Even before the IT boom hit Europe, No Wires Needed (NWN), a Dutch start-up specializing in wireless communications, was a darling of venture capitalists. The fledgling firm, a brainchild of five students at the University of Twente in the Netherlands, survived for its first five years on small cash investments by friends and family.
But as the commercial possibilities of wireless became apparent, venture capital (VC) firms started to beat a path to its doors. Between late 1998 and 2000, VC firms invested E7.6m in NWM, reaping big returns when the start-up was later sold for E158m in a share swap.
That was then. Today, the landscape facing budding entrepreneurs couldn’t be more different. “In the past year, venture capital managers have become very, very risk averse,” says Hans van der Hoek, NWN’s former CEO and current head of a wireless venture called Gemtek Systems.
Unlike their predecessors, today’s start-ups face a long process of “pre-due diligence,” which includes much fuller disclosure of strategic information and the development of business plans with frequent (often monthly) milestones and targets. This means investment funds can be drip-fed as each milestone is met, rather than paid in a lump sum at the outset.
This is not all bad. “In the present environment, it becomes clear who the real entrepreneurs are,” says Anton Arts, a director and partner of Gilde IT Fund, a Dutch VC firm. “Our deal flow has slightly decreased, but the quality of the proposals has gone up. A lot of the less attractive deals have gone away.”
The tougher environment has caught out many promising ventures that received their first round of financing in the boom times and now need a second round. Consider Spirea, a Swedish start-up that makes radio chips for Wi-Fi (wireless fidelity) products. It began life during the internet boom as a specialist supplier to Bluetooth, a short-range, low-speed radio technology pioneered by Ericsson. But as time wore on and the technology failed to show a profit, VC firms began to back away.
About a year ago, with future VC backing in doubt, Spirea changed its focus to Wi-Fi, a broadband wireless radio technology. But having spent half of its initial round of funding on Bluetooth-related products, Spirea has been hard-pressed to prove to backers that its change in direction will succeed.
“We are talking with established and new VC firms, and I am seeing a very careful, ‘OK let’s check, then let’s check again’ approach,” says van der Hoek, who is a non-executive director of the Swedish firm.
Spirea is hardly alone. According to the European Private Equity and Venture Capital Association (EVCA), total funds invested in seed, start-up and expansion phases in Europe fell 27.5 percent between 2001 and 2002 to E8.9 billion, and the number of deals fell by about 18 percent to 7,622. Seed-stage funding specifically experienced the steepest drop as investment fell 42.6 percent, to E305m, and the number of deals fell by 33.5 percent, to 494.
Even the start-ups that succeed in obtaining VC financing are having to wait longer than they used to for their approvals. Gemtek Systems, a Dutch Wi-Fi venture, has sought second-stage financing since last November, “and we have come to the stage where we have a few VCs who say they will join if other [VCs] join,” says van der Hoek. “In the past it was more a case of, ‘Yes, we’re joining, now let’s find others.'”
From the venture capitalists’ point of view, the caution is warranted. Many of them are struggling with their portfolios, and some have had to write off their entire book of IT investments.
The rule of thumb for VC firms during the boom years was that if one in ten firms in their portfolios became a big hit, and three or four others were profitable, then that would fund the remaining start-ups in their book of business. Now, entrepreneurs complain that VC managers approach their business more like bankers, looking for a guaranteed return each time, yet still expecting the high rates of return associated with venture capital investments.
“There has been minimal raising of funds by VC firms in the early-stage technology sector in the past year,” observes Patrick Dunne, group communications director of 3i, one of Europe’s largest private equity firms. “The VC firms have been focused on managing their portfolios, picking the likely winners from within that portfolio and supporting them.”
It may come as scant consolation to Europe’s entrepreneurs that their American counterparts are experiencing an even tighter squeeze. According to a PricewaterhouseCoopers/Venture Economics/NVCA MoneyTree survey, expansion-stage investment by America’s VC firms fell about 60 percent — to $13.3 billion (E12.3 billion)-between 1999 and 2002.
The crunch has led to the demise of many promising ventures. Consider Massachusetts-based PlumRiver Technology, a producer of online services and software for consumer goods manufacturers. In mid-2002, despite what seemed a likely commercial breakthrough-a deal with a prominent consumer goods manufacturer-PlumRiver received some very bad news. Its lead VC financier, Venture Investment Management Company (Vimac), was pulling the plug, despite supporting earlier rounds of financing, spelling the end for PlumRiver. “Up to early 2002, [Vimac was] in the mode of keeping companies alive,” says Henry White, PlumRiver’s founder.
In Europe, as in the US, the tougher economic climate makes any start-up a shaky proposition. At the same time, the typical exit strategy of a start-up-selling the new firm to a big company in the same sector-is no longer a sure thing. Companies like router giant Cisco Systems, for example, acquired an average of one start-up a month during 2000. So far this year, it has just made one acquisition.
