Part II: Venture Capital Investing in the EU vs. US — Where Europe Falls Short
The Macro Factors Leading to the EU’s Shortcomings in VC & Entrepreneurship
This is the second Medium post in a three-part series that will look at the discrepancies between VC investing in the US vs. Europe, and the EU in particular. The series will take a macro-perspective on the issue and look for various correlations and variables that play a role and then seek to prove or disprove common sense intuitions on the possible discrepancies and reasons for them.
As we saw in the first post in this series, VC investing & the availability of funds for startups are closely intertwined with economic variables. Below, we see how the dollars invested in European startups increased by ~$7bn from 2018–19, yet there was a drop-off in deal volume. I won’t speculate on possible reasons for this, but it is interesting to note that VC investing on average from 2015–2017 in Silicon Valley was $27.3bn which dwarfs Europe as a whole during the same time period. So why does Europe fall so short even though the population exceeds that of the US by nearly 200M people?
The role of the government is crucial in promoting VC investment, along with economic growth and will therefore be the first component that we will take a deeper look at.
Government Regulation & Policies
Economic and political policies are driven by two kinds of government intervention and policy: direct and indirect. How does the EU compare against the US in terms of direct policy moves?
The US has created a program called the Overseas Private Investment Corporation (OPIC) which offers small business loans, finance, political risk insurance, loan guarantees for US companies taking projects abroad. The US also has legislation that gives loans to small businesses, and a whole government agency dedicated to their support: the Small Business Administration (SBA). Europe has tried to replicate some of this, but has not devoted nearly enough time to coming to a proper solution or enough capital.
Another direct method in which the governments in the EU and the US differ in their support of new business formation is through tax incentives. High tax rates can be a serious impediment for economic growth; when governments reduce capital gains taxes, it promotes VC investment and therefore new businesses. The US has been in a period of low interest rates, low corporate taxes, and currently considering a capital gains tax cut as well. The EU’s tax rate differs by country, but a majority have higher corporate tax rates and many have higher income and capital gains taxes as well. These factors contribute to investors investing their money in the US rather than Europe.
Some indirect methods in which governments can promote entrepreneurship is through better legal infrastructure. This includes copyright and patent systems and their cost, bankruptcy laws, and litigation risk. While Europe has an efficient patent process, it is considerably more expensive (4–5x more) than the US and their bankruptcy laws make it much more difficult for entrepreneurs to start a second business if their first does fail and result in bankruptcy.
In the US, going through bankruptcy does not harm an entrepreneur’s reputation nearly as much, and actually gives a positive signal for some investors in the form of experience and understanding of how to not fail (again). The litigation risk in Europe is actually one positive that it does have over the US, as the average lawsuit won for large companies suing smaller businesses is much lower than in the US; this in turn, helps to persuade entrepreneurs to take risks even if it could result in a court case or patent infringement. Overall, economic and political policies greatly favor the US and promote more entrepreneurship and VC investment than their EU counterparts.
The first important part of capital markets for start-ups and new businesses is venture capital. VC funding in the US has been historically larger due to the fact that the US market has pension funds, insurance companies, major endowments, fund-of-funds and family offices all backing venture funds, which isn’t the case in Europe. Europe lacks the large university endowments that are heavily committed to venture capital and make up such an important LP (limited partner) set in the US. European investment instead continues to be led by state funds and family offices, which means that the development of a broader LP base will be a key development for the next 20 years if they plan to close this gap with the US.
A second important point that has limited VC investment in Europe vs. the US is that VC returns in Europe have been historically lower than their US counterparts. In this study, they found that this was for largely four main reasons, “(1) European fund managers monitor their portfolio companies much less frequently than their U.S. peers, (2) European VC funds face less liquid markets, both in terms of human capital and in terms of exit strategies that are available to them (forcing them to shop around longer when it comes to replacing key employees or selling shares in one of their ventures), (3) European venture capitalists syndicate less frequently, thus incurring higher risk, and (4) European venture capitalists are much less likely to use convertible securities.”
