Are we losing entrepreneurial talent due to a seed funding gap in Europe?
by Eva-Valérie Gfrerer & Tanja Jänicke
It was a great party. In the past five years capital invested in Europe was jumping from one record high to the next. While in 2017 investors spent $22 billion on the European tech industry this amount has increased fivefold reaching an all-time high of $121 billion in 2021 (State of European Tech Report). However, the money has not been distributed equally.
Data from Dealroom shows that the amounts invested did not grow proportionally along the different funding stages: While capital invested in rounds larger than $250 million (later stage) increased by more than 800 % from 2020 to 2021 capital invested in rounds smaller than $5 million (pre-seed & seed) only increased by 10%.
Looking at the growth rates between 2017 and 2021 the gap is even larger: Capital invested in rounds larger than $ 250 million increased by 1153% while capital invested in rounds smaller than $5 million (pre-seed & seed) only increased by 6%.
This means that investments in later rounds skyrocketed, while the total sum invested in earlier smaller rounds barely increased.
Looking at the distribution of capital over the different rounds the seed funding gap becomes more apparent. While in 2017, 20% of total capital was invested in rounds smaller than $5 million , i.e. pre-seed & seed rounds, this share dropped to 5% in 2021. At the same time the share of later stage investments increased from 14% to 39%.
Diving deeper in the underlying data we see that the median deal size slightly increased in the pre-seed and seed stage. However, in the later stage this growth has been much more explicit (Venture Pulse Report KPMG).
Data of the State of European Tech Report shows that rounds under $5 million dropped since 2017.
Despite an increasing inflow of capital in Europe, the number of investments in pre-seed and seed start-ups has decreased.
This hints to a serious problem: There is not enough money flowing into start-ups in pre-seed and seed stage.
In conclusion: We miss out on entrepreneurial talent. Every day.
This problem is even more pronounced for founders from underrepresented groups such as female and non-white founders (State of European Tech Report).
Why does the seed gap cause problems?
Research has shown that venture capital investments are an important driver for employment, innovation and economic growth. Empirical data shows that 40% of the companies who went public in the US between 1979 and 2015 were backed by venture capital. These 40% contributed 82% of the total research and development of the total number (Stanford Business).
Data from Dealroom and Index Ventures indicates that start-ups in Europe have become a significant contributor of new jobs in the past years.
A study by Lakestar from 2021 estimates that in Germany alone there is an average growth financing need of €80 — €100 bn per year for the next 20 years in order to keep the level of prosperity that we are used to.
But money for growth alone will not be enough. We need ideas and founders who have the courage to start a firm. We need founders who build the superstar companies of tomorrow, founders who innovate and contribute to solving the massive problems we face such as climate change, increasing inequality and finite natural resources. Those founders need funding when they start their businesses. The current numbers indicate that there is not enough support for very early-stage entrepreneurs.
What are the reasons for the seed funding gap?
One explanation for the seed funding gap is a reporting lag of seed investments. This implies that many investments in this stage are not reported and only become known to the public in later rounds e.g. in a follow-on Series A rounds. At this point, start-ups report earlier rounds and the data on pre-seed and seed deals is corrected for the previous years.
Dealroom estimates that 10% of the most current data is not included due to a reporting lag. That means the reporting lag is not the whole story. Even if we correct for that, a huge gap persists.
Another driver for the gap is the pandemic and how it changed the way venture capital operates. Researchers analyzed empirical data about funding rounds between January 2019 and July 2020 (Bellavitis et al., 2021). They find that VC investors particularly reduced their investments in seed stage companies due to higher degrees of uncertainty. Later stage companies have a track record and numbers to show which reduces the degree of uncertainty for the investor. For pre-seed and seed stage there is much less information on paper. Therefore, the information collected from personal meetings has a higher weight in the pre-seed and seed stage than in later stages.
Before the pandemic, venture capital was mainly allocated based on personal interactions. A study by Gompers et al. (2021) shows that around 90% of the dealflow come over the personal network or active outreach of the venture capitalists. Only 5% of the surveyed VCs used data in order to make their investment decisions.
Personal meetings and networking at events were the common ways to get to know the founders and acquire information about their businesses.
Due to the pandemic all these touch points were gone. Traditional VCs could meet founders only virtually, with virtual meetings not delivering as much information as personal interaction do. This resulted in a negative impact on pre-seed and seed investments.
Three reasons why data and technology can drive pre-seed and seed investments
Not all investors had to change their way of working due to the pandemic. Thomas Thurston, Partner and Chief Technology Officer at WE Hambrecht + Co, a venture capital firm which uses data analytics to make investment decisions, said in an interview in April 2020:
“The emphasis on analytics has really been helpful when you cannot fly anywhere. (…) Because the ability to sit at our terminals and look at hundreds of start-ups around the world (…) has been really helpful while a lot of my colleagues are stuck at home trying to figure out what to do.”
With more data and technology in venture capital, the impact of the pandemic on seed investment would not have been as severe.
Here comes why:
- Less uncertainty
Data and technology allow us to make predictions about future outcomes. Even for very young companies there is data out there. By using technology and a data driven approach we progress from a situation of uncertainty, in which we have almost no information, to a situation of risk, in which we can estimates success and failure probabilities. We have to use available information to give very young start-ups a fair chance of receiving funding. Relying on personal interaction limits outreach and is prone to bias.
2. Increased efficiency
Technology allows to build more efficient processes. It supports investment managers to use their limited time more efficiently which allows for higher rates of capital allocation and in turn more access to funding for outstanding teams. It leads to more diversified portfolios which will result in lower degrees of risk and higher returns for investors.
3. Increased dealflow
With more efficient processes VCs can handle more dealflow because they are not only relying on their limited time. Technology allows to source start-ups around the world. More opportunities will show up on the VC’s radar and with less uncertainty and more efficient processes, this will result in more pre-seed and seed investments.
At Morphais we invest in pre-seed start-ups because we believe that entrepreneurs are the change-makers of tomorrow. With the help of technology we identify entrepreneurial talent and allocate capital — faster, at a higher scale and more efficiently.
