How to finance a Start Up

Table of Contents

List of Abbreviations

List of Figures

List of Tables

1 Introduction
1.1 Problem definition
1.2 Research question and objectives
1.3 Structure and methodology

2 Framework and theoretical background
2.1 Business Life Cycle Concept
2.2 Definitions
2.3 Overview of the types of financing
2.3.1 Internal financing
2.3.2 External financing
2.3.3 Mezzanine financing

3 Financing sources for StartUps
3.1 Equity financing
3.1.1 Bootstrapping
3.1.2 Friends and Relatives
3.1.3 Angel Investors / Business Angels
3.1.4 Venture Capital
3.1.5 Crownd funding & Crownd investing
3.1.6 Government Grants & Public support programs
3.1.7 Incubators
3.2 Debt financing
3.2.1 Bank loans
3.2.2 Government Grants & Public support programs
3.3 Mezzanine capital

4 Categorisation of StartUps

5 Results

6 Conclusion
6.1 Summary
6.2 Answering the research question
6.3 Limitation of the research
6.4 Recommendation for further research

References

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1: Founding rates in Germany 2000-2013 (source: KfW-Gründungsmonitor 2014)

Figure 2: Business life cycle according to financing phases

Figure 3: System of types of financing – source: Becker (2013), p.

Figure 4: Financial requirement for business founding.

List of Tables

Table 1: Overview capital requirement and types of financing.

1 Introduction

For many people the word StartUp^[1] is connected with Silicon Vally the home of many of the world’s largest technology corporations, as well as thousands of technology startup companies in the U.S. But also Germany has a slowly recovering StartUp scene after years of decreasing and stagnating as shown in figure 1. In the last two years the StartUp scene in Germany has become more and more colorful and offers more and more promising ideas. This has many reasons. There are numerous renowned founder competitions representing the springboard for many new ideas. There are numerous incubators, business angels and seed investors, to help with the first steps. The Crowd Investing scene is also "grow up" and brings important impulses. An increasing number of universities are systematically "bred" entrepreneurs and also there are more and more multi entrepreneurs that go with their recipe for success in "series". The best conditions to found a StartUp in Germany are offered Berlin, so a few people see in Berlin already the next Silicon Valley.

illustration not visible in this excerpt

Figure 1: Founding rates in Germany 2000-2013 (source: KfW-Gründungsmonitor 2014)

But StartUps do not stand automatically and only for innovation, growth and success. Every company foundation is also associated with uncertainty and risk. Nevertheless, more and more people in Germany facing the risk and starting their own business. This is really important for the German economic because the new entrepreneurs are challenging the already established players and putting them constant under pressure to increase efficiency potential. Furthermore, the new ideas of the company founders contributing to the technology renewal of the country and thereby to the improvement in the competitiveness of Germany. Beside that company founders creating jobs for themselves and others.^[2]

1.1 Problem definition

Especially in the early years entrepreneurs have a heavy need for investment for example for company establishment, product development, machinery, computer, tools, shop- and office equipment, inventory, vehicles, licenses, franchise fees etc. Often the amount of investments is determined as capital requirement in the context of a business plan. The capital requirement consists of the operating cost, the one-time investment and the required capital reserve. The calculation of the capital requirement is strongly dependent on the business model of the company. Without the investment the commencement of business is endangered or impossible. That is why getting financing is one of the most important activities for a StartUp.

Many entrepreneurs don’t know where to go or are unaware of some of the options for financing their businesses. Particularly in the early years of a company the distrust and skepticism of banks against the StartUp is very large, since the company usually has just a few customers and many competitors. Lenders are put off by the risk that the StartUp may fail. Therefore, a financing through traditional banking products such as credit is hardly possible in this phase of business life cycle.

1.2 Research question and objectives

Therefore, the question arises what finance options existing for the different business models of StartUps and what financing fits best at what business model.

The objective of this work is it on one hand the determination of the different opportunities to finance a StartUp and one the other hand to categorize or segment StartUps according to their business model in order to find the best source of financing for the different business models.

1.3 Structure and methodology

This work is divided into different parts. The first part Framework and theoretical background introduces the business life cycle concept and the definition of the basic terms StartUp, finance and investment. Furthermore the first part presents briefly the different types of financing. The second section Financing sources of StartUps goes much depper into the different financing types for StartUps by differencing according to equity financing, debt financing, internal and external financing. The third part Categorization of StartUps attempts to find similarities in the different business models of StartUps in order to segment the StartUps. The fourth chapter Results tries to match the results of section two Financing sources of StartUps and section three Categorization of StartUps in order to answer the research question. The last section Conclusion will complete and limit the entire work and will give recommendation for further research.

For that work no primary data was gathered, the entire work is based on secondary data as the scope of this assignment does not allow for any explorative approaches, interviews or surveys. The necessary information for the work that were previously scattered published or accessible will be arranged, analyzed and interpreted. The sources of secondary data are gathered form books, magazines and sources in the world-wide-web.

