Month: September 2021

With the advancement of digitalization in nearly every world of life and business, the importance of technology M&A transactions has also increased significantly – a trend that is expected to intensify in the years to come. Established business models of traditional industrial companies are challenged by easily scalable digital offerings; and institutional and financial investors, struggling with low or negative interest rates, seek appropriate and lucrative investment opportunities while minimizing risk amid the “money glut”. As a result, companies and financial investors are welcoming emerging start-ups, especially in the IT / software and healthcare sectors: in 2020 alone, according to PitchBook (European Venture Report 2020), European start-ups have raised nearly € 43 billion in investor funds, including nearly € 20 billion from strategic investors – two records that will (most likely) be set again in 2021.

Interest and instruments

In their (co-) investments in start-ups, financial investors mainly seek the highest possible financial return, which they realize in the event of an exit, i.e. a sale or an IPO of the company concerned. Depending on the respective orientation of the industry and the phase of the business, corresponding venture capital funds are set up and invest in selected start-ups over a certain period of time. The motivations of industrial companies, on the other hand, are more complex, but mainly strategic and aim, among other things, at access to new innovative technologies, a strengthening of the innovation pipeline or, in general, “learning effects”. and / or presence in the new emerging sector ecosystem of market players. Companies can cooperate with or participate in start-ups in different ways. Depending on the strategic objective and the sector, the following may be considered: (technological) development and cooperation agreements, licensing agreements, joint ventures, incubation / acceleration programs or investments in start-ups for which companies receive a minority stake in return. Firms generally invest through specially designed investment vehicles (called “enterprise venture capital”), but sometimes also directly “from the balance sheet”. In Germany and in Europe, enterprise risk capital is now an integral part of the (external) innovation strategy of companies.

Structuring of (co-) investments

Financial investors and strategic investors who invest in technology companies typically aim for a 10-25% minority stake. Depending on the stage of development or the liquidity needs of the start-up concerned, convertible bonds are issued as an alternative, allowing the investor to become a shareholder of the company during a financing round subsequent to a valuation of capped company (plus any discount). Financial investors are primarily exit oriented in their investments and tend to interfere less in operational issues of management. On the other hand, strategic investors attach particular importance to contractual regulations that allow them to acquire the start-up completely at a later date, or at least grant them a right of veto on the sale to competing companies, as well as a right of veto on the sale to competing companies. active influence and involvement in relevant decision-making processes, which is reflected accordingly in the governance of the start-up. However, the contractual fixing of acquisition rights in favor of strategic investors is a double-edged sword: it limits the start-up to a concrete exit option and can therefore have a negative impact on its valuation (achievable in the event of exit) in the long run.

Particularities of technological investments

The essential value of technology companies lies in the technology they have developed, their know-how and their key employees. Therefore, the “protection” of these critical assets plays a major role in technology investments. This is done, on the one hand, by contractual guarantees with which the respective company (and the founders behind it) ensure that the rights to the software concerned and the source code underlying it belong to the company and that the possible use of “open source” does not oblige the company to disclose its source code (“copy-left” effect). However, such standard guarantees are often not worth much in the case of start-ups (and the corresponding W&I insurance policies are not yet in place). Depending on the size of the specific investment, it may therefore be wise to subject the start-up to in-depth IP / IT due diligence and, for example, to identify the risks associated with the use of open source software by means of back duck due diligence as well as analyzing the existing IT infrastructure (s) and data protection management systems. In order to “lengthen” the risks to a certain extent, financial and strategic investors also invest in technology companies whose technology is still in the early stages of its development and commercialization depending on the achievement of certain technological milestones and / or commercial – and it is only when these milestones are reached that contractually agreed installments of the total investment are due. Finally, creating incentives for founders and other key employees as well as their retention in the company is of particular importance in technology investments. Particular attention must therefore be paid to the appropriate provisions to bind key employees to the start-up as well as to the usual non-competition clauses (and their support by appropriate contractual sanctions) in the event of departure from the company.

Success factors for technology investments

The key structural success factors for investment strategies for technology investments, in particular by industrial companies as part of their corporate venture capital activities, are: well networked within the parent company itself; a clear investment objective aligned with the industrial company’s strategy as well as clear indicators of success by which technological investments in the company are assessed (and, if necessary, terminated); rapid decision-making processes on (follow-up) investments that are not influenced by hierarchical levels; and finally, the establishment of organizational and human “bridges” between the start-up and the company, which on the one hand allow the start-up to access critical resources and company experts, and on the other hand allow the knowledge gained from the technological investment for the company to be used in the best possible way and in the right place in the company.

