An Overview of the VC Market in Germany (DOC) by jolinmilioncherie


									            AGAINST ALL ODDS:



                    Marc-Oliver Fiedler

                    Thomas Hellmann

           Stanford Graduate School of Business

        forthcoming in the Journal of Private Equity

                         May 2001

For years it was claimed that the German economy is too conservative to develop a significant
venture capital industry. Yet, in a period of few years, German venture capital transformed itself
from a small, stagnant and obscure niche industry into one of the fastest growing and most
visible segments of the economy. What happened? Why did the reasons for Germany’s inability
to develop a venture capital industry suddenly vanish? What made the industry leap forward in a
space of two or three years? And are these changes only part of a bubble, or is the German
venture capital industry here to stay?

Historically, the overall market for private equity investments has been rather underdeveloped in
Germany. While the first investment funds date all the way back to 1965, the number of private
equity funds remained small; – approximately 60sixty funds were active in Germany in 1995.
The gross investment volume had stagnated at approximately DM 1 billion a year in the earlier
nineties. In 1995, the volume of all private equity investments in Germany represented a mere
0.03% of the gross domestic product, compared to 0.11% in the United States.i The private
equity industry in Germany seemed to be in a dormant state.

But tThen something remarkable happened. In 1997, the private equity industry suddenly came
to life. The volume of gross private equity investment almost doubled year-on-year from DM
1,4 billion in 1996 to DM 2,6 billion in 1997. The industry association (Bundesverband
Deutscher Kapitalbeteiligungsgesellschaften or BVK) saw its membership jump by 20% per
year. And bBy 1999, the investment volume had further increasedexpanded to DM 6,2 billion,
representing more than a fourfold increase over only four years (see Figure 1).

Figure 1: Private Equity Investments in Germany 1990-99 ii

                                 Gross Private Equity Investments (Billion DM)

                 941   995    1,229   1,112   1,449 1,141 1,367 2,607 3,837         6,178   DM Million
         7 .0                                                   5

         6 .0

         5 .0                                                               +61%
         4 .0
         3 .0                                                                                   Bridge

                                                            +91%                                Expansion
         2 .0
         1 .0

                1990   1991    1992   1993    1994   1995    1996    1997    1998   1999

However, eEven more intriguing than the mere growth in overall investment activity was the
source of that growth. In Germany, the term “venture capital” is used loosely and includes a lot
of LBOs, MBO/MBIs, turnarounds and expansion investments, which in the U.S. would have
been classified as (non-venture) private equity in the US. Yet tThis kind of financing
traditionally dominated the German venture capital industry. The spectacular growth after 1997,
however, was clearly driven by “proper” venture capital investments. Seed and start-up
investing experienced an incredible explosion, growing by almost 1,300% between 1995 and
1999, which was —three times faster than the overall private equity investment volume (see
Figure 2). In 1999, venture capital investments had reached a level of DM 2,0 billion., This was
almost 50% higher than the entire private equity investments in 1996.

Figure 2: Growth of Private Equity Investments by Type 1995-1999

                          Growth of Investment Volume by Type (Indexed)


                                                                     + 1,262%     Seed/Startup

           1100                                                          + 959%   Bridge



                                                                         + 441%   TOTAL
                                                                         + 282%   LBO/MBO/MBI
            300                                                          + 262%   Expansion

                                                                          -80%    Turnaround
                   1995         1996       1997       1998        1999

Why this extraordinary boom? Most industry pundits have pointed to the introduction in March
1997 introduction of the Neuer Markt, the German stock market equivalent of the NASDAQ.
They argue that the Neuer Markt created a new exit channel that provided liquidity for venture
capitalists. The liquid stock market promised higher returns than trade sales or management
buy-outs could offer. With better return, investors became much more willing to make venture
capital investments. This aAccording to this “pull” theory, where entrepreneurial activity was
“pulled” or triggered by changes in the financial market.

In this article, we willWe argue that this “pull” theory is grossly oversimplified. It captures only
a small part of the real driving forces behind the dramatic industry developments. For one, it
clearly ignores the advent of the Internet, which changed the nature of technological
opportunities. Interestingly, however, there appear to have been many other factors that, while
they did not always make headline news, nonetheless seemed to have been equally if not more
important. In this paper, we therefore, we explore the more complex confluence of several
factors that were necessary for the spectacular boom. Indeed, we will emphasize that there were
a number of “push” factors that made entrepreneurship and venture capital more attractive to

Why should we care about what happened? There are two mainThe first reasons why an proper
understanding of the German experience is important. Fist, the German experience is because
ithis holds offers many lessons for other countries to developing their own venture capital
industryies. For the longest time there was a belief that Germany would never developbe home
to a vivid venture capital industry. Yet, against all odds, it happened. If venture capital can
flourish itn Germany, maybeperhaps there is hope for many other countries tooas well?. Second,
a proper understanding of what happened is critical to makescripting a prognosis for the
industry’s future of the industry. An oversimplified explanation that puts all the weight
onoveremphasizes a single factor would imply that as this critical factor changes, the industry
would again recede again. In particular, with the recent bursting of the stock market and Internet
bubble, it might seem that the time has come to write a German requiem for the German venture
capital industry. Our analysis, however, allows for a subtler, and interestingly more optimistic,
prognosis, for the future of German venture capital.

The purpose of this study is to examine the underlying reasons for the sudden rise in German
venture capital. While it is difficult to draw an exact line between private equity and venture
capital activities in Europe – the distinction in Europe is not as clear-cut as it is in the United
States – we will focus primarily on the early stage venture capital market.

