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A new model for VC investing in Europe.

A new model for VC investing in Europe.

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  • 1.    1  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  A  new  model  for  VC  investing  in  Europe    by  Daniel  Stachowiak,  Managing  Partner,  Ambit  Ventures    Summary  In  this  white  paper  we  argue  that  the  European  VC  industry  needs  to  change  its  modus  operandi  if  it  is  to  continue  catching  up  with  the  US  equivalent  –  it  needs  platform  investors,  which  provide  a  suite  of  non-­‐investment  services  to  its  portfolio  companies.      This  strategy  should  work  particularly  well  in  new  EU  member  states  (“New  Europe”),  which  have  emerged  as  a  source  of  innovation  with  global  potential  but  lack  the  social  infrastructure  to  scale  fast  beyond  their  boarders.  The  best  place  to  run  such  an  operation  is  London,  which  should  become  both  the  Delaware  of  Europe  as  a  place  of  choice  to  incorporate  start-­‐ups  and  the  premiere  European  tech  hub.      Investing  in  tech  in  New  Europe  should  offer  returns  seen  in  ‘emerging  markets’,  but  should  offer  lower  risk  due  to  the  ‘EU  membership  dividend’  –  ability  to  borrow  mature  institutional  frameworks  for  corporate  governance  and  easy  access  to  a  rich  internal  European  market.      It  will  take  a  highly  entrepreneurial  and  multi-­‐ethnic  VC  management  team  to  take  advantage  of  this  opportunity,  which  is  not  without  risks.      We  at  Ambit  believe  that  we  have  built  the  team  that  has  what  it  takes  and  are  now  ready  to  engage  with  Limited  Partners.  
  • 2.    2  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  The  New  Model  for  VC  investing  in  Europe  We  believe  that  the  days  of  investing  only  in  those  start-­‐ups  that  are  within  an  hour’s  drive  from  one’s  office  are  gone.    Good  ideas  can  come  from  anywhere  these  days  because  of  the  dramatic  fall  in  tech  infrastructure  prices  and  the  democratization  of  access  to  that  infrastructure.    This  makes  the  job  spec  of  a  VC  much  broader  than  before.      Finding  a  good  idea  in  Arizona  and  moving  it  to  California  is  easy  compared  to  turning  an  Estonian  start-­‐up  from  Tallinn  into  a  London  based  European  player.    A  new  breed  of  VC  firms  is  needed  to  do  that  job  well.    The  US  has  something  to  teach  Europe  in  this  respect  but  only  to  a  degree,  as  the  EU  has  the  additional  complexity  of  varied  cultural,  linguistic  and  legal  traditions  of  its  members.    A  successful  European  VC  needs  to  structure  itself  properly  if  it  aims  to  build  tomorrow’s  European  tech  powerhouses.    The  “to  do”  list  includes:  1. Assemble  a  team  that  culturally  and  linguistically  mirrors  the  European  countries  one  focuses  on.    We  believe  that  it  would  take  a  multi-­‐ethnic  management  team  that  speaks  local  languages  to  find  and  build  rapport  with  great  entrepreneurs.      That  is  not  an  easy  task  as  cultural  diversity  within  a  management  team  might  be  both  a  curse  and  a  blessing,  especially  since  teams  need  to  last  for  at  least  a  decade.    2. Build  a  platform  of  non-­‐investment  services.    Platform  investing  was  arguably  first  developed  by  New  York’s  Y-­‐Combinator,  then  taken  on  by  Andreessen  Horowitz,  and  then  by  Dave  McClure’s  500  Startups.    The  concept  is  based  on  the  idea  that  a  VC  is  much  more  than  just  a  provider  of  high  risk  capital  but  also  an  agent  which  maintains  a  platform  of  non-­‐investment  service  providers  who  support  portfolio  companies  operationally  and  function  as  ‘shared-­‐resources’.    