© Copyright 2000: Council on
Foreign Relations & Westview Press
INTERNATIONAL VENTURE CAPITAL --
The Role of Start-Up Financing in the United States, Europe, and Asia.
Jeffrey D. Nuechterlein, J.D. D.Phil
(Oxon).
This article describes and analyzes the role of venture capital as a
key source of financing for start-up companies in the United States, Europe,
and Asia. Venture capitalists provide
equity financing to private companies with rapid-growth potential for a variety
of purposes, including product development, production, marketing, sales, and
expansion. In essence, venture capital
is high-risk, high-reward finance designed for young companies that have
different asset structures, cash flows, and growth rates than mature companies. Companies backed by venture capital historically
have produced a disproportionate share of new jobs, particularly well-paid and
highly-skilled jobs. Moreover, U.S.
venture capital-backed companies generate about three times more export sales
per dollar of equity than more established companies and are a key source of
research and development spending and applied technological innovation. Consequently, governments are increasingly
aware that venture capital is an important source of economic growth and a means
of developing targeted sectors of the economy.
U.S. venture capitalists pioneered and continue to dominate the venture
capital business. In 1998, U.S. venture
capitalists again raised and had more capital under management than venture
capitalists in any other region of the world.
While European and Asian venture capitalists have an increasing amount
of capital under management, much of this capital is dedicated to buyouts of
established companies, as opposed to start-up and expansion financing. In addition, most venture capital investments
in Europe and Asia are in safer, more mature, and less dynamic companies than
venture-financed firms in the United States.
In fact, most European and Asian countries have had relatively little
success in early-stage venture capital.
The U.S. lead in venture financing for start-up companies partly
explains the U.S. dominance in developing many new technologies, including
software (nine of the top ten companies are American) and the Internet.
Venture
capital is defined herein as early and expansion-stage financing, as opposed to
financing for buyouts (the outright purchase of a company, usually with borrowed funds) and workouts (the turnaround
of a troubled company). Venture
capitalists provide equity financing rather than loans to young companies in
exchange for ownership of part of the company.
As a result, entrepreneurs avoid interest payments and can more quickly
achieve profitability. Entrepreneurs
seeking venture financing typically prepare a business plan that provides a
description of the product and the
market, financial statements and projections, as well as the background of key
managers and directors. Venture
capitalists assess the quality of the management team and the competitive
position and financial prospects of the company. On average, venture capitalists invest in only about 1% of the
opportunities presented. Once they
invest, venture capitalists actively work with the company’s management by
contributing their business experience and industry knowledge gained from helping
other young companies.[1]
During the first few years, before significant revenues are generated,
about two-thirds of the average venture capital-backed company’s total equity
is supplied by venture financing. The
average U.S. venture-backed company raises about $16 million of venture capital
during its first five years.[2] Start-ups typically use initial financings
to develop a prototype and fund marketing and sales. Later financings allow companies to grow more quickly than
proceeds from sales alone would allow.
At this point, the company could be ready to go public, putting
financing in the market’s hands and allowing venture capitalists to realize a
return on their investment.
In the United States, however, it is as common for a venture capitalist
to sell a start-up to another firm as to offer it to the public through an
initial public offering. For example,
101 venture-backed firms were sold to other companies in 1996, 152 were sold in
1997, and 190 were sold in 1998. By
contrast, 275 venture-backed firms went public in 1996, 136 went public in
1997, and 77 went public in 1998.[3] In Europe, which lacks a liquid,
transnational stock market on a par with the U.S. National Association of
Securities Dealers Automated Quotation (NASDAQ) market and which has an
underdeveloped equity culture, venture-backed companies are more likely to be
acquired by another company than sold to the public through an initial public
offering. The time period from start-up
to an initial public offering varies considerably from country to country. In the United States, the average time is
about five years, whereas in Japan the average has been about 30 years because
of regulations that make it difficult for young companies to list on the Tokyo
Stock Exchange.[4]
In addition to the institutional venture capital market analyzed in
this article, there are approximately 250,000 so-called “angel” investors
(generally wealthy individuals) in the United States who invest about $20
billion in 30,000 companies annually.
Angel investors generally operate as individual investors, but some
angels meet informally in groups to consider investments. The best known group of angel investors is
the Band of Angels, comprised of more than 100 Silicon Valley high-tech
executives who meet monthly to hear business presentations and make
investments. The Band of Angels
invested $45 million in 86 companies between 1995 and 1998 with a rate of
return of 30 percent.[5]
Venture
Capital in the United States
U.S. venture capitalists pioneered the venture capital business
immediately after World War II, roughly three decades before venture capital
grew to a significant size in any other country. Milestones in the development of venture capital in the United
States include the formation in 1946 of American Research and Development (ARD)
-- the first publicly traded company specializing in equity investing in
start-up companies -- which had some spectacular early successes, particularly
on the $70,000 it invested in 1957 for a 77% equity stake in the Digital
Equipment Corporation that produced a 5000-fold return over 14 years.[6] The founders of ARD believed that scientists
at the Massachusetts Institute of Technology and elsewhere who had developed
promising new technologies during the war years needed financing and hands-on
assistance to successfully commercialize their research.
In 1958, Congress -- reacting in part to a 1957 Federal Reserve Bank
study that revealed a lack of equity capital for new companies -- enacted the
Small Business Investment Company (SBIC) Act.
SBICs are private corporations licensed by the Small Business
Administration (SBA) to provide venture capital to new companies. SBICs can lever their private capital with
loans from, or guaranteed by, the SBA; the additional funds made available
through SBA guarantees may equal 2 to 3 times the invested private
capital. By 1963, the 692 SBICs
licensed by the SBA managed $464 million of private capital and included 47
publicly owned SBICs that raised $350 million through public offerings. By comparison, ARD raised only $7.4 million
in its first 13 years.[7] In the 1960s and 1970s, SBICs accounted for
as much as one-third of venture financing, but by 1990 accounted for less than
5% of such financing.
