During the 1990s, some important changes have transformed the prospects of European entrepreneurial firms. First, the introduction of the euro, and its consequences at both product and financial market level, substantially advanced the creation of a truly European economic area. Second, there was the creation of several new equity markets targeted at innovative firms, as European stock markets have traditionally been unwelcoming of young companies without an established track record. A third major change was the dramatic increase in the supply of venture capital (VC) in most EU countries, which provided access to risk capital financing for entrepreneurial companies.
These changes have been potentially very important. Studies based on US evidence have shown that venture-backed companies are more effective in innovation and grow at a higher pace. The lack of well-established venture capital industry has therefore been identified as a major cause for the paucity of European star entrepreneurial companies. Hence one of the European Commission's goals has become the development of a European venture capital industry as a crucial step to foster entrepreneurship, competition, innovation and growth.
Unfortunately, much of the public debate on the European venture capital industry has been based on weak scientific evidence.
The facts on European venture capital
The Survey of European Venture Capital (SEVeCa) is the largest academic study to date about the industry. Its goal is to provide objective data on the state of the European venture capital industry. To that end, data were collected on the activities of European venture capital firms for the period 1998-2001, including information on more than 1,300 investment companies, more than 400 venture capital partners, and more than 150 venture capital funds. The main data collection for SEVeCa consisted of a survey sent to all registered European venture capital firms. The data were augmented with publicly available sources (e.g., web pages) and numerous direct enquiries at the venture capital firms. The overall response rate (15%, which is considered quite high for this type of research) has guaranteed a dataset which is highly representative in terms of countries and typology of VC.
The main findings from the research project are that the European venture capital industry is much more integrated than previously believed. It also has significant links to the US, and is increasingly emulating US investment practices. However, some aspects remain distinctively European, such as the prominence of banks and corporations as investors. Bank venture capital firms have different investment styles: They tend to invest much less in early-stage deals and are less likely to frequently monitor their firms or to sit on the board of directors. That fact might be one possible explanation of the lack of evidence of a positive role of venture capital on firms' growth, when the analysis is conducted on firms listed on the Euro.NM in the same period.1
It is often believed that European venture capitalists are purely local investors who do not venture beyond their country borders. The SEVeCa study disproves this belief, showing that the European venture capital market is surprisingly integrated. First, 27% of all venture firms in the sample have a secondary office in a foreign country. Second, 25% of all venture capital firms have partners that come from a foreign country. Third, 24% of investments are made in foreign companies. The fraction of deals with foreign investors is particularly high in industries such as in financial services (42%), media and entertainment (34%), and telecommunications (31%). The US is by far the most popular destination for foreign investments, accounting for almost a third of all foreign deals. There are multiple additional links between the European and US venture capital markets. For example, as many as 34% of all European venture capitalists had some work experience in the US.
A unique feature of the research project is that it allows to examine the human-capital basis of the European venture capital firms.2
By linking data on investment deals to the partners who are in charge, the study documents the interrelationships between human capital and investment styles. For example, the data show that partners with advanced degrees (master’s or doctoral level) are more likely to make early-stage deals and sit on the board of directors. Level of professional experience prior to entering the field is important as well. Almost all venture capitalists who sit on the board have prior experience in finance, and three out of four also have a science education.
Compared with their US colleagues, European venture capitalists have the reputation of being “hands-off ”— i.e. conservative and non-interfering. The SEVeCa data, however, point to the presence of an increasing variety of investment styles across the continent. Sixty percent of all deals are seed or early-stage investments, indicating a healthy level of risk tolerance. In terms of getting involved with their companies, 68% of venture capitalists sit on the board of directors, 69% monitor their company on a monthly or weekly basis, and 42% help to recruit key managers for their investment companies. The industry is also undergoing changes—whereas older venture capital firms tend to have more conservative investment styles, new entrants tend to be more risk-tolerant and to get more involved. The data show that new entrant firms invest more at the seed stage and that they monitor their investments more closely. Interestingly, partners in new entrant firms are no younger than those in the old guard firms (the average age of a European venture capitalist is 42 years); this suggests that they have more prior professional experience. Partners in new entrant firms are also more likely to have a business education and a master’s degree. All of these characteristics help to explain why the new entrant firms adopt investment styles that more closely resemble those of US venture capital firms.
Obviously, it would also be important to know whether the level of VC involvement with the companies they finance affect their performance. Ideally one would like to measure investor returns, but it is well known that venture capital returns are not publicly available. One possible way of measuring performance is to look at whether the invested companies experience a successful exit, defined either as an IPO or an acquisition. The SEVeCa data indeed show that investor activism has a positive effect on exit performance.
However, it is not only the difference in organisational and human capital that matters. There is ample evidence that factors like regulations, the size of openness of the economy, the development of equity markets, and the legal system create institutional constraints that shape the demand and supply of credit, and result in very different financial structures among economies.
The richness of the data allows to look at how the entire relationship – contractual and non-contractual – between an investor and an entrepreneur depends on the legal system.3 The results support that better legal systems are associated with more investors’ involvement and more downside protection for the investors: in bad states of the world, the venture capitalists and the entrepreneurs use securities such as debt, convertible debt, or preferred equity. The underlying intuition is that investing in support activities is only worthwhile if the legal system provides investors with sufficient guarantees that these efforts will not be wasted.
The SEVeCa study generates many important and novel policy implications. Our first and most important finding is that human capital is a key driver of the investment activities of venture capital firms. Improving the availability of postgraduate education, including executive education or other professional training, is likely to have a very positive effect on the level of professionalism in the industry. Second, the extent of cross-country activity within Europe—and across the Atlantic—shows promising signs of an integrating market. European venture capitalists clearly consider it important to be able to invest outside their own country. Simplifications of tax rules and cross-border investment regulations are likely to have a strong beneficial impact on the integration of the European venture capital industry. Third, we document a wide variety of behaviours by different types of venture firms. It is very important that healthy competition among these different approaches to venture financing be encouraged. Measures which reduce bureaucratic red tape, or which increase limited partners’ ability to invest in all types of venture firms, as well as across borders, are likely to serve this purpose.
1 See “Venture capital in Europe and the financing of innovative companies,” L. Bottazzi and M. Da Rin, Economic Policy, 2002.
2 “Active Financial Intermediation: Evidence on the Role of Organizational Specialization and Human Capital,” Laura Bottazzi, Marco Da Rin and Thomas F. Hellmann, ECGI - Finance Working Paper No. 49, 2004.
3 “What Role of Legal Systems in Financial Intermediation? Theory and Evidence,” Laura Bottazzi, Marco Da Rin and Thomas F. Hellmann, ECGI - Finance Working Paper No. 82, 2005.