Our methodology involved an extensive study of available literature, such as business
magazines, newspapers and industry statistics. At tThe core of the research was then an
extensive series of interviews with a wide variety of key industry participants.iii The different
perspectives we gained from this researchexpressed allowed us to thoroughly develop our main
argument. To present our findings, we first briefly explore theAfter offering a brief history of
German venture capital., The main part of the paperwe explores the central factors that explain
the explosion of the industry in the late nineties. We also evaluate the current state of the
industry, and we conclude with some questions about the future of the industry.


We begin our study by providing a historical framework of venture capital in Germany,
including a discussion of the institutional deficiencies that contributed to the stagnation of the

German venture capital market. This historical background will be helpful to understand what
changes were required to make the recent surge in venture capital investments in Germany

Slow growth over the first thirty years
1965 probably marks the birth year of the German venture capital industry,: with the founding of
the first four organized venture capital funds. In the following years, some more funds were
started, but most of them produced disappointing results and perished quickly. By 1975, the total
investment volume had reached DM 372 million.iv

In 1975, the industry witnessed its first significant event with the creation of the Deutsche
Wagnisfinanzierungsgesellschaft mbH (WFG). This was the first ambitious effort to create a
proper venture capital vehicle. It was founded by a consortium of all the leading German
financial institutions, and further supported by the federal government. ItThe motivation was a
belief that Germany was in danger of falling behind the United States especially in terms of the
commercialization of new technologies, and that this matteredtheir importance for economic
growth and employment. However, the experiment of the WFG proved to be a complete failure.
The majority of investments made by the WFG resulted in a net loss, and the WFG soon
abandoned the idea of makingits early stage technology investment strategy (see Becker and
Hellmann, 2000).

In the eighties, a number of venture capital firms that followed the U.S. model and emerged with
moderate success. By 1985, the overall market portfolio had grown to DM1 billion. Despite
new federal initiatives to foster start-ups in high technology, such as the “Beteiligungskapital für
junge Technologieunternehmen” (BJTU), venture capital investments in the early nineties
remained stagnant at approximately DM1 billion a year. By 1996 the entire venture capital
portfolio reached DM7 billion, and consisted mainly of mature private equity investments.
Overall, the growth of the venture capital industry before 1997 had been frustrating and slow.v

Entrepreneurship à la Germany: “Mittelstand”
A popular myth is that Germany has no entrepreneurial culture. There is a longstanding tradition
of entrepreneurship in Germany, except thatbut it follows a somewhat different pattern than the
Anglo-Saxon model of entrepreneurship. Entrepreneurship in Germany dates back to the second

half of the 19th nineteenth century, the so-called “founding years” (Gründerjahre). At the end of
the 19th nineteenth century and the beginning of the 20th centurytwentieth, we find the creation of
some of the well-known industrial empires, such as Siemens and Daimler-Benz. And while
some of these entrepreneurial start-ups turnedgrew into large conglomerates, most of the
entrepreneurial activity centered on the so-called “Mittelstand.” The term “Mittelstand” refers to
medium-sized enterprises (up to approximately 1,000 employees) that are usually regional,
family-owned businesses. They tTypically they specialize in very specific industrial niche
markets, especially in manufacturing machinery and automotive parts. Particularly aAfter World
War II, the “Mittelstand” formed fashioned an important engine for theGermany’s economic
reconstruction in Germany. With more than 800,000 companies, the “Mittelstand” remains an
important force in the German economy

So iIf an entrepreneurial spirit always existed in Germany, why did venture capital nottake so
long to develop for the longest time? The answer can be foundlies in the types of entrepreneurial
activities and the entrepreneurs behind the ventures. A typical “Mittelstand” company would
usually begenerally was started and managed by a family. It would iInitially be bootstrapped
from family resources, and with time it would take onsecure loans from commercial banks., with
For this, the founders would need to pledgeing both personal and company assets as collateral.
Given the more traditional, slow-moving industries in which these businesses competed
(especially in machine tool manufacturing, -or “Maschinenbau”), there was no need for rapid
growth. Instead, they grew more gradually, relaying mostly on retained earnings, rather than
external equity. Many founders wanted to make a good living with their enterprises, but few had
the intention – or skills, for that matter – to build large-scale businesses. In addition, tThe
concept of sharing equity with outsiders was entirely foreign to these entrepreneurs. They
founders viewed their family businesses with pride and put great emphasis on retaining control.
The business model pursued by a typical “Mittelstand” company, while clearly very
entrepreneurial, was very distinct from the business models that would attract venture capital.
As a resultConsequently, venture capitalists encountered considerable difficulty working with
the traditional German entrepreneurs. The chairman of the venture capital industry association,
Dr. Holger Frommann, commented: “[German venture capitalists] had difficulty to build a
positive image and had to fight against the deep-rooted and widespread mentality of the German
‘Mittelstand’, the ‘King of the Castle’ mentality.”vii

Social norms as disincentives
In addition, the sSocial norms ofembedded in German society prevented the widespread
acceptance of venture capital. Traditionally, the ideal job for a middle manager was a stable
career position with good compensation and status within an established company. Those who
hadwith the skills to run a successful start-up had little incentive to do so. Professional failure
was associated with a negativeinvited social stigma, which a failed founder would carry for a
lifetime. At the same timeConcurrently, financial success was not necessarily viewed with
admiration either, but rather with envy. In the rather egalitarian German society, a successful
entrepreneur could easily be admonished as a “capitalist pig.” It was relative safe fFrom a social
perspective, it was relatively safe to start a family-oriented “Mittelstand” company.; Bbut there
waswere no social incentives to start a high-risk, large-scale business that would require venture
capital. Interestingly, these social norms created some adverse selection among entrepreneurs.
Successful managers were less likely to give up the security of their current employment., Aand
the managers thatwho were willing to take the risk, were more likely those who had not achieved
a great dealhigh level of success in the corporate world.