Some  focus  on  building  in-­‐house  recruiting  and  business  development  functions,  others  also  include  technical  expertise  around  product  design,  user  experience  and  technical  architecture.  There  are  currently  no  platform  investors  in  Europe  although  Rocket  Internet,  a  ‘clone-­‐  builder’  showed  how  ancillary  services  benefit  the  speed  of  growth  of  young  companies  but  do  not  replace  true  innovation.      In  a  European  context,  the  platform  should  include  ‘internationalization  services’  –  ability  to  launch  products  beyond  one’s  home  market  shortly  after  testing  it  in  one’s  home  market.  3. Use  English  law  for  transactions.    Arguably,  UK  has  the  most  fungible  European  legal  system  with  the  US,  making  migration  across  the  pond  and  syndication  of  later  stage  capital  rounds  faster  and  cheaper.      It  is  also  important  for  the  legal  documentation  to  be  written  in  English  from  an  early  stage,  to  simplify  due  diligence  and  cross-­‐border  migrations.        4. Use  London  as  the  base.    To  add  the  value  mentioned  above,  the  VC  team  should  be  well  connected  with  high  tech  ecosystems.    Although  there  are  several  cities  in  Europe  which  try  to  become  the  high  tech  capital  of  the  continent,  it  is  London  which  is  most  likely  to  win  the  race  due  to  the  breadth  and  depth  of  its  human  capital  and  infrastructure:  from  its  creative  and  music  industries,  the  financial  district,  through  to  thousands  of  active  angel  investors.    It  is  also    one  of  the  most  international  cities,  with  over  a  third  of  residents  born  abroad  and  almost  a  quarter  who  are  not  British  nationals.    Silicon  Valley  is  too  competitive  and  too  far  from  most  European  early  stage  start-­‐ups  to  be  a  viable  home  in  the  early  stages.    Its  image  has  also  been  tarnished  by  unfriendly  immigration  laws  and  the  promise  of  entrepreneur’s  visa  which  is  still  in  the  works.    The  UK  stole  the  thunder  of  putting  one  in  place  making  London  even  more  attractive  to  those  who  originally  set  sail  for  the  Bay  area.    London  is  not  as  cheap  as  Berlin  to  
  • 3.    3  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  live  in,  which  is  the  biggest  challenge  for  the  city  to  keep  its  attraction  as  the  best  place  for  young,  clever  brains.    This  strategy  is  likely  to  work  anywhere  in  Europe,  but  particularly  well  within  a  subset  of  European  countries  which  have  recently  joined  the  European  Union,  which  we  call  New  Europe.      We  first  explain  why  the  European  VC  asset  class  is  the  place  to  be,  what  New  Europe  is  and  why  more  capital  should  flow  there  in  particular.      European  VC  asset  class  It  is  important  to  dispel  some  perceived  wisdom  about  European  venture  success.    A  recent  study  commissioned  by  BVCA1  argues  that  Europe  is  no  longer  a  poor  cousin  of  the  US  in  terms  of  various  entrepreneurship  and  VC  performance  metrics.    Part  of  the  misconception  had  to  do  with  a  smaller  track  record  of  the  European  VC  industry,  which  started  later  than  the  American  counterpart.    The  conclusions  of  the  study  are  encouraging:      a. The  same  vintage  years  produce  similar  results  in  terms  of  the  probability  of  an  IPO  although  the  US  is  still  more  likely  to  produce  a  trade  sale.      b. Venture  success  has  the  same  determinants  in  both  Europe  and  US,  with  more  experienced  entrepreneurs  and  venture  capitalists  being  associated  with  higher  probabilities  of  exit.  