The Venture Gap in Europe.

European startup ecosystems have matured over the past three years. Most of the discussion was: which cities – London or Berlin – have most startups? Who has exits or lack thereof? My personal view: After an explosion in numbers of startups, I recently see a significant uptick in quality of startups in Europe.

I see better teams and better strategies. With companies like Criteo from France and Zalando from Germany and potentally Soundcloud, there are now the first “Billion Dollar exits” on the horizon. The best indicator of European success according to the EU is that app revenue in Apple’s app store are equally divided equally between US and Europe.

But what about the quality of venture capital firms in Europe? Turning the attention to VCs instead of startups should help entrepreneurs to separate the wheat from the chaff. It also shows that there is still a huge gap in the market for more US-style VCs in Europe.

1. Some basics about Venture Capital

(Experts in the field will want to scroll down to the next heading) 

While many companies have “venture” in their name, most are too small to be considered real venture capital firms. In my view, the minimum size to be able to have a diversified portfolio of early stage investments is 25 M US$. For a reasonable Series A size fund we look at a of 100 M US$ fund size. At my last count there were are acutally less than 10 funds in Germany who fit that criteria. To mind spring eVenture, T-Venture (corporate), Earlybird, Target Partners, Wellingon (Happy to amend if I missed someone). UK has a bit of VC history and larger fund sizes into 500 MUS$, but many of these are focused on non-internet industries. In France there are also several of the 100 MUS$ size. In most other European markets fund sizes peak at about 40 MUS$. In summary: There is simply very little European money in venture capital, paticularly in contintental Europe.

Venture Capital as an investment is on average a terrible asset class. This is not because 60% of funded companies are being written off – that is actually a good thing. It is because on average, the return is just 2%. And for that meagre reward, an investo – a limited partner or LP – is locked in for up to 10 years. And this average return includes the stellar returns of stars like Peter Thiel who seems to turn everything he touches into gold (Paypal, linkedin, facebook and a scary CIA funded beast called Palantir which he recently mentioned in Berlin as his best return). So if you take the stellar returns out, average returns are probably less than zero. Fees are high and often criticised. For a really good general update on what is broken in the VC industry, read the excellent report by the Kauffmann foundation. Regarding Europe: Returns are even a bit worse than US, but again that could change quickly once larger exits do come.

VC as an industry is in danger of being disrupted as well: Angellist built a platform that creates virtual VCs – syndicates – which will broaden the base of investors into super Angels and blurrs the lines to a professional VC.

2. Differences between European and US Style VCs

in the past ten years and across four companies, I have been working closely with more than ten US and European VC firms. I must have pitched close to 100. Two of the funds I worked with had US origins and then partially moved to Europe: Partech in France, the lead investor in Qype, was started by a French guy in San Francisco, and similarly eVenture, the lead investor in 9flats, was started by Germans in San Francisco 12 years before they opened office in Europe. Later I worked with Redpoint in Menlo Park and Greycroft. I have also worked with the larger German funds, Wellington and T-Venture as well as with some UK firms.

Longer History

The most obvious difference between European VCs and US is how old the US industry is. When I pitched Venrock three years ago, I was struck by the pictures in the lobby of aircraft that had been funded in the 1940s. Several of the large US venture funds were founded in the 80s. Very few in Europe were founded before 2000. With many VCs in the US you get an impression that people are very exprienced. Particularly with the principals you often get the impression – once you get to talk to them – that they have seen many cycles and are not easily thrown off. With experience and size comes a sometimes a fantastic network. When you talk to Alan Patricof, who prior to running his VC firm Greycroft was the founder of APAX, you get the impression that there is nobody in US media who is not in his Rolodex. Also with other US funds I was often impressed with how quickly they had access to a stellar expert on any given subject.

Different attitude to risk: Fail fast and back your winners

The most important difference between the good and the not so great funds is: The good funds will let companies fail quickly and reserve their cash for the winners. Companies are much more encouraged to pivot and start fresh. With quite a few European VCs having a background in corporate structures, there seems to be a bigger tendency to keep companies on the balance sheet as long as possible. Also there seems to be a slightly longer hesitation until a company will be allowed to pivot as this also has an effect on how to put the company on the balance sheet. In Europe I still often see a tendency to nudge all starters across some kind of finish line.

Boldness and ability that comes from past success

It is my observation that all investors become bolder when their past invesments were a success. This may be a simplification, but it seems to work. Unfortunately, past successes are still slightly more likely in the US. So later stage funds are rare in Europe, although some are being raised at the moment. Until now, nearly all large B, C, D rounds originate from US funds.

We have some fantastic VCs in Europe. Personally, I think the portfolio of Index is admirable. But Index in my view is very much a US style VC. And again with Index, you can see here that boldness comes from past success.

The effect of quick flips versus thesis driven investments

Experience does shape industries. In Germany, we see an amazing and long lasting success story of the Samwer brothers, who have not been innovating but have been extremely successful in globalising concepts. Sometimes this has lead to ultra fast exits (Alando to ebay in less than four months after launching, Citydeal to Groupon in less than a year and potentially a billion Euro IPO for Zalando in less than five years). In the same way that some American players have been shaped by their past of betting big on risky ideas, some very successful funds have been shaped with their experience of getting fantastic returns by backing the Samwers or similar outfits in clone stories. This of course leads to a predisposition for quick turnarounds with perceived low risk and may leave many more innovative companies waiting for investments.

I personally believe very much in the opposite model: Thesis driven investments. The most famous example of this are for example Union Square Ventures who with an exremely small team managed to fund nearly a fantastic roast of companies in a very short time (Twitter, Tumblr, Etsy, Foursquare etc.) – based on their thesis to focus on companies that can generate huge network effects.

In a more competitive environment for VCs, another extremely lucrative approach is specialization: One European example I like very much is Point Nine Capital. The portfolio looks quite mixed, but there is a clear knowledge in “software as a service” that helps the team to stand out for founders.

The role of limited partners

In the same way as there is a lack of experience in VCs, of course there is a lack of experience with limited partners in Europe. The asset class “venture capital” faces some severy challenges in Europe as many vehicles like pension funds or insurance companies often simply are not allowed to invest. But also the experience of the bolder limited partners in Europe who have tried VC in the past, has been mixed at best. Hence it is not easy to raise capital. Also in my observation if someone has made the family’s fortune with mechanical engineering, he is unlikely to be a bold investor in software afterwards. Again, a different past, inhibits a massive inflow of capital in the future.

3. How active are US style VCs  in Europe?

With all those differences and the notion that capital is free to roam globally: How active are US style funds in Europe? There are of course real statistics somewhere. From my point of view, I see some of later stage funds like Insight (Series B onwards) beeing very active. Particularly in Berlin, it is great to see how thought leaders like Union Square (Soundcloud, Auxmoney), and also Peter Thiels Founders Fund are investing. Blumberg Capital has also been very active in Germany in the past couple of years. But the majority of US funds I speak to, are still very reluctant to invest that far away.

4. Conclusion: A huge gap means a huge opportunity.

Given what I see in the startup market and the lack of venture capital and experience, I am convinced that there is ample room for new venture funds with the following criteria:

  1. Entrepreneurial approach of risk taking and letting companies fail if necessary.
  2. Thesis driven approach or niche specialists.
  3. Fund size between 25 and 100 M US$.
  4. European focus, as the number of sucesses per square mile is not big enough in any European eco system.

Given the pivotal role that venture capital has in generating innovations and future industries, it is vital that these funds get started. I also believe that right now is the time where new companies are being founded in Europe that justify these investments. The challenge remains to convince investors into these funds.

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