After years of mismanagement and abuse, culminating in numerous SBICs
going bankrupt between 1986 and 1992, Congress restructured the SBIC program by
enacting the Small Business Equity Enhancement Act of 1992 and its 1994
implementing legislation. In addition
to correcting a number of structural problems in the program, the 1992 Act
enables SBICs to defer paying the accrued costs on their debenture leverage
until the SBICs realize sufficient capital gains and income to achieve
cumulative profitability. As a result
of this legislation, the licensing of new SBICs has increased
dramatically. Between 1994 and 1998,
138 new SBICs were licensed with initial private capital of $1.8 billion. Combined with additions to the private
capital of existing SBICs, this resulted in a doubling of private capital in
the program from $2.3 billion in 1993 to $5.8 billion in 1998. In 1997, SBICs accounted for 45% of the
total number of venture financings and 20% of the total dollar volume of
venture financings in the United States.
By mid-1998, there were 242 active regular SBICs and 78 Specialized
SBICs (which finance businesses owned by socially or economically disadvantaged
persons). Of the regular SBICs, 83 are
owned by banks, which are limited by banking regulations in their ability to
make large equity investments except through an SBIC subsidiary. Bank-owned SBICs represent 63% of the
private capital in the program and generally do not use SBA-guaranteed
leverage. Companies that trace their
initial financings to SBICs include America Online, Apple, Federal Express, and
Intel.[8]
In addition to the creation of the SBIC program, the late 1950s and the
1960s also saw the establishment of the first venture capital limited
partnerships where professional venture capital managers acting as general
partners invest funds on behalf of limited partners, which are commonly
institutional investors like pension funds.[9] Limited partners are so-called because their
liability extends only to the capital they contribute. Limited partnerships typically have a 10
year life, during which the limited partners forgo nearly all control over the
management of the partnership. Limited
partnerships now manage about 80% of all private equity investments.[10]
U.S. venture capital funds grew markedly in the 1980s, in part because
of six key legislative acts between 1978 and 1981: the Revenue Act of 1978, which reduced the capital gains tax rate
from 49.5% to 28%; the 1981 Economic Recovery Tax Act, which further reduced the
capital gains rate to 20%; 1979 and 1980 legislation that allows pension funds
to invest in private equity; the 1980 Small Business Investment Incentive Act,
which reduced the regulatory burden on venture capitalists; and the 1981
Incentive Stock Option Act, which allows holders of stock options to defer tax
liability to the date when the stocks are sold rather than the date when the
options are exercised. The U.S. venture
capital industry also profited enormously from the boom in personal computers
in the 1980s. Between 1980 and 1990,
the value of the personal computer industry grew from virtually zero to $100
billion, the largest legal accumulation of wealth in history. More than 70% of these firms were
venture-backed.[11] Cisco, Compaq, Cray, Genentech, Lotus,
Microsoft, Netscape, Starbucks, and Sun Microsystems are some of the well-known
U.S. companies nurtured by venture capital.
U.S. venture capitalists raise about three times more venture funding
each year than those in any other country.
In 1997, U.S. venture capitalists raised more than $10 billion (up from
$4.4 billion in 1995 and $7.5 billion in 1996), largely from pension funds
(55%), corporations (13%), and endowments and foundations (10%) flush with
capital from the doubling of the S&P 500 over the last three years.[12] U.S. venture capitalists raised an
additional $25 billion in 1998 (largely from pension funds – 60%) and $9.5
billion during the first six months of 1999.[13] Investors have increased their allocations
to venture capital in part because of historical figures showing average annual
returns of approximately 20% for venture capital investments compared to 11%
for the S&P 500.[14] As a result of 1998’s inflow, net capital
under management by U.S. venture capital firms increased to about $75 billion,
up from $3 billion in 1980. Moreover,
the internal rate of return of venture capital investments historically is
considerably higher in the United States (approximately 20%) than elsewhere in
the world (e.g. Britain and France where returns have averaged about 10%).[15]
U.S. venture capitalists invested a record $14 billion in nearly 3000
companies in 1998, compared to $12 billion in 1997, $10 billion in 1996, and $8
billion in 1995. The average size of
each financing in 1998 was $5 million.
There was more venture capital invested in California ($5.8 billion),
Massachusetts ($1.7 billion), and Texas ($800 million) than in all of Europe.[16] Venture capital investments in the United
States, unlike in Europe and Asia, are highly concentrated in technology. In 1997, U.S. software companies captured
22% of the total invested, networking/communications companies 19%, Internet
companies 18% (up from just 2% in 1994), healthcare services 9%, biotechnology
8%, and medical devices 6%. Retailing
and consumer products companies combined accounted for only 8.8% of the total.[17] U.S. venture capitalists invested an
additional $11.4 billion during the first six months of 1999. During the second quarter of 1999 alone,
U.S. venture capitalists invested $6.8 billion; 56% of that amount went to
Internet companies.[18]
The United States has the world’s most successful venture capital
industry in large part because of a strong entrepreneurial culture that allows
managers to take substantial ownership positions in their companies. U.S. managers are much more likely than
their European and Asian counterparts to join a rapidly-growing start-up that
cannot afford to pay large salaries but can attract top talent by offering
equity ownership through generous stock option grants.[19] European and Asian managers, on the other
hand, generally prefer the security of large corporations and are unlikely to
have equity interests in their companies.
In fact, many European and Asian countries have severely restricted or
prohibited the use of stock options.
The United States also has the most competitive market in the world,
which produces excellent managers and gives U.S. companies a significant
advantage in increasingly competitive international markets. In addition, the United States, unlike many
European and Asian countries, has well-developed and liquid stock markets,
which are critical for a vibrant venture capital sector because venture
investors and entrepreneurs must have an exit mechanism for realizing capital
gains. The U.S. venture capital
industry also benefits from ready access to institutional financing, a
relatively flexible labor market that allows companies to hire and fire workers
more easily than can European and Asian companies, bankruptcy laws that do not
prohibit failed entrepreneurs from starting another company, a tax system that
generally allows entrepreneurs to retain a higher percentage of profits than
their European and Asian counterparts, strong intellectual property rights
protection, the world’s preeminent business schools,[20]
and a merit-oriented business culture that directs capital to good ideas
usually without regard to the entrepreneur’s pedigree.