The  fact  that  repeat  or  ‘serial’  entrepreneurs  are  less  common  in  Europe  and  that  European  VCs  lag  US  VCs  in  terms  of  experience  explains  the  remaining  difference  in  performance.    c. There  is  no  evidence  of  a  stigma  of  failure  for  entrepreneurs  in  Europe.  There  are  additional  factors  that  inspire  even  more  optimism.    On  the  start-­‐up  supply  side,  the  financial  crisis  had  the  unintended  consequence  of  pushing  more  and  more  young  university  graduates  into  entrepreneurship,  who  are  no  longer  sucked  in  by  the  financial  services  industry.    On                                                                                                                            1European  Venture  Capital:  Myths  and  Facts;  Dr.  Ulf  Axelson,  Mr.  Milan  Martinovic,  LSE,  2012
  • 4.    4  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  the  demand  side,  the  tax  breaks  and  publicly  backed  funds  (SEIS  and  EIS  schemes  in  the  UK,  KFK  funds  in  Poland  for  example)  have  provided  a  growing  pool  of  seed  funds  that  was  not  there  even  five  years  ago.    The  best  years  of  early  stage  capital  providers  in  Europe  are  just  beginning.  What  is  New  Europe?    We  define  New  Europe  as  the  new  EU  member  states  from  Eastern  Europe:  Estonia,  Latvia,  Lithuania,  Poland,  Czech  Republic,  Slovakia,  Hungary,  Romania,  Bulgaria,  Slovenia  and  Croatia  (soon  to  join  the  EU).    They  are  mostly  middle  income  countries  with  the  exception  of  Slovenia.    On  Purchasing  Parity  Basis,  some  are  perceived  as  developed  economics  (Czech  Rep.,  Hungary,  Poland).  It  is  worth  mentioning  that  there  is  no  Eastern  Europe  at  it  was  once  known.    During  the  Cold  War  the  term  described  the  countries  between  Western  Europe  and  the  Soviet  Union,  ruled  by  the  Communist  parties  of  various  hues,  mostly  subservient  to  Moscow  but  included  the  mavericks  of  Romania,  Yugoslavia  and  Albania.      Since  the  fall  of  Communism  in  1989  and  subsequent  expansion  of  NATO  and  the  European  Union,  Eastern  Europe  quickly  became  an  outdated  and  even  dangerous  term,  as  illustrated  by  this  2  minute  clip  produced  by  the  Economist:    http://www.economist.com/blogs/easternapproaches/2012/07/%E2%80%9Ceast%E2%80%9D-­‐dead.        Countries  of  New  Europe    
  • 5.    5  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  Why  New  Europe?    The  countries  of  ‘New  Europe’  continue  to  share  certain  useful  characteristics,  which  make  them  a  particularly  attractive  operating  theatre  of  an  early  stage  Venture  Capital  firm.    These  characteristics  include:  FDI  patterns  moving  into  knowledge  based  sectors  –  since  1989  one  could  divide  the  FDI  flows  into  New  Europe  into  three  broad    categories:  the  first  wave  involved  the  creation  of  low  value  adding  assembly  plants  of  white  goods,  cars  and  engineering  products;  the  second  wave  involved  the  creation  of  BPO  and  near-­‐shoring  centres  of  accounting  and  back  office  functions;  the  third  was  driven  by  the  creation  of  Research  &  Development  centres  of  some  of  the  most  innovative  global  corporations  (see  below  a  list  of  those  centres  in  Poland)  .    The  FDI  migration  towards  knowledge  intensive  industries  was  based  on  the  observation  that  local  labour  force  is  relatively  inexpensive  but  very  well  educated,  especially  in  technical  fields  such  as  mathematics,  physics,  chemistry  and  computer  science.        
