Is Germany on the Road to Silicon Valley?

Frankfurt's Neuer Markt and the IPO Explosion: Is
Germany on the Road to Silicon Valley?
Sigurt Vitols
Sigurt Vitols, Wissenschaftszentrum Berlin für Sozialforschung (WZB), Reichpietschufer
50, D-10785 Berlin, Germany. E-mail: [email protected]
Introduction
Germany has long been seen as one of the premier examples of a ‘bank-based’ financial
system, i.e. a system in which banks are the dominant financial organization and loans
(rather than publicly-traded stocks and bonds) account for the lion’s share of external
financing of the firm (Vitols 1998; Zysman 1983).1 In the 1980s this system was widely
praised for providing stable, long-term finance to industry and was frequently
recommended for emulation in other countries (Porter 1992). In the 1990s, however, the
bank-based system has come under increasing criticism within Germany as unsuitable for
promoting high tech. Interestingly enough, the same elements that were previously seen
as strengths are now partially seen as weaknesses: the German banks’ preference for
making loans to established, capital-intensive companies, according to this view, starves
new technology-based firms of needed high-risk venture capital (Pfirrmann, Wupperfeld,
and Lerner 1997).
In part as a response to this criticism, a special segment of the Frankfurt stock
exchange called the Neuer Markt (New Market) was established in 1997. The aim of the
Neuer Markt, which at least at a rhetorical level is modeled on the US’s Nasdaq, is to
serve the needs of both investors and young companies involved in high-risk new
technologies (Plückelmann 2000). After a somewhat slow start in its first year, interest in
this new exchange segment thereafter accelerated to the point that there has been a
veritable explosion in IPOs (initial public offerings, or first-time listings of companies on
an exchange). The Neuer Markt is now by far the most important growth stock markets
founded in the 1990s in Europe in terms of both market value and number of listed
companies, a fact that is most surprising given the conservatism of Germany's postwar
financial system.
The success of the Neuer Markt has led to speculation that Germany is rapidly closing
the gap with the US in high tech. In addition, it may also be developing a ‘dream-team’
dual economy in which the established stock market services traditional industry and the
Neuer Markt finances the ‘new economy’. The Munich region in particular, which has
accounted for a large proportion of the Neuer Markt IPOs, is compared with Silicon
Valley.
This article contests the convergence thesis by exploring the characteristics of Neuer
Markt companies and their meaning for the broader German political economy. Although
the Neuer Markt is in fact evolving into an important institution for raising new finance,
the bulk of the companies listed there appear to be following a path quite distinct from
the ‘Silicon Valley’ model of innovation, finance and corporate governance. This
alternative model is based more on the diffusion of, rather than on the development of
path-breaking (or radical) innovations that involves relatively little high risk venture
capital, and shows a number of continuities with the traditional German ‘Herr-im-Hause’
(master of the house) insider model of small-firm governance.
The Silicon Valley Model and the Genesis of the Neuer Markt
A common conceptual tool used to analyze the innovative capacity of political economies
is the product life cycle. According to this concept, research on and the development of
new products initially involves losses due to the lack of sales income (left hand side of
diagram 1). When a market for the new product is discovered and exploited sales increase
rapidly and the break-even point, where sales cover costs, is eventually reached (middle
of diagram). As a product matures, however, both sales and profitability grow at a
diminishing rate (right hand side).
[insert diagram 1 here]
In principle, there are different possible business models for realizing this product life
cycle. For example, an established firm seeking to enter new markets could develop a
new product, or it could be developed by a new firm founded to focus on this product.
The Silicon Valley model is here understood as one specific type of path to realize this
development. First of all, it is based on the foundation of new firms to develop new, highrisk products. In practice it is easier for new firms to develop such products, since older
firms often lack the proper incentives for risk-taking and thus have difficulty with radical
innovation. Second, since the costs of development of a new technology may be quite
high and future prospects for success uncertain, it is generally necessary to obtain
substantial external funding with a high tolerance for risk. So-called early stage venture
capital fits this profile since these investors are willing to accept a high failure rate in
investments in search of a ‘blockbuster’ success that will more than pay for the losses.
Third, since the firm founder often has considerable technical skills but lacks the
necessary business skills to navigate the company through its various growth stages, the
management team has to be expanded. Venture capitalists can play a key role in
networking to find suitable new managers. Also important is their ability to impose new
management structures on firm founders reluctant to share authority. Fourth, a lucrative
‘exit option’ in the form of a stock market receptive to new companies allows venture
capitalists to cash in their investments so that they can realize their profit and start the
cycle of investing again (Lerner 2000).
