The US has seen a sharp decline in dealmaking this year, as venture capitalists try to figure out how to price deals and rationalize their pace in an economic downturn. The same cannot be said for Europe. Nearly $60 billion flowed into European start-ups and late-stage companies in the first half of this year, the second-highest amount on record.
What’s more, the European venture market continues to churn out $1 billion-plus unicorns at a record pace, something not even the collapsing value of Klarna can undo.
What explains the difference between the two markets? There are a number of reasons:
- Start-up valuations did not get as bloated in Europe as they did in the US.
- Most of the investments made in Europe have until recently been in early-stage start-ups, whose capital needs are generally much lower than those of late-stage companies and therefore less vulnerable to a projected capital crunch in the event of an extended market downturn.
- Higher-quality funds and portfolio companies have been socking away capital in preparation for periods of market volatility.
- Europe has matured into a key part of the global venture market. More and more VCs in the US and elsewhere recognize they must stay engaged in Europe so as not to lose out on compelling talent and investments.
Success breeds success. As unicorns proliferate, the market is expected to attract more capital, which will be spent to produce more unicorns, and so on. For all of these reasons, both GPs and LPs tell Venture Capital Journal they are optimistic about Europe even as a growing number of economists foresee a recession for the world’s largest economies.
If you’re looking for a bargain on an early- or late-stage company, Europe is more attractive than the US.
In the first year of the pandemic, the median pre-money valuations for late-stage and early-stage companies in the US were already more than triple and four times, respectively, those of their European counterparts, and the valuation gap has widened over the past year and a half.
The median pre-money valuation for late-stage companies in Europe is more than three times less than in the US – about $29.3 million compared with $100 million as of Q1, PitchBook reports.
The story is even better for early-stage companies, where the median pre-money valuation is more than five times less for European start-ups than for their US counterparts, or about $12.4 million compared with $70 million as of Q1, per PitchBook.
One factor that prevented valuations in Europe from getting as inflated as they did in the US is a smaller and less enabling IPO market that provided far fewer opportunities for high-priced exits than in the US.
“When the markets are in a downturn, the capital markets are the ones that react more strongly and immediately. And that’s something that is not felt here in Europe so much”
The number of VC exits in the US spiked 67 percent from 1,123 in 2020 to 1,875 in 2021, with almost 90 percent of those in 2021 achieved through public listings, according to PitchBook. That’s a far larger IPO market than in Europe and Israel, where 142 European and Israeli start-ups went public through December 6, PitchBook notes.
Europe’s less mature capital markets and less available liquidity actually works to its advantage during economic downturns, says Oliver Kahl, a principal at Munich-based MIG Capital, which makes early-stage investments in deep-tech companies. “When the markets are in a downturn, the capital markets are the ones that react more strongly and immediately,” he says. “And that’s something that is not felt here in Europe so much.”
Jessica Archibald, managing director of fund of funds Top Tier Capital Partners, agrees that European venture funds and start-ups won’t be as adversely impacted by public market volatility.
Many of Europe’s VC funds are newer, having launched just five to 10 years ago, with portfolio companies that aren’t yet mature enough to be raising pre-IPO or even late-stage rounds. “It still feels like the good funds are getting raised very easily, regardless of location,” says Archibald.
The entire fundraising process, from announcing a new fund to LPs, going through due diligence and holding a first close, is still being completed relatively quickly, she says. “That’s a sign that there are plenty of investors out there willing to invest in the top part of the ecosystem, whether it’s [in] the US or Europe.”
In Europe, LPs now have attractive opportunities because there are fewer there than in the US. Although some VC funds remain hard to access, LPs like the fact that if they’re willing to take a little more risk, they can scale with those that are still growing in fund size, and reap the benefits, which is harder in the US, says Archibald.
She suspects other LPs such as endowments and pension funds are investing in Europe for the same reason Top Tier is. “You have a belief that innovation is global, so I don’t care where the apps on my smartphone have been created,” she explains. “That became so much clearer through the pandemic. You don’t know and you don’t care where people are working.”
Combine that with lower valuations for tech start-ups than in the US and a growing track record of exits and realized performance over time, and global investors that already have exposure to the US and Asia are saying, “Let’s make sure we have all three legs” of the stool and are “not excluding a large part of the venture ecosystem,” Archibald adds.
