Reshaping the European Startup Scene in a Crisis Context: The Role of Venture Capital
Written by Alexis Raedemaecker
It is now a widely acknowledged fact among scholars that entrepreneurship is a powerful engine for prosperity (e.g. Kritikos, 2014; Baumol & Strom, 2007; Decker, Haltiwanger, Jarmin, & Miranda, 2014; Van Praag & Versloot, 2007). Given that classic theories aimed at providing frameworks for stimulating growth seem to fail in meeting initial expectations, hopes have indeed been shifted towards entrepreneurship as an efficient and effective fuel for powering societal and economic development (Audretsch, 2009). This paradigmatic shift towards the so-called “entrepreneurial society” is indeed striking and the European Union (EU) explicitly seeks to embrace this idea of fostering entrepreneurship to catalyze development (European Commission). In the aftermath of the 2008 economic meltdown, the EU ignited its “Entrepreneurship 2020 Action Plan” in order to catalyze the European entrepreneurial scene and clear hurdles for European entrepreneurs, thereby helping the economy bounce back by promoting economic development in the Union (European Commission, 2012).
Last year, Ganderson, Giulla, & Gauci (2019) argued that despite its noble intentions, the 2020 Action Plan struggled to deliver meaningful results and therefore called for a new action plan. Now that another crisis is hitting all members of the Union, it appears increasingly evident that a new action plan will indeed be required to dynamize the European entrepreneurial scene in order create new jobs, drive innovation, and foster economic and societal prosperity. But the question then becomes: what key entrepreneurial levers can be pulled by the European Commission (EC) to catalyze a healthy economic recovery from the current crisis? Given that recent research tends to suggest that promoting entrepreneurial funding is key to fostering entrepreneurship (Hellmann & Thiele, 2019), I review how the European Venture Capital (VC) market is reacting to the crisis and report what has been proposed so far to support early-stage investing so that access to capital does not become too scarce.
II. Young ventures’ future in jeopardy?
Unsurprisingly, even many of the most promising startups are having important troubles to stay afloat amidst these government-mandated lockdowns. As commercial activity is mandatorily put on halt in many sectors and as the purchasing power of consumers is severely affected, many of our European entrepreneurs have to cope with a sudden demand shock that directly impacts their liquidity position and threatens their continuity. At the same time, investors hit the brakes on financing young promising ventures, worsening their situation even further. So can promoting VC funding be effective at fixing the entrepreneurial machine? Before answering that question, let’s have a look at how VC funding has been impacted by the outbreak.
In China, and despite an important rebound in VC activity in March with funds trying to profit from lower valuations due to the pandemic, VC activity dropped to less than half of its 2019 level during the first quarter (Ruehl & McMorrow, 2020). The European market has not yet been hit to the same extent, with around $2 billion of VC money being invested in Europe in March, which is not significantly low as compared to levels observed in the past couple of years during the same period (European Startups, 2020). But the report also notes that as many of the struck deals were in the works long before the crisis, VC activity is a lagging indicator and a decline is therefore expected to be observed in the coming months and beyond. In an EC Joint Research Center report, Mason (2020) argues that despite the recent growth of VC investment in Europe, slowly reducing the gap with investment hotspots in the US and Asia, the accumulated dry powder will likely be used to further support existing investments that burn cash quickly due to demand shocks and will require new funds sooner than expected. Additionnally, he argues that it is likely to become much harder for VCs to raise new funds from institutional investors and high net worth individuals. Consequently, it will probably be increasingly tough for hit startups to raise new funds in a context where VC money will become scarce and allocated to existing investees in priority, whose bargaining power against reluctant and cautious VC will be affected as compared to the last couple of years where VC money was abundant with funds competing for investment opportunities. As highlighted by Mason (2020), the only ventures likely to attract funders are the ones with a “pandemic purpose”. This might lead to over-investment in these sectors and therefore result in capital allocation inefficiencies, leaving other sectors alone.
