Oiling Europe’s wheels: what will it take for venture capital to take off?

Despite being hailed as one of the drivers of innovation and economic growth, venture capital is lagging in Europe. What will it take for the continent to catch up with the US?

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Despite Europe struggling to attract venture capital, cities such as London (pictured) have been able sustain levels of it thanks to low corporation taxes and the creation of various innovation schemes

Venture capital is an investment sector that has been the toast of Silicon Valley and is often fawned over by politicians who are hoping to fix all kinds of economic and fiscal problems. Despite this, European venture capital is rather unloved these days. It has long been a well-known problem that Europe has never been able to muster nearly the same quantity or quality of venture capital as the US sector has and that this, in many ways, has stifled innovation in the continent. Problematically, the lack of faith in European investments and the deficient VC structure available is costing jobs. Without capital, entrepreneurs are finding it harder to get companies up and running, and this, to a certain extent, is stunting European growth.

For various reasons, investors who put up venture capital in other parts of the world – such as pension funds, banks and billionaires – are not especially eager to funnel money to start-ups battling to thrive in Europe’s often-hostile business environment. First, this comes down to the pool of potential entrepreneurs being smaller, partially because many investors fear that failure of an investment is more likely in Europe than the US. The level of expertise among venture capitalists in Europe has also been criticised, and exit opportunities are purported to be less favourable. Some of these concerns are not entirely unrealistic either, as previous research has shown a significant underperformance of European venture capital deals.

[T]he lack of faith in European investments and the deficient VC structure available is costing jobs

Numbers also don’t bolster the outlook on venture capital in Europe, which has delivered returns of just 2.1 percent a year since 1990, according to Thomson Reuters, making it perhaps the worst investment class outside Japan. In comparison, American VC managed around 13 percent yearly. This all contributes to a view that if entrepreneurs want successful backing, they need to venture outside of Europe, and if investors want to find solid start-ups to finance, the US is where it’s at.

Europe lacks venture experience
The issue of lacking expertise in the European VC sector is particularly concerning as industry research has shown evidence of persistent skill differences between entrepreneurs, and that venture capitalists identify these skills in their financing decisions. Consequently, entrepreneurs that get financing for a second venture have typically been successful in their first, because venture capitalists believe that success is a reflection of persistent skill. Such entrepreneurs are also more successful on average in their second venture than the general population. In this respect, the existence of a pool of serial entrepreneurs is considered crucial for the success of the venture industry. A talent pool of proven entrepreneurs can be dipped into when VC’s wish to finance new ventures and secondly, experience itself builds skill for future ventures. The problem in Europe is that the talent pool generally has less experience, and according to a recent report on the European venture capital sector, this perception of the European VC industry is creating a stigma that it isn’t worth investing in.

“Because of the information problems and inherent riskiness of new ventures, successfully financing start-up companies requires actively involved expert investors. Furthermore, getting a decent return on investments into start- up firms within a reasonable time frame requires that capital markets are developed enough to allow for exits either through an initial public offering or trade sale,” write Dr. Ulf Axelson and Milan Martinovic, from London School of Economics in a report for the British Private Equity & Venture Capital Association.

With the exception of the UK government – which has sought to boost tax-deductible investment portfolios for fledgling businesses through initiatives such as the Enterprise Investment Schemes – the climate for venture capital has been poor generally. For example, the market for initial public offerings has been slow and yet, at a time when traditional bank funding has been squeezed by tighter bank capital rules, there is a need to find alternative sources of financing for the Apples and Facebooks of the future.

Long-term investment
Venture capital falls into that broad asset class known as private equity, but as far as many European clients are concerned, venture capital is far less attractive than other private equity options (such as buyout funds or distressed debt vehicles). One obstacle is clients’ demand for liquidity: venture capital is not a liquid asset class and it is without a doubt, a long-term investment.

“Venture in Europe has challenges in that the most important factors in the VC sector are access to capital, experience and exposure in the talent pool and a good culture of equity that understands that this is about long-term glory and not short money. Venture in the US has been around for a long time and been successful – this has created a pool of capital. In Europe, entrepreneurs find it harder to find access to capital and the quantity available is also smaller,” explains Arun Jayadev, European Venture Advisor for Wellington Venture Capital and member of the steering committee for the European Venture Capital Network.

