Author: Thomas Meyer (+49) 69 910-46830
March 16, 2012
The German federal government plans to promote start-up financing for young innovative companies. An investment grant for business angels as well as a further tax privileges for venture capital funds and their investors are under debate. The idea is praiseworthy, but a real investment boom also requires highly developed stock markets where innovative companies achieve high prices.
The low financing volume for innovative company start-ups in Germany and other continental European countries is both a symptom and a cause of new ideas not being transported sufficiently into commercially successful products. In particular, investments in the venture capital segment (VC) are low when compared to other countries. The result is a lack of key driving forces for a knowledge-based economy.
Against this backdrop, it is surprising that the number of VC funded companies in Germany is almost equivalent to the US – in both countries, there were around 11 to 12 VC financings per one million inhabitants last year. However, start-ups in Germany are operating on a much smaller scale: the average venture capital investment last year amounted to only EUR 780,000 compared to close to EUR 6 m in the US. On the other side of the Atlantic, small investments typically come from business angels. The initiative of the German government (see press statement in German) thus addresses a relevant weakness – whether grants are the appropriate instrument is currently hard to say as details are not available yet.
Venture capital is part of a financing chain which functions only when upstream and downstream elements are well connected. A larger role of business angels in the financing of very small and very young start-ups could enable the VC segment to concentrate its capital and management expertise on bigger transactions and thus to operate more efficiently. This would be a sensible division of labour and should help to bolster venture capital profitability. This would also make VC more interesting for investors, and fundraising would become easier.
It is insufficient to look at the early elements alone, however. The later-stage parts of the financing chain – especially the stock market – are also of major importance. It is via an IPO that founders and their financial sponsors typically achieve the highest proceeds for successful start-ups. There are major differences between countries, however.
In Meyer und Ehmer (2011) we measured R&D elasticity based on a sample of more than 1,000 highly innovative companies worldwide. The R&D elasticity shows the influence of corporate spending on research and development (R&D) on the market capitalisation of a company. The higher the value, the more the stock market rewards a company’s research efforts – all other things being equal. Our analyses show that average R&D elasticity in Germany is lower than on Anglo-Saxon or, for instance, Scandinavian stock markets. Thus, an important R&D incentive is missing.
There are many reasons for the lower R&D elasticity. Studies show, for example, that the size and depth of capital markets, the protection of minority shareholders and the efficiency of conflict resolution are major criteria. However, weak R&D elasticity also has effects on start-up funding, as VC funds typically invest in particularly innovative young firms. Start-ups that are ready for an IPO are likely to achieve a higher price on innovation-friendly stock markets during this process. This boosts the proceeds on exit of the VC funds and the funds can boast overall higher returns, thus increasing the investment incentive. Therefore, it is probably no coincidence that VC investments are particularly low in countries and regions where R&D elasticity is also low (see chart). At the time of the establishing of an innovative start-up it is therefore very important to already consider the later exit of venture capital providers. Thus, a real investment boom in the start-up financing segment also requires highly effective stock markets.
Meyer, Thomas and Philipp Ehmer (2011). Capital markets reward R&D. Economics 83. Deutsche Bank Research. Frankfurt am Main.
Author: Thomas Meyer (+49) 69 910-46830
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