Why Europe needs a tech exchange

The summer break between the first and final years at MIT's Sloan School of Management is a riskfree opportunity for MBA students to learn about a new industry. As a former software entrepreneur from Atlanta, my summer of 2004 proved to be far more exciting and eye-opening than I ever could have imagined. I spent it in Europe, where in June and July I conducted a feasibility study for creating a pan-European stock market for technology growth companies. Contracted by Jos Peeters, founder and CEO of Easdaq, I was recruited from MIT to shed an unbiased light on the need and conditions for the creation of such a market.

Having recently re-purchased a controlling share in Easdaq (formerly Nasdaq Europe, and Easdaq before that), Jos was looking for answers to some key questions: What led to the rise and fall of Easdaq and other technology markets launched in Europe in the mid-1990s? Is there currently a need for such a market? And is it feasible?

In the search for answers I interviewed more than 80 European executives from a wide range of industries. Most of the hour-long interviews were conducted in person, summarised in detailed notes, and supplemented with extensive literature research.

As the study progressed, a central theme emerged. All respondents seemed to agree on one – and only one – issue: Europe is struggling to produce globally competitive technology companies. But despite unanimity on the existence of this problem, views on how to solve it couldn't have been more diverse. Consequently, the scope of the study was expanded to include a detailed analysis of Europe's performance in technology industries.

THE CORE PROBLEM
When compared against the US, Europe's failure to produce globally competitive technology companies on a comparable level is irrefutable. During the last 25 years, the US has vastly outperformed Europe in producing VCbacked companies with market capitalisations greater than $500 million. According to Lester Thurow, a prominent MIT economist, of the world's 25 largest companies in 2000, six were US companies founded after 1960, including Microsoft and Intel. None were European.

While Europeans appear to be greatly divided on the underlying causes of this problem, data from both the interviews and literature research points to three key factors: a fragmented market place, venture capital groups that are spreading their capital too thinly, and the absence of a well-functioning IPO market for technology stocks.

1. National and cultural fragmentation. This is perhaps the most obvious impediment to the rapid growth of technology startups in Europe. There is no single European market. Instead, Europe is a collection of smaller submarkets, each with it sown nuances. The European Union, with 25 member nations and nearly 500 million people, is a giant step towards increased harmony, but Europeans still identify with their national origins above their status as Europeans. Further, each country still maintains its own regulations, language, and cultural norms. By contrast, consider the US where an entrepreneur immediately faces a market of 290 million people with one language and a single federal government. To make matters worse, Europe lacks centers of critical mass – equivalent to Silicon Valley and Boston in the US–where entrepreneurs, investors and engineers aggregate for synergy. The net effect is that growing a technology company in Europe to the level of a global competitor can be difficult.

2. Venture capital spread too thin. The second factor that contributes to Europe's inability to produce globally competitive technology companies is the indigenous VC community's tendency to invest funds too thinly across too many startups. In 2003, the European VC community invested about $10 billion in 6,400 portfolio companies. The US, by contrast, invested more than $18 billion, but only in 2,700 portfolio companies. Accordingly, the average VC investment in the US is about $6.6 million, while the average VC investment in Europe is only $1.2 million. Thus, if a European and US tech startup were competing in the same market place, the US company would have on average five times the amount of capital. The contrast is equally stark if one looks specifically at seed investments. European VCs made 377 seed investments averaging about $500,000 each, while US VCs made only 181 seed investments, averaging about $2 million each.

The picture emerges that European tech companies are under-funded at all stages of VC backing. Further, too many receive funding which creates an overly competitive environment. This phenomenon can be explained as a combination of risk aversion and immaturity within the VC community, evidenced by the fact that only 18 percent of all European venture deals in 2003 involved transnational syndication, whereas nearly two-thirds of the total involved no syndication at all.

3. Fragmentation of Europe's capital markets. Having a national stock exchange is perceived as a source of national pride. Consequently, Europe is currently home to more than 30 exchanges. A recent Grant Thornton report identified 21 of these as “new markets”, catering to small, young, technology-focused companies with growth potential. These 21 markets share a pool of about 1400 listed companies, but four didn't have a single listing at the start of 2004, and only five had 40 or more listings. Of those, only Italy's Nuovo Mercato had businesses listed with an average market cap greater than $100 million. Clearly, this is an unsustainable situation where the supply of exchanges outstrips market demand. (By contrast, the US has effectively two markets, and Nasdaq alone has over 3000 listed companies, with an average market cap over $900 million.)

