September 28, 2017

Bet that …?

Christian Hammel heads the Technology and the City department at the Technology Foundation Berlin. He observes technological and economic trends from all over the world and examines them in terms of their significance for Berlin as a business location. It’s no great surprise that much of his work currently revolves around the advancing digitalisation of life. Many start-ups are now financed with venture capital. We asked what venture capital is and what else you should know about the topic.

Viktor Hildebrandt: Mr Hammel, what is venture capital?

Christian Hammel: The term “venture capital” can be translated into German as “Wagniskapital” or “risk capital” and indeed the name says it all. Venture capital is used to finance companies, especially promising start-ups. But venture capital is not a normal loan. The founders do not have to provide financial collateral, nor do they ever have to pay back a single cent to the lenders. Instead, the creditors demand shares in the business, with the hope of being able to sell them on at a much higher price in a few years’ time. So the financiers plan their exit from the beginning, but of course they wait for the best time from their point of view.

That means that if such a company fails, the investor’s money is lost?

Exactly. That’s why we talk about venture capital. Backers in this area always have to reckon with high default rates. It is not uncommon for investors to be able to resell their acquired shares only at a loss or not at all in seven, eight or even nine out of ten cases. One must be able to afford these defaults.

Why do investors take such risks?

Because one lucky investment can often more than make up for these losses. Venture capital is mostly invested in industries where a small group of companies divides up a rather large cake among themselves, while all other competitors get nothing but crumbs. In extreme cases, even the entire market is dominated by a single company. This is called “the winner takes it all”. If an investor has the impression that a certain business idea is particularly innovative and scalable, and if he or she is also convinced of the competence of the founders, then it is of course worthwhile to invest a lot of money. Because only with sufficient financial resources can the start-up’s growth potential be realised quickly. Otherwise, in case of doubt, someone else will be quicker. Or the start-up will look for other financiers. Conversely, this means for founders: If I want to raise venture capital, I not only need a good product and personal competence, but I also have to convince the financiers that my company will grow strongly in a short time and dominate the market. If you want to win over investors, you have to raise their hopes for big sales and high returns. For a chip shop, for example, I might be able to get a bank loan, but no one is going to give me venture capital. Unless it’s a new, unprecedented kind of chip shop and I want to open thousands of them all over the world.

For entrepreneurs, this model seems to be an absolute godsend: they get money for their ideas and if the project fails, they are still debt-free. What’s the catch?

As already mentioned, the founders have to hand over shares in the company. This means that they no longer fully own their own company and that, in case of doubt, they can no longer decide independently on the fate of the company. Now, the number of shares to be surrendered and the actual influence of the financiers on the operative business and on fundamental strategic decisions naturally varies from case to case, but in principle this is the crux of the matter.

What determines how many shares the founders have to surrender?

The earlier one seeks venture capital, the riskier the investment is for the financiers. Therefore, the following usually applies: So-called early-stage investors give relatively little money for relatively many shares. If you only get involved when the idea has already proven its growth potential, you have to put up a relatively large amount of money for fewer shares, but then you also get shares in something bigger. Founders naturally try to improve their negotiating position by securing several potential investors and playing them off against each other in case of doubt. In many cases, however, the financiers, without whom no progress can be made, are obviously in the driver’s seat.

Who should I contact as a founder if I am looking for venture capital?

There are very different types of financiers. Only the traditional financial institutions do not play a role in principle, because they are of course not allowed to take such risks with the savings of their investors. Apart from that, you could, for example, come across fund managers who invest money on behalf of rich people. In the same way, there are also entrepreneurs who have already amassed a fortune themselves and now want to increase it through targeted investments in up-and-coming start-ups.

In addition, there are more and more companies that have discovered venture capital for themselves. In this case, one speaks of corporate venture capital. In contrast to fund managers and entrepreneurs, corporates do not only strive for financial gain, but also pursue strategic goals. They often want to use equity capital to secure direct access to technical innovations or to diversify their own business. Instead of implementing innovations laboriously and at great risk in their own companies, they prefer to invest in start-ups and often support them additionally with technical knowledge and management expertise to increase their chances of success. Finally, even the public sector is increasingly taking on the role of venture capitalist. In Berlin, for example, the IBB Beteiligungsgesellschaft (IBB Bet) was founded as early as 1997. In this case, too, the focus is not exclusively on returns, but in particular on strategic business development and profiling Berlin as a leading location in certain sectors. The public financiers often follow the investment decisions of the private investors, for example by adding a second euro for every euro that a founder is able to raise.