This situation changed abruptly in 1997 when German venture capital exploded. In this paper
we ask wWhy? Our overarching finding is thatClearly the emergence of venture capital cannot
be explained by a single factor, such as the introduction of the Neuer Markt. Instead, wWe will
show that there were multiple factors that complemented each other. To structure the analysis,
we grouped these multiple factors into four main groups.

1. A sharp rise in entrepreneurial opportunities and entrepreneurial activities, the Internet being
   the most visible component of this.

2. A new breed of progressive, less risk-averse entrepreneurs with more affinity towards Anglo-
   Saxon funding models.

3. An iIncreased necessity to fund ventures through equity rather than debt or retained earnings.

4. An iIncreased availability of funds to befor investeding into start-ups and stock markets

A.    The Internet and deregulation bring about new opportunities

The Internet brought alongopened a large number of new business opportunities that
promiseding to transform entire industries. In the United States, public access to the Internet and
commercial applications first became prevalent around 1995. User-friendly browsers made the
Internet accessible to anyone, regardless of their technical know-how. Once the general public
started adopting the Internet as a new communications mediaum, and the user group reached
critical mass, the development of commercial applications became economically viable.

Due to oObstacles in infrastructure and more conservative consumer behavior, the Europe’s
adoption of the Internet in Europe occurred with a time lagged tobehind the United States. Most
industry experts estimate that this time lag was on the order ofspanned one to two years.,
Hhence, it was not until 1997 that the Internet euphoria really spilled over from the United States
into Europeeastward across the Atlantic Ocean. In 1997, 7% of the German population had
access to the Internet, —approximately the same percentage as in the United States 1 ½ years
earlier (see Figure 3). But once the euphoria spreadswept across Europe, savvy entrepreneurs
quickly began to realized the opportunities on the Internetto be harvested.

Figure 3: Internet User Penetration (in Percent of Total Population) viii


                    40%       1 ½ years



                       1995   1996   1997   1998       1999   2000   2001   2002

It is important to recognize that the Internet had some unique characteristics that made it a
relatively “safe” platform for new entrepreneurial activity in Germany. Earlier waves of
entrepreneurial innovation, such as the computer hardware and software revolution in the
eighties and early nineties, had thrived on technological breakthroughs and proprietary
developments. The Internet, on the other hand, was marked by the emergence of new business
models (such as reverse auctions, consumer-to-consumer transactions, communities, etc.) and the
application of old business models to a new medium. Business models were built on new, but
highly transparent business processes, rather than proprietary technology. These business
models could easily be copied and applied to new target audiences. Not surprisingly, a majority
of the Internet start-ups that began to springing up in Germany were essentially copycats of U.S.
concepts (see Figure 4 for some prominent examples). Taking proven business models that
already underwent thehad been scrutinyized ofby U.S. venture capitalists in the United States,
and transplanting them into the German market, was perceived as an easy, low-risk way to start a

Figure 4: Prominent Copycat Examples of German Internet Start-ups

                                US Model              German Copycats

                        eBay                            alando, ricardo

                        epinions                        dooyoo, ciao




In addition to the Internet, the privatization and deregulation of the German telecom market
created further opportunities for new entrepreneurs. Obviously, telecommunication played an
integral part in the exploitation of the new Internet media, so the deregulation of the telecom
industry created particularly exciting opportunities in the German market. As network access
became liberalized, and emancipated customers increasingly demanded innovative new services,
a broad spectrum of new competitors emerged. While some of the new competitors represented
divisions or spin-offs of established industry conglomerates (e.g. Mannesmann Arcor and VIAG
Interkom), numerous others were formed asentirely independent ventures (e.g. Mobilcom, QSC,
Primacom, Strato Medien AG). Clearly, the combination of a new technology and
communication platform, i.e. (the Internet,) and alongside the deregulation of the
telecommunications market opened the door for tremendous entrepreneurial opportunities.

B.    A new generation of entrepreneurs emerges

Who were the entrepreneurs thatwho could take advantage of these new opportunities? The
more conservative Mittelstand mentality did nothardly lendt itself for theto exploitationing of
these new opportunitiestechnological breakthroughs. A new generation of entrepreneurs needed
to step up to the plate and take a swing at the new economy.

And a new breed of entrepreneurs did emerge. Most of them were young, highly educated, and
had been exposed to a very dynamic professional environment in their short previous careers. A

fairly large percentage of these entrepreneurs had earned a business degree as part of their
education. A study of one thousand start-ups in the German Internet and e-commerce industry
conducted at the European Business School (EBS) illustrates this picture (see Figure 5).

Figure 5: Profile of New German Entrepreneurs ix

                         Age of Founders at                         Level of Education of
                        Inception of Venture                              Founders

                                                                        PhD             High
                                 7%                                                     school
                      35-39           18%                                     14% 21%

                                                             Graduate               13% Col-
                               32%     30%     25-29                                    lege
                    30-34                                     school          52%

                        Educational Degree of                           Professional Back-
                             Founders                                   ground of Founders

                            Natural Science                             Industry        Research/
                   Social       11%                              Media        12%
                  Science     10%          Business/                                26%
                                       34% Economics
                                                                  IT 23%
                              21%                                                  18%
                                                                              13% 5%      Consulting
              Engineering           25%
                                                                    Services         Banking

The background of these “new” entrepreneurs stands in sharp contrast to the backgroundthat of
the traditional “Mittelstand” entrepreneurs, who were usually older and came to a much larger
degree frommore likely held engineering positions in established industries. These differences in
backgrounds appear to be particularly relevant as data from the EBS study suggest that founders
with business backgrounds show more affinity to venture capital than founders with more
technical backgrounds.x One German venture capitalist noted: “Today, the typical entrepreneur
is no longer the cigar-smoking middle-aged Mercedes driver who would rather die than give up
control over his company. Today’s entrepreneurs are young, enthusiastic and don’t shy away
from risk.” Another venture capitalist added: “Today’s entrepreneurs are much more money-
driven. They realize that equity funding is the only way they can grow their start-up quickly and
attain high personal returns.”

