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Early-stage investments in Germany: new challenges and opportunities

German start-ups have learned valuable lessons from the past and are now equipped with good quality teams and world-class business models. Friedrich Bornikoel of Techno Venture Management on why it is a good time to look to invest in Germany once again.

The technology-driven markets have changed dramatically over the last 18 months. In the private equity community, the euphoric (and sometimes senseless) days are over, and we observe a rational ‘back to normal, back to quality' approach to business. Realistic valuations are once again modeled on quantitative criteria that were already well understood prior to the boom. Breathless competition has made way for a healthier pace of growth by allowing early stage investments four to six years' development before a financial exit (or, in other words, before we can see a real return on investment). In fact, the outlook is more promising than at any time since 1998.

The current situation offers a number of benefits:

• Experienced management is easier to find and to integrate.
  Management talent nowadays available on the market do not necessarily regard big companies as an altogether safe career alternative. If a start-up has a solid financial backing, it can offer managers an interesting area of work with vast opportunities of professional development. The labour market is much more fluid than before.
• Large corporate R&D groups are being scaled back.
  Traditional value chains are being transformed again, and are emphasizing outsourcing. Happily, this creates significant opportunities for venture capital (VC) backed companies. For instance, until the late eighties telecom equipment vendors like Siemens had to have an internal supply of the laser components necessary for optical networks due to a missing merchant supply. Nowadays, the outsourcing trend is continuing with recently established technology companies taking over increasingly complex sub-systems assembly, thus becoming merchant suppliers of large corporations.
• What would have been hardly conceivable even some five years ago is fact today: corporate Germany is taking the risk of buying technology from small businesses, if a VC backed company has, or is able to integrate, managers belonging to the peer group of the decision makers on the buy side.

Exactly these kinds of quality deals will find a successful financial exit.

At the same time Germany, as the largest IT market in Europe, offers US companies terrific opportunities. Apart from world-class research and development infrastructure, German business practices are increasingly adopting the US high technology business model. The regional entry barriers are crumbling. In continental Europe this process is the most advanced in Germany. An increasing number of German managers in their late thirties and early forties have gained international experience and exposure after completing their studies abroad, and by working in international environments. Their experience in dealing with multi-cultural issues is essential for top tier European start-ups, especially in the field of strategic marketing.

Corporate Germany is now regularly buying from start-ups. Examples such as TVM-backed Alfabet AG, Berlin, - which as a solution provider for Strategic IT Infrastructure Management (SIIM) software has provided critical applications to Deutsche Telekom -- give proof of considerable benefits for large corporates. Indeed, Alfabet has saved Deutsche Telekom several ten million Euros in one year. Another example is Munich based Axxom Software AG, which also has gained top-tier clients such as Schering, BMW, DuPont and Avon Cosmetics, who also report significant impact: 15 to 25 per cent higher efficiency in their production environment after deploying the software suite.

Blue chip companies still have comparatively large IT budgets, because they recognize that their internal IT platform is essential to retain a competitive edge. Classical German concepts such as the VW car platform concept would not be possible without such strong IT frameworks.

The segments opto-electronic components, MEMS and nanotechnology further demonstrate how German research centers have a strong and broad know-how base. German start-ups are developing special strengths in such multi disciplinary enterprises. Nonetheless, some of the greatest pitfalls very often lurk in these hot technologies:

• a concentration on material science and new process technologies, instead of recombining existing processes, often can be costly in terms of  time and capital, and may also entail developing new industrial equipment.
• approaches which rely on feature differentiation in applications with too small a market

In this sector the few start-ups that rely on a new combination of well-known processes are considered uncut diamonds, and is exactly the place where private equity is best applied.

German start-ups are very well positioned in the field of bioinformatics and high-through-put analysis as a crossover technology between IT and life science. On the one hand, they can build on a strong industry that enjoys healthy budgets and suffers urgent pain, and on the other their excellent positioning is based on a strong interdisciplinary know-how in R&D centers and the VC community.
In the field of enterprise software German start-ups also have a lot to offer. SAP's great success was no coincidence. Process optimization, with IT being a substitute for labour, is a permanent issue in many German Fortune 500 companies. Interesting innovations in enterprise software can be found in

• software for business processes optimisation
• supply chain extension and management software and
• technical software for collaborative design and deployment.

However, in all areas from enterprise software, to networking components and systems, to security solutions (where establishing alliances that create, deploy, and enforce standards are essential), one key factor remains: superior technology is a must, but execution wins the game. For us in Europe, understanding the US market is often key.

Consequently, German technology start-ups are utterly dependent upon the creation of a strategic marketing that quickly earns them the critical external endorsements and enables OEM channel occupation. They need a good understanding of the company's market positioning, a clear view of the value proposition and competition, and a solid, reliable, and supportive partnership with established players.

Superior technology is not always a strong, or even determining factor in the creation of a marketing strategy. Indeed, only once the price-performance ratio is two to ten times better than the nearest competition market opportunities can be monetised. The search for the first key customers hinges on the ability to execute and deliver, as well as the understanding that there is only one shot. Therefore, strong financial backing by well-known VCs is an absolute must when entering the transatlantic market.

Finally, opportunities arising from external growth (M&A) should not be left unheeded. Acquisitions can bring a fast extension of the product and technology suites, and an integration of existing best in class teams, adding brains and IP. However, experience has shown that such a process should be guided by experts with M&A and VC know-how so as to find a successful exit. The risks that arise from a loss of business focus, the increased complexity, the additional financial, legal and human liabilities as well as the post-deal integration should not be underrated. Nonetheless, M&A is the shortest path to technical footprint and execution power.

Despite all the risks in Germany's early stage market, there are sufficient opportunities. The momentum of innovation in ICT technologies remains unchanged and the timing has never been better for early stage investments. The positive outlook for the next two years is based on seven factors and findings:

• Rich inventory of intellectual property
• Strong research and development infrastructure
• Excellent talent pool, eager to “get started”
• Experienced managers join winning teams
• A much healthier pace of growth, with a better revenue-to-loss ratio until break-even
• A leveling out of regional entry barriers
• The private equity community has learned hard lessons and
• Overall quality is improving.

TVM Techno Venture Management, founded in 1983, is one of the first venture capital funds formed in Germany, and a leader in transatlantic operations. For many years, TVM has focused on information & communications technology and life sciences, high growth sectors where innovation, effective management and sound financial backing have enormous impact on company growth. TVM funds have made investments in 200 technology companies in Europe and the United States. A pivotal objective is to create transnational businesses that enjoy access to science, management talent and capital on both sides of the Atlantic. For more information please visit www.tvmvc.com