  • 6.    6  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  Low  cost  &  world  class  programming  talent,  shortage  of  commercial  talent  –  New  Europe  has  a  long  tradition  of  world  class  education  in  mathematics,  computer  science,  chemistry  and  engineering.      University  graduates  with  technical  degrees  are  usually  free  from  educational  debt.    Most  of  them  choose  to  remain  in  their  home  countries  which  offer  a  low  cost  of  living  and  high  social  standing.    A  top  notch  programmer  in  Cracow  costs  a  third  of  what  he  or  she  would  cost  in  the  US,  or  half  of  the  cost  in  London.    One  based  in  Sofia  or  Bucharest  is  even  less  expensive.    Building  tech  teams  and  prototypes  of  products  is  therefore  cheaper  in  New  Europe  than  it  is  in  America  or  London.    The  cost  quality  ratio  is  also  very  favourable  (programmers  from  New  Europe,  especially  Poland,  are  high  up  in  the  international  programming  competitions2).      The  problems  begin  when  internationally  experienced  commercial  talent  is  required.    Successful  companies  that  broke  out  of  the  region  managed  to  source  western  executives  (AVG,  Skype,  LogMeIn),  although  finding  senior  management  early  in  the  development  cycle  is  difficult  and  is  often  perceived  as  unnecessarily  expensive  by  the  founders.      True  innovation  is  the  only  option;  building  local  champions  is  a  risky  strategy  –  it  is  very  hard  to  replicate  the  success  of  Allegro  which  built  a  successful  ecommerce  franchise  across  the  region  and  managed  to  defeat  several  attempts  of  eBay  to  take  the  limelight.    Nasza  Klasa,  which  copied  Facebook,  used  to  dominate  the  Polish  market  but  has  since  ceded  more  than  half  the  traffic  to  the  US  giant  with  the  worst  yet  to  come.    Entrepreneurs  took  notice.    Copycats  are  seen  as  a  naïve  approach  to  getting  rich.    In  the  last  several  years  the  region  started  producing  true  innovation  with  regional  or  global  potential.    Most  of  those  start-­‐ups  use  their  local  markets  to  test  their  prototypes,  some  start  with  an  English  version  of  their  products  from  day  one.    The  lucky  ones  are  snapped  by  better  funded  US  companies  (Ivona,  Topicmarks),  probably  too  early.    Others  are  now  looking  for  foreign  capital  partners  who  can  help  them  leave  the  region  and  swim  in  deeper  waters.  World  class  entrepreneurs  without  social  capital  –  inspired  by  early  high  tech  success  stories  coming  out  of  the  region  (see  below)  and  a  growing  cadre  of  world  class  engineering  talent,  New  European  high  tech  entrepreneurs  are  increasingly  well  resourced,  well  organized,  confident,  and  ambitious.    They  lack  however  the  social  and  advisory  infrastructure  present  in  California  or  London  for  that  matter.      The  societies  in  New  Europe,  with  the  exception  of  Estonia,  are  under  OECD  average  in  terms  of  social  trust3.    Most  still  suffer  from  weak  legal  systems,  which  are  based  on  Napoleonic  code  that  limits  the  freedom  to  unbundle  voting  and  economic  rights  of  share  classes  making  the  job  of  structuring  VC  transactions  difficult.    Lawyers  conversant  in  those  structures  are  expensive  and  few  and  far  between,  the  courts  in  turn  are  slow  and  have  little  experience  adjudicating  cases  involving  early  stage  institutional  investors.    Finally,  there  are  few  wealthy  entrepreneurs  who  made  their  money  in  the  digital  economy.    Most  local  ‘brick  and  mortar’  millionaires  do  not  understand  tech  and  do  not  speak  the  same  language  as  the  up  and  coming  generation  of  entrepreneurs,  who  are  left  with  few  mentors  to  look  up  to.                                                                                                                                      2Source:  http://community.topcoder.com/stat?c=country_avg_rating3http://tinyurl.com/bmrusb6
