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Venture Capital: fuelling innovation and economic growth

Portrait of Klaus Fuest
Klaus Fuest
Principal
Dusseldorf Office, Central Europe
+49 211 4389-2231

Germany needs more venture capital to boost the economy's efforts to attract tech firms

Germany suffers from an absence of venture capital. There is a lack of capital to fund the startups and innovations the economy needs to attract tech firms to set up business in the country. Roland Berger, the Internet Economy Foundation and the German Private Equity and Venture Capital Association highlight in their joint study how critical the situation is and what can be done about it.

Venture capital lays the foundations for innovation and successful growth.
Venture capital lays the foundations for innovation and successful growth.

Venture capital is what fuels startups and entrepreneurship. It facilitates innovations and allows them to be developed into marketable products, and it enables the financing of business ideas that would otherwise not have a chance of gaining access to the necessary capital. As such, it lays the foundations for Germany's success in attracting tech firms and ensuring the country's future economic growth.

But neither Germany nor Europe are good at mobilizing venture capital. Investments across Europe have tripled in the past five years but the gap to the US and Asian tech hubs is enormous. Venture capital worth almost EUR 64 billion was invested in the US in 2017 – which is 0.37 percent of that country's gross domestic product (GDP). Across the whole of Europe the equivalent figure did not exceed EUR 16 billion, with just EUR 1 billion of the total being invested in Germany, equating to 0.1 percent of German GDP – only one quarter as much as was invested in the US in GDP terms. It is no coincidence that five of the world's most valuable companies are based in the United States where there is a long tradition of funding startups with venture capital.

No capital = No innovation

Asia, too, which was Europe's equal in funding terms in 2012, has since steamed ahead and – with annual VC investments of around EUR 63 billion – has almost caught up with the United States. Countries like China are pumping huge amounts of government money into tech ecosystems and thereby positioning themselves at the forefront of key sectors of the future like artificial intelligence. So it is no wonder that new digital champions are emerging there, whereas in Germany good ideas and innovations often suffer from a lack of funding, are abandoned, or are ultimately realized and brought to market in other countries.

Startups are particularly in need of what's known as later stage funding to get them through the phase when they are financing their market entry and their growth. Less than one third of Germany's already limited stock of venture capital is available to firms in this phase that is so crucial to business success, thus exacerbating the problem of an absence of capital and diminishing the German economy's power to innovate. By way of comparison, more than half of all venture capital investment, EUR 34 billion, goes into later stage funding in the US.

Two vicious cycles are impeding the German venture capital market

Why is it that so little venture capital is invested in Germany? There are two main reasons: Firstly, Germany does not have enough big venture capital funds in which institutional investors like pension funds and insurance companies can invest their capital. This important source of capital is therefore missing, which in turn prevents the funds from growing and hinders the development of new funds – this is the "vicious cycle of insufficient capital creation". And then we have the "vicious cycle of insufficient scaling": Since there is not enough venture capital in circulation, startups are undercapitalized and lag behind their international peers. This means that there are no landmark startups to encourage additional capital to be pumped into other promising startups.

The two vicious cycles are interconnected and mutually reinforcing. They threaten to set off a downward spiral of inadequate capital and a migration of startups into countries beyond Europe's boundaries. To break the vicious cycles and transform them into virtuous cycles, the general framework for venture capital needs to be improved – ideally on a pan-European scale: Europe needs not only to get rid of red tape and fiscal barriers but also to create tax incentives for venture capital investments, by enabling them to be partly written down.

Measures to foster innovation

In order to mobilize more capital from institutional investors and get it flowing into venture capital, a German "Innovation Fund" should be set up to enable organizations like insurance companies and pension funds to invest part of their assets in innovative business models in the form of venture capital. As a fund of funds, it would offer the necessary scale and could lessen the risk for investors. Given that more capital is needed, especially in later stage investments, every euro invested in this important stage by private-sector financiers should be matched by government co-investment funding.

Other significant measures for fostering and funding innovations include improving the links between innovative academic research and business practice, such as through new Excellence Initiatives, and more actively communicating landmark projects and startup success stories. And asset-backed elements within pension systems, including venture capital investments, also need to be considered. Not only would that mobilize additional capital but it would enable the population at large to share in the returns of digitalization. The future-oriented regeneration of the economy would thus become a project that benefits the whole of society.

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Study

Venture Capital: fuelling innovation and economic growth

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A lack of venture capital diminishes the German economy's power to innovate and hinders the growth of new companies. We outline six actions that Germany can take to mobilize more venture capital.

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