U.S. entrepreneurs also have benefited enormously from relatively close
links among universities, government laboratories, and private companies. The transfer of research and development and
technology innovations from research universities (e.g. Stanford and MIT) and
government laboratories (e.g. Oak Ridge in Tennessee)[21]
to the private sector has led to clusters of entrepreneurial companies and
venture capitalists in areas like Silicon Valley in Northern California, the
Route 128 corridor in Boston, Northern Virginia, the Research Triangle Park in
Raleigh-Durham, North Carolina, and Austin, Texas where much of the development
of the semiconductor, software, computer, biotech, and Internet industries has
occurred. While there are some examples
of universities in other countries transferring technology research to the
private sector (e.g. the relationship between Cambridge University and the
1,000 high-technology companies in Silicon Fen in England), there generally is
little cooperation between universities and the private sector in Europe and
Asia. Unlike U.S. universities, most
European and Asian universities do not encourage the commercialization of
research, focus more on theory and less on applied innovation, and rarely
recruit from the private sector to fill academic positions.[22]
Venture capital did not become a significant source of financing in
Europe until the 1980s. In the last few
years, however, the amount of venture capital under management has grown
steadily. By 1997, the approximately
500 European venture capital firms had made cumulative investments of about $30
billion in 20,000 companies.[23] The level of venture capital financing in
Europe, however, would need to be three or four times its current level for
venture capital as a percentage of the region’s GDP to match the equivalent
ratio in the United States. Baan,
British Biotech, Business Objects, Filofax, Parker Pen, and Zodiac are some of
the well-known European companies nurtured by venture capital.
For a number of reasons, however, the greater use of venture capital in
Europe over the last few years has not resulted in the same kind of dynamic
start-ups that venture capitalists in the United States have helped
nurture. First, much of what is
classified as venture capital in Europe (and Asia) is dedicated to buyouts and
workouts, as opposed to start-up and expansion financing. More than half of Europe’s $11.5 billion in
venture financing in 1997 went to management buyouts as opposed to start-up or
expansion funding.[24] Less than 10% of Europe’s venture financing
is invested in start-ups, compared to about 37% in the United States, in large
part because investments in European start-ups have produced low rates of
return.[25] In 1997, European venture capitalists
invested about $840 million in early stage companies whereas U.S. venture
capitalists invested $2.5 billion in such companies.[26] Second, venture capitalists in Europe tend
to fund safer, more mature, and less dynamic companies than venture capitalists
in the United States. In 1995 and 1996,
European venture capitalists allocated only about 2% of their investments to
biotechnology firms and less than 20% to various technology sectors, including
communications, computer, and electronics firms.[27] In 1996, U.S. venture capitalists invested
12 times more funds in technology companies than their European counterparts.[28] In fact, a larger percentage of venture
financing in Europe goes to consumer-related industries than to technology
companies. In Europe as a whole, less
than 10% of venture financing is invested in technology companies. By comparison, in 1997, U.S. venture
capitalists invested more than 70% of their funds in technology-based companies
and only 9% in retailing and consumer products companies.
Compared to their U.S. counterparts, most European institutional
investors (outside of Britain and the Netherlands) are more wary of equity investments
in start-up firms and prefer the relative safety of fixed income
investments. In addition, while the
United States has allowed pension funds to invest in private equity since 1979,
some European and Asian countries prohibit pension funds from participating in
the private equity market.
Consequently, pension funds supply more than 50% of venture capital
raised in the United States compared to 25% in Europe (up from 16% in 1993) and
5% in Japan. Because many European
countries allow banks to lend money and make equity investments in the same
company, banks are still the leading source (26%) of venture capital funding in
Europe.[29] In the United States, banks account for a
much smaller percentage of venture capital financing because U.S. banking laws
(e.g. the Glass-Steagall Act) impose more restrictions on banks making equity
investments in companies in their loan portfolios. Banks, particularly in Europe, however, are much more likely than
venture capitalists to invest in relatively safe investments and normally do
not bring the type of expertise needed to nurture young entrepreneurial
companies.
In Germany, the commercial banks, insurance companies, and venture capital
firms that invest in start-ups historically have had limited success. The total amount of venture capital that has
been invested in Germany is about $4 billion, roughly equivalent to the amount
of venture capital invested in the United States in the second quarter of 1998
alone.[30] About $300 million (7%) of this total is
invested in start-ups and less than 15% is invested in high-technology
companies (although the amount of venture capital provided to technology
start-ups is growing rapidly).[31] German banks provide 58% of all venture
financing and favor large investments in expansion stage companies.[32] Techno Venture Management, established in
1984 as an offshoot of Siemens, is Germany’s oldest venture capital firm, while
Deutsche Bank’s venture capital arm is Germany’s largest provider of venture
financing.
The primary problems facing German entrepreneurs have been excessive
government regulation, relatively high capital gains taxes, high labor costs,
inflexible labor laws (supported by powerful labor unions) that limit the
ability to hire and fire employees and a general political concern with
protecting workers from layoffs, inadequate exit mechanisms for investors, a
lack of management talent to nurture early stage companies, a dearth of employees
willing to leave the safety of well-paid jobs with large German companies to
join a start-up (in part because of the stigma associated with failure in
Germany), and an underdeveloped entrepreneurial culture. In part because of these problems, as well
as the German preference for bonds over stocks, Germany has less than half the
number of quoted companies as Great Britain.
Numerous German entrepreneurs have moved their high-tech ventures to the
United States to escape Germany’s taxation system and to be closer to potential
investors and partners.
The German government and business sector have recognized the
importance of encouraging entrepreneurial activity and recently have taken
steps to bolster support for start-ups.
For example, Deutsche Börse, which runs the Frankfurt securities
exchanges, established the Neuer Markt in March 1997 to assist young companies
in raising capital and to provide venture capitalists with an effective exit
route. By August 1999, nearly 150
companies had listed on the exchange.[33] (By comparison, U.S. stock exchanges list
approximately 1500 high-technology companies with a market capitalization twice
that of all non-U.S. high-technology companies combined.) In addition, Deutsche Ausgleichsbank, a
government-owned bank that is one of the largest start-up financiers in
Germany, sponsors the Technology Participation Society that helps finance young
technology companies. The German
government’s BioRegio initiative, begun in 1995, appropriated $90 million to
three winning areas (Munich, Rheinland, and Rhein-Neckar-Dreieck) to help
develop a more robust biotechnology industry.
