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The classic startup ecosystem Catch-22

I’ve now analyzed over 30 startup ecosystems, mostly nascent ones. I’ve been trying to understand what works and what doesn’t by identifying the patterns between the ecosystems I’ve dove into. One of the main findings is what I like to call the “classic startup ecosystem Catch-22, " which led me to write this article to explain what it is, and where I think the solution to it lies.

The classic startup ecosystem Catch-22 is a phenomenon experienced by all startup ecosystems, from the US to Tunisia. Here’s what it consists of:

• A new ecosystem needs “risk capital” such as venture capital firms (VCs) and angel investors in order to finance its burgeoning startup scene.

• VCs need to raise money from limited partners (LPs), who are often local “institutional investors” such as pension funds, family offices, or insurance companies.

• Most LPs handle other people’s money, and therefore need to be convinced of the viability of investing in local VCs.

• However, since local VCs have no money, they have little to no track record, and thus very little material to convince potential LPs that startup investments are viable.

• Local VCs thus end up with no financing, which leaves startups with no financing, which severely decreases the probability of startups succeeding, which is a prerequisite for VCs to raise money!

This situation makes it very hard for new ecosystems to truly take off. Some exceptions exist such as Estonia, where a visionary group of founders (in this case the Skype founders) provide an initial flow of capital and talent into the ecosystem. But for most ecosystems, the Catch-22 situation holds.

How the US went about it

Before exploring what I think the solution to this problem is, let’s see how the world’s oldest and most successful startup ecosystem to date, the United States, went about this problem.

The origins of venture capital in the US is best exemplified by the whaling days, when brave crews would set out to sea in search of whales that were then used for all types of goods from illuminants, to perfumes, to umbrellas. The parallels between whaling and VCs are striking:

Whaling agents intermediated between the wealthy individuals who supplied funds and the captains and crew who undertook voyages, just as VCs intermediate between limited partners and entrepreneurial teams in portfolio companies. The rise of American inventiveness in whaling reflected a distinct culture of entrepreneurial exceptionalism, risk capital deployment, and the pursuit of outsized returns. Rates of return on capital could be high in whaling, but so was the downside risk associated with this unpredictable and hazardous industry. In the United States, whaling was one of the earliest kinds of enterprise to grapple with the complexities of risk capital intermediation, organizational form, ownership structure, incentives, team building, and principal-agent tradeoffs. - Tom Nicholas: VC, an American History

In 1958, the Small Business Administration (SBA) launched the SBIC program, which intended, in simple terms, to lend money to businesses banks wouldn’t lend to. Not venture capital yet, but definitely risk-capital. Tim Draper, one of America’s most renowned venture capitalists, famously got his start in the trade by leveraging the SBIC program.

DARPA, a government program aimed at defense projects, also had a crucial role in financing university-developed technology, cementing America's now powerful university-startup relationship.

To summarize, the US government financed risky technological ventures (ie: startups) either directly or indirectly, during a period when the country’s young investors and future VCs didn’t have the track record needed to raise funds. Keep that idea in mind as we continue onto the main topic of this piece: fund of funds.

Fund of funds: an explanation

The US was a pioneer in the startup world. Its government experimented with different solutions to the ‘startup ecosystem Catch-22’ problem, solutions that led to pretty great success given the current vitality of the American VC industry. Today, countries with nascent startup ecosystems have the benefit of hindsight and have codified their answer to the Catch-22 through a specific measure: fund of funds.

Simply put, a fund of funds is a fund that invests in other funds. In our context, this relates to a scenario whereby a government invests in new, local VCs, that will then go on to invest in local startups. One of the first countries to formally do this was Israel, through its Yozma program.

A government launching a fund of funds essentially ‘unblocks’ the Catch-22 problem by acting as the country’s VCs’ first LP. The goal is for those VCs to successfully exit some of their first portfolio companies, giving them the track record needed to subsequently raise money from other potential LPs such as pension funds, family offices, and academic institutions.

Furthermore, the fund of funds model can make government funds available to startups while passing through a competent intermediary (a VC fund manager) instead of lengthy governmental procedures. Public fund of funds can either be national, or supra-national (a good example of that being the EU’s ScaleUp initiative). Lastly, being a public fund of funds doesn’t exclude the possibility to raise money from “private” actors.

However, a fund of funds doesn’t have to be necessarily government-led. Indeed, initiatives such as Isomer in Europe raise money from LPs in order to back a portfolio of VCs (instead of startups). I would opine that private fund of funds can be extremely impactful at the later stages of an ecosystem, but that the Catch-22 remains the same for them at the start as they try to raise from ‘regular’ LPs just like other VCs.

