High stakes

European venture may be set for its headiest days yet, with a raft of positive announcements in 2008. The year kicked off with a rare European venture homerun when a gaggle of VCs including Index Ventures and Benchmark sold Swedish software company MySQL to SUN Microsystems. The $1bn sale generated an IRR of 70% and money multiple of 16x.

"MySQL was very good news," says John Holloway, director at the European Investment Fund, Europe's largest venture fund-of-funds investor. "It is a strong example of a company being started in Europe, funded initially by European venture capitalists and then generating a strong return." While sharing the good news similarity, Skype had been funded at the outset by both European and US backers, so the success wasn't a purely European one.

The hefty price tag on My SQL surprised many. The company employs 350 people, generated only around EUR40m in revenues last year and analysts pointed out that with just 1% of MySQL's customers actually paying for a service, the price paid is gambling on a lot of future growth. But the backers weren't discouraged. "Whether an IPO or trade sale, the outcome would have been strong no mater what," Danny Rimer of Index told Nordic unquote".

Graham O'Keeffe of Atlas Venture agrees. "Venture is all about homeruns - that's what gets you out of bed in the morning. What has historically held European venture back is the lack of homerun opportunities and entrepreneurs who think big." He feels this has turned round in the last ten years, evidenced by a number of billion dollar exits, repeat entrepreneurs, and migration of talent from the US to European startups. "Despite the relatively small number of active early stage VCs we've also proven that even the more capital-intensive deals, like Icera or Plastic Logic, can attract significant funding precisely because they are going after large global markets."

Eager investors

A telltale sign that venture is picking up is keener LPs. A survey conducted by placement agent Almeida Capital reveals that over a quarter of global LPs intend to increase their allocations to venture this year, with just a tenth intending to decrease. European LPs are the most optimistic, with nearly a third looking to increase; against under a quarter of those hailing from the US (and nearly a fifth are negative: planning to scale back). "I am encouraged by the results," Holloway says. "But not sure we will see this sentiment convert to commitment signatures. Most venture GPs are below the radar screens of big limited partners aiming for EUR50-100m slogs into funds. Even for those willing to commit EUR30-50m individual tickets the market does not offer many opportunities." David Hall of YFM is more optimistic: "Those LPs that have been through cycles will probably realise it is the right time to invest. In ten years' time investors could be looking back as 2008 and 2009 as the pick of the crop."

Most recently, MTI's latest fund UMIP Premier, which will invest primarily in spinouts from the University of Manchester, attracted EUR42m at first close, a record in its space. "It is encouraging to see that many backers are traditional limited partners," says MTI managing partner Ernie Richardson. "It is a sign of changing attitudes amongst institutional investors."

Indeed a handful of venture funds are raising money this year (see table, right) including Environmental Technologies Fund, which raised £110m for its debut fund to invest in clean technologies. Commitments came from Swiss Re, EIF, Robeco, The Co-operative Insurance Society and F&C. LPs are hot on cleantech - unsurprising, given legislation that should mean the future is bright in that area. 3i just sold Germany's hte AG to chemicals corporate BASF following a five-year courtship with the cleanteach company. 3i's other recent exits in the sector include E.R.M., Insensys and Zero Waste.

That LPs may be more interested in venture has certain non-traditional GPs setting their sights on new areas. Imperial Innovations, which was set up to invest in spinouts from Imperial College London, roused speculation it will embark on an institutional fund for wider venture investing since it brought Russ Cummings on board 18 months ago. Cummings is a venture veteran who cut his teeth at Scottish Equity Partners and 3i before that. Another new type of fund, TT Venture, was set up by State Street Global Investments in Italy, which has raised EUR60m to invest in technology transfer from universities to companies, mostly in Italy.

Show 'em where to put it

Armed with cash, GPs must have a strong pipeline to impress LPs. "Now is a good time to have funds to invest if you've got a medium-term time horizon (around five years)," says David Hall of YFM. "The opportunities are as good now as they were two years ago, but less expensive. Also we are seeing development capital businesses still requiring cash - since debt is tightening up, the equity requirement is higher."

In fact some draw parallels with today's backdrop to that seen just after the dotcom debacle - meaning the Darwinian shake-up has left scope, but just for the fittest. "There is a real paucity of equity finance available for businesses. It is similar to 2001/2002 - and the companies that were bought then and sold in 2006 and 2007 did very well." Hall points the Cozart deal, which YFM backed in May 2001. The medical diagnostics specialist received a total of £3m then, with YFM putting in £1m and Avlar Bioventures and investor network Pi Capital providing the rest. The backers floated the business on AIM in July 2004 with a valuation of £27m. Ultimately Cozart was exited in 2007, when it was sold to Concateno plc for a hefty £64m, generating a multiple of 4x money for two of YFM's VCTs.