III. Incentivizing early-stage investing to support the future
Crises are also undeniably fertile grounds for young entrepreneurial seeds. Several giants dominating the tech landscape have been founded during the 2008 global financial crisis. If the Union wants these opportunities to materialize during the current crisis, it has its role to play in order to ensure capital is accessible to young seeds that will potentially be significant contributors to future job creation and economic growth. At the time this article is written, several countries such as France and Germany have put in place programs and relief packages aimed at supporting their startup ecosystems, but no EU-wide plan focused on promoting the European entrepreneurial scene has yet been proposed. Early stage finance is critical to startup ecosystems, and backed ventures are shown to have a significantly higher survival rate and better future performance (e.g. Manigart & Struyf, 1997; Van Pottelsberghe De La Potterie & Bozkaya, 2008; Gompers & Lerner, 2002). It is time for a new action plan for entrepreneurship, and EU-wide access to VC should be emphasized in this plan. In a report published less than three years ago, Ständer (2017) argued that market imperfections characterizing the European venture capital industry already resulted in inefficient and insufficient VC funding given the potential societal benefits even before the crisis.
One major hurdle to the proper development of the VC industry in Europe is its fragmentation and the significant home bias of European VC ecosystems, which will be exacerbated by the loss of EU’s most internationalized VC market, the UK. As mentioned by Ständer (2017), this market fragmentation is an aggravating factor of other problems of the European VC market, such as less profitable exits on average than in the US or Asia, limited scale-up capital for the growth and expansion phases of young businesses, and an evident lack of private investors. Reducing the fragmentation of the European VC market could help it reach a critical mass and overcome some of these inherent weaknesses (Acevedo, et al., 2016).
Public policies could and should thus do better at supporting VC investment. Despite encouraging integration efforts of National Promotional Institutions (NPIs) and the European Investment Fund (EIF), cooperation is still limited and challenges arise from the materialization of synergies between both (Ständer, 2017). To pave the way towards further VC-harmonization, Ständer proposed a “EIF-NPI Equity Pool” that would syntethtize national and EU equity instruments in a single common framework. Its main principles would be to set cooperation targets, to refrain from home-country restrictions on resources in the pool, to share capacities of market analysis and to identify cross-border investments more effectively. The implementation hurdles of such institutionalized agreement that shares public resources are nonetheless likely to be high in the times of a crisis during which public funds are especially scarce, and during which nationalism and euroscepticism are exacerbated.
A second area in which there is room for improvement is the one of taxes. Tax harmonization within the EU has been widely debated for a long time now, and the dynamism of the European VC market would also benefit from tax harmonization. Ständer (2017) notes that this does not require to harmonize baseline tax rates, but can rather be materialized by a single tax framework for VC which allows for a single declaration, ensures an equal tax treatment for national and international legal fund structures, and incorporates other features aimed at incentivizing cross-border investment through the reduction of barriers for foreigners and the convergence of VC tax relief schemes.
Mason (2020) suggests further avenues to help the European entrepreneurial ecosystem thrive during the crisis. Among them, tax incentives that shift the risk-reward balance of business angels can help increase the supply of funds for young seeds. Convertible debt instruments are also being discussed as a potentially impactful financial product to help entrepreneurs at their seed stage to stay afloat during the crisis and get back to a healthy commercial trajectory afterwards as they could provide an interesting return and flexibility for investors once the situation gets less uncertain. Non-dilutive finance is mentioned as an important catalyzer for young ventures that could be promoted during these times, but as public funds directed towards healthcare and other aids for established businesses make public money increasingly scarce, offering innovation grants on risky ventures might be a politically controversial move.
