With only 7 per cent of the world’s population, the EU makes 20 per cent of global R&D investments and has a leading position in global public R&D investments. It produces one third of the top 10 per cent most cited scientific publications worldwide. However, the EU does not manage to turn its scientific excellence into innovations as quickly as its main competitors. Science Business
Over the past few years, Europe has been catching up in terms of both size and professionalism of its venture capital industry. However, let’s not forget that we still see significantly less venture capital invested ($23bn in Europe vs. $130bn in the US and €92bn in China in 2018) and, even more so, relatively few startup success stories (as of February 2019, the EU only had 33 unicorns vs. the US with 151 and China with 83). This article explores eight popular theories as to why Europe has been so slow in the development of a venture capital landscape and what it could take to really catch up.
1. Too late in the game
The “father of venture capital”, Georges Doriot, established the first venture capital fund as early as 1946, the American Research & Development Corporation (ARDC). Over the next decades, the development of the VC industry would be basically monopolized in the US. Europe entered the VC game only in the mid-1990s. As such, Europe of course has a lot to catch up on — and has been catching up over the past couple of years (2018 saw 4.4x the level of 2013 in terms of capital invested). So while the timing could be seen as the main contributor to a weaker industry, it puts into question why regions such as Israel and China (which both started their VC activities not much earlier, in the 1980s) have been able to overtake Europe in the meantime. So while time will have definitely played a role in the development, it can’t be the only reason.
2. No support from the government
The role of governments in venture capital is argued about: on the one hand, many studies have found an underperformance of government funds and little correlation between government investments and the creation of entrepreneurial companies. On the other hand, it was found that especially in less developed VC regions, investments by the government were able to significantly increase private investments as well. Asia, for example, was at the same funding level as Europe in 2012 and has since caught up with the US due to massive amounts of government investments.
While the US government started supporting innovative ventures much earlier (as early as World War II, where they gave financial support to military research), Europe realized this potential only much later. By now, however, with the creation of the European Investment Fund (EIF) as well as many initiatives and grants on national levels, such as the German High Tech Gründer Fonds (HTGF) and the Austrian AWS, Europe seems to have caught up in terms of government budget available to venture capital (at least with the US).
3. Few late stage investors
One of Europe’s weakest spots has remained the ability to provide later stage financing after series A rounds. Still today, most later stage investment rounds in Europe are led by non-European investors: Softbank (Japan) led the €460M investment for Auto1, DST Global (Russia) led the $250M investment in Revolut, Mubadala (UAE) led the €110M investment round for WeFox,… Or, looking at the numbers: in 2018, out of a total of $23bn VC money invested in 2609 deals, $3.8bn came from Asian investors in 127 deals (Atomico’s The State of European Tech). In other words: Asian investors accounted for almost 17% of VC money in Europe but only 5% of the deals, i.e. they mostly participated in later stage deals. Practically speaking, this means that in order to be able to sustain their companies after the initial investment rounds European founders have to start looking outside of the European VC ecosystem or find a seed investor that has connections to venture capital funds that can follow-on.
Going more upstream, the attempt to create a European equivalent to the tech stock exchange NASDAQ, e.g. the EASDAQ, failed, with most still existing stock markets showing very little activity. Statistically, European startups are more likely than their US counterparts to exit via a (less lucrative) trade sale.
4. Lack of pension funds investments
Pension funds have been the biggest source of contribution to venture capital funds in the US, providing up to 20% of all investment money. Compare this to Europe, where pension funds account for only little more than 2% of all funds raised since 2013. The Nordics are a clear outlier here, where pension funds account for 16% of total capital committed in the region (Atomico), with the GSA region naturally on the other side of this spectrum. Pension fund managers highlight various difficulties with VC investments: returns are only made in the long-term (cf. the J-curve), a weak secondary market in Europe makes the investments even more illiquid and of course the high risk involved with investing in start-ups. On the other hand, Swedish pension fund managers highlight diversification and a longer-term strategy, and they seem to be satisfied with returns so far: a new rule in Sweden implemented in 2018 allows private pension schemes to now put up to 40% of their money into alternative investments.
Whether one is an advocate of using pension fund money to finance risky ventures or not: given the enormous amounts of money available to pension funds, this puts European VC funds at a clear disadvantage. And it highlights how risk aversion can be a huge disadvantage in the tech sector.