The German bank-based financial system, it has been argued, represents a serious
barrier to the achievement of this Silicon Valley model of development (Albach 1983;
Pfirrmann, Wupperfeld and Lerner 1997). Firstly, since German banks are generally riskaverse, the dominance of banks means that most bank loans are channeled towards
established firms with stable cash flow. Secondly, the Frankfurt Stock Exchange is
unsuited to the needs of both young companies and investors involved in high-risk new
technologies. Conservative listing requirements meant that only companies with a history
of solid profitability could be brought to market. Furthermore, the existing system of
trading lacked market makers willing to buy and sell shares to provide liquidity and
reduce the volatility of the share prices of small companies. A third problem was that the
Frankfurt Stock Exchange used the German system of accounting standards (HGB or
Handelsgesetzbuch), that gives finance directors considerable leeway in reporting on the
company's financial status. This large room to maneuver reduces the reliability of
financial statements in presenting the true state of company affairs. The Frankfurt Stock
Exchange was therefore considered unsuitable as an exit channel for venture capital
investments. As a result of these shortcomings, according to this view, start-up firms in
the early stages of the product life cycle in Germany were starved of external capital.
The Neuer Markt was created in 1997 as a separate segment of the Frankfurt Stock
Exchange, specifically in order to address these shortcomings (Plückelmann 2000). A
number of features were included that were designed to meet the needs of institutional
investors in small, young, high-growth companies. One important aspect of the Neuer
Markt is the waiver of minimum requirements regarding profitability and age of IPO
candidates. A second aspect is the requirement that all listed companies have at least one
designated sponsor, i.e. a bank or brokerage house obligated to ‘make markets’ for their
shares. Markets for the stock of individual small growth companies are notoriously
illiquid and fund managers will avoid such companies if they are not able to exit (i.e. sell
shares) their investment without depressing share price. The requirement that designated
sponsors to not only match bid and sell orders but also buy and sell on their own account
is intended to smooth over temporary imbalances in the supply of, and demand for, shares
and thus encourage fund managers to invest in small capitalization companies. A third
important aspect of the Neuer Markt is the requirement for greater transparency in the
form of quarterly financial reporting on the basis of minority-shareholder friendly
accounting systems, either US-GAAP (Generally Accepted Accounting Principles
developed in the US) or IAS (International Accounting Standards). The lack of
transparent accounting on a frequent basis has been considered another significant
deterrent to investment, particularly in the rapidly changing high-tech world.
On the surface of it, the Neuer Markt has been a huge success, particularly after its
first year of operation. Whereas before its foundation a year with thirty IPOs would have
been quite active, since 1997 there has been a veritable explosion in new listings (see
chart 1).
[Insert Chart 1 here]
In 1998, 1999 and 2000 there were 67, 168 and 152 IPOs in Germany, respectively. The
Neuer Markt alone accounted for 61 percent, 79 percent and 87 percent of all German
IPOs in those years, respectively. By the end of 2000 there were 338 companies listed on
the Neuer Markt, with a high concentration in the sectors technology (20.1 percent),
internet (19.8 percent) and software (14.8 percent) (see chart 2).
[Insert Chart 2 here]
One surprising feature given the traditional conservatism of Germany's financial system
is the fact that quite a few foreign companies are coming to Germany to raise their ‘risk
capital’ – 56 of the companies listed on the Neuer Markt (i.e. about one-sixth) were based
outside Germany. A second quite surprising result is that Germany's Neuer Markt alone
accounts for considerably more than half of the total market capitalization of Europe's
new ‘growth markets’ or stock exchange segments for young, high-growth companies.
Although these growth markets were established in other countries at roughly the same
time and a number of them would presumably enjoy greater advantages, the Neuer Markt
has become Europe's premier growth market far surpassing the pan-European growth
market EASDAQ and the UK's AIM (see chart 3).
[Insert Chart 3 here]
This success has given rise to claims that Germany is ‘catching up’ with the US with
respect to the high technology gap. The Munich region in particular has received much
attention as a regional technology agglomeration and has even been christened the ‘Isar
Valley’ after the name of the river flowing through the center of the city. Munich alone
has accounted for 56 or 20 percent of all Neuer Markt IPOs of German-based firms.
However, other urban agglomerations such as Hamburg and Frankfurt are also the homes
of a significant number of Neuer Markt companies and are increasingly being referred to
as high tech or multimedia centers.
Is Germany on the Road to Silicon Valley?
