Industry introspection

A Darwinian winnowing of the European VC industry will not be enough to finally produce respectable results, writes Simon Clark.

Every year, Coller Capital surveys alternative asset managers and asks them to rank asset classes in order of attractiveness. European venture has never left the bottom slot for all reports on record.

It’s hard to disagree with the investors polled; the record of European venture firms, in funding and building great technology businesses is dismal. The US industry has also had an awful decade, but at least it has a few great companies like Google to brag about – their European counterparts don’t even have that. It’s not surprising then that according to VentureSource, European IT investments in the third quarter of 2008 dropped to under €400 million, the lowest since it started tracking the category.

Simon Clark

Returns reflect the same pattern of underperformance. According to a Thomson Financial report, between 2005-2007 European venture only produced an internal rate of return of 0.4 percent. In addition, the five- and 10-year investment horizon IRR for early stage funds remains negative and only rises to 0.9 per cent and 1.8 per cent for the same periods, for all venture activities.

So how can the future be better than this pretty grim past? Well, one argument is that the inevitable shrinkage of the industry should help those who survive. Another is that only the real entrepreneurs are going to start businesses now, which again should lead to better returns. But will a Darwinian winnowing of the industry be enough to bring respectable results?

Perhaps the issue is more fundamental: finding an investing approach that will deliver respectable venture returns in Europe. Slavishly following the Silicon Valley model is unlikely to be appropriate for such a different market, so European venture firms have to find an approach that meets their own market’s needs.

The venture business is fundamentally a simple one: VCs fund businesses that have extraordinary potential thanks to their products and position in a high growth market and which can achieve that growth with modest capital needs. They then work with the founders and managers to achieve the business’ potential and realise their investment through a trade sale or public offering.

Europe has never had a problem building technology companies with great products, but positioning those products in the right high growth market and building the leadership that could manage the growth, has traditionally been more difficult. This is exactly where the European venture industry can help by understanding how value is built and funding businesses accordingly.

The first critical task for European venture firms is to build relationships with trade acquirers. This is often neglected but is fundamental to the success of the model as VCs need to understand what will be attractive to the buyers in a few years from now and invest and guide their portfolio companies to meet their needs. Trade exits are, after all, the exit for the vast majority of venture-backed businesses.

The second task is to understand the public equity market and prepare their largest and fastest growing companies for public offerings. Only then should firms go out and find the right companies to invest in, help them build management as they grow and fund their business for the best possible result.

The great service that European venture firms can provide to the European technology industry is to be a bridge between strong entrepreneurs who build world class products and their ultimate shareholders, be they trade acquirers or the public markets. By doing so venture firms can not only start to provide their own investors with the returns they deserve, but also build a healthy and thriving European technology industry.

Simon Clark is a London-based partner at Fidelity Ventures.