Last week, German fintech N26 announced it had raised another $170m in its latest funding round, taking its total investment to date to more than $680m, according to Crunchbase, and elevating its valuation to a lofty $3.5bn. That’s for a company that says “profitability is not one of our core metrics”, and whose annual revenue is estimated to be around $17.5m (a healthy price-to-sales ratio of… 200).

In the coming months, London-based Revolut — which has already raised almost $340m over 12 rounds — hopes to raise another half a billion dollars, which reportedly will give the company a valuation of more than $5bn. That’s for a company that not only isn’t making any profits, but also has been through a series of embarrassments and controversies in recent months, including having to admit that it had “erroneously” switched off a system for flagging potential money-laundering for several months last year, and being investigated for false advertising.

And will it soon be time for the exit door for four-year-old Revolut? Not so much. CEO Nikolay Storonsky has said he wants the firm to reach a valuation of between $20bn and $40bn before floating on the stock market.

That might not be that difficult. We’ve just had a record quarter for venture capital investment into European tech, with more than $10bn ploughed into the continent’s start-ups between March and June, according to Dealroom, and four $500m-plus fundraising rounds, which included Alphaville favourite Deliveroo and, erm, Alphaville favourite Greensill.

So all good, right? This is what a thriving European tech ecosystem should look like surely? Yes, the US is still way ahead — and so is Asia — but VCs are finally investing proper money into Europe, and start-ups are lapping it up. What’s not to like?

Take a look at this graph, drawn up by Magister Advisors, a specialist tech merchant bank. It shows the number of mid-to-high-tier ($25m-500m) fundraising rounds for European “tech-enabled companies” — ie companies whose core business relies on the internet — since 2013, versus the number of mid-to-high-tier exits (the graph does not include N26’s latest round, nor of course Revolut’s upcoming raise):

Funding rounds increased by more than 350 per cent between 2013 and 2018, and six months into 2019, the number of $25m+ rounds is already 20 per cent higher than last year, at 207. The total capital raised, meanwhile, has followed a similar trajectory: it increased by more than 300 per cent over the same period, from $2.9bn to over $10.5bn, and has almost reached that level in 2019 already.

But take a look at the darker line in the graph, showing M&A exits. Over the same period, they increased by just 80 per cent. And having been roughly the same in number as fundraising founds in 2013, they are now dwarfed by them: so far in 2019, there have been just 40 M&A exits among Europe tech companies, less than a fifth of the number of fundraises.

Victor Basta, founder and managing partner of Magister Investors, told us:

Three, four, five, years ago all the work we were doing was exits. And then people started asking us: can you help us do larger rounds? At first it was an experiment… and now more than half of everything we do is fundraising.

The problem with start-ups raising more and more money in this way, and reaching such stratospheric valuations, is that they are setting themselves up with a Herculean task when it comes to actually trying to sell. They might be buying time, but they are effectively mortgaging themselves.

Here’s Basta, again:

People are raising bigger rounds, and more of them, because they can. All good. But raising larger and larger rounds is a treadmill. You have to exit some time. You start raising these kind of rounds and then all of a sudden these companies have to be sold, for billions. We do not want high quality European companies who find they have no choice but to aim high, and who risk flaming out as a result… Going for broke is not for everyone.

Basta says that Europe has a particular problem here, because of the experience level of most of its founders. Whereas in San Francisco’s Bay Area — a tech ecosystem that has been around some 50 years — entrepreneurs are surrounded by a huge amount of expertise that they can tap into, Europe’s tech founders are effectively the first generation, and they therefore don’t have access to the kind of guidance that might advise against this kind of relentless fundraising and intensive cash-burning.

Another problem with this trend is that early investors are having to wait much longer to access their cash than they might have reasonably expected to. This means they are sometimes having to sell their shares in secondary marketplace — see the recent share sale in eight-year-old TransferWise, for example — which is a far less attractive proposition than selling to a strategic buyer in an M&A deal, where there would be an expectation of a premium. And with such a change in the dynamic of A- and B-round fundraising, investors’ decision-making about where to put their capital is also likely to change.

According to Basta:

Among A- and B-round investors, there’s a growing level of frustration. They got into these companies five, six, seven years ago and expected by now they’d get a good exit. What’s happening is that people are on the treadmill because they can keep raising, but the earlier round investors — how do they get out? And they’re the ones who actually funded these companies — they’re the ones who actually made it possible for them to get to this point…

This has implications for how they raise future funds, it has implications for how they think about how they get in and out, it has implications for what does the A- and B-round VC industry in Europe end up looking like. If it’s a feeder for later rounds rather than an accelerator for companies to be worth real money in cash, which was the original premise, it’s a different business.

Of course, it is the nature of some of these businesses to burn through huge amounts of cash without worrying too much about profits, in order to scale to the extent that makes their business models viable (and indeed that is the justification for the huge amounts being invested into the likes of N26 and Revolut), but many of these business models are untested.

It’s yet to be seen whether Europe’s billion-dollar price tags can translate into real cash for the companies’ early investors and founders. But being “worth” a billion dollars and exiting for a billion dollars are two different things. A quick look at Square’s stock market flotation can tell you that.

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