When it comes to company formation, European VCs are on par with those in the US in writing checks below $5 million in seed and other early-stage funding rounds, says Ross Morrison, a partner in the London office of Adams Street Capital, a fund of funds manager with about three quarters of its assets invested in early-stage funds.
This is not to say fundraising will be easy for European funds. What capital is available will go to funds that are performing well, whether measured by multiples, IRR or distributions. Emerging managers, on the other hand, will struggle to attract funding, LPs say.
“We are creating the same velocity in new companies in tech as what the US has done”
Vital Laptenok, a general partner at Flyer One Ventures, which has offices in Kyiv and London, has a brighter outlook for new managers. He says there’s still room for emerging venture funds to get in the game, especially if they focus on just one industry, or a narrow area like sustainability, and can support their portfolio companies with specific knowledge and relationships. This has not traditionally been the strength of European VC fund managers, which tend to be generalists, Laptenok says.
However, fundraising challenges will likely be alleviated by the flywheel effect made possible by the growing quality, sophistication and depth of capital accumulated by entrepreneurs over the last two decades, says Tom Wehmeier, a partner at Atomico in London. Many founders come from the ranks of operators who helped to build earlier start-ups.
“Every successful company that gets built has a leveling-up effect in creating more talent that’s been through the cycle,” Wehmeier notes. “It creates capital liquidity that gets reinvested back into the ecosystem, and each time there’s a success case, it sets a new bar for ambition.”
Atomico has seen this firsthand as the firm was started in 2006 with proceeds from Skype, the first global breakout company to emerge from Europe. Wehmeier points to the many companies started by Skype alumni that have gone on to become investors themselves, including Eileen Burbidge, former director of product for Skype, who founded Passion Capital, an early-stage venture firm in London.
“Every successful company that gets built has a leveling-up effect in creating more talent that’s been through the cycle”
Higher-quality VC funds have been socking away cash in preparation for periods of elevated market volatility and have urged their portfolio companies to do the same, says Morrison of Adams Street.
He believes the best funds have amassed enough capital to enable their portfolio companies to weather the volatility until the public markets rebound, which could take up to two years. They can also use the cash they have accrued to acquire struggling companies as private markets consolidate, he says.
In downturns like the current one, MIG Capital’s focus is first and foremost on its existing portfolio. “When it’s harder to raise money, VC funds want to make sure the [companies] you have invested in do well and will survive” before considering new investments, Kahl says.
MIG, which has been able to raise nearly one fund a year since 2004, is currently reserving 20 to 30 percent of its total assets to be able to keep funding portfolio companies if fundraising headwinds persist for an extended period. That’s more than the firm would have set aside in prior years, Kahl notes.
Funds with reserves will also be well positioned to take advantage of lower valuations on new deals. An excess supply of start-ups should bring down the price of equity.
While it’s still early days for declining valuations, Kahl hears from companies raising rounds that they are no longer able to dictate a price to VC funds as they could previously. “These days, we hear statements like ‘let the market decide,’” he says.
Venture funds poured $58.6 billion into European start-ups in the first half of this year, the second-highest level of deployment in a half-year after investing $59.9 billion in the first six months of 2021, according to data compiled by Dealroom.co and Silicon Valley Bank UK. Capital infusions in Q2, however, fell 18 percent from Q1, they say.
“[Many start-ups are] not going to come to the US for capital. They’re going to stay in Europe”
Top Tier Capital Partners
Foreign investors contributed close to half (47 percent) of the capital deployed to start-ups from January through June, and nearly 60 percent of the money that went into rounds of $100 million or more.
Investment in European early-stage start-ups rose to an all-time high for a six-month period, up 21 percent to $16.9 billion from $14 billion in H1 2021. Late-stage funding fell worldwide, but the 8 percent decline in Europe was smaller than the 19 percent drop in the US.
European start-ups continue to draw a larger share of global venture capital, now accounting for 20 percent of global funding versus 17 percent last year, Dealroom.co and Silicon Valley Bank UK say.
Some late-stage investments may continue to thrive due more to the structural evolution of certain sectors like biotech during the 10-year VC boom than to greater confidence in the inherent ability of late-stage over early-stage funds to ride out a potentially prolonged bear market.
