Financing Hightech Startups

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Financing Hightech Startups

• Georg LichtCentre for European Economic Research
  (ZEW)Industrial Economics and International
  Management
• Mannheim

DIMETIC PhD WorkshopJuly 8, 2009Pécs, Hungary
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Outline

• Some examples of startups in high tech
• How are entrepreneurial ventures financed?
• Business Angels
• Venture Capital
• Banks

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Miltenyi
Biotech firm in Bergisch Gladbach (mid-sized town
close to Cologne) Leading firm in magnetic cell
separation (MACS technology) and cell analytics
measurement.

• Started in 1989
• Spin-off from University of Cologne, Institute
  for Genetics (Prof. Andreas Radbruch)
• Founder Stefan Miltenyi(Ph.D. in Physics)
• Today 1100 employees
• Locations Bergisch Gladbach, Teterow, Boston
  (and in more then 10 other countries
• Financing Venture capital

The autoMACS Separator and the autoMACS Pro
Separator are benchtop automated magnetic cell
sorters for the isolation of virtually any cell
type from any species based on MACS Technology
(IPR for MACS is owned by Miltenyi)
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Metaio

• Leading in development of Augmented Reality
  Technology. Unique software platform to combine
  interaktiv solutions and application in mixed
  real and virtual worlds
• Application Marketing (e.g. furniture, cars,..),
  automation, factory planing,
• Application possible via internet, mobile phones,
  PCs, ..
• Started in 2003 in Munich
• Spin-off from Munich Technical University
• Today 50 employees
• Sales and development units in San Francisco and
  Seoul
• Financing Cash flow, founding teams equity
  government RD money

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COPS
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Based on this information would you invested in
these two PhD candidates 800K US-? (to transform
the paper into a workable program and a firm to
commercialize this program?
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Financial Constraints

• Asymmetric Information Entrepreneur and
  financing institutions (Banks, Private Equity,
  Venture capital, Individuals) face different sets
  of information about the technology, market,
  market development, etc. (ex ante)
• Moral HazardEntrepreneurs behaviour can not be
  observed fully (after the financing contract) or
  change her behavior (ex post)
• How to overcome these problems?

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How are young ventures financed?
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Distribution of Financial Resources UsedYoung
Hightech-Firms in Germany 2007
Cohort 2005/2006
Cohort 2000/2001
Source ZEW HT-Survey 2007
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Use of External Sources of Finance
Share of firm using source
Contribution of sourceto volume of financing
Bank overdraft / Short term bank loan
Long term bank loan
Loan from KfW
Loan local government banks
Family friends ( fools)
Federal labour office (startup from unemployment)
Business Angels, Private Equity, Venture capital
Mezzanine loans
Other external sources
HT-Manufact.
HT-Service/Software
NonHighTech - industries
KfW/ZEW Start-up Panel 2008
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Stage of Company Development
Seed The idea/concept stage. Company proves a
concept and qualifies for start-up capital.
Start-Up Company completes product development
and initial marketing. Early Stage Expansion of
company that is producing and delivering products
or services. Expansion Product or service is in
production and commercially available. The
company demonstrates significant revenue growth,
but may or may not be showing a profit. Later
Product or service is widely available. Company
is generating ongoing revenue probably positive
cash flow. It is more likely to be, but not
necessarily profitable.
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Demand for External Funds and Company Development
Seed / Start-up
Stage
Pre-Seed
Later
Early
FFF/ Government
Owner/Government
Source
Angels
Venture Funds
Demand
500K
100K
25K
2000K
Supply
EquityGap
Lack of information / Matching
Capital gap
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Financial structure of firms with outside
equity- Average values for startups with outside
equity from 2005-2006 cohort -

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Financial structure of firms with outside
equity- Average values for startups with outside
equity from 2005-2006 cohort -

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Business Angel Finance
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Business Angels

• Rich individuals
• Investing their own money
• Aiming at profit
• Investing in small companies not listed at a
  stock exchange
• No family ties
• (sometimes philanthropic motivation)
• Investing in seed and early stages
• Investment size 20k Euro to 250k Euro (as a rule)