In addition, mMany of the “new” founders have had significant exposure to American culture,
having studied or lived in the United States, or having worked for U.S. corporations in Europe.
As a result, these entrepreneurs wereare comfortable following the U.S. model of starting
businesses, including giving up equity in return for funding and managerial support.

Inspirational success stories
The affinity of the nNew entrepreneurs’ affinity towards venture capital was further reinforced
by inspirational success stories that quickly spreading inthrough business circles and at
universities. These success stories inspired many young professionals to try their luck at a start-
up and helped boost boost both the image and prominence and image of venture capital.

Many young professionals looked in awe to Silicon Valley icons, such as Jerry Yang of Yahoo,
Marc Andreesen of Netscape, or Jeff Bezos of Amazon. Much of tThe fascination
surroundingover Silicon Valley spilled over into Germany, so that major business magazines
(e.g. Wirtschaftswoche, Capital, DM) introduced Silicon Valley columns and special reports that
provideding current information about the Californian “field of dreams.” Aspiring German
entrepreneurs were eager to follow the path of these role models., Aand since venture capital
seemed to have played an important role in the success stories of Silicon Valley, the new
German entrepreneurs were also more favorably disposed towards venture capital.

The inspiration for a new generation of entrepreneurs became even more “real”all the more vivid
when some high-profile German success stories emerged.: They established that German
entrepreneurs, too, could make it in the Internet world. Some of the most talked about examples
included Stephan Schambach, founder of Intershop—, a world leader in Internet shopping
applications—, or Stefan Röver, who started Brokat, an online bank. And iIn some instances,
such as occurred with the Samwer brothers, the founders of alando (now eBay Germany),
television and the boulevard press elevated these entrepreneurs to a status of pop icons.

A point of debate is whether these role models inspired awe or greed. One partner of a large
German VC firm asserted: “Greed has been the major driver for many of entrepreneurs over here
in recent years. They watch how some kids make millions in Silicon Valley starting their own
company, and now they want to do it too.” Whatever the motivation may have been, these
entrepreneurial idols paved the way for fledging new founders in Germany in various manners.
They created awareness in the general public, they established credibility and legitimacy for
entrepreneurs, and they validated a business model where venture capital played a central role.

It is worth noting to whatthe extent to which established organizations changed their attitude
towards this entrepreneurialship movement. German universities are hardly known for
institutional change, but almost every major University started tobegan launching its own
business plan competitions. Ironically, these events were frequently co-sponsored by established
companies, such as BMW, Siemens, Deutsche Bank, McKinsey, Deutsche Post, or the
Frankfurter Allgemeine Zeitung.

Shifts in the labor market
The sStart-up fever also reached German employees, who historically showed little job mobility.
For the first time a large number of employees “jumped ship” from traditional jobs, especially in
banking and consulting firms. One former IT consultant who had joined an Internet start-up
noted: “People fleeing from consulting firms’ doors have worn out their hinges…. There were
probably only a few years of this madness left, so it was now or never.”xi

Other factors reinforced this movement. In the late nineties, Germany faced a very grim labor
market. Unemployment rates, for example, had almost doubled since the beginning of the
decade to more than 10%. It was not that the unemployed that started the company, nor that the
founders feared unemployment. But tThe unemployment figures partly reflected the stagnation
in the traditional industries. Those attracted to entrepreneurship often perceived the traditional
industry as lacking dynamism.

Closely related to this, the government supported venture capital as a means to reduce
unemployment. Initiatives such as the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW
(Kreditanstalt für Wiederaufbau) provided federal funds for new start-ups. Entrepreneurs and
venture capitalists gradually became recognized as leading facilitators in the creation of new
jobs. One VC partner commented on this new role of entrepreneurs and venture capitalists: “Just
five years ago, entrepreneurs and venture capitalist were seen as blood drinkers. Now, they are
seen as heroes creating new jobs. We don’t have yet the same go-for-broke culture as California,
but Germans really see the need for catalysts to pump up the economy here.”xii

C.    The nNew business models require equity financing

Traditionally, German business founders relied almost exclusively on personal wealth, retained
earnings, and bank loans to fund their new ventures. Few entrepreneurs even knew about the
possibility of obtaining equity funding as an financing alternative, and in any case, method of
financing. In addition, German founders were resistanted to relinquishing control over their
ventures. However, the late nineties brought a clear change in attitude: occurred in the late
nineties. Nnew founders became much more aware of equity financing,discovered and in many
cases chose to rely on venture capital to start their ventures. By 1999, the share of companies at
the Neuer Markt that was venture capital financed increased to almost 40%.xiii A central reason
for this shift was that the new business models had very distinct financing requirements.

