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Beware EU money in startups

The European Innovation Council plans to invest €3bn in startups — but is that wise?

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Credit: Kai Pilger
Nicolas Colin

By Nicolas Colin

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.

“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?

 

Nicolas Colin works for The Family and writes a regular column for Sifted.

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Michael Iasinskyi
Michael Iasinskyi

governments are just a bunch of parasites redistributing money from profitable and thriving companies to non-effective ones, thus the core VC concept of “efficiency measured by market investment return” is foreign to the government talking heads and blowhards

Thomas Standaert
Thomas Standaert

In the opinion piece “Beware EU money in startups”, the author expresses concerns about the new European Innovation Council Fund. Through the European Innovation Council Fund, the European Commission will, for the first time, make direct equity investments in innovative companies at the start-up stage. According to the author, direct equity investments by governments are unlikely to bring about the desired effects. The author goes as far as to state that entrepreneurs should be afraid of having their business killed by a direct influx of government money. Our review of the academic literature on government intervention in European VC markets… Read more »

Luca Longhi
Luca Longhi

Unfortunately, a superficial and partisan view, that goes incredibly against the entire EU startup ecosystem. There are plenty of researches that showed how syndication between Independent VC and Governmental VC lead more benefits that just private VC investment. Considering our geographical and cultural barriers, for Europe this role is even more crucial. One of the main goal of Governmental direct intervention should be to channel private VC towards European rural area, outside capital cities, actually completely left out by private VC. This is leading to potential loss of talents and ideas, something that our still tiny EU ecosystem cannot allow… Read more »

Paul Finnigan
Paul Finnigan

The key is what will be different – I suspect the Gvt direct investment to be run by a newly hired exVC or PE exec – leopards don’t change their spots – so What Difference?

Bernard Chanliau
Bernard Chanliau

I work with some of these beneficiaries as a business coach with EIC – the majority already benefited from a very competitive grant under the Accelerator scheme and I see this as a move to boost early-stage firms targeting pre-series A funding. Many of my EIC SME clients spend months or even years in search of funding in order to cross the chasm, this is just another funding channel supporting capital intensive verticals such as Medtech or others. A common denominator of broken cap tables is misalignment of shareholders’ interests and perhaps we’ll see some innovation outside of start-ups on… Read more »

Ruben van Werven
Ruben van Werven

To add to the points made by Alex Pospekhov and Mikolaj Szpunar: the government will only be seen as having ‘a terrible track record as a VC’ if we compare its performance to that of VCs. But we shouldn’t, because the government will invest in nascent industries that venture capitalists shy away from, and thereby takes much larger risks. If we lower our expectations for the return on the investments the EU makes, any return is a bonus – a much needed one, as most startups that now benefit from government grants ‘hack’ that source of funding by taking the… Read more »

Dirk
Dirk

Yes, and to add to this: Private VC returns are FAR away from a normal distribution. The top 5% of VC funds generate good returns, but most VC funds burn money without creating much value for their LPs. I don’t believe the government will do worse than the average VC fund. That’s why you see so much propaganda against the idea, because fund fees = comfy life for partners and they don’t want to compete. If government money is so bad, then why do many VC funds themselves happily accept EIB funding? Now they are scared that by the EU… Read more »

Thijs Povel
Thijs Povel

A shame to see how one sided this article is and how it only portrays the view that equity investments from governments are a bad thing without really backing that up. There certainly are some problems with the Pilot project of the EIC fund but in my opinion it has much more to do with the issues of any new project, namely the lack of communication and the lack of speed, both of which were to be expected from a pilot project. The clear push from the article that the underlying principle is bad seems biased and it is completely… Read more »

Henrik
Henrik

You went from reasonable to supporting socialism. Yikes!

Mikolaj Szpunar
Mikolaj Szpunar

Saying that governments make money via taxes paid by companies is highly misleading. CIT (Corporate Income Tax) only accounts for less than 10% of total tax revenue. What could be further examined in the text is the actual benefit of supporting projects, which are non-bankable – such as providing new medical solutions, which require a longer investment horizon than usually accepted by the European VCs. Supporting such projects could not only create numerous jobs but also potentially save lives, which would supposedly be the greatest advantage of gov-led funding.

Thijs Povel
Thijs Povel

A shame to see how one sided this article is and how it only portrays the view that equity investments from the government are a bad thing. There certainly are some problems with the Pilot project of the EIC fund but it has much more to do with the issues of any new government project, namely the lack of communication and the lack of speed, both of which were to be expected from a pilot project and both are clearly being fixed at the moment. The clear push from the article that the underlying principle is bad seems very biased.… Read more »

Alex Pospekhov
Alex Pospekhov

Well, when The Family will be investing to the deeptech? I think answer is never. I’m the the biggest fan of bootstratping, hater of blitzscaling and lover of European way, but the deeptech is totally different from everything.

Ian Brotherston
Ian Brotherston

There is another way – using procurement, whether ‘pre-commercial procurement of innovation’ (PCP – in the US this is SBIR, in the UK SBRI) or the ‘procurement of innovative solutions’. Both are demand side pull and can create businesses and markets for innovators or innovations but without the issue of direct investment in the businesses. SBIR in the US has been particularly successful as it has been done at scale.