Swedish venture faces critical funding gap

For the last five years, Sweden has been the third largest market in Europe for venture capital-backed exits, trailing only France and the UK, according to unquote" data. The nation has consistently ranked among the top five most active markets in Europe for venture investment, taking fourth place in 2012.

Skype, co-founded by a Swede and an Estonian, was first backed in 2004 with a €1.9m capital injection from Draper Investment Company. Seven years and several venture rounds later, Silver Lake Partners, Joltid Ltd, Andreessen Horowitz and the Canada Pension Plan Investment Board sold the firm to Microsoft for $8.5bn.

The market's credentials are clear and its dealflow understood by the rising number of international investors opening offices in Stockholm or expanding their remit to include it. But it could be running on borrowed time.

"There is a real gap in funds investing €500,000-1.5m," says Martin Gemvik, investment manager at early-stage investor Sting Capital. "We used to have the Sixth Swedish Pension Fund (AP6)," he reminisces, "which acted as a fund-of-funds investor. It meant that there were national LPs that could contribute maybe 20, 30, or 40% of these funds," he adds. AP6's CEO Karl Swartling told unquote" that changes to the fund's allocations and strategy were inspired by the pursuit of higher returns.

"For various reasons the management did not deliver the expected returns, and so the government decided to stop all investment activities. This has created a substantial lack of resources for early-stage fund-of-funds capital in Sweden, which today is a well-known problem among entrepreneurs," he explains. Dealflow and drive there may be, but how to fill the tanks of those early-stage funds hoping to jumpstart new businesses?

"If you go back to the year 2000, there was ample supply - even too much supply - of capital for VCs," explains Gabriel Urwitz, chairman of the Swedish Venture Capital Association (SVCA) and founder of buyout firm Segulah. "Back then we had 100-200 VC firms, now we have only a handful. There is always discussion of whether or not there is enough money for seed capital. In a country like Sweden, the government is active with a fair amount of money," he explains. "But the question is, is it active in a meaningful way? I think Sweden still has some lessons to learn here."

For the nation, this shortage could be bad news as it lies at a crucial stage for the host country; the early stages of a business often decide whether an entrepreneur commercialises an idea at home or abroad. Recent news that the crowd-funding platform Crowdcube has launched in Sweden may provide some short-term relief for hard-pressed entrepreneurs. But, while entrepreneurial innovation is firmly ingrained in Swedish culture - the nation was one of the first to adopt broadband on a national scale, while the government ensured all Swedes had access to PCs in the 1990s - some have wondered how long Sweden will be able to foster its homegrown talents if the drought in seed capital remains.

The invisible hand
Although it appears a problem of national importance, most agree that the state should not make direct private equity investments, though contributions to commercially-driven funds are welcomed. Perhaps the Israeli government's Yozma programme could provide a textbook example, widely accredited as the foundations upon which the thriving VC scene - dubbed Silicon Wadi - is built.

"Entrepreneurship is not something that can be defined by government," says Daniel Blomquist (pictured), principal at VC investor Creandum. "It is more about making sure you create an environment where it is easy to start a company and share incentives. With favourable tax regulation," he adds.

On the one hand, the strength of Swedish welfare provisions in the area of childcare for example leaves those entrepreneurs with children free to wholly dedicate their time to their start-up. What's more, Swedes may be more willing to take a risk knowing that the weave of their state-provided support net is so strong that failure will not make or break you. But it is not entirely plain sailing.

Take the example of including options in employees' remuneration packages, often standard practice for cash-strapped start-ups. While a start-up founder may log earnings as capital gains, employees with a holding in the start-up are taxed more heavily than those who invest in the stock market. Skype famously moved its base to Luxembourg to solve this issue.

What's more, if an entrepreneur falls ill and requires state sick-pay contributions, the entrepreneur is required to sell their shares in the start-up if they want to ensure contributions beyond a limited period. "And it is the same with the unions; if you claim support from your union you have to sell your shares," Gemvik says. "How entrepreneur-friendly is that?"

But the tide could be set to change. "One of the big parties in opposition recently suggested a change to the law regarding the taxation of personal or employee options. After 20 years of trying to convince politicians, it seems they are finally understanding what they need to do," Gemvik says.

Björn again
Yet entrepreneurialism is on the rise, fuelled by the so-called Björn Borg effect - whereby headline-hitting success inspires the next generation, according to Gemvik - and encouraged by the flipped perception of job security at large corporates following mass lay-offs at Ericsson. This zeitgeist could sustain the industry. "[The number of] people setting up a presence locally is likely to increase given the number of opportunities that exist," predicts Carl Bergholtz, vice president at international technology investment banking group GP Bullhound. "On the early-stage side of the spectrum, where capital is increasingly scarce, I think the entrepreneurs that have started businesses and sold them will return to the market and be increasingly active as super angel investors, helping to fill the funding gap to a certain extent."

And they may even take it one step further and found a VC firm; Skype co-founder Niklas Zennström now manages investments at Atomico. The Björn Borg effect could spread to the investment management space too.

The industry also appears to have woken up to threats to its future. "Those who used to invest in early-stage before shifting up the chain are now coming back," says Gemvik. "And not only in the pursuit of returns. They see that they need to contribute to the ecosystem and help to source new companies, so that later on they will be able to invest in promising and exciting later-stage businesses," he adds.

A different story
But for those investing in the slightly later stages of venture capital, the current state of the market spells opportunity. "As VCs nowadays, we are in the big winners," explains Blomquist. "Unlike previous decades, we have the funds to follow the winners through. The ecosystem is more mature, and there are fewer VCs. Yes, there is less capital deployed, but that means there is more of a chance to make better returns now," he says. And as the first institutional backers of Spotify, hopes are high for Creandum's exit metrics. The firm certainly does not seem to be suffering from a shortage of LPs.

It is hoped the ecosystem will develop organically, attracting further international investors as a consequence - a development path Blomquist welcomes. "Finland has much more of a supporting system for investment in early-stage. But it may have some negative impact in terms of too many start-ups getting funding from the state," he suggests. "Companies get better at winning money from the state than they are at winning customers!"

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