Innovative young companies that create novel and previously unknown products and services face difficulties in finding resources to enter the market. The traditional financing method through bank loans is usually not an option for these companies, whose undertakings are deemed to be too risky by banks and who often lack the necessary collateral. As a consequence, these firms rely on private or institutional investors, who buy company stakes and are later compensated for the company’s success in the form of profit-sharing or, more frequently, with proceeds from selling corporate shares. In case of bankruptcy, however, investors face the risk of losing their entire investment.

Young companies are mostly dependent on investors or funds, because banks fear the risk of loss.
The importance of private investors and business angels for the financing of young companies has increased significantly in the past few years.

In a representative study funded by the Federal Ministry for Economic Affairs and Energy, ZEW analysed how equity investments in German high-technology firms that were not more than four years old changed in the period between 2013 and 2018. As the study shows, comprehensive changes took place over the considered period:

  • The number of young companies that received funding from private investors rose by 50 per cent since 2013 (from around 3,350 to approximately 5,100 firms).
  • In high-technology sectors, the share of companies gaining access to such funds increased from seven to 13 per cent. 
  • In the period between 2013 and 2018, total financing volume increased more than tenfold (from almost 85 million euros to around 925 million euros) as a result of private-sector investment in young high-tech companies.
  • The average amount of capital invested in young high-tech companies by private investors rose almost sixfold between 2013 and 2018 (from around 115,000 euros to 780,000 euros per company).

Overall, the involvement of private investors providing venture capital for innovative start-up projects and young high-tech companies saw a significant increase since 2013.

Having access to ‘enough’ venture capital is often considered a vital prerequisite for allowing founders to actually carry out promising start-up projects. The hope is that more companies will be able to implement start-up projects, as more venture capital becomes available. In fact, one would have expected that the increased supply of capital between 2013 and 2018 would have led to a rise in the number of high-tech start-ups.

“However, the opposite happened,” emphasises Dr. Georg Light, department head at ZEW. “The number of high-tech start-up companies decreased from around 46,500 to approximately 39,500 firms between 2013 and 2018, a decrease of 15 per cent.” This implies that the increased involvement of private investors in high-technology firms is most likely due to the framework conditions in financial markets, rather than a result of the situation in the respective sectors. “It is hardly worthwhile for private investors to invest in bonds or financial securities, which is why they are very strongly oriented towards the real economy. The stock market situation is to a great extent determined by large institutional investors or hedge funds; investing in new market entrants is therefore considered a profitable alternative,” explains Licht. However, due to the decreasing number of innovative start-ups, i.e. potential investment objects, investments are concentrated more strongly on individual companies, which thus have significantly better chances of successfully surviving the market entry phase. As the study shows, start-up activity in high-technology sectors cannot be stimulated through more venture capital. “Policymakers should therefore try to find other ways to leverage additional funding,” concludes Licht.

Good financing conditions for private investors to outlast the crisis

There is no reason to expect that the coronavirus crisis will fundamentally change the situation for private investors, who generally draw their financial resources from assets, not from current income. The crisis is therefore unlikely to significantly reduce potential investment resources in the short term. Even for the success of innovative start-up projects, the current market situation will only play a minor role. What matters are the medium to long-term prospects in the markets for innovative products and services. On an optimistic note, Licht concludes: “We can therefore expect the favourable conditions for private sector investment to outlast the crisis.” According to Licht, private investors are likely to stand by ‘their’ start-up companies in case they do run into crisis-related liquidity constraints. In this case, it would be important for the federal government to finally take action and introduce a rescue package for innovative start-up companies to help particularly promising firms survive the initial phase until the next round of funding.

Date

19.05.2020

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sabine.elbert@zew.de