Venture capitalists in Central Europe

Drivers behind venture

Most venture capital investors are international firms that have started looking at the region, and there are also local managers such as 3TS, Eagle Ventures, MCI and Poteza.

In addition to a constant stream of people coming back from the West, it has recently also been observed that more talented people wish to stay in their home countries, which will also help increase the pool of qualified people and send a sign of confidence about the region to the world.

In CEE, the attitude towards starting an own business is somewhere between what it is in the US and Western Europe. Yoav Leitersdorf of YL Ventures, who is focused on early stage deals in CEE as well as in Western Europe and in Israel, says that 'here the entrepreneur is a hero'. There is less fear of failure than in Western Europe, which is commonly regarded as one of the reasons why venture in Europe has not yet produced substantial returns. 'In CEE, the entrepreneurial mindset is more daring, more risk-taking, compared with the more conservative views prevalent in the West. It probably also plays a role that many Eastern European entrepreneurs have less to lose in terms of privileges such as healthcare, social security and high basic income,' explains Leitersdorf.

However, that is not always the case, as Jonathan Cooper of Poteza Projektno Svetovanje has observed: 'While the number of skilled, motivated and daring entrepreneurs in CEE has been increasing, CEE - just like Western Europe - still lacks the critical mass of people who want to start out on their own. Many young people I have met want to go and work for the government or the incumbent telecom - not start a company or work for a start-up. They value security more than anything.'

'We have been observing a significant increase in the number of skilled and motivated entrepreneurs over the past ten years,' Sylwester Janik of MCI Management comments. 'What the CEE market needs, however, is more examples of success stories of technology companies originated in the region. This is what drives entrepreneurship.'

(Good) job opportunities have been scarce as state-owned businesses collapsed or were broken up. Especially when it comes to challenging, well-paid jobs, the younger generation often looks for opportunities outside of the region, at least for a number of years at the start of their career. However, the all-new environment combined with low-cost staff make for an excellent environment for start-up entrepreneurs and management teams who dare going it alone and spin out of larger organisations.

CEE has an excellent academic track record and a reputation for outstanding scientific research. Young managers who have been gaining experience in the West increasingly look for opportunities to deploy their academic skills and management knowledge in their home countries. 'Everyone recognises that there is a lot of talent in the region. What many people do not know is that back in the days of communism, each country of the Eastern block had its specialisation. Hence, to this day, some countries are stronger in, for example twireless technologies, IT or biotechnology, than others,' says Orasche.

Cooper adds, 'Regarding cooperation with universities and technology parks, this is an area we have explored extensively, but with little results. The universities need to reform themselves before they can become hotbeds of innovation, and the technology centres need more experience and money. I would say the technology centres are moving in the right direction, but the universities seem to be stuck in the past. They do a good job when it comes to training engineers to work for Siemens or Ericsson, but a poor job in terms of supporting young entrepreneurs.'

Janik agrees: 'There is still a long way to go to leverage and unlock a commercial potential of universities, incubators and technology parks. The "Continental" model of "doing" the science is strong there and there are only a few examples of technology companies developed with success by entrepreneurs with academic backgrounds. However, the CEE region still has a viable opportunity to build on its advantage of the high quality of academic education.'

Two factors from outside the region have contributed to the growth of the venture industry in CEE: 1) the massive capital inflow into the private equity asset class during the credit boom years, which forced investors to look outside their traditional territories to put capital to work (although this trend contributed more to the growth of the buy-out rather than the venture industry in CEE) and 2) the more recent search for returns and investment opportunities at the smaller end of the investment spectrum following the credit crunch.

Hurdles in the way of further growth

Theentrepreneurial environment needs to improve to provide entrepreneurs and investors with a more solid base for growth, no matter in which region exactly they look to operate or expand. Investments in infrastructure are badly needed and form the basis for future growth.

Tax incentives for venture capital investors do exist in some countries but they need to be assessed and adapted to actually do what they are meant to do: attract investors from outside a country and motivate local investors to set up companies and venture capital funds.