The new business models of the late nineties were capital-intensive, but not asset-intensive. This
change required a shift from bootstrapping and debt financing to equity financing. Traditional
German start-ups focused on the manufacturing industryies. Besides the investment in property
and equipment, little additional capital was needed to start operations. Since the
investmentfinancing was mostly used mostly to acquire tangible assets, these assets could often
be pledged against the borrowed money, making as collateralized bank loans possible. In
addition, these ventures tended to operated in fairly stable market environments where rapid
growth was not critical to survival;. Hence, these startups could afford to grow and gradually
growth, based on their own cash flow and their borrowing capacity—, expanding in good years
and consolidating in not so good years—was the norm. Moreover, mManufacturing operations
were usually expected to turn profitable soon after the start-up, so that a gradual expansion could
be financed from the retained earnings.

The financing requirement for Internet companies was radically different. Internet business
models could not rely on gradual evolution but required aggressive expansion strategies. The
competitive challenge was to quickly acquire and then defend a market position. Capturing
market share early on, to dominate a segment, was deemed to be the key to success. The
performance of Internet start-ups was often measured in the “number of eyeballs,” i.e., the
number of users drawn to a company’s web site. As a cConsequencetly companies tried to
attract as many users as possible, often by relying on free services. As a general rule, Internet
start-ups anticipated to looseing money for several years.: Ttheir entire strategy was predicated

on a willingness to sacrifice short-term profits in the hopes of capturing a large user base in the
longer run. These strategies required extraordinarily large up-front investment. Bootstrapping
was certainly not an option for these companies.

At the same time, Internet start-ups possessed very few tangible assets that could be usedagainst
which to secure a bank loan. This was especially true if companies used their fund to invested
heavily in the areas of marketing and customer acquisition. As a consequence, mMost of
thetraditional bank credit analysis that banks were used to approval funding, werewas ill-suited
or meaningless when applied to Internet start-ups;s . And since these companies could never
meet the standard criteria for credit approval, thus the banks considered them too risky tfor lend

Equity financing naturally became the only viable financing alternative for these kinds of start-
ups., It provideding the necessary cash to fund the rapid expansion plans. In many cases, the
new start-ups would not have been founded, or could not have lived for very long without this
source of funding. Obviously, eEntrepreneurs had to give up a sizable stakes in their
companyies, something that the “Mittelstand” companiesfirms traditionally had resisted. But the
new entrepreneurs were more willing to accept this, in part because it relieved them of the
financial liabilities that could cripple a founder’s professional and personal life. Given the high
risk of the Internet, it was thus not surprising that the new generation of entrepreneurs readily
opted to finance their ventures by giving up equity stakes in their companysharing ownership
with their financial backers.

D.    Equity funding becomes readily available

With more and more entrepreneurs looking to fund their businesses through equity, a question
remainedone could wonder whether the supply of funds would be sufficient to meet thise
growing demand. Of course, the sSupply of funds depended stronglyheavily on the investors’
perception of how attractive theVC returns to venture capital would be, as well as any other
investment incentives.

Creation of new exit options
One of the crucialA prerequisites for an attractive venture capital market is the existence of
highly liquid exit options that allowenabling investors to cash out easily. In Germany, the March
1997 introduction of the Neuer Markt (NEMAX) in March of 1997 significantly improved the
available exit options. Prioreviously, investors would mostlywere likely to sell their
shareholdings in trade sales to strategic investors or in buybacks to the original founders.
Neither of these options yielded a reliable source of liquidity, so that it was much more difficult
for venture capitalist to exit out of an investment at a desired point in time. and Iin addition,
given the limited number of buyers, trade sales were less likely to result in grant the samea lower
valuations asthan a stock exchange. Most interviewees agreed that an initial public offering
(IPO) at a stock exchange is unquestionably the “Königsweg” (literally translated as “kings
route”) for an exit.

One may obviously ask why German venture capitalists did not exit through placing their
companies on the NASDAQ?. Most interviewees pointed out that it wasto the extremely
difficulty forof listing a German companiesy to have their stock listed on the exchange. Indeed,
they claimed that it was almost impossible to attract the interest of U.S. investors forin a German
high-growth stock. Most U.S. investors found it hard and cumbersome to evaluate the German
market, and investment banks were not unwilling to provide analyst coverage for comparatively
small companies outside the U.S. Hence, a placement on the NASDAQ placement was a viable
exit option for only for a very select number of ventures that had been able to attained global
leadership in a significant market segment. In fact, sSince the inception of the NASDAQ only a
small number ofew German companies (such as Rofin-Sinar or Digital Telekabel) had pursued a
listing on the world’s largest high-growth stock exchange.

In 1997, most iInvestors therefore welcomed the introduction of the Neuer Markt., and Iit
quickly developed beyond the wildest expectations. From 1997 to 1998, IPOs went from 4% to
16% of venture capital divestments, a fourfold increase (see Figure 6). The number of listed
companies on the Neuer Markt more than tripled to 202 over a period of thirteen months between
spanning the end oflate 1998 and early 2000. Its total market capitalization zoomed to $140
billion by early 2000, doubling in size over just a few months.,xiv though Tthis growth turned out
to be short-lived. While aAt its peak, the Neuer Markt’s NEMAX50 index had climbed above
9000,; but it had declined to under 3000 by the end of 2000. If the Neuer Markt iswere all there

extent is tof the German venture capital market, then it would clearly be in trouble. Our analysis,
however, emphasizes that while the Neuer Markt is an important exit option, it is not the only
factor that determinesing the viability and growth of the German venture capital market.