2 Framework and theoretical background

The purpose of this chapter is to provide the reader with the theoretical framework like various definitions, the life cycle concept and the different types of financing which is useful to understanding and interpreting this assignment.

2.1 Business Life Cycle Concept

The idea of the business life cycle concept is like the industry or product life cycle concept adopted by the biological life cycle and describes an idealized, dynamic and economic development of a company from birth to death. The model shows that most businesses pass through a series of well-defined stages based on their level of development. Each different stage differs in terms of risk, strategy, revenue, profit, organizational structures, management systems, leadership styles, investment and financing of a company. The number and designation of the different stages varies greatly in the literature. However, all variations are based on the four main stages introduction, growth, maturity and decline as illustrated in figure 2 “Business life cycle”.^[3]

illustration not visible in this excerpt

Figure 2: Business life cycle according to financing phases^[4]

Following this idealized cycle model, so arise depending on the life stage and the related financial and results position different risks for the investors and various financial needs for the company. These capital requirements can be ideally divided into three main funding phases: the early stage phase, the expansion phase and the late phase. These phases consist of smaller phases like e.g. the early stage is distinguished in the seed, startup and first stage. The capital requirements in each phase can be covered by various financial instruments.^[5] By the life cycle model the consideration of financing becomes a dynamisztion, because in certain stages of the life cycle the use of individual forms of financing has various benefits and advantages. These financing techniques change during the transition to a new phase of the life cycle.^[6]

2.2Definitions

StartUp

It seems as if in science and practice exist very different interpretations and definitions of the term StartUp. Most definitions say, that a StartUp has to be highly innovative related to their business model or technology.^[7] Since this work refers to all business foundations and not only highly innovative business models the following simpliest definition is taken as a basis for this work. A StartUp is a recently established company that is located in the first stage of the life cycle (introduction phase), independent of the types of business model.^[8]

Investition

For the term investment a variety of different definition exists depending on the context. If the explanation for the term investment is based on the balance sheet, so an investment is the decision how the capital is used, which is reflected on the asset side of the balance sheet.^[9] If the explanation is based on the cash flow the investment can always be represented as a series of payments that typically begins with a payoff and leads to a cash surpluses within the investment of time.^[10]

Finance

Investment and finance are closely linked to each other. Any investment has to be financed and any finance has to be invested. The finance is concerned with the question "Where a company receives money to make investments?" so the finance is focusing on fundraising.^[11]

2.3Overview of the types of financing

The numerous financing options can be structured in different ways. According to figure 3: “System of types of financing”, the financial instruments can be distiguished into external and internal sources and at the same time into equity or debt sources. By the terms external and internal financing is differentiated from where the physical capital comes to finance. Comes the capital from the outside of the company, it is called an external financing. Is the capital already in access of the company e.g. through sales, profit or asset it is called internal financing. The terms equity and debt financing provide a conceptual distinction to the legal position. When an investors receives through his shares participation rights or influence on the company itself, it is called equity financing. But receives the investor through the injection of capital no influence and no further rights as the repayment of his capital it is called debt financing. Mixed forms between equity and debt financing are called mezzanine financing.^[12]

illustration not visible in this excerpt

Figure 3: System of types of financing.^[13]

2.3.1 Internal financing

Self-financing

At the internal financing the company receives or releases cash or cash equivalents due to processes within the company itself. These are either the normal operational sales processes or asset reallocation processes that lead to capital releases outside the normal turnover processes. The self-financing is generated by a deduction of profits (retained earnings). If profit does not flow in the form of dividends to the shareholders or in form of tax to the tax authorities, the company can use it for financing purposes. The self-financing is simultaneously internal and equity-financing. It can be differentiate between open and silent self-financing.^[14]

Financing out depreciation

Depreciation detect the decreasing value of assets in one period, therefore it is an expense or cost factor. In addition, depreciation has finance effects. With regard to the financing effects of depreciation, two forms can be distinguished: the capital release effect and the capacity expansion effect. At the capital release effect the depreciation is considered as costs in the calculation of sales prices, therefore over the revenues it flows back into the company. Due to the capacity expansion effect a company can reinvest released depreciation values immediately in other noncurrent assets, thereby the capacity and the number produced goods can be increased. Consequently, expansion investments can be carried out due to the capacity expansion effect.^[15]

Financing out asset reallocation

At asset reallocation material, goods, and intangible assets are sold to obtain cash. This releases capital outside the normal turnover processes. The company can use the released funds for redemption or investiton. For sales primarily positions from current assets come into consideration, such as securities, funds, accounts receivable (factoring) and inventories but also positions of the fixed assets offer themselves such as patents, property, plant and fleet. However, it is important to ensure that the sold items or rights not endanger the production process.^[16]

Financing out pension provisions

With a pension commitment an employer is obligated to grant its employees a retirement, survivors or disability pension. The company has to make provisions from the date of commitment, so the pension provisions can increase in the period between commitment and their date of retirement. Pension provisions are claims of the employees therefore it is attributable to debt capital. A positive financial effect only arises if the additions to pension provision are higher than the pension payments in a period.^[17]