German banks and investors have agreed to invest an additional $900
million in the initiative over the next five years.[34] On the local level, the Bavarian government
has begun funding scientific research to aid the region’s growing information
technology and biotech sectors.[35] SAP, the German enterprise software maker
that is the world’s fourth largest software company, is developing a German
venture capital arm and recently established four professorships in
entrepreneurial studies at German universities. In part because of these developments, Germany’s venture capital
sector is growing rapidly.
France has some of the right elements for a strong venture capital
industry, including a strong technology base, an entrepreneurial culture
exemplified by a large number of small companies,[36]
and a new small company stock market (Le Nouveau Marché).[37] Total venture investments in France,
however, are small. In 1996, French
venture capitalists invested only about $500 million, less than $200 million of
which went to start-ups.[38] In 1997, French venture capitalists invested
only about $100 million in start-ups.[39]
The primary problems facing the French venture capital industry are
relatively poor performance records, the absence of sizable pension funds,[40]
the inability of France’s financial system to channel significant funds into
private equity, relatively high capital gains taxes, a dearth of skilled
management teams willing to join start-ups, and a highly regulated labor market
weighed down with social charges.[41] In part because of these problems, nearly 50
French companies recently have moved or committed to move to Great Britain,
which has a more welcoming business climate.[42]
Great Britain has made the most progress among European countries in
stimulating venture capital investments, in part because of government reforms
in the 1980s and 1990s that reduced high tax rates, promoted more flexible labor
markets, and streamlined burdensome regulations that had disproportionately
disadvantaged small companies. In
addition, Britain has the most liquid stock markets in Europe. In 1995, the London Stock Exchange
established the Alternative Investment Market in London, which is designed
specifically for small growth companies; by 1999, more than 300 companies had
listed on the exchange.[43] In 1999, the London Stock Exchange launched
Techmark, a new market designed specifically for high-tech companies.
Unlike France and Germany, British pension funds are the dominant
source (32.8%) of venture financing, whereas insurance companies and
corporations provide 20.6% and 16.0%, respectively.[44] In 1996, Britain, with less than half the
population, attracted twice as much venture capital as France and Germany
combined; Britain accounted for 44% of total European investment whereas France
and Germany accounted for 12% and 10%, respectively.[45] In 1997, British venture capital firms
invested about $265 million in 219 early stage companies (whereas U.S. venture
capitalists invested $2.5 billion in more than 700 early stage companies).[46] British venture capitalists invest about 5%
of their funds in start-ups and about 16% in technology companies.[47] Although small by U.S. standards, Britain is
the second-largest high-technology venture capital market in the world after
the United States. Britain also has
Europe’s largest biotechnology industry, with more than 180 companies, about twice
the size of the biotech sectors in France and Germany.[48] More than any other country in Europe or
Asia, Britain offers an experienced array of entrepreneurial managers who are
available for new start-ups as their older venture-backed companies mature.[49]
One of the centers of Britain’s technology venture boom is Cambridge
Science Park (“Silicon Fen”) in and around Cambridge, which is home to about
1,000 high-technology companies that employ 30,000 people and produce more than
$3 billion in annual revenues.[50] In 1997, Microsoft established an $80
million research laboratory in Cambridge to take advantage of Cambridge
University’s strengths in the sciences and its long history of collaborating
with industry. Microsoft’s links with
Cambridge are particularly close – the head of the University’s computer
laboratory also heads the Microsoft facility.
(The Gates Foundation also donated $20 million to the University’s
computer science department and Microsoft committed $8 million -- plus an
additional $8 million for possible co-investments -- to a Cambridge and
London-based venture capital fund managed by Amadeus Capital Partners.)[51] Cambridge University recently established a
management school, after years of ambivalence about business as an academic
discipline, and has announced that it will establish a school of
entrepreneurship modeled on the entrepreneurship program at the Massachusetts
Institute of Technology.
A second concentration of venture-backed companies in Britain is in
Oxford and the Thames Valley (the M4 corridor), west of London. The Oxford Science Park (established in
1991, 21 years after Cambridge’s) and the Oxfordshire region generally are home
to 730 high-technology companies that employ about 26,400 people. In addition, 8 of the top 10 U.S.
information technology companies have their British or European headquarters in
the Thames Valley and the other two, Apple and Sun Microsystems, are on the
outskirts of the region. Numerous other
electronics, telecommunications, and biotechnology companies also are based in
the Valley. For many years, a large
percentage of Oxford University academics were hostile to the commercialization
of research and, like many Cambridge academics, questioned whether business
should be part of the academic curriculum.
Nevertheless, Oxford established a graduate business school in the 1980s
and, after a fierce debate, recently established an undergraduate business
school. In addition, Oxford formed Isis
Innovation in 1988 to help the University’s 2500 funded researchers and 2000
doctoral candidates in science and medicine commercialize their research. Since its inception, Isis Innovation has
filed 200 patents, completed 50 licensing deals, and attracted venture capital
to help establish several biotechnology companies that employ intellectual
property developed in University laboratories.[52]
Many European countries have an imbalance between venture capital
investments and divestments, indicating that while there is a large supply of
venture capital, the exit mechanisms for these investments have been
insufficient. Efficient exit mechanisms
are critical for a vibrant venture capital sector because venture investors and
entrepreneurs must have a mechanism for realizing capital gains. One reason for the imbalance in Europe is
that, until 1996, European venture capitalists were hampered by the lack of a
liquid, transnational stock market designed for start-up firms on a par with
the U.S. NASDAQ market. Although a
number of European countries (Belgium, Britain, Denmark, France, Germany,
Ireland, Italy, and the Netherlands) established stock markets in the 1980s and
1990s that are designed to broaden the supply of capital to small companies
that do not meet the requirements of the primary markets, these small-company
markets have not lived up to expectations for a number of reasons. First, unlike in the United States and
Japan, the European small-company markets are under the same management as the
primary markets. In general, managers
of the European markets are more interested in promoting the primary markets
than the secondary markets. Second,
European companies generally seek to move their listings to the primary markets
as soon as possible (unlike in the United States where many large companies --
e.g. Cisco, Dell, Intel, and Microsoft -- have retained their listings on
NASDAQ). Third, European institutional
investors are less likely to have significant holdings of small-capitalization
stocks than U.S. institutional investors, which has depressed the liquidity of
the small-company markets. While some
European venture-backed companies are listed on NASDAQ, such cross-border
offerings represent only a small percentage of European small companies. For all these reasons, a venture-backed
company in Europe is much more likely to be acquired by another company than
sold to the public through an initial public offering (the preferred exit
mechanism in the United States and Japan).
