Growth stage funding picks up in Europe

Growth stage or growth equity tech investing is on the rise in Europe. According to Invest Europe, growth investments rose 11% year-on-year in 2015 to reach €6.5 billion ($7.3 billion), reflecting the increasing number of European companies leaving their startup years behind them to embark on the next stage of their life cycle. But unlike in the US, where — due to the maturity of the ecosystem — growth stage is seen as a key investment category in its own right, in Europe it is still widely considered a mere branch of venture capital, with little to distinguish it from Series A or B.

Part of the reason these categories are often confused in Europe is that historically, there have been far fewer growth investors here than in the US, while a large proportion of the growth investment that has been available on this side of the Atlantic has come from American funds, who saw the European opportunity but logistically could only cover the most visible of startups.

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The other main reason for category confusion is that the funds that are active in Europe tend to define growth stage businesses slightly differently. Each firm will have its own particular benchmarks. But in general, a growth stage company has a number of clear markers. Typically, it has a product in the marketplace, which customers are starting to use and like. In all probability the product has yet to be perfected and the company may not be making much, if any, profit — but it will have decided on a business model and have demonstrably growing revenues.

Such companies will usually be on the brink of breaking through to the next level, in scaling terms, and while they may already be selling into one or two countries, they will need to expand rapidly into many more. Similarly, their headcount will be growing inexorably, from perhaps 30 to a few hundred people and rising, meaning that they need to put in new systems, covering everything from IT to HR.

While of course there’s a degree of overlap between growth equity and VC investing, there are fundamental differences too. As a rule, VCs invest from far earlier in the cycle, often focusing on companies that don’t yet have customers, or even a business model. Indeed, VC investing is a lot more about the quality of the team the investor is backing; it’s about discovering those two brilliant, yet elusive founders building a prototype in a garage, as well as the sheer ingenuity of an idea or size of an opportunity.

What VCs consider to be traction can be anything from a few scrawled words on a napkin to a startup that has already signed up a large number of users. If they can get in early enough as investors, there’s a chance they can hit the jackpot – providing, of course, that the startup in question defies the odds and becomes a breakout hit. In essence, VCs are in the business of purchasing lottery tickets, knowing that the majority (perhaps 60% or more) of their investments will fail, whatever their initial promise, meaning that they need to take multiple “shots at goal” to maximize their chances.

Growth stage investors have quite a different approach. First, because we invest larger amounts (of up to €29 million, or $33 million, a time) in far fewer companies overall, we can focus our time and resources intensively on one or two investments rather than across the five or more companies a VC might be backing at any given moment (inevitably prioritizing successful companies over struggling ones as a result). And while VC firms, due to the riskier stage at which they are investing, tend to club together when they make investments, partly because there’s “safety in numbers,” growth stage investors frequently invest alone. Having a single point of contact has tremendous upside for the companies we back, from speeding up decision-making to freeing up board seats for (often crucially important) independent directors.

Second, growth investors tend to strike more appropriate deals with entrepreneurs: We do not require the same extent of control and protections that VCs typically expect, as the entrepreneurs we work with have already proven that they know how to run and grow a business. At the same time, we can take a more aggressive approach to valuation, based on future growth prospects, compared with traditional private equity investors or even the public markets, which usually prioritize current financial results.

Third, the advice and support growth stage investors can offer entrepreneurs is highly specific to the stage they are at. While – like VCs – we invariably work across a wide range of verticals, growth investors tend to be specialists inasmuch as we work exclusively with companies who are roughly at the same stage and encounter the same “growing pains,” among other things, around scaling internationally, making strategic acquisitions, and headhunting the very best talent.

Most significantly, however, as Europe’s tech revolution continues and more midsize companies start to join the big league, the growth stage tier of investing plays an increasingly vital role in helping build the next world leaders. Previously, such companies, denied access to growth capital, would have had to settle for an early exit, probably through being acquired, often by a US giant. Now, many more of them can get the runway they need to pull out all the stops.

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Tony Zappalà is a partner at Highland Europe.