The number of European start-ups is growing at a rapid pace. Over the past decade, 36 percent of all active start-ups in the world were established in Europe. That number is approaching the number of start-ups that were established in the United States over the same period. This is according to a report issued by the Italian division of consultancy firm McKinsey, which came out this month.
Very few unicorns
No matter how well things are going, few European start-ups manage to reach the status of ;unicorn;. This is the designation for a start-up that achieves a market valuation of at least $1 billion.
An example of a (rare) European unicorn is the originally Italian company Depop. This is an app for peer-to-peer clothing sales, which was acquired this summer by the American company Etsy for approximately €1.5 billion. Its immediate success indicates the limitations of the European ecosystem. Although Depop was funded by an Italian incubator in its initial stages back in 2011, it was forced to look outside Europe for money in subsequent investment rounds.
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McKinsey’s report shows that there are a few roadblocks that often prevent European start-ups from advancing to the top. One element is that the market is fragmented. In order to enter a market of the same size as the US, European start-ups need to have a presence in 28 different European countries. This frequently means that they have to deal with a multitude of regulations and languages.
Also, there is a scarcity of talented people. Attracting talent in Europe is more difficult because working in a start-up is still seen as risky and less appealing than other career opportunities. A third problem is the difficult access to funding. In the US, money is brought to the table faster and in greater amounts.
Low valuation in the early stages will never, ever turn a start-up into a unicorn,” Angelo Coletta
Low financial valuation
According to Angelo Coletta, Europe’s Achilles heel lies in the difficulty in accessing funding. One of the main reasons that European start-ups remain too small is that the financial valuation of a promising start-up is kept too low, he explains. Coletta is founder and CEO of Zakeke, a young company that provides visual personalization of products in e-commerce. But we also spoke to Coletta in his role as head of InnovUp, which brings together Italy’s leading start-ups, incubators and investors. “To become a unicorn, you have to have evolve in a certain way in the cap table,” Coletta says..
The term capitalization table (‘cap table’) refers to the value of a company’s equity which becomes more watered down with each round of investment. “All too often in Europe, and especially in Italy, the value of a start-up is underestimated. Take two similar start-ups. One is based in the UK, the other in, say, Italy. In England the company is valued at four million euros, while in Italy it is valued at one million. If during the seed round, when start-up capital is raised, an investment of one million is made, the capital value instantly drops by 25%. Whereas in the United Kingdom, it’s by just 8%. Consequently, in Italy there is very little left over for the subsequent investment rounds. A start-up like that will never, ever become a unicorn.”
According to Coletta, the solution lies in technical financial solutions. First of all, governments need to create investment funds that have a lot of leeway to give promising start-ups a flying start. The initial investments should be raised. And not just hundreds of thousands euros or a million, but between five and six million euros straight away. Investors in such (nevertheless risky) companies should be rewarded with tax breaks.
Germany and France are on the right track. Last spring, the German government put an additional €10 billion into the Zukunftsfonds (Future Fund). This is a government fund geared towards start-ups in their growth phase. Germany also has funds for financing as a start-up continues to grow (A, B and C rounds).
In Coletta’s view, an important tool to help start-ups grow is the convertible loan. That is a loan that can be converted to shares in the company with a term of five years including a lengthy grace period for repayment. This frees up the company’s hands for the first few years.
Even though the example of Depop (the European unicorn that is now in American hands) suggests otherwise, Europe, with Germany at the forefront, is getting more adept at keeping out American, British or Chinese investors that like to snatch up promising European start-ups. “Europe is doing much better than in the past,” Coletta also acknowledges. “On the one hand, some competitors have become less strong. The start-up culture in China has slowed down somewhat due to the government’s crackdown on tech companies in particular.
Europe has been actively building a financial arsenal for innovation. “It has become clear that there is no point in having interesting start-ups if they are whisked away by Chinese or American competition. Successful, former start-ups are more often being taken to the European stock market.”
But the most important thing in the eyes of Coletta is that the realization has sunk in that start-ups are fundamental to the development of established companies and the economy in general. A change in mentality, in other words.
Read how the enthusiasm for open innovation has to some degree dissipated.
Read how the ‘cap table’ formsa a key factor in the development of a start-up.
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