UNIVERSITY OF TILBURG INTERNATIONAL BUSINESS LAW …

UNIVERSITY OF TILBURG

INTERNATIONAL BUSINESS LAW

MASTER PROGRAM

GOVERNMENT AS VENTURE

CAPITALIST IN HUNGARY

THESIS

dr. János Kőszegi

ANR: 846256

Student No.: 1247591

- 2012 -

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Table of contents

1. Introduction ......................................................................................................................................... 3

2. The venture capital industry ................................................................................................................ 6

2.1 How to satisfy the capital needs? .................................................................................................. 6

2.2 History of venture capital .............................................................................................................. 7

2.3 The international standards of venture capital ............................................................................... 9

3. Venture capital in Hungary ............................................................................................................... 12

3.1 History of venture capital in Hungary ......................................................................................... 12

3.2 Assessment of the legal environment .......................................................................................... 13

3.2.1 The first act on venture capital industry ............................................................................... 13

3.2.2 Second act on venture capital industry ................................................................................. 15

3.3. Presence of venture capital in Hungary ...................................................................................... 17

3.4 Usual types of investments .......................................................................................................... 18

3.5 Exits in Hungary .......................................................................................................................... 19

4. Government as venture capitalist in Hungary – The current regime ................................................. 20

4.1 Established VC Funds ................................................................................................................. 21

4.1.1 MFB Invest Plc. .................................................................................................................... 21

4.1.2 CORVINUS Plc. .................................................................................................................. 24

4.1.3 Venture Finance Hungary Plc. (MVF Plc.) – the fund of funds ........................................... 26

4.1.4 IKT Plc. ................................................................................................................................ 30

4.1.5 KVFP Plc. ............................................................................................................................. 31

4.1.6. SZTA Plc. ............................................................................................................................ 33

4.2 Sub-conclusion ............................................................................................................................ 36

5. Case studies of GVC – Lessons from the world ................................................................................ 42

5.1. How not to do – out of control ................................................................................................... 42

5.2. How not to do – Bad timing and lack of endurance ................................................................... 44

5.3. How not to do – Sizing the GVC................................................................................................ 46

5.4 How not to do – Lack of flexibility ............................................................................................. 48

5.5. How not to do – Problems caused by top-down approach ......................................................... 49

5.6. How not to do – agency problems .............................................................................................. 51

6. Conclusion – do we need a policy change? ....................................................................................... 53

6.1. What not to change ..................................................................................................................... 53

6.2. Where change might improve the performance of the program ................................................. 53

Bibliography and list of references........................................................................................................ 60

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1. Introduction

Venture capitalists dedicated their financial sources and knowledge to fund the most

innovative entrepreneurs all over the word. This relationship between venture capitalists and

entrepreneurs is much more than what would stem from a simple loan contract; the venture

capitalists are interested in the success of entrepreneurs, therefore they work closely together

with them in order to transform their breakthrough ideas into successful emerging companies.

They provide not just financial aid, but guidance and know-how in the business sphere; they

take part in the company management and problem resolution. They work as a motor of start-

up companies by putting enough pressure on entrepreneurs in order to do their best for the

success of the enterprise.

It is very important to know whether in a specific country entrepreneurs with

breakthrough ideas are present. One indicator for that could be the number of patents

registered in a specific country. According to the Annual Report of the Hungarian Intellectual

Property Office in 2011, 660 patents were filed, while patent granting and validation

procedures before the office were completed in 4652 cases together with European

validations. The number of domestic (Hungarian) patents from the granted protections

amounted to 205.1 The numbers show that innovative entrepreneurs are present in Hungary.

Venture capitalists have also a very important role in a specific country’s economy. In

the absence of venture capitalists successful ideas could be lost forever, without turning them

into a profitable, competitive business which could employ many citizens. “According to a

2011 Global Insight study, venture-backed companies accounted for nearly 12 million jobs

and $3.1 trillion in revenues in the United States in 2010.”2 These numbers definitely point

out the importance of venture capital industry on one nation’s economy. We can state

generally that the higher the employment is, the stronger the economy of a specific country is.

This is really true if we consider the simple fact that on one hand an employed person will be

able to pay taxes, to consume goods, which produce tax revenue as well, and on the other

hand venture-backed companies as employers will also pay taxes after the employed person

and realize profits, which will be distributed to shareholders and which will also be taxed as

capital gains, hence producing tax revenues. Furthermore the state will not have to take care

1 In: Hungarian Intellectual Property Office, Annual report (2011): 38

2 In: National Venture Capital Association opened 10

th May 2012.

http://www.nvca.org/index.php?option=com_content&view=article&id=339&Itemid=653

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of its unemployed citizens; therefore the state will save money on every employed taxpayer.

In theory it is a clear win situation for every party.

However, in practice the situation is much more sophisticated, serious risks are

involved in venture capital investments. Due to the financial crisis a huge amount of investors

investing in venture capital funds disappeared from venture capital industry, which led to

substantial changes. These changes are palpable in the significant change of the venture

capital cycle. The decrease of the number of the investors in the industry led to two

consequences; on one hand fundraising takes more time (up to two years), and on the other

hand the number of the venture capital funds have significantly decreased. This process had

dreadful consequences. The existing venture capital funds moved their focus to less risky

start-ups and mainly take part in second, third etc. round of finance, which led to financial

gaps in start-up’s lifecycle. But, every crisis gives a new opportunity for development, and it

was the case of venture capital industry as well.3

New players in the venture capital industry appeared to fill out the gaps in start-up’s

lifecycle. These new players are wealthy private persons (the so called angels), corporations

and the government. These new players have significant capital to invest in start-ups in their

early (seed) stages. Furthermore governments realized that a significant decrease in financing

of start-ups will greatly hinder the economy, therefore they had to take economic measures in

order to keep their economy stable and growing.

Governments have different tools to intervene in order to reach their targets. It is

especially so when it comes to the economy. They can take passive/indirect and/or

active/direct measures.

Passive measures are different legislative measures in order to make favorable

conditions to entrepreneurs and investors. Tax benefits and other fiscal incentives, removing

barriers to domestic and foreign direct investment are as well important as setting up a

favorable judicial system which avoids overregulation and burdensome procedures.4 This is

definitely important on the field of company law and insolvency law, where the biggest

competition is between states on European (and even on worldwide) market. In the

framework of European Union entrepreneurs and investors can easily choose between

different countries’ legal framework, and incorporate their start-ups in the most favorable one.

3 The section is based on Prof. Dr. Erik P.M. Vermeulen’s lecture on Venture Capital, Tilburg University

International Business Law LLM (2011) 4 As explained by Mr. Diogo A. Pereira Dias Nunes’ lecture on Legal Negotiation Workshop, Tilburg University

International Business Law LLM (2012)

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Without making yet any further analysis of the existing situation, I will begin by stating that

legislative reforms are necessary in Hungary as well. However, this will not be the main focus

of this thesis.

Governments can boost their economy with active/direct measures as well, such as

venture capital funds established by government (hereinafter: government venture capital or

GVC), governmental grants and loans, public procurement procedures etc. The focus of this

thesis will be on GVC’s.

The idea of GVC is not new, however its importance has risen significantly in last

couple years worldwide. In my thesis I will show examples on earlier attempts on GVC’s as

well. Some of these GVC’s reached significant success, some of them have failed. In my

thesis I will argue that government’s intervention in the venture capital cycle is essential,

especially in post-communist countries like Hungary, where the venture capital industry is not

that developed as it is in countries without a communist heritage.

The Hungarian government in 2011 launched its New Széchenyi5 Plan in order to

improve Hungary’s competitiveness and to create one million new jobs within ten years. The

program shall respond to the challenges Hungary is facing, and it shall ensure a sustainable

growth for a long term.

I profoundly believe that these goals can be reached only if the government – besides

passive measures – takes an active role in Hungarian economy, more precisely if it appears as

a venture capital investor and invests in portfolio companies which through their success will

create new jobs, bring a decent return on the invested money and will produce new income to

the state trough taxation system as well.

Although the Hungarian government has already established its GVC’s many years

ago, the role and policy of these shall be reconsidered for many reasons described in this

thesis.

5 Szechényi was one of the greatest statesmen of Hungarian history. In his political writings (Hitel (Credit) 1830,

Világ, (World/Light) 1831, and Stádium (1833)) he encouraged the nobility to become the driver of the

modernization of the country. He donated all of his annual income in order to establish the Hungarian Academy

of Sciences and also took a big part in the building the first permanent bridge between Pest and Buda and in

foundation of railways.

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2. The venture capital industry

2.1 How to satisfy the capital needs?

In order to satisfy their capital needs, firms have different options to choose from, but

each of these has its advantages and disadvantages.

First of all, the so called “bootstrapping”, the “American Way” of development is a

possibility where the entrepreneur will found and build a company from his/her personal

financial sources and/or operating revenues. An obvious advantage of this financing form is

that the ownership of the company will not change, the entrepreneur will stay in control above

his/her company, and there will be no monthly payments to a financial institution. On the

other hand it is an unsophisticated form of satisfying the capital needs, furthermore the

entrepreneur risks his/her own money and revenues. Furthermore in this form of financing

capital commitment basically depends on entrepreneurs financial abilities and revenues,

therefore it is difficult to make large capital commitments. Another disadvantage of

bootstrapping is that it may result in losing of strategic focus, since great energies must be

focused on financial issues instead of developing the idea.

The second option is debt finance which might take form in a private or bank loan, or

issuance of bonds, etc. While issuing a bond might be an option for a well established,

registered entity, start-ups rarely can do so, while in practice there will be no investor which

will buy a bond of an unknown small company. Also there can be legislative restrictions on

issuance for such small companies. Therefore these companies are basically forced to take a

private or bank loan if they would like to choose the debt finance as capital raising method.

Before the pop-out of the financial crisis in 2008, banks had plenty of capital to invest;

therefore it was relatively easy to take a loan which satisfies the company’s capital needs.

Another advantage of debt finance is that shareholders did not have to face with the (direct)

reduction of their ownership in the company. Of course the company had to have history/track

record, and relevant tangible assets which may be used as a guarantee for the loan. However,

these preconditions can be huge barriers for a start-up company which has relatively small

amount of tangible assets, and a short history/track record.

An additional disadvantage of this financing form is that a loan must be repaid in

monthly installments usually directly after taking such loan. This obligation can put a big

pressure on the company and it might consume relevant sources of cash to repay the loan

which otherwise could be used for improvement of the company and its product. In other

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words, the lenders will care about the repayment of the loan and the corresponding interest, so

their main interest may be not the success of the company.

Third option is equity finance. An obvious advantage of equity finance is that a large

amount of capital can be acquired without the obligation of repayment in installments. Also

some preconditions like history of the company and having relevant tangible assets are not

playing a central role. Equity finance gives the opportunity for the company to focus on its

ultimate goal.

The downside of this financing form is that founders and shareholders have to face

with the process of losing or dissolving their ownership and often control in the company

which involves further obligations such as regular reporting to investor(s). Still it is the most

convenient form to finance a start-up company. If it comes to equity finance then venture

capital industry comes in as its grandest character in this asset class.

2.2 History of venture capital

Venture capital has a long history. Its first appearance was probably in China during

Shong Dynasty more than 800 years ago, where in form of bidding auction the

“entrepreneurs” presented their ideas and the “investors” bid on them. The “investor” which

offered the highest bid acquired the right to finance the “entrepreneur”.6

In Europe the rise of the venture capital “industry” was connected to merchant’s

voyages to far places. These costly, highly risky voyages were financed by wealthy private

persons (kings and nobles). In order to share the risks of these investments company forms

started to emerge, which provided limited liability to their members.7

Concerning the modern venture capital industry, its emergence has started in the

United States after the Second World War. General Georges Doriot (professor at Harvard

Business School) is considered as the founding father of the industry, who with other

investors established American Research and Development in 1946. The American Research

and Development made investments in companies which commercialized military

technologies developed for Second World War.8 United States proved to be a perfect place for

6 Richard Thompson “Real venture capital” (2008): 5

7 As explained by Prof. Dr. Erik P.M. Vermeulen’s lecture on International Business Law, Tilburg University

International Business Law LLM (2011), See also: Joseph A. McCahery and Erik P. M. Vermeulen “Corporate

Governance of Non-listed Companies” (2008): 16-17 8 Hans Landström “Handbook on research of venture capital” (2007): 11

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the emergence of the venture capital industry. During late 1950’s and early 1960’s venture

capital firms started to emerge all-over the country, especially in Silicon Valley, where a

technological center started to form around that time. Favorable tax regimes, and new

regulations, such as allowing pension funds to invest in venture capital funds, has speed up

the development of the industry and by the end of 1980’s it formed a well developed

industry.9

The emergence of venture capital industry in Europe can be backdated until late

1970’s, however earlier individual companies were present which provided equity capital to

companies, but the presence of these individual companies cannot be considered as an

existing industry. The center of the emergence of venture capital industry was in UK, and it

took almost a decade until a significant venture capital industry emerged in Europe.10

Venture capital industry is today a well established industry which consists of several

ten thousands professionals worldwide which undertakes a variety of roles. Firstly they are

maintaining relationship with investors – pension funds, insurance companies, wealthy private

investors – who provide them with capital to invest.11

Secondly, they are reviewing the proposed investments and filtering out desperate

business plans. Serious candidates will be closely inspected both from the side of their

technological and business strategy and from the side of their management team.12

Once the investment decision is made the venture capital firms must ensure that the

money will be not wasted on unprofitable projects. Therefore venture capital firms make

portfolio companies to repeatedly return to them for additional capital (after reaching

milestones), and they are also maintaining a strong monitoring system on the management. In

order to ensure all of these rights, investors demand preferred stock in the portfolio company

with numerous restrictive provisions.13

Usually they also demand seats on the board of

directors of the portfolio company in order to ensure their representation in the company and

to influence the decision made by the board of directors.

