Frankfurt's Neuer Markt and the IPO Explosion: Is Germany on the Road to Silicon Valley?

Transcription

1 Frankfurt's Neuer Markt and the IPO Explosion: Is Germany on the Road to Silicon Valley? Sigurt Vitols Sigurt Vitols, Wissenschaftszentrum Berlin für Sozialforschung (WZB), Reichpietschufer 50, D Berlin, Germany.

2 Introduction Germany has long been seen as one of the premier examples of a bank-based financial system, i.e. a system in which banks are the dominant financial organization and loans (rather than publicly-traded stocks and bonds) account for the lion s share of external financing of the firm (Vitols 1998; Zysman 1983). 1 In the 1980s this system was widely praised for providing stable, long-term finance to industry and was frequently recommended for emulation in other countries (Porter 1992). In the 1990s, however, the bank-based system has come under increasing criticism within Germany as unsuitable for promoting high tech. Interestingly enough, the same elements that were previously seen as strengths are now partially seen as weaknesses: the German banks preference for making loans to established, capital-intensive companies, according to this view, starves new technology-based firms of needed high-risk venture capital (Pfirrmann, Wupperfeld, and Lerner 1997). In part as a response to this criticism, a special segment of the Frankfurt stock exchange called the Neuer Markt (New Market) was established in The aim of the Neuer Markt, which at least at a rhetorical level is modeled on the US s Nasdaq, is to serve the needs of both investors and young companies involved in high-risk new technologies (Plückelmann 2000). After a somewhat slow start in its first year, interest in this new exchange segment thereafter accelerated to the point that there has been a veritable explosion in IPOs (initial public offerings, or first-time listings of companies on an exchange). The Neuer Markt is now by far the most important growth stock markets founded in the 1990s in Europe in terms of both market value and number of listed

3 companies, a fact that is most surprising given the conservatism of Germany's postwar financial system. The success of the Neuer Markt has led to speculation that Germany is rapidly closing the gap with the US in high tech. In addition, it may also be developing a dream-team dual economy in which the established stock market services traditional industry and the Neuer Markt finances the new economy. The Munich region in particular, which has accounted for a large proportion of the Neuer Markt IPOs, is compared with Silicon Valley. This article contests the convergence thesis by exploring the characteristics of Neuer Markt companies and their meaning for the broader German political economy. Although the Neuer Markt is in fact evolving into an important institution for raising new finance, the bulk of the companies listed there appear to be following a path quite distinct from the Silicon Valley model of innovation, finance and corporate governance. This alternative model is based more on the diffusion of, rather than on the development of path-breaking (or radical) innovations that involves relatively little high risk venture capital, and shows a number of continuities with the traditional German Herr-im-Hause (master of the house) insider model of small-firm governance. The Silicon Valley Model and the Genesis of the Neuer Markt A common conceptual tool used to analyze the innovative capacity of political economies is the product life cycle. According to this concept, research on and the development of new products initially involves losses due to the lack of sales income (left hand side of diagram 1). When a market for the new product is discovered and exploited sales increase

4 rapidly and the break-even point, where sales cover costs, is eventually reached (middle of diagram). As a product matures, however, both sales and profitability grow at a diminishing rate (right hand side). [insert diagram 1 here] In principle, there are different possible business models for realizing this product life cycle. For example, an established firm seeking to enter new markets could develop a new product, or it could be developed by a new firm founded to focus on this product. The Silicon Valley model is here understood as one specific type of path to realize this development. First of all, it is based on the foundation of new firms to develop new, highrisk products. In practice it is easier for new firms to develop such products, since older firms often lack the proper incentives for risk-taking and thus have difficulty with radical innovation. Second, since the costs of development of a new technology may be quite high and future prospects for success uncertain, it is generally necessary to obtain substantial external funding with a high tolerance for risk. So-called early stage venture capital fits this profile since these investors are willing to accept a high failure rate in investments in search of a blockbuster success that will more than pay for the losses. Third, since the firm founder often has considerable technical skills but lacks the necessary business skills to navigate the company through its various growth stages, the management team has to be expanded. Venture capitalists can play a key role in networking to find suitable new managers. Also important is their ability to impose new management structures on firm founders reluctant to share authority. Fourth, a lucrative