5. No successful exits
In a vicious circle, the fact that Europe has been unable to grow and retain tech giants such as Facebook and Google also leads to fewer opportunities for startups: in total, Microsoft has acquired 189 startups, Cisco 193 startups and Google as many as 214 (Visual Capitalist). In terms of money, these three companies together have already spent $175bn on acquisitions — investment money that is not as easily available to startups in Europe. Aside from the monetary implications, this is also means a lack of experienced talent that could go on to found new startups: take the Paypal mafia as an example, and even the employees of the very first VC fund, ARDC, would later go on to start their own funds.
6. Small country sizes
Another theory is that before merging towards a single market, European countries were simply too small to provide an interesting “playground”. Why would any founder consider investing resources into starting up a tech company with significant risk, when the first total addressable market is limited by the economic size of a small home country? Most EU citizens today have forgotten how hard it was to do business outside of one’s home country in Europe. But consider how just one scheme introduced in 2015, the VAT Mini One Stop Shop (MOSS), has simplified this, whereby companies don’t have to register with tax authorities in every EU country they sell in.
Other examples for making the EU a more unilateral market include of course the introduction of the Schengen area and more recently the introduction and amendment of the EuVECA scheme to allow for easier pan-European fundraising.
7. Lack of founder culture and characteristics
Americans simply seem to be better sales people than Europeans, something that I already detailed in an earlier blog post on the Silicon Valley. It’s hard to imagine a European Steve Jobs, describing the vision of Apple, and then in the next sentence providing a disclaimer as to why the company has not reached this vision yet (something that I have heard European founders do countless times, but never an American founder). It’s difficult to be captivated by the vision of a founder when he/she has already pushed all the risks on top of your mind (cf. don’t think of the pink elephant). And while this risk aversion was surely a major contributor to our advances in e.g. the automotive and insurance industries, it’s not helping in the risky and fast-paced world of start-ups.
In 2017, Index Ventures and Balderton Capital (both VCs at least originated in the US) started a campaign to highlight the benefits of giving out equity to employees, after realizing that European ESOP levels were only around half of the levels in the US (10% vs. 20% in later-stage companies). However, based on personal experience I wonder whether this is because the founders want to keep equity to themselves, or because employees simply do not understand the potential value that equity can have. I’ve already heard of several occasions where employees have turned down ESOP for a higher fixed salary: are Europeans more risk-averse, do they see a higher salary as more prestigious, or are there simply too few successful exit stories in Europe? Or is it because the level of applied taxes in Europe washes out the gains from employee options anyways?
Then again, from founder side I’ve already seen ESOP being used to decrease the founder dilution after a final pre-money valuation was agreed on (e.g. think decreasing the ESOP by a few percentage points, or putting in the ESOP before vs. after the investment) — a practice that does not imply that these founders have understood the true value of incentivizing their employees with a sufficient amount of shares.
8. A broken VC model
A somewhat similar theme to the above has occurred in European VC funds. There has been lots of criticism around the fact that many VC funds here are effectively managed by people who are not incentivized by performance but by a fixed salary, i.e. they don’t have “skin in the game”. More specifically, it’s not common in Europe for fund managers to invest their own money into a fund — which is positive in a way that it doesn’t necessitate these managers to own such an amount of money in the first place. But on the other hand, the 2/20 incentive scheme of VC (2% fixed management fee, 20% carry: I’ve already covered this topic here) combined with the historically low performances of European VC funds means that fund managers can easily live off the fixed management fee, which in turn means they have little incentive to work hard to support their portfolio companies after having invested. Consider sharing a yearly 2% management fee on a €20M fund with one other partner over the whole life time of a fund (typically 10 years) — sounds like a good living to me. Some Europeans funds, mostly raised in the past couple of years, are openly criticizing this approach and have created new fund models, e.g. our fund, Speedinvest, and The Family.
The real question that remains is whether the European ecosystem will be able to catch up based on the current infrastructure and players. While many have been highlighting the strong growth rates in VC capital raised and invested, the real challenge will be to invest this into companies that grow to be “unicorns” — and these are notoriously still lacking: of the 20 most valuable tech companies in the world, not a single one is based in Europe.
So, what is the key to producing these unicorns? Should we pump more government money into the system, as China did? Incentivize pension funds to invest their funds into VC, as the US did? Continue making it easier for startups and VCs to be established and do business across the EU? Stop trying to fit a framework that was originated in the US to our very different culture and start finding our own technology niches and VC models? Or were we simply too late in the game, and a combination of the above theories has led us to a dead end?
At Speedinvest, we’re currently raising our third fund with an investment volume of $175m for European startups. Moreover, we’ve already helped several of our startups raise their follow-on rounds in the Silicon Valley. Whether our portfolio companies stay in Europe or move to the US: we’re committed to closing the funding gap in Europe.