The Financial Challenges Facing Europe’s Tech Startups

Why is Europe Struggling to Create Its Own Google, Amazon, or Facebook?

The question of why the European Union (EU) has yet to produce its own tech giants akin to Google, Amazon, or Facebook is a complex one. Many speculate that the continent may be lacking in entrepreneurship, technical expertise, or even the imaginative vision necessary for such groundbreaking innovations. However, the reality is that the EU actually outperforms the US in terms of generating high-tech start-ups. The underlying issue lies in the financing of these ventures. The solution is straightforward and has been overlooked for years: the crux of the matter is money.

In fact, over the past five years, the EU has successfully launched more high-tech start-ups than the US. Yet, a significant number of these enterprises fail to scale up, while others relocate to more favorable environments across the Atlantic.

Europe’s Timidness on Display

A fundamental reason for this predicament is the cautious nature of European investors. Many Europeans lack the financial sophistication required to make informed investment choices. In the EU, a staggering 31% of household savings are held in cash or deposits, compared to just 12% in the US. This disparity leaves less room for engagement with stocks and bonds within the union. Consequently, the EU banks are awash with deposits, holding twice as much money relative to GDP as their US counterparts, while their capital markets for stocks are only half as robust. The situation is similar for bonds.

European institutions have been aware of this issue for years and occasionally manage to allocate one or two billion euros toward funding start-ups. While this is a positive step, it pales in comparison to the vast scale of the funding gap.

This lack of financial backing has dire consequences for innovation. Approximately 80% of financing for EU firms is derived from bank loans, which is clearly not an ideal mechanism for funding high-risk start-ups. These ventures typically lack a proven track record and possess primarily intangible assets that are unsuitable for use as collateral.

When examining the landscape of finance for start-up companies, the situation becomes even more alarming. The US boasts 20 times more venture capital than the EU, with €1.3 trillion compared to a mere €72 billion in Europe.

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Moreover, firms that are not yet prepared to go public through an IPO struggle to secure venture capital or private equity funding, receiving on average only one-fifth of the venture capital or one-twentieth of the private equity funding available to their US counterparts.

Despite the occasional influx of funding from European institutions, the amounts allocated are insignificant when viewed against the enormity of the challenge.

How Did the US Achieve Its Silicon Valley?

Often overlooked in this discussion is an understanding of how the US cultivated its Silicon Valley. Certainly, brilliant and enterprising technologists played a role, as did government funding for research initiatives. However, a pivotal change occurred with the enactment of the Employee Retirement Income Security Act (ERISA) in 1974, which transformed the regulation of pension funds. Prior to ERISA, pension funds were largely restricted to safe investments. The legislation altered this landscape by acknowledging that a “prudent person” would typically seek a portfolio that included a blend of riskier instruments. This change unleashed a significant influx of pension fund capital into venture capital, making the evolution of Silicon Valley as we know it today possible.

Today, the EU finds itself in a similar situation to that of the pre-ERISA US, and this is a critical reason why the notion of a “European Silicon Valley” remains elusive.

However, this need not be the case. EU pension funds currently hold assets totaling around €4 trillion, while the insurance sector, which includes pension-like plans, boasts assets of approximately €9 trillion. Although pension funds do invest billions into venture capital annually, these investments represent a mere fraction—less than one-hundredth of 1% of their total assets.

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There is no shortage of promising EU firms ripe for investment. In fact, the EU generates more start-ups than the US each year, with venture capital returns running about 6% higher in Europe. The average returns on venture capital investments in the EU are around 29%, characterized by surprisingly low volatility.

Clear and Straightforward Measures Needed

One might instinctively argue against pension funds investing in high-risk ventures for the sake of future pensioners, but this perspective overlooks a crucial point. Investment advisors typically recommend diversification in portfolios, which should include a mix of risk-return profiles aligned with individual investment goals. Pension funds recognize this, and many are eager to shed overly restrictive regulations imposed by member states.

A twenty-fold increase in pension funds’ current investments in venture capital could effectively triple the EU’s annual contribution to this sector, all while still representing less than 0.2% of pension funds’ assets. This approach would not only benefit the digital sector but also enhance the performance of our pension funds, insurance sector, and ultimately, the financial security of future pensioners.

While concerns may arise regarding those nearing retirement, implementing straightforward rules or guidelines could help mitigate the risks associated with high-risk investments for this demographic.

In summary, the measures necessary to enable the EU to cultivate large-scale digital champions are clear and actionable. The path forward promises to enhance not only Europe’s digital landscape but also the well-being of its pension funds and citizens. The only obstacles in our way are a sense of timidity, conservatism within Europe, and a lack of a comprehensive policy framework to implement these essential changes.

J. Scott Marcus is an economist, engineer, and public policy analyst. He serves as an Associate Senior Research Fellow in the Global Governance, Regulation, Innovation, and Digital Economy (GRID) Unit at the Centre for European Policy Studies (CEPS).

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