5 exit option in the form of a stock market receptive to new companies allows venture capitalists to cash in their investments so that they can realize their profit and start the cycle of investing again (Lerner 2000). The German bank-based financial system, it has been argued, represents a serious barrier to the achievement of this Silicon Valley model of development (Albach 1983; Pfirrmann, Wupperfeld and Lerner 1997). Firstly, since German banks are generally riskaverse, the dominance of banks means that most bank loans are channeled towards established firms with stable cash flow. Secondly, the Frankfurt Stock Exchange is unsuited to the needs of both young companies and investors involved in high-risk new technologies. Conservative listing requirements meant that only companies with a history of solid profitability could be brought to market. Furthermore, the existing system of trading lacked market makers willing to buy and sell shares to provide liquidity and reduce the volatility of the share prices of small companies. A third problem was that the Frankfurt Stock Exchange used the German system of accounting standards (HGB or Handelsgesetzbuch), that gives finance directors considerable leeway in reporting on the company's financial status. This large room to maneuver reduces the reliability of financial statements in presenting the true state of company affairs. The Frankfurt Stock Exchange was therefore considered unsuitable as an exit channel for venture capital investments. As a result of these shortcomings, according to this view, start-up firms in the early stages of the product life cycle in Germany were starved of external capital. The Neuer Markt was created in 1997 as a separate segment of the Frankfurt Stock Exchange, specifically in order to address these shortcomings (Plückelmann 2000). A number of features were included that were designed to meet the needs of institutional

6 investors in small, young, high-growth companies. One important aspect of the Neuer Markt is the waiver of minimum requirements regarding profitability and age of IPO candidates. A second aspect is the requirement that all listed companies have at least one designated sponsor, i.e. a bank or brokerage house obligated to make markets for their shares. Markets for the stock of individual small growth companies are notoriously illiquid and fund managers will avoid such companies if they are not able to exit (i.e. sell shares) their investment without depressing share price. The requirement that designated sponsors to not only match bid and sell orders but also buy and sell on their own account is intended to smooth over temporary imbalances in the supply of, and demand for, shares and thus encourage fund managers to invest in small capitalization companies. A third important aspect of the Neuer Markt is the requirement for greater transparency in the form of quarterly financial reporting on the basis of minority-shareholder friendly accounting systems, either US-GAAP (Generally Accepted Accounting Principles developed in the US) or IAS (International Accounting Standards). The lack of transparent accounting on a frequent basis has been considered another significant deterrent to investment, particularly in the rapidly changing high-tech world. On the surface of it, the Neuer Markt has been a huge success, particularly after its first year of operation. Whereas before its foundation a year with thirty IPOs would have been quite active, since 1997 there has been a veritable explosion in new listings (see chart 1). [Insert Chart 1 here] In 1998, 1999 and 2000 there were 67, 168 and 152 IPOs in Germany, respectively. The Neuer Markt alone accounted for 61 percent, 79 percent and 87 percent of all German

7 IPOs in those years, respectively. By the end of 2000 there were 338 companies listed on the Neuer Markt, with a high concentration in the sectors technology (20.1 percent), internet (19.8 percent) and software (14.8 percent) (see chart 2). [Insert Chart 2 here] One surprising feature given the traditional conservatism of Germany's financial system is the fact that quite a few foreign companies are coming to Germany to raise their risk capital 56 of the companies listed on the Neuer Markt (i.e. about one-sixth) were based outside Germany. A second quite surprising result is that Germany's Neuer Markt alone accounts for considerably more than half of the total market capitalization of Europe's new growth markets or stock exchange segments for young, high-growth companies. Although these growth markets were established in other countries at roughly the same time and a number of them would presumably enjoy greater advantages, the Neuer Markt has become Europe's premier growth market far surpassing the pan-european growth market EASDAQ and the UK's AIM (see chart 3). [Insert Chart 3 here] This success has given rise to claims that Germany is catching up with the US with respect to the high technology gap. The Munich region in particular has received much attention as a regional technology agglomeration and has even been christened the Isar Valley after the name of the river flowing through the center of the city. Munich alone has accounted for 56 or 20 percent of all Neuer Markt IPOs of German-based firms. However, other urban agglomerations such as Hamburg and Frankfurt are also the homes of a significant number of Neuer Markt companies and are increasingly being referred to as high tech or multimedia centers.