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Definition of Firms with Equity Financing by
Private Investors Business Angels

Private Investors Individuals investing in young
firms (incl. Investments via BA Fonds or BA
networks) Business Angels Private Investors
providing money and additional support services
for their portfolio companies Firm management
values the support as helpful(Advice,
Contacts, Infrastructure, Administration, RD,
Production, ..)
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Role of Business Angels VCin financing
HT-Start-ups
Alle Unternehmens-gründungen
18000 startups in Hightech-sectors 7 of all
startups
Share of high-tech firms having these types of
financing
Source ZEW-Survey 2007
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BA-Financing in Germany

• About 5 of HT-Startups have BA financing ( 3
  with equity by passive private investors)More
  important for university spinoffs (9)
• Average 1,9 BA per portfolio firm
• BAs invest in early stages (41 during year of
  start-up, even 7 before start-up)But also
  investment in expansion phase (31 invested 3
  years after start-up or later)
• Average investment size 100 000. (Median 30 000
  ) per firm.?HT sector receives in 2005 about
  190 Mio. (0,0085 BIP)
• Average share of BA 26 of total equity

Quelle ZEW-Hightech-Gründungspanel 2007
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Which firms are typically financed by BAs?

• Human capital of founding team is significantly
  larger (65 vs. 48 have university degrees).
• Firms found by a team
• University spin-offs und RD intensive firms
• BA portfolio companies utilized more often
  technologies developed by founders or develop
  in-house, hold patents and have a larger share of
  sales with new products
• Difference between BA-financed and companies
  financed by other private investors are smal
  (similar selection criteria of both groups)

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Support by Business Angels
Areas of support by BAs
Multiple answers possibleSource ZEW HT Survey
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How portfolio companies value the support by BAs?
Remark These are conditional probabilities
because only those firms are considered which
have received some slight support in these
areas. Source ZEW HT Survey 2007
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How BAs and portfolio find each other?
Share of firms by means of type of search and
investor (only firms where contact lead to
investment
Aktive Search By chance
BA-financing 27 73
Other private investors 40 60
Total 31 69
Average duration of search lt 1 month for 50
of private investors lt 1 month for 35 of BA
portfolio companies
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Who was helpful in finding a private investor?
Multiply answers possible
Source ZEW HT Survey 2007
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Success probability for various channels?
Relation between contract points, which turned
into an equity investment, and all contact
points tried to receive an investment
Slource ZEW-HAT survey 2007
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Why no agreement with BAs is reached?
Multiple answers possible
Source ZEW-HAT Survey 2007
Share of enterprises having contract with a
potential private investor
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Venture Capital Financing
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A Typical VC Fund
General Partner (VC Firm) 1 of Capital 2.5
Mgmt. Fee 20 Carry
Limited Partners 99 of Capital 80 Carry


Expertise



Starter A
Highflyer A
Profitable exit B
Starter B
No gain C
Starter C
Total loss D
Starter D
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How Firms signal their type

• Track record of owners / founders
• Owners / founders invest their own money
• IPR (Patents, .)
• Government RD support
• Links to other organisations
• (BAs)

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How VCs Overcome Problems Resulting from
Asymmetric Information and Moral Hazard

• Careful and extended due diligence / Highly
  selective
• Staggered contracts / Milestone payments
• Multiple rounds of financing
• Hands-on management
• Specific governance rights (e.g. right to
  dismiss CEO)
• Involvement in board
• Fix income (e.g. management fee) residual claim

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Size of VC Market in Selected Countries
VC / BIP (in )
USA UK Germany France Japan
Source EVCA NCVA
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Venture Capital Market in Germany
Share of Segments in Total VC Investments in
Seed
Expansion
Start-ups
Source BVK 2006
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Banks and Financing of SMEs
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Dominance of Loans- Supply Side Explanations -

• Continental European Relationship-Banking
• Three-pillar-model Large private banks, Small
  (regional) private banks, Public/Community banks
• Strong regional anchorage
• Traditionally pricing of loans not risk adequate
  