The final role of venture capitalists is to manage the exiting of these investments,

typically through an initial public offering or trade sales like merger and acquisitions, or, in an

9 Ibidem, page 12-13

10 Ibidem, page 13

11 Paul Gompers and Josh Lerner “The Venture Capital Cycle” (1999): page 7

12 Ibidem, page 7

13 Paul Gompers and Josh Lerner “The Venture Capital Cycle” (1999): page 7

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unfavorable situation, through redemption, liquidation and/or dissolution.14

The venture

capitalist will likely seek that its portfolio companies go public. Usually these portfolio

companies will make the vast majority of the profit even though they will be in minority

considering the number of the companies in the venture capitalists portfolio. Considering this

it is not surprising that the preferred form of exiting for the venture capitalist is a public

offering of the shares of its portfolio companies.

However it is a very hard way where equity markets are “lazy”. For instance in United

States, which is a huge country with a well established and powerful secondary market, and

where it is a usual way for the citizens to keep their build up their savings by investing in

public-listed equities and to participate in initial public offerings, it is easy to sell a large

number of shares to the public. Contrary to this, the situation in Europe is very different. Even

though there are many secondary markets across Europe, the willingness of citizens to

participate in initial public offerings and to invest their savings in shares is very different from

country to country, and in general from the situation in United States. In the Central and

Eastern European region – where Hungary belongs – the most frequent mode of divestment

(represented more than third of all exits) is the trade sale which usually delivers the highest

value as well. Public offering occurred in approximately 10% of the exits. 20% of the deals

were equity shares buy-backs by the owner-managers of the concerned companies. This type

of exit was typically done by government backed organizations.15

2.3 The international standards of venture capital

Provided that the modern venture capital industry was born in United States, the

industry standards were formulated mainly there. Therefore, the term private venture capital

and venture capitalists in my thesis shall mean the industrial standards and techniques applied

by the venture capitalists in the United States.

Venture capitalists typically raise their fund on a temporary basis. The typical lifetime

for a venture capital fund used to be 10 years before the financial crisis, though the extension

of several years of a specific funds lifetime often happens.16

The vast majority of venture

capital funds are designed to be “self-liquidating”, which means that the fund will be

14

Ibidem, page 7 15

Hungarian Venture Capital and Private Equity Association “Jubilee 20 year Yearbook”: page 41 16

Paul Gompers and Josh Lerner „The Venture Capital Cycle” The MIT press Cambridge, Massachusetts,

London, England” (1999): page 7

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dissolved when the time stated in its founding document elapsed. This imposes a healthy

discipline making private equity investors to terminate the underperforming companies in

their portfolio. The downside of this termination pressure is that in some cases unprepared

portfolio companies will hit the primary market through an initial public offering, which can

have harmful effect on the long-run prospects of the portfolio company.17

The venture capital cycle basically involves four stations: first, the fundraising period

which usually took one year before the financial crisis, however nowadays it takes up to two

years. The second station is the investment period, when venture capitalists invest the raised

capital into startup companies. In the third period of a venture capital fund lifecycle

management of the portfolio companies takes place. Venture capitalist intensively monitoring

their investments and intervenes where it is needed in order to get the most out of each

investment. In the last step of the venture capital cycle venture capitalist are managing the

exits from their investment and returning the raised capital and its interest to their investors.

In meantime the venture capital funds general partner starts to raise its new fund, and the

cycle starts again. This periods cannot be strictly divide from each other, they are overlapping

in time and as it was mentioned above, one turn of the cycle took 10 years, but under special

circumstances extension of the funds lifespan is possible.18

The financial crisis led to a big change in the venture capital cycle, which is depicted

in the following figure.

Source: Legal Negotiation Workshop Lecture 2 slides, Presented by: Mr. Diogo Pereira Dias Nunes LLM

17

Ibidem, page 19-20 18

As explained by Prof. Dr. Erik P.M. Vermeulen’s lecture on International Business Law, Tilburg University

International Business Law LLM (2011), See also: Paul Gompers and Josh Lerner „The Venture Capital Cycle”

The MIT press Cambridge, Massachusetts, London, England” (1999)

11

Today the fundraising takes up to two years, and all other periods have extended in

time. In sum of these extensions, a venture capital cycle turns around in approximately twelve

years instead of ten. However the startup companies still need the different rounds of finance

even before the venture capital funds are raised and start to spread money all-over the market.

This led to liquidity gaps in venture capital cycle, which gaps are filled by corporate venture

capital funds, governmental venture capital funds, and so called “super-angels”.19

Venture capitalist are not just investing their money to portfolio companies, but

closely monitors the entrepreneurs in order to insure that they will get the most out of their

investment. This monitoring involves presence of the venture capitalist in the entrepreneurs

company on its boards such as board of directors or supervisory board. Moreover in some

cases venture capitalists take the majority control over in the entrepreneurial company when it

facilitates the success. This strict monitoring can be regarded as a hostile behavior, however it

has to be borne in mind that venture capitalists are the ones who risks large amount of money

in favor of the entrepreneur. Without this entrepreneur might not be able to develop its idea

into a commercially viable good.20

Venture capitalists fulfill one more important role on the market. They contribute to

raise the level of common business culture by providing guidance to entrepreneurs in their

portfolio companies. This is an important role, given that entrepreneurs are not businessmen,

but they have to make business decisions in their day-to-day operation. These business

decisions might have such an importance that a bad decision might be able to disrupt the

whole startup company.21

As far as the exits are concerned, venture capitalists prefer to exit from their portfolios

through an initial public offering, which usually gives the biggest returns on the investment.

However, only the most successful portfolio companies will reach initial public offerings,

which is the case in minority of the investments. Other, less successful investments will be

exited through trade sales or entrepreneur might redeem the investment. Under the worst

scenario venture capitalist will liquidate the portfolio company and write-off the loss made on

the investment.22

19

As explained by Prof. Dr. Erik P.M. Vermeulen’s lecture on International Business Law, Tilburg University

International Business Law LLM (2011) 20

Ibidem 21

Ibidem 22

Ibidem

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3. Venture capital in Hungary

3.1 History of venture capital in Hungary

The history of venture capital industry in Hungary is even shorter, regarding the fact

that Hungary was part of the socialist block. This meant that no private sector existed, the

economy was centrally planned and controlled and therefore there was no room for private

equity and venture capital.

On the history of venture capital in Hungary numerous papers have been written by

Dr. Judit Karsai.23

She – among other authors – divides the development of Hungarian

venture capital and private equity industry into four phases.

According to Karsai the first phase of the development lasted from 1989, when the

Hungarian political regime has changed (the first democratic elections after socialism took

place in spring of 1990), until 1992. That time the Hungarian market was basically dominated

by two types of investors. On one hand global funds invested foreign government capital in

Hungary, on the other hand the venture capital market was dominated by country funds. The

size of the funds was relatively small – around 50 million dollars – since at that time fund

managers had no relevant experience in the Hungarian market and in the risks’ assessment.

Concerning the types of the investment, investment opportunities arising from industrial

restructuring and privatization of state-owned entities processes dominated.24

The second phase of development (1993-1997) was dominated by the proliferation of

regional funds. Furthermore few sectorial funds and smaller country funds were established.

At that time in connection with the stabilization of the CEE region and gained experience by

the fund managers, the size of the funds drastically increased. A typical sum of the managed

capital reached 100-200 million US dollars. The authors refer to this period as the beginning

of consolidation of the Hungarian private equity market.25

The third stage is dated from 1998 to 2000. This time was the period of rapid

expansion, where the dominance of regional funds prevailed. The typical fund size continued

to grow reaching 250-300 million US dollars. Besides major financial institutional investors,

investors which were successful in the region and investors targeting whole Europe were

23

Dr. Judit Karsai is a senior research fellow at the Institute of Economics, Hungarian Academy of Sciences, and

the chairman of the Statistical Commitee of the Hungarian Venture Capital Association. 24

Dr. Judit Karsai and Gábor Baranyai “The development of Venture Capital and Private Equity industry in

Hungary 1989-2004” In: Hungarian Venture Capital and Private Equity Association booklet (2005): page 7 25

Ibidem

13

present on the Hungarian market.26

The focus of the funds was primarily on technology sector

(IT and media), which is not surprising, considering the fact that this was the period of

internet-boom.

Fourth phase of the development is dated from 2001. This stage can be characterized

as streamlining of the market, where the less successful funds ceased their activities and

disappeared from Hungarian market, while new worldwide investors appeared with their main

focus on high-value buy-outs. Furthermore next to the regional and country funds, specialized

investors began to emerge as well as GVC’s start to invest budgetary sources into Hungarian

small and medium enterprises, therefore filling the gap emerged on the market. In this phase

venture capitalist focus on companies in expansion stage, and also start to finance buy-outs.27

Regarding the life cycle of the companies financed by venture capitalists between

1991 and 2005 the financing of the expansive stage dominated the industry (64% of the total

number of the transactions), while companies in early stages had less opportunity to gain

capital (32% of the investments made in early stage companies with the value of 10% of

whole invested amount).28

3.2 Assessment of the legal environment

To examine the structure of venture capital funds it is necessary to overlook the rules

and regulation framework which is affecting the industry.

In Hungary two acts were passed in order to promote venture capital investments.

Until 1998 there was no act regulating venture capital industry in Hungary; venture capital

funds operated as off-shore companies registered abroad.

3.2.1 The first act on venture capital industry

The first act was passed in 1998, which main objective was to create the legal form for

the establishment and functioning of venture capital funds. The act was a quite big failure,

since during its six years of existence only one (state-owned) venture capital fund was created

under its auspices. The reason for this failure was the act’s aspiration to prevent abuse.

26

Dr. Judit Karsai and Gábor Baranyai “The development of Venture Capital and Private Equity industry in

Hungary 1989-2004” In: Hungarian Venture Capital and Private Equity Association booklet (2005): page 9 27

Ibidem 28

Idem, page 33.

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Without specifying all of its deficiencies, I would like to point out only two rules, which can

highlight the big distance between act and venture capital industry standards. The act

specified that the proposed capital contribution shall be paid-up at the establishment of fund,

and so the fund had to hold non-invested money in its portfolio. Moreover the act ruled that

the capital segment must be invested time-proportionally relative to date of foundation.29

The

consequence of not compliance with this latter rule was termination of the fund.

As we can see these rules were far not in compliance with the international standards

of venture capital industry, concerning that in practice funds are not holding non-invested

money in their portfolio.30

Furthermore if there is no appropriate investment opportunity the

funds will not invest their money. Moreover the act did not allow for institutional investors,

such as pension funds or insurance companies, to invest their money in venture capital funds,

while these investors contribute the most capital to venture capital funds internationally. On

the other hand the act provided tax benefits for investors, but in total it remained inefficient;

venture capitalists continued to operate as off-shore companies registered abroad or as

domestic company – in other business form – not claiming tax benefits.31

After the realization of this failure, the Hungarian government and professional forums

started to reconcile the legal framework, and as a result in 2005 new regulation was enacted.

The old regulation was abolished and the provisions concerning the venture capital industry

became part of the Act on Capital Market. In addition, two regulations were also changed

which made possible for the institutional investors (like pension funds) to invest a part of their

money (up to 5%) in venture capital funds.32

In the following sections based on the Act on Capital Market I will sum up the most

important provisions. Of course not all detailed provisions of the act will be discussed, while

it is not subject of my thesis.

29

Dr. Judit Karsai “Can the state replace private capital investors? Public finance of venture capital in Hungry”

In: Institute of Economics Hungarian Academy of Sciences Discussion Paper, (2004): page 9 30

Kovács Balázs „Állami kockázati tőke a magyar KKV finanszírozásban” - Doctoral thesis (2011): 47; see also:

Banyár L. – Csáki B. “A kockázati tőkeágazat szabályozása Magyarországon.” In: Makra Zs.(szerk.): A

kockázati tőke világa, (2006): page 183-198. 31

Dr. Judit Karsai “Can the state replace private capital investors? Public finance of venture capital in Hungry”

In: Institute of Economics Hungarian Academy of Sciences Discussion Paper, (2004): page 9 32

Kovács Balázs „Állami kockázati tőke a magyar KKV finanszírozásban” - Doctoral thesis (2011): page 47

15

3.2.2 Second act on venture capital industry

According to new regulation venture capital funds shall be deemed established upon

being registered by the Hungarian Financial Supervisory Authority (hereinafter Authority),

and shall be terminated upon being removed from the register.33

Venture capital funds may only be established for fixed periods by the private offering

of non-redeemable venture capital fund certificates.34

The fixed period shall be at least six

full calendar years, which can be extended by the fund manager, if it is so allowed by the

venture capital fund’s management protocol, by a period of time not to exceed the original

term.35

The subscribed capital of a venture capital fund shall not be less than two hundred and

fifty million forints (approximately 833.000 EUR). The subscribed capital of a venture capital

fund may be increased or decreased during the fund’s original term; however, the subscribed

capital may not be allowed to drop below two hundred and fifty million forints in any case.

