Europe's Tech Startup Boom

Fueled by plentiful venture capital, plus cheap talent from Eastern Europe, tech entrepreneurs are pulling in U.S.-size profits

Two-year-old London-based startup Garlik has the whiff of Silicon Valley about it. Its co-founders, Tom Ilube and Mike Harris, sold their first Internet-based company for an estimated $1 billion to Citigroup (C). The bulk of Garlik's research and development is outsourced to talented computer engineers in Poland who work for a fraction of what they'd cost in Western Europe. And it is backed by $18 million in venture capital.

With the speed of a well-heeled California startup, Garlik has raced to market in 18 months with DataPatrol, a privacy program that surfs the digital universe and, to deter abuse, tracks all the information about an individual on the Internet. Users now top 56,000 and Garlik is being hailed as a pioneer in the sector.

There's plenty more startups like Garlik emerging in Europe these days, fueling a tech-investing boom not seen on the Continent since the dot-com days. Successful serial entrepreneurs, cutting-edge technology, flush venture capital backing, and unfettered access to a continental talent pool: That quintessential Silicon Valley alchemy, once missing in Europe, is now powering venture investment to record levels. Venture funds raised last year for startups and early-stage companies in Europe rose 60%, to $23.5 billion, according to data released June 12 by the European Venture Capital Assn.—the second-highest level since the record 22 billion euros raised in 2000.

Soaring Returns

Just how big a boom is this? Consider that seed funding—capital for companies that do not yet have a product to market—jumped from $134 million in 2005 to $2.3 billion. "Europe is entering a new phase in entrepreneurship," says Sven Lingjaerde, managing partner at Endeavour Vision, which is raising a $214 million European venture fund for information technology and life sciences.

Further evidence that fortunes are changing in Europe: After years of disappointing returns, European venture capitalists are finally starting to show improved financial health, narrowing the returns gap with the U.S. One-year net returns in 2006 averaged 17.2%, while three-year average returns hit 5%, up from 1.7% last year. The average return since 1980 by the top-quarter funds was 17.4%.

The new, European crop of software and Internet startups driving those returns has sparked U.S. fund managers' interest. Enthralled by the sale of Skype Technologies (EBAY), the venture-backed, Luxembourg-based, Internet telephone service sold to eBay (EBAY) for $2.6 billion in 2005, many investors are now setting up funds in Europe and scouring the Old World for deals. The U.S. was the largest source of European private equity in 2006, providing 28.8% of the total $150 billion raised. "We are more bullish than ever on Europe," says Fergal Mullen, partner at Boston-based Highland Capital Partners, which recently closed an $800 million European fund. Mullen is now setting up an office for Highland in Geneva. "Skype was a truly European company, with Swedish and Danish founders who came together in London and offshored their development to Estonia," Mullen says.

Access to Eastern European Talent

That kind of cross-border mobility for startups was once unheard of in Europe. Long plagued by national regulations, red tape, and 15 different currencies, they typically set their sights on small domestic markets. Now the 20-year-old drive to forge a single European economy is finally helping entrepreneurs tap a continent of talent, technologies, and markets, and target the global market faster.

One of the biggest catalysts for Europe's startups is the 2004 arrival of eight new eastern European countries to the European Union.

World-class science and math education in the former Soviet bloc has created a deep pool of technology talent that puts the equivalent of India in Europe's backyard. Western startups are now racing to hire Eastern European computer scientists, who make 20% to 50% less than Western Europeans and often are more highly motivated. It's now possible for Western European companies to expand their R&D capacity and better compete with other startups in the global market," says Edward Braginsky, a partner at TVM Capital in Boston.

Garlik's Ilube, for example, was stunned to discover that his Polish software engineers were working all night long to crack the coding needed for the company's first product. "There is a fascination with the technology and a hunger to prove their worth," says Ilube. "They don't want to miss a deadline. We can go very light on management because we know they will deliver." Other venture capitalists agree that Eastern European entrepreneurs are more driven and hungrier for success. "It's phenomenal. They work as hard as engineers did in Silicon Valley 30 years ago," says TVM's Braginsky.

Better Brain Trust than India

For tech startups, cheaper brainpower in Eastern Europe speeds time to market and turbocharges returns (see, 5/30/07, "Where the VCs Are Flocking Now"). Venture-backed Dutch software startup Tridion set up a joint venture with a Ukrainian software house and outsourced a large chunk of its core R&D for three years to the Kiev-based operation. "We use Eastern Europe as a talent pool to lower the cost of R&D," says Ivan Farneti, partner at Doughty Hanson Technology Ventures in London. "You can support 22 software engineers in the East for the price of six in the U.K. It's a no-brainer."

Doughty Hanson netted 250% on its $6.7 million early-stage investment in Tridion when the company was sold last month for $93 million to SDL International. "The results of this kind of outsourcing in Eastern Europe are phenomenally good compared to India, where they are more random," adds Farneti.

Eastern Europe's brain trust may outshine India's and China's when it comes to the creative talent for developing new products, some venture capitalists say. Eastern Europeans excel at building systems from scratch, and they rank tops in the programming contests hosted by the likes of Google (GOOG) and Microsoft (MSFT) to cull the world's best software talent. "Russians and East Europeans tend to be more creative and less disciplined," says Esther Dyson, an investor in several Russian software houses. "If you want a problem solved, go to Central and Eastern Europe. If you know the solution and want to farm out the work, go to India."

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