The European Union (EU) lags behind the United States in terms of the development and strength of its venture capital (VC) industry.
This fragile VC environment is not only holding back productivity and economic growth within the EU, it is also hampering the bloc’s environmental ambitions and global competitiveness, according to a new study by the International Monetary Fund (IMF).
The paper, entitled “Strengthening Venture Capital for Innovation in Europe” published in July, examines the current state of the EU’s VC industry and highlights key obstacles to its development. It argues that building a robust and advanced VC ecosystem is essential to fostering innovative startups and boosting economic growth and productivity, and provides recommendations to support the growth of the European VC industry.
Vulnerable VC Environment
Over the past decade, EU VC investment has averaged 0.2% of GDP per year, significantly lower than the U.S. average of 0.7%. This difference is also reflected in the fact that U.S. VC funds have raised $800 billion more than EU funds to invest in innovative startups.
The EU’s weak VC industry has negative implications for competitiveness, growth prospects and green ambitions. Several studies have shown that innovative, young and fast-growing companies that become “superstars” contribute proportionally to total jobs and growth. These companies typically invest heavily in research and development (R&D) and information and communication technology (ICT), two key areas where the EU lags far behind the US.
Europe also lags behind the US in terms of overall productivity: if the EU had maintained the same level of productivity growth since 2000, real output per hour in the EU would have been 26 percentage points lower.
VC funding is also essential for developing new technologies and scaling companies in the so-called “cleantech” sector, which the EU has identified as strategically important in its Green Deal industrial plan. However, European VC investment in these sectors is currently only a fraction of the level in the United States.
The EU’s weak VC environment has led many of the most successful EU startups to seek funding elsewhere, leaving the EU missing out on both the direct growth benefits and positive spillover effects that these innovative companies could generate.
For example, Miro, a Russian enterprise software publisher, moved its headquarters to the United States in 2019. The startup is valued at $17.5 billion. Chainalysis, a blockchain analytics company founded in Copenhagen in 2014, is now headquartered in New York and is valued at $8.6 billion. And Hugging Face, a French artificial intelligence (AI) startup, is now headquartered in New York and is valued at $4.5 billion.
Factors hindering VC activities
According to the IMF report, several factors contribute to the funding challenges faced by European startups. First, the EU’s fragmented economy and financial markets are a major obstacle. The European financial system is largely bank-based, and banks are often unprepared to finance high-tech startups due to a lack of tangible collateral, mismatches between bank risk models and the needs of fast-growing but initially unprofitable companies, and regulatory constraints that discourage risky investments.
European households are also more risk averse than their American counterparts. They prefer to place a greater portion of their savings in bank deposits rather than in stocks, investment funds, or private pension plans. This risk aversion contributes to a greater reliance on bank loans and unlisted stocks for financing in Europe, while listed stocks play a more central role in the United States.
Another major obstacle is the fragmentation of the European financial system. Cross-border banking integration is today lower than before the global financial crisis, capital markets remain fragmented, and private capital pools are confined to national borders. Most occupational pension schemes do not offer cross-border pension products because of differences in national social benefits and labor laws, and the associated costs, complexity, and operational risks. Pension funds and insurers also tend to have strong home country biases in their asset allocations.
In addition, regulatory, legal and tax frictions hinder cross-border investment and integration. Finally, lengthy and complex procedures for recovering withholding taxes discourage cross-border investment within the EU.
The report found that these restrictions resulted in the EU having fewer and smaller VC funds than the US, and similarly limited options for successful startups to “exit” through an initial public offering (IPO) or acquisition.
Fostering VC funding activities
The report outlines several proposals for reforming the EU’s economic and financial policies, while highlighting the need for greater market integration, targeted investment and regulatory coordination across the bloc.
First, it argues that the best solution to the EU’s size, productivity and growth problems lies in fully integrating markets for goods, services, labor and capital. The paper argues that achieving a truly single market would make it easier and less costly for the most productive firms to grow, find the talent they need, reap economies of scale and access deeper pools of capital.
He also stressed the importance of investing in education, R&D, and ICT to foster innovative startups, citing Estonia as an example, where the country’s emphasis on digital skills in education and public and private investments in digital infrastructure have helped create fertile ground for innovative startups to emerge and grow.
The paper also notes that startups need access to skilled workers and the flexibility to adapt as they grow. It recommends that EU policy assess immigration and labor laws to ensure that they do not impede startups’ ability to attract talent or adjust their strategies. The paper also highlights the importance of stock options as a form of compensation for employees in startups and calls for harmonized tax treatment of stock options across EU countries. In addition, developing portable private pension systems across the EU would make it easier for companies to attract skilled workers from other EU countries.
In the financial sector, the paper identifies VC as an important area of policy focus and suggests increasing public support for the VC industry. Reforms should consider tax incentives to stimulate VC investment, and national public finance institutions (PFIs) should play a more important role, complementing private investment. The paper also calls for closer partnerships between national PFIs and EU institutions such as the European Investment Bank (EIB) and the European Investment Fund (EIF) to strengthen regional VC ecosystems and connect them with more developed hubs across the EU.
Regarding the regulatory framework, the document notes that while the EU rules on VC are generally well-received, some fine-tuning may be needed. For example, the eligibility criteria for investors in large VC funds should be aligned with those for smaller funds to avoid unnecessary barriers. Furthermore, regulatory reform of the insurance sector and pension funds is needed to remove obstacles that prevent them from investing in private equity and VC.
Finally, the paper recommends a broad review of EU laws and regulations affecting high-tech sectors to identify unintended consequences that could hinder the growth of innovative companies. For example, recent regulations such as the General Data Protection Regulation and the Digital Markets Act have generally improved competition in the digital sector. However, the paper suggests that they can also create inconsistencies and complexity for start-ups.
Europe continues to lag behind the US in VC funding. According to CB Insights’ State of Venture Q2 2024 data, European startups raised a total of $14 billion in equity funding across 1,522 deals in Q2 2024, a far cry from the $39 billion and 2,419 deals raised by US tech startups.
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