The pace and sustainability of the economic recovery in the Union will strongly depend on the reaction and dynamism of its entrepreneurial ecosystem. Since early-stage funding is essential to the health and growth of tomorrow’s jobs and economy, it is critical for the EU to ensure the VC market remains effective at nurturing our entrepreneurs as well as liquid and attractive for investors whose risk aversion is likely to increase in the near future due to the recent losses incurred. The EU should create a new action plan that promotes and incentivizes early stage funding throughout the crisis, and it should aim for a policy set that overcomes the market failures characterizing European venture capital. Building momentum in VC will not only require national policies, but also a certain harmonization a the EU level to reduce the fragmentation of the market that has an escalation effect on its underlying market failures (Acevedo, et al., 2016; Ständer, 2017; Mason, 2020). As noted by Ständer (2017), overcoming barriers and market failures does not require more resources but rather better coordination of existing measures that are already fueled by important fiscal resources. In times where government money is especially scarce and European solidarity hurt in the mind of people, this goal of sharing resources more effectively and efficiently to nurture our entrepreneurs might not be easily accepted by Europeans who struggle to make their ends meet and feel they need more financial support. Consequently, building momentum in the European venture capital industry to foster future prosperity will first require to heal the wounds created by the crisis on the European identity and solidarity. This will help convince Europeans of this coordination need and thereby convince national political leaders to participate in coordination efforts without losing public support in their respective countries.
- Hellmann, T., & Thiele, V. (2019). Fostering Entrepreneurship: Promoting Founding or Funding? Management Science, 65(6), 2502-2521.
- Kritikos, A. (2014). Entrepreneurs and their impact on jobs and economic growth. IZA World of Labor.
- Baumol, W., & Strom, R. (2007). Entrepreneurship and economic growth. Strategic entrepreneurship journal, 1(3-4), 233-237.
- Decker, R., Haltiwanger, J., Jarmin, R., & Miranda, J. (2014). The role of entrepreneurship in US job creation and economic dynamism. Journal of Economic Perspectives, 28(3), 3-24.
- Manigart, S., & Struyf, C. (1997). Financing High-Technology Start-Ups in Belgium - An Explorative Study. Small Business Economics, 9(2), 125-135.
- Van Pottelsberghe De La Potterie, B., & Bozkaya, A. (2008). Who funds technology-based firms? Evidence from Belgium. Economics of Innovation and New Technology, 17, 97-122.
- Gompers, P. A., & Lerner, J. (2002). The money o invention: How venture capital creates new wealth. Ubiquity.
- Audretsch, D. B. (2009). The entrepreneurial society. The Journal of Technology Transfer, 34(3), 245-254.
- European Commission. (n.d.). Promoting Entrepreneurship. Retrieved from European Commission: https://ec.europa.eu/growth/smes/promoting-entrepreneurship_en
- European Commission. (2012). Report on the results of public consultation on The Entrepreneurship 2020 Action Plan.
- Van Praag, C. M., & Versloot, P. H. (2007). The economic benefits and costs of entrepreneurship: A review of the research. Foundations and Trends® in Entrepreneurship, 4(2), 65-154.
- Ganderson, J., Giulla, T., & Gauci, K. (2019). Entrepreneurship 2020: Time for a new settlement? Retrieved from The London School of Economics and Political Science: https://blogs.lse.ac.uk/europpblog/2019/03/19/entrepreneurship-2020-time-for-a-new-settlement/
- Ruehl, M., & McMorrow, R. (2020). China’s venture capital funding rallies after coronavirus lockdown. Retrieved from Financial Times: https://www.ft.com/content/60359c79-0161-46e2-bed5-a30d372834b7
- European Startups. (2020). What does it take? Europe's startup ecosystem navigating the covid-19 crisis. Dealroom.co & Sifted.
- Mason, C. (2020). THE CORONAVIRUS ECONOMIC CRISIS: ITS IMPACT ON VENTURE CAPITAL AND HIGH GROWTH ENTERPRISES. Luxembourg: Publication Office of the European Union.
- Ständer, P. (2017). Public policies to promote venture capital: how to get national and EU measures in sync. Jacques Delors Institut - Berlin.
- Acevedo, M. F., Adey, M., Bruno, C., del Bufalo, G., Gazaniol, A., Lo, V., & Thornary, B. (2016). France, Germany, Italy, Spain and the United Kingdom - Building Momentum in Venture Capital across Europe. Bpifrance.