“A company that sells three packs of coffee more every year and grows hardly at all this way, but consistently, is not financed with venture capital.”

Berlin is by some distance the most important location in Germany when it comes to venture capital. Why is that?

First of all, the financiers want to be present where their clientele is located. Just as every supermarket wants to open a branch where its clientele hangs out. Conversely, the growth-oriented start-ups naturally want to work where the path to the financiers is short. These efforts reinforce each other and thus support Berlin as a location.

Now, of course, one can ask why it came to this in Berlin in the first place?

This is mainly because until recently it was possible to rent plenty of office space here for comparatively little money, even in extremely attractive locations with a very high quality of stay for one’s own employees. This made the city extremely interesting for start-ups. In addition, start-ups (just like any other company) naturally look for suitable staff, and there is plenty to choose from in Berlin, especially when it comes to digital skills of all kinds.

In addition, young founders make much less fuss about the location than established companies, where entire armies of analysts sometimes create and evaluate dozens of Excel spreadsheets to prepare a location decision. Young people, on the other hand, simply start up where they are, or they move to where their gut instinct leads them. In many cases, that seems to be Berlin. But one should always keep in mind that neither the start-ups nor the investors are evenly distributed across the city. On the contrary, there are some hot-spots of economic innovation in Berlin. These include the eastern part of the Kreuzberg and Mitte districts, where the majority of the start-up scene is located, on the one hand, and the established science locations on the other. There you will find many university spin-offs, which are particularly interesting for technology-driven companies looking for new business sectors. On the other hand, I have not yet heard of a start-up boom in Reinickendorf or Steglitz.

Do you think the high presence of funders and buyers in Berlin leads to even relatively bad ideas being funded? Or asked the other way round: Are some particularly good ideas not funded because the founders are not based in Berlin?

There is no clear evidence of such a thing. However, I don’t believe that good ideas and capable founders fail because of the location. The location helps. In Berlin, there are simply many more opportunities to present one’s own idea and gain supporters for it. But you can also live in Kyritz an der Knatter and start a successful business. It’s just a lot more complicated and involves a lot more driving.

And apart from that: The city of Berlin couldn’t care less. If there is so much capital here that even worse ideas can be brought to the market, then that is not a reason for concern, but rather a reason for joy.

The Technology Foundation Berlin has dealt in detail with the topic of venture capital in a study. Start-ups (financed with venture capital or not), it says, have an “outstanding” significance for Berlin’s economic development. Moreover, venture capital is described as an “almost ideal financing model” for start-ups. However, the authors also note that in 2015, just 0.5 per cent of all jobs subject to social security contributions in Berlin were accounted for by companies that raised venture capital in 2015. So where does the special interest of the Technology Foundation in venture capital come from?

The statistics do not lie. The number of jobs created by companies with venture capital financing is indeed relatively small. Compared to, for example, large service industries, the public sector or individual large Berlin companies, it’s almost a doddle. But if you look at the number of jobs per company, the figures for companies financed with venture capital are not that small compared to the manufacturing industry or technology service providers.

If one looks not only at the number of jobs, but also at the associated value added per employee or job, the picture changes. Value creation is particularly high in the knowledge-intensive and technology-driven sectors of the economy – precisely where venture capital is most often invested. Our interest in venture capital is also based on the fact that high-growth start-ups, which are almost all financed with venture capital, exert a certain attraction on other high-growth companies, which is of course also good for the region from an economic perspective.

However, as you pointed out at the beginning, many of these start-ups go bankrupt again. Investors expect a high failure rate and hope for a few particularly successful start-ups. Several studies prove this principle. They show that from the initially rapid company growth made possible by venture capital, promised by the founders and demanded by the financiers, there is often very little left after a few years. Does venture capital promote sustainable economic growth?

A company that sells three more packets of coffee every year and grows hardly at all this way, but steadily, is not financed with venture capital. Venture capital seeks to enable particularly promising young companies to grow quickly, and just like the rest of the economy, the venture capital business is driven by profit interests. To what extent this is sustainable or not depends on the perspective one takes.