The subscribed capital of venture capital funds shall consist of cash contributions only. At

least ten per cent of the venture capital fund’s subscribed capital, or not less than two hundred

and fifty million forints, must be paid up at the time of subscription of the venture capital fund

certificates.36

The new regulation also permits the transformation of a venture capital fund. This

shall mean the merger (takeover, fusion) and demerger (division, separation) of venture

capital funds. The venture capital fund established upon the transformation of a venture

capital fund shall be its legal successor.37

Some important provisions are provided on dividend payments as well. Accordingly,

the venture capital fund is allowed to pay dividends only from the fund’s own assets.

Dividends may not be paid from sources acquired by loan or by way of the issue of debt

securities. No dividends may be paid if in consequence the venture capital fund’s own capital

drops below the paid up portion of the venture capital fund’s subscribed capital as calculated

in accordance with accounting regulations.38

33

See: Act XX of 2001 on Capital Market, § 296/G 34


See: Act XX of 2001 on Capital Market, § 296/I 36


See: Act XX of 2001 on Capital Market, § 296/H 38

See: Act XX of 2001 on Capital Market, § 296/L

16

Concerning the fund management, the act rules that only limited companies

(established under the act on business associations) or branches of foreign companies can act

as fund manager (hereinafter fund management company). The subscribed capital of venture

capital fund management companies must be paid up in cash only. A venture capital fund

management company may commence operations in possession of the Authority’s

authorization granted under the Act on Capital Market. There is also a limitation on activities

of management companies, namely they can engage exclusively in venture capital fund

management activities as it is specified in the Act on Capital Market and in consulting

activities related to fund management activities.39

As we can see, the management companies

must be assigned to their special activity.

Just as an interesting detail in the act I would like to point out one provision related to

termination of the venture capital fund. A venture capital fund must be terminated when its

management company is terminated without succession, or if the fund management

company’s authorization is withdrawn and the venture capital fund is not taken over by

another venture capital fund management company.40

As we can see the fund is in strong

relation with the management company, we can state that the existence of given venture

capital fund is subordinated to fund management.

There is no restriction on the number of funds which a management company can

establish and manage, but – naturally – they shall manage and keep the assets of venture

capital funds separately from its own, and from the assets of other venture capital funds.41

The act contains provisions on investment operations as well. The most important

provision relating to this is that the share acquired by a venture capital fund in any company,

and on the aggregate in any other company controlled by that company, financed from the

assets of the venture capital fund, may not exceed twenty per cent of the subscribed capital of

the venture capital fund.42

The new act allows to venture capital funds to acquire securities which have been

listed on a regulated market, but only if it has holdings of at least ten per cent in the issuer’s

39

See: Act XX of 2001 on Capital Market, § 296/A-296/C 40

See: Act XX of 2001 on Capital Market, § 296/N 41

See: Act XX of 2001 on Capital Market, § 296/F 42

See: Act XX of 2001 on Capital Market, § 296/Q

17

capital within twelve months from the date of first acquisition. The securities obtained in this

manner may not be alienated within six months.43

To sum up the legal background, the new regulation is closer to the venture capital

industrial standards.

3.3. Presence of venture capital in Hungary

As we saw it earlier venture capital industry in Hungary has a relatively short history.

In 2011 Hungarian Venture Capital and Private Equity Association issued a 20 year Jubilee

Yearbook, where a study on development of the venture capital and private equity industry

was analyzed based on European Venture Capital and Private Equity Association PEREP

Analytics database and the associations own data provided by its members. Given that all of

the key players in the Hungarian venture capital and private equity industry were members of

association, the study adequately represents the sector.44

In the last two decades, 126 venture capital funds had interest in Hungarian market,

which has managed over $20 billion total. From this $20 billion, $8 billion was available for

investments in Hungary, and less than half of it, $3.2 billion was invested into Hungary based

companies over approximately 420 transactions. However, as we will see, the bigger part of

this capital was used to finance buy-outs. Classical venture capital activity was very low in

the country (in this regard Hungary was ranked last in Europe), thus the proportion of

companies requiring access to venture capital and private equity investment far exceeds the

available supply.45

In this twenty year period an average of 19 companies located in Hungary

received approximately $170 million investment yearly. In average $9 million was invested

per transaction.46

Concerning the capitalization of the funds operated in Hungary and in the region in the

last two decades, the survey shows that the average capitalization of funds invested only in

Hungary did not reach $30 million, while the average size of funds invested in the Central and

Eastern European region (hereinafter CEE region) was more than double of that.47

43

See: Act XX of 2001 on Capital Market, § 296/Q 44

Dr. Judit Karsai „Development of the Hungarian venture capital and private equity industry over the past two

decades” In: 20 Year Jubilee Yearbook of Hungarian Venture Capital and Private Equity Association (2011):

page 22 45

Ibidem, page 24 46

Ibidem, page 29 47

Ibidem, page 25

18

Both private and governmental organizations were present on the Hungarian market

fulfilling different roles. While governmental organizations invested an average of $3 million

per transaction, private venture capital funds invested more than $15 million per transaction.

This is due the fact that governmental organizations mainly financed companies in early and

expansion stages, where a smaller amount of capital is needed, while private sector – as it was

already mentioned – are oriented to buy-outs.

3.4 Usual types of investments

For the latter phenomenon a big inconsistency between the value of the investment

made by the private and the governmental sectors can be observed. Private venture capital

funds accounted for approximately 83% of the total value of investment made, which was

only approximately 48% of all deals.48

Consequently, companies in different life-cycle stages

have not gotten a similar chance to receive capital investment.

Table 149

provides a clear view into this discrepancy. It can be observed that

companies in expansive phase have drastically bigger chances to attract investors, rather than

early stage companies. “Early stage investments were made predominantly in 1992, 2001 and

2010, while the weighting of investment in the expansive phase dominated almost

continuously until 2004.”50

Table 1 No. of

investments

(pieces)

Number of

Investments (%)

Investment

Value

($ million)

Investment

Value

(%)

Early stage 132 31,7 147,0 4,0

Expansion stage 246 59,1 1037,3 28,0

Buyout stage 38 9,1 2521,8 68,0

Total: 416 100 3706,1 100

Source: Hungarian Venture Capital and Private Equity Association

48


decades” In: 20 Year Jubilee Yearbook of Hungarian Venture Capital and Private Equity Association (2011): 33 49

The almost similar table with more additional information on average investment value can be found in

„Development of the Hungarian venture capital and private equity industry over the past two decades” study on

in 20 Year Jubilee Yearbook of Hungarian Venture Capital and Private Equity Association (2011) on page 34 50


decades” In: 20 Year Jubilee Yearbook of Hungarian Venture Capital and Private Equity Association (2011): 36

19

3.5 Exits in Hungary51

Concerning capital divestments, similarly to the CEE region the highest value of exist

were trade sales representing more than third of all exits and two thirds in value.

Secondary market sales, where venture capital funds sold their shares in portfolio

companies to each other had a similar average exit value than trade sales; however this type of

exit was used only in 5% of divestments.

Only every tenth exit is made through a public offering in total value of approximately

9% of the total value of divested capital.

The owner-managers of portfolio companies bought back shares from venture capital

funds in one fifth of the cases, typically where the capital was provided by GVC.

This data is summarized in the following table.52

Table 2

Exit routes

Number of

transactions

(pieces)

Number of

transactions

(%)

Exit value

($ million)

Exit value

(%)

Trade sale 63 34,0 569,4 63,4

Public offering 17 9,2 80,0 8,9

Write-off 13 7,0 27,8 3,1

Repayment of the loan 5 2,7 21,9 2,4

Secondary market sale 15 7,1 103,6 11,5

Management buy-out 36 19,4 43,4 4,8

Divestment by other means 9 4,9 6,0 0,7

Unknown 29 15,7 46,5 5,2

Total divestment 185 100,0 898,7 100,0

Source: Hungarian Venture Capital and Private Equity Association

51

This chapter is based on the study of Dr. Judit Karsai „Development of the Hungarian venture capital and

private equity industry over the past two decades” In: 20 Year Jubilee Yearbook of Hungarian Venture Capital

and Private Equity Association (2011): page 41 52

The almost similar table with more additional information on average investment value can be found in

„Development of the Hungarian venture capital and private equity industry over the past two decades” study on

in 20 Year Jubilee Yearbook of Hungarian Venture Capital and Private Equity Association (2011) on page 42

20

To sum up, the dominant mode of exit is the trade sale which dominated the last two

decades in the industry. The degree of other modes of exits varied significantly over in past

twenty years, but their value compared to trade sales is very low.

4. Government as venture capitalist in Hungary – The current regime

Hungary has developed a whole net of equity financing, which is summarized in

Figure 1. The structure is the following: State is 100% owner of Hungarian Development

Bank Plc. (MFB Plc.), which is the epicenter of equity financing regarding that on one hand

MFB Plc. established its own subsidiaries which are directly involved in equity financing

(MVF Plc., MFB Invest Plc.), on the other hand MFB Plc. is responsible to manage and

control the Regional Development Holding Plc (RFH Plc.) and Small Business Development

Company Plc. (KVFP Plc.). The only chain which hangs out from this scenario, the

Széchenyi Equity Fund (SZTA Plc.) which is under the control of National Development

Agency since 2010.

Figure 1.

There are two organizations in structure, which main task is to co-ordinate the

different economic development policies of the government, therefore RFH Plc. and

Hungarian Economic Development Centre (MAG Plc.) will not be analyzed in the following

section, instead a brief summary will be provided.

State

RFH Plc. (co-ordination)

IKT Plc.

MFB Plc.

MAG Plc. (co-ordination)

MVF Plc. (fund of funds)

MFB Invest Plc.

CORVINUS Plc. (CELIN)

KVFP Plc. SZTA Plc.

21

RFH Plc.’s main task is to foster the regional competitiveness of different regions in

Hungary and to co-ordinate the economic development through its local subsidiaries. RFH

Plc. provides guidance and help for different economic participants to successfully apply for

different tenders. It also provides loans for small- and mid-size enterprises on fair better terms

than it is usually possible to get on the market.53

RFH Plc. has two subsidiaries which do not

operate on regional basis, but in the whole country. One of these is IKT Plc. a venture capital

fund established to provide capital for micro-, small-, and mid-size enterprises in IT and

telecommunication sector (discussed in detail below). The other subsidiary (not mentioned in

Figure 1.) deals with direct financing of enterprises in form of loans, therefore it falls out of

scope of my thesis.54

As far as MAG Plc. is concerned it is the intermediary organization for economic

development programs financed form sources provided by the European Union to member

states. MAG Plc. as its ultimate goal provides cooperation services for development policy

planners and beneficiaries of different programs.55

4.1 Established VC Funds

4.1.1 MFB Invest Plc.56

MFB Invest Plc. was founded in the end of 2006 by integration of National Property

Development and Investment Plc. and one of the MFB Plc. subsidiaries which main task was

capital financing of development projects.57

MFB Invest Plc. is a 100% subsidiary of MFB Plc., and it has three business branches. First, it

is present on Hungarian venture capital market as investor investing in fast growing,

economically important areas. Second, MFB Invest Plc. provides consulting services in

strategic areas like mergers and acquisition, business and strategy planning, recruitment of

investment partners, privatization, selling off of companies and project financing. Thirdly as a

complementary activity it provides real estate management.

Given the characteristics of MFB Invest Plc. we can see, that it is not a venture capital

fund, but a fund manager established by government to enforce its venture capital policies. It

53

See: http://www.rfh-rt.hu/index.php?mpc=bemutatkozas 54

See: http://www.rffzrt.hu/index.php?mpc=bemutatkozas 55

See: http://en.magzrt.hu/index.php/introduction 56

This section is based on publicly available information at MFB Invest Plc.’s website. see: www.mfbinvest.hu 57

See: http://www.mfbinvest.hu/mainpage

22

is unique, because it did not establish any venture capital fund; it invests directly into

portfolio companies.

Regarding the scope of my thesis, in the following section I will examine only MFB

Invest Plc. investment activity. Considering its professional background in that field, there is

only brief information on MFB Invest Plc.’s webpage that the investment decisions are made

by highly experienced experts in the field of investment and asset management.58

The aim of MFB Invest Plc.’s venture capital program is to provide capital for

business entities which are developing in economically important areas such as information

technology, renewable energy resources, infrastructure, logistics and environmental

protection. More closely it is targeting the following areas: IT technological development,

electrification, chemical industry, pharmaceutical industry, energy, biotechnology, food

industry, traffic and transport, logistics, environmental protection, health care and engineering

industry.59

As we can see it is a broad list which might need lots of information and

knowledge in those fields in order to be able to make proper investment decisions. The

question arises whether in all of these fields MFB Invest Plc. has proper experts?

MFB Invest Plc.’s investment strategy is generally defined; it can invest in a broad

spectrum, even in real estate and in companies which are established in order to carry out a

particular project (project company). However, there is a fundamental change in MFB Invest

Plc.’s investment strategy, which also redefines its role in the whole structure. Namely, MFB

Invest Plc. in future will invest less money directly into portfolio companies; instead looks

forward to invest more recently in venture capital funds. In some cases MFB Invest Plc. will

establish venture capital fund on its own (the author is not aware of any until drafting of this

thesis), on the other hand it looks forward to invest as investor in venture capital funds which

promises positive returns on the investment (co-investment), or to establish a venture capital

fund together with private sector (joint-investment).60

According to MFB Invest Plc.’s web page it invests in fast growing, innovative

companies, but in special cases start-up companies may be financed as well. Furthermore it

promotes the development of active companies. Unfortunately the term of “active companies”

is not defined, but if we take the amount of investment it is intended to put in one business

(see below) as starting point to clarify its meaning, we can find that the term active company

58

See: http://www.mfbinvest.hu/mainpage/roficient-bakcground 59

See: http://www.mfbinvest.hu/mainpage/main-target-areas 60

See: http://www.mfbinvest.hu/mainpage/strategy

23

shall mean companies which already passed the “death valley”. The investment will be made

under business conditions, but some other factors like job creation and economic stimulation

will also be considered.