Figure 6: Divestments by exit channel

        G r o s s D iv e s t m e n t s b y E x it C h a n n e l          IP O P la c e m e n t
                                                     O th e r
                                                                                        In t 'l. C a p it a l M a r k e t s

                                                     T ra d e
                                                                                        O t h e r D o m e s t ic
         70%                                         S a le s
                                                                                        C a p it a l M a r k e t s


         40%                                         back

                                                                                         N e u e r M a rk t


                                                     IP O

                     19 9 7               19 9 8                       1 99 8 I P O s

Rising popularity of stock market investments
After the economic struggles following reunification in the early nineties, the German economy
enjoyed a period of prolonged prosperity. In the period bBetween 1996 and 2000, the gross
domestic product (GDP) grew consistently, increasing overall by 8.3%. This provided the start-
up businesses with a healthy environment in which they were able to flourish and take advantage
of the generally strong buying behavior of consumers and corporate customers. For instance,
nNational spending increased by 2.7% and 2.9%, respectively, in 1998 and 1999.xv

The eEconomic prosperity was reflected in the performance of the stock markets, which
witnessed abundant value growth and overall stability. In this economic uptake, investors
became less risk-averse and more willing to invest in high-risk projects. Both institutional and
private investors increasingly sought to invest in the market’s high-growth segment, of the
market. In addition,and with more money chasing high-risk projects, market valuations for start-
ups exploded. Ironically, the high valuations attracted further investments, leading to a self-
reinforcing growth cycle and the creation of an economic bubble.

Historically, Germany’s capital markets in Germany failed to attract the attention of the broad
public. Capital markets were tainted with an image of imprudent gambling. Unlike in the U.S.,
making money by investing was not considered “serious business for honest people.” In the late

nineties, however, the public attitude towards stocks market investing changed dramatically.
About the time of the privatization of Deutsche Telekom in 1996 (the largest IPO in German
history), Germans seem to have adopted stock market investing as a new “hobby.” Between
1996 and 1998 the volume of stocks traded more than doubled, gosurging from DM2378 billion
to DM5238 billion (see Figure 7). Throughout all segments of the population, the number of
stockholders increased rapidly, so thatwith more Germans invested their savings in the stock
market (see Figure 8). DM, a business magazine, enticed its readers: “Make your first million!
Start getting rich today.” Another leading newspaper, Die Welt, declared: “People have
succumbed to a stock market frenzy.”

     Figure 7: Volume of Stocks Traded xvi             Figure 8: Growth of Shareholders xvii

             Total Value of Stocks Traded                 Growth of Shareholders Since
                      (Billion DM)                                    1988
                                                        Office                       93%
         4.000                                          employees

         3.000                                          Professionals          40%

         2.000                                          Managers               37%

                                                        Homemakers       10%

                                                        Students        2%















It is easy to see how this new public excitement about capital markets affected the
entrepreneurial sector. Capital markets became a more common source of funding. The much-
publicized Silicon Valley start-ups became a source of revelation to many entrepreneurs.
Witnessing how U.S. entrepreneurs grew their companies with equity investments opened the
eyes of German entrepreneurs, particularly the younger ones. Capital markets became a more
common source of funding for the newly invigorated entrepreneurial sector. The change in
sentiment regarding capital markets – by the public in general and by entrepreneurs specifically –
thus also contributed to the German venture capital boom.

Another related factor that encouraged the supply ofpushing money into high risk capital was the
abolition of preferential tax treatment for other forms of investment. In the past, many German
investors reaped tax benefits by investing in real- estate funds or economic projects in former
East Germany. In the late nineties, however, many of these benefits were abolished and people
sought new investment alternatives., Ssome investors turneding to venture capital as a new high-
return investment opportunity. Yet another factor was athe trend away from the public pension
system toward private provisions. Historically, German society relied almost exclusively on an
extensive public pension system. InBy the late nineties, however, it becamewas clear that public
funds would not suffice to provide adequate support for retirees. New government programs
placed more emphasis on private pension provision (e.g. Altersvorsorge-Sondervermögen-
Fonds)., Aand a public discussion ensued about liberalizing regulations pertaining to the
investment of pension funds.

High leverage through government programs
A peculiarity of the German venture capital market is the existence of various government
programs that foster investment in high-growth companies. The two main sponsors of the
subsidy initiatives are the tbg (Technologie-Beteiligungs-Gesellschaft) and the KfW
(Kreditanstalt für Wiederaufbau).

The tbg is part of the Deutsche Ausgleichsbank (DtA) and supports start-ups through a number
of different subsidy programs, e.g. “Beteiligungskapital für kleine Technologieunternehmen”
(BTU), “DtA-Technologie-Beteiligungsprogramm,”, “Förderung und Unterstützung von
technologieorientierten Unternehmensgründungen.” The various programs are tailored towards
companies in different financing cycles (from seed funding to mezzanine financing) and in
different locations (e.g., special programs for former East Germany). All programs have some
fundamental investment principles in common. The tbg requires an outside lead investor in all
investments. It co-invests as a silent partner in portfolio companies as a silent partner, matching
the funds of the lead investor. The tbg itself plays a rather passive role in the investment., It
performsing little of its own due diligence, butrelying instead relies on the lead investor’s
analysis of the investment of the lead investor. Most importantly, the tbg funds are essentially
treated like a loan: there is a fixed payback rate associated with the tbg investment, part of which
is tied to the profits of the portfolio company. Hence, the VC firms use these programs to

leverage their own investments., In addition,and in case of a venture’s failure the tbg assumes
half the losses of the private investors.