From the point of view of the few big winners, the growth is quite sustainable, because they build up a very strong market position through rapid growth rates immediately after founding the company. To put it metaphorically, no one can easily knock them off their thrones. From the point of view of the many losers, on the other hand, the initial growth is of course not sustainable, because obviously it did not work out. Rapid growth is playing with fire and many entrepreneurs burn their fingers in the process. But that doesn’t stop many founders from trying a second, third and fourth time with new ideas. Anyone who gets involved in venture capital knows that rapid growth is expected and will be demanded at some point – no matter what the cost.

Drawn piggy bank

Apart from that, there are of course not only two extremes in the venture capital sector. There are the big winners and there are start-ups whose business idea does not catch on or which fail because they grow too quickly. But beyond that, there are also a whole series of companies that first collect venture capital and then neither develop into market leaders nor have to file for insolvency. They find a niche and nest there for the long term. If the cake is big enough, to use the metaphor from earlier, then you can live quite well on the crumbs. Still other companies develop promisingly, but are swallowed up at some point by a competitor that develops even better or was simply able to raise more capital. In this case, the business is not lost, at least not in its entirety, but is absorbed into another company. From the perspective of the region, on the other hand, the growth that comes from venture capital is sustainable, provided it bears fruit here. If offices are rented here, if taxes and wages are paid here, if jobs are created here, if profits are distributed and spent or reinvested here. Statistically speaking, it doesn’t matter if many companies financed with venture capital disappear from the market, as long as there are enough new start-ups. However, employees should not be indifferent if they have to join a new company every year.

Let’s stay a little longer with the perspective of the region: The venture capital-funded start-ups often displace existing businesses. A large online delivery service displaces many small delivery services. A large online shoe retailer displaces many small shoe shops and so on. How should the region deal with this?

Of course, this displacement is taking place. But we also have to take note that it mostly occurs in particularly saturated markets and that it is not an unfortunate side effect, but basically the raison d’être of the start-ups. Of course, they enter the market as competitors with the aim of displacing as many competitors as possible. These are the rules of the game of capitalism and not some special variety of company whose growth was financed by venture capital. As a good businessman, every kebab shop owner will try to displace all other kebab shops in the vicinity. In this respect, the critics of crowding-out processes should not start with venture capital.

The displacement of “real” shops in the city by online portals is a new form of displacement. You can either think it’s bad or not. In any case, one should not confuse correlation with causality. Just because start-ups with venture capital financing in particular are displacing shops does not mean that this form of displacement is caused by venture capital or, conversely, that it could be stopped by banning venture capital – if it can be banned at all. Apart from that: If you know that this displacement exists anyway and will continue to exist, then you are happy if it is at least driven by a company that is then also based here in the region.

“The displacement of “real” shops in the city by online portals is a new form of displacement. You can either think it’s bad or not.

At the same time, start-ups with venture capital financing have a bad reputation because, it is said, many hardly pay any taxes, engage in massive lobbying, use all their power to resist political regulation and do not pay their employees properly, if they hire people at all. Do you not see a cause-effect relationship here either?

First of all, of course, one would have to discuss all these points individually and with regard to specific companies. I think a generalisation is dangerous. Moreover, I do not share this perception unreservedly: I perceive massive lobbying more in large international companies than in start-ups. And the fact that companies that make losses or postpone old losses pay no or hardly any taxes does not seem to me to be very start-up-specific. I am also rather critical of some of the business practices of some start-ups. However, I have doubts whether their corporate financing, of all things, provides an explanation for this.


By the way, there have been comparable developments in every phase of capitalism, regardless of how the companies financed themselves. Read Friedrich Engels or go to the theatre and see a performance of Gerhart Hauptmann’s “The Weavers”. In classical industry, waste was still considered “disposed of” a few decades ago if you just threw it over the factory fence, and in some countries it still is. That is why I am sceptical about criticism that wants to attribute entrepreneurial action that is perceived as immoral to financing with venture capital, of all things. And as far as working conditions are concerned, I would like to add the following: When I look at the salary report of the Berlin start-up scene, my jaw drops – who would have thought, for example, that the salary differences between men and women are the greatest in such companies? – but at the same time I hear little about the employees themselves pushing for change. As long as colourful beanbags, fancy job titles, a sense of belonging and fun culture are more important to the employees than a few hundred more a month. And the excesses that people are now trying to counter with minimum wages and rules on bogus self-employment did not originate in the knowledge-intensive and venture capital-financed start-up sector, but came from completely different sectors of the economy.

Thank you very much for this exciting conversation.


September 28, 2017

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