Accession countries play VC catch-up

With rising stock markets, a few choice exits and governments announcing innovation strategies, the climate for R&D-based start-ups in Central and Eastern Europe should be improving. But there’s still a way to go, writes Mary Lisbeth D’Amico.  

When US-based Mercury Systems announced in January that it was acquiring Systinet, a company that makes software to simplify companies IT architectures, early-stage players in Central and Eastern Europe took it as a good sign. Systinet’s founder, Roman Stanek, is Czech and the deal is one of a few scattered exits in recent months showing that, in some instances, venture capital in the region can work.

“This confirms that there are pure technology companies in Central Europe that have IP exportable on a global level, and may become attractive acquisition targets for major international players,” says Jiri Benes, investment director with Prague-based 3TS partners, one of the investors in Systinet.

Ironically, 3TS is itself no longer in the early-stage market. Since it raised €100 million for its second fund in the second quarter of last year, it is focusing on expansion and later-stage investments. Benes says the size of the fund is too large to be effectively dispersed among dozens of start-ups, which would need €1 million or less and a lot of hands-on coaching.  

That is the frequent conundrum of the VC markets in new EU entrant countries such as the Czech Republic, Hungary, Poland, Slovakia, Estonia and Slovenia. While there is high interest on the part of foreign companies and stock market investors in putting money into the region – foreign companies in particular are drawn by the skilled workforce, tax benefits and low labour costs – few institutions or individuals exist to help technology start-ups get off the ground.

Sparks of light

To look first at the bright side, the exit and funding picture for later stage companies has brightened considerably over the past few years. Most of the glory, however, has gone thus far to serial entrepreneurs.  Still the most talked about exit is the sale of Estonian entrepreneur Niklas Zennström’s second company, Skype, to Ebay for $2.6 billion last year. And Systinet’s founder Stanek is also on his second company.

But other deals also indicate an increasingly positive investment climate for high-tech companies. Last March, Intel Capital and Warsaw-based Enterprise Investors gave a vote of confidence to Grisoft, a 15-year-old anti-virus software vendor based in Brno, Czech Republic, taking a 65 per cent stake in the company.

Around the same time came a highly successful IPO from Warsaw-based Bioton, a profitable maker of recombinant human insulin and antibiotics spun-out of Poland’s Institute for Biotechnology and Antibiotics.

The company took advantage of the ongoing bull run on the Warsaw Stock Exchange and launched its shares in March 2005 with an initial share price of 4.40 zloty (€1.17). Since then they have more than tripled in value; shares were trading recently at a price of 16.95 zloty (€4.51). Indeed, over the past year, the Warsaw markets have seen vigorous growth. The TechWIG, a basket of 20 Polish technology stocks, has risen more than 40 per cent.

But R&D-based companies such as Bioton are more the exception than the rule, say market participants. Many of the domestic stars of the tech sector there are IT services companies (Prokom and Softbank) or telecoms companies (Netia).

“Poland is not a place to come to invest in innovation,” believes Adam de Sola Pool, chief investment officer with Environmental Investment Partners, an environmental technology fund near Warsaw.

The rising stock market says more about Poland’s attractiveness as an investment target than as a place to start a new company. Poland has accrued some of the highest per capita foreign direct investment in Europe over the past decade, according to data collected by Primus Capital Partners, a Budapest-based early-stage investment house (see chart). That can be seen in the interest of US companies such as Motorola and Delphi Engineering in setting up facilities in Poland. But, with limited early-stage funding options and no entrepreneurial tradition, few are starting their own companies.

Investment strong, but early-stage scarce

Similar trends can be seen across the region. According to Primus, Central and Eastern Europe was Europe’s fastest growing investment area in 2004, and the recipient of an average of $490 million per capita between 1994 and 2003. The firm expects that to continue rising by 20 per cent per year, according to Zoltán Bruckner, Primus managing director.    

Overall private equity investment also went up. A report released last October by the European Private Equity and Venture Capital Association (EVCA) shows that investment in the region in 2004 totalled €547 million, up 22 per cent from the previous year. But an overwhelming majority of the funds went towards buyouts, expansion and replacement capital (the 2005 figures will be out in March).  

Looking at the very early-stage scene, the picture is dismal. “It is fair to say that the equity gap seen across Europe is even more visible in the CEE region,” the EVCA notes in the report.  EVCA figures show virtually no seed funding market in the region (although local players say that what Western Europeans call seed is called early-stage in the region.)

Organised business angel networks don’t really exist

“We need more business angels and the few we have don’t want to organise themselves,” says Vlastimil Vesely, a Prague-based technology consultant and founder of the Virtual Innovation Park, an internet-based information service for the region.   

Only the Czech Republic, Hungary, Slovakia and the Baltic States recorded any early-stage volume to speak of in 2004, according to EVCA. (See the chart on page 4 of the EVCA’s 2005 report).

The few VCs who do focus on early-stage say they would welcome a few more competitors to co-finance deals. “I see this as building a market that is severely underfunded,” says Bruckner of Primus.  “The same companies and technologies would get millions in funding in the UK or the US, or even in France or Germany.”   

Central and Eastern European countries also rank low across the board for their R&D expenditures. Besides the Czech Republic, none of them invests more than 1 per cent of their GDP in R&D.   

Some governments have taken steps to improve R&D expenditures or are at least talking about doing so. Many countries now offer tax deductions for R&D expenses. Hungary has launched a comprehensive innovation program, for example, that includes tax incentives, reforming spin-off laws, and offering financial support to qualified spin-offs and SMEs via the Hungarian Development Bank.

The Czech Republic also has passed laws to allow spin-outs, and its development agency, Czechinvest, is heavily pushing the biotech sector (see accompanying article). But most of the financial support there still seems to come from the European Union rather than the federal government.

The Estonian government, perhaps inspired by Skype, has also announced formation of a roughly €30 million seed fund to be launched this year.

As for the free market, many VCs appear to have become risk averse, a decision that Primus’ Bruckner feels is short-sighted. “Investors can get better valuations here and so better value for their money – but only if they're willing to put in the time and attention these companies need to develop,” he says.