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Issues of the Ariadne Capital Journal - Through the Maze

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The paper was a summary of the research carried out within the industry sector and amongst its peers. Hale found:

1.There is a lack of management talent pool with startup experience.
2. Poorer execution of product and service delivery and inability to develop a balanced channel partner strategy.
3. An inability to exploit the potential of a single European market and successfully penetrating the US market.
4. Differences in investor behaviour between Europe and the USA.
Below is a summary of the key points in the debate and The Chilli perspective on each of the major points.

First give us the evidence
The number of European software companies with revenues of greater than $40 million have fallen to less than 30 in 2005, compared to over 40 in 2002. Only two European companies have revenues greater than $1 billion, namely SAP and Misys. In terms of valuations only three Europeans companies, namely SAP, Dassault Systems and Sage, have comparable valuation with their worldwide peers. The number of sizeable European software companies is declining fast as more of the remaining pool gets acquired by US companies; recent examples include Staffware, Merant, London Bridge, Eyretel and Sherwood. And European software companies tend to stall when they hit $15 million in revenues.

Lack of management talent pool with startup experience
All of the top 50 software companies in Europe have a first time CEO - which means they are performing a function they have not performed before. While some might overcome the steep learning curve this presents, it has a ripple down effect on the rest of the management, many of them having to perform tasks for a first time too. This lack of experience may be one of the reasons why investors are wary and slightly distrustful about investing in European startups - because they cannot see a demonstrable track record among the senior management team. The result is that European investors often drip-feed capital in a piecemeal fashion over several rounds as opposed to US investors who are known to be 'tough' but more generous and at an earlier stage.

In US companies, many of the CEOs are often on their second, third or fourth assignment as CEO. They prefer to keep their skills in the talent pool or the industry ecosystem, rather than withdraw after making enough one time financial gain - a typical characteristic of a European first-time CEO. They are often motivated by peer pressure, to repeat the experience and achieve greater things. For example, if they made $1m the first time round, then they want to make $5m the next time, and so on.

By contrast, in Europe, the CEO is often not willing to take on the effort, strain and risk of doing it again, aiming to realise enough wealth 'so I don't have to be a CEO gain'. By not repeating their experience, there is less likelihood of that experience being passed on to others.

The Chilli perspective: the scenario portrayed is not necessarily a software specific problem, but applies to many other technology sectors in Europe and other parts of the world - as was pointed out by Mitchell Kertzmann of VC firm Hummer Winbald. Domination by a handful of vendors, especially where one or two worldwide vendors have monopolistic power and disproportionate market share in a given sector, is a major problem worldwide.

The semiconductor industry is one such example. For a sector to have a degree of successes, it needs a healthy local market and an ecosystem of suppliers and customers. The situation has been exasperated further by the now well-accepted market failure of early stage and seed capital market in Europe. The US started addressing this problem way back in the 1950s, and supported its nascent technology industry with long-term support by guaranteeing a percentage of the massive federal research budgets and federal procurement programmes to small companies, worth more than $100 billion.

They also overcame the market failure of early stage capital by formulating many seed level, high risk and early stage capital infusions via small business investment companies (SBICs) and support programmes like loan guarantees via small business administration SBA, without which the likes of Fairchild, Intel, AMD, TI, Motorola, Compaq, HP or even Microsoft, would not exist today. This created a whole new pool of technology startup companies which fed off each other creating a whole new ecosystem of experienced technology managers and, equally important, an early stage capital management pool.

The Chilli has been campaigning for four years to have similar programmes in Europe, and as of today, the European governments are still debating these issues, confusing the key objectives with state aid programmes; this is literally wasting the massive EU wide research programmes which will not be commercialised or exploited successfully.

Europe needs more visionary industry leaders, trade bodies, government and educational institutes and executive teams. Experienced entrepreneurs and managers need more public recognition, plus peer and financial rewards if they are to remain as active participants in the industry even after relative success, in order to develop, nurture or mentor the next generation of bigger and better companies. Furthermore an educational effort to remove the stigma of failures needs to be encouraged so that if an entrepreneurs falls down, he is more likely to get up and be encouraged to give it another go, rather than been ostracised, as at the present. This will encourage a larger pool of experienced entrepreneurs and startup CxOs.

Poorer execution of product and service delivery, and inability to develop a balanced channel partner strategy

According to the paper, there is a huge skills gap between being head of a European sales and marketing operation of a US based company, and being a CEO of a European startup.

The vast majority of European managers who had previously worked in sales, marketing, customer support and applications feel rather daunted when faced with decision making in areas where they have very little exposure. For example in disciplines like corporate governance, board management, financial metrics like balance sheets, as well as P & L and product development and HR management issues. European firms tend to focus too much on the product and product customisation rather than develop reseller and partner channels.

