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VC Market Is Failing Startups, Says Report

A joint European-American working group suggests that one remedy may be using public money to fund early-stage ventures on both sides of the Atlantic.
LONDON — The venture capital market is turning to more mature companies and declining to invest in early-stage startups, and this represents a “fundamental market failure”, according to a report produced by a joint working group set up between the European Commission and the U.S. Department of Commerce.

The working group, which held meetings in March and June 2005, was co-chaired by Mario Cardullo from the Department of Commerce and Vesa Vanhanen from the European Commission. Representatives of venture capital funds, industry advisors and associations, academics and others participated in the discussions.

The working group had been set up under an initiative to promote transatlantic economic integration agreed between the European Union and the U.S. in 2004. The working group’s report warned that the failure of the VC market, on both sides of the Atlantic, is so significant that public intervention is desirable. It also suggested that public money should go to large, well-established funds that can command economies of scale, rather than creating a proliferation of small funds.

At the same time as saying the public authorities should step in to what has traditionally been a free market, the report also concluded that politicians need to be educated on the importance of the venture capital and private equity markets to wealth generation.

“The work of the group confirmed that there is a fundamental market failure in the provision of early-stage financing in both the U.S. and the E.U.,” the report said. It added that funds are leaving small and risky early-stage deals aside to pursue the higher returns and lower risks available in later-stage investments and this could become a self-reinforcing cycle.

“The few remaining seed funds and the business angel investors cannot by themselves cover the demand for equity investments,” the report said. “Public sector measures are justified to overcome this market failure in seed and early-stage investments,” it concluded.

The report said that any public sector action to stimulate early-stage investment should work with markets but not crowd out private investment. The group also concluded that small funds lack economies of scale, struggle to provide suitable advice to the companies they invest in, and have difficulties recruiting experienced managers.

“Allocating public funding to substandard venture capital funds would work against the development of the market by prolonging the life of underperforming funds without improving the overall situation of the industry,” the report said.

In terms of follow-up activity the report suggested that a number of conferences were scheduled to continue the debate on public investment in private venture capital funds.

The report could be found here, when this story was first posted.