Chronic Under-financing of EU Start-ups Driven by Mindset

I've read and written about it many times but I think there is one thing which is never loudly spoken about when comparing the EU to Silicon Valley (or the US in general). I decided to make a blog post out of this since my answer over on Quora to a similar question seems to have quite a bit of resonance: "Differences in Entrepreneurial Mindset between the US and Europe". I personally believe that one of the major drawbacks to venture capital in Europe is chronic under-financing and people skirt around this issue. It's a bit disconcerting to see how often reams of arguments are given for Europe's lag in comparison to the US when it's so clear that companies are drip fed money. 

We keep hearing about lean start-ups and how much costs have dropped when launching and growing a business. At the same time, businesses in Europe have always been forced to make do with less. Historically, venture fund sizes have been significantly lower here. Hence, financing rounds have been smaller (roughly a ratio of 5 to 1 when comparing US to EU). Valuations were also therefore lower and I believe you could extrapolate that exit valuations too were lower. Net returns may have been in line as many EU VC's like to argue but the sums going in and coming out paled in comparison to US deals. Exits with "homerun valuations" such as Skype, MySql, Bebo and so forth are far more outliers in the EU than they ever would be in the US. 

This I believe also comes down to mindset. Unfortunately, everything is intertwined and there isn't one person or group to point your finger at. You could say the entrepreneurs aren't thinking big enough and hence aren't selling a vision worth financing with larger rounds. You could also point the finger at the VC's for not having the balls to take bigger bets and hence deliver greater exit valuations. Conversely you could blame the LP's (limited partners: the investors in venture funds) and say they are the one's not risking it enough. They invest far too little in the venture funds which then don't have the funds to place larger bets. Finally, you could also blame the large corporates who technically could be buying up these start-ups but are far too complacent and cheap to pay the valuations seen in the US. The fear of failure is truly holding back the risk takers!

It's clear to me though that the Tier-1 VC's have realized this in the EU. If you look at funds such as Index, Balderton or Accel and newly Northzone, they are taking the big bets. Their funds allow them to invest 5 if not 10 million Euro into a company fairly early to get it growing quickly. Even if they enter with a low 2 or 3 million round, they are easily able to scale the business quickly with additional capital. This leads to founders being able to hire the best people, get subsidiaries in place in the US or elsewhere and grow far faster than their competitors in the EU with far less money. Hence you're seeing a vicious circle where the Tier-1 funds pull much further ahead of the pack. Unfortunately, all ships do not rise with the tide. The Tier-1 funds continue getting the money from the LP's and before LP's give their money to other VC's, they'll increase the amount of money they invest in the Tier-1 funds. 

You could of course argue that the lean start-up method doesn't call for much money but this is misleading. Sure, you can get a project up and running on 100k to 500K but you can't grow a company to 100 million or more valuations without raising far more venture bucks. If you want billion dollar exits, you're looking at having to raise at least 20 million if not more. I don't know of many venture-backed businesses which raised less than 500k and sold for 100 million plus. Take a look at Facebook, Twitter, Groupon or even companies like Dropbox or Etsy. Initial costs are peanuts to get something up and running. Yet, if you want to go big time, you have to raise 500 million as Facebook just did. Even Dropbox and Etsy have done far larger rounds to finance their growth. Therefore, it's an illusion to think that you can get by raising far less nowadays if you want to deliver the necessary returns venture capital calls for. 

What does this all boil down to? Well, it's a matter of talent. Sure, start-ups are chronically under-funded but this isn't because there isn't money in the system. It's simply because of lacking talent. It's a numbers game and the US has more talent because it draws it like moths to a light. Regardless of whether we're talking entrepreneurs, VC's, LP's or corporates, it's talent that's holding back Europe mixed in with a bit of fear of failure. We're working on building up a talent base in Europe at all levels but it takes time. Entrepreneurs need to get the skillset necessary to be players outside of Europe. They'll have to start taking risks earlier and thinking bigger. Further, VC's will have to simply learn to syndicate more and work together. If you can pool resources, you can properly finance start-ups to compete globally. This too will lead to better returns attracting the LP's to venture funds. LP's will have to step it up and place their bets on the best teams in Europe. Unfortunately you don't always know ahead of time who these VC teams are. Sometimes you have to go for it instead of always re-investing in the Tier-1 funds (who don't necessarily always deliver the best returns as we all know.) It's all about mindset. If the right people get it into their heads that Europe wants to be a player, we'll get it done. We all know what's holding Europe back. For me, it's no longer a question of what but when. I'm pulling for sooner than later but I'm biased as you can imagine. 