MFB Invest Plc.’s capital reached 19 billion HUF (approximately 63 million EUR) in

the end of 2011 which was available for investment. According to its investment policy, MFB

Invest Plc. looks forward to invest at least 450.000 EUR up to 25% of the capital of MFB

Invest Plc., but if a possible investment is exceeding this amount, the transaction still can be

passed by special resolution.61

Within the above mentioned limitations, the amount of the investment in each

transaction will be determined by the principle of prudent operations, business and asset

appraisal, market circumstances and economic rationality, the real market value of the

company and the return.62

Concerning the interest expectations, MFB Invest Plc. will only make investments in

portfolio companies which are considered profitable based on the provided business plan. The

profitability shall mean that the interest generated by the investment must be over the yield of

government bonds and shall meet private investors’ interest expectations (pari passu

principle).63

The duration of the investment is flexible. It is based on the provided business plan

and market situation and in addition it may be defined in accordance with legal regulations in

force. In practice this means that MFB Invest Plc. invests for three to five years, which can be

considered as a quite short term. If parties not agree on the duration of the investment in their

financing contract, according to MFB Invest Plc.’s policy the exit must be realized within five

years counting from the date of payment of the investment to portfolio company.

MFB Invest Plc. is investing capital into portfolio companies by increasing their

registered capital on par above par principle or, it will take part in the establishment of project

company. MFB Invest Plc. usually takes a minority stake in the portfolio company, and

monitors them actively.

The exit will take place in accordance with the investment contract’s provisions on

exit in form of sale at stock exchange, over-the-counter sale, leverage buyout, initial public

offering, management buyout, trade sale (sale to strategic or other investors) or exercise of an

61

See: http://www.mfbinvest.hu/businesses/investment 62

Ibidem 63

Ibidem

24

option. In case of project companies, the co-owners can decide on liquidation of the project

company.

The following table summarizes the investments made by MFB Invest Plc. between

2005 and 2008.

Table 3 Micro enterprise Small enterprise Mid enterprise Total

Request for capital

(pieces)

98 10 0 108

Investments made

2 5 10 17

Value of investments

(million HUF)

119 864 7949 8932

Source: Nemzeti Fejlesztési és Gazdasági Minisztérium “2008. évi jelentés A mikro-, kis- és középvállalkozások

részére meghirdetett kötött célú állami támogatásokról és – a vállalkozók pénzügyi forrásokhoz való hozzájutását

segítő – államilag támogatott finanszírozó eszközökről”, page 67-68

In 2011 MFB Invest Plc. made three new investments in value of 4.9 billion HUF

(approximately 1.6 million EUR), and it plans to invest 20-30 billion HUF (approximately

6.6-10 million EUR) in 2012 in order to foster Hungarian economy.64

However this amount

will be not invested in new firms solely, but will be used for strategic buyouts as well.

4.1.2 CORVINUS Plc.65

CORVINUS Plc. is member of MFB Group, and it is a 100% subsidiary of MFB

Invest Plc. First of all it has to be seen, that CORVINUS Plc. is also a fund manager, but

unlike MFB Invest Plc. it does not make any direct investments in portfolio companies, its

role is a clear fund manager role.

In 2005 CORVINUS Plc. has established its own venture capital fund, the

CORVINUS First Innovation Venture Capital Fund (CELIN) with the goal to invest in

innovative start-up companies in ICT and biotechnology sectors, but the investments are not

limited to only these sectors.66

Furthermore CORVINUS Plc. is ready to make co-investment

in private venture capital funds.

64

See:

http://sso.nol.hu/login/index.php?backurl=http%3A%2F%2Fnol.hu%2Fgazdasag%2Fiden_tobb_penzt_fektet_be

_az_allam 65

This section is based on publicly available information on CORVINUS Plc.’s website. See: www.ckta.hu 66

See: http://erawatch.jrc.ec.europa.eu/information/country_pages/hu/supportmeasure/support_mig_0012

25

CORVINUS Plc. provided its general investment policy on its webpage which is

guidance for those investors which are interested in setting up a co-investment fund. These

general investment policies will be discussed only with regard to CELIN’s investment policy

provided on CORINUS Plc.’s webpage as well.

The CELIN venture capital fund

The fund was established in October 2005 in accordance with Act on Capital Market

for a period of 15 year with a capital equals to 5 billion HUF (approximately 16.7 million

EUR). According to its investment policy CELIN is looking forward to invest an amount

between 150 to 250 million HUF (approximately 500.000 to 660.000 EUR) in portfolio

companies on market conditions. The planned extent of an investment is typically five to eight

years which is extendable within the planned lifetime of the fund.

In line with the investment policy of CORVINUS Plc., CELIN invests in innovative

SMEs with high growth potential in their start-up and early stage, when they are not eligible

for a bank loan. More precisely CELIN does not invest in companies which are doing basic

research; it aims companies which has already developed an idea which is commercially

viable. In other words the focus will be on commercialization of an already developed

product.67

The investment decision will be made by the board of directors of CORVINUS Plc.

based on provided business plan which shall contain discounted cash-flow, net present value

etc.68

The provided business plan will be first examined by professionals working at

CORVINUS Plc. with a scope on viability and possible return. Furthermore the business idea

will be examined regarding its innovativeness by independent professional experts of the give

technological field.69

The fund will take a minority stake in portfolio company between 25 to 50%,

depending on the invested amount in order to ensure a strong minority control. The fund

manager will delegate members in portfolio company’s board of directors (in case of private

limited company) or in its supervisory board (in case of private limited-liability company).

67

See: http://bkik.hu 68

See: http://erawatch.jrc.ec.europa.eu/information/country_pages/hu/supportmeasure/support_mig_0012 69

See: http://www.ckta.hu/pages/14

26

CELIN maintains a strong monitoring system, where the progress of the given project

will be examined. If the performance of the portfolio company is not in line with the expected

results CELIN may intervene and provide assistance. The fund will take majority stake in the

portfolio company only in cases if the loss of the investment is avoidable with such measures.

If the above mentioned measures prove unsuccessful CELIN may exit the portfolio company.

CELIN’s general investment policy does not prefer any of the available exit modes.

Exit and all other terms shall be negotiated by parties, which provide flexibility.

The following table summarizes the CELIN funds business activity between 2005 and 2008.


Request for capital

(pieces)

98 10 0 108

Investments made

3 1 0 11


(million HUF)

356 640 0 996



segítő – államilag támogatott finanszírozó eszközökről”, page 67-68

4.1.3 Venture Finance Hungary Plc. (MVF Plc.) – the fund of funds70

MVF Plc. just like MFB Invest Plc. has different tasks in development of Hungarian

economy. It maintains loan and guarantee programs next to its venture capital activity.

Realizing the fact that Hungarian venture capital market is underdeveloped in seed and startup

financing, and taking the opportunity of European Union’s JEREMIE project, the

Government entrusted MVF Plc. with this new task. Under this program MVF Plc. as the fund

manager of fund of funds invests its capital into private venture capital funds.

MVF Plc. selected its venture capital fund management partners through an open

tender in 2009. These partners had to raise a fix proportion of additional private funding to

capital committed by MVF Plc.

Two forms of cooperation are foreseen in the framework of this program:

establishment of a joint fund or co-operation in a co-investment fund structure.

70

This section is based on publicly available information at MVF Plc.’s website. See: www.mvzrt.hu

27

As far as the joint fund is concerned, MVF Plc. and its selected partner will create a

joint venture capital fund under the auspices of Hungarian regulations. MVF Plc. will take a

stake up to 70% of the joint fund and its contribution to any given fund an amount of 700

million HUF to 5 billion HUF (approximately 2.3 million to 16.7 million EUR). The

maximum lifespan of a given fund is 10 years which can be extended in accordance with Act

on Capital Market. The parties shall provide their own contribution to the seed amount of the

funds. Any other payments will be made up on fund managers down calls in proportion to

their stake in the fund.71

In co-investment structure MVF Plc. will establish an independent legal entity venture

capital fund for a period maximum of 10 years. The fund will execute investments together

with private co-investors. The terms of each investment will be agreed on a case-by-case

basis. The co-investment fund will take a maximum of 70% in each deal, the other part shall

be provided by private partner. The co-investment fund has a special “pledge fund” character,

which means that MVF Plc. pledges to pay in the necessary contribution.

Fund managers in order to be allowed to participate in a joint or co-investment fund

must be registered and entitled to manage venture capital funds in accordance with Act on

Capital Markets and possess professional references, and shall be capable to provide part in

capital contribution to the fund.72

As it was mentioned above that the fund managers were selected through open tenders.

The tender took place in 2009 and ended with selection of eight fund managers, seven for

joint investment funds and one for co-investment fund.

The fund managers are compensated for their services. The compensation consists

from two elements, first they get a fixed fee based on the volume of the fund, and second they

get a carry after successful investments. The fixed fee was agreed with each fund manager

separately during the tender; however it is maximized in 3% of the registered capital of the

managed fund per year. The fund managers will get carry after the termination of given

venture capital fund, if the fund generated annual profit above agreed interest rate.73

MFV Plc.’s program foresees some requirements concerning private investors. Private

investors must be independent in sense that they cannot have any connection with portfolio

companies, and capital they provide shall not come from public finance subsystems. The

71

See: http://www.mvzrt.hu/content.php?id=i42d06616b227d9b281d185516f3f4da 72

Ibidem 73

Ibidem

28

program also provides different incentives including yield limitations and loss mitigation for

private investors too foster their participation.74

The incentives are summarized in the following table75

:

Table 5

Incentive

joint fund investors

co-investment fund investors

Yield limitations “On the level of the investors, the

yield restriction means that the

measure will provide private

investors with the whole upside

reward above a given rate (a

weighted average of EU Base

rates), meaning that public

investors are not entitled to the

profit realized above this level. The

rules on yield restrictions shall be

applied if at the end of the term of

the fund (also taking into account

possible interim payments) the fund

reaches - on the whole - an annual

yield above the above rate.”

“If the exit from an investment

results profit, the co-investment

Fund (wholly owned by the

holding fund) undertakes to claim

only an annual yield equal to a

weighted average of EU Base

rates. The associated investor(s)

is/are entitled to the yield

exceeding this amount.”

Loss mitigation

“The loss equaling 5% of the

highest subscribed capital of a joint

fund, reduced by the operating

costs, falls upon the public owners.

Any further losses are allocated

according to the participation (70 %

public – 30 % private) of the

investors in the fund.”

“Inasmuch as there is a loss at the

end of the investment, the co-

investment fund bears the loss of

the joint investment alone to the

extent of 5% of the net capital

invested jointly. The remaining

loss shall be borne by the co-

investment fund and private

investors in proportion to their

investments, and as a result of the

compensation procedure, private

investors cannot be paid a sum

exceeding the capital originally

invested by them less the related

operational costs.”

Source: MVF Plc. - www.mvzrt.hu

Investment policy is defined broadly, given that fund managers shall take the

responsibility to invest the capital in profitable startups. However some interesting conditions

apply which such as that business form of the portfolio companies is limited to private limited

liability partnerships and private limited companies. Portfolio companies also most meet

74

Ibidem 75

The table contains information provided on MVF Plc.’s website. see: www.mvzrt.hu

29

conditions of micro-, small- or medium-sized enterprises defined in separate act. The portfolio

must have its registered head office in Hungary and it must be either in seed, startup or

growth stage and must be founded no more than five years prior to the investment.76

Concerning the volume of the investment it is defined that that the annual investment

in any individual portfolio company cannot exceed 1.5 million EUR for a maximum of three

years in succession.77

This means, that the total amount of investment which can be made in a

given portfolio company is 4.5 million EUR. The investment can be made either as capital

contribution or in form of shareholder loan.78

This latter form of investment is quite unique

and dissent from industrial standard.

In the table79

6 below the allocated venture capital funds are summarized.

Table 6

Fund manager State’s contribution

(million HUF)

Fund’s size

(million HUF)

Biggeorge's-NV EQUITY

Kockázati Tőkealap-kezelő Zrt.

2800 4000

Central-Fund


3500 5000

DBH Investment Zrt. 3500 5000

Etalon Capital Kockázati Tőkealap-kezelő

Zrt. (Co-investment fund)

4000 4000

Finext Startup


5000 7360

MORANDO


4550 6506

Portfolion


3800 6800

Primus Capital


4340 6200

Total: 31570 43866

Source: MVF Plc. - www.mvzrt.hu

76

See: http://www.mvzrt.hu/content.php?id=i42d06616b227d9b281d185516f3f4da 77

Ibidem 78

Ibidem 79

The table is based on public information publicized on www.mvzrt.hu

30

4.1.4 IKT Plc.80

IKT Plc. is a 100% subsidiary of RFH Plc., which was established in June 2002 with a

capital contribution of 3 billion HUF (approximately 10 million EUR) for a period of 15

years. This was the only venture capital fund which was founded under the auspices of the

first act on venture capital market.

The main task of the fund was to provide capital for Hungarian micro-, small-, and

middle-size enterprises which operates in information technology and communication

technology sector in their early and startup stages and has a high growth potential.81

According to its publicized policy the fund provide capital under usual market

conditions, it is profit oriented and the examination of possible return is a fundamental

condition in each investment. The venture capital fund usually takes a minority stake up to

49% by providing capital contribution in exchange of shares, but in its portfolio companies

where it had already took at least 25% of the shares will provide shareholder loan. The initial

investment period is 3 to 7 years.82

The investment decision will be based on provided business plan which will be

examined in more rounds by Investment Committee and Fund Manager’s Board of Directors

which is in charge for the investment decision as well.

