13 Mar 2017

Where are Europe’s unicorns?

In February 2015, the EU embarked on one of its most ambitious initiatives to date: The Capital Markets Union or “CMU”. The main aim? Unlocking funding for Europe’s much-needed growth.

Two years on from the launch of this flagship programme and some are beginning to sow seeds of doubt that it may not manage to be completed, given the speed of the progress made and particularly following the UK’s decision to leave the EU.

But this makes it even more important to complete the CMU project. Indeed, the European Commission is now gearing up to announce the findings of its mid-term review. And while there is still much work to do, there is one crucial issue which especially requires the project’s momentum to be maintained: addressing Europe’s lack of risk capital.

Among the 23 million small and medium-sized enterprises (SMEs) in Europe, only a fraction are high-growth companies, quick to grow, invest, create jobs and become leaders in their respective markets. For example, in Belgium, young small firms represent 17% of total employment, but 41% of total job creation, according to Belgium’s Federal Planning Bureau. Yet, start-ups, scale-ups and high growth companies struggle to access the risk capital they need to survive and grow and that’s a problem.

While some sources of capital, such as crowdfunding and business angels, are becoming more accessible, the crux of the problem remains the “entrepreneurship gap” between the EU and other large economic blocks, notably the US. If companies do not have the understanding of, or are unwilling to, tap capital markets to fund their growth, it will be difficult for the EU economy to break out of its current sluggish pattern.

Pinch points
As AFME shows in a new report entitled The Shortage of Risk Capital for Europe’s High Growth Businesses, one area where Europe is lagging far behind the US and Asia is in terms of the number and value of unicorns. (Not the mythical variety, but high-growth, venture capital-backed companies with valuations of more than $1bn.) For example, Uber ¬¬- the most valuable venture-backed private company in the US - is worth $68 billion while Europe’s most valuable unicorn, Spotify, is worth just $8.5 billion, according to Dow Jones VentureSource.

The EU’s fragmented internal market is partly to blame. The sheer complexity of different rules, taxes and standards across the 28 Member States hamper young businesses seeking to scale up across borders. Establishing a single EU framework for start-ups, with standardised rules across countries, would help to remove this barrier.

Fragmentation also occurs within the business environment in Europe. According to the European Commission’s Regional Innovation Scoreboard, Southern Germany, Southern England and the Nordic regions, as well as Paris and Berlin are among the most innovative locations while Southern Europe and Central Eastern Europe continue to heavily rely on more traditional bank finance. While many existing SMEs use bank loans as an appropriate source of financing, high-growth or innovative businesses have different needs and require risk capital to grow.

The high-growth period is a critical time where companies burn cash and have to find the capital to invest in research, the numerous organisational changes, marketing and staff numbers required to sustain the growth.

But fragmentation is not the only challenge in Europe. There is a lack of awareness among Europe’s entrepreneurs and “family and friend” investors about the benefits of risk capital at the seed stage of development. Although many entrepreneurs turn to bank loans or take loans from family and friends when they need cash, in many cases risk capital in the form of equity or quasi-equity is more suitable for young businesses without dependable cash flows or assets. But the willingness in Europe to use these products is significantly different to the US.

As a result, many equity products in Europe are underused. The development of private individual investments from so-called business angels or crowdfunders would help young businesses to get the necessary capacity for building their products at the earliest stage of investments and at the same time contribute to an entrepreneurial culture of private individuals.  

Institutional investors could also be put to work by scaling-up the venture capital industry which is a pre-requisite for the development of high-growth companies. VC funds do not deploy enough investments to businesses that desperately need this money, especially in later stages where important investments need to be done in their value chain and to hire, develop perfected products and expand internationally.

Other financing roads could be investigated. Venture debt, for example, is relatively new but poorly understood financing method. Venture debt provides customised debt financing for young and innovative venture-backed companies as an interim financing method to grow operations before having another venture capital financing round. As such, promoting and increasing awareness of this financing route could significantly help the growth of Europe’s innovative businesses.

The bottom line is start-ups with long-term prospects, a relevant business plan and management team should seek large amounts of start-up funds - ideally equity or quasi-equity– to really boost their chances of success.

Building on recent initiatives
The CMU Action Plan states that “so far, external equity funding for SMEs is rather limited in Europe”. EU policymakers are undoubtedly aware of the challenges they face and have their work cut out.

In fact, there have been many constructive initiatives to increase access to finance for SMEs. Recent examples are the launch the Start-Up and Scale-Up initiative and the expansion of the Investment Plan for Europe – which also provides significant support in terms of risk capital via the European Investment Fund (EIF) - unlocking €75bn for SMEs, the review of the Prospectus Regulation to improve larger SMEs’ access to capital markets, the review of the securitisation framework and the launch of the European Venture Capital Funds (EuVECA) regulation.

But further flagship initiatives for unlocking risk capital across Europe, covering the various investment stages and sectors are much-needed. A good starting point could be for policymakers to create a high-level group, including all the stakeholders involved in pre-IPO finance to review all the different challenges and opportunities surrounding the funding escalator.

If Europe’s high growth businesses are going to be competitive on the global stage, momentum on the Capital Markets Union project has to be a priority.

A version of this op-ed appeared in Handelsblatt on 7 March 2017.

AFME’s report, “The Shortage of Risk Capital for Europe’s High Growth Businesses” can be downloaded here

The Shortage of Risk Capital for Europe’s High Growth Businesses