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Why European VCs are lean, mean and more extreme

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Manny Pacquaio, under Creative Commons license from sjsharktankYou’ve probably all heard the cliches about European startups and investors: venture money in Europe is more conservative, entrepreneurs are afraid of risk, the businesses are less ambitious and there are fewer blockbuster successes. These are trotted out all the time to explain why it’s better to start up or invest in America.

Is it true? A new report suggests that the opposite may actually be the case — and that Europe’s venture capital industry may, in fact, be dramatically more successful than its American counterpart.

The report, written by Hendrik Brandis and Jason Whitmire of German venture firm Earlybird, looks at the underlying data behind the two industries, and comes to the conclusion that while the European venture industry is significantly smaller (around a quarter of the size of the U.S. market) it punches well above its weight. This, they say, represents a real comeback for the continent’s investors.

Ultimately, their argument is based around a series of pieces of data that show how European venture capitalists achieve a higher level of success, proportionally, than their transatlantic counterparts.

  • Europe has better exits than you think
    Over the last two years, European venture-backed companies have made exits worth $15 billion (acquisitions or stock flotations). That is half the size of the $30 billion American market, and yet the venture market in Europe is just one fifth of the size: US venture firms invested $25 billion from 2009-2010, while their European equivalents invested just $6 billion.
  • European deals are better value for investors
    Across the two year period, Europe had 131 deals with a median exit valuation of $173 million, and more than 57 percent of those deals were significant successes that brought investors at least five times more money than they put in. In the U.S. there were many more deals over the same period — 596 in total — and the average deal size was higher, too, at $236 million. But the value to investors was lower: less than half of all deals brought in multiples of five times or more.
  • European investment is more efficient
    The average exit capitalization of a large company (worth $100 million or more) is almost the same; yet European VCs get there by investing just half the amount of capital that their American cousins do.

In addition, the report points out that the difference in success after there has been an exit can be even more pronounced: this graph shows the relative performances of European and American venture-backed companies, post IPO.

Earlybird report - the post-IPO climate for European and American companies

So why is this happening?

Essentially, the report puts forward the case that American VC has had too much of a good thing: too many venture funds drives up valuations, makes it more likely that people invest in bad ideas and get smaller returns. Because venture money is scarce in Europe, on the other hand, companies have to compete harder for funding — which keeps the value of investments down. At the same time, it also means that VCs can cherry pick the very best investments and focus on backing real winners — which keeps their hit rate high. It’s a combination that creates a more efficient ecosystem, for investors at least.

This is encapsulated by a quote in the report from the head of Deutsche Bank Private Equity, who says that “European venture capital is a cottage industry characterized by an insufficient number of private investors with the capacity and willingness to invest in venture capital, mainly due to past disappointments and the resulting lack of confidence which still inhibits the European venture industry today.

Europe, it says, suffered when many of the big organizations that had backed venture companies during the first dotcom boom — the pension and endowment funds — decided that it was too risky for them. They backed off. That meant that those who survived were the best in breed, and have since been able to make the most of the flourishing entrepreneurial scene across many European cities.

It’s a great tale based on great data. But there are a few reasons to remain skeptical about these findings. First there’s the fact that, of course, a German VC has a vested interest in pointing out how successful venture capital in its region can be. Then there’s the fact that venture capital is not the primary vehicle for startup investment in Europe, with private equity much more influential than across the Atlantic. The wider picture may not look quite so rosy if you took into account the entire ecosystem beyond venture-backed firms.

And it is also worth remembering that the American and European markets are different — so much so that pitting the two against each other is a bit like putting Manny Pacquaio in the ring to fight Wladimir Klitscho. Pound for pound, the little Filipino may be the better boxer, but when the punches start flying I’d rather put my money on the towering Ukrainian, who has a full foot in height and around 100 lbs as an advantage.

But perhaps the biggest issue could be that simply discussing this success makes it more likely that others will try and get in on the action — which, in turn, is likely to make it less efficient. If Europe is suddenly seen as a promised land for new venture funds, a place where small investments are magically transformed into large returns, then an influx of competition could dilute the market and end up killing off the very thing that everyone wants. However, given that they’re some of the planet’s most successful venture capitalists, that is a paradox that I imagine Europe’s VCs will probably be happy to live with for now.

14 Responses to “Why European VCs are lean, mean and more extreme”

  1. First of all wow, what a slideset ! The macro case is beautifully made. One has to give a nod to Simon Cook at DFJ Esprit who formalized much of this data a while ago, but this is more comprehensive and nicely up to date. Let’s summarize the case thus: hardship created capital scarcity and improvement in deal terms over the lifecycle which in turns means stronger overall returns than the US (“it’s a buyers’ market”). Hence European venture is at a macro level a good place to put your money, especially since access to the top 20 funds is not restricted (unlike top US funds like Benchmark or AHo).

    I have one overriding problem with this though: I am not sure that the US vs Europe debate is particularly relevant to much of the LP community. In other words, European VC showing US VC it does better relatively at a macro level is like the one eyed making fun of the cripple. Europe’s had trouble reliably creating large exits and the US has 800 venture firms and probably needs to shrink to half that number.

    Over the last few years, LP’s have started to look at venture alongside other pools of illiquid capital. In other words instead of saying “what’s my venture allocation” they’re looking at “how much of my assets can I safely put into illiquid asset categories and how much additional return should i expect from being illiquid”.

