What’s structurally wrong with European VC?
Summary
7gc was born on a cross-border philosophy of how to best benefit from deep networks in Europe and the US for both investing and the investors that support us. We have deployed most of our capital in the US market (per our strategy) and continue to, yet have witnessed a tremendous increase in value creation in the private EU tech markets.
The purpose of this research paper is not to make obvious comparisons or point to superiority but rather to examine, from a structural point of view, what ingredients are necessary for a robust VC ecosystem and where Europe stands from a global point of view. Success in venture capital in its most basic sense requires scaled funding sources, talent, robust markets to sell into, and ultimately a high risk-adjusted return of capital over ten-year cycles. While all of those ingredients are present and have ramped dramatically within the last ten years, there is tremendous nuance to the European approach and what it means going forward.
This paper was proudly written with the assistance of our portfolio company Anthropic’s chatbot, Claude.ai.
1. Introduction
Venture capital markets in Europe and the United States have developed along distinctly different trajectories, reflecting disparate financial traditions, regulatory environments, and investment cultures. While the United States has fostered a vibrant ecosystem that has produced numerous technology giants and created tremendous economic value, the European venture capital market has struggled to achieve comparable scale and success. This research paper aims to identify and analyze the structural deficiencies in the European venture capital model that have led to this divergence, with particular emphasis on the following key areas:
The European Investment Fund's dominant position and influence in shaping investment criteria
Fundamental differences in fund structure, particularly regarding hurdle rates and waterfall distributions
Liquidity dynamics across global markets, including exit pathways and unicorn development
The regulatory environment's impact on innovation, particularly in emerging sectors like artificial intelligence
We're comparing these factors to understand the nuance of the european market and explore ways the EU could strengthen its venture capital ecosystem and become more competitive globally.
2. The European Investment Fund: The influential cornerstone of the LP market
2.1 Overview of the EIF's Role in European Venture Capital
The European Investment Fund (EIF) stands as a cornerstone institution in the European venture capital landscape, serving as the primary catalyst for funding early-stage companies and venture capital firms across the continent. Established in 1994, the EIF operates as part of the European Investment Bank Group, with its shareholders comprising the European Investment Bank (62%), the European Union represented by the European Commission (29%), and various financial institutions (9%).
The EIF's primary objective is to support small and medium-sized enterprises (SMEs) by improving their access to finance through intermediaries rather than direct lending. Its engagement in the European equity arena has grown substantially, evolving from approximately €60 million across 22 deals in its first year of operations to around 146 transactions reaching more than €3.3 billion by 2017. Today, the EIF maintains over €14 billion in assets under management in its equity investment portfolio.
2.2 EIF Investment Patterns and Market Impact
The EIF's investment strategy has significantly influenced the broader European venture capital ecosystem. As a cornerstone investor, the EIF has aimed to catalyze further investments and "crowd in" private investors to nurture market development. The fund specifically targets independent management teams raising capital from various investors to provide risk capital to growing SMEs in Europe. Through this approach, the EIF has played a pivotal role in establishing and shaping venture capital markets across the continent.
However, the EIF's dominance as a limited partner (LP) has created structural dependencies within the European venture capital industry. Many European venture capital firms rely heavily on EIF funding, which comes with stringent investment criteria and reporting requirements. This dependency creates a situation where fund managers must align their investment strategies with EIF preferences, potentially limiting innovation and risk-taking that might otherwise characterize a more diverse funding ecosystem.
2.3 Conservative Investment Terms and Their Consequences
The EIF's investment terms reflect a conservative approach that more closely resembles private equity than traditional venture capital. This approach includes provisions such as:
Requirement of a European waterfall structure in funds
Financial requirements of startups that can inhibit large-scale investment from breakout winners
Geographic restrictions for non-EU or global companies
Extensive reporting and compliance requirements
The most basic limitation of the waterfall structure on aggregate vs. on a deal-by-deal basis is a matter of negotiation between GPs and LPs and is to be debated. We raise this here and go into further detail because of the anchor nature and terms, setting this requirement of the EIF ends up imposing on the entire market. There is a very simple argument to be made to allow the best managers to quantify their risk and manage their portfolios in order to drive liquidity in the near term and realize success versus assuming the ultimate benefit of carry is so long dated the manager is incentivized to collect and deploy more capital vs. focus on the near term return of capital and benefit alongside their LPs.
