Innovation by fiat

Well-meaning governments are killing the continent’s startups with kindness

May 17th 2014 | From the print edition
Timekeeper

IN A suburban office on the road to Luxembourg airport, a small group of civil servants is busy picking the next generation of European venture capitalists. Every year, hundreds of would-be financiers set out their stalls at the European Investment Fund (EIF), a body financed by the European Union, hoping they will be given money to create the next Facebook.

Europe has never been able to muster nearly the same quantity or quality of venture capital (VC) as Silicon Valley. That is frustrating to its politicians, who see venture capitalists as job-creating innovation machines, and love them nearly as much as they loathe other financial types. But investors who put up such capital in other parts of the world, such as pension funds, banks and billionaires, are not especially eager to funnel money to startups battling to thrive in Europe’s often hostile business environment. By and large, the politicians’ solution has not been to make the environment friendlier to business, thus increasing entrepreneurs’ chances of luring private-sector backing. Instead, they have replaced the reticent financiers with state-funded bureaucrats.

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Europe
Nearly 40% of all the funds pumped into European VC last year came from state-backed sources, up from just 14% in 2007 (see chart). The EIF alone ploughed €600m ($800m) into VC funds last year, out of a Europe-wide total of €4 billion. On top of this, nearly every country has its own pet programme to back chosen venture capitalists.

Despite taxpayers’ generosity, few think Europe’s VC industry has much chance of attracting American levels of capital from private investors, given its feeble record. Venture capital in Europe has delivered returns of just 2.1% a year since 1990, according to Thomson Reuters, making it perhaps the worst investment class outside Japan (American VC managed around 13%). The 2008 crash, which came just as investors were getting over the fortunes they lost in the internet bubble, sapped what little interest remained.

The public cash slushing around VC-land may in fact be repelling private money. Investors turn to VC hoping to attain vast riches by nurturing the next Google or WhatsApp; they are loth to invest alongside governments whose interests lie only partly in turning a profit. State money comes with strings attached, be it an encouragement for venture capitalists (or the companies they finance) to create jobs in particular countries or to focus on certain favoured sectors. This is anathema to private investors, who fear their money would be used to pursue political goals. “I understand why governments invest in venture capital, but they are spoiling it for the rest of us,” says an endowment-fund boss.

Several studies of public VC schemes have found that for every dollar the public sector puts in, the private sector pulls one out. The EIF says it worries about this, so it only matches funds that VC firms attract from private backers. “We are driven by a need and a wish to address market gaps,” says John Holloway, a high-up there.

Some think that the handouts from taxpayers are also impairing the quality of European venture capitalists’ investments. The EIF alone has sunk more than €3.8 billion into 260 venture funds, but provides no data on how its investments have fared. Ho-hum entrepreneurs whose firms only launch because of government backing (and dud firms that would have folded long ago without it) drive down average returns. Meanwhile, funds relying on private capital have to pay more to outbid government-backed rivals.

European funds have poor returns in part because they sell companies too early, missing out on bumper returns that come from placing longer-lasting bets. Government money spurs such conservatism: it is better for a fund to “bank” a good deal and guarantee access to later dollops of government cash than to roll the dice again. Such thinking horrifies private investors.

Several European startups have successfully launched initial public offerings recently, including King.com, which makes an addictive game called Candy Crush Saga, and Criteo, an advertising-technology firm. But both had been backed by American as well as European money, and have listed their shares in America. They may soon be joined by Spotify, a trendy music service that has been European VC’s poster child. Many bright Europeans continue to flock to California before they even start their businesses.

It is not that Europe has no need for innovative startups and the jobs they bring—just the opposite. But entrepreneurs say there are better ways of boosting their chances than dollops of taxpayers’ cash. “We have labour laws designed for workers in large corporations, they don’t work for startups,” says Niklas Zennstrom, a founder of Skype who now runs an (EIF-backed) venture fund. Tax laws in several EU countries make it hard to pay staff with stock options, a standard carrot for American startups. Rules about procurement often favour established firms. More broadly, Europe’s staid business culture is too slow to forgive failure, in contrast to America where setbacks are celebrated as a necessary staging point to success.

Josh Lerner of Harvard Business School compares doling out public-sector cash, EIF-style, to serving a main dish before the table is set. Governments the world over have long backed innovation, for example through public funding of universities. Silicon Valley thrived in part due to bloated defence spending from the 1940s onwards. But that is altogether different from Europe’s approach of picking the firms that pick the winners. Better to make entrepreneurialism pay than to subsidise it.