In the first two years after the establishment of the venture capital fund no investment

was made because of managerial problems. Until the end of 2008 the fund has invested

almost 80% of its capital in 11 portfolio companies and made 3 successful exits.83

The table below summarizes the investments made by the IKT Plc. between 2002 and

2008. As we can see every fourth request for capital was awarded with an investment, and

almost 80% of the available capital has been invested.

80

The section is based on publicly available information at IKT Plc.’s website. See: www.ikta.rfh-rt.hu 81

See: http://ikta.rfh-rt.hu/regio_ikta/tevekenyseg 82

Kovácsné Antal Anita “Kockázatitőke-finanszírozás a hazai kis és középvállalkozásokban”: 69 See also:

Nemzeti Fejlesztési és Gazdasági Minisztérium “2008. évi jelentés A mikro-, kis- és középvállalkozások részére

meghirdetett kötött célú állami támogatásokról és – a vállalkozók pénzügyi forrásokhoz való hozzájutását segítő

– államilag támogatott finanszírozó eszközökről” 83

Ibidem

31


Request for capital

(pieces)

0 46 0 46

Investments made

0 11 0 11


(million HUF)

0 2675 0 2675



segítő – államilag támogatott finanszírozó eszközökről”, page 74

Unfortunately no information about investments or exits is available after 2008. On

the other hand these numbers have to be seen in the light of ongoing criminal investigation84

at the fund, which aims to find out whether the investment decisions were made on rational

bases or on political pressing.

Furthermore the fund was established for a period of 15 years in 2002, therefore it is

unlikely that under the above mentioned circumstances and the fact that less than 5 years

remained from its lifespan new investments will be made in the future. However in the

following five years the fund will have to exit its investments and its performance can be

judged afterwards.

4.1.5 KVFP Plc.85

KVFP Plc. was established in the end of 2001 with a total equity 4.4 billion HUF

(approximately 14.5 million EUR) in order to foster the development and growth of

Hungarian small- and mid-size enterprises. The life-span of KVFP Plc. is indefinite.

KVFP Plc. pursues an economic sector neutral investment policy; however some

sectors of heavy industry such as steel manufacturing industry, shipbuilding industry or coal-

mining industry and agricultural and financial enterprises are excluded from the scope of

potential investments.86

The Articles of Corporation provides further restrictions on

investment. These provisions explicitly restrict to invest the capital provided by KVFP Plc. in

direct export activity or direct import substitution.87

84

See: http://www.kormany.hu/hu/miniszterelnokseg/hirek/feljelentest-tett-budai-gyula-az-informatikai-

kockazati-tokealap-kezelo-ugyeben 85

This section is based on publicly available information on KFVP Plc.’s website. See: www.kvfp.hu 86

See: http://kvfp.hu/index.php?m=20110 87

Ibidem

32

Concerning the size of the investment, KVFP Plc. invests an amount between 10 to

100 million HUF (approximately 33.000 to 330.000 EUR) in one portfolio company, however

additional capital can be acquired in form of bank loans. According to the investment policy,

KVFP Plc.’s ownership in the portfolio company cannot exceed 49% or acquire majority

interest. The reason for this is that KVFP Plc. explicitly stays out from the management of the

given portfolio company, it will remain in the entrepreneurs hands, and like this incentivizing

them to get the most out of their business. However this does not mean that KVFP Plc. has no

control in the company, it definitely maintains a strong monitoring system. All relevant

business data of the portfolio company is regularly followed analyzed and evaluated in

comparison with the portfolio company’s business plan. Given that experts at KVFP Plc. have

strong knowledge in business, they also provide guidance for the management of the portfolio

companies in case they face hurdles related to their business activity.88

KVFP Plc. typically invests capital to portfolio companies for a term of 3 to 5 years,

and it expects that its ownership we be redeemed by the management within this period. The

management does not have to redeem the whole investments at once, it is allowed to redeem it

partially between 3rd

and 5th

year, therefore the it is insured that the level of invested capital

by KVFP Plc. will be always on the necessary level.89

Concerning the expected return, KVFP’s policy is that expects a limited return on the

investment made in a specific portfolio company, which depends on the risk involved in the

investment. Accordingly, the expected rate of return varies between 12 months of BUBOR

plus 0,025% to 12 months of BUBOR plus 4,5%. It is especially examined before the

investment whether the portfolio company will be capable to produce such profit which

allows him to redeem the investment plus the interest.90

88

Ibidem 89

Ibidem 90

Ibidem

33

The following table contains KVFP’s activity between 2003 and 2008.


Request for capital

(pieces)

171 116 26 313

Investments made

29 20 2 51


(million HUF)

1452 1583 185 3320



segítő – államilag támogatott finanszírozó eszközökről”, page 70

Approximately 25% of 51 portfolio companies were in its startup phase and in 19

cases KVFP Plc. made a successful exit.91

4.1.6. SZTA Plc.92

The SZTA Plc. is a fund manager company fully owned by the State and it is

controlled through National Development Agency since 2010. On 1st of June 2011 SZTA Plc.

become authorized to establish venture capital funds and it established the Széchenyi Capital

Investment Fund.93

In summer of 2011 the SZTA Plc. launched its nationwide program to identify micro-,

small- and medium-size enterprises which have a growth potential and lacking capital for

further development. The SZTA Plc. considers every SME as a potential partner which is

capable to stabilize and further improve its position on the market with a maximum of

200.000 EUR capital investments.94

The Széchenyi Capital Investment Fund

The Széchenyi Capital Investment Fund (hereinafter: Fund) was established for a fixed

period of 10 years of on 1st of June 2011 with a capital contribution of 14 billion HUF

91

Kovácsné Antal Anita “Kockázatitőke-finanszírozás a hazai kis és középvállalkozásokban”: page 68 See also:

Nemzeti Fejlesztési és Gazdasági Minisztérium “2008. évi jelentés A mikro-, kis- és középvállalkozások részére

meghirdetett kötött célú állami támogatásokról és – a vállalkozók pénzügyi forrásokhoz való hozzájutását segítő

– államilag támogatott finanszírozó eszközökről” 92

This section is based on publicly available information at SZTA Plc.’s website. See: www.szta.hu 93

See: http://szta.hu/szta/index.php?page=main 94

See: http://szta.hu/szta/index.php?page=termekek

34

(approximately 46.6 million EUR). It is especially defined in its Articles of Corporation

document that the Fund can make investment decisions until 31st of December 2015.95

The Fund is looking forward to invest an amount between 100.000 to 200.000 EUR in

a given portfolio company. Under special circumstances a lower investment can be made, but

the amount of invested money must reach 75.000 EUR. As other GVC’s in Hungary the Fund

can also provide shareholder loan to its portfolio company as well.

The Fund will take a minority stake between 25 to 50% in the portfolio company. The

decision on the size of the stake will be based on individual needs of the company and on

current market conditions, however the Fund will always stay minority owner of the portfolio

company.96

Some criteria must be fulfilled by portfolio companies. First of all, it must meet the

conditions related to the number of employed persons (at least 25 persons employed directly

or indirectly), and it shall be founded at least two years before the investment decision is

made.97

Enterprises developing in coal- and steel industry or shipbuilding industry and

enterprises which made more than 50% of their income from agriculture activities are

excluded from the possibility of investment.98

The duration of the investment will be agreed between the Fund and the management

of the portfolio company in advance within the framework below. The duration of the

investment is usually 5 to 7 years. After expiration of this period the Fund will sell its stake in

the portfolio company, where the management has priority to buy back the stake

(redemption). If the redemption is not possible the Fund will sell its stake to another financial

investor.99

The investment decision will take place in two steps. In the first step the financial

history of the company and the provided business plan will be examined whether the basic

conditions are fulfilled (number of employed persons, potential for growth, etc.). In the

second step the company’s future growth potential will be examined more closely with regard

95

SZTA Plc. “Information Booklet on Széchenyi Capital Investment Fund”: page 2 96

Ibidem 97

SZTA Plc. “Information Booklet on Széchenyi Capital Investment Fund”: page 3 98

Ibidem, page 4 99

Ibidem, page 4

35

to the risk involved in the specific business activity pursued by the company. The investment

decision will be made by the Fund Manager based the proposal of Investment Committee.100

The expected rate of return is not defined in advance; it shall be subject to the

agreement between the Fund and the portfolio company.

The Fund has provided a sample term sheet on its website, which contains the general

terms of the investment. According to this document the investment will be paid in

installments after reaching milestones defined in the agreement between the parties. As it was

mentioned before the duration of the investment is defined in advance, it will be a period of

time between 5 to 7 years. It will be also defined in the term sheet that the portfolio company

for which goals can use the capital provided by the Fund, however these agreed aims might be

changed during the investment period. The internal rate of return will be also defined in the

term sheet.101

The sample term sheet provides different provisions in case of fundamental breach of

the contract and in case if the portfolio company permanently produces losses. More

precisely, the Fund has the right to buy the stake of the entrepreneurs in the company in case

of fundamental breach of the contract for a price which equals to 10% of nominal value of the

entrepreneurs stake or for an amount which is defined by investor’s auditor.102

The Fund also demands pre-emption, tag along and drag along rights. Also in case of

liquidation the portfolio company shall pay back the investment to the Fund first (liquidation

preference). The Fund demands also right to remove any members of the board in situations

provided in the term-sheet. These situations are in connection with bad performance and

possible insolvency of the company; however the Fund does not demand the right to delegate

any member of the board. Instead a supervisory board shall be set up where one of the three

members will be delegated by the Fund.103

The term-sheet contains also provisions on non-competition by the entrepreneurs until

the Fund has any interest in the portfolio company. The Fund also demands exclusivity rights

in the terms sheet, which means in this case, that the portfolio company has to quit all other

100

Ibidem, page 5 101

SZTA Fund’s Term Sheet; See: http://szta.hu/szta/index.php?page=termekek 102

Ibidem 103

Ibidem

36

negotiations with other investors within 8 days after the signing of the term sheet, and cannot

engage in negotiation with other investors within a period of 90 days.104

The following table contains information on the investments made by the fund since its

existence.

Table 9105

Company

Industry

Invested amount

(million HUF)

Shareholder loan

(million HUF)

Total

Fabian Anti-Aging

Clinic LLC Healthcare 47.8 72 119.8

Cortina Service

LLC

Cultural event

management 58.7 61.3 120

Euro-Unior LLC Production 55 0 55

HBF Construction

LLC

Facility

management 54 0 54

Source: www.szta.hu

4.2 Sub-conclusion

Hungarian Government set up a wide net of venture capital financing in order to foster

economical growth of micro-, small- and medium size enterprises. In this structure we can

observe three different approaches to the same “problem”. Some of these firms investing

capital directly into portfolio companies and formally they did not create a separate venture

capital fund. These companies can be seen more as “angels”, given that the separated fund

from the fund manager is one of the essential traits of venture capital funds.

Other firms have established separate venture capital funds, and providing capital

through them. The third approach is the so called fund-of-funds structure, which pours money

in private venture capital funds which have the same investment preferences as the GVC has.

Some of the above depicted models are in the end of their lifecycle, and no new

investments from these GVC’s can be expected. However the exits are not yet made, therefore

some time still has to pass until we can assay their performance. Given the “historical”

character of these funds, the their weaknesses will fall out of my final conclusion, where I

104

Ibidem 105

This table contains information publicly available at SZTA Plc.’s website. See: www.szta.hu

37

sum up the possible policy changes in the existing framework; however they are still existing

as a possible investor, therefore their presentation was necessary.

With the MFB Invest Plc. Hungarian government has established a colorful institution

which is in charge for many aspects of economic development. It has to be seen, that MFB

Invest Plc. is not a venture capital fund. It invests capital directly in selected portfolio

companies and this takes it closer to the position of “business angel” or fund manager. This

is also supported by the fact that it provides consultation services for its portfolio companies,

and it maintains an active monitoring system as well. Furthermore, MFB Invest Plc. besides

venture capital activity manages different aspects of government’s economic policy.

Moreover, one more essential characteristic of venture capital funds is missing; MFB Invest

Plc. is established for an indefinite period which is in contrast to industry standards

concerning venture capital funds.

In practice MFB Invest Plc. exercising venture capital activity on behalf of Hungarian

government. Its investment policy is strongly profit oriented, provides capital finance on

market conditions, however factors such as job creation might take part in its investment

decisions. The amount of capital available for investment is enough to make significant

investment in portfolio companies. However the duration of its investments can be considered

short.

On the other hand a substantial change in MFB Invest Plc.’s investment policy is

going on, and it tends to shift its activity towards a fund-of-funds model, which is in

accordance with European Union regulations.

CORVINUS Plc. as venture capital fund manager has established CELIN fund,

which’s 100% investor is Hungarian Government. This structure is closer to the venture

capital market standards; we can consider this as the “classical” structure.

The fund targets SMEs in their early and start-up stage, which are gaining capital to

commercialize their developed idea and are not eligible for a bank loan because of their high-

risk character.

The investment policy of the fund provides a broad framework, which can be fitted to

each investment individually. This flexibility gives the possibility to negotiate a contract

which takes into consideration both parties interest.

Considering the fact that the registered capital of the fund is only 16.7 million EUR,

we can consider its size small. However the size of each individual investment is very small,

38

between 500.000 to 660.000 EUR, therefore we can find that it is well sized to reach its goal.