8 Is Germany on the Road to Silicon Valley? What is the meaning and significance of the Neuer Markt for Germany? Can the innovative capacity of a political economy be significantly altered through a relatively simple act of institutional innovation? Although the Neuer Markt's achievements are certainly impressive in the context of Germany's past, a number of important facts caution against drawing too much of a parallel with the US's Nasdaq and imply that Germany is following its own path of high-tech development. One important difference with regard to the US is that, although the increase in the number of IPOs has been impressive, the amount of money raised through IPOs is still far behind the US. Altogether, about 33 billion DM has been raised by German firms through IPOs on the Neuer Markt since its foundation in IPOs on the Nasdaq, in contrast, raised over $50 billion (about 100 billion DM) in 1999 alone (Deutsche Börse, 2001 #708; NASDAQ, 2001 #709; own calculations). A second difference is that venture capital, particularly of the high risk early stage variety, has played a much less significant role in Germany. Venture capital investments in the US exceeded the German level by a factor of 15 in 2000 (Mackewicz & Partner 2000). It is often claimed that venture capital has played a very significant role on the Neuer Markt (and has in fact been involved in 45 percent of all IPOs) but much of this appears to have been (relatively low risk) bridge financing which is used to increase the capital base of companies immediately before the IPO. One proxy for high-risk capital is the involvement of venture capital funds participating in the BTU (Beteiligungskapital für kleine Technologieunternehmen) program, the federal program for supporting early-stage

9 venture investing. Less than 20 percent of the German-based Neuer Markt firms received financing from venture capital firms involved in this program. A third difference is that many Neuer Markt firms do not appear to fit the Silicon Valley image of the loss-making start-up. The majority (57 percent) of the Neuer Markt s listed (domestic) companies are profitable and 52 percent are at least 10 years old; one company, Pfeiffer Vaccuum, was in fact founded in Not surprising given these differences, the Silicon Valley model of governance, in which venture capitalists are the dominant investor group and are represented on the company board, accounts for only a small minority of Neuer Markt companies. An analysis of a database with the characteristics of Neuer Markt firms shows that venture capitalists constitute the most important investor group for eleven percent of the German companies listed at the end of [Insert Table 1 here] The predominant form of firm governance on the Neuer Markt has more in common with the traditional German Mittelstand or Herr im Hause ( master of the house ) form of organization than with the Silicon Valley model. Insiders, dominate this model particularly by the founder/ceo, who typically owns a controlling stake in the company and also dominates the company board through appointment of directors. The primary goals of the founder/ceo are often stability of company (through solid finances) and maintenance of personal control. The corresponding innovation strategy is the incremental development of the existing product portfolio. This model accounts for two thirds of Neuer Markt firms (190 of 274).

10 A third form of governance, which also sometimes contributes to high tech development in the US, corporate control also accounts for a small minority of Neuer Markt companies. This model involves creating a new subsidiary company that is responsible for developing new products and which enjoys a certain degree of organizational independence from the Parent Corporation. Key board members, however, are typically managers from the Parent Corporation. A portion of shares in the company are sold on the market through an IPO in order to raise money for the parent's further activities. This model accounts for 10.4 percent of Neuer Markt companies, i.e. slightly less than the Silicon Valley model of governance. 3 Companies based on this dominant Herr im Hause model appear to have significantly different firm characteristics and innovation strategies than other models. Companies are older, have much lower growth rates, are more solidly profitable, and spend less on R&D as a percentage of sales. Herr im Hause companies are much more based in areas such as IT services and in established parts of software and technology. Silicon Valley companies in contrast are concentrated in the biotechnology and Internet software sectors and the corporate control model in multimedia and direct banking/discount brokering. To better understand the varying strategies pursued by different types of firms, it is useful to take a closer look at a particular sector. Software is particularly interesting since it is the most important sector on the Neuer Markt in terms of number of companies, and also because of the range of products offered and customer types serviced by the industry. 4 Different types of innovation strategies are being pursued within the software sector, and that these strategies are highly correlated with ownership type and age of company. 5