In September 1996, Europe created the European Association of
Securities Dealers Automated Quotation (EASDAQ) market, which is intended to
make it much easier for European entrepreneurs and venture capitalists to offer
start-up companies to the public.
EASDAQ, modeled on NASDAQ, seeks to bring together high-growth
companies, their investors, and financial intermediaries into one highly
liquid, well-regulated, pan-European stock market. Companies listed on EASDAQ have direct access to, and an
increased profile with, a wider range of capital sources than can be found in
any one national stock market in Europe.
Based in Brussels, EASDAQ operates across 14 European countries and is
independent of all other European stock markets. EASDAQ is off to a slow start -- by August 1999, it had attracted
only 49 companies with a combined market capitalization of $21 billion.[53]
EASDAQ’s competition in the effort to create a European version of
NASDAQ is the EURO.NM market, also created in 1996 to allow cross-border
trading by the five small company markets in Amsterdam, Brussels, Frankfurt,
Milan, and Paris. The small company
markets in Denmark, Italy, Sweden, and Switzerland are scheduled to join the
EURO.NM market in 1999. EURO.NM has
more than 150 listed companies with a combined market capitalization of more
than $30 billion.[54] The companies listed on EASDAQ, however, are
generally larger and face tougher listing and disclosure requirements and the
exchange has a fast-track trading link with NASDAQ, all of which appeals to
institutional investors. In choosing
whether to list on EASDAQ or EURO.NM, nationality continues to plays a role,
which illustrates one of the key issues that must be overcome before Europe
succeeds in creating a single stock market to complement a single European
currency.[55]
The amount of venture financing in Asia has grown steadily in the 1980s
and 1990s. By late 1997, Asia’s 800
venture capital firms (up from 50 in 1989) had $38 billion under management (up
from $21 billion in 1991). Asian
venture capitalists invested $5.5 billion in 1996; of that total, Japanese
venture capitalists invested about $1.4 billion. By comparison, U.S. venture capitalists invested nearly $4
billion in Silicon Valley alone in 1997.
Historically, Japan has been the most popular destination for venture
capital with about two-thirds of the total.
Excluding Japan, Korea (17%), Hong Kong (11%), and Singapore (8%) are
the largest recipients of venture financing.
Funds are distributed across the spectrum with industrial products
(17%), consumer-related products (16%), and other manufacturing industries
(15%) attracting the most capital. In
1996, more than 18,000 Asian companies had venture capital backing.[56]
As is the case in Europe, however, much of what is classified as
venture capital in Asia is either long-term debt or is dedicated to later-stage
financing, as opposed to start-up financing.
About 70% of Asia’s venture capital goes to later-stage financing, while
only 21% is invested in start-ups.[57] The latter number is misleading, however,
because the start-up category in Asia includes new ventures incorporating
long-standing state or family-run businesses.
By comparison, about 37% of all venture financing in the United States
is dedicated to actual start-ups. Asian
venture capitalists are more likely to invest in older, maturer companies than
U.S. venture capitalists. For example,
more than 60% of venture investments made by Nippon Investment & Finance
Company, an established venture capital company, are made in companies 10 years
or older.[58]
Unlike the United States, three of the largest sources of venture
capital in Asia are corporations (41%), banks (16%), and government agencies
(7%).[59] Non-Asians are among the largest venture
investors in the region -- about 25% of all venture capital invested in Asia is
sourced from outside the region.
Excluding Japan (which historically has not readily welcomed foreign
venture capital), about 50% of Asian venture capital is raised locally, 35% is
raised outside Asia, and 15% is raised in other Asian countries.[60] U.S. venture capitalists, and the pension
and other large funds that back them, are among the largest investors backing
Asian entrepreneurs. U.S. investors
have been attracted to Asia because of the high growth rates across the region
in the 1990s and because returns on investment in the U.S. private equity
market are coming under pressure as competition for deals among U.S. venture
capitalists drives up valuations.[61]
In Japan, the largest sources of venture capital are corporations
(46%), banks (30%), and insurance companies (10%).[62] Japanese venture capital firms allocate a
much smaller share of funds to technology companies (35%) than do U.S. venture
capitalists (70%). Japan’s largest
venture capital firm is the Japan Associated Finance Company (JAFCO), a
publicly-traded company founded in 1973 and associated with the Nomura
Securities house. JAFCO has made more
than 1800 investments worldwide and its portfolio companies represent about 30%
of the initial public offerings in Japan.
It has offices throughout Japan, as well as in eight other Asian
countries, Britain, and the United States.[63]
Most Japanese venture capital firms are subsidiaries of large
corporations. For example, in 1996,
Toyota Motor Corporation created one of Japan’s largest venture capital funds
(nearly $400 million) to finance companies inside and outside the Toyota
keiretsu. Like most Japanese
corporations, Toyota’s primary goal for its venture capital unit is not capital
gains, but rather the development of new technologies.[64] In 1996, Nippon Telephone and Telegraph,
Nippon Life Insurance, Sanyo, and several other large corporations created
Nippon Venture Capital Company; to date, it has invested $64 million in 122
companies inside and outside of Japan.[65] Several other Japanese corporations recently
established venture capital arms, including Mitsui and Mitsubishi.
The Japanese government, like many governments in Asia, continues to
work closely with the private sector to formulate business strategy. Japan’s reaction to the growth of the
Internet is illustrative. Although U.S.
government researchers created the Internet in the 1960s to enable scientists
around the country to communicate with each other, U.S. entrepreneurs -- and
the venture capitalists that have rushed to fund them -- are responsible for
the tremendous growth in Internet services over the last few years. What has most impressed Japan’s Ministry of
International Trade and Industry (MITI), however, is the U.S. government’s
initial role in creating the Internet.