A successful public fund of fund case study: Greece’s Equi’Fund

Everyone reading this is likely familiar with the Greek economic debacle of the early-2010s, punctuated by EU bail-out packages and austerity measures. This essentially cut public services while simultaneously reducing the population’s purchasing power, leading to a death spiral of economic malaise.

Greece’s recovery is still ongoing and perfectible, but one exciting byproduct of it has been the growth and consolidation of its startup ecosystem. By consolidation, I mean the creation of reliable local VCs capable of financing the country’s innovative startups. A large chunk of those VCs was created through one of the country’s fund of fund initiatives, Equi’Fund, financed (ironically) by the European Union.

To do so, money from the program was used to create six different, local VC funds, each of them carrying out a singular investment thesis. These include:

• BigPi Ventures: Focuses on technology transfer by assisting both research-based projects and companies, mostly active in the B2B segment.

• Metavallon Fund: An accelerator fund that focuses on pre-seed and seed stage companies in Greece and targets technology and intellectual property (IP)-driven start-ups primarily in information and communications technology (ICT) and engineering products.

• Unifund: Targets pre-seed and seed investments in the broad technology sector, aiming to leverage the hidden potential that exists in the Greek university, R&D and technological space.

• Velocity Partners: A pre-seed and seed acceleration fund that focuses on technology companies in verticals where the Greek economy can provide global validation and real market traction.

• Marathon VC: Brings together a team that combines investment, entrepreneurial, technical, and operational skills in order to help the new generation of ambitious founders build world-class technology companies. The fund targets SMEs at the seed and Series A stages.

• Venture Friends: Brings together a strong and cohesive team able to provide substantial value to ICT SMEs in the seed and Series A stages.

What’s interesting about this initiative is that the funds are led by relevant managers with experience in the startup world. I bet Equi’Fund’s results would’ve been very different if each VC was managed by a government bureaucrat. The recent struggles and delays faced by the EU’s startup investment scheme show what can happen when money meant for fast-paced ventures (startups) is managed by a bureaucratic behemoth (the EU). This isn’t meant as a diss to the EU, but rather that the money the EU sets aside for startup investments should be handled by competent, professional VCs rather than the EU itself.

Fund of funds initiatives have been gaining steam worldwide, as governments start to realize the impact startups can have on the economy, but also the crucial role they have in supporting them. Some other notable fund of funds to check out include Tunisia’s ANAVA fund of funds, India’s SIDBI fund of funds, and the European Scaleup Initiative, which aims to finance late-stage European VCs in order for them to compete with American ones. Some say government-led fund of funds have a marketing problem, as their “publicness” gives a false impression that they can’t turn a profit.

Conclusion: Rethinking the role of government in startup ecosystems

Most of the startup world’s ‘pop culture’, way of thinking, and general views about a number of topics emanate from Silicon Valley. This includes a widespread distrust (and even disgust?) of any government intervention. Not only is that intellectually dishonest given the history of the American startup ecosystem, but it also deprives startups of what has historically been their biggest ally: a free-market-oriented government.

As startup ecosystems start to develop around the world, ecosystem builders are re-thinking the traditional “anti-government” approach. I think this is the case for a multitude of reasons.

In countries with historically heavy government presence, such as France, founders have a very different view of the state’s role. For example, one of the country’s largest investors is still the BPI, a public investment fund, and it can be argued one of the country’s prominent business angels is no other than the national unemployment scheme, which provides to-be founders with living expenses while they try to get profitable and/or raise money.

In countries such as Tunisia, the role of the government is essential in rethinking the country’s business laws to make them adapted for startups. In Pakistan, the government was instrumental in modifying its foreign investment rules into Pakistani startups. In Brazil, the government’s push to promote Open Banking policies spurred a wave of fintech innovation. In Uzbekistan, the change from a communist to a more economically-liberal government transformed the country’s startup ecosystem.

My point is the following: governments are essential to the development of startup ecosystems. Either because they need to update legislation stifling the ecosystem or because they can provide the initial money to kickstart the country’s VC scene. In the vast majority of cases, it’s both.

The startup world needs to stop viewing the government as an enemy. In the worst case, you need to painfully convince them to change outdated business legislation. In the best case, they can prove to be an essential ally in supporting the development, legislative relevancy, and initial financing of the ecosystem.

The Realistic Optimist provides weekly, in-depth analyses of some of the hottest stories in our now globalized startup world. Subscribe below to receive it directly to your inbox and don’t hesitate to share it to like-minded people :)