With lower returns, it makes sense that European VC firms have a harder time raising capital and therefore invest less money in start-ups when their returns are generally lower than firms in the US. Yet, VC is only one aspect of the capital markets. Debt, crowdfunding, and self-funding are all good options to help fund a new business. Crowdfunding companies such as Indiegogo and KickStarter were both started in the US and help more US companies raise capital. As we discussed above, the US generally has a better small business loan program as well.
The last component that goes into capital markets funding and availability is the ability of start-up companies to exit either through being acquired or being listed publicly (IPO). This chart below shows the wide gap between VC-backed exits in the US vs EU between 2012–2016.
Governments have become very interested in promoting as many exit opportunities for companies as possible through larger public markets, smaller exchanges, and different financial laws for M&A deals.
The valuation of companies upon exit is also key for VCs to get a high return on their invested capital. Research by GP Bullhound notes that unicorns in Europe are typically valued 18 times their revenue, while in the U.S. unicorns are valued 46 times their revenue. With higher exit multiples, it makes sense that entrepreneurs are more likely to start a business in the US than in Europe, as they see that they can return more money on their invested time and investors get a larger return on their invested capital. This fact whether it be known to entrepreneurs consciously or subconsciously, certainly has an impact on their willingness to devote their time to starting a business or joining an already established business.
Human capital is an important consideration when we look at the start-up cultures in the EU vs the US. Human capital can be defined as the traits, skills, intelligence, ability, and experience that allows one to contribute value to a company or organization. Some of the traits and characteristics of a good entrepreneur are that they are not risk-averse, excellent leaders, independent, smart, charismatic, and well-spoken. American entrepreneurs differ from their European counterparts mostly in the categories of risk-aversion and independence. The pioneer spirit of early settlers in North America came with the belief that hard work and a good attitude can help one to achieve anything; this fostered a strong entrepreneurial spirit in Americans early on. The government has similarly promoted entrepreneurship through its bankruptcy and patent laws and lending programs as discussed previously. While Europe has sought to catch up with the US in this regard, Europeans tend to be more risk-averse. This means they are less likely to go out and start a business in the first place and tend to be job seekers rather than job creators. This is not a bad thing, but more a result of the government factors and culture.
In the US, being an entrepreneur is a part of the American dream; we are taught from a young age that it is a good thing to take risks because many times you will be rewarded.
Even if you fail, it is an amazing learning opportunity. Another important consideration is intelligence and its relationship to VC funding and start-ups. In the US, Silicon Valley is known as the epicenter of start-ups in large part because of its large presence of VC firms. The reason that VCs tend to linger in northern California (besides the weather) is the access to young, talented entrepreneurs. Whether they be from Stanford or UC Berkeley, or other schools in California, some of the best human capital is right in their backyard. Similarly, Boston has a hub of top-notch human capital with schools like Harvard, MIT, Boston University, Boston College, and others that fuels their bio-tech scene. Europe has a tough time competing with this, as many of their own brightest students decide to head to the US for higher education.
How the EU has Attempted to Close the Gap
To combat this, Europe has been aggressive with creating incubators and accelerators to congregate talent and human capital under one roof.
“The efforts of Western European policy makers to support start-ups through incubators are in line with a global trend: the number of incubators increases rapidly around the world, which has led to a diverse global population of incubators and related start-up support initiatives” (van Weele, 2018).
This study delves deeper into why Western Europe has chosen to use incubators so heavily across their cities. In short, the main reasons are that it fosters a sense of community, there is healthy competition among start-ups, mentorship from advisors, access to investors, educational and technical expertise, and protection from institutional shortcomings.
Yet, this is still not enough to overcome some of the EU’s failed policy changes. The authors conclude with,
“As such, incubators do not address the institutional causes of malfunctioning entrepreneurial ecosystems but provide symptomatic solutions instead. Consequently, whereas prior studies emphasized the potential of incubator’s in contributing to entrepreneurial ecosystems, our study points at the limitations of incubators in strengthening the entrepreneurial ecosystem.”
So, while incubators and accelerators are a noble attempt at helping foster a better start-up culture in Europe, ultimately they fall short of their goal.
In the final post in this series, we will explore some better solutions to how the EU can better compete with the US in terms of VC funding returns, availability, and fostering economic growth through new startups.
I hope you enjoyed this post and if you have any questions, comments, or concerns please comment below!!
Links to other posts: