From Scale to Purpose? The EU should support homegrown tech startups

EU start ups: As the global race for tech dominance intensifies, the EU has shifted gears to support its homegrown startups. Yet creating European unicorns that can compete with the US and China will require bigger thinking than the EU can currently muster. In the meantime, why not reinforce Europe’s other strength, by using technology strategically to help solve the social and environmental challenges of our time?

Bold EU thinking – but global leadership out of reach

As China rises and the US wavers, the European political debate is awash with terms such as “strategic autonomy,” “digital sovereignty,” and “innovation made in Europe.” And ever since European tech companies seem to be catching up with their US competitors, European political leaders have begun to express new ambitions for homegrown tech sectors.

Take French President Macron, for instance, who argues that Europe must switch from its 70-year-old “catch-up economic model” to instead “lead the digital transformation through radical innovation” – a key priority of the French EU presidency that began this month. Such bold assertions are in line with Europe’s trend of geopolitical self-assertion with respect to the US and China.

Suddenly, European startups find themselves in the midst of a new global battle conflating economic interests, new technology, and political ambitions. Their apparent new role is to grow quickly into the new European “Digital Champions” called for by ambitious politicians.

However, a closer look at the European startup ecosystem reveals a paradox. Europe boasts a long tradition of successful research and innovation. And European economic integration offers the prospect of a single market that should compete globally. But the European startup industry appears underdeveloped compared to its global competitors – despite an explosion in the number of companies setting out to conquer new markets over the last decade.

One simple reason for this stands out. While US startups have received $1.2trn in Venture Capital (VC) investment since 1995, the figure for Europe is just one-sixth of that at $200bn. Optimists point out that Europe is catching up: Its VC market has grown from 4% of the global market in 2004 to 15% in 2020. And European VCs raised record amounts of new funds in 2020. What’s more, a remarkable 38% of global seed-stage capital – that is, funding for the growth phase – is raised by European startups.

The crucial figure, however, is this: while Europe’s startups raised more than a third of early-stage capital, the funding raised by scaleups – that is, companies aiming to grow – declines sharply to only 9% of so-called “mega-rounds plus,” where funding is beyond $250m. Instead, 50% of such rounds came from the US and almost 40% from Asia.

In short, pretty much every successful company emerging from European universities and startup ecosystems is destined, sooner or later, to leave the continent. This has a direct impact on Europe’s global standing – by harming its competitiveness, employment, tax base, and indeed the growth of its innovation ecosystem, which relies on virtuous feedback-loop

The EU joins hands with the sector – but a funding gap remains

Unsurprisingly, then, the issue of funding is central in the most recent demands formulated by European startup associations, restated succinctly in light of the COVID-19 pandemic and – for the first time – aimed directly at European policymakers.

Regarding investment and finance, associations call for a “multi-tier plan to unleash private funding, especially the VC sector,” and for an “increase in public funding.” Regarding the crucial issue of late-stage funding, they recommend that the EU create “a tech buy-out fund to accelerate direct and indirect shareholdings in strategic sectors for Europe, such as health, cybersecurity, Artificial Intelligence (AI), quantum computing or blockchain.”

Following intense consultations with the startup sector, the EU has undoubtedly shifted gears. The newly designed European Innovation Council (EIC), for instance, began making direct equity investments into European tech startups in January 2021, a groundbreaking development in the EU’s innovation policy. The EIC fund will have the capacity to inject €3.5-4bn into the market by 2027 and hopes to attract a further €30-50bn in private investments.

Such efforts would contribute to reducing the gap in VC funding between Europe and the US. And – at least in theory – this means that the European Commission, which runs the EIC, could become a shareholder of a future European Google of its own. And the EU is doing more – InvestEU, the bloc’s guarantee program for European SMEs, will also provide additional support.

In the long-term, however, the lack of large-scale financing in Europe means that the probability of European-bred companies being bought by – most likely – American VCs will remain as high as ever.

One of the key differences between the US and European capital markets is the fact that institutional investors play a much larger role in providing VC in the former than in the latter: more than half of the nearly $160bn fundraising in the US between 2012-16 came from institutional investors compared with just over a quarter of the nearly $50bn raised in Europe over the same period. Pension funds make up a large part of these institutional investors.

These profound structural differences make it difficult for Europe to generate the private-sector savings required to support significant VC activities to become the world’s leading region for tech development. Regulatory differences exacerbate the problem.