Outlook

(Co-) investments in technology companies open up great opportunities for financial investors and strategic investors to participate financially and / or strategically in current growth trends. At the same time, the structuring of such investments entails a complexity that should not be underestimated. Due to lowered thresholds (according to the 17th Amendment currently in force to the German Foreign Trade and Payments Ordinance, already from an acquisition of 10% or 20% of the shares) and further expansion in related areas security – in particular technological fields such as artificial intelligence, autonomous driving, robotics or cybersecurity – depending on the origin of the investor, the obstacles of foreign trade law must increasingly be taken into account and treaties in technology investments – a development that is expected to intensify in the coming years in view of the struggle between the United States, China and Europe for global supremacy in key technology industries.

The stimulating federal policy regime that has supported the current bull market so much is changing. The Federal Reserve is about to begin the process of removing monetary stimulus, while fiscal policy is about to refocus. Taken together, these emerging developments create a degree of uncertainty, to the point that some market watchers warn of a period of higher volatility, and perhaps a correction in the stock market. The fact that such uncertainty coincides with a period of seasonal weakness historically makes such warnings all the more troubling. Of course, it remains to be seen whether the markets react unfavorably to these developments.

The Federal Reserve has been preparing the ground for the start of its reduction in its bond buying program for some time. It is not a question of if, but when this process will begin. The Fed is meeting next week and could then present its plan. The weaker-than-expected August employment report could push that decision back to November, although the Federal Open Markets Committee (FOMC) hawks would rather not wait. But how much of a difference a few weeks makes is debatable. Either way, the weakening is coming. The bigger question for investors is how quickly the tapering ends, further setting the stage for the first rate hike of the next tightening cycle. President Powell was careful to point out that the rate cut and the rate hikes must be considered independently. And while this distinction may be important, it’s also likely that rate hikes are unlikely to start until the cut is complete. If the Fed acts faster than expected to end its bond purchases, it would advance the market’s estimate of how quickly rates might rise and how quickly the Fed would get rid of them.

Rising inflation gives the Fed a reason to act quickly; But the employment situation justifies caution

The argument for moving faster down this path is rising inflation. The Fed has stuck to its judgment that much of the increase is due to supply side constraints that will dissipate over time, and therefore a modest concern. But not all FOMC members agree. On Tuesday of this week, the August Consumer Price Index (CPI) report will be released and should show some welcome moderation from the previous month. The headline rate is expected to rise 5.3% year-on-year, down slightly from 5.4% in July, its highest level since 2008. The policy rate is expected to rise 4.2%, from 4%. 3 in July. and 4.5 percent in June.

An uneven recovery in the labor market has been the counter-argument for moving more slowly towards reduction. The Delta variant is partly responsible for this, as is the mismatch between job vacancies and skills. But it is undeniable that jobs are plentiful and working conditions are improving, despite the disappointment of August. Initial jobless claims last week fell to a new recovery low, and the July Job Openings and Workforce Turnover (JOLTS) report showed a record 10, 9 million job openings.

Fiscal policy is changing and investors are on the lookout for any surprises

Fiscal policy is also changing. Emergency spending designed to move the economy forward rapidly in the aftermath of the pandemic has been financed primarily through debt. The federal budget deficit for fiscal 2020 was 14.9% of GDP. The 2021 budget deficit, which ends in three weeks, is expected to total 13.4% of GDP. (For those with a nostalgic inclination, the budget was last balanced twenty years ago).

By contrast, the current surge in spending on both physical and social infrastructure is expected to be funded, at least in part, by higher taxes. High income businesses and individuals are in the crosshairs. Developments are moving rapidly, although Democratic Senator Manchin said yesterday that he doubts the September 27 voting deadline can be met. But a glimpse of the proposed tax increases is starting to emerge. A discussion paper released to Congress would call for an increase in statutory corporate income tax to 26.5 percent, from the current 21 percent. That’s lower than the 28 percent preferred by the White House, but higher than the 25 percent rate preferred by moderate Senate Democrats. The top individual bracket would rise to 39.6% and include a surtax on income above $ 5 million. Capital gains would drop from 20% to 25%, excluding the current increase in investment income. The proposal also contains some changes to the inheritance tax regime, although an effort to eliminate the current raised base provision has met strong opposition, even among Democrats.

There is no doubt that politics is changing and investors are on the lookout for any surprises. But it’s also important to remember that the economy remains healthy and that balance sheets, both corporate and personal, are strong. And while some tax code changes are on the way, they will come against the backdrop of yet another round of massive federal spending, even if that spending turns out to be lower than the White House would prefer.

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