The KfW has its roots in the post-war Marshall plan for the restructuring of the German
economy. It gGenerally it does not invest directly in the portfolio companies, but instead offers
refinancing for VC funds at very attractive conditions. The most popular program, the “ERP-
Beteiligungsprogramm,”, offers refinancing of up to 75% (85% in Berlin and former East
Germany) of the VC fund’s investment, —though generally however not more than EUR
500,000 per company. The interest rates on the loans are set at the lower end of market rates and
are fixed over the entire duration of the loan. The KfW also covers part of the investment losses
in case of a venture’s failure. Its investments, however, are capped at EUR 1.5 million per
portfolio company. Overall, the funds that can be obtainedavailable through co-investment from
the tbg and through refinancing from the KfW can increase the leverage of the VC investment

The preferential treatment of start-up investments made theGermany’s venture capital market in
Germany highly attractive. Most interview partners thoughtbelieved that these programs played
an important role in jump-starting the German venture capital market. However, some industry
experts also expressed some concerns about relying on these programs in the future,
especiallyparticularly since they engendered less scrutiny on the part of the investors.


The confluence of all the factors described above thus generatedfed the German venture capital
boom. Against all odds, Germany developed a thriving venture capital market. This, however,
does not mean that German venture capitalVC is just likeidentical to Silicon Valley venture
capitalVC. In this sectionNext we examine some of the distinct features of the currenttoday’s
German venture capital market.

A.    Managerial and entrepreneurial labor markets

While there was a lot ofDespite recent monumental changes, German entrepreneurs still struggle
more for legitimacy than do their U.S. counterparts. Given the rich entrepreneurial tradition in

the United States, a significant number of high-technology entrepreneurs are former employees
of large technology companies such as IBM, HP or Cisco. Yet oOthers leave one start-up
company to startfound another. In Silicon Valley, employees are exposed to the technology, the
markets and the culture that propel them into becominge successful company founders. Venture
capitalists can thus draw on a large pool of management talent for starting and mannstaffing their
portfolio companies. In Germany, on the other handcontrast, several German venture capitalists
noted that the majority of business plans they received came frorm ex-consultants and recent
graduates from technical school graduates.        One venture capitalistVC noted: “Most of the
business plans I see are really nothing more than hot air. The founders have no experience and it
really shows in the business plans they put together.”           This venture capitalistperson also
commented that a smaller, but growing, percentage of the business plans were from more
experienced managers with industry experience. Not surprisingly, these plans also tended to be
the stronger business plans. He expected to see more of such business plansofferings in the

In contrast to the United States where fFounder replacement is a frequent occurrence in the U.S.,
but German venture capitalistsVCs have littlelimited ability to bring in newreconstruct their
portfolio companies’ management teams to their portfolio companies. This is not only because
German founders are more opposed toresist such transitions, but also because of theit is
difficulty into recruiting experienced managers away fromwho enjoy their stable, high-status
positions. Ten years ago, the idea of leaving a good management position at a prestigious
company, like(e.g., Siemens,) to join a start-up, would have been consideredthought absurd. In
recent years this has changed, but only slightly. Some venture capitalists commented that the
success of companies such as Intershop and Mobilcom, and the extraordinary value of
management stock options at those companies, made recruiting experienced managers a
littlesomewhat easier. One venture capitalistVC argued, “You can make a case for many factors
having contributed to the increase in entrepreneurial activity, but it really comes down to one
thing,: greed. Potential entrepreneurs read about the huge sums of money made by the success
stories and that is the reason for the surge in entrepreneurial activity.” Nonetheless, there is still
no comparison between the U.S. and Germany in terms if the liquidity of managerial labor

B.    Sources of funding

In the United States, pension funds are the largest source of VC funds,; but in Germany, banks
are the largest source (see Figure 9). (German pension funds, however, seem likely to gain in
importance, as the federal government contemplates legal changes allowing them to invest more
significantly in private equity.) German banks have tended to view venture capital as a solution
to the equity gap (i.e., excessive leverage of bank-dependent private companies). They usually
wanted the moneyfunds to go towards more established companies. , which explains why
expansion stage investments and buyouts traditionally accounted for the majority of investments.
This changed in the late nineties, when seed and start-up stage investments began to boom. A
related shift is also apparent in the mix of companies receiving venture capital funding.
Traditional areas such as machine tool manufacturing declined in importance (from 16% in 1997
to 12% in 1998), whereas investments in biotechnology and the Internet increased (IT
investments increased from 7% in 1997 to 17% in 1998).

Figure 9: Source of funds

           S o u r c e s o f V e n t u r e C a p it a l in G e r m a n y                          C o m p a r is o n U S A
                                                                         F e d e ra l F u n d s                    F o r e ig n
                                                                         P r iv a t e                              E n d o w m e n ts

                                                                         C o rp o ra te                            P r iv a t e

                                                                         P e n s io n F u n d s                    C o rp o ra te

                                                                         In s u r a n c e
                                                                         C o m p a n ie s

                                                                                                                   P e n s io n


                                                                                                                   In s . C o .
                      19 9 6            1997               19 9 8                                         1 99 8

C.    Quality of venture capital

Several trends have become apparent for the structure of venture capital firms. With the
explosion in investment volume, there has been a rapid increase in the number of German
venture capital funds. In the years since 1996, close to forty new funds were founded each year,

approximately three times the rate of previous years (see Figure 10). By 2000, the German
Venture Capital Association counted a totaled of 178 members.

Figure 10: Number of New VC Funds by Year of Founding

              Number of
            New VC Funds


                                                                       39     38    35

                                       14             12         13                         11

                             1992      1993   1994   1995    1996     1997   1998   1999   2000   Founding
                           and earlier                                                              year

This growth came from two sources.: On the one side, there was a plethora of local funds were
founded by venture capitalists with little entrepreneurial experience. OnAt the other endextreme,
foreign funds decided to enter the Germany market. Now, mMany venture capitalists worry
about too much competition, and there is a belief that a shakeout and consolidation lies ahead.