The geographic restriction of managers has become more prominent post-Brexit as EU-based venture firms are now forced to disregard Europe's most successful and longest-running technology market. Also, the limitation extends to marginalized opportunities for US or global firms with significant presence in Europe, which theoretically should fit the mandate of funding job growth and innovation economies within the continent.
These conservative parameters have ripple effects throughout the European venture capital market, encouraging fund managers to adopt similar criteria in their investment decisions. The result is a market that often prioritizes stable, incremental growth over the high-risk, high-reward opportunities that have fueled breakthrough innovations in the United States. This conservative orientation may explain, in part, why Europe has struggled to produce the same volume of disruptive technology companies as the US, despite having comparable pools of talent and technical expertise.
3. Fund Structure Disparities: Hurdle Rates and Waterfall Models
3.1 The Incongruity of Hurdle Rates in Venture Capital
A fundamental difference between European and American venture capital fund structures lies in the application of hurdle rates. Hurdle rates—the minimum rate of return that fund managers must deliver before earning carried interest—are a standard feature in European venture capital funds but are much less common in US funds, particularly for smaller funds under $30 million.
The incorporation of hurdle rates in venture capital creates a philosophical incongruity. Venture capital, by definition, targets investments with exponential growth potential rather than predictable returns. The application of fixed hurdle rates, typically around 7-9%, reflects a private equity mindset that emphasizes consistent performance across a portfolio. This approach contradicts the fundamental nature of venture investing, where returns often follow a power law distribution with a few outsized winners compensating for numerous failures.
In our view, this term is an “investor-friendly” holdover from private equity investing, which, in theory, is beneficial to LPs who are providing capital in exchange for long-term lockups with discretion and underwriting a minimum return profile. However, the applicability does not apply as readily (or at all) in venture capital investing, as by its nature, it is minority and non-control vs. PE.
The logic of a hurdle rate in pE is more defensible as managers with control should be: 1.) operationally improving the value of their investments via their ability to control their assets holistically and 2.) should be able to generate liquidity at their sole discretion, at a time of their choosing, via M&A, IPO or alternative paths within their oversight to achieve and exceed the hurdle rate.
A minority investor in reality has limited ability to individually grow the value of assets (however, can and should make efforts to, alongside the collective investor syndicate, when possible) and also cannot singularly control the time of exit for a minority stake. To subject a venture manager to a hurdle rate is an unrealistic expectation on the GP.
As one industry source notes, "It's super uncommon for VCs to have hurdles. For the Private Equity asset class, hurdles are usually in the 5% - 10% range." The insertion of hurdle rates in venture capital funds creates misaligned incentives between general partners (GPs) and limited partners (LPs), potentially encouraging fund managers to pursue safer investments with more predictable returns rather than the transformative opportunities that characterize successful venture investing.
3.2 European vs. American Waterfall Structures
The distribution of proceeds from investments, known as the "waterfall" structure, represents another key divergence between European and American venture capital models. These structures determine how and when investment returns are distributed between LPs and GPs.
American vs. European Waterfall: Key Characteristics
In a European waterfall (also called a "whole-fund" waterfall):
100% of distributions go to LPs until they have received back their entire contributed capital
LPs then receive distributions until they achieve their preferred return (typically 7-9% per anum)
Only after these thresholds are met do GPs begin to receive carried interest
In contrast, an American waterfall (or "deal-by-deal" waterfall):
Evaluates each investment separately
Allows GPs to receive carried interest from successful investments before LPs have been made whole on their entire contribution
Often includes clawback provisions to protect LPs if the overall fund underperforms
The European structure fundamentally alters the economics and incentives for fund managers. Under this model, GPs may wait years or decades before earning carried interest, even if some of their early investments prove highly successful. This delay in compensation can discourage risk-taking and potentially reduce the attractiveness of the venture capital profession for top talent in Europe.
