European Startups as an Asset Class
European Straits #162
Hi, it’s Nicolas from The Family. Today, I’m making the case for European tech, sharing a synthesis of what could become an investment thesis for asset allocators.
⚠️ I wrote a new column for Sifted about the industrial policy lessons we should draw from the success of so many European startups in the fintech space. Basically, you need two things: a supportive ecosystem at the local level (in fintech, that’s London); and the European Union enacting rules to ensure a level-playing field at the continental level and remove obstacles to scaling. It’s good that it worked in financial services—now we need the same thing in mobility, healthcare, education, agriculture, and more! Read the whole column here 👉 What European startups can learn from the success of the fintechs 👀
Also, last week I had the pleasure of speaking in front of a group of representatives of very large family offices from Europe and beyond, and the topic was European Startups: A New Asset Class. Below are the ideas I shared with them (and this week I’ve added links within the text rather than at the end) 👇
1/ There’s a group of people in the world who are interested in the fact that more and more startups are growing outside of Silicon Valley. Because it’s such a fringe topic, this is a small group and most of these people know each other. I’m one of them, but there’s also Ben Wiener (in Jerusalem), Matt Clifford (CEO of Entrepreneur First), Ian Hathaway and Richard Florida (who wrote this report together), Steve Case (who coined the concept of the “rise of the rest”), and Christopher M. Schroeder (who shared his thesis about startups in the Middle East in his great book Startup Rising).
Recently I was exchanging emails with Chris about this topic (startups outside the US) and we ended up with the list of objections that people usually make when we explain that maybe they should look beyond Silicon Valley when it comes to investment opportunities:
There are so many fantastic, less risky, more liquid opportunities.
If you were in the public markets over the last decade you generally did better than most VC firms [See my recent issue on What’s Happening With the Stock Market?]
Yes, things are changing for the better outside the US, but if I invest in a top US VC firm I will benefit from their portfolio companies expanding there without risk.
OK, there have been real up-rounds, but where are the exits? [Check out my Sifted column Investors in European startups need a clearer path to exit.]
The rule of law is getting more unpredictable than ever.
I’ve lost too much in emerging markets before.
You may be right, but there’s no urgency.
For additional context, please have a look at Chris’s recently launched newsletter, and then subscribe 👊 (two VERY interesting issues to date):
2/ When you read all of the above and you know a thing or two about innovation, the late Clayton M. Christensen and his theory of disruption immediately come to mind. Here’s a quote from The Innovator’s Dilemma:
First, disruptive products are simpler and cheaper; they generally promise lower margins, not greater profits. Second, disruptive technologies typically are first commercialized in emerging or insignificant markets. And third, leading firms’ most profitable customers generally don’t want, and indeed initially can’t use, products based on disruptive technologies.
Now translate that quote in terms of tech startups, venture capital, limited partners, and returns on investment. Here’s the result:
First, non-US startups are simpler and cheaper; they generally promise lower valuations, not greater returns. Second, those typically grow on emerging or insignificant markets. And third, leading VC firms’ most demanding LPs generally don’t want, and indeed initially can’t use, exposure to startups outside the US.
I guess you know where I’m headed: asset allocators are following a known and safe playbook by overlooking European startups (like Christensen’s integrated steel companies). But that then becomes an opportunity for new (disruptive) allocators (Christensen’s minimills) who are willing to make an early bet on these “lesser” startups, grow from there, and then eventually compete with established players for the best, most lucrative deals at the high end of the startup market in Silicon Valley.
What Europe Could Learn from Clay Christensen (me, European Straits, January 2020)
The Future of Silicon Valley (me, European Straits, February 2020)
3/ Now, it’s true that European startups don’t look like much yet. We don’t really know about returns because VC firms don’t advertise them (although I’m told by people in the LP world that most European VC firms are doing terribly when compared with leading firms in Silicon Valley). What we know, however, is the following:
We have a liquidity problem. The fragmentation of today’s world makes it increasingly difficult for US and Chinese tech companies to acquire European startups. And large European corporations have been so disappointed with most past acquisitions that they’re not in the market for buying startups anymore. So since we don’t have European tech giants (yet) nor a functioning secondary market, it’s very hard for investors to cash out of European startups.