What is the meaning and significance of the Neuer Markt for Germany? Can the
innovative capacity of a political economy be significantly altered through a relatively
simple act of institutional innovation? Although the Neuer Markt's achievements are
certainly impressive in the context of Germany's past, a number of important facts
caution against drawing too much of a parallel with the US's Nasdaq and imply that
Germany is following its own path of high-tech development.
One important difference with regard to the US is that, although the increase in the
number of IPOs has been impressive, the amount of money raised through IPOs is still far
behind the US. Altogether, about 33 billion DM has been raised by German firms through
IPOs on the Neuer Markt since its foundation in 1997. IPOs on the Nasdaq, in contrast,
raised over $50 billion (about 100 billion DM) in 1999 alone (Deutsche Börse, 2001
#708; NASDAQ, 2001 #709; own calculations).
A second difference is that venture capital, particularly of the high risk ‘early stage’
variety, has played a much less significant role in Germany. Venture capital investments
in the US exceeded the German level by a factor of 15 in 2000 (Mackewicz & Partner
2000). It is often claimed that venture capital has played a very significant role on the
Neuer Markt (and has in fact been involved in 45 percent of all IPOs) but much of this
appears to have been (relatively low risk) ‘bridge financing’ which is used to increase the
capital base of companies immediately before the IPO. One proxy for high-risk capital is
the involvement of venture capital funds participating in the BTU (Beteiligungskapital für
kleine Technologieunternehmen) program, the federal program for supporting early-stage
venture investing. Less than 20 percent of the German-based Neuer Markt firms received
financing from venture capital firms involved in this program.
A third difference is that many Neuer Markt firms do not appear to fit the Silicon
Valley image of the loss-making start-up. The majority (57 percent) of the Neuer Markt’s
listed (domestic) companies are profitable and 52 percent are at least 10 years old; one
company, Pfeiffer Vaccuum, was in fact founded in 1890.
Not surprising given these differences, the Silicon Valley model of governance, in
which venture capitalists are the dominant investor group and are represented on the
company board, accounts for only a small minority of Neuer Markt companies. An
analysis of a database with the characteristics of Neuer Markt firms shows that venture
capitalists constitute the most important investor group for eleven percent of the German
companies listed at the end of 2000.2
[Insert Table 1 here]
The predominant form of firm governance on the Neuer Markt has more in common
with the traditional German Mittelstand or ‘Herr im Hause’ (‘master of the house’) form
of organization than with the Silicon Valley model. ‘Insiders’, dominate this model
particularly by the founder/CEO, who typically owns a controlling stake in the company
and also dominates the company board through appointment of directors. The primary
goals of the founder/CEO are often stability of company (through solid finances) and
maintenance of personal control. The corresponding innovation strategy is the
incremental development of the existing product portfolio. This model accounts for two
thirds of Neuer Markt firms (190 of 274).
A third form of governance, which also sometimes contributes to high tech
development in the US, ‘corporate control’ also accounts for a small minority of Neuer
Markt companies. This model involves creating a new subsidiary company that is
responsible for developing new products and which enjoys a certain degree of
organizational independence from the Parent Corporation. Key board members, however,
are typically managers from the Parent Corporation. A portion of shares in the company
are sold on the market through an IPO in order to raise money for the parent's further
activities. This model accounts for 10.4 percent of Neuer Markt companies, i.e. slightly
less than the Silicon Valley model of governance.3
Companies based on this dominant Herr im Hause model appear to have significantly
different firm characteristics and innovation strategies than other models. Companies are
older, have much lower growth rates, are more solidly profitable, and spend less on R&D
as a percentage of sales. Herr im Hause companies are much more based in areas such as
IT services and in established parts of software and technology. Silicon Valley companies
in contrast are concentrated in the biotechnology and Internet software sectors and the
corporate control model in multimedia and direct banking/discount brokering.
To better understand the varying strategies pursued by different types of firms, it is
useful to take a closer look at a particular sector. Software is particularly interesting since
it is the most important sector on the Neuer Markt in terms of number of companies, and
also because of the range of products offered and customer types serviced by the
industry.4 Different types of innovation strategies are being pursued within the software
sector, and that these strategies are highly correlated with ownership type and age of
company.5
Development of blockbuster products.