This links in with a venture capital-friendly environment which still needs to be constructed in CEE. 'Certain local hubs, such as London, feature an established network of serial entrepreneurs, experienced venture capitalists, lawyers, accountants, intermediaries, journalists, bloggers and event organisers that provide a platform for innovation. This is still just in its early stages of development in CEE,' according to Leitersdorf. 'Western European entrepreneurs and venture capitalists have access to multiple government-sponsored programmes that offer debt financing to small-and-medium-size-businesses, tax breaks and various forms of assistance in attracting investment. Academic institutions offer incubation programmes and guidance. All those things are needed across CEE.'

In terms of labour cost, CEE is more expensive than India and China, which means that entrepreneurs, businesses and investors with a focus on low labour costs are likely to look at other emerging markets. Obviously, this is not a 'hurdle', more a fact, and needs to be compensated with other benefits that CEE can offer and other emerging markets cannot.

Another barrier to overcome, however, is related to language and cultural issues. CEE is very diverse, broken up into some larger and many smaller countries and regions, each with their very own identity. Not many people in the West, where most of the capital for innovation is expected to come from, speak any of those languages and people in the regions are often not fluent enough in Western languages. 'Communication between venture capitalists and entrepreneurs can be a bit tricky at the best of times,' Orasche, who speaks several languages himself, emphasises, and he adds, 'that is why we have set up a multinational team across the Balkans.' Cultural diversity is sometimes underestimated and experienced local investors and entrepreneurs often feel unhappy about investment firms trying to cover the whole of CEE from one single office.

Janik adds, 'The diversity of the CEE region in both culture and economic development requires fund managers with a local knowledge and on-the-ground presence in the major CEE markets.'

Orasche also stresses the lack of co-investors: 'Dealmakers in CEE often have difficulty in finding co-investors, especially those that add value. Nevertheless, we do not see this issue for technology companies with global potential, where the interest of international top VCs is significant.'

Another issue relates to the entrepreneurs themselves more than to the environment in which they operate. It is that oftentimes entrepreneurs lack the drive to become serial entrepreneurs, as is much more common in the US. 'In CEE, most entrepreneurs want to get rich on one deal. The problem with it is that they see their single idea as "the" idea of their lifetime, which makes it very difficult to negotiate a deal and make an investment, as entrepreneurs tend to hold on to their majority stakes. Consequently, companies become national champions worth several million euros, but are unable to take the next step to become regional or global players,' says Cooper.

He adds, 'I also hear about A round, B round, C round, etc., in Western Europe and in the US - this does not really exist in CEE. Companies are lucky to get an A round, and if it all goes well, maybe a B round. But by then, everyone is looking for an exit so they can claim victory with their LP's. We need LPs to be more patient and more risk tolerant in CEE. Another issue is that it is more common for a Polish company to look to partner with a UK company than, say, with a Czech company. In many cases this makes sense, but often it does not. In my opinion, this has to do with low self esteem in the region - a Polish company would be considered more successful if they partner or cooperate with a UK company than a Czech company. This needs to change to make the region stronger.'

'One can find an attitude of "a lifestyle business" among entrepreneurs in the CEE region and focus on building dominant positions in local markets,' says Janik. 'Some of the markets of the CEE region are big enough to make such a strategy viable. However, as the costs of running online companies dropped significantly due to the increase in internet penetration increased, more entrepreneurs started to aim at building regional or global companies.'

Pekka Mäki of 3TS says, 'We have seen that venture capital and private equity deals take longer to complete in CEE, mainly due to the fact that it is a less mature market. However, that has been changing.'

Need for angel investment

CEE is seeing a significant funding gap for investments below €500,000. 'Angel investing is just getting started in CEE. In fact, to support the establishment of angel networks, Poteza is a founder and sponsor of two new angel networks, one in Slovenia and the other one in Croatia. The idea behind both networks is to fill the sub-€500,000 funding gap for small companies,' says Cooper.

Some government grant programmes do exist for small companies, but the funds available too often are too insignificant, especially taking the lengthy bureaucratic process into consideration that entrepreneurs have to go through to secure some of that capital. Cooper is also worried about a lack of role models: 'I would say that there have not been many success stories for new entrepreneurs to follow. This makes for a "gap" with regards to mentors and experience with early stage companies in the region.'