Europe seems to be doing better in general, but it is in part an illusion. First, venture capital is growing in Europe, but no more than in the rest of the world. Europe is rising with the global tide, not racing ahead. Second, there’s more money flowing in from Asia and the US, but the flow is still sporadic rather than systemic (have a look at this article discussing the problems that Sequoia is having with hiring a local partner in London). Third, many Europeans cling to the idea that Europe can fall back on deep tech startups, but I believe that’s a likely dead end. As I wrote in a past issue, developing deep tech assets is not the same as building successful startups.
Still, we can be optimistic and think that things are bound to get better. One argument, developed here, is that there is now a plurality of models when it comes to growing tech giants (Silicon Valley, China, Southeast Asia, the Middle East, soon Africa), and so there’s no reason why Europe can’t discover its own, different way. Another argument is the one I introduced above, echoing Christensen’s theory of disruptive innovation, that Silicon Valley is doing so well that it’s bound to be disrupted by rising entrepreneurial ecosystems (and their happy investors) elsewhere in the world. Let me make a list of seven disruptive trends that I think could favor Europe eventually standing out on the global tech scene.
Investors in European startups need a clearer path to exit (me, Sifted, September 2019)
Europe Shouldn’t Be Content With Boring IPOs (me, European Straits, October 2019)
4/ The first is the fact that software is eating the world, bringing tech entrepreneurs into industries that demand more of a local presence:
More tangible. Simply put, operating a truly global business was conceivable when it was about providing content. But when it’s about creating an experience based on tangible assets, such as in retail (Amazon), mobility (Uber), hospitality (Airbnb) or healthcare (still no winner in sight), it distorts your capital allocation to the point where it’s less relevant to minimize your local presence. Asset-light approaches like those taken by Uber and Airbnb are still an option, but they can come with a very high price, best seen in the case of Uber: it makes it easy for many competitors to come into the ring and grab market share from you.
More regulated. It’s very rare that regulations are the same from one country to another, let alone from one continent to another. Therefore if you want to operate beyond your domestic market, you need to comply with different sets of regulations, which in turn requires having a lot of people on the ground. Ultimately any business trying to expand internationally on a regulated market will take a hit in terms of scalability and it will make riding local champions more viable.
Go further on these topics:
The Digital World Is not a Flat Circle (me, The Family Papers, October 2015)
Unicorns: Why This Bubble Is Different (William H. Janeway, Forbes, May 2015)
5/ The second trend is that the world is fragmenting at an accelerated pace. Asset-heavy business models and local regulations are not the only reasons why it’s getting difficult for tech companies to operate at a global scale. The world’s economy is fragmenting due to the retreat of free trade and increased economic patriotism that leads many countries to support the rise of local tech champions.
Five years ago, you could still think that Uber would be to mobility was Google was to search: a global company operating at a global scale. But now that Uber has been kicked out of entire regions such as China and Southeast Asia and is struggling to maintain a foothold in India, we all realize that the digital economy is much more fragmented than we expected. Business strategy and geopolitics collide to make it more probable that local champions will emerge on many regional markets, including Europe.
What Trump Did to Silicon Valley (me, European Straits, October 2019)
Big Tech in a Fragmented World (me, European Straits, November 2019)
6/ Third, local ecosystems are getting better by the day. This is our realm at The Family. Over seven years of operations we’ve seen the Paris entrepreneurial ecosystem change a great deal. Entrepreneurship has become more of an option for more people. The level of ambition has gone way up. Entrepreneurs have an easier time accessing talent and capital, and government authorities tend to be less hostile when startups enter regulated markets.
And the exact same phenomenon is happening in almost every other capital in Europe. We know because last year we went on a European tour and spent several days on the ground in each city, meeting founders, angel investors, ecosystem builders, and others. Some are doing better than others, certainly, but the same trend is at work everywhere: startups are on the rise and founders are learning at a very fast pace.
