressly prohibited from procuring products and services from small businesses.

If this relative shallowness of domestic markets is one reason why venture capitalists are raising their heads above the European parapet, the absence of a viable public market exit route is certainly another. Recent technologydriven IPO activity in London notwithstanding, Europe doesn't have an equivalent of NASDAQ, despite several attempts to create it. Technology investors therefore are forced to look for liquidity elsewhere. Ever since the demise of EASDAQ and subsequently the Neuer Markt, whose closure in 2002 marked a dramatic end to the dotcom driven equity boom in Germany and beyond, the trade sale has emerged as practically the sole remaining exit mechanism for venture-backed companies in Europe.

Some practitioners believe that Europe's lack of a liquid public technology market is only damaging to a degree, provided strategic acquirers of technology companies are sufficiently active to allow VCs to sell their investments. ?A European NASDAQ is desirable, though not a necessity,? insists Michael Elias, managing partner of Kennet Venture Partners in London. ?M&A is the key exit mechanism for venture-backed companies in Europe, although public markets do have significance as providers of acquisition currency to potential strategic buyers.?

However, even in a vibrant M&A market, having the alternative of floating a venture-backed business can make a crucial difference: knowing that an IPO is indeed a credible alternative route to liquidity for a target company, a trade buyer is likely to approach negotiations with a greater sense of urgency and a propensity to ultimately pay a higher price.

Subscribers to the latter view, working from the premise that Europe will not generate a credible IPO platform to rival NASDAQ any time soon, argue that the main challenge facing Europe's venture capital community is its ability to not only build portfolio companies that can compete globally, but also to position them for a public market exit in the United States. Mastering this challenge has allowed Israel's venture capital industry to create several billion-dollar technology leaders and to achieve over 100 IPOs of Israeli companies on NASDAQ. ?The closure of the Neuer Markt was in fact a good thing,? told Gilead Halevy, managing director of Israel-based Giza Venture Capital, at a recent gathering of VCs and technology entrepreneurs in London. ?It has made people realise that there is no IPO alternative to NASDAQ.? To qualify, Halevy went on, venture capitalists and their portfolio companies had to aim for global growth.

But even if a US stock market exit is not deemed essential for a specific business plan to succeed, the ability to fully leverage a company's technology on a global scale so as to position it among the dominant players in its field is obviously important. Key to any successful technology venture is to establish a presence in whichever market the technology is first adopted, be it Europe, North America or Asia. (Historically, this market has typically been the US, providing domestic VCs with the advantage of reduced expansion risk.) The question of how a venture capital business ought to be organised in order to best execute an investment strategy that builds on this premise is at the centre of much of the introspection that takes place in the venture industry at present.

Finding an answer ? there is more than one – is not just essential for European practitioners: it matters to venture capitalists everywhere. It is especially urgent in Europe though, where many other participants (including investors such as George Anson quoted earlier) worry that the VC community are struggling to re-engage with the market. One charge frequently levelled against the European venture industry in particular is that it has funded too many ?me-too? companies – technology businesses that entered a market locally at a time when others elsewhere had already successfully established themselves with a similar product or service. The latecomers often proved incapable of forging a sustainable business compared to these first movers and faded ? possibly only after A, B and C rounds of financing – from view.

Moving closer
Strategies intended to avoid similar disappointments going forward are beginning to emerge though. For example, Europe is seeing a trend towards greater collaboration among venture funds. Syndication occurs partly in response to the realisation that, as portfolio companies require more time to come to market, some European venture funds lack the financial depth to see a project through to fruition on their own. It is also an attempt to leverage others' technical know-how, regional expertise, industry contacts and other non-financial benefits in order to add more value to an investment faster.

Unsurprisingly, venture capitalists say they are devoting more time to finding the appropriate partners to join a syndicate than they did in the past: it is now seen as critical to ensure that a co-investor is likely to be around and willing to stay in a deal next time a portfolio company requires funding. ?European VCs are moving closer [together], and there is much more focus on choosing the right co-investors,? says Peter Baines of Advent Venture Partners in London.

Investment partners are also selected based on what other than capital they can bring to the table. Any VC capable of helping a European company enter major technology markets elsewhere, and the US in particular, is an obvious candidate for joining an investor group.

In addition to participating in syndicates that can help push a technology into international markets, venture houses are also undertaking their own geographic expansion. A number of the larger European groups such as Atlas Venture, Partech International, TVM and Schroder Ventures Life Sciences already have offices on more than one continent. So do US venture houses including General Atlantic Partners, Benchmark Capital and Accel Partners. Other firms, such as Paris-based Sofinnova Partners, operate strategic partnerships with US-based GPs and vice versa.

Running an international operation is costly and may not be viable for some of the smaller European country-focused or regional venture funds. These groups will continue to tap local deal flow that they can then take to the international stage with the help of partners. Whether this is a sustainable business model depends in part on the specific skills and networks that these groups can utilise.

Should LPs bother?
Given the dominance of the US technology sector and its protagonists, the US is set to remain the pacemaker of the world's technology markets for some time. Limited partners investing in venture capital funds have staked out their priorities accordingly. As a result, the leading US venture groups are in demand: a host of brand name GPs are expected to hit the fundraising trail next year (one placement agent expects 25 key firms will be on the road in 2004), confident they will be well received. Some of these funds are already pre-marketing and are astutely nurturing an aura of potential scarcity around their upcoming fund.

European venture groups in need of fresh capital are bracing themselves for a more difficult ride. They will have to demonstrate to the buyside that they are equipped and willing to compete in an increasingly global business, and capable of growing companies that can successfully export their technologies into global markets. Europe's technological wealth and the strategic advantages that derive from its geographic position between the US and Asia are important factors here. What is needed now, in the words of a London-based technology banker, is a generation of European venture capitalists and entrepreneurs ?willing to go for it.?

In doing so, Europe's frontrunners will need to outline exit strategies that offer the prospect of internationally competitive returns on investment. Adopting a two-stage venture capital process of investing locally and exiting globally may be inevitable. Whether this means that Europe's technology sector will ultimately be successful only if it is quoted on NASDAQ remains to be seen. But the industry's soul searching in Europe is certainly not over yet.