Show Us the Money
“Three years ago, people assumed that a big hit would be an exit sales price of E500m to E1 billion,” says Arts of Gilde IT Fund. “So it was perfectly justifiable to invest up to E100m in a single company. But today the exit price is more like E100 to E150m. Unless you can build the company with an investment of only E20 to E30m, it is not worth it if you apply the risk metrics of the VC industry.”
In the face of the lower likely returns, VC firms are asking for quicker, incremental returns, such as a revenue stream from consulting services while the start-up develops its technology. “The whole idea of a start-up going into development mode and coming out with a new product two years later-that’s gone now,” Arts says.
What remains for entrepreneurs to do if their VC funding dries up entirely? Most entrepreneurs seek out “angel money”-funds invested by individuals who believe in the firm’s prospects. These infusions tend to be small-E100,000 to E500,000-and to carry a shorter-range commitment than that associated with VC financing.
Moreover, cash infusions from business angels lack other benefits that VC firms offer: advice on such matters as putting a corporate governance system in place and help with the firm’s organizational structure or marketing strategy. A VC house can also confer credibility on a start-up, making it easier to find customers for the firm’s technology and products.
Beyond that, small firms can simply cut back their activities, conserve cash and hope for the best. “If you are willing to make the switch [to entrepreneur] now, you have to be willing to live on bread and water for a couple of years,” says Arts.
Despite the gloomy outlook, the VC industry is far from dormant, especially in the related activity of financing management buyouts with private equity. This segment of the industry actually grew in Europe in 2002, comprising 65% of total investment in 2002 compared to 45% in 2001. In all, E18 billion were invested in buyout-stage firms in Europe last year.
Mid-market equity deals are most common in the UK, which is also Europe’s largest private equity market by far. (See box above.) Mid-market deals in the range of E14.4 million to E144.7 million in the first quarter of 2003 were the highest since 1999, rising from to 37 from 29 in the fourth quarter of 2002, according to the Centre for Management Buy-out Research.
The growth in leveraged buyouts-particularly those involving subsidiaries or business units of large corporations-is often the flip side of the financial distress experienced by the sellers.
“In the last two years, a lot of restructuring has been going on by corporates, under the general heading of ‘balance sheet repair,'” says Max Burger-Calderón, executive director of Apax, a global private equity firm, and chairman of the EVCA. “It’s easiest to sell off a few things and reduce debt. So many opportunities are coming onto the market at reasonable prices.”
And the upward trend in the buyout side is likely to continue. “Since the M&A market is quiet and corporate acquirers are quiet, we [private equity investors] will be the principal buyers [of such units] in the next 18 months,” predicts Jonathan Russell, director of transactions for 3i.
VC firms, of course, do not have the private equity market to themselves. Many large companies formed VC divisions during the boom years. Now that VC returns are less assured, many corporate VC divisions have scaled back their operations.
Indeed, such investments are often cheaper for the parent company than investing in their own corporate R&D, and can fill gaps in product lines and technological capabilities. “This can enable [corporate buyers] to win big contracts where there is a service or a system or a piece of software, or some drug or intermediate good supplied by the start-up, that fills the bit of the chain that is missing for them,” says 3i’s Dunne. What’s more, he says, “the corporate gets a window on the [small] business, a piece of the action, but doesn’t have the management tasks.”
Some corporate investors, in fact, will invest only in start-ups that fit into their product lines. BMW, the E42 billion German carmaker, is a case in point. Its corporate VC division asks outside VC houses to find entrepreneurs whose products could potentially be used in BMW’s cars. If the product passes muster, the VC firms invest in the start-up and BMW takes a stake as well, often receiving its shares for free in exchange for awarding a contract to buy the company’s products.
That contract is like money in the bank, says Burger-Calderón of Apax. It provides a much-needed revenue stream, as well as boosting the start-up’s credibility with other financiers and clients.
Other examples abound. Webraska, a French start-up manufacturer of location-based software systems (enabling users to locate destinations on an electronic map), recently signed a contract to supply its technology to Orange, the E17 billion French mobile phone company. “Whenever one of these companies signs up with a large corporate, that makes all the difference,” says Burger-Calderón.
The shift in investment patterns has not escaped the attention of entrepreneurs. “The smart ones, and the smart investors, have been focusing their product development on things that they know the large corporates would buy,” says Dunne of 3i. “In the past, entrepreneurs developed great technology on the basis that someone will buy it. Now they try to identify the natural buyers of their technology at a much earlier stage.”
The shift in emphasis has caused entrepreneurs to operate differently from in the past, putting more effort into corporate relationship marketing and paying more attention to the target corporations’ product distribution channels. Many large companies have reduced the number of their suppliers, and for entrepreneurs this means that “you need to team up with someone who is already supplying them,” says Dunne.
The change reflects a growing maturity in the VC industry and among start-ups, as well as the tougher economic times, according to Burger-Calderón. “We are not eclectic, wild cowboys any more,” he says. “We are an organized industry, with systems and structures, that can play on the same field with the major corporates.”