11 Development of blockbuster products. A particular feature of the software industry is that production costs are practically zero since they are limited to producing copies of programs on CD-ROMs or floppy discs. Much more significant are the costs of software development (writing code) and marketing of software. One competitive strategy is to try to develop standard software, i.e. software that can be used by a wide variety of customers and installed with relatively little or no customization. Once the software is developed, the product is marketed as aggressively as possible in order to maximize revenues, in the ideal case in many countries at the same time. The potential profits from a successful blockbuster product are huge. The lucrative nature of these markets, however, typically attracts numerous competitors trying to become major players in the field. Since software users generally gravitate toward standard applications (e.g. Microsoft Windows for PC operating systems), very few companies can achieve major market share (Hoch et al. 1999). As a result, new markets for software applications are characterized by a shakeout phase involving a high failure rate of new companies and the consolidation of market share among a small number (or even one) software firm. Although external finance can speed up development time and accelerate marketing, the high probability of failure means that often only venture capitalists, business angels, or friends and family will be willing to provide such finance. In practice the most recent area offering the potential for blockbuster products has been the Internet software area, including applications for e-commerce, auction sites, search engines, etc. Companies in this area generally emphasize the huge growth

12 potential of the Internet software market and aim to rapidly internationalize their marketing and sales efforts in order to reach thousands of customers. Alternative strategies: a customer-service based strategy and a niche market strategy. The competitive strategy of companies here is to offer a high quality service component in areas where considerable customization or installation costs are involved (and, typically, where long-standing and strong relations with customers are needed), or to focus on niche markets. This includes companies developing software for applications such as enterprise resource planning (ERP), graphics, or sector-specific applications such as actuarial software for insurance companies. Although these markets are more stable and offer much more protection from competition than mass markets for standardized software, the potential size and/or growth rate of these markets is also constrained. The lack of blockbuster potential may therefore render this type of firm unattractive to venture capital. However, firms here will be more likely to finance themselves. The blockbuster type of strategy (internet software) accounted for only 13 of the 67 German-based software companies on the Neuer Markt. The large majority of software companies are characterized by the other types of competitive strategies, and focused on more mature product markets such as enterprise resource planning software. Though most of these companies have to deal with a recent radical change in the software environment and the development of the internet, most of these companies have dealt with this change by contracting out the development of new internet modules for their software (e.g. the addition of an e-commerce module for ERP software) or licensing-in standards or code from US companies (e.g. security standards for banking software).

13 The characteristics of firms pursuing blockbuster versus incremental innovative and niche strategies are quite different (see table 2). The average age of internet software companies is less than half than that of non-internet software companies (7.5 years versus 17.2 years). The average size of equity accounted for by venture capitalists as well as R&D as a proportion of sales are both roughly twice as large for internet software companies as compared to other software companies (12.4 % versus 6.9% and 35.4% versus 18.3%, respectively). Internet software companies were also much smaller in size, with an average of 33 million DM in sales versus 61 million DM for other software companies. Only one internet software company was breaking even, whereas about half of the other software companies were solidly profitable. Conclusion: Germany's Own Road of High-Tech Development The fact that the Silicon Valley model of governance accounts for only a relatively small number of Neuer Markt companies is not necessarily a weakness. In fact, one can argue that the heterogeneity of firm types that can be supported on the Neuer Markt may be one of its greatest strengths. The outcome of corporate Germany's foray into biotech and the chance of survival of its Internet software companies, all of which are making great losses, is uncertain. The greatest contribution to German economic growth and competitiveness appears to be made by the Herr im Hause type companies. These companies play a key role in diffusing important new innovations to their customer base (e.g. addition of e-commerce module to the ERP software package) and may be better able to survive stock market boom/bust cycles due to their strong financial status. In this sense, the innovative strength