Comments

[Virginia Raemy]

Great blog! I have gone through 2 seed rounds by now with TalentPuzzle.com and find myself exactly in that situation: the majority of early stage funds tell me to ask for less, whilst the Tier 1 funds tell me to ask for more.... I don't think it is in the mind set of the European entrepreneur to actually ask for less and run a lean start up, but it is what we are pushed to do by investors.

[Paul Jozefak]

It's not only the investors pushing for lean start-ups. The press is full of stories arguing for the lean start-up. People unfortunately forget that the lean start-up is fine at launch. If you want to go big and scale, you have to raise money and far more than angels alone can invest. I think it's becoming clear again that you can't really get big enough remaining forever lean. It was more the hype of it in 2010. 2011 will be back to reality and we'll again clearly see that you need to raise a larger round to get to the exit valuations necessary in the venture business. Again, not everyone needs to go the venture route and in that case, lean is the way to go. If you want to raise venture capital and attain a stellar exit though you have to have a different mindset.

[Mark_ellul]

Great Article Paul. As an Australian Living in Spain, I see the mindset gap from the people I have met here.

[Greg Gentschev]

It's interesting that there's such a difference in mindset. Here in Belgium, I have to restrain myself from shaking my head sometimes when I see people targeting a market of 10 million people. There's something to be said for proximity, but I think you're right that people need to be more aggressive.

Lean startup is in some ways an unfortunate term. It was intended as a play on the idea of lean manufacturing, with a focus on short cycle time, low inventory, and quality through direct contact with customer needs and feedback. In the case of a software company, inventory is code that may or may not add customer value, which is why lean startups try to iterate rapidly rather than waiting to complete big releases.

However, lean in this case doesn't necessarily mean skinny or under-funded at all, although I find myself thinking of that connotation all the time anyway. The key is to focus on repeatable unit economics and product/market fit before turning on the fire hose. In that sense, home runs like Amazon, eBay, Skype, and Facebook could be considered lean startups.

Here's to more European home runs in the near future.

[Paul Jozefak]

Thanks Mark.

[Paul Jozefak]

Greg, you're correct in noting that lean start-up was misinterpreted. It doesn't mean to drip feed a company. Unfortunately too many VC's interpreted it as such.

[Renatovaldes]

As already mentioned on Twitter, agree with the points you mention in the article. But would love to hear your thoughts on the lack of seed and angel-level investors in Europe. We've noticed this in the Netherlands - also that post-exit entrepreneurs often don't get into angel investing - in high contrast to the US tech scene.

On the other hand, this situation does force companies to focus on revenue (we experienced this firsthand) - but that does mean that 'larger scopes' as mentioned in your post need adjusting if the company's revenue prospect is negative at first.

That being said, would love to hear your thoughts on the lack of seed and angel investors in Europe - or why they don't profile themselves more publicly.

[Johnmcnicol01]

Paul

I sent you a response via twitter but wanted to reinforce it.

Anne Glover, CEO of Amadeus VC said recently that she had given up on UK pension funds as investors in this sector. So a large potential source of capital for the funds is not even available. When you consider that Scotland alone has over £500bn under management and not going into this sector, is it any wonder that VC funds are short of cash?

John

[Didierv]

The mindset of many European entrepreneurs is right. The problem is largely in the ecosystem in which we build our startups, and the dependency between startups and their ecosystem. Also many of us are first time entrepreneurs.

For us to seed stronger startups and become more independent and have entrepreneurs taking care of other entrepreneurs we need more and bigger European exits. We need more EU successes, and EU companies with guts buying US companies (i.e. citydeal buying groupon). We need more European angels investing in Europe (who are the European Super Angels), more serial entrepreneurs backing start-ups, more VC teams managed by entrepreneurs, governments valuing true entrepreneurship the same as innovation, entrepreneurs that can execute upon their vision rather than being pushed to focus on monetization from day one, ...

Typically entrepreneurs from small EU countries (Belgium, Latvia, Luxembourg,..) are quicker in building international companies: Playfish (founded by Sebastian Halleux - Belgian), Tapulous (founded by Bart Decrem - Belgian), Netlog (BE), Nimbuzz (NL), ...

Nonetheless, there are plenty of kick-ass entrepreneurs building kick-ass products and businesses in Europe: Skype, VentePrivee, Spotify,.. and cool startups as those from my peers above that I happen to know: HelloMyNameIsE founded by Renn and Brekiri founded by Greg.

So, to conclude, there is talent working on the next big thing here in Europe. We just need to make sure that some of the spillovers as a result of exits (money, networks, expertise) stay in Europe for the benefit of the next generation of Entrepreneurs.