Consequently, the Japanese government’s emphasis has been on funding a
government-industry partnership to integrate the operations of Japanese
manufacturing facilities worldwide, an initiative that MITI says it eventually
will turn over to the private sector.
Although Japan has the largest venture capital market in Asia, a
venture capital industry has never developed in Japan on a par with the United
States for numerous reasons. First,
Japan’s Ministry of Finance long has maintained tight regulation of financial
markets, which limits the ability of Japanese entrepreneurs to obtain capital,
and has prohibited Japanese pension funds from investing in venture capital
funds. Second, Japanese banks are
reluctant to lend to new businesses, in part because bank lending generally is
contingent on ownership of land as collateral and few entrepreneurs can afford
Japan’s high-priced real estate. Third,
Japanese entrepreneurs confront a high tax rate that can take 50% of taxable
income. Fourth, Japan’s culture has
hindered the development of an entrepreneurial sector backed by venture
capital. It is often said that the nail
that sticks out gets hammered down in Japan.
The Japanese emphasis on order, conformity, and seniority contrasts
with the U.S. tradition of supporting individualism and limited government
power. Japan has spent years nurturing
and protecting big manufacturing exporters rather than emulating the
entrepreneurial spirit that has driven the high-technology boom in Silicon
Valley. Although Japan has had some
entrepreneurial heroes – like Soichiro Honda, who created Honda Motor Company,
and Akio Morita, who co-founded Sony Corporation – most emerged in the years
just after WW II. The current
environment is not designed to foster entrepreneurial activity. Because most Japanese favor lifetime
employment at major companies like Sony or a major bank and view jobs at
start-ups as second rate, it is difficult for entrepreneurs to attract good
management. Americans, on the other
hand, are more willing to accept risk and tolerate career shifts. The result is that the United States, with
about twice the population of Japan, produces more than seven times as many new
companies each year as Japan.[66]
The Japanese government, however, recently has taken a number of
significant steps to increase support for Japanese entrepreneurs. For example, in 1991, Japan established
JASDAQ, a stock market designed for start-up firms that is modeled on NASDAQ.[67] In 1995, Japan approved the use of stock
options and, in 1997, amended tax laws to make options more attractive to
employees at Japanese start-ups.[68] U.S. start-ups, which often have limited
cash flow and are forced to pay low salaries to employees, have used stock
options for years to attract and retain talented managers, software engineers,
and scientists.
In addition, MITI recently created a program that provides grants of up
to $500,000 to start-ups and another program that provides loan guarantees.[69] In the last several years, most other
Japanese government ministries, as well as local and regional governments, have
also adopted programs to encourage Japanese entrepreneurs, including setting up
venture business incubator programs that bring capital, facilities, and
entrepreneurs together. The Japanese
venture incubators are modeled in part on the 300 venture incubators that U.S.
states have established with mixed success.
Moreover, MITI recently rescinded the law prohibiting Japanese venture
capitalists from serving on and appointing others to the boards of their
portfolio companies. MITI and the
Finance Ministry also are drafting a limited liability law (similar to that
which exists in the United States) that would enable pension funds and other
institutional investors to invest in venture capital funds by providing some
protection from poor investments.
Recognizing the important role that university research has had in
advancing U.S. entrepreneurial activity, the Japanese Ministry of Education and
Science and the Ministry of International Trade and Industry recently began
funding more than 20 so-called venture business laboratories in Japan’s largest
universities through the Original Industrial Technology R&D Promotion
Program, which is designed to promote original research and development that
will seed new industries and train new researchers. Significantly, MITI broke with its long-standing practice of
unilaterally identifying important new technologies for research and
development and now openly solicits proposals for university research projects
and encourages researchers to compete for funding.[70]
Despite these efforts by the Japanese government, venture capital
activity recently has been declining in Japan.
The Japanese recession and the instability of the financial system have
led to the failure of numerous venture-backed businesses. Unlike the United States, where venture
capitalists increased investments from $8 billion in 1995 to $10 billion in
1996, Japanese venture investments were flat, $1.4 billion in both years.[71]
Although Japan accounts for the majority of venture capital activity in
Asia, venture investments have been increasing in a number of other Asian
nations. For example, a number of
Chinese, Asian, and U.S. venture funds have been investing in China over the
last several years, primarily in provinces on the coast and near Hong Kong.
China has some of the right elements for a strong venture capital industry,
including an entrepreneurial culture (exemplified by Chinese living not just in
China, but in Taiwan, Indonesia, and numerous other Asian countries),[72]
as well as an educational system that directs large numbers of Chinese students
to programs in engineering and business at Chinese and U.S. universities.
Nevertheless, venture investors face an array of obstacles in China, in
large part because of decades of communist policies that have curtailed
entrepreneurial activity. A key
difficulty is finding experienced managers to run entrepreneurial companies in
a country that only recently began adopting capitalism. In addition, the relationship between
venture capitalists and companies is often different in China than in the
United States and Europe; Chinese entrepreneurs welcome investment but may
chafe at the degree of influence that venture capitalists want over the
company’s activities. Moreover, China
does not have accounting and reporting standards, credit ratings, or a legal
system on a par with the United States, and China’s two major stock markets in
Shanghai and Shenzhen -- like most exchanges in Asia -- are primitive. Consequently, venture capital returns in
China are generally in the single digits.[73]
Elsewhere in Asia, the Taiwanese government established a national
laboratory -- the Industrial Technology Research Institute (ITRI) -- in the mid-1970s
in order to focus Taiwan’s attention on critical technology markets. It has actively embraced venture capital
since 1983, when it formally began encouraging formation of a venture capital
industry by easing government restrictions and providing financial backing for
venture funds. Taiwan’s government has
financed and recruited managers for scores of young companies. For example, in 1986, ITRI supplied about
50% of the start-up capital, lined up other investors, and recruited Morris
Chang, a 25 year veteran of Texas Instruments, to establish the Taiwan
Semiconductor Manufacturing Corporation, now one of the world’s largest
producers of semiconductors. Numerous
other Taiwanese citizens, educated in the United States and trained at U.S.
companies, have returned home to run Taiwanese technology companies.[74]
Although the Taiwanese government provides start-up capital and offers
young companies subsidized land-lease rates and generous tax credits, it does
not, unlike most of its Asian counterparts, offer much help after companies are
up and running. In fact, one key to
Taiwan’s success is that uncompetitive companies are not shielded from market
forces and are allowed to fail. Unlike
Japan, declaring bankruptcy in Taiwan does not carry an overwhelming stigma;
many failed entrepreneurs immediately start new companies.