A particular feature of the software industry is that production costs are practically
zero since they are limited to producing copies of programs on CD-ROMs or floppy
discs. Much more significant are the costs of software development (writing code) and
marketing of software. One competitive strategy is to try to develop standard software,
i.e. software that can be used by a wide variety of customers and installed with relatively
little or no customization. Once the software is developed, the product is marketed as
aggressively as possible in order to maximize revenues, in the ideal case in many
countries at the same time. The potential profits from a successful ‘blockbuster’ product
are huge. The lucrative nature of these markets, however, typically attracts numerous
competitors trying to become major players in the field. Since software users generally
gravitate toward ‘standard’ applications (e.g. Microsoft Windows for PC operating
systems), very few companies can achieve major market share (Hoch et al. 1999). As a
result, new markets for software applications are characterized by a shakeout phase
involving a high failure rate of new companies and the consolidation of market share
among a small number (or even one) software firm. Although external finance can speed
up development time and accelerate marketing, the high probability of failure means that
often only venture capitalists, business angels, or ‘friends and family’ will be willing to
provide such finance.
In practice the most recent area offering the potential for blockbuster products has
been the Internet software area, including applications for e-commerce, auction sites,
search engines, etc. Companies in this area generally emphasize the huge growth
potential of the Internet software market and aim to rapidly internationalize their
marketing and sales efforts in order to reach thousands of customers.
Alternative strategies: a customer-service based strategy and a niche market strategy.
The competitive strategy of companies here is to offer a high quality service
component in areas where considerable customization or installation costs are involved
(and, typically, where long-standing and strong relations with customers are needed), or
to focus on niche markets. This includes companies developing software for applications
such as enterprise resource planning (ERP), graphics, or sector-specific applications such
as actuarial software for insurance companies. Although these markets are more stable
and offer much more protection from competition than mass markets for standardized
software, the potential size and/or growth rate of these markets is also constrained. The
lack of blockbuster potential may therefore render this type of firm unattractive to venture
capital. However, firms here will be more likely to finance themselves.
The blockbuster type of strategy (internet software) accounted for only 13 of the 67
German-based software companies on the Neuer Markt. The large majority of software
companies are characterized by the other types of competitive strategies, and focused on
more mature product markets such as enterprise resource planning software. Though
most of these companies have to deal with a recent radical change in the software
environment and the development of the internet, most of these companies have dealt
with this change by contracting out the development of new internet modules for their
software (e.g. the addition of an e-commerce module for ERP software) or licensing-in
standards or code from US companies (e.g. security standards for banking software).
The characteristics of firms pursuing blockbuster versus incremental innovative and
niche strategies are quite different (see table 2). The average age of internet software
companies is less than half than that of non-internet software companies (7.5 years versus
17.2 years). The average size of equity accounted for by venture capitalists as well as
R&D as a proportion of sales are both roughly twice as large for internet software
companies as compared to other software companies (12.4 % versus 6.9% and 35.4%
versus 18.3%, respectively). Internet software companies were also much smaller in size,
with an average of 33 million DM in sales versus 61 million DM for other software
companies. Only one internet software company was breaking even, whereas about half
of the other software companies were solidly profitable.
Conclusion: Germany's Own Road of High-Tech Development
The fact that the Silicon Valley model of governance accounts for only a relatively small
number of Neuer Markt companies is not necessarily a weakness. In fact, one can argue
that the heterogeneity of firm types that can be supported on the Neuer Markt may be one
of its greatest strengths. The outcome of corporate Germany's foray into biotech and the
chance of survival of its Internet software companies, all of which are making great
losses, is uncertain.
The greatest contribution to German economic growth and competitiveness appears to
be made by the Herr im Hause type companies. These companies play a key role in
diffusing important new innovations to their customer base (e.g. addition of e-commerce
module to the ERP software package) and may be better able to survive stock market
boom/bust cycles due to their strong financial status. In this sense, the innovative strength
of companies on the Neuer Markt conform more to the traditional pattern of German
industry than to that of a certain valley 5,000 miles to the west: diffusion of (rather than
development of) radical innovations and customization according to customer needs in
the context of long-term relationships. Given Germany's track record of success in
integrating previous radical innovations, e.g. diffusion of microchip technologies in
traditional industries such as machine tools and automobiles, this may not be a bad road
to follow.
Notes
1
Special thanks to Lutz Engelhardt and Jana Meier for invaluable help in the compilation and analyis of a
database on Neuer Markt companies. This article is based on collaborative research with Steven Capser
(Judge School of Management, Cambridge University).
2
This database on Neuer Markt companies draws primarily on IPO prospectuses, which are long
documents issued shortly before the company's IPO. Due to the need to fully inform investors of all major
risks involved in investing in a new company, these documents are quite lengthy (frequently over 100
pages) and provide a comprehensive view of ownership and governance arrangements, company
organization, product market strategy, main competitors, and various details like stock option plans.