14 of companies on the Neuer Markt conform more to the traditional pattern of German industry than to that of a certain valley 5,000 miles to the west: diffusion of (rather than development of) radical innovations and customization according to customer needs in the context of long-term relationships. Given Germany's track record of success in integrating previous radical innovations, e.g. diffusion of microchip technologies in traditional industries such as machine tools and automobiles, this may not be a bad road to follow. Notes 1 Special thanks to Lutz Engelhardt and Jana Meier for invaluable help in the compilation and analyis of a database on Neuer Markt companies. This article is based on collaborative research with Steven Capser (Judge School of Management, Cambridge University). 2 This database on Neuer Markt companies draws primarily on IPO prospectuses, which are long documents issued shortly before the company's IPO. Due to the need to fully inform investors of all major risks involved in investing in a new company, these documents are quite lengthy (frequently over 100 pages) and provide a comprehensive view of ownership and governance arrangements, company organization, product market strategy, main competitors, and various details like stock option plans. Additional information is garnered from company annual reports, from information provided by the Frankfurt stock exchange, and from a variety of web sites dedicated to either the Neuer Markt or the German IPO market. 3 Other models represented include: the cooperative ownership model, the so-called Deutschland AG ( Germany Inc. ) model of bank domination (see Pfeiffer 1993), and the dispersed ownership model in which no investors account for more than 5 percent of shares. 4 Although software is only the third important sector according to the Neuer Markt sectoral indices, in fact many specialized software companies are classified under other indices, e.g. e-commerce software under internet, telephone billing software under telecommunications, etc.

15 5 In addition to analyzing the data base, interviews with twenty Neuer Markt software companies were conducted together with Steven Casper.

16 References Albach, H. (1983) Zur Versorgung der deutschen Wirtschaft mit Risikokapital, IfM- Materialien, No. 9, Bonn: Institut für Mittelstandsforschung. Hoch, D., Roeding, C., Purkert, G. and Lindner, S. (1999) Secrets of Software Success: Management Insights from 000 Software Firms around the World, Boston: Harvard Business School Press. Lerner, J. (2000) Venture Capital and Private Equity: A Casebook, New York: John Wiley & Sons. Mackewicz & Partner (2000) Mythos, Visionen, Chancen: Venture Capital in den USA, Deutschland und Europa, Munich: Mackewicz & Partner. Pfirrmann, O, Wupperfeld, U. and Lerner, J. (1997) Venture Capital and New Technology Based Firms: A US-German Comparison, Heidelberg: Physica Verlag. Plückelmann, K. (2000) Der Neue Markt der Deutsche Börse AG, Frankfurt am Main: Peter Lang. Porter, M. (1992) Capital Choices, Washington: Council on Competitiveness. Vitols, S. (1998) Are German Banks Different? Small Business Economics 10 (2): Zysman, J. (1983) Governments, Markets and Growth: Financial Systems and the Politics of Industrial Change, Ithica: Cornell University Press.

17 Diagram 1: Product Life Cycle Financial Risk PROFITABILITY + Early Stage Seed Startup Expansion Maturity STAGE OF CYCLE -

18 Chart 1: Number of German IPOs No. of IPOs

19 25% 20% 15% 10% 5% 0% 5% 2% 5% Chart 2: Sectoral Distribution of Neuer Markt Firms 20% 12% 12% 3% 15% 20% 5% Technology Telecommunications Software Internet IT Services Media and Entertainment Medtech & Healthcare Industrial Services Financial Services Biotechnology

20 Chart 3: Distribution of European Growth Market Capitalization, June % 60% 60.6% 50% 40% 30% 20% 20.9% 10% 10.5% 5.7% 0% Neuer Markt EASDAQ AIM Nouveau Marchè 1.3% 0.6% 0.3% 0.1% Nieuwe Markt SWX EURO.NM Belgium Nuovo Mercato

21 Table 1: Alternative Governance Types Governance Type Herr im Hause (Master of the House) Dominant Investor Founder/CEO Investor Preferences Innovation Strategy Frequency on Neuer Markt Low risk Solid finances Personal control Incremental Innovation of Proven Product 69.1 % Silicon Valley Private venture capitalist High return (willing to accept high risk Radical Innovation/ New Blockbuster 11.2 % Corporate Control Other company Other Types (e.g. Cooperative, Bank-dominated, Market control) Members, Banks, Dispersed Investors Strategic interest (e.g. expand market share or exploit new market segment) Develop related product or new market for existing product 10.4 % Various Various 9.3 %

22 Table 2: Characteristics of Neuer Markt Software Companies (averages for 1999) Company Charateristics Internet Software Other Software Venture Capital Share of Equity 12.4% 6.9% Age (in Years) Sales (in million DM) R&D as % of Sales Number of companies 13 54