In addition to the Taiwanese government’s support, major Taiwanese
companies have provided venture financing to Taiwanese start-ups for
years. Acer, the world’s third largest
personal computer manufacturer, has announced that it will provide venture
financing to create 100 Taiwanese software companies by 2010.[75] An increasing number of Taiwan’s
approximately 100 venture capital firms are establishing branch offices in
Silicon Valley, in part to prospect for cutting-edge technologies that can be
commercialized by Taiwanese companies.
One of Taiwan’s largest venture capital firm’s is Crimson Asia Capital
Holdings, which raised a $400 million fund in 1997. In large part because of the strong entrepreneurial mindset of
Taiwan’s 22 million people, Taiwan has the highest concentration of small to
medium-sized technology companies in Asia, whereas the Japanese and South
Korean economies are dominated by large conglomerates.[76] Taiwanese workers are much more likely than
their Japanese or Korean counterparts to take a low-salaried position with a
start-up in exchange for payment in stock (options are still illegal) and the
hope of gaining wealth through a successful initial public offering. Since the beginning of 1997, 32 of the 82
companies that have gone public on Taiwan’s over-the-counter market have been
technology-based.[77]
Unlike Taiwan, South Korea’s government has long maintained high
barriers to entry and exit and shielded uncompetitive companies from market
forces by offering generous government loans and allowing creative
accounting. The lack of exposure to
constantly changing markets has plagued the country’s chaebol conglomerates. Nevertheless, the South Korea government recognized
the role that U.S. venture capital plays in spawning high-technology
companies. Consequently, the government
set up Korea’s first four venture capital firms between 1974 and 1984 in an
attempt to help commercialize technologies developed by state-financed research
institutes. Although the first venture
capital firms met with mixed success, there were 60 independent venture capital
firms in South Korea by the early 1990s.
Between 1987 and 1997, South Korea venture capitalists invested about $1
billion in 1,891 firms, three-quarters of which were electronics and
communications companies. In early
1998, the government announced that it would appropriate $620 million to help
finance 2,000 venture-backed firms. In
addition, a recently enacted law grants tax concessions to venture investors,
lifts the usual ceiling on foreign investment, and, for the first time, allows
the country’s pension funds to invest in venture capital.
Despite the progress that South Korea has made in fostering a venture
capital industry, Korea’s high-technology firms have proved much less
innovative than Taiwan’s, in part because of the oppressive presence of the
chaebol, which dominate most sectors of the economy. In addition, although the number of venture capital firms is
increasing, their profitability is decreasing, in part because of a lack of
managerial experience in running entrepreneurial companies. Moreover, South Korea has yet to develop
much of a shareholder culture. On
average, South Korea’s venture-backed companies take 10 years to list on the
Korea Security Dealers Association Automated Quotation (KOSDAQ), the country’s
small-company equivalent to the U.S. NASDAQ market. (One third of the companies listed on KOSDAQ are
venture-backed.) Most companies also seek
the added credibility that comes with leaving the KOSDAQ for the larger Korea
Stock Exchange. Consequently, KOSDAQ
lacks liquidity, which makes it difficult for venture capitalists to sell their
stake in portfolio companies that trade on the smaller market.[78]
Governments are increasingly aware that venture capital investing is
critical to the health of their economies.
Venture-backed companies historically have produced a disproportionate
share of new jobs, particularly well-paid and highly-skilled jobs, and are a
key source of research and development spending. For example, from 1991 through 1995, U.S. venture-backed
companies created new jobs at a rate of about 34% annually while Fortune 500
companies reduced jobs at a rate of about 4% annually. During the same time period, venture-backed
companies’ revenues increased 38% while Fortune 500 companies’ revenues
increased only 3.5%. U.S. venture-backed
companies also have increased their annual research and development budgets at
about three times the rate of Fortune 500 companies and are an important source
of applied technological innovation. In
addition, U.S. venture capital-backed companies generate about three times more
export sales per dollar of equity than more established corporations.[79] Moreover, venture capitalists have helped
create entirely new industries by financing companies like biotechnology
pioneer Genentech and overnight shipping provider Federal Express.
Similarly, European venture-backed companies outperform the 500 largest
European companies in a number of categories.
From 1991 through 1995, venture-backed companies created new jobs at a
rate of about 15% annually, compared to 2% for the top 500 European
companies. During the same time period,
venture-backed companies’ revenues increased 35%, while the top 500 companies’
revenues increased by only 14%. In
1995, research and development expenditures by European venture-backed
companies represented 8.6% of total sales compared to 1.3% for the top European
companies.[80] In Britain, the number of people employed in
venture-backed companies has increased by 15% annually, compared to a national
growth rate of less than 1%. More than
1 million people in Britain are employed by companies currently using venture
capital. In addition, venture-backed
companies in Britain increased their sales by 34% annually, 5 times faster than
FTSE 100 companies.[81] In countries like France, Germany, Italy,
and Spain, which have unemployment rates ranging from 11% to 19% and which need
more new companies that can compete globally and contribute to Europe’s
economic revival, venture financing can play an enormously positive role.
The staggering difference in job growth between the United States and
Europe is at least partly caused by much higher levels of venture financing in
the United States during the last 25 years.
Between 1970 and 1995, the European Union, which has one-third more people
than the United States, added only 8.5 million jobs or 6% of the work force,
whereas the United States increased its work force by 46 million or 65%.[82] Since 1993, the United States has created
more than 13 million new jobs net, whereas the nations of Europe have lost 1
million jobs.[83] The EU’s unemployment rate is more than
double the U.S. rate. One of the EU’s
primary problems is that while large companies are cutting jobs, there is
relatively little new business formation.