3.3 Incentive Misalignment and Asset Gathering Behavior
The combination of hurdle rates and European waterfall structures creates a systemic incentive misalignment in the European venture capital industry. Since GPs must achieve specific return thresholds across their entire portfolio before earning carried interest, they face pressure to:
Prioritize management fees over carried interest as a reliable income source
Grow assets under management (AUM) to increase fee revenue
Avoid high-risk, high-reward opportunities that could jeopardize achieving the hurdle rate
This emphasis on asset gathering rather than investment performance fundamentally alters the nature of venture capital in Europe. In the US model, where GPs can earn carried interest on successful investments regardless of overall fund performance, managers are incentivized to pursue outsized returns even if it means accepting higher failure rates. The European structure, by contrast, encourages more conservative portfolio construction and larger fund sizes, potentially at the expense of maximizing returns.
4. Liquidity Environments and Exit Pathways
4.1 Comparative Analysis of Liquidity Across Global Markets
The availability of exit opportunities represents a critical factor in venture capital ecosystem health, as it determines investors' ability to realize returns and recycle capital into new investments. The data shows significant disparities in venture capital fundraising between the US and Europe over recent years:
VC Fundraising Trends: US vs. Europe (2018-2023)
This data illustrates that US venture capital fundraising consistently outpaces European fundraising by a factor of approximately 6-8x, despite the European Union having a comparable GDP and population to the United States. This disparity in capital formation creates cascading effects throughout the venture ecosystem, limiting the scale and scope of European venture investments.
This is a critical comparison because liquidity drives reinvestment. With equivalent economic output, access to talent, and open markets, there is no macro reason why the European fundraising levels should not mirror or come within 75% of the US. The key problem that must be addressed to attract more capital is demonstrated liquidity with healthy return profiles.
4.2 IPO and M&A Activity: Regional Disparities
The pathways to liquidity also differ significantly across regions. In the United States, initial public offerings (IPOs) have historically played a crucial role in venture capital exits, although mergers and acquisitions (M&As) also represent a significant exit channel. The US benefits from deep and liquid capital markets that are receptive to technology companies at various stages of maturity.
VC Exit Values: US vs. Europe (2019-2023)
The data reveals a striking disparity in exit values between the US and Europe. In 2021, the peak year, US VC exits reached a record $287 billion, while European exits only achieved $41 billion. Even in more subdued years like 2023, US exit values ($95 billion) continued to dwarf those in Europe ($12 billion).
This gap in exit values directly impacts investor returns and creates a challenging feedback loop for the European venture ecosystem. Lower exit values mean reduced returns for LPs, potentially discouraging future investment in European venture funds, and limit the recycling of capital that fuels the next generation of startups.
4.3 Capital Markets Restrictions in Europe
European ventures face additional structural barriers in accessing capital markets. These include:
Fragmented national stock exchanges with varying listing requirements
Lower liquidity and trading volumes compared to US exchanges
Institutional investor preferences for dividend-paying stocks over growth-oriented technology companies
Regulatory requirements that can increase the cost and complexity of going public
These restrictions in European capital markets create a systemic disadvantage for venture-backed companies seeking liquidity. The absence of a unified, technology-focused exchange comparable to the NASDAQ limits the appeal of public listings for European companies, potentially driving them to consider US listings or alternative exit strategies.
The impact of these capital market limitations extends beyond just exit valuations. They also influence earlier-stage investment decisions, as venture capitalists must factor in more constrained exit pathways when evaluating potential opportunities. This consideration may lead to more conservative valuations and investment terms, further compounding the challenges facing European entrepreneurs.
