Europeans have a lot of catching up to do compared to the U.S. when it comes to the number of scaleup companies, as earlier noted in this post. While there may be many reasons for this lag in scaleup activity in Europe, three scholars argue that lawmakers should turn to the supply-side of this problem first.
In other words: the key to understanding, and addressing Europe’s scaleup gap is to explore the specifics of financing for scaleup companies. Unusually for most academics, they are also bullish on Europe’s opportunities to address these challenges, and they provide a wide array of recommendations for policymakers – see below.
Scaleups have specific funding requirements, mostly unmet in Europe.
Gilles Duruflé, Thomas Hellman, and Karen Wilson argue that a key component of Europe’s scaleup deficit is that scaleups have special financing needs, largely unmet in Europe. Based on evidence from a variety of sources including the OECD, PREQIN, VentureSource, and Crunchbase, the authors make a strong case that scaleup financing in the E.U. is far behind scaleup financing in the U.S., whether measured by venture capital (VC) as a fraction of GDP, percentage of late stage investment amounts, average number of investors, or average investment amount per investor – you name it.
In an effort to understand why funding is so scarce for scaleups on the continent, they first explore their specific financing needs, and they argue that there are four main requirements for scaleup investors:
- Deep pockets. Scaleups usually seek large funding rounds – which typically come from larger funds, and even larger funds-of-funds. (Having funding come from too many sources is not ideal for a company, because it might lead to a fragmented ownership structure.)
- Smart money. While most startups’ challenges are similar, later stage entrepreneurs often need investors who can assist them with growing their companies in more specific ways. International expansion, and access to talent are two areas where entrepreneurs tend to need specific advice from experienced professionals.
- Networks. Scaleup entrepreneurs with larger networks have better odds at meeting financing and growth challenges, including the ones mentioned above: larger networks allow entrepreneurs to find better financing options, strategic partners, or talented hires.
- Patient money. The risk involved in supporting a high-growth firm means that funding sources should ideally be patient. Later-round venture investors should be able to take a long-term view, while keeping an eye on an eventual exit event.
European venture markets are young and liquidity events are uncertain.
The shortage of VC funding for scaleups could be a result of scarce investment opportunities – there might not be enough high quality scaleups in Europe. But the amount of American investments in European scaleups, and well as the frequency with which American companies acquire European scaleups, suggests that the problem lies on the supply side.
The authors list a few possible explanations: European venture markets are young, and, as a result, European VC firms have not been able to generate quite as handsome returns as their American counterparts, so investors are not compelled to invest larger and larger amounts. Another, equally plausible explanation is that funding sources for VC funds are different from those in the U.S. In Europe, there has been a decline in private funding sources, but governments have remained active in investing. But governments are more risk-averse, and tend to prefer allocating funds in smaller increments to disperse risk.
Finally, liquidity events, perhaps the most important consideration for any VC, are different in Europe. IPOs, in particular, are very rare on the continent: while in 2015, 16 percent of American VC exits came in the form of an IPO, only 2.6 percent of exits occurred on the stock exchange in Europe. Not only that: the performance of companies after an IPO compares unfavorably to the performance of American scaleups too.
European governments can improve the state of financing for scaleups.
Before listing recommendations, the authors warn that, while there are lots of ways that governments can influence scaleup financing, it is important that they do so in the way that best meets the challenge or the market failure in their particular market. That said, they make a strong point that scaleups deserve more focus from policymakers. Below are some of their suggestions.
- Provide funding directly to scaleups. Governments can directly increase the supply of funding available for these companies through development banks, in the form of limited partnerships, or investments in funds-of-funds. Going back to the requirements for scaleup investors above, it is clear that there are a few challenges governments will encounter as an investor: notably, most governments’ natural reluctance to allocate funding in large increments, and their lack of expertise to advise entrepreneurs on growing their companies.
- Increase the supply of venture funding through taxation. There are two main ways to increase funding for scaleups through taxation: tax credits and capital gains relief, the main distinction being that capital gains relief only matters in the case of a successful exit, while tax credits apply to anyone who is willing to invest in scaleups. Influencing the funding supply through taxation might be valuable because it might improve on investor patience, one of the key requirements for investors in scaleups.
- Adjust financial regulation to incentivize investors. Notably, one of the most pressing problems for scaleups is the unlikeliness of certain liquidity events, like IPOs, mostly because Europe is such a segmented stock market. According to the authors, an all-European stock market, or at least the option for European companies to inter-list on different stock markets, would be very beneficial for scaleups on the continent.
To read the full paper called From Start-Up to Scale-Up: Examining Public Policies for the Financing of High-Growth Ventures, please click here.
Contributed by Lili Torok.