Investing: Long day's journey...

For her latest fortnightly funding column, Mary Lisbeth D'Amico set out to find European seed funders. That was as easy as finding a needle in a haystack.

The story sounds like a fairy tale come true. In 2003, Swedish entrepreneur Niklas Zennström has an idea for a voice over IP technology company. He gets about $1.5 million in startup funding from VCs. His company grows rapidly and he receives another $18.8 million to finance the expansion. He then sells his company in September of 2005 for a cool $2.6 billion in cash and stock to E-bay.

Stories like that should be good news for other European entrepreneurs trying to get their companies funded, right? Well, if you’re not Niklas Zennström, don’t hold your breath. Funding at the idea stage may work for superstar serial entrepreneurs like Zennström – who already founded peer-to-peer company Kazaa and expects his latest company, Skype, to pull in up to $60 million in revenues this year and $120 million in 2006. But for the run-of-the mill European scientist with an innovation, finding investors who will fund a very early-stage company is still a major challenge.

Its no secret that since the Internet bubble burst in March 2000, venture capital has been hard to come by in Europe. In countries such as France and Germany, where the venture capital industry was just getting off the ground, the collapse of stock markets hit VCs hard.

In particular, those who had invested heavily in Internet-related technologies had to spend most of their time over the past few years putting out fires – providing follow-on funding to struggling portfolio companies or writing off their losses – rather than focusing on new early-stage investments.

On top of that, the poor performance of many of the funds, and the lack of exits due to the difficult IPO market puts European VCs under pressure to show investors good results. That has made them overly cautious. Just to give an example, early stage German VC Dr. Neuhaus Techno Nord says its second fund, invested in 2000, was only break-even. In spite of that, the firm says the fund is ranked in the top quartile of all funds worldwide.

Seed funding has been hardest hit of all. According to the European Venture Capital Association seed funding by its members last year amounted to only €148 million in 355 companies, compared to €820 million in 833 companies in 2000. That level of investment was equivalent to levels in 1998, according to the EVCA. And overall, seed financing made up only 0.4 per cent of total VC investing.

There are signs that improvement is on the way. EVCA says that according to preliminary data, in the second quarter of 2005, early-stage investing has jumped 13 per cent over the previous quarter, although in general an uptick in investment has been driven more by expansion stage finance [see charts].

Clearly the path is not easy. But surely there must be some venture capital firms out there willing to take a risk on a bright idea - isn't that, after all, what VCs do? I set myself the task of locating some of these firms.

No seed here

I figured one good place to start would be the European Private Equity and Venture Capital Association's database which is divided up into financing stages. If you search for seed phase investors, you come up with an impressive list of 143 companies.

But take a closer look, and the list of active seed investors quickly shrinks. Firms such as 3i and Atlas Venture, for example, have turned their attention more to the buyout segment in recent years. And even those called early-stage—such as Wellington Partners, Sofinnova Partners and Polytechnos Venture Partners--are more focused on first rounds than on nurturing seed stage companies.

A not untypical answer comes from Eric Achtmann, managing partner with Polytechnos in Munich, "In general, we do not do seed," he says. "However, we will make exceptions in certain cases depending on the magnitude of the opportunity and the management team," he adds. For its tech investments, he notes, Polytechnos expects to see revenues of between €1 million and €2 million within 18 months.

Next I turn to the European Union's European Investment Fund, in Luxembourg. After all, the EIF's mission is to invest in "venture capital funds and business incubators that support SMEs, particularly those that are early stage and technology-oriented," according to the EIF web site. This should lead me to some true seed investors.

I see immediately that the EIF has made some investments in a handful of promising sounding names, such as the New Tech Venture Capital II, which just closed a €38 million fund managed by Luxembourg-based Mangrove Capital Partners – incidentally an investor in Skype. I shoot an email to the appropriate partner at Mangrove, but we don't connect by press time. I also do a search for seed investments, and learn that the EIF has made two such investments in UK-based Pentech Fund 1, and EMBL Technology, a biotech fund based in Germany.

The EMBL team is unreachable by phone. But with Pentech Ventures, I finally locate a VC that is not only willing to speak with me, but also doesn’t hide the fact that it is indeed a seed funder. "We like to see a firm with a product that is now ready to engage the market," says Eddie Anderson, a former software entrepreneur who co-founded the Glasgow-based company in 2001. "We firmly believe that the space we are in is right," he adds.

The firm typically invests between £25,000 and £1 million in software infrastructure and applications companies. It has invested about £12.5 million of the £23 million it raised in 10 companies, and expects to complete between two to four more deals by mid 2006.

But Pentech suffers from the same problem as a number of early-stage investors share that were founded over the past five years: a lack of spectacular exits. Pentech has sold one text-to-speech company to Scansoft of the U.S, but otherwise, has seen no IPOs. No serious fundraising can be done until two or three exits have occurred, Anderson says. The future for such firms is unclear.

What is also clear is that Pentech does not have a lot of company. Anderson says he sees other investors such as Pond, Alta Berkeley and Amadeus Capital Partners competing on deals but after that the list gets short. "When it comes time to build syndicate partners, it’s a challenge," he adds.

Once burned...twice shy

Next I take a look around my home market, Germany. Finding active early-stage players is even more of a challenge. (See column 1, 13 October, "Where’s the Seed?")