Exit environment and returns

While venture capital returns across the whole of Europe have not been amazing overall yet, there have been some really good exits, among them some very successful IPOs on the Warsaw Stock Exchange. 'Emerging exchanges such as the Warsaw Stock Exchange have shown significant progress over the years, although valuations and liquidity are still low in global terms,' says Leitersdorf.

Prior to the recent stock market crashes, it was not just the Warsaw Stock Exchange that had been offering exit routes for venture-backed companies, but also the Prague Stock Exchange, which had clearly been on the up. It remains to be seen whether those stock exchanges will be able to continue the positive trend when the markets come back. AIM and, to some extent, the Vienna Stock Exchange and the small-cap exchange in Vienna have in the past also been very popular destinations for venture-backed companies looking to raise capital or investors to exit.

'There have been some rather sizeable IPOs in CEE,' Mäki stresses.

M&As seem more promising in CEE than IPOs because the region's start-ups are interesting targets for both Ameritern European strategic acquirers. In general, the exit environment had been improving steadily since 2005. It remains to be seen how much CEE is affected by the current downturn.

'It will vary from industry sector to industry sector, but I expect the exit environment to continue to be good because it is more trade sale-based and, hence, less affected by the turmoil in the stock markets,' Orasche says.

Cooper adds, 'M&A has been quite vibrant in the region. Many of the larger Western European companies or funds that are looking for expansion opportunities look towards CEE as a natural geographic extension of their business.'

Shortage of funding

Matthew Gertner is a local venture capitalist in the region. He says, 'My experience has been that it is still pretty much impossible to secure financing for an early stage software company in CEE from a venture capitalist. Funds here tend to focus more on the later stages.'

Gertner also stresses that for a venture capitalist to be a useful partner to an entrepreneur, the venture capitalists needs to have an extensive network of contacts to help portfolio companies succeed. Their networks should include large technology companies (as potential acquirers), other venture funds (for co-investments, follow-on rounds) and PR/marketing firms. 'There are very few people here in the region with those types of networks,' Gertner finds.

Future potential

Venture capital has a long way to go in CEE but there are many encouraging signs for future growth. 'In the years to come, CEE may prove to be more promising than Western Europe from a venture perspective. CEE entrepreneurs are generally more focused on their entrepreneurial challenges than their Western counterparts. At the same time, their cost base is a fraction of Western standards,' Leitersdorf thinks.

There is still just is not enough capital available for early stage investment. However, there are many reasons why CEE venture capital funds and entrepreneurs stand a good chance of attracting a good portion of the capital that is going to be allocated to the emerging markets by institutional and high-net-worth investors over the next few years. Orasche agrees: 'Several venture capital firms have recently started their activities in the region, and there are more to come in the future. The number of angel networks is also on the up.'

CEE venture capitalists expect to raise more capital from local banks, pension funds and insurance companies in the near future. Those institutions typically want to be seen as supporting local entrepreneurship and they are expected to open up more to the alternative asset class, and certain investors sometimes also go for direct investments.

Orasche confirms that he has 'observed a trend towards higher allocations to venture funds by local investors. However, pension funds are still very small compared to the West and rather conservative. Hence, I would not expect too much capital to come from local pension funds in the near future.'

Cooper adds, 'Our fund has 33 LPs, including banks, insurance companies and wealthy individuals. Of that total, one is from Western Europe (Italy), one is from the US, and all the other LPs are from Slovenia, Croatia, and Estonia. Without the support of local LPs, we would not have raised our fund.'

'The acceleration of ecosystem development is the main factor that can make early stage investing more successful in CEE. Government-sponsored programmes that encourage entrepreneurship and small-to-medium-size-enterprises (SMEs) such as making debt financing more accessible will help boost an already-existing entrepreneurial mindset. 'Reduced capital gains taxes, better employment and stock option legislation, more investment in education, and more active measures to encourage foreign investment can all help venture capitalists and entrepreneurs' Leitersdorf underlines, while Orasche stresses the need for more technology centres.

Cooper wants the venture capital community to work together better to help the industry evolve in CEE: 'Better cooperation between CEE venture capitalists would be very beneficial, as would cooperation between CEE technology companies. There should also be more cooperation between venture capitalists and tech companies in the West and their CEE counterparts.'


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