4.4 Unicorn Development Across Regions
The development of "unicorns"—privately held companies valued at over $1 billion—provides another lens through which to analyze the health of venture ecosystems. The data shows stark disparities in unicorn creation across regions:
Unicorn Count by Country (2024)
As of recent data, the United States leads globally with approximately 600 unicorns, representing more than 50% of the world's total. China follows as the second-largest unicorn hub with around 170 companies, while India ranks third with approximately 70. Europe's unicorn count lags significantly behind, with the United Kingdom hosting approximately 50 unicorns, Germany around 30, and France about 25. This unicorn gap reflects broader challenges in the European venture environment, including difficulties in scaling companies to achieve global competitiveness.
The distribution of unicorns across regions also reveals interesting patterns in company development and investment focus. For instance, Europe's unicorns tend to cluster in specific sectors like fintech, enterprise software, and digital health, while US unicorns span a broader range of industries, including deep tech, consumer applications, and frontier technologies.
5. Talent and General Partner Market
5.1 Europe's Talent Advantage
Despite the structural challenges in its venture capital ecosystem, Europe maintains a significant advantage in its talent pool. The continent boasts world-class universities, research institutions, and a diverse, highly educated workforce. This talent foundation has enabled the emergence of innovative startups across various sectors, from fintech and digital health to artificial intelligence and climate technology.
European technical talent is particularly strong in fields like artificial intelligence, cybersecurity, and enterprise software. Cities such as London, Berlin, Paris, and Stockholm have developed thriving tech communities that continue to produce promising startups. The question is not whether Europe can generate innovative ideas or talented entrepreneurs, but rather whether its financial ecosystem can effectively nurture and scale these ventures.
5.2 Evolution of the European GP Market
The European general partner market has evolved significantly in recent years, with a growing number of experienced venture capitalists establishing funds. Many of these GPs have international experience, often having worked in the United States or with American venture firms, and bring global perspectives to their investment approaches.
Despite prior critique of the terms embedded in government-backed investment schemes, which exist at the EU level (EIF) and also at the country level, the public sector has made great strides to encourage and invest in a robust VC ecosystem with funds that can back promising companies from seed stage through growth. This phenomenon is a product of the last ten years. It is unequivocally responsible for the increased number of European unicorns, which matches capital to the existing high-quality talent and opportunities.
However, the European GP market still faces challenges related to the previously discussed fund structures and incentive mechanisms. The emphasis on management fees over carried interest can attract GPs focused on asset gathering rather than performance. The challenge for European venture managers is how to drive returns in the construct within which they must operate.
Despite these challenges, the maturation of the European GP market represents a positive development for the continent's venture ecosystem. The key to growth will remain returning capital with strong return profiles, creating a cascading waterfall effect.
With meaningful and more regular exits, managers are first able to point to a clear track record of strong returns and open the aperture for global financial investors to raise their funds. History has also shown us that large-scale outcomes create repeat entrepreneurs, groups of angel investors, and successful entrepreneurs transition into institutional investing roles, bringing valuable operational experience and networks that can benefit the next generation of founders.
Demonstrated success and the recycling of capital have a snowball effect.
6. Regulatory Capture and Innovation Constraints
6.1 AI Investment Environment: EU vs. US Comparison
A particularly instructive case study in regulatory differences between Europe and the United States can be found in the artificial intelligence sector. The regulatory approaches to AI in these regions reflect broader philosophical differences that impact innovation and investment.
AI Investment: US vs. Europe (2019-2023)
The data shows that AI investment in the US consistently outpaces Europe by a substantial margin, with the gap widening in recent years. By 2023, US AI investment was nearly 9 times larger than European investment, despite Europe's strong technical talent in AI-related fields.
