Big news in De Volkskrant this weekend. The most leftist newspaper reported that in 2014 some 500 million worth of international investments was channeled to Dutch startups. Although much of that was in a small number of high-valued individual firms, still we are witnessing a financing revolution. And startups are politically becoming an important issue too. Recently, former European Competition Commissioner Neelie Kroes was appointed to lead Startup Delta, an initiative to map the entrepreneurial ecosystem in the Netherlands and promote it globally as the next place to be. In a bit of conspiracy theory, the lead article in De Volkskrant (traditionally the Labor Party’s newspaper) is there to show that Iron Neelie (right wing liberals VVD) has nothing to gain and even more to lose in het mission of startup ambassador.

Why the Netherlands is suddenly successful as a startup country may have some deeper roots. For the last ten years, entrepreneurship has been promoted in universities and in science parks. This more and more seems to be paying off for society. In addition, there is a boom in public and private incubators and accelerators that play the intermediary role in channeling (bank) finance to startups. In a land where venture capital has for long been quite absent, this is a very useful function. And last, there is an increasing interest from the big corporates to stimulate innovation through entrepreneurship, see for example high profile initiatives like StartupBootcamp.

However, to explain the rise in startup finance in the Netherlands, we need the theoretical lens. To start, a very basic insight is that the nature of economic activity is shaped by the structure of the financial sector. This implies that whether finance is dominated by banks or exchanges (equity, bonds) affects the type of economic activity. Certainly, there is reverse causality, but starting from a specific financial structure, there is a central path-dependant ‘evolutionary’ route for future finance of economic activity. Concrete, it could well be that Europe’s banking dominance in finance results in a bias against startup entrepreneurship. This seems to be eroding.

In financial economics, there basically are two approaches to explaining the different composition of investments. The first approach to finance stresses the logic of the capital asset pricing model (CAPM). Portfolios spread the risk over various assets and in that way reduce the individual risk of assets. Since individuals are risk averse and financial institutions risk neutral – because and can spread their money – there is scope for trade between banks and the individual citizen. Especially is Europe’s egalitarian society the affluent but not rich (hence, risk-averse) middle class finances through the banking sector. As a not unimportant side note, the rise in financing entrepreneurship in the Netherland may thus reflect the increasing income inequality.

Bank have problems applying the CAPM model to startups or including them in the portfolio. Although these startups are potentially high return, the lack of track record creates ‘Knightian’ uncertainty (‘we are uncertain about an ‘event’ but we do not know which event, so we have no idea about the distribution of outcomes). Such investment do not fit the risk models that banks apply when creating portfolio’s. Second, startup success has some Pareto distribution (only a very few succeed, but then do big time) and the models are mostly based on some kind of normal distribution of returns (of which the models can calculate a mean return and a variance as measure of risk). All in all, bank finance models have a hard time including startups.

What has changed? Well time plays a role. If banks and their affiliate large investors know more about startup track records in general, Knightian uncertainty gradually disappears. Further, scale matters. If there are more startups, then this does not eliminates the Pareto distribution, however, bets can be spread better. Hence, we see an increasing interest from the side of European institutional investors and banks in the early stage of entrepreneurship.

The second and probably more practical approach is rooted in agency theory stress the inherent imperfection and ‘incompleteness’ of contracts between agents (entrepreneurs) and principals (financiers). Because there is imperfect information (the entrepreneur knows more about the firm than the financier does) this opens-up to moral hazard. For example, suppose that the bank gets 10 percent interest on its loan. Then in the extreme case, the entrepreneur can make a one-sided bet in taking a big gamble. If she succeeds, she has the big gains (ballooning share price) but if she fail she simply goes bankrupt and the costs are for the bank – today this latter is increasing a badge of honour, also in the Netherlands. To avoid such moral hazard, the bank has to align the incentives by asking collateral. But this then results in only partial financing of activities, which keeps firms too small and leaves many initiatives unfunded. And, collateral in startups is often in the form of (tacit) intellectual property, which is difficult to price and to use as a security. A further agency problem is adverse selection. If the risks are high on average outsiders cannot assess firm specific risks, the financiers have to ask a high interest rate on their money. But then the risk is that only the highly over-optimistic entrepreneurs will apply for funding, which ultimately are not the guys with the best ‘locus of control’. On average, but really real the financier goes bankrupt and anticipating this abstains from finance.

The way out of these agency problems is to impose strict screening and monitoring of startups so as to reduce information asymmetries. This is where the New Venture’s, Get in the Ring’s, and the Rockstart’s come in. The boom in startup contests provides some way of weeding out the overoptimistic and naive entrepreneurs, after which finance can take place. Then, in addition financiers can ‘outsource’ the monitoring of the high risk high imperfect information phase to the incubators. Such trial periods provide good information on the risks involved at the level of the individual new venture.

So, the success of the new Dutch startup culture has its roots in the big improvement of the entrepreneurial ecosystem. More startups and better records attract large venture funds and increase the interest of the traditional banking system. The quickly developing landscape of incubators and accelerators imposes a monitoring system that starts to pay-off. Now, lets make that known to the world.


Hein Roelfsema