Additional information is garnered from company annual reports, from information provided by the
Frankfurt stock exchange, and from a variety of web sites dedicated to either the Neuer Markt or the
German IPO market.
3
Other models represented include: the cooperative ownership model, the so-called Deutschland AG
(‘Germany Inc.’) model of bank domination (see Pfeiffer 1993), and the dispersed ownership model in
which no investors account for more than 5 percent of shares.
4
Although software is only the third important sector according to the Neuer Markt sectoral indices, in fact
many specialized software companies are classified under other indices, e.g. e-commerce software under
internet, telephone billing software under telecommunications, etc.
5
In addition to analyzing the data base, interviews with twenty Neuer Markt software companies were
conducted together with Steven Casper.
References
Albach, H. (1983) ‘Zur Versorgung der deutschen Wirtschaft mit Risikokapital, IfMMaterialien, No. 9’, Bonn: Institut für Mittelstandsforschung.
Hoch, D., Roeding, C., Purkert, G. and Lindner, S. (1999) Secrets of Software
Success: Management Insights from 000 Software Firms around the World, Boston:
Harvard Business School Press.
Lerner, J. (2000) Venture Capital and Private Equity: A Casebook, New York: John
Wiley & Sons.
Mackewicz & Partner (2000) Mythos, Visionen, Chancen: Venture Capital in den USA,
Deutschland und Europa, Munich: Mackewicz & Partner.
Pfirrmann, O, Wupperfeld, U. and Lerner, J. (1997) Venture Capital and New
Technology Based Firms: A US-German Comparison, Heidelberg: Physica Verlag.
Plückelmann, K. (2000) Der Neue Markt der Deutsche Börse AG, Frankfurt am Main:
Peter Lang.
Porter, M. (1992) Capital Choices, Washington: Council on Competitiveness.
Vitols, S. (1998) ‘Are German Banks Different?’ Small Business Economics 10 (2): 7991.
Zysman, J. (1983) Governments, Markets and Growth: Financial Systems and the
Politics of Industrial Change, Ithica: Cornell University Press.
Diagram 1: Product Life Cycle Financial Risk
PROFITABILITY
+
Early Stage
Seed
Startup
Expansion
Maturity
STAGE OF
CYCLE
-
20
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
00
98
96
94
92
90
88
86
84
82
80
78
76
74
72
70
68
66
64
62
60
58
56
54
52
50
No. of IPOs
Chart 1: Number of German IPOs
180
160
140
120
100
80
60
40
20
0
an
d
es
co
m
m
un
e
io
ns
gy
ar
lo
at
no
ftw
ic
ch
So
H
ea
lth
ca
re
Te
&
15%
le
ic
20%
Te
rv
En
te
rta
in
m
en
t
Se
et
12%
M
ed
te
ch
M
ed
ia
rn
20%
IT
te
5%
In
Fi
na
nc
ia
lS
er
vi
ce
s
In
du
st
ria
lS
er
vi
ce
s
Bi
ot
ec
hn
ol
og
y
Chart 2: Sectoral Distribution of Neuer Markt Firms
25%
20%
15%
12%
10%
5%
5%
5%
3%
2%
0%
Chart 3: Distribution of European Growth Market Capitalization, June 1999
70%
60.6%
60%
50%
40%
30%
20.9%
20%
10.5%
10%
5.7%
1.3%
0.6%
0.3%
0.1%
Nieuwe Markt
SWX
EURO.NM
Belgium
Nuovo Mercato
0%
Neuer Markt
EASDAQ
AIM
Nouveau
Marchè
Table 1: Alternative Governance Types
Governance Type
Dominant
Investor
Investor Preferences
Innovation Strategy
‘Herr im Hause’
(Master of the
House)
Founder/CEO
Low risk
Solid finances
Personal control
Incremental
Innovation of Proven
Product
Silicon Valley
Private venture
capitalist
High return (willing to
accept high risk
Radical Innovation/
New Blockbuster
11.2 %
Strategic interest
(e.g. expand market
share or exploit new
market segment)
Various
Develop related
product or new market
for existing product
10.4 %
Various
9.3 %
Corporate Control Other company
Other Types (e.g.
Cooperative,
Bank-dominated,
Market control)
Members, Banks,
Dispersed
Investors
Frequency
on Neuer
Markt
69.1 %
Table 2: Characteristics of Neuer Markt Software Companies
(averages for 1999)
Company Charateristics
Internet Software Other Software
Venture Capital Share of Equity
12.4%
6.9%
Age (in Years)
7.5
17.2
Sales (in million DM)
33.3
60.9
R&D as % of Sales
35.4
18.3
Number of companies
13
54