  • 7.    7  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013    Why  isn’t  everyone  a  believer  in  the  New  Model?  Dysfunctional  and  under-­‐resourced  local  capital  scene  –  Based  on  Ambit’s  interviews  with  companies  that  raised  local  early  stage  capital,  it  seems  that  many  deals  that  do  get  done  suffer  from  over  dilution  of  entrepreneurs  leaving  little  room  for  follow  on  investors  without  the  need  to  redo  the  cap  table  which  again,  increases  the  cost  of  deals.      The  angel  networks,  which  effectively  replaced  early  stage  VCs  in  the  US,  are  very  weak  in  New  Europe.    State  sponsored  seed  funds  are  trying  to  fill  that  niche  although  they  suffer  from  structural  problems.    They  are  unable,  for  example,  to  co-­‐invest  with  their  peers  because  of  legal  restrictions  which  cap  the  total  capital  provided  by  publicly  seeded  funds  that  can  go  into  a  single  company  even  across  many  transactions.    Mistrust  and  little  deal  sharing  plays  its  part  as  well.    The  seed  funds  also  need  to  rush  to  spend  their  money  which  creates  an  artificial  over-­‐supply  of  seed  capital.    Entrepreneurs  try  to  take  advantage  of  this  situtation  by  bidding  up  valuations.    Those  who  place  little  value  in  having  an  institutional  investor  on-­‐board  go  straight  to  the  public  market  (ex.  NewConnect  in  Warsaw,  an  equivalent  of  London  AIM).    Both  strategies  tend  to  turn  sour  when  follow  on  funding  is  required.      Having  a  mispriced  and  structurally  complex  seed  round  turns  off  Series  A  providers,  who  shy  away  from  the  region,  while  having  a  publicly  listed  start-­‐up    leaves  entrepreneurs  without  the  counsel  of  experienced  investors  as  VCs  cannot  or  do  not  want  to  invest  in  listed  equities.    Infatuation  with  Silicon  Valley  –  it  is  not  surprising  that  those  entrepreneurs  who  can,  try  to  escape  the  constraints  of  their  local  eco-­‐systems  and  go  where  they  think  they  can  flourish:  the  Bay  area.    Since  most  of  them  speak  English  rather  than  German  and  French  (although  the  Romanians  might  be  an  exception),  the  US  with  its  vast  market,  seems  like  a  good  choice.    They  are  not  in  any  way  unusual  about  falling  for  the  American  dream.    Even  Western  European  governments  commit  serious  recourses  trying  to  showcase  the  Swedish,  German  or  British  start-­‐ups  in  the  Valley.    While  (still?)  well-­‐resourced  Western  countries  are  trying  to  promote  their  own  champions,  New  European  entrepreneurs  are  on  their  own:  without  the  financial  muscle  of  public  coffers  and  a  welcoming  US-­‐based  diaspora.    It  is  not  a  surprise  that  most  of  them  fail  –  going  too  early  in  the  development  cycle,  spending  too  little  time  there,  shuttling  across  8  time  zones  to  manage  their  R&D  teams  and  
  • 8.    8  Copyright  Ambit  Ventures  LLP,  25  Harley  Street,  SW1G  9BR,  London  @  2013  families.        Most  are  unpleasantly  surprised  at  how  competitive  the  Valley  really  is,  how  expensive  it  is  to  hire  good  people  and  how  committed  one  must  be  to  the  US  market  to  succeed  there  (if  one  gets  the  immigration  matters  sorted  first).    Their  eyes  then  migrate  towards  London,  an  overlooked  English  speaking  tech  hub  –  where  Spotify  and  Skype  made  their  intermediate  home  having  left  Sweden  and  Estonia,  respectively,  to  get  ready  for  a  global  expansion.  Low  supply  of  capital,  hence  highest  expected  returns.    It  is  a  well-­‐known  fact  that  Europe  is  severely  underserved  by  providers  of  risk  capital  compared  to  the  US.    However,  New  Europe  is  particularly  poorly  served.    An  incremental  capital  provider,  especially  one  who  also  offers  additional  “platform  services”,  will  therefore  be  able  to  access  the  best  available  projects  and  will  not  face  the  pricing  pressures  over  valuations  present  in  more  competitive  markets.      Ambit  Ventures  We  have  what  it  takes.  New  Europe  remains  different  from  the  rest  of  the  EU  because  of  its  deeply  rooted  idiosyncrasies  explained  above.    We  believe  that  only  a  dedicated  specialist  team  can  do  justice  to  the  region.      The  right  team  would  expect  to  produce  higher  returns  than  an  equivalent  Western  European  VC  because  of  lower  competition  for  deals,  lower  entry  price,  and  a  more  robust  operating  environment  allowing  for  more  reliable  exits.  Ambit  Ventures  has  already  built  the  team,  the  advisory  board,  the  investment  processes  and  part  of  the  platform  required  to  implement  the  strategy  described  above.    We  have  already  started  investing  as  an  informal  angel  syndicate.    We  are  now  launching  the  fund  raising  effort  of  our  dedicated  New  European  Tech  Fund.    We  welcome  the  opportunity  to  discuss  our  ideas  and  approach  with  potential  limited  partners  and  other  interested  parties.  If  you  would  be  interested  in  learning  more  about  our  team  and  approach,  please  do  get  in  touch.  Daniel  Stachowiak,  Managing  Partner,  Ambit  Ventures                      daniel@ambitventures.com                    +44  7792970679