    This means venture is now fighting for allocation alongside say, Brazilian forests or Chinese retail. Given that a monkey throwing darts would have made money being long commodities or China, you can see why it’s harder to get many LP’s to part with their money. And naturally the liquidity crisis has shrunk the pools available to illiquid assets overall fairly dramatically. That’s why the absolute return debate is really one that matters.

  2. Mukund Mohan

    What surprises me:
    1. $ for Euro: Europe is more expensive overall. Still, European startups are more “capital efficient”. How is that possible? Is it that they hire fewer people? Or manage their CAPEX better?

    2. Comparing “Europe” to US is not the right model I believe. The various markets are vastly different. Comparing UK to Nor Cal and Germany to Boston and France to New York might give you a better picture. Since NY, BOS and SF are vastly different themselves.

    • Peter Kadas, MD.

      Dear Mukund,

      As a european entrepreneur in social and web business I totally agree with your second paragraph. European countries are highly different. In UK, France or Germany the culture of involving venture capital is about the same as in the US. In contrary, in countries like Hungary -where I live -, Romania or Bulgaria simply there’s not enough equity to form a decent VC sector – so there is practically no VC activity. The few how tries to invest in start-ups are funding companies in the pre-pre-pre seed with amounts according to that.

      Also, in reply to European start-ups being more capital efficient. Yes and no. They don’t manage their CAPEX any better nor hiring fewer employees. They might seem to be more capital efficient because first they usually cover only the market of their country of origin, which costs much less spending. My other guess is that European start-ups usually seeking for capital in a later stage, of course that doesn’t raise their efficiency, yet confuses measurements of how effective they are.

  3. tomleyden

    Great article. I’ve been involved in three startups in Europe with two exits so far and see similar trends. the trend is changing though: I’ve seen more early stage funds and incubators coming up and also a lot more entrepreneurial activity. In many ways that is a good thing, as entrepreneurs speed up the economy. Let’s just hope we can keep the high level of common sense we have when it comes to getting extra funding.

  4. Great to see the report by Jason and Hendrik, it puts some meat on the bone on a few things we believed in when starting a new European VC Opean Ocean Capital – and launching our Fund III in May this year:
    1. the early stage of start-ups in general, and in Europe (still) in particular, can be built pretty inexpensively nowadays, especially if you can benefit from communities supporting the development and commercialization of your product, and of course utilizing – and potentially building your – open source software (where Europe has innovation and competences with the LAMP stack being quite “European”).
    2. Europe can indeed build success-stories, although quite often – but definitely not always – they end up being acquired by US companies, as the valuations tend to often be higher when “selling to America” (as they also are in early stage rounds). The Exit Analysis report by Creandum from early 2011 also showed quite well how a small area like the Nordics can overindex on great tech exits (being from Finland we had to comment on this also :).
    3. Still, in the growth / scaling stage we need to make sure the European start-ups behave more like our American counterparts, ie. really focus on branding, marketing, selling and BD to become at minimum a phenomen within their own industry if not more widely. We still have too many strong companies that just aren’t that well known, a little too locally “flavored”, and thus do suffer in BD and exit opportunities. MySQL is an example of a European firm that really did manage it’s positioning well on the way to success.

    So in conclusion, yes, we agree that we can build companies efficiently, find winners and make good money on VC in Europe! Thanks again gentlemen for putting more facts behind our beliefs!

  5. As one of the surviving VC firms in Europe, we see the picture much like Earlybird. The past 10 years has been (and remains) a great time to invest in early-stage companies here. With improving exit opportunities the picture should also continue to get better.

  6. If you’re an investor, European VC seem to be more efficient than their US counterparts. However if you’re an entrepreneur, US VCs seem to be much more willing to take risks. That’s the main difference in my opinion. Of course when you take more risks, your returns are lower. But you also have more chances to find the diamond in the rough. Investing is lower-risk ventures is almost like buying stocks on the Nasdaq. Not sure it’s helping innovative startups.

  7. Wolfgang

    Hi Bobbie,

    Thanks for the good and balanced article about Europe vs the US. Good to see some hard facts which underline that Europe (at least the key geographies) is not a bad place for VCs. Leaving the discussion about absolute returns aside for a minute I’d like to point out two key topics I find quite important bearing in mind. First, the European VC industry is still at an early stage as far as the industry as a whole is concerned (10-15y vs 60y in the US), so very few European VCs have a strong track record over a number of fund generations. Secondly, I expect to see an explosion of start-ups founded and getting funded by repeat entrepreneurs which will level the playing field going forward.

  8. Good piece of analysis by our friends at Earlybird that we at Fidelity Growth Partners Europe definitely believe in. There are great VCs in Europe although perhaps not as many relative to the number of interesting startups. That being said, this analysis also supports Nick’s (Datasift) view that he is likely to get better valuation in the US (since they are less valuation sensitive). I don’t find that to be true in most interesting deals in Europe which seem really competitive. Take examples of Seatwave or Wonga, all deals that looked at both continents and then chosen the best combo of investor/valuation which ended up being European. (I am sure there are plenty of counter examples as well since the market is pretty global today).

    Finally, we are definitely bullish on European entrepreneurship and think the next 10 years will be miles better than the last 10 years for entrepreneurs and VCs alike.


  9. I think the European VCs who survived the last few years are a pretty savvy bunch, and I also see a new generation of early-stage funds that aren’t afraid to go in at concept stage.

    It takes two to tango, and while European VCs are learning the game, the same can be said of entrepreneurs, who more often than not, have one or several start-ups under their belt now. These past experiences on both sides of the table are making the ecosystem more efficient and ultimately drive more value for all involved.