Many economists believe that innovation is one of the main building blocks of economic growth and job creation. Not all economic infrastructures, however, are equally supportive of innovation. In 1995 venture capital investments in Europe amounted up to 4 percent of total Gross Domestic Product (GDP), compared to 6 percent of GDP in the United States. During the second half of the 1990s, European and US venture capital investments experienced an explosive but distinctively different level of growth. In fact, in 2000 venture capitalists invested an amount equal to 17 percent of European GDP in European companies, while investing 78 percent of US GDP in US companies.21 The availability of venture capital can be crucial in the development of innovation. Venture capitalists serve an important role as intermediaries in capital markets because they separate good business ideas from bad ones and bestow their reputation on the start-ups that they finance. In addition to providing capital, venture capitalists offer their expertise in management and finance and let start-up companies benefit from their network of contacts. Their close involvement with start-ups’ day-to-day operations and their ability to give finance in installments, conditional on start-ups’ success, allows venture capitalists to invest in risky business ideas that public capital markets typically ignore.

To improve young, innovative, and fast-growing companies’ access to external finance, several European stock exchanges founded separate trading segments for this group of companies at the end of the 1990s. Examples of such trading segments were the Nuovo Mercato in Italy, the Nouveau Marché in France, the NMAX in the Netherlands, and the Neuer Markt in Germany. These new markets coordinated some of their activities under the Euro.NM umbrella. For example, starting in 1999 the markets facilitated cross-border electronic trading to create a pan-European exchange. Another important way of cooperation was to harmonize the admission requirements for new listings.22 These requirements were not easier to comply with than the admission requirements of the traditional, established trading segments of the European stock exchanges. On the contrary, the common idea was that a separate trading segment for innovative fast-growing companies needed stricter regulation than the established segments that targeted matured companies with proven track records. If this was true, having (some) common listing requirements across European new markets helped to prevent a race to the bottom in which companies would flee to markets with lenient listing requirements and markets would start to compete with each other on the basis of their leniency.

The European new markets had also harmonized some of their disclosure requirements. All new markets required that companies produced quarterly reports of, at least, sales figures. Further, most of the new markets required that companies prepared their financial reports in accordance with either US GAAP or International Accounting Standards.

Given the opportunities for electronic cross-border trading, strict disclosure requirements could help in broadening companies’ investor base as well as improve investors’ opportunities for diversifying their risky investments. However, because the new markets experienced difficulties in further harmonizing their admission and listing requirements and eventually came to realize that the small cap companies appealed primarily to local investors, their cooperative venture was dissolved in December 2000.

One of the European new markets was the Neuer Markt, a trading segment of the “Deutsche Börse,” the German stock exchange. The Neuer Markt’s target companies were innovative companies that opened up new markets; used new processes in development, production, or marketing and sales; offered new products or services; and were likely to achieve above-average growth in revenue and profit. On March 10, 1997, the initial public offering of Mobilcom AG started the existence of the exchange. The offering of Mobilcom’s 640 thousand shares for an issue price of €31.95 was heavily oversubscribed, as €20 million additional shares could have been sold.

Mobilcom’s closing price at the end of the first trading day equaled €50.10, yielding an initial return of 56.8 percent. Other success stories followed. For example, on October 30, 1997, Entertainment München, better known as EM.TV, went public on the German Neuer Markt. The Munich-based producer and distributor of children’s programs was able to place 600,000 of its common shares at a price set at the upper end of the book-building range, collecting approximately €5.3 million in total. There was a strong demand for the company’s shares. At the end of the first trading day, the share price closed at €9.72, up by 9.4 percent. At its peak, in February 2000, EM.TV’s share price had increased from € 0.35 (split-adjusted) to slightly more than €120.

At the end of February 2000, being close to its three-year anniversary, the Neuer Markt comprised 229 companies with a total market capitalization of approximately €234 billion. However, in March 2000 the downfall began, in line with the plunge of the NASDAQ exchange. In September 2000 Gigabell AG was the first company to file for insolvency. The total market capitalization of the growth segment of the Deutsche Börse declined further from €121 billion (339 firms) at the end of 2000 to €50 billion (327 firms) at the end of 2001. Because both the “going public” and the “being public” requirements were very strict compared to other segments and markets, several companies left the Neuer Markt, changing to the less regulated Geregelter Markt. During the first years of the 2000s, several Neuer Markt firms were found to have manipulated their financial statements.

For example, in September 2000 EM.TV announced that it had overstated the revenue and profit figures of its most recently acquired subsidiaries, the Jim Henson Company and Speed Investments, in the company’s semiannual financial statements. Following this announcement, EM.TV’s market capitalization declined by more than 30 percent. Other examples include computer games developer Phenomedia and Comroad, a provider of traffic information systems that was found to have falsified more than 90 percent of its 1998–2001 revenues.

On September 26, 2002, the Deutsche Börse announced that it would close its Neuer Markt trading segment in 2003. The remaining Neuer Markt companies could join the exchange’s Prime Standard segment, which would adopt the Neuer Markt’s strict listing requirements (i.e., quarterly reporting; IAS or US GAAP; at least one analyst conference per year; ad hoc and ongoing disclosures in English), or its General Standard segment, with legal minimum transparency requirements. Approximately two-thirds of the remaining Neuer Markt firms decided to join the Prime Standard segment.

1 Do you think that exchange market segments such as the Euro.NM markets can be a good alternative to venture capital? If not, what should be their function?

2 This chapter described four institutional features of accounting systems that affect the quality of financial statements. Which of these features may have been particularly important in reducing the quality of Neuer Markt companies’

financial statements?

3 The decline of the Neuer Markt could be viewed as the result of a lemons problem. Can you think of some mechanisms that might have prevented the market’s collapse?

4 What could have been the Deutsche Börse’s objective of introducing two new segments and letting Neuer Markt firms choose and apply for admission to one of these segments? When is this strategy most likely to be effective?