• Strong position of creditors in case of default
  (Insolvency)

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Dominance of Loans - Demand Side Explanations -

• Size-related restrictions regarding certain
  financing options(Significant fixed costs
  related to the size of loans)
• Fiscal treatment of loans vs. equity
• Outstanding position of the entrepreneur-personali
  ty
• Accentuation of operative business vs.
  financing-management
• Comparable low knowledge of financing-issues in
  medium-sized companies
• No systematic analysis of financing alternatives
• High preference in the entrepreneurial freedom of
  decisions

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Main Reason to Start a New Firm
Startups with market novelty
All startups
Being his own master Exploitation of a new market
(niche) Way out of unemployment Utilising
favourable tax treatment
Commercialisation of new business model/idea No
other opportunity in the labour market Forced by
previous employer
KfW/ZEW Start-up Panel 2008
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Further Reading

• RECOMMENDED
• Gompers, P. And J. Lerner (1999), The Venture
  Capital Cycle, MIT Press Boston
• Freear, J., Sohl, J. and Wetzel, W., 1994, Angels
  and non-Angels are there differences?, Journal
  of Business Venturing, 9, 85-94.
• UN Economic Commission For Europe (2007),
  Financing Innovative Development. Comparative
  Review of the Experiences of UNECE Countries in
  Early-Stage Financing, New York and Geneva.
• Shane, Scott (2008), The Illusions of
  Entrepreneurship The Costly Myths that
  Entrepreneurs, Investors and Policy Makers Live
  By, Yale University Press New Haven. (esp.
  chapter 5 How are New Businesses Financed?)
• Gorman/Sahlman (1989) What do Venture
  Capitalists do? in Journal of Business
  Venturing, 4. Jg., S. 231-248
• ADDITIONAL LITERATURE
• Vise, David A., Mark Malseed (2005), The Google
  Story Inside the Hottest Business, Media and
  Technology of Our Times, Delacorte Press/Random
  House New York. .
• Sahlman (1990) The Structure and Governance of
  Venture-Capital Organizations, in Journal of
  Financial Economics, 27, 473-521.
• Kaplan, S. and Zingales, L. (1997) Do investment
  - cash flow sensitivies provide useful measures
  of financing constraints?, Quarterly Journal of
  Economics 112, 169-216.
• Hubbard, R.G. (1998) Capital-Market
  Imperfections and Investment, Journal of
  Economic Literature, 36, 193-225.

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The EndThanks for your attention
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Definition of Hightech Industries
Knowledge intensive Services
Cutting Edge
RD intensive Industries

• Pharma
• Biotech
• Spec. Chemisty
• Electronics
• Control tech.
• Automation-Telecom

• Chemistry-Mechanical I.
• Engineering
• Automotive
• Consumer Elec.
• Medical devices

• Telecom services
• RD services
• Software
• Information services
• Technical consulting
• Technical labs

16.000 (86,9)
1.500 (8,2)
900 (4,9)
Estimated number of annual start-ups
Startups in these industries 7 of all start-ups
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Definition of Hightech Industries
Knowledge intensive Services
Cutting Edge
RD intensive Industries

• Pharma
• Biotech
• Spec. Chemisty
• Electronics
• Control tech.
• Automation-Telecom

• Chemisty-Mechanical I.
• Engineering
• Automotive
• Consumer Elec.
• Medical devices

• Telecom services
• RD services
• Software
• Information services
• Technical consulting
• Technical labs

Software
ICT-Hardware
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25
16.000 (86,9)
1.500 (8,2)
900 (4,9)
Estimated number of annual start-ups
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Econometric Evidence for Financial Constraints

• Modigliani-Miller theorem In the absence of
  taxes, bankruptcy costs, and asymmetric
  information, and in an efficient market, the
  value of a firm is unaffected by how a firm is
  financed.
• Variety of explanation why MM does not hold
• Hence Search for evidence that (free) cash-flow
  has an impact on size and structure of
  investments of firms (e.g. RD)
• Regression-based evidence is available for a
  large number of countries
• SMEs young companies are more restricted