On the other hand CELIN is present in a niche market, where private investments are

not or marginally present (only 4% of the value of all investments is made in this sector,

mainly by GVC’s). Furthermore CELIN expressly aims to encourage private investors to

invest in startup companies on market basis.106

This effort was not without result, given that in

CORVINUS Plc. (40%) together with SBI Capital Partners (60%), a Japanese private equity

investor in the end of 2008 created ELAN venture capital fund with its registered capital of

100 million EUR, which venture capital fund targets the same sector as CELIN.

Hungarian government has tried different approaches to boost the venture capital

market. Between these efforts MVF Plc. represents the “fund-of-funds” approach. This

approach is one of the latest tools used to foster the venture capital industry.

This approach is supported by European Union, in fact the government’s contribution

to these joint investment and co-investment funds is provided by the European Union, which

also has influence on the fund policies. Therefore this approach can be seen more as a

European Union’s another experiment in venture capital industry.

The established eight funds are well sized to reach the foreseen goal, namely to

provide capital in range of 1.5 to 4.5 million EUR to individual portfolio company. On the

other hand the question arises whether the foreseen 10 years for existence of the funds will be

enough time to invest such amount of money.

IKT Plc. with its 3 billion HUF capital targets the information and communication

technology sector. IKT Plc. has already invested almost 80% of its capital, and its lifespan of

15 years will expire within 5 years. Therefore no new investments are likely to happen in the

future. The same is true for IKT Plc. as for MFB Invest Plc., namely it is not a real venture

capital fund, given that IKT Plc. did not create a separate fund under the related act. It is a

fund manager company investing directly its capital.

The KVFP Plc. targets micro-, small- and medium-size enterprises to provide them

capital between 10 and 100 million HUF for a period of 3 to 5 years. It is definitely expected

from the portfolio companies that the provided capital will be redeemed between 3rd

and 5th

year of the investment. The same is true here, that KVFP Plc. does not have a separate fund, it

provides its own capital directly.

106

See: http://erawatch.jrc.ec.europa.eu/information/country_pages/hu/supportmeasure/support_mig_0012

39

SZTA Plc. is the newest venture capital organization in the system, which can be

considered as a real venture capital fund, given it has established its fund, the Széchenyi

Capital Investment Fund. The Fund looks forward to invest at least 75.000 EUR but

maximum an amount of 200.000 EUR’s for a period of 5 to 7 years. It also provides

shareholder loan for its portfolio companies. This is the only actor which published its model

term sheet, therefore we can compare the terms of an investment with terms used by venture

capitalist. In sum we can say that the Fund provides capital under same terms as a private

venture capital fund, however two main differences can be discovered. On one hand the Fund

will exit the investment after the period foreseen by the investment contract (5 to 7 years), and

the existence of venture capital fund cannot be extended. This rigidity might be harmful.

Table 10 (below) intends to summarize the main characteristics of the analyzed

members of the Hungarian Government’s venture capital policy. Even though these venture

capital funds are small by its size, and make tiny investments in portfolio companies

compared to a venture capital funds in Western Europe or United States, they are vital in

Hungarian financial system. As we have concluded venture capital funds are almost “non-

existing” for startup and early stage portfolio companies, they are investing in expansion and

buy-out stages. Therefore these GVC’s provide essential capital investment in these earlier

periods of portfolio firms.

In other words, GVC’s are present on a niche market of capital financing and

providing sufficient amount of capital for companies in their startup and early stage.

Still, as we saw on statistics not many of candidates will get capital and a big portion

of available resources remain non-invested. The reason for this is at least twofold. On one

hand it is normal that a venture capital firm will not provide capital to each candidate, given

that it is not interested to waste its money on non-valuable ideas. On the other hand some

valuable startups might find the conditions set forth in term sheet too strict, and therefore they

will look for other financial sources like bank loans and bootstrapping.

Unfortunately in the most of the cases I could not analyze the exact terms under which

the investment agreements are concluded. However in the case of SZTA Plc.’s Fund a sample

term-sheet was available, which can be a good starting point to derive conclusions on the

whole system while it embodies the latest approach of the government. Furthermore the

general information provided on different venture capital firm’s website points to same

direction.

40

SZ

TA

Plc.

“F

un

d”

KV

FP

Plc.

IKT

Plc.

MF

V P

lc.*

(fun

d o

f

fun

ds)

CE

LIN

MF

B In

vest

Plc

Tab

le 10

Fu

nd

’s nam

e

46.6

14.6

10

146.2

16.6

63

Cap

ital

(millio

n

EU

R)

100.0

00 to

200.0

00

(min

75.0

00)

330.0

00 to

3.3

00.0

00

166.0

00 to

1.5

00.0

00

2.3

00.0

00 to

16.7

00.0

00

500.0

00 to

600.0

00

from

450.0

00

Size o

f

investm

ent

(EU

R)

5 to

7

3 to

5

3 to

7

10

5 to

8

not av

ailable

Du

ratio

n o

f

the

investm

ent

(yea

rs)

10

indefin

ite

15

10

15

Indefin

ite

Lifesp

an

of

the fu

nd

(yea

rs)

25 to

50

up to

49

25 to

49

up to

70

25 to

50

min

ority

Size o

f the

stak

e tak

en

(%)

micro

and S

ME

micro

and S

ME

micro

and S

ME

FU

ND

S

SM

E

SM

E

Mark

et segm

ent

*MVF Plc. is investing in joint investment and co-investment funds which afterwards invest

the provided capital to enterprises.

41

What is going wrong then?

Each fund tends to provide capital on market terms. This is something what the

entrepreneurs have to deal with. However we can observe a huge rigidity in the system in

terms of duration of individual investments. As we can see most of the funds provide

capital for a period of time of 3 to 7 years, and they declare that they will exit their investment

without evaluating whether the given venture backed firm is “ready” to find an investor on the

“private market” or to redeem the stake. This might largely reduce the attractiveness of a

venture capital program.

The second problem is related to investment policies pursued by GVC’s, namely I

believe that they set forward unnecessary conditions such as minimum number of

employees, or minimum years of existence of the company.

Thirdly, although it was said that venture capital funds do not have to spend all of their

capital on investments if they are unable to find proper investment opportunities, a too strict

investment policy which filters out too much startups might have adversary effects.

Forth, as we saw Hungarian GVC’s take always a minority stake (only under special

circumstances will they take over the portfolio company) and delegate only one person to the

supervisory board. The question arises whether this type and amount of control and

monitoring is enough?

Fifth, we could observe that some GVC’s provide guidance for managers as well,

however this is not based on problems they discover during the monitoring, but the managers

can voluntarily approach the GVC and ask for help. In this framework lots of problems might

be wiped under the carpet, which might largely influence the performance of the portfolio

company.

Lastly, the whole system in itself seems really complicated involving six different

“fund managers”, which are providing different amount of capital on almost the same, but still

a little bit different terms. This creates a maze of governmental venture capital financing

and startups looking for investment might not find the proper fund which can provide the

needed amount of capital and professional guidance.

These problems must be addressed based on the lessons which can be learned from

other countries governmental venture capital programs.

42

5. Case studies of GVC – Lessons from the world

In the following section I will analyze some of the problems committed by

governments during the establishment of their venture capital programs. Some programs were

connected directly to their venture capital activity, whereas the government set up a venture

capital fund – involving other parties, or all alone – like the German WFG, in some projects

government just tried to encourage venture capital activity by providing facilities for

entrepreneurs to settle down and through their innovative projects attract venture capitalists.

As we will see problems might arise on the conceptual and the implementation level.

On the conceptual level things can go wrong when the venture capital program of a given

country is not properly designed. Setting up a venture capital fund which design goes against

the international standards is unlikely to become successful. Even if the concept of the venture

capital program is suitable to reach the proposed goals, things can still go wrong during the

implementation of it. But in the most cases both conceptual and implementation problems are

present.

5.1. How not to do – out of control

The German “Deutsche Wagnisfinanzierungsgesellschaft” (WFG) was an early

experiment in Europe on creating a national venture capital market. Although its goals were

noble, due to basic engineering and design problems the program ended up in a miserable

failure. As Gilson argues in his paper107

the structure and the implied principles of WFG were

going against standards of venture capital contracting and showed the limits of governmental

engineering.

WFG108

was founded in 1975 by the German federal government with the express goal

of developing German venture capital market. In the beginning the capital of WFG was 10

million DM in funding, which was increased to 50 million DM. The capital was provided by

twenty-nine German financial institutions, including the leading savings and loan institutions

and banks. The involvement of these financial institutions was largely encouraged by

government, namely the government insured the financial institutions that up to seventy-five

percent of WFG’s losses will be covered by it. On the other hand the government also

107

Ronald J. Gilson “Engineering a venture capital market: Lessons from the American experience” (2003), In:

Stanford Law Review: 1094-1096 108

This section about WFG is based on the above mentioned paper of Ronald J. Gilson, see also: Ralf Becker

and Thomas Hellmann “The genesis of venture capital - Lessons from the German Experience” (2003)

43

encouraged the entrepreneurs by providing a call option to the entrepreneur on the WFG’s

equity stake, permitting an eventual share buyback by the entrepreneur. In the case of

execution of call option the entrepreneur had to repay WFG’s position at cost plus a moderate

interest. As we can see, the system was highly regulated on both ends, provided that

investment risk was highly eliminated by the government guarantee, and the possible high

return was also eliminated by the moderate interest rate. As Gilson states in his above

mentioned paper, this is a strange vehicle for investing in early stage technology companies

whose essential characteristic is their high risk (and possible high return).

Concerning the WFG’s governance it had a twelve person board – comprised from

three government members representing the ministers of finance, commerce and research and

development, three bank members, two management consultants, two scientists and two

industry representatives – a which was in charge to select the project to be funded. The

investment criteria were not really sophisticated: the technology had to be innovative with the

existence of an attractive commercial application, and the entrepreneur had to show some

quality.109

Moreover no member of the selection committee was awarded or penalized for

WFG performance, which also killed the incentives for good performance on individual level.

The investments policy of WFG was structured in a passive way: WFG took only a

minority stake in the portfolio company without receiving any control over it, not even in very

important decisions. On the other hand WFG did not provide any technological or

management assistance which is one of the classical role of a venture capitalist. This passivity

is not surprising if we consider that the whole system was structured that way that the possible

high return on the investment was basically excluded and this fact gave no incentives for

venture capitalist for activism.

Comparing this investment policy to the US venture capital contracting structure we

can see, that in the WFG everything went against the global standards. In US venture capital

investors demand greater control positions than their stake is in the portfolio company.

Furthermore they obtain veto rights over major decisions, retain the continuation decision,

and often the control above majority of the board of directors, furthermore they also retain the

right to terminate the portfolio company.110

109


Stanford Law Review: page 1095 110


Stanford Law Review: page 1096

44

The differences can be summarized as follows: while the US venture capitalists highly

monitor their investments and give strong guidance to entrepreneurs, WFG did not monitor

any of its investments nor it influenced the decisions of portfolio companies. The reason for

that is twofold, and inherent in structure. On one hand because of the governments guarantee

on investments the contributors of the capital – banks and financial institutions – had no

incentive to do efforts on monitoring. On the other hand, even if a problem would be

discovered, WFG did not have any right to influence the decisions of the portfolio company

given that it took only a minority stake without any veto rights.

After the above described problems it is not surprising that the WFG program was a

significant failure producing massive loss for German government (over its lifetime the

internal rate of return was -25.07%). The lessons from WFG are quite clear: a government

program cannot be based simply on political goals detached from the market reality. On the

market nobody will refund the losses created by bad investments, and no entrepreneur will

perform better without strong supervision and monitoring. Furthermore neither party had real

obligations, bad decisions stayed without consequences, which is not tolerable. Creating a

security net like the German government did for venture capitalists and entrepreneurs will

definitely lead to these consequences. A real incentive for parties and real control over

investment is a must.

5.2. How not to do – Bad timing and lack of endurance

When a government decides to take legislative measures in order to change a current

situation it always has to take in consideration the amount of time that is necessary to see the

results of its efforts. This is definitely true if venture capital investments are in question.

Building a venture capital industry is a long-run project; it might take many years until the

first results become palpable.111

Unfortunately this is not compatible with one of the

important peculiarity of democracies, namely that periodical elections will be organized, and

there is no guarantee, that the same economic direction will be followed by new government.

A good example on problems might caused by quick policy changes and impatience is

the case of Malaysia. Even though Malay policy makers recognized early the importance of

encouraging entrepreneurial activity they failed to wait for the outcomes. Between 1970’s and

1990 Malaysia successfully shifted its economy from production of raw materials to

111

Josh Lerner, “Boulevard of broken dreams” (2009): page 112

45

manufacturing electronic devices. It was also realized that the future growth of the country

depends on innovation; therefore in 1993 Malaysian government established Malaysian

Industry-Government Group for High-Technology (MIGHT).

MIGHT was an independent non-profit organization which aimed to facilitate

partnership between industry and government in the field of high-technology industries.112

In

the beginning it promoted successfully high-technology entrepreneurship, but after a

paradigm shift the efforts of government ran into serious brick walls. One of the good

examples of that was the BioValley, a costly investment which ended in a huge failure.

Blinded from other countries success Malaysian government forgot to answer some

fundamental questions, for instance is there a need for such project, are there enough properly

trained personnel to run the facilities. Furthermore the lack of intellectual property rights and

its enforcement made BioValley certainly not an attractive place to settle down for foreign

companies. Moreover inconsistent policy of government largely discouraged biotechnology

firms which choose to settle down elsewhere.113

In the end the BioValley project was largely

reduced and Malay government started to focus their resources on other projects.