Interestingly, while many German venture capitalists commented about the inexperience of most
entrepreneurs, the same comment seems tomay apply to the venture capitalistsVCs themselves.
German venture capitalists very often come from a consulting or investment banking
background. They tend to have little entrepreneurial experience and their priorbusiness networks
are not always relevant for start-ups.

Another concern is that as the size of German venture capitalVC funds grows, new gaps
mightmay emerge. One venture capitalist remarked that as the average deal size was risingrose,
a new equity gap was emerging in the DM 1-5 million range. One response to this concern,
however, is that there is also an increasing number of incubators. Moreover, tThere are some
firstalso signs that a more lively angel community is beginning to emergeing in Germany,
although this segments is still much less developed than in the U.S. (see Cadenhead et. al.,


After our detailed analysis of the history and the current state of the German venture capital
market, it seems appropriate to conclude with a few thoughts aboutwe now consider the future
prospects of the industry. With the current bursting of the Internet bubble now burst, the German
venture capital has entered a make-or-break phase that ultimately will show whether the recent
boom was merely a fad, or whether it was the beginning of a thriving industry. We would argue
that wWhile there may be some difficulty in the near future, there is reason towe believe that the
medium to long-term outlook of the industry is actually very solid. Our analysis shows that the
market’s growth of the market was based on a number of drivers. The current lull in the stock
market should therefore not be able to choke off this more fundamental momentum in the
German economy. However, in order to thrive three important issues will have to be resolved:
Will consolidation help the long-term survival of the industry? Can Germany produce its own
breed of real entrepreneurs? And will the industry generate true innovation?

A.    Is consolidation a good or a bad thing?

The rise in venture capital alongin tandem with the booming capital markets led to the creation
of many new venture capital funds. In these exceptional times, attractive investment
opportunities seemed abundant, and the number of start-ups that promiseding outstanding
investment returns appeared to be almost unlimited. There was money to be made for
everyone.—until However, this situation changed after the market downturn in the spring of
2000. Not every deal is a winner anymore, and obtaining a good exit event seems no longer
seems a “sure thing.” In this environment, a natural selection takes place. The best funds with
the best skills and the best reputation attract the best deals. And the less reputable funds are
likely to end up with much less attractive deals. The likely result will be a consolidation of
venture capital funds, with the top-performing funds outlasting and taking over the rest.

While most industry experts expect such a consolidation to take place over the next year, the real
question remains what the more fundamental effects of this consolidation will be. Some industry
participants paint a more somber picture: the consolidation may lead to a stall in the development
of venture capital in Germany. As public investors lose confidence in the high-growth market
and less experienced funds start to crumble, even more start-ups will find themselves in
searching for continued financial support. Ultimately, dried-upfailed start-ups and

haywiredrained funds may cause such deep scars with investors and entrepreneurs that the
momentum comes to a grindingcould grind to a halt. Others haveYet there is also a more
optimistic outlook., They argue thatanticipating the consolidation will have an overdue
cleansing effect, and selectseparating the “serious” investors from the unprofessional “cowboys.”
According to tThis view, holds that the industry will emerge healthier and fundamentally
stronger than before.

B.    Where are the “real” entrepreneurs?

In tThe recent boom many people were attracted many to start-ups bywith the prospect of
enormous financial gains. This trend quickly created a snowball effect: as successful
entrepreneurs continued to emergeWitnessing entrepreneurial success, others compounded the
snowball effect, were more likely to leaveing established jobs to follow in their footsteps and
found yet more start-ups. It was hip and fashionable to be part of theis booming startup
scenesector. However, with the market downturn, thise picture has changed once again.lost its
sharp focus, and Nnew economy start-ups are nowagain viewed with much more skepticism.
Startups have lost a little of their attractiveness for potential entrepreneurs, especially those who
strive for quick success. With manythe most opportunistic entrepreneurs fleeing the scene, it
remains to be seen how strong the “real” entrepreneurial movement is?. How many
entrepreneurs are actually willing to build enterprises for the long term? Is itWill the most
talented or the less talented people who remain in the entrepreneurial sector? In this context, it
will also be important for the Germany’s start-up scene to developnurture serial entrepreneurs
who can contribute to the maturityation of the entrepreneurial culture. In the United States,
serial entrepreneurs have become an important stabilizing element in the entrepreneurial

C.    Do we have innovators or imitators?

ATo date, a significant amount of the entrepreneurial activity in Germany to date, particularly in
the Internet, has consisted of copycat models. It was relatively easy to take successful business
models that had been established successfully infrom the United States and transplant them to
Germany,. but this is hardly Most of this activity, however, is not very innovative. While
cCopying successful business models may have been a convenient way to jump-start thefor
entrepreneurial activity in Germany, this cannot replace true innovation as the basis for

entrepreneurship. The window of opportunity for copying U.S. Internet business models was
only a passing phenomenon., and Moreover,with so many Internet models have provening to be
more difficult than anticipated, and the wave of new Internet start-ups has ceased in the United
States. As a result, cCopycat entrepreneurs may simplynow have run out of business models to
copy., and Tthis will force German entrepreneurs to become more innovative in their business

It remains to be seen whetherWill German entrepreneurs will live up to this new challenge and
whether they can build a culture of true innovation.? The developmentsExperience ofover the
last few years haves shown that Germany is well capable of developing an entrepreneurial spirit.
In this paper, however, we arguedWe believe that after the dust has settled on Internet and stock
market booms and busts, there is reason to believeit is likely that Germany will sustain a lively
venture capital industry.


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