Stumbling blocks

Despite recent optimism, the path to success is not a clear one. A lack of funds for VCs to follow companies with; an ailing US market and lack of any real track record for European venture still prove troublesome.

"The sweetspot for venture will be in seed stage investing and following it on to the end. Traditionally there are seed investors and then there are later stage investors. "The truism is that no one makes money from seed," says Richardson. "But it is not true. Seed funds do not make money, but those later stage funds that sweep up the target in later rounds are able to make the big returns. So you need to have the capacity to carry on with an investment to make the returns." Indeed State Street Global Investment's TT Venture, which focuses on tech transfer in Italy, has 10% earmarked for seed, with another 35% for start up and 40% for development, meaning it has the ability to invest throughout a target's lifecycle.

"If GPs have the ability to do follow-on rounds, then that is best. Otherwise an investor seeds a company, it grows successfully and eventually needs more funding. Often times the seed investor is unable to provide this, meaning they face dilution of their stake," Holloway explains. The problem is that GPs often struggle to raise sufficient funds to be able to do this investing or are exposed to longer-than-expected holding periods, especially for those "around the Bubble" vintages. This also highlights the lack of technology growth capital players.

Another issue affecting European venture comes from across the pond. Traditionally exits have been through IPOs or sales to trade buyers, meaning exit prospects depend on the appetite of retail investors or corporates. Since US trade buyers make up a substantial portion of European venture exits, a big problem for European venture is a weak dollar. The proceeds of the MySQL sale involved $800m in cash and an additional $200m paid in SUN options, which is typical for a US trade buyer, since they usually buy in cash and not shares. But it means exchange rate fluctuations feature heavily on exit prices, and with the US undergoing difficult times, there is no end in sight for the weak greenback. PolyTechnos' latest fund, which will invest in software in DACH, has stated that its preferred exit route will be via trade buyers, with IPOs being considered only in exceptional circumstances.

Of course the most pressing problem for venture is its lack of any real track record and evidence of capacity to return cash. "As a general comment, the European VC market lacks homeruns. Returns from the bubble period were not spectacular," Holloway explains. "And those GPs able to return to the market in 2005-2006 have only been investing for 18 months, so it is too early to tell how they are faring. This lack of adequate and sustainable return levels does little to attract interest from LPs."

Even with homeruns, O'Keeffe feels it is hard to justify venture returns with less than 20 companies in a portfolio. "The reason is that VC, like the music industry, is a hits business, with only about 10% of companies really making it big, and without at least one big winner in a fund your performance will be average. For the winner to have a meaningful impact on your fund you also need a decent ownership percentage at exit.". Thus with these odds, to be 90% confident of capturing a big winner in a fund you need about 20 "shots on goal".

Once the shots are lined up it is important to know which to shoot down early. "The skill in effective portfolio management is to start off with an interesting set of companies and then carefully channel capital to the emerging winners and cut your losses early," O'Keeffe explains. Unsurprisingly he suggests the best venture investments are ones that require relatively small amounts of money to prove out a concept before building out an organisation and then scaling internationally to maximise exit potential. "'Prove, Build, Scale" is a discipline that anybody involved in early stage venture investing needs to follow to stand a chance of delivering top-quartile performance."

Perhaps the biggest problem, on a global level - the credit crunch - could prove positive for the asset. The global slowdown and resultant layoffs could actually spawn a new breed of venture opportunities. "When the economy is strong, why leave your day job to create a very risky start-up?" Richardson muses. "With more people facing redundancy, a new wave of entrepreneurs could be on the cards."

My SQL

The Credit Suisse-run exit process of MySQL originally sought an IPO on NASDAQ, however during preparations a number of industry bidders, including SUN, approached the company. As is often the case with trade buyers, a good price came with certainty of execution - and a nice strategic fit for MySQL. Even before the process was under, in 2006, Oracle had expressed interest in the company.

MySQL was founded in the 1980s and received its first venture round in 2001, when Sweden's Scope Venture, ABN Amro, Industrifinans, Eficor Venture and Texcel banded together to provide funding. Over the years the company attracted Benchmark, Index Ventures, SAP Ventures, Intel Capital, Red Hat and Presidio STX. In total, five venture rounds saw $39m pumped into the company - not bad considering the $1m ultimately paid by SUN.

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