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Central Europeans like to remind visitors of the great thinkers and innovators their countries have produced: inventors like Nikola Tesla, László Biró, Jozsef Murgaš and Edward Teller, composers such as Anotinín Dvorak and Miklós Rózsa, mathematicians like Benoit Mandelbrot and Pál Erdôs, and writers such as Józef Korzeniowski (Joseph Conrad) and Milan Kundera.

When pressed, Central Europeans will also concede that many of their greatest native sons – including those listed above – only achieved greatness in exile. This is the region’s historical dilemma: How to ensure that local innovators have an opportunity to be successful at home.

The most obvious piece of the puzzle is money. It takes capital to develop a novel idea into patentable intellectual property or a healthy, growing business.

The good news in 2006 is that money is now available – perhaps more than at any other time in the region’s troubled history. It is still an open question, however, whether Central Europe’s professional investors are ready to direct that capital toward riskier, early stage investments in innovative companies.

The goal of this whitepaper is to provide an overview of the venture capital environment in Central Europe, particularly as concerns investments in innovation. This paper focuses on Central Europe as a region because most investors address this region as a whole.

Making a case for funding innovation

Many observers arriving in Central Europe in the early ‘90s took note of the region’s large pool of IT talent and concluded that the region would soon be a hotbed of software development and innovative new companies.

Indeed, Communist educational policy had placed a strong emphasis on technical training. Journalists wrote glowingly of ‘Silicon Pusztas.’ Some observers even went as far as to declare that the various peoples of Central Europe had a native proficiency for higher mathematics and computer programming. Perhaps.

What these early optimists failed to note was that Central Europe was sorely lacking in other skills necessary to build successful businesses - in particular management, marketing and sales skills. In any case, investors arriving in the region weren’t particularly interested in funding technology ventures; they preferred larger privatization and infrastructure deals. So it went for most of the ‘90s.

The handful of innovative companies that did manage to establish themselves in Central Europe during the ‘90s proved to be exceptions rather than the rule. Such early innovators included Netbeans, in the Czech Republic, and Graphisoft and Recognita in Hungary.

From an investor’s point of view, the most obvious downside to funding innovative businesses is that they are inherently risky. Add to that the economic and political uncertainties of Central Europe in the last decade of the 20th century and it seems obvious why so few pioneering businesses in the region were able to obtain venture capital backing.

A less intuitive problem is that early stage innovators in Central Europe require relatively little money to develop their ideas. A venture capitalist needs to spend the same amount of energy and effort to manage a half million-dollar deal as five million dollar deal. A shrewd investor would rather manage a small number of big investments rather than a large number of smaller deals.

In the end, the most persuasive argument for investors to fund early stage innovators is that larger privatization and infrastructure deals have mostly dried up. And while buyout deals remain attractive, those opportunities are relatively few. By the end of the 1990s, the region’s investors were looking for new opportunities, and this coincided with a worldwide hysteria for speculative technology investments.

Central Europe’s dotcom experience

In 2000, stimulated by the frenzy of the global dotcom boom, the region’s venture capitalists invested an unprecedented $100 million in Hungary. This figure represented an increase of 150% over the previous year’s investment total which, granted, was depressed due to the Russian crisis of 1999.

The majority of Hungary’s 2000 investment activity was directed toward early stage companies in more innovative sectors. According to the Hungarian Venture Capitalist Association, 70% of the year’s total went to deals in telecommunications, media, entertainment, IT and medical technologies. The majority of funds were placed in early stage deals under $2.5 million.

While no similar research was conducted in the Czech Republic, Slovakia or Poland for 2000, anecdotal evidence suggests the investments figures were not nearly so high in Hungary’s neighbors. Nevertheless, this phenomenon was regional in nature. According to the HVCA, half of the money invested in Hungary that year went towards deals that addressed regional or global opportunities.

The inevitable dotcom crash hit Central Europe just as in the rest of the world, and the results were just as predictable. Funds around the region curtailed their activities and cut off funding to their more dubious investments. US investors pulled back from emerging market investments, including Central Europe, however European investors were not yet ready to take up the slack. Investment in Central Europe slowed dramatically, as in the rest of Europe.

The longer-term consequences of Central Europe’s dotcom experience may be more positive. The 2000 investment boom demonstrated that a new generation of managers had come of age in Central Europe, many of them having cut their teeth at multinational companies. By 2000, several of these young executives were ready to take the plunge as entrepreneurs, or as members of startup management teams. In the same fashion, many of the Central Europe’s investors were prepared to work with more innovative deals. That year, the HVCA identified nine venture capital funds geared specifically to early stage deals.

Most of the those funds have since pulled back from their commitment to early stage investments and many of those 2000-era entrepreneurs are now pursuing more conventional careers. Nevertheless the precedence has been set. Six years after the fact, Central Europe’s dotcom hangover is beginning to fade; As the European economy swings toward recovery and growth, such high-risk high-return deals are becoming more attractive.

