Guest post: European venture capital and a theory of evolution

This is a guest post by Jos White, a partner at Notion Capital. This is in part a response to recent criticism of European VC by Datasift which raised money from US VCs.

All you ever hear about these days with European venture capital is either that it is miles behind the US or that it can contribute greatly to economic growth and should be subsidised by governments. While I mostly agree with both these statements I think they are missing the central point. By investing in early stage European technology companies you can make a lot of money if you get it right.

I don’t understand why people shy away from this. Perhaps people feel unable to make this case and quietly step around it. Or, in these austere times, maybe us Europeans feel uncomfortable being outspoken capitalists. Yet I feel strongly that the evolution of virtually any successful market anywhere in the world was fuelled by the opportunity to make money, and I don’t believe European VC is any different.

The European early stage investment market as a whole has under-performed over the last decade. I’d put this down to an over-supply of cash, spurred on by the success seen across the pond, combined with an immature start-up ecosystem, all leading to too much indiscriminate investing.

At the same time, I don’t believe that the European market is performing as badly as reports suggest. It’s too early to measure the performance of funds from around 2005 onwards and the data available for the industry in Europe is poor and unrepresentative due to less regulation and disclosure – estimates put the number of funds that are included in industry reports at less than 5% of the total market.

As a result of this real and perceived underperformance, combined with the worst recession for decades, there has been a Darwinian like culling of the European VC industry. According to the EVCA, the number of funds dropped from 1,600 in 1999 to 596 in 2009 and, out of those remaining funds, only 30% are considered active.

Despite this, European innovation is continuing at a fast pace. INSEAD’s latest report, ‘The Global Innovations Rankings and Report 2008 – 2009’ (PDF) may rank the US as the innovation leader, but three European countries – Germany, Sweden and the UK – are close behind, each ranking miles above the global average.

Europe generates around 30 exits per year of more than $100M – this is still some way behind the US but, when you look at things proportionately, between funding available and the size of the exit market, Europe looks like a more attractive place to invest.

The early stage investment market is now 6x larger in the US and yet the subsequent exit market is only around 3x larger and I believe there are many exciting European exits in the pipeline that will close this gap even further. This all means, I would argue, that there is now a clear imbalance between supply and demand in the European market that creates great opportunities for investors.

This argument becomes more compelling when you learn that European start-ups on average have lower entry valuations and require less capital to build. From living in New York it is clear that the US market is overheated; all you hear about is too much money trying to get into every deal leading to both over-inflated valuations and rushed decision making that will most likely bring down performance levels. And the knock-on effect of this is rising costs for talent, office space and just about anything else an early stage company needs.

Another important point to make here is that the world’s top ten tech companies, all US based, have unprecedented levels of cash reserves currently standing at around $300B. A decent percentage of this cash is held in Europe and it is not tax efficient to bring it back to the US. Assume that this percentage is say 20% and that leaves $60B of cash sitting in Europe with little to do other than buy or invest in European based companies – certainly a factor in the Microsoft acquisition of Skype.

What can European funds do to take advantage of this opportunity? First, they need to raise a fund, which is easier said than done in difficult economic times and where investors tend to focus on past performance rather than future opportunity. Second, European funds should have proven entrepreneurs on the team with real experience of the markets they are planning to invest in.

Lastly, I believe European funds need to adopt a US style focus on out-size returns and get themselves and their portfolio companies thinking ‘big’ to take full advantage of the market opportunity. I think, all too often, there is an overly defensive attitude in Europe and a lack of belief in the global potential of the business – and this needs to change if Europe wants to become more and more relevant as a technology centre.

The European market has evolved and will continue to evolve – and the main driver for this will always be money. Current vintages could very well cause a few surprises and deliver a level of performance that surpasses anything we have seen before and at the same time close the gap with our friends in the US.