Another example for the inconsistency and recently policy changes in Malaysia was

the Advanced Microchip Design and Training Center project, which was launched in 1999

and basically shut down in 2003 after the realizing the slow pace of progress. The program

ended in a miserable failure and litigation with its foreign partners.114

What was the problem? First of all, Malaysian government did not appropriately

analyzed the market needs and did not carefully planned its projects, which led to

inconsistency of Malaysian government’s actions, and to frequent policy changes when the

outcome was not satisfying after short period of time. This led to a situation where investors

and even government itself became largely discouraged. Moreover the timing of projects was

inappropriate concerning the fact that Malaysian projects lagged behind its peers.

Furthermore, the only measure with which Malaysian government tried to attract

investors was the building of science parks. Unfortunately studies show that science parks

have no measurable impact on venture activity. Moreover, because of the short-run

orientation of leaders they assume that science parks solve the problem immediately once they

are completed, but as the example shows it is misleading expectation.

112

Josh Lerner, “Boulevard of broken dreams” (2009): page 113 113

Ibidem 114

Ibidem, page 115

46

An example on good timing can be seen in Taiwan, where government officials have

targeted the right sector at right time.115

It was the time, when a revolution in personal

computer industry structure was going on due to lowering of entry barriers worldwide. Many

companies started to compete in niches of this fast growing market. A coordinated

government strategy which supported entrepreneurship, government’s efforts to provide

sufficient number of well-trained professionals and government’s policies which aim

complementing and supporting private sector were successful and made Taiwan one of the

leaders in manufacturing of personal computer industry.

To sum up, governments must carefully plan their venture capital program and believe

in it. Success is unlikely to come in countries which are going after the world trends only

without carefully assessing whether there are effective conditions, at the national scale, to

succeed in following such trends.

5.3. How not to do – Sizing the GVC

One of the pros of GVC is that it might encourage venture capitalists to invest in a

specific country. In this regard proper sizing of the GVC project is crucial. Too small projects

are likely to not to have significant effect on economy, therefore the investment possibilities

might not come in the view of venture capitalists. On the other hand, if GVC project is too big

and it provides more than enough capital on a specific market venture capitalist might lose the

incentive to enter the market. This is the so called crowd-out effect. It has to be borne in mind

that there is no one-size-fits-all mechanism in this regard. The proper size of a fund varies

from sector to sector, country to country, but still venture capitalists suggest at least $60 to

75$ million as smallest size for an effective venture fund.116

In the United States Peter K. Eisinger117

made a study on the average size of the

venture capital funds established by different states. He found that the average size of the $6.5

million which was far less than the typical size of a venture capital fund begun that year ($31

million). The reason for this undercapitalization is quite obvious: states have more important

115

Josh Lerner, “Boulevard of broken dreams” (2009): page 131; see also: Kenneth L. Kraemer

“Entrepreneurship, Flexibility, and Policy Coordination: Taiwan’s Computer Industry” In: Information Society

12 (1996): page 215-249 116


Josh Lerner, “Boulevard of broken dreams” (2009): 118; see also: Peter K. Eisinger, “The State of State

Venture Capitalism” Economic Development Quarterly 5 (1991) 64-76; Peter K. Eisinger, “State Venture

Capitalism, State Politics, and the World of High-Risk Investment”, In: Economic Development Quarterly 7

(1993): page 131-139

47

issues to deal with, such as funding healthcare, education and other needs of the citizens. This

is understandable if we consider that a good venture capital program will not bring significant

votes to politicians on next elections.

On the other hand with such limited amount of money it is unlikely to achieve the

goals pursued by the establishment of the funds. Indeed, when Peter K. Eisinger returned

twenty months later to check the status of these GVC’s he found that over third has been

already dissolved, which is the ultimate recognition of the failure.

Another inefficient attempt can be observed in Europe, where the European Union

launched efforts to encourage the financing of new companies.118

The European Union has

established reasonable-sized funds, but each member state had to get its “fair share”, which

led to fragmentation of the available sources. In fact they were so undercapitalized that – as

Gordon Murray points out – the available money was not even enough for salaries and other

expenses for the proposed 10 years of fund’s lifespan, not to take the entrepreneurial

companies to the point where it would be interesting for a corporate acquirer or to go public.

On the other end a good example for overcapitalized GVC program is the Canadian

Labor Fund Program.119

These funds were established between 1980’s and 1990’s by number

of provincial governments in order to develop venture capital market. These funds had very

peculiar elements – without describing each of them – for instance most of the investors were

individual persons which received outstanding tax benefits for their investment, the funds

were managed by labor unions which lack fund managerial knowledge, and many other bad

designs were applied. However the investment opportunity into these funds became extremely

popular and the amount of capital investors put into these funds grew radically. Not

surprisingly these wealthy public funds became too extensive and took all of the incentives

from (real) venture capitalists to invest in Canada, because all the good investment

opportunities were already funded. The loss of the incentives made venture capitalists

(temporary) exit the Canadian market, which was just the opposite of the original goal.

118

Josh Lerner, “Boulevard of broken dreams” (2009): page 118; see also: Gordon Murray, “The European

Union’s Support for New Technology-Based Firms: An Assessment of the First Three Years of the European

Seed Capital Fund Program” In: European Planning Studies 2 (1994): page 435-461 119

Josh Lerner, “Boulevard of broken dreams” (2009): page 119; see also: Andrew Carragher and Darren Kelly,

“A Comparison of the Canadian and American Private Equity Markets”, Journal of Private Equity 1 (1998): 23-

39; Organization for Economic Cooperation and Development, Venture Capital Policy Review: Canada, STI

Working Paper (Paris: OECD, 2003): no. 2003/4; and Daniel Sandler, Venture Capital Tax Incentives: A

Comparative Study of Canada and the United States (Toronto: Canada Tax Foundation, 2004)

48

In Europe we can see a similar picture to the Canadian one, where in recent decades

many national and European funds were established to promote funding and raise venture

capital funds. For instance in 2001 European Commission provided over two billion Euros to

the European Investment Fund, which became the largest venture capital fund on the

European market.120

This was done because the low level of fundraising and low historical

returns created a need for public finance; at least this was argued by the policy makers. On the

other hand venture capitalists argued that this unfair competition from public funds might

have dangerous counter effects; venture capital funds might quit the European venture capital

market just like in Canada.121

This scenario is also supported by studies, where the completed

data shows that every dollar invested by the government will exclude one dollar invested by

venture capitalists from the market.122

To sum up, the proper sizing of the GVC is crucial, too small or fragmented fund is

unlikely to achieve the desired goals, on the other hand too big funds will terminate the

incentives of venture capitalists to invest their money in specific market. Defining the correct

fund size is one of the most difficult tasks; however during doing so it must be bear in mind

that there are no one-size-fits-all resolutions for this, every market is unique.

5.4 How not to do – Lack of flexibility

Legislators are willing to address all possible scenarios during creating new

regulations or setting up a new organization. However, in a quickly changing environment it

is not possible to reflect to all problems which may arise in the future. This is especially true

when it comes to investing money in a new start-up company where countless uncertainties in

the management, technology and commercialization are present. To avoid these possible

problems and to reduce information asymmetries, venture capitalists remain actively involved

in their portfolio companies’ life. Control and guidance are two functions – among others – of

venture capitalists which are essential in this industry. We have already seen in the case of

WFG that venture capitalist cannot devoid these two functions, otherwise it will lead to a

significant failure.

120


Josh Lerner, “Boulevard of broken dreams” (2009): page 122; see also: Wim Borgdorff “Public Money is

Harming the VC Industry”, Financial Times, February 16, 2004. 122


49

However, flexibility is also needed when it comes to policies set forth by GVC or

other policy makers. In United States many cases represent good examples on the serious

consequences of rigidity: even a successful start-up company can fail.123

While a venture

capitalist will flexibly overcome on issues like the portfolio company became larger than the

venture capitalist wants to finance according to its funds policy, GVC’s – lacking flexibility –

will consider such an issue as a reason of termination. Also excluding some promising

candidates because not every detail of their project can be fitted into the framework of GVC’s

policy is a very narrow-minded approach. The intentions of the policy makers may have been

innocent, but the ticking-the-box approach will have troubling consequences.124

To sum up, GVC’s policies must stay flexible in order to be able to deal with issues

arising from the nature of venture capital investment (information asymmetries, management

problems etc.), and should not be hobbled by excessive regulation, which might exclude a

reasonable investment opportunity.125

5.5. How not to do – Problems caused by top-down approach

This problem was marginally addressed during discussing of bad timing and lack of

endurance. Public venture capital programs involve political decisions. Politicians are short-

term oriented, they have to show the success of their work to citizens in order to gain votes on

elections. No politician is interested in taking measures which probably will show success in a

longer period of time, when possibly his/her opponent is in power. This natural self-interest

can lead to bad allocation of the resources. Also lobbying as a part of political activity can

mislead the policymakers.

Spreading the wealth approach – as we have seen it in the case of European Union,

where from a reasonably sized venture capital fund each Member State had to get its “fair

share” – will lead to fragmentation of the fund, and it is likely that considerable resources will

be focused on territories where no significant entrepreneurial activity is present.

Entrepreneurs are not fair-players in sense that they will not divide a given territory in equal

parts and settle down. Contrary, they will settle down in particular places where the best

opportunities are given to develop, thereby creating clusters.126

Measures can be taken of

123

See: CBR Laboratories and Intron case In: Josh Lerner, “Boulevard of broken dreams” (2009): page 126-127 124


Ibidem 126

Ibidem, page 129

50

course in order to make a particular place more attractive to entrepreneurs, but the failure of

Malaysia shows that the simple “If you build it, they will come”127

approach will not work.

The Small Business Innovation Research (SBIR) Program in United States provides

illustration of this problem. Congressmen and their staff did put political pressure on the

managers of SBIR Program in order to award companies in the given congressmen’s state. As

a result companies in every state have received at least one SBIR award in almost every fiscal

year.128

On one hand it was appreciable, because every company receiving award developed,

but on the other hand the comparison of awarded companies which settled down in regions

which are characterized by high-tech activity with those ones which are not located in such

region a significant difference can be observed. Awarded firms in high-tech activity regions

grew considerably faster. “In addition to this geographic pressure, particular firms managed to

capture disproportionate number of awards.”129

As we saw it in the case of Taiwan, a well timed and planned policy can be successful

in a particular industry, but unfortunately the practice shows that the case of Taiwan is more

an exception than the rule. Investing public money in territories and companies which has

limited potential to grow is useless, moreover harmful. The question arises: How can the

government identify good investment opportunities? Josh Lerner provides a possible solution

to address this problem at least partially. “The most direct way is to insist on matching funds.

If venture or entrepreneurial firms need to raise money from outside sources, organizations

that will ultimately not be commercially viable will be kept off the playing field. In order to

ensure that matching requirement should involve a substantial amount of capital (ideally, one-

half the funding or more should be from the private sector.”130

As an example he presents the

success story of New Zeeland, which country decided to establish a “fund of funds” system.

Under this scenario government shall establish a venture capital fund, which acts as an equity

investor in (private) venture capital funds.

Obvious advantage of this structure is that government does not have to face with the

risk involved by burden of choice; fund managers, who have sufficient practice and

knowledge, will bear these liabilities. On the downside, this regime eliminates the possibility

of achieving political goals set forth by government. Furthermore, this kind of structure works

127


Ibidem, page 129; see also Josh Lerner “The Government as Venture Capitalist: The Long-Run Effects of the

SBIR Program” Journal of Business 72 (1999): 285-318 129

Ibidem, page 130 130

Ibidem, page 132

51

only in countries where a single venture capital market is present, more precisely, where

venture capital funds are concentrating on a single state. This is because of the fact that

governments are not interested to provide equity for venture capital funds which will invest it

abroad.

In CEE region most of the venture capital funds are present on region level.131

They

are not focusing only on one country, but looking for investment opportunities in the whole

CEE region. Hungarian government has no incentives to provide capital to funds which will

invest not only in Hungary, but in Poland, Czech Republic or Romania etc.

For these reasons a fund of funds approach is not an option in case of Hungary. The

problem must be addressed in more “traditional” way; GVC must attract professional fund

managers which are able to distinguish the good investment opportunities from bad.

5.6. How not to do – agency problems

Concerning the problems may arise in connection with implementation of public

venture capital fund policies two questions can be pointed out as important ones. The first is

the question of agency problems, which can be addressed by proper set of incentives given to

the parties. As we will see, this problem has two levels: first between fund managers and

entrepreneurs, second between the investors and fund managers.

Venture capital investors in their investment strategy put large emphasize on

incentivizing the entrepreneurs, which sometimes can be seen as exploitation of the

entrepreneur. But the reason for that is very different. Investors have to ensure that the

entrepreneur will focus on the project, the management of the portfolio company is not self-

interested, and they are working in order to maximize the value of the portfolio company.