This fragmentation reduces liquidity for listed companies for several reasons. First, local regulators tend to favour local companies and intermediaries. Second, national exchanges don't inspire the same degree of trust and confidence among investors from other countries. Third, there are significant differences in transaction costs between the exchanges. As a result, the few European tech companies that reach a level where they need large amounts of capital for global expansion find it difficult to raise it from the public markets.

THE CASE FOR A DEDICATED TECHNOLOGY GROWTH MARKET
The net effect of these three core factors is that Europe's technology companies are starved for cash at both ends of the technology capital pipeline. At the beginning of the funding process, at the seed through to expansion capital stage, they are not receiving enough funding to gather momentum to ever grow to a size that would support an IPO. Further, too many receive funding, and thus they all face an overly competitive landscape.

At the other end of the pipeline, those few VC-backed companies that do make it to the doorstep of global expansion find it exceedingly difficult to raise large amounts of capital from the public markets. And in the middle, without the potential for a healthy valuation via IPO, negotiated exits via M&A transactions have depressed valuations. Consequently, Europe's best entrepreneurs, engineers and technology are drawn away from Europe to the US where the possible rewards are greater. In this scenario, everyone loses: the entrepreneur, the investor, and Europe as a whole.

To remedy this state of affairs, a well functioning market dedicated to Europe's technology growth stocks would have three crucial benefits. First, it would greatly improve the ability of Europe's best VC-backed companies to raise the large sums of capital required to compete globally. Second, by virtue of the process by which M&A transactions are evaluated, it would increase average valuations. Third, it would help to retain Europe's best entrepreneurs, scientists and technology by providing a pathway for them to be recognised and rewarded at a level commensurate with that of the US.

WHAT THE MARKET SHOULD LOOK LIKE
Substantial data on the optimal form and feasibility of a dedicated market for Europe's tech stocks was collected. This revealed that, first, a successful market must enable companies to access apan – European base of investors. A company's home market is most effective at providing capital and liquidity to tech companies in their infancy. However, when they grow large enough to expand globally, they will need a depth of capital and liquidity that can only be amassed at a pan-European level.

Second, the ideal market will be based on market making, which is the only model that can generate liquidity for small-cap stocks while simultaneously paying for the required research.

Third, to inspire investor confidence, the market should have increased levels of disclosure and transparency. To prevent dumping of shares, it should also incorporate a registration process that imposes a time-delay for a given percentage of registered shares.

Further, any new initiative to build a market should be backed by an ample budget, and should run an extensive marketing campaign across Europe to project the image of being the destination of choice for tech growth securities.

Lastly, based on the lessons learned from the downfall of the 90s growth exchanges, the best home for a renewed effort would be one with a strong home market. A new initiative must build critical mass as quickly as possible, and be able to stave off the inevitable national response from the local markets. If located in a small market, the new initiative risks losing liquidity and listings to a larger market.

There is much data to support the notion that London has a critical mass of financial institutions, entrepreneurship, and liquidity to best support any efforts to create a dedicated technology market. In the PricewaterhouseCoopers 2003 IPO report, London secured 52 percent of total IPOs in Europe. It also accounted for 44 percent of the total value of all European IPOs. According to the 2004 EVCA Yearbook, the UK leads Europe as both the destination and country of management for all VC and PE investments in Europe. Given its financial dominance within Europe, London would serve as the best home for any new initiative.

IS IT FEASIBLE?
There have been several key changes since the failed launch of Easdaq in 1996 that would benefit renewed efforts to create a pan- European tech market. First, there has been widespread adoption of the Euro, with the notable exceptions of the UK, Switzerland and the Nordic countries. Europe has experienced increased regulatory harmonisation. Also, technology advances have vastly improved clearing and settlement processes.

Some of the changes, however, will make efforts more difficult. Chief among them are painful memories of the recent dot.com collapse and of the failures of Easdaq, the Neuer Markt and other growth markets in the past. Further, this has led to reduced availability and demand for research, which will impede adoption of the market making model. Perhaps most challenging is the continued stranglehold of the US capital markets; Europe's best tech companies will naturally look to Nasdaq before any new European initiative.

