Last week the European tech world was abuzz with the news that the EU Commission has decided to become a direct investor in European startups — and help them compete with their American and Chinese counterparts.
It certainly fits the current mood. The pandemic has accelerated the transition to a more digital economy, and Europe fears lagging even further behind. It has also inspired governments to insist on the importance of ‘digital sovereignty’, whereby we should make sure that essential digital services are supplied by European companies rather than foreign ones.
But the announcement that €3bn would be deployed by the European Innovation Council Fund and that it would be taking large direct stakes in European startups generated pushback from several tech personalities. Benedict Evans, author of a popular tech newsletter and a venture partner with Mosaic Ventures, warned about the dangers of accepting EU money — namely, ending up with a “f***-up cap table”. Meanwhile, a CEO of a company that has benefited from EU money in the past gave a stark warning to fellow entrepreneurs: “Don’t touch this instrument because it’s going to kill your business”.
But what’s so terrible about governments playing the VC game?
Why VC works like it does
The truth is, there aren’t many historical precedents that suggest the current course of action is a good idea. For one, there’s a reason venture capital works as it does, with independent (private) firms taking assets under management, deploying capital over a fixed period of time, and having their managing partners rewarded with management fees and carried interest on the actual returns.
Don’t touch this instrument because it’s going to kill your business.
This standard setup is the result of decades of trial and error that revealed two critical points. First, VC firms should be focused exclusively on pursuing financial returns; they shouldn’t be distracted by other, non-financial goals, such as those that can occupy large corporations or governments when they deploy capital in startups. Second, individual partners should be incentivised with their own share in the potential returns — a very different paradigm from how governments allocate capital.
There certainly are precedents of governments contributing to healthier entrepreneurial ecosystems — whether it’s in the US, Israel, or China, among others. But the dynamics of those efforts were much more complex than the government directly funding private ventures by becoming a VC.
Hacking government money
In practice, much of that government money ended up being wasted — because, well, lots of startups going bust is simply how the game goes. But some of that money was also hacked by clever players who used it to train themselves, warm up their own operations and then break free.
For instance, the Small Business Investment Act of 1958 pushed the US federal government to lend money to newly formed investment firms (so-called ‘Small Business Investment Companies’ — SBIC). It mostly didn’t work, for various reasons described here and here. But it helped younger management teams start up their businesses and develop proper investing techniques for the then-new world of tech startups.
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There certainly are precedents of governments contributing to healthier entrepreneurial ecosystems — whether it’s in the US, Israel, or China, among others.
Legendary VC Franklin ‘Pitch’ Johnson learned the ropes by managing a not-so-successful SBIC. He then moved on to raise a fund without any government money — and none of the strings attached; the rest is history. Was it a good investment for the government to pay for Pitch Johnson’s education, even without making money on his SBIC investments? I would say yes — but I’m not sure the bureaucrats in Brussels, or most of their constituents, would agree.
Likewise, developing Silicon Valley wasn’t the US government’s goal when it spent billions during the Cold War. Still, Stanford University’s Frederick Terman made sure that some of that money ended up financing his students’ startups (headquartered in Stanford Technology Park), effectively giving birth to Silicon Valley.
The key lesson here? Government money is welcome, but it needs to be hackable!
The worst VC of all?
Here’s what we need to realise: if the government deploys money directly in startups, it’s likely that most of the upside won’t ever be found within the corresponding portfolio. And if taxpayer money is captured and reinvested by the Frederick Termans of our time who then use it to kickstart a virtuous, self-sustaining cycle, the government could still end up with a terrible track record as a VC. Meanwhile, the most successful companies, which will have found their own ways to benefit from the overall effort, will keep themselves far out of reach for fear of having their business killed by a direct influx of government money.
...if the government deploys money directly in startups, it’s likely that most of the upside won’t ever be found within the corresponding portfolio.
This doesn’t mean that governments are irrelevant or that they can’t reap significant benefits from the value created by startups. After all, governments generally make money via taxes, which get paid by thriving and profitable companies. The government doesn’t need to act or succeed as a direct investor to win that way.
And of course, if governments really want to splash their cash, develop their economies and gain technological sovereignty, there’s another option. They could build their own state-owned companies aimed at solving difficult problems and shaping new markets. This is, admittedly, quite foreign to EU traditions. But several member states do have a long history of building up successful state-owned enterprises to advance their economic interests, from France with EDF to Germany with Deutsche Bahn to the UK with the BBC to all of these countries together with Airbus.
Sure, most of those old state-owned enterprises are in pretty bad shape at the moment, but that shouldn’t suggest there’s no point in revisiting this approach in a way that fits the digital age. So many markets, from housing to transportation to healthcare to financial services to education, would benefit from a radical innovation effort on the part of state-owned ventures. Wouldn’t all that public money be better invested there rather than in all those soon-to-be-f***-up cap tables in the private sector?