Between 1992 and 1996, 3,000 U.S. companies went public raising more
than $150 billion, whereas only 150 EU companies went public between 1990 and
1996.[84] The European Commission recognizes the
importance of venture capital to Europe’s economy and, in May 1998, called for
an “action plan” to remove various barriers to venture financing, including a
review of national tax systems.
Governments can encourage venture investing by offering legal, fiscal,
and financial support that benefits venture capitalists and entrepreneurs. In fact, government incentives often have
been crucial to attracting venture capital to risky, cutting-edge start-ups
that may result in job and wealth creation that otherwise would not occur.
For example, although an increasingly large percentage of venture
financing comes from tax-exempt investors like pension funds, the capital gains
tax rate is an important factor determining the overall level of venture
financing. In the United States, for
example, venture financing increased significantly after the government lowered
the capital gains tax rate from 49% to 28% in 1978 and to 20% in 1981. By comparison, capital gains tax rates in
Europe and Asia can reach 60% and higher.
U.S. tax law also permits owners of closely held companies to make
so-called “sub-S” elections and to issue section 1244 stock, provisions that
allow for favorable tax treatment of losses.
The taxation of stock options also has an important effect on
entrepreneurs. Start-ups, which cannot
afford to pay large salaries, often offer stock options to attract skilled
managers. Securities laws governing the
issuance of options and fiscal laws governing the level of taxation determine
whether managers will be willing to leave the security of larger companies to
risk working for a start-ups. In the
United States, wealth accumulated from stock options is taxed as a capital gain
when the stock is sold, whereas in many European countries (including France
and Germany) options are taxed as regular income when granted, even though the
employee may not be able to cash in the options for several years.[85]
State governments also can use tax incentives to target certain points
in the investment cycle (i.e. start-ups) or encourage venture investing by
certain types of investors. For
example, Louisiana, Missouri, and New York have enacted legislation allowing
Certified Capital Companies (CAPCO), which are venture capital funds that
invest at least 60% of their capital in private, in-state companies. They are funded primarily by insurance
companies, which are given tax credits as an incentive to become limited
partners. Several other states have
CAPCO bills under consideration.[86] Such incentive programs are particularly
helpful to entrepreneurs in states (e.g. Missouri) that traditionally have not
received large amounts of venture capital.[87]
Governments also can target certain types of venture financing by
offering loan guarantees, project finance, and insurance to investors. For example, the Overseas Private Investment
Corporation (OPIC) has offered financial support to U.S. investors who are
developing and expanding business operations in certain emerging markets that
have the effect of creating U.S. jobs and increasing U.S. exports. This OPIC program is designed, among other
things, to support U.S. foreign policy objectives, assist in the economic
development of emerging countries, and support the transfer of ownership of
businesses from state to private hands.
By 1998, 26 U.S. investment funds had been approved for OPIC loan
guarantees for their investment activities in emerging markets ranging from
Latin America to Asia to the Newly Independent States. OPIC has committed $2.2 billion in loans, or
two-thirds of its $3.26 billion funds program.
For example, OPIC currently is providing a guarantee of $100 million to
an investment fund managed by Olympus Capital Asia that is investing in
Bangladesh, India, Indonesia, Laos, the Philippines, South Korea, Sri Lanka,
Thailand, and Vietnam. Under this
public-private partnership, OPIC guarantees $100 million of financing that is
used to support a $50 million equity fund, providing a total of $150 million
available for investment. If the
investments fail and OPIC must pay on its guarantee, OPIC could lose up to $100
million.[88]
In some cases, U.S. government agencies directly fund entrepreneurs. For example, the U.S. Department of
Agriculture’s Alternative Agricultural Research and Commercialization
Corporation has provided $33 million in venture capital financing over the last
five years to companies to help commercialize bio-based industrial products
from agricultural and forestry materials and animal byproducts.[89] Governments also can fund research and
development consortiums like the Semiconductor Manufacturing Technology
Initiative (SEMATECH), a U.S. government-industry R&D project designed to
advance semiconductor equipment manufacturing techniques, and ESPRIT and JESSI,
EU efforts to stimulate transnational research and development efforts in
information technology. In addition,
governments can allow venture capitalists the right to acquire the government’s
share of an investment at reduced rates if the investment succeeds. If improperly administered, however, public
venture financing can have the detrimental effect of displacing or retarding
the development of private venture capital and can cause economic distortions
by creating unfair competition or by sustaining unprofitable projects.
Governments also can assist
entrepreneurs and venture capitalists by establishing adequate infrastructure,
such as strong intellectual property rights protection. For many entrepreneurs, intellectual
property rights are their only assets.
Consequently, it is essential that patents and copyrights be processed
efficiently and that there is adequate enforcement. The United States provides the strongest patent protection in the
world and has taken the lead in the World Trade Organization in encouraging
other countries to adopt similar protection.
In Europe and Asia, however, intellectual property often is not adequately
protected. For example, in Europe,
there are three patent systems -- national, European, and Community -- that can
conflict with each other and with international obligations. Currently, however, no European court has
jurisdiction over patents. The European
patent system is the most effective system in Europe, but the lengthy patent
protection process costs $120,000 compared to $13,000 in the United States.[90] In Japan, patents are narrower in scope than
in most other developed economies, which allows competitors more latitude in
inventing around existing patents. In
China, the enforcement of intellectual property rights is often completely
inadequate.
Governments also can support
entrepreneurial companies by helping to create efficient exit mechanisms, such
as stock markets for young companies, which are critical for a vibrant venture
capital sector because they increase liquidity and allow for realization of
capital gains. In addition, governments
can establish regulatory systems to ensure that new drugs and biotech products
are given a timely review.
Bankruptcy laws also have an
important effect on entrepreneurs. The
U.S. bankruptcy law is designed to give those who suffer bankruptcy an
opportunity for a fresh start and quickly channels resources away from companies
that are not competitive. In some
cases, managing a company that goes bankrupt is viewed as a useful
apprenticeship for starting another company.[91] Declaring bankruptcy in many European and
Asian countries, on the other hand, carries a stigma that frequently destroys
an entrepreneur’s future.[92] In addition, some Asian countries either
have inadequate bankruptcy laws or no law at all.