The Chilli perspective: what the report is highlighting is the symptom of under-capitalisation that is faced by numerous European startups and technology firms. European firms are expected to survive on one quarter of the capital amount in a non-homogenous European market, which adds further costs. It is easy to criticise a firm that is literally in survival mode as it strives to meet all customer requests, and hit its revenue target set by the investors.

Not doing the customisation means lost orders, and that is not always wise unless you have an investor who will give you enough market development time to let you stick to your standard offering. Under-capitalisation also has a nasty side effect: lack of sufficient capital means you cannot hire the requisite numbers of sales, marketing, channel and partner strategy staff that will deliver effective results over a reasonable time period. So European companies focus on product development as they don't have the luxury of doing both, due to inadequate capital infusion.

Inability to exploit the potential of a single European market and successfully penetrating the US market

The UK Technology Innovation and Growth Forum debated this point on several discussion panels, highlighting some of the daunting challenges. There are several different issues regarding the difficulty of penetrating the multilingual European market, as well as preference for domestic suppliers, especially in the service sector.

The debate raised the issue that it would be easier for a UK-based software company to penetrate the US market than build a presence in the European market. The subject of hiring an experienced US executive who then goes and builds a whole set of sales, marketing, product support and application infrastructure locally, thus creating a dual HQ structure, was also highlighted as one of the key challenges facing a European startup. The dual HQ creates unnecessary conflicts, confusion and bad feeling, resulting in some startups ending up being acquired or liquidated as a result. European CEOs who haven't had sufficient US experience will also not get much respect from their US employees. Conversely, it was found useful to hire US staff with some European exposure or affiliation, via work assignments or family ties.

The Chilli perspective: in some market sectors, Europe has major strengths, namely mobile, consumer electronics, and telecoms. It is far easier to penetrate and build strength in your home market, than rush off to a distant market, where the business rules are different and where the competition is more local, ambitious and hungry.

Many European companies go to the US market, without adequate preparation; as one executive put it, "We opened our first US office in Washington state, home of the well known software company, but we soon found out that it was easier to deal with our customers from the UK, as most of them were located on the East coast. We soon learned our mistake and closed our west coast operation and moved to the east coast."

Although, it may be true that the US is the biggest market, it is also true that it is the most competitive market, with strong local vendors who are always better equipped than a European vendor with only skeleton staff. It is therefore critical that the decision to move to the US is well prepared and well timed. Nevertheless, one must keep coming to the same old subject of under-capitalisation. It would be suicidal for a vendor to start their US operation without adequate funding in place, as it may jeopardise the whole company. Interestingly, the debate hardly touched on the subject of China and India, as the next big opportunities, both in terms of deflationary operating expense, R & D and new market potential.

Indifferent investor behaviour
The debate acknowledged that, like in the software industry, the VC industry is also under-developed in Europe, with very few VC partners having business-building experience. This sometimes leads to VCs not knowing where the weak stress points are and how to fix them. Sometimes, they solely rely on the management team to feed them with market information and benchmarks for milestones. This sometimes inhibits them in replacing non performing founders, CEO and executives.

The issues debated throughout the conference have previously been covered in various articles in The Chilli . For example, that of European VCs drip feeding their portfolio companies in smaller amounts rather than taking bigger risks and bolder, more ambitious goals. The conflicts of new CEOs with existing tribes following the original founders was also brought to light.

The Chilli perspective: there are two distinct but related issues here, one of managing a successful portfolio company, and that of the underdeveloped VC industry. The biggest achievement so far in the European VC industry is recognising and acknowledging the shortcomings. Although Europe started relatively late in the venture-backed business building process, it can learn from the mistakes of others. Fortunately, there are many industry sectors in Europe, where business building is part of the lifeblood.

The VC industry needs to tap into this pool and be more bold in their recruitment efforts. Experienced global CEOs and business builders are not a limited monopolistic market, as the private equity industry has found out in the leveraged buyout markets. Global, ambitious companies need global, ambitious leaders. So find them and hire them, regardless of their nationality, even if it means that they earn twice as much as your senior general partner and you don't feel comfortable with them.

Having said that the VC industry is taking note and hiring more industry experienced General Partners; it will be some time before their efforts come to light. The relative successes of some post-IPO companies is also encouraging VCs to take a bolder role in co-syndicating, so that larger dollops of cash can be invested.

With regard to relationships with original founders and the A-team, more industry-wide effort needs to be made to align the interests of related parties. This is partly educational and partly related to how much equity is given out at the beginning. Investors need to figure out what is a reasonable threshold, beyond which the original founders become the enemy within. If at the onset, an expectation is built up as to how to progress the career of the original founders and visionary leaders, then transition to a new management team would be much easier.