Europe’s private equity sector matures

In 2006, Central Europe’s prospects are looking up because Europe’s private equity market is showing strong signs of maturity.

According to the European Venture Capitalist Association, 2005 was a banner year for private equity. Last year, Europe doubled the amount of investment funds raised to €60 billion. The increasing number of exits gave investors further grounds for confidence. The European private equity sector was also buoyed by the increasing openness of the debt market, enabling more highly leveraged deals and earlier refinancing.

Europe’s investors were particularly encouraged by the continent’s increasing IPO activity. In 2004, a record 318 companies launched shares on European bourses, amounting to triple the activity of the previous year. Europe’s IPO performance even exceeded the US result of 235 issues in 2004, according to Thomas Financial. By November 2005, the value of European IPOs reached €43 billion, a 48% gain over 2004.

These positive signals should have the effect of drawing further investment into the European private equity market. In a survey of EVCA members, 49% expected their fundraising opportunities to improve in 2006. This increased confidence is also likely to result in further investment: 63% of EVCA members indicated they would increase their activities in 2006.

Central Europe follows in step

While Central Europe is still considered in a separate category than the rest of Europe, the region is warming the hearts of investors with similarly impressive results. Central Europe’s entry into the European Union has removed the region’s emerging market stigma. These and other factors are attracting an inflow of investment capital.

The most spectacular European exit of 2005 was, in fact an Eastern European deal: the $2.6 billion sale of the Estonian technology startup, Skype. Other noteworthy exits in recent months include the sale of Orange Slovakia to France Telecom ($628 million), the sale of Czech software vendor, Systinet, to Mercury Interactive ($102 million) and the successful IPO of Polish biotech company, Bioton. The Warsaw Stock Exchange has performed especially well in the last year, and a local index of technology stocks, the TechWIG, has risen more than 40%.

In step with the Euroepan trend, buyouts have become increasingly popular in Central Europe. The largest recent deals have been Mobitel, a €1.2 billion deal, financed with 650 worth of debt, and DGS, a €100 million deal including 40% debt. Another encouraging sign is that a number of the region’s financial institutions are developing buyout practices, including PeKaO, BPH and Erste Bank.

Europe’s investors are increasingly bullish about investments in the region. According to a recent EVCA survey, 95% of members polled agreed that EU accession has increased investor interest in Central Europe, while 84% said that limited partners share this interest. Of the 46% of EVCA members who had already invested in the region, two thirds have increased their activities over the last year.

Significantly, none of the EVCA members polled indicated they were investing in early stage deals in Central Europe.

Closing the funding gap

According to EVCA data, the majority of the region’s funds are chasing later stage deals (64%) while a handful of funds are prepared to invest in all stages (18%). To some degree this mirrors the European trend; Limited partners on the continent tend to take a dim view of venture capital.

In fact, early stage deals in Central Europe are just too small. One former champion, 3TS Venture Partners, stopped investing in early stage after raising $100 million for a new fund. At that scale, it no longer made sense to focus on $1 million deals.

Could angel investors play a role? In the United States and Western Europe, business angels are wealthy individuals who usually offer not only cash, but often know-how and connections. According to research conducted by Andreasz Kosztopulosz of the University of Szeged, just 18 individuals in Hungary have played the role of business angel. The numbers of active angels in neighboring countries is likely even smaller.

In the end, the public sector has stepped in where the private sector is failing. With its 2000 Lisbon Agenda, the European Union declared its intention to close the ‘innovation gap’ with the United States. The European Investment Fund supports innovation by working as a ‘fund of funds’ that targets early stage investments and by providing guarantees to cover the credit risk of loans or leans. Under the Competitive Innovation Framework, the Commission provides additional support through a number of specialized initiatives, including FP6 and FP7.

Many Central European governments have matched this effort with similar, programs of their own, including tax breaks for R&D expenditures (Central European R&D budgets are still among the lowest in Europe). Other initiatives included specialized developing funds, reform of laws allowing university spin-off companies, and financial support to qualified spin-offs. It’s still too early to gauge effectiveness of these measures, and some even argue that this public money in fact distorts the market, but there is no conclusive evidence that this is the case.

Has Central Europe succeeded in solving its innovation dilemma? The answer is a qualified ‘maybe.’ The region’s investment climate has improved considerably over the last five years, to the point where investors no longer see much difference between ‘developed Europe’ and its poorer Eastern cousins. Early stage companies may still find it difficult to obtain VC funding in the region, but this problem is by no means unique to Central Europe. The European Union and local governments now offer a variety of initiatives to support innovation.

Nevertheless one can’t help thinking Central Europe is a modest stage for its truly great innovators. Local markets are small, and many ambitious businesses are inevitably global in nature. In 2006, Central Europe’s great minds no longer emigrate due to war, persecution or economic hardship, but they may find more attractive opportunities in Silicon Valley, New York or Tokyo. At least now they can choose.