Interests must be properly aligned between the parties, and one way to do so is by limiting or

eliminating the entrepreneur’s right to cash-out from the company before investor.132

The second level of agency problems which must be addressed rises between fund

managers and investors. Fund managers must be also properly incentivized in order to

perform as good as it is possible. Under a scenario, where fund managers will get high

management fees for their services independently from their performance is likely that

131

This statement is supported by my empirical examination on target regions of members of Hungarian Private

Equity and Venture Capital Association. I found that the vast majority of venture capital funds are investing in

CEE region not only in specific country. 132


52

venture capital fund will underperform. A lower management fee compared with stock option

will make the fund manager to get the most out of fund’s portfolio.133

A good example for the dangers inherent this problem can be observed in the case of

Hearthland Seed Capital Fund, an Iowa based GVC which aimed to boost venture activity

within the state.134

State of Iowa in order to address the problems might arise from top-down

approach after a tender appointed a professional venture group to fulfill the role of fund

manager. The managerial fee was set high above the industrial standard (3% per year, while a

fee of 1 to 2.5% was more likely in the venture capital industry that time), and State Iowa had

to pay the managerial fee independently from performance of the fund manager (even in case

if no investment was made at all). This ended in a situation where after a three year period

fund manager collected more in managerial fee ($1.4 million), than they invested until that

time ($1 million). Not surprisingly State Iowa decided to abandon the project and liquidate the

fund. The situation came even more awkward when fund manager sued State Iowa demanding

all the management fees for the period of 10 years, which was the original length of their

agreement.

The case of Hearthland Seed Capital Fund provides a clear lesson: investors must be

almost such strict with the fund managers as the fund managers are with the entrepreneurs.

Paying fund managers fee partially in stocks of the portfolio companies will give incentives

for fund manager to invest funds money in valuable companies and to make them perform as

good as possible.

Without repeating the facts, the German WFG program also showed the problem of

badly incentivized fund managers.

In addition, in the case of Hearthland Seed Capital Fund one more problem had arisen:

the fund manager had no experience and personnel in Iowa, therefore it is not surprising that it

was not able to make proper investments.

As it was pointed out before, GVC’s can hire professional fund managers to manage

the fund and to assess portfolio companies. However, getting rid of duty of evaluation of

portfolio companies does not mean that investors do not have to evaluate anything afterwards.

At least one assessment must be made by the government: the evaluation of fund manager.

This is a duty which cannot be passed on someone else. It is not easy to answer the question

133


Ibidem, page 140; see also: “Iowa Suit Tests LP’s Authority to Abolish Fund” In: Private Equity Analyst 4

(1994): page 1-9

53

how government officials should evaluate fund managers, but a comprehensive evaluation of

a fund managers past performance, find managers experience in the targeted industry and

territory might be a good starting point.135

The evaluation of the progress of the program is

also an important question which must be done by government itself.

6. Conclusion – do we need a policy change?

6.1. What not to change

As it was stated in the sub-conclusion, the size of the GVC’s can be considered small

compared to other venture capital funds. However Hungarian GVC’s are targeting a niche

sector, where no private venture capital is present, namely the sector of startup and early stage

companies, where smaller amount of capital is needed, therefore the capital available for

investment seems enough.

Furthermore, given the unfortunate situation that in Hungary business angels are

almost not existing, government must fulfill this role as well. Business angels are providing

even smaller amount of capital than venture capitalist, therefore a policy which would exclude

the possibility to provide such a small amount of money would lead to a gap in startup

finance.

For these reasons, I have to conclude that the size of the GVC’s, and in general the

amount of capital which is available for micro-, small- and medium size enterprises is enough

to satisfy the market needs. Moreover we can see that large portion of the available capital is

not invested; however this is a problem which will be analyzed below.

6.2. Where change might improve the performance of the program

In my sub-conclusion I pointed out the following problems:

1. High rigidity in duration of the investment

2. Unnecessary conditions

3. Strict policy might filter out too many entrepreneurs

4. Lack of control and monitoring

5. Lack of guidance

6. Maze of GVC’s

135


54

1. Even though it was mentioned last I would start to analyze the problem of maze of

GVC’s. As we saw it there are six different GVC programs with closely related tasks

targeting almost the same segment of the market. However the control of these GVCs is

separated, and some of them are under the control of MFB and some of them are under the

control of National Development Agency. This separation has an obvious disadvantage,

namely in such a “network” the human resources are widely diffused. This might lead to a

situation where the limited number of good analysts, managers, business coaches are spread

across different GVC’s, and neither has a good staff to make good investment decisions, to

coordinate and monitor the investments.

Another disadvantage of this system is that entrepreneurs might hardly find the proper

GVC which will provide him with capital. The other side of this coin is, that given the fact

that targeted sectors by the GVCs are overlapping, the entrepreneurs are able to engage in

“forum shopping” between the GVCs. This is clearly not in interest of the government, given

that the idea of application of different conditions to same transaction dependent on the entity

through it provides the capital contribution is unsupportable.

Furthermore, each analysis of the same business plan involves transaction costs. If an

entrepreneur is able to apply for investment at different fund managers (GVCs), which

ultimately provides money of the same investor (the government) the transaction costs might

multiply on the cost of government. This must be avoided.

For these reasons I propose the idea of restructuring the whole system, and establish

one professional organization, a fund manager with indefinite lifespan, which is in charge for

the different aspects of the government venture capital policy. This professional organization

would be the “general partner” which is liable to invest the “limited partners” (state’s) capital

and monitor the investments. The different aspect of government’s policies could be

represented in the different funds managed by the established professional organization. (See

Figure 2. below.)

This system has the following advantages. First, the entrepreneurs does not have to

familiar with all details of a complicated GVC structure, simply they have to be familiar with

one organization which co-ordinates all of the available programs.

Secondly, this centralized system would exclude the possibility of “forum shopping”,

given that only one organization is present. This automatically solves the problem of multiply

transaction costs, given that if an entrepreneur’s business plan is refused, he is not able to

present it before another GVC in order to obtain capital investment.

55

Figure 2.

Thirdly, this structure enables the possibility of allocation of the best professionals in

one single organization. There is no need for multiply investment committees and boards of

directors. One investment committee will examine all of the business plans and one board of

directors will make the investment decisions. This provides also consistency of the decisions

in the system.

Fourth, this structure enables the professional organization to monitor all of the

governmental venture capital programs and to analyze and compare how a given program

functions in the system. If it is discovered that a given program does not function sufficiently

well, the decision makers can act promptly to correct the possible mistakes.

Fifth, as it was said in connection with the investment committee, such a structure

would enable a common monitoring of the investments. Best personnel can monitor the

entrepreneurs and give guidance in case of its need.

Lastly, the system provides cost savings for government as well, given that only one

professional organization has to be funded from its sources. This structure might contribute to

solution of problems identified above.

2. Concerning the problem of rigidity it must be seen that provisions on duration of

investment might be problematic and unenforceable. As we can see most of the funds provide

capital for a period of time of 3 to 7 years, and they declare that they will exit their investment

without evaluating whether the given portfolio company is ready to be financed by an investor

State

The "Limited Partner"

Professional organization liable for venture capital investments

The "General Partner"

Fund 1

(e.g. SZTA)

Fund 2

(e.g. MFV)

Fund 3

(e.g. KVFP)

Fund 4

(e.g. CELIN)

56

on the “private market” or to redeem the GVC’s stake. The portfolio company has to redeem

GVC’s stake under all circumstances or it might face liquidation or even worse scenario like

selling its stake to third persons which might be also a competitor.

Even though it would be desirable by the contracting parties, the market conditions

and realities are not based on provisions agreed by the investor and entrepreneur. If they agree

that the entrepreneur will redeem the investment between the fifth and seventh year of the

investment, but it is not possible due another financial crisis, the parties would both be better

off if they change their agreement. This would be the normal behavior on the market both

from the investor and from entrepreneur. For this kind of situations the venture capital funds

usually maintain the possibility of expanding the funds lifespan.

However as I found it, the GVC’s are not open for these kind of solution; they expect

to exit their investment if the agreed period of investment elapsed. If they enforce such a

provision it might lead to ruination of a promising portfolio company and government’s

ultimate goals such as more tax income, higher level of employment would ultimately fail.

This kind of strict provisions must be abolished, and flexible provisions on exits must

be introduced. This does not mean that GVC cannot maintain a policy where it sets forth that

within a period of time the investment should be redeemed, but instead of strict date on

redemption incentives to do so should be promoted. Such an incentive might be a yearly

increasing level of expected rate of return after the agreed deadline of redemption. Of course

it should be always evaluated whether the portfolio company is still promising one or it is

better to terminate the given investment contract.

3. Conditions such as minimum number of employees or years of existence of the

company are going against the norms of venture capital industry, and they are unreasonable

for many reasons. First, venture capitalist should be not interested in such details, it has to

analyze only whether the given company is a possible good investment with high potential of

growth or not. On the other hand one of the main characteristics of the startup companies is

that they have been founded “yesterday” therefore it is natural that they cannot fulfill a

condition which prescribes two or more years of existence.

Furthermore, when a startup company starts to develop, it is natural that it will require

more employees; therefore after a while conditions on number of employed persons will be

57

fulfilled. But this might not happen without capital investment which was not made because

of a condition which will be fulfilled later automatically.

For these reasons unnecessary conditions must be abolished and avoided in the future

during the designing of venture capital program.

4. As we saw on statistics not many of candidates will get capital and a big portion of

available resources remain non-invested. The reason for this is at least twofold. On one hand

it is normal that a venture capital firm will not provide capital to each candidate, given that it

is not interested to waste its money on non-valuable ideas. On the other hand some valuable

startups might find the conditions set forth in term sheet too strict, and therefore they will look

for other financial sources like bank loans and bootstrapping.

Unfortunately in the most of the cases I could not analyze the exact terms under which

the investment agreements are concluded. However in the case of SZTA Plc.’s Fund a sample

term-sheet was available, which depicts the current situation and embodies the latest approach

of the government to venture capital investments.

Concerning the forth problem, it has to be seen that GVC’s role is not perfectly same

as venture capitalists role; they must catch a wider circle of startups and try to lead them to a

point where venture capitalists might have incentive to invest into the portfolio company.

They suppose to function as a guide which helps to the entrepreneurs to reach the “big field”,

where professional investors are “hunting” for them.

I have argued that GVC’s structure, approach to the investments and applied solutions

must be as close to the industrial standards as it is possible. However some characteristics of

venture capital funds are not necessary to be satisfied. One of these characteristics is

profitability. The venture capital program of a given government must not be profitable under

every circumstance. We have to see the government’s venture capital activity in a system,

where it is only a tool to enable higher incomes on other programs of the government, or to

contribute to other goals pursued. In other words, making money on GVC’s shall not be the

primary goal.

Of course it cannot be allowed to make excessive deficit, but a higher amount of risk

can be taken compared to private venture capital funds. As I stated above, a strict, profit

oriented policy might filter out many startup companies which maybe will not produce great

58

profit to the investor, but can contribute a lot to other governmental goals such as employment

or tax income.

Furthermore, as we saw it, a huge portion of available capital is still not invested,

which might be a result of a too strict investment policy. Every cent of non-invested capital

“make loss” for the government, because its nominal value decreases at least with the level of

inflation, and on the other hand it cannot be used for other programs once it is delegated to

GVC.

A controlled “spray and pray” approach in this regard might be better than “sitting”

on a large amount non-invested capital, which will not produce any profit or contribute to

other governmental goals for sure. However the lessons from German WFG must be borne in

mind of the policy makers during the review of the current one. This can be done if a proper

solution on the following two issues is created.

5. Venture capitalists are monitoring closely their investments through delegated

members to the board of directors or supervisory board. The importance of monitoring must

be emphasized given that without it even the most diligent entrepreneurs might became “lazy”

and not putting optimal energy in the development of the portfolio company.

Venture capitalist in order to boost their influence in the portfolio company usually

takes even the majority in the board of directors therefore eliminating the entrepreneurs

control in the company. This might be seen as an unfair condition, but it has to be borne in the

entrepreneurs mind that without the venture capitalist he might be not able to develop at all,

and losing control is only temporary. When the venture capitalist exits the investment through

an IPO for instance, he will regain the control.

However, when I examined the Hungarian GVCs I had to conclude that those usually

marginally monitor their investments. It is likely that GVC will delegate only one member to

the supervisory board, and will not take any seat in the board of the directors.

As it was argued that government’s venture capital program must be as close to the

venture capital industry standards as it is possible a fundamental change in this regard must be

made. GVCs shall closely monitor its investments and at least take the majority of seats at the

level of supervisory board.

59

It would be preferable to identify a number of issues where GVC has reasonable

interest to be involved in decision making, and those decisions should enter into force only

once the supervisory board, where the GVC has majority has agreed with it. This solution will

not paralyze the day-to-day operation of the portfolio company, but gives the power to GVC

to influence strategically important decisions.

It can be argued that this kind of strong monitoring compared with a more open

investment policy which results in hundreds or thousands of investments will put an

enormous workload on the GVC’s monitoring department. However that is the reason why

only strategically important decisions should be the subject of GVC’s agreement.

It cannot be forgotten that a strong monitoring system is largely capable to incentivize

the entrepreneurs to perform better. This gives protection to the investor and can avoid that its

investment will not become a useless and expensive expenditure.

Finally, a more open investment policy needs strong surveillance. In other words, if

GVC provides capital for entrepreneurs on lighter preconditions a higher level of monitoring

of the investments is needed.

6. The final weakness of the existing system is the lack of guidance provided by the

GVCs to their entrepreneurs. As it was concluded some of them maintains professional

consultancy services, but entrepreneurs can use them voluntary.

Contrary to this, venture capitalists usually provide guidance to their entrepreneur on a

mandatory basis. If it is discovered during the monitoring that some guidance on business

decision is needed, the venture capitalist will definitely provide entrepreneur with the know-

how related to business issues. It must be borne in mind that entrepreneurs are usually not

well trained businessmen, however they have to make business decisions like they was. On

the other hand venture capitalist by “training” the entrepreneurs largely contribute to the raise

of the level of common business culture.

This role cannot be abolished by the GVCs. They must maintain a system which is

capable to provide sufficient coaching to their entrepreneurs on mandatory basis.

- The End -

60

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