Abundant talent and FOMO
Investors from outside Europe are realizing they need to be actively investing in the region if they want to stay abreast of the talent and unique mini-industries emerging in countries such as Ukraine, Archibald says. (Fewer companies are based in Ukraine since the start of the Russia-Ukraine war, but a lot of development teams remain there.) Many of the people starting companies are “not going to come to the US for capital. They’re going to stay in Europe.”
That has spurred major VC firms such as Battery Ventures, General Catalyst and Sequoia to open offices in Europe in recent years.
Just as specific cities in the US have become identified with certain kinds of start-ups, regional specialization has emerged within Europe. When it comes to unicorns, Scandinavia is now known for its gaming and communications companies, including Angry Birds, Candy Crush Saga, Skype and Spotify, while London has gained a reputation as a fintech hub.
US investors are increasingly disinclined to ignore any of these varied regions in Europe, just as several years ago nobody wanted to ignore emerging start-ups in China or India. “I don’t know whether it’s a fear of missing out, or a portfolio diversification, but I think that’s driving some investors to Europe,” says Archibald.
The rise of partnerships between VC firms like MIG and academic centers such as Technical University of Munich is also helping to identify talent worthy of investment. Numerous tech companies have been spun out of universities including Delft in the Netherlands that have developed innovative technologies, says Kahl.
While public listings in Europe account for a fraction of exits for European VCs, the M&A market is quite robust.
In fact, some big sectors rely almost entirely on acquisitions for new products and innovations. For example, European drug companies have “made themselves fully dependent on buying innovation from the outside,” with about 80 percent of approved drugs currently originating from smaller biotech companies, says Sander Slootweg, a managing partner at Forbion, a Dutch VC firm with about €2.3 billion in AUM that invests across all stages of life sciences development. “That is quite difficult to reverse.”
Because pharma companies still have strong balance sheets, “there is a large group of willing buyers for the best innovation out there,” Slootweg says.
He estimates big pharma has roughly €500 billion in reserve for acquisitions over what could be a very fallow period for capital.
“There is a large group of willing [pharma] buyers for the best innovation
Forbion has raised nearly €470 million for its Growth Opportunities Fund II with an aim to close on €600 million sometime over the summer. “That shows there’s still plenty of interest with our LPs in this strategy,” Slootweg explains. “But I can imagine across the board that LPs will have to think through the new market circumstances and will have to prioritize where they will still play and where [they will] not.”
Despite minimal change so far in acquisition valuations, Archibald says she expects the number of acquisitions to climb in Europe and elsewhere. “Especially with the public markets the way they are, there’s a lot of potential acquirers sitting on a lot of cash. Usually what we see is when the public markets go down, the number of acquisitions goes up.”
The extent to which target companies’ acquisition prices hold up “depends on the vintage year of the VC Funds,” Massimiliano Magrini, co-founder and managing partner of United Ventures in Italy, says via email.
“There will be a trade-off with funds with good portfolio companies that need to exit despite suboptimal market conditions, but traditionally funds starting to invest in a period dominated by ‘bear’ markets historically have been the best performers.”
The enthusiasm about Europe may come down to a simple fact: VCs have found tremendous success, judging by the proliferation of unicorns.
Europe has 133 privately backed companies valued at $1 billion or more, including 44 that earned that distinction this year, according to CB Insights, which ran the calculation on July 27.
That’s not to mention another 250 or so companies that M&A firm i5invest has identified as “soonicorns,” meaning they are likely to reach a valuation of $1 billion or more in the next 24 months.
“Isn’t that an amazing fact? It’s a forward leading indicator of future growth within the ecosystem,” says Morrison of Adams Street. “We are creating the same velocity in new companies in tech as what the US has done.”
To be fair, Europe still has a long way to go to match the unicorn production volume of the US, which CB Insights says is home to about 630 such creatures, including 130 birthed this year.
Where Europe remains behind the US is in building “a wall of capital to sustain that growth,” Morrison says. But he is confident that the money is coming. The best global investors are being drawn to Europe’s venture market because they recognize that Europe is now competing on the global stage, he says.
As more capital flows into the market, privately held European companies one day soon may no longer have to worry about money to fuel future development.