5 Steps to a Healthy Entrepreneurial Ecosystem (me, The Family Papers, July 2016)
Thoughts on Copenhagen, Intensity & Hygge (my colleague Mathias Pastor, The Family, October 2018)
7/ Fourth trend: there is now such a thing as a pan-European ecosystem. Here are two examples:
We now have several media covering European tech with a pan-European perspective. There are veterans (Tech.eu), and more recent entrants like the Financial Times-backed Sifted (where I’m a columnist), Reflexive (which, for now, sends a daily newsletter called Close of Business), and Politico Europe. (Wired UK could be part of that group, but sadly it’s focused on one European country only.) It’s important that European founders read about themselves and their peers with a European perspective rather than a US one (which always comes with mental and cultural distortions as well as understaffing on the ground).
VC firms, too, are learning to cover Europe as a whole. There are obviously different approaches: opening offices in several European cities, hiring scouts to generate deal flow at the earliest stage, having senior partners criss-crossing geographies, and doubling down on content to make yourself known by founders across the continent. Unlike 10 years ago, it’s now normal for an ambitious founder to go and pitch VCs in London—just like it’s normal for a VC to look at investment opportunities beyond their domestic market.
But we’re still lacking a pan-European market for talent as well as a shared European tech culture that would make it easier for people with very different cultural backgrounds to come together and build great companies.
The European Tech Ecosystem Doesn’t Really Exist (Yet) (my colleague Hugo Amsellem, The Family, September 2019)
Will Fragmentation Doom Europe to Another Lost Decade? (me, European Straits, January 2020)
As distributed work is becoming the norm, European entrepreneurs can embrace it to finally make the most of the fragmented pan-European market. This approach would make it easier to build pan-European tech companies with employees located in different European countries yet part of the same organisation.
I think, however, that it could go in two very different directions. One is that European founders acknowledge the potential of distributed work for building pan-European companies. The other is that Silicon Valley piggybacks on that trend, capturing European talent for the benefit of US tech companies and thus depriving local founders of a critical resource. It’s too early to tell, of course, but I hope that the former scenario will prevail.
Silicon Valley Nearing the Breaking Point (me, European Straits, April 2019)
The year of remote working (me, Sifted, December 2019)
9/ Sixth, there’s the fact that funding options are more and more diverse and adapted to the particular financial profile and needs of European startups. We may have difficulties blitzscaling because of the continent’s fragmentation, but viewed from another perspective this weakness becomes a strength: European startups are much more cash efficient and reach profitability faster. That means it’s only a question of time before the financial services industry learns to provide them with the funding that they need—not the traditional venture capital designed for blitzscaling, but more diverse, complex funding options serving the needs of a new generation of startups in more tangible industries, with tougher regulatory challenges, and needing to scale on a much more fragmented market.
Reinventing Financial Services (me, European Straits, May 2019)
Debt Is Coming (Alex Danco, Two Truths and a Take, February 2020)
10/ Finally, the European Union, despite all its shortcomings, is contributing to making things better. A good example is in financial services, where startups have been thriving for a few years now, thanks to two factors. One is the supportive ecosystem that is London, while the other is the many directives enacted by the European Union to ensure a level-playing field in financial services in Europe.
We’re not sure what will happen with all that after Brexit, but it’s worth mentioning that the European Union, far from being a foe of innovative startups, can actually become an ally for any entrepreneur that wants to use technology to deliver quality at scale on the very large market that is Europe. Again, read my latest Sifted column: What European startups can learn from the success of the fintechs.
Will these seven favorable trends be enough for European startups to thrive? We can only try to spot the trends and act upon our hunch that the next decade won’t be like the last. Meanwhile, keep in mind Christensen’s theory that if you play by the book and do everything it says, you’re certain to lose in the end. It’s true for incumbents in traditional industries focused on the high end of their market, and it’s true for asset allocators that stick with Silicon Valley and its high returns, not seeing any reason to put more of their cash into the nascent asset class that is European startups.
🇫🇷 I’ve just spent 10 days in France to meet as many journalists as possible and talk about my new book Un contrat social pour l’âge entrepreneurial (the French version of Hedge). For those among you who speak French, here are some videos and articles released during the last few days:
📹L’avènement de l’économie numérique (BFM Business)
From Paris, France 🇫🇷