The European Union (EU) lags behind the US in the development and strength of its venture capital (VC) industry.

This weak VC landscape is not only stifling productivity and economic growth within the EU but also hindering the bloc’s environmental ambitions and global competitiveness, a new working paper by the International Monetary Fund (IMF) says.

The paper, titled “Stepping Up Venture Capital to Finance Innovation in Europe” and released in July, examines the current state of the VC industry in the EU, highlighting the main obstacles to its development. It argues that building a robust and advanced VC ecosystem is crucial for fostering innovative startups and enhancing economic growth and productivity, and offers recommendations to support the growth of the VC industry in Europe.

A weak VC landscape

Over the past decade, VC investments in the EU have averaged 0.2% of gross domestic product (GDP) per year, significantly lower than the 0.7% average in the US. This difference is also reflected in the fact that US VC funds have raised US$800 billion more than EU funds for investing in innovative startups.

The EU’s weak VC industry negatively affects its competitiveness, growth prospects, and green ambitions. Several studies find that innovative, young fast-growing firms that go on to be “superstars” contribute disproportionately to aggregate jobs and growth. Such firms typically invest heavily in research and development (R&D) and information and communications technology (ICT), two key areas where the EU lags significantly behind the US.

Europe also trails behind the US in aggregate productivity, with real output per hour worked 26% points lower in the EU than it would be if it had kept pace with US productivity growth since 2000.

VC financing is also critical for developing new technologies and scaling up firms in the so-called “clean tech” sectors, which the EU in its Green Deal Industrial Plan has identified as strategically important. However, European VC investments in these sectors currently represent just a fraction of US levels.

EU’s weak VC landscape has also prompted many of the most successful EU startups to move elsewhere for financing, causing the EU to lose out on both the direct growth benefits and positive spillovers from these innovative firms.

For example, Miro, an enterprise software publisher from Russia, moved its headquarters to the US in 2019. The startup is valued at US$17.5 billion. Chainalysis is a blockchain analysis firm founded in 2014 in Copenhagen. The company is now headquartered in New York and is valued at US$8.6 billion. And Hugging Face, an artificial intelligence (AI) startup from France, is now headquartered in New York and is valued at US$4.5 billion.

Factors hindering VC activity

According to the IMF paper, several factors are contributing to the financing challenges faced by European startups. For one, the EU’s fragmented economic and financial markets are a major obstacle. The European financial system is predominantly bank-based, and banks are often ill-equipped to finance high-tech startups due to the lack of tangible collateral, the mismatch between bank risk models and the needs of fast-growing but initially unprofitable firms, and regulatory constraints that discourage riskier investments.

Additionally, European households tend to be more risk-averse compared to US households. They prefer to place a larger proportion of their savings in bank deposits rather than in equities, investment funds, or private pension schemes. This risk aversion contributes to a greater reliance on bank loans and unlisted equity for financing in Europe, whereas in the US, listed equity plays a more central role.

Another major hurdle is the fragmentation of Europe’s financial system. Cross-border integration in banking is lower today than before the global financial crisis, and capital markets remain fragmented, with pools of private capital confined to national boundaries. Most occupational pension schemes do not offer pension products across borders because of the differences in national social benefits and labor laws and the attendant costs, complexity, and operational risks. Pension funds and insurers also tend to exhibit strong home-country bias in their asset allocations.

Furthermore, regulatory, legal, and tax frictions impede cross-border investment and consolidation. Finally, long and complicated procedures for reclaiming withholding taxes discourage cross-border investment within the EU.

These constraints leave the EU with fewer and smaller VC funds than the US, with “exit” options for successful startups through initial public offerings (IPOs) or acquisitions being similarly constrained, the report says.

Fostering VC funding activity

The paper outlines several proposals for reforming the EU’s economic and financial policies, emphasizing the need for greater market integration across the bloc, targeted investments and regulatory adjustments.

First, it argues that the best solution to the EU’s scale, productivity and growth issues lies in fully integrating its market for goods, services, labor, and capital. Achieving a true single market would make it easier and less costly for the most productive firms to grow, find the necessary talent, reap economies of scale, and access deeper pools of capital, the paper says.

It also emphasizes the importance of investing in education, R&D, and ICT to foster innovative startups, citing Estonia as an example where an emphasis on digital skills in education along with public and private investment in digital infrastructure has helped create fertile ground for innovative startups to emerge and grow.

The paper further notes that startups require access to skilled employees and the flexibility to adapt as they grow. It recommends that EU policies should evaluate immigration and labor laws to ensure they do not hinder startups’ ability to attract talent or adjust their strategies. The paper also underscores the importance of stock options as a form of compensation for startup employees and calls for harmonized tax treatment of stock options across EU countries. Additionally, the development of portable private pension schemes across the EU would make it easier for firms to attract skilled workers from other EU countries.

In the financial sector, the paper identifies VC as a critical area for policy focus and suggests expanding public support for the VC industry. Reforms should consider tax incentives to stimulate VC investments, and national public financial institutions (PFIs) should play a more significant role by complementing private investments, it says. The paper also calls for closer partnerships between national PFIs and EU institutions like the European Investment Bank (EIB) and European Investment Fund (EIF) to strengthen local VC ecosystems and connect them with more developed hubs across the EU.

Regarding the regulatory framework, the document notes that while EU rules on VC are generally well-received, some fine-tuning may be necessary. For instance, the eligibility criteria for investors in large VC funds should be aligned with those for smaller funds to avoid unnecessary barriers. Furthermore, regulatory reforms in the insurance sector and for pension funds are needed to remove obstacles preventing them from investing in private equity and VC.

Finally, the paper recommends a broad review of EU laws and regulations affecting high-tech sectors to identify unintended consequences that may impede the growth of innovative firms. Recent regulations like the General Data Protection Regulation and the Digital Markets Act, for example, have generally improved competition in the digital sector. However, they may also create inconsistencies and complications for startups, the paper says.

Europe has consistently trailed behind the US in VC funding. In Q2 2024, European startups secured a total of US$14 billion in equity funding across 1,522 deals, a far cry from the US$39 billion and 2,419 transactions raised by tech startups in the US, data from CB Insights’ State of Venture Q2 2024 show.

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