Part I: Venture Capital Investing in the EU vs. US — VC Funding Availability

Relationships between VC funding and macroeconomic factors and their respective impacts on Europe and the US

This is the first 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.

How does VC funding impact innovation and technological revolutions? What determines the availability of start-up funding in a country? Why does the abundance of start-up funding in a country play such a key role in economic development and growth?

Innovation and technological revolutions are determined largely by the success of new start-ups. The strong relationship between Venture Capital funding and the success of start-ups in a country therefore provides support for the central role of VC funding on innovation and techno-economic progress.

But, what are the reasons for the correlation between VC and successful innovation?

Simply put there are five main reasons:

  1. Access to future capital — VC-backed firms can raise funds more easily in the future
  2. Positive signal to the market — Results in more future investors and potential acquirers
  3. Network — VCs provide an amazing built-in network of people who can help the company
  4. Experience — VCs are often seasoned professionals and entrepreneurs who know how to lead a company
  5. Cash — The four little word that every start-up so desperately needs is exactly what VCs provide, and is arguably the most crucial

With more start-ups succeeding in a country through either: transforming into larger and more mature companies or being acquired, it stands to reason that this organic and inorganic growth respectively is healthy for a country’s economy.

Studies show that venture capital has a very positive effect “on a series of economic performances, both at a micro‐level (e.g. firm growth and innovativeness) and at a macro‐level (e.g. entrepreneurship rates, employment, aggregate income).

Economic Determinants on Venture Capital

I researched ways in which the availability of venture capital funding could be impacted by different economic variables. The five variables that I looked at to find a correlation between VC funding availability were: a) unemployment rate (% of total labor force) b) GDP growth (annual %) c) human capital index (HCI, on a 0–1 scale) d) inflation (consumer prices %) and e) Total Market Capitalization of domestically listed companies.

I theorized that unemployment rate and inflation would both show a negative correlation, meaning that the lower inflation and unemployment rate a country had, the more VC funding was available for start-ups. I then hypothesized there would be a positive correlation for GDP growth, HCI, and total market cap with VC funding availability.

All of the data was pulled from The World Bank with a baseline year of 2018, and the regression was run on 35 various countries to make it as diverse as possible.

The results of the regression analysis are shown below:

First, we see that the unemployment rate has a negative correlation with the availability of VC funding, and a statistically significant relationship. The results show a negative relationship which means that if it is a causal relationship, it would generally mean that the lower the unemployment in a country, the higher the availability of VC funds for start-ups or new firms. This seems to make sense, as poorer countries will generally have higher unemployment rates, and less VC funding, while richer countries like the US, UK, and others have lower unemployment rates and a great deal of VC funding availability.

The picture above shows the unemployment rates in the EU and how the northern parts have lower unemployment, and therefore potentially more VC funding available for start-up founders.

Moving on to GDP growth, the regression showed a negative relationship and statistical significance. This was surprising, but relooking at some potential reasons why, it could be that VC funds are more available in countries that are more mature and developed rather than emerging economies. I would conjecture that if the relationship was causal, most investment in countries with high GDP growth comes from foreign investors and VC firms, living in more developed countries.

The third variable was Human Capital, which showed a positive relationship, but the p-value was 0.28, meaning that it had a large standard error and was not a strong correlation. One reason for this could be the fact that the scale of HCI was only 0–1, with little discrepancies between countries. With little variance, it is harder to find a strong correlation for countries that have higher VC funding availability than those who do not based on HCI alone.

The fourth variable tested was inflation which showed a negative correlation and a low p-value. In essence, this relationship (if causal) would mean that countries with lower inflation have more VC investment. Without high inflation or hyperinflation, a country’s currency is more stable.

This relates to my previous point on GDP growth, as countries with low inflation and slower GDP growth are already global superpowers with stronger and more developed economies — and therefore more available VC dollars.

The final variable was the total market cap of listed companies within a country. The results for this show a strong positive correlation and a very low p-value. This mimics other studies done on this relationship and only furthers the other results that seem to point to the idea that VC funding is most available in countries with large and developed economies. One reason for this could be that VC firms main goal is to have the companies they invest in IPO or be acquired by other businesses, as this provides them with liquidity. So, countries with large stock markets and many companies who have been successful in the past in doing just that, would generally give VCs an incentive to invest in start-ups in those countries.

This could be a causal relationship as described, or a reverse-causal relationship. A reverse-causal relationship could mean that VC funds being more available in a country dictates the size of that country’s total market capitalization, whereas a causal relationship would be the inverse. Either way, it is an important relationship that shows you how crucial VC funds are in helping smaller countries to grow while enabling more powerful countries to maintain their position/status in the global economy.

The results suggest a defined relationship between large and developed countries with strong labor markets (such as the US, Germany, Singapore, the United Arab Emirates) and the availability of VC funds. Being a global economic force correlates with a lower unemployment rate, lower GDP growth, lower inflation, a higher market cap, and generally more access to human capital.

These variables probably all affect one another and play a significant part in their GDP/capita and other measures of wealth, but most importantly the scarcity or abundance of funding for start-ups.

Who has more VC funding available — EU vs US

The above just serves to show some of the factors that play a role in where VC funding is available. Most people already know that VC investments in the US dwarf any other country in comparison, but did you know that the US accounts for over 50% of global VC investment?

Over the years, the number has actually declined and then picked up the last couple of years. Why is this? Again, many of the macroeconomic factors discussed above.

The non-macro economic determinants can be summed up in two words: Silicon Valley. The Valley has repeatedly produced massive tech companies and allowed for start-ups to succeed like nowhere else in the world. The power of the Valley lies in its ability to connect start-up founders with willing investors. But, many other cities can do the same thing (and in fact many have tried to replicate the Silicon Valley model). So what truly separates the Valley? Is it the social signaling aspect? Something in the water? According to Paul Graham, it really is about connecting investors, or “rich people” as he calls them, with founders, or “nerds.” But, these types of people want to live in a certain type of city, one with character, charm, and good weather of course. The other factor that Graham identifies is human capital and the simple idea that the smartest “nerds” typically go to the best schools with the best CS programs (Stanford, Berkeley).

That is why the Bay Area dominates in terms of VC investment and availability, despite it being the smallest on this list in terms of population. Human capital is the one thing that is so hard to replicate.

Yet, the EU has tried to do just that and wants to mimic the success of Silicon Valley. Over the past 8 years, it has continually invested more and more into start-ups.

So where does it fall short? Find out in the next blog: Venture Capital Investing in the EU vs. US — Part 2: Where Europe Falls Short

I hope you enjoyed this post and if you have any questions, comments, or concerns please comment below!!

Links to next posts:

Part II: Venture Capital Investing in the EU vs. US — Where Europe Falls Short

Part III: Venture Capital Investing in the EU vs. US — How Europe Can Close the Gap



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Jonathan Kendall

Jonathan Kendall

Startups & VC with a ~dash~ of philosophy