So even the achievement of more modest goals – such as a degree of control over strategically relevant tech industries – would require much larger funding structures at the European level. One answer is the creation of a European Sovereign Wealth Fund (SWF). Indeed, plans for such an entity are reported to circulate within the European Commission under the title “European Future Fund,” with a view to investing European public money into sectors deemed strategically important.

However, such a fund quickly ran into political resistance and did not make it into the EU’s 2021-27 budget. Instead, the European Investment Fund (EIF) tested the waters for a Pan-European Investment Platform for European Digital Champions to invest in growth stage VC firms which in turn invest in the pre-and post-IPO segments of European tech startups – a compromise, given the political obstacles towards going full-throttle towards an SWF. Again, political differences relating to the complex ownership structures that the creation of companies funded through such a mechanism would ensure that the idea has not yet seen the light of day.

The measures set out by the EU – implemented or posited – are pioneering by European standards. And as calls for reforms to the EU’s industrial policy become more strident and groundbreaking initiatives on the part of Europe’s competitors begin to bear fruit, more creative initiatives will undoubtedly emerge.

Yet the policies and funding programs in existence at the EU level are unlikely to fulfill the bloc’s ambitions of leveraging the power of European tech startups to contribute to digital sovereignty. Instead, a substantially more active industrial policy that focuses on supporting young companies to grow will be necessary. In parallel, progress in completing the Single Market, particularly the Capital Markets Union (CMU), will be required to ensure deep, wide, and liquid investment flow across Europe.

Until then, current exertions in support of European tech startups could even be seen as somewhat self-defeating – at least in the informal view of one seasoned public investor: “Imagine setting up a Michelin Star Restaurant – but instead of developing a full menu, you focus only on high-quality starters. Don’t be surprised if other restaurants buy your starters and you end up a caterer.”

A different way forward?

If digital champions in the traditional, US-inspired sense are as of yet out of reach, what might the EU dedicate its attention to in the meantime when it comes to supporting its nascent tech start-up industry?

Interestingly, a closer look at the reasoning behind European policy-makers’ tech-sovereignty-rhetoric suggests that such ambitions are fueled not only by traditional objectives of growth and competitiveness – but more and more by a realization that disruptive innovation is required to solve the long-term social and environmental challenges faced within Europe.

This perspective is gaining ground in policy circles that were traditionally inclined to view innovation policy as technology- and sector-neutral. Virtually all EU-initiatives in support of startups and indeed innovation as a whole are branded politically as cornerstones to achieving the Green Deal or, more broadly, the United Nations’ Sustainable Development Goals (SDGs), which the EU supports.

The COVID-19 pandemic has intensified this focus, with public funds strategically channeled into the biotech-sector to create a vaccine being the most obvious example of such a “purpose-driven” approach to fostering innovation.

Using technology strategically to solve genuine social and ecological problems – that is, inventing green cement rather than yet another pizza-delivery-app – certainly resonates with a new generation of founders, as evidenced by a rapid growth in the field of social entrepreneurship and other forms of impact-oriented ventures.

The European Commission has indeed seized the momentum and followed expert advice to implement a “mission-oriented” approach to its €100bn Horizon-Europe programme. Focus and funds will be centred around five such missions, as diverse as climate neutral cities, healthy oceans and cancer treatment.

As for funding such ventures, ideas for harnessing both public funds and private markets to act as a key lever abound. These range from boosting the role of the European Investment Bank (EIB) as a key, risk-sharing “change agent”, to building up niche areas within global capital markets that are experimenting with purely purpose-oriented finance, such as impact investing.

Innovations in the field of accounting complement this shift towards using the force of business to solve societal challenges – “impact-weighted accounts” for instance enable companies – such as tech-startups – to demonstrate their net contribution towards stated missions. This in turn allows impact-oriented investors to channel funds accordingly.

Harnessing creative tech startups in support of both European sovereignty through a fully revamped industrial policy will take time; given deep-seated problems in the area of funding, the extent to which this will lead to European digital champions remains open. In the meantime, moving forward with steps that support and incentivize the next generation of European entrepreneurs to take on the challenges that matter could be the European way to go.

The EU, then, would do well to push for purpose rather than search purely for scale in developing the European startup ecosystem. In doing so, it would make a virtue out of necessity by playing to Europe’s comparative advantage, while visions of digital sovereignty via digital champions remain elusive.

A more detailed Policy Brief on the subject, co-authored with Frank Eich, can be found here:

Publikation (bertelsmann-stiftung.de)

BIO NOTE

Jake Benford works on Bertelsmann Stiftung’s Europe Programme, currently focussing on innovation and technology. He previously developed the foundation’s work on impact investing.