Unless an investment firm can get access to the best venture capital funds, which in itself is a difficult task, the sector holds few charms. The problem lies in that the massive successes, such as Facebook’s IPO, stand out as a rarity that have to make up for a lot of money lost on smaller companies that didn’t quite cut it. In this respect, the strongest VC funds are based in the US and are heavily oversubscribed. Which is why there needs to be a greater focus on developing entrepreneurial talent and fostering more successes. According to Jayadev, there’s a lack of faith in the European sector, which needs to be remedied.

“Despite the challenges in Europe, this is where the real alpha operates in my opinion. The EU market isn’t as efficient as the US market, which has a large talent pool and a homogenous sector across states. However, this is changing because the environment for VC in Europe is also becoming more homogenous thanks to EU laws. So if you are able to find that young, strong talent with experience to create a good business plan, I don’t think the European market is any less lucrative than the US sector,” he explained.

Mingle for capital
Jayadev’s points emphasise the importance of fostering a stronger network for venture capital and entrepreneurs in Europe. It will be easier for seed firms to attract capital if they interact and cooperate as a sector, rather than individually. The lack of community for the VC sector in Europe is partly to blame for the somewhat miniscule amount of capital available. The European Venture Capital Network is just one of several professional or social communities which are working to create a Pan-European network for venture capital. Because at the end of the day, most VC investors prefer to make deals with a friend or someone they know, rather than making a completely random investment in seed, argues Jayadev.

“There are never enough entrepreneurs in the world, if you ask me, but it is getting better thanks to seed camps and networks,” said Jayadev. “We are trying to create a sense of community amongst the venture capitalists and trying to get younger entrepreneurs into the network. Younger people typically have more risk appetite and a greater willingness to launch companies and take the risks associated with that, as opposed to someone older, who has gotten used to a corporate lifestyle”.

Risk appetite among entrepreneurs and investors is particularly important in the venture industry in order to foster the capital and innovation that leads to great success stories. However, in a post-crisis environment, sector investors are becoming increasingly risk averse and this works against the high risk, potential high return model known from the US. With investors preferring to place money in safer, short-term options seed companies need to be more convincing as an investment themselves. But without the confidence or experience to haul in capital, entrepreneurs are embracing other financing options, such as crowd funding, despite this not generating the same levels of income. Consequently, a change in attitude towards the European venture sector is very much needed and politicians need to take the lead in order to foster faith in the system and generate the jobs and economic growth they long for.

Large-scale solutions
By and large, the politicians’ solution has not been to make the environment friendlier to business by i.e. lowering taxes on innovation and thereby increasing entrepreneurs’ chances of luring private sector backing. For instance, European labour laws are largely designed for employees in large corporations, and don’t work for smaller start-ups. Tax laws in several EU countries make it hard to pay staff with stock options, which is typically a standard carrot for US seed firms. Instead of addressing such national laws working against innovation, politicians have replaced private financiers with state-funded institutions such as the European Investment Fund.

Nearly 40 percent of all funds pumped into European VC last year came from state-backed sources, up from just 14 percent in 2007. The EIF alone poured €600m into venture capital funds last year, out of a Europe-wide total of €4bn. On top of this, nearly every country on the continent has its own national programme to back chosen venture capitalists. A state-funded VC sector is for many politicians at least, becoming a solution to the lack of regional investment.

“European governments need to do something to create capital and investment funds like the EIF can help do that. But fostering innovation from a governmental perspective is more short-term; they need to work on getting private investors interested in the European venture industry. The EU is doing a lot to improve labour and tax laws that can make it easier for start-ups, but there’s still a mismatch between EU goals and certain geographies in the Euro-area,” concludes Jayadev.

It would seem a combination of more government-backed and private venture funds with larger capital, a stronger network of investors and seed firms, as well as improved labour and tax laws specific to entrepreneurs, could seriously boost the European venture sector. The UK is proof of this, having lead the way fostering unprecedented levels of VC in London, thanks to low corporate taxes and the creation of various innovation schemes. The question is whether individual European countries will follow suit and make the changes necessary to foster a strong entrepreneurial talent pool that can draw in the billions of venture money out there.