I speak with Christian Nagel, investment manager at Earlybird Ventures in Hamburg. Earlybird is eager for press, as they are about to launch new fundraising efforts. But apparently Earlybird has learned that being early does not always mean getting the worm. “There were many cases where we invested too early for the market,” says Nagel, remembering an ill-fated investment in a voice over IP company.

From its first two parallel funds totalling €70 million raised in 1999, 14 of 27 portfolio companies were write-offs. In 2000 Earlybird raised $225 million, which helped it bridge the difficult times, Nagel said. Of those, 40 per cent were write-offs. This has made the VC more cautious. Earlybird now at least likes to see a finished prototype and a full management team in place before it invests.

Still, the VC can crow that it has recently brought three of its portfolio firms public, one of which, Esmertec, is a spin-out from the Swiss Federal Institute of Technology (ETH) in Zürich. And the VC says it now plans to move more fully into early-stage investing again for its next fund, which it plans to officially start raising at the beginning of next year.

Other market players tell me that Dr. Neuhaus Techno Nord in Hamburg is a true seed investor. They, too, are eager to talk to me because they’ve just launched fundraising efforts and are happy to announce that the EIF will serve as an anchor investor to the new fund, taking a 30 per cent stake with an investment of €30 million. "We feel we owe it to our investors to be anti-cyclical," says Matthias Grychta, managing partner at the Hamburg-based VC.

But while Dr. Neuhaus does indeed do early-stage investing, and has funded several startups from local universities in the past, its more recent funding efforts have focused on less technically-oriented companies. Recent investments have included blau.de, a mobile phone discounter started by serial entrepreneurs with whom the VC has already invested, as well as computer games developer Intenium. And although the firm has co-sponsored a local business plan competition with early-stage advisor CatCap since 2003, it has only made two investments in companies emerging from the competition.

Biotech still calling some

While on the EIF web site, I noticed that it had recently invested €10.4 million in Nordic Biotech Venture Fund II, a Danish venture capital fund focused on drug development companies. It occurred to me that biotech entrepreneurs do appear to have a wider array of funding choices than a tech entrepreneurs.

TVM in Munich, for example, recently closed a hefty €240.3 m fund, TVM Life Science Ventures VI, and claims it is committed to finding new early-stage investments. It has already made an investment from the fund, taking part in a €35 million A-round for AWD spin-out Elbion, which develops small-molecule drugs for inflammatory and central nervous system diseases. Healthcap and Innovationskapital are two other big names in this area that say they do early-stage funding.

But again, after nosing around a bit, it becomes clear that for their very earliest stages, biotech companies should look elsewhere than private VCs. One of the biggest promoters of such seed deals turns out to be Swedish medical university Karolinska Institutet, which supports both its own research teams and those from other regional institutions.

Initial support comes from tech transfer unit and incubator Karolinska Innovations. That in turn selects portfolio companies to be funded further by its seed funds, which includes the €10.4 million Karolinska Development I (KDI), and the €39.4 million KDII.

These funds are not financed by the university: they are made up of funds from mainly Swedish institutional investors, business angels and foundations. Together the two funds have invested in 15 life sciences companies. For expansion stages, Karolinska also is a co-founder with pension administrator Alectra of the Karolinska Investment Fund, a €65 million biotech fund whose money comes mainly from Swedish pension funds.

But the fund has the same problem as other VCs: set up in 1999, it hasn't yet made a single exit, says Hans Wigzell, member of the board of directors at KDI and the former president of the Karolinska Institute. But there appears to be no turning away from the sector. Plans are already being made to raise money for KDIII. "We think it is unethical if we don't support getting our research into applications," Wigzell says.

Government help

My last stop along the way for some answers is with Modwenna Rees-Mogg. She’s not only the editor of the VCR Directory, a listing of 3000 investors in unquoted companies, but Mogg also serves as editor of Angel News a new UK information service designed to create more transparency in the market among startup companies, VCs and angel investors.

She confirms to me that the scene among private VCs is still pretty sparse. Tax breaks that the UK government awards to venture capital trusts still makes them an attractive early-stage vehicle. One of the most active, she notes, is the Oxford Technology Fund. Help is also on the way via the UK government’s new Enterprise Capital Funds (ECFs), which will mix public and private funds to invest in UK SMEs.

Universities also do their part. For example, NanobioDesign, an in vitro testing and diagnostics company, in August received £520,000 from Imperial Innovations, the investment arm of Imperial College London, and Nikko Securities subsidiary NPI Ventures.

Yet, all in all, it’s not enough. "We estimate that the demand out there for financing among UK companies that deserve to be funded is about ten times the number of deals happening," Mogg says.

Perhaps efforts like that of the UK government, or the EIF – which has started a special fund in conjunction with the European Investment Bank (EIB) to help the badly hurting German market – will indeed give the market the jump-start it needs. But that will only work if the private VCs do their part.

Pentech’s Anderson sums it up when he says, "Eventually these later-stage guys and their [investors] will realise that they are cutting off the food chain by not supporting early-stage deals. Who is going to feed and support the next set of companies?"

In a future column, I'll be looking at the role that business angels have to play in the early-stage ecosystem, as well as how improved technology transfer vehicles may help. If you have something to share about this column, or other ideas, please email me at [email protected]