The European Union has adopted a comprehensive regulatory framework for AI, embodied in the EU AI Act, which was approved by the European Parliament in March 2024. This legislation takes a risk-based approach, classifying AI systems according to their potential risks and imposing corresponding obligations. High-risk AI applications face stringent requirements, including detailed documentation, human oversight, and transparency obligations.
In contrast, the United States has pursued a more decentralized, innovation-focused approach to AI regulation. Rather than enacting comprehensive legislation, the US has emphasized non-regulatory infrastructure, such as risk management frameworks, voluntary standards, and substantial research funding. This approach prioritizes innovation while addressing specific risks through targeted measures.
These divergent regulatory philosophies have significant implications for AI investment. In Europe, the more prescriptive regulatory environment can increase compliance costs and create uncertainty for startups developing AI applications. US-based AI companies, operating in a more flexible regulatory landscape, potentially face fewer barriers to experimentation and scaling.
6.2 Political Constraints on the Knowledge Economy
Beyond specific sectoral regulations, broader political dynamics in Europe have sometimes constrained the development of a robust knowledge economy. European policymakers often prioritize stability and protection of existing industries over the creative destruction that characterizes successful innovation ecosystems.
This preference for stability manifests in various ways:
Labor regulations that can make it difficult for startups to hire and scale rapidly
Insolvency laws that create higher costs and stigma around business failure
Public procurement practices that favor established companies over innovative newcomers
Risk-averse public funding mechanisms that emphasize incremental rather than disruptive innovation
While these policies may serve important social objectives, they collectively create an environment less conducive to high-growth entrepreneurship than the more dynamic American system. European policymakers face the challenge of balancing legitimate social protections with the flexibility needed to foster a thriving innovation economy.
7. What does the future hold for EUropean Venture
7.1 Summary
To level set, in our view, the European venture capital ecosystem has seen a transformational ten-year period as evidenced by the asset quality (~200+ unicorns) and roughly 2,000 active VC investors.
The increase of activity to date is a combination of political will and private investment interest to match capital into what was always a highly robust market for talent and innovation, coupled with markets ready for novel locally relevant startups.
The key questions we seek to address center around the idea that the market has now been established at scale, yet it lacks the crucial liquidity requirements to both return and recycle capital into this irrefutable market.
as we enter the AI supercycle, Europe is now incredibly well positioned from both a talent, markets, and capitalization perspective. the key differentiator to understand how this plays out will remain in the level of influence of public policy makers in the VC asset class.
7.2 Recommendations for Structural Reform
Addressing these structural challenges requires coordinated action from policymakers, investors, and entrepreneurs. Key recommendations include:
Diversify funding sources beyond the EIF: Encouraging more private institutional investors to participate in venture capital would reduce dependency on the EIF and potentially introduce more diverse investment approaches.
Reform fund structures: Eliminating or modifying hurdle rates for true venture capital (as opposed to growth equity) and adopting more GP-friendly waterfall structures would better align incentives with the realities of venture investing.
Develop stronger exit pathways: a softening of listing requirements on local exchanges would prove beneficial but a deficit in large scale M&A is the true inhibitor for liquidity to mirror US markets
Balance regulation with innovation: Adopting more flexible, principles-based regulatory approaches, particularly in emerging technology sectors, would enable greater experimentation while still protecting key public interests.
7.3 Opportunities for Future Growth
Despite the challenges outlined in this paper, Europe's venture capital market possesses several strengths that could support future growth. These include:
World-class technical talent, particularly in fields like artificial intelligence, cybersecurity, and enterprise software
Growing numbers of experienced entrepreneurs transitioning into investor roles
Increasing recognition among policymakers of the importance of innovation to economic competitiveness
Strong institutional infrastructure and rule of law that can provide a stable foundation for business development
By addressing its structural deficiencies while building on these strengths, Europe has the potential to develop a more dynamic and productive venture capital ecosystem. Such an evolution would benefit not only European entrepreneurs and investors but also the broader European economy through increased innovation, job creation, and economic growth.
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