Beyond these changes, the feasibility of such an attempt will hinge on two key factors: whether there is a sufficient supply of quality technology companies within Europe, and whether there is sufficient demand from investors for tech securities.

Regarding the supply of technology companies, consider the number of IPOs that in theory could be generated from Europe's $10 billion investment in 2003. From 1995 to 2003, the US produced 0.04 IPOs per investment, or 4.05 IPOs per $1 billion invested. This suggests that if Europe altered its investment patterns to more closely mirror those of the US – i.e. larger investments in fewer companies – the class of 2003 had the potential to produce 40 IPOs. Even if this number were discounted by 50 percent to account for Europe's inherent cultural and market fragmentation, it would still produce 20 IPOs. If sustained annually, clearly there would be enough companies to support a dedicated market.

As another litmus test, consider the 1400 companies currently listed on Europe's “new” exchanges. If they were aggregated on one single exchange, it would be approximately half the size of Nasdaq. Undoubtedly, many of these companies would not survive given their small size. Equally likely however, those that did would experience greater liquidity and growth, and create an upward spiral.

Demand for tech stock within the European investment community is far more difficult to predict. Clearly, demand is currently lacking – which is not surprising given recent memories of the dot.com crash. Further, European retail investors have a history of non-participation in equities. However, if this asset class performed better and the tech community produced a few visible success stories, it is not unreasonable to assume that Europeans would support the tech markets, just as they did in the late 90s.

RECOMMENDATIONS: A TWO-FRONT ATTACK
Sceptics will be critical of any attempts to address the public markets if they don't see the VC community improve its strategies for growing tech companies. What the study showed, first of all, is that the VC community must become emboldened and shake off its aversion to risk. This means dramatically increasing the average amount invested in a given company while simultaneously reducing the number of companies that get funded.

The VC community also has the opportunity to lead Europe to a higher level of cooperation and collaboration by increasing its cross-border syndication. To offset the increased risk of larger investments in fewer deals, the VC community will need to dramatically increase its level of transnational syndication.

Further, the VC community can help to foster the emergence of centres of entrepreneurial excellence similar to Silicon Valley and Boston. This can be accomplished by identifying where these centres have natural roots, and then focusing investment activities there. The objective would be to generate synergies by drawing Europe's best entrepreneurial and engineering talent to a limited number of centres through focused investment activities.

Concurrently, the study also supports the conclusion that a dedicated, pan-European market for technology growth securities should be established. Interviewees pointed to a range of possible solutions for creating such a market, including a collaborative effort among LSE, Deutsche Börse and Euronext, building AIM into a pan- European tech exchange, and systematically grooming Europe's best VC-backed companies for a Nasdaq listing.

EURONEXT A CONTENDER
In my view, a marketplace within Euronext represents an attractive opportunity for several reasons. To begin, the interview data overwhelmingly supports an initiative that builds of fan existing exchange, rather than creating a new exchange. Further, of the eight exchanges represented in the study (including LSE/AIM and Deutsche Börse), only Euronext expressed a willingness to address the problem faced by technology startups. With exchanges in Lisbon, Paris, Brussels, and Amsterdam, Euronext already leverages local markets, while simultaneously drawing liquidity at the pan- European level – a key attribute of the ideal market. Lastly, Euronext represents the second-largest pool of liquidity within Europe, which will help it to quickly acquire critical mass. The glaring disadvantages of Euronext are that it does not use the market making model, and that it is not located in London.

Given the importance of technology to economic development and progress, underperformance in producing globally competitive technology companies should be of concern to all Europeans. Already trailing the US economy, Europe is now in danger of falling behind China and other Asian rising stars. With global markets currently on the upswing, now is the time for Europeans to show unity and get behind a plan to improve the performance of technology startups, and investors ability to profit from them. As exemplified by the rise of Easdaq, great accomplishments often are borne of the efforts of a small group of dedicated and highly motivated people, rather than large committees and organisations. If nothing else, it is my hope that this report will spark the debate among Europe's leading executives from which that plan arises.

Robert Abbanat is currently studying for an MBA at the Massachusetts Institute of Technology's Sloan School of Management. He can be contacted at rabbanat@mit.edu.