2.3.2 External financing

Deposit finance

Deposit finance includes all forms of supply of equity through existing and new shareholders. The equity financing is both equity and external financing (see figure 3). The new cash serves primarily for business founding and the financing of additional investments. Basically at the deposit financing the investors receives - through the acquired shares in the company - the rights on earnings and assets of the company. In addition, investors receive so-called property and administrative rights. Deposit financing is generally long term, but can be also applied in short-term exceptional cases. Depending on the legal form one the one hand there are a variety of forms of participation and on the other the risk is limited to the amount of the deposit.^[18]

Credit financing

Since the credit and mezzanine finance provide to the company funds from external investors, both forms include the deposit financing count to external financing. Credit financing is also a external and debt financing. The investor brings form the outside debt capital into the company and thus play a role as a creditor. In addition, the creditor has no voting rights and is not liable for losses. However, these creditors will receive the agreed interest rates and principal payments to fixed deadlines. The amount of the interest and the height of the credit often depend on the available collateral and / or ratings of the company.^[19]

2.3.3 Mezzanine financing

The mixed form between equity and debt is called mezzanine financing and becomes more and more important. The equity nature is shown especially by the performance-based compensation, running time, loss sharing and subordination agreed in the event of insolvency. The debt nature arises from the often limited duration, the fixed repayment claim and agreed to pay interest. The term mezzanine capital reflects the risk and return situation: both in terms of credit risk and in terms of potential returns, it is located between equity and debt. There is big variety of instruments of the mezzanine financing.^[20]

3 Financing sources for StartUps

Like mentioned in chapter 2.1 Business Life Cycle Concept, businesses go through different stages within their life cycle. The stage the business is in determines the type of financing. In the introducion or early stage the main focus of the management is on create a product and marketing concept, develop the product idea to the product maturity and set up a shop. At the same time the company barely has any customers or revenues but the capital requirement is increasing rapidly. The risk of financing is in the early stage is quite high especially for investors because they do not have the information of the management but they need to estimate the future value.^[21] In addition, founders prefer those financial instruments that promise them the best possible decision autonomy in running the company. Therefore, the foundation financing is in the area of conflict between information asymmetry and the security of the autonomy of the founder. It turns out that the finance of a company foundation is characterized by many peculiarities which greatly affect the financing opportunities.^[22]

In the following the characteristic funding possibilities for the introduction phase will be presented categorized according to debt and eqity sources.

3.1 Equity financing

3.1.1 Bootstrapping

The bootstrap financing describes a form of financing which consciously removes the need of foreign capital. The goal is to set up an own business without external and internal investors. This means bootstrapping only uses the private money of the founder like personal savings or money of a life insurance policies. Therefore the basic rule is to avoid expenditure while maximizing revenue. It is advisable to bootstrap financing, especially at a foundation for the low-budget model. A big advantage of this type of financing is definitly that the founder participates to100% at the success of the company and also that the founder has the 100% autonomy of the business. On the other hand when the company does not run as expected the founder gets no precious tips of an experienced investors. In conclusion it can be stated that this financing form is only meant for business models with short development cycles that reach in a short time to break even.^[23]

3.1.2 Friends and Relatives

Especially in the seed-phase founders of a business may look to private financing sources such as family or friends. It may be in the form of equity financing in which the friend or relative receives an ownership interest in the business. However, these investments should be made with the same formality that would be used with outside investors.^[24]

3.1.3 Angel Investors / Business Angels

Angel investors are individuals and businesses that are interested in helping small businesses survive and grow. So their objective may be more than just focusing on economic returns. Although angel inves­tors often have somewhat of a mission focus, they are still interested in profitability and security for their investment. So they may still make many of the same demands as a venture capitalist. Angel investors may be interested in the economic development of a specific geographic area in which they are located. Angel investors may focus on earlier stage financing and smaller financing amounts than venture capitalists.^[25]

3.1.4 Venture Capital

Venture capital refers to financing that comes from companies or individuals in the business of investing in young, privately held businesses. They provide capital to young businesses in exchange for an ownership share of the business. Venture capital firms usually don’t want to participate in the initial financing of a business unless the company has management with a proven track record. Generally, they prefer to invest in companies that have received significant equity investments from the founders and are already profitable. They also prefer businesses that have a competitive advantage or a strong value proposition in the form of a patent, a proven demand for the product, or a very special (and protectable) idea. Venture capital investors often take a hands-on approach to their investments, requiring representation on the board of directors and sometimes the hiring of managers. Venture capital investors can provide valuable guidance and business advice. However, they are looking for substantial returns on their investments and their objectives may be at cross purposes with those of the founders. They are often focused on short-term gain. Venture capital firms are usually focused on creating an investment portfolio of businesses with high-growth potential resulting in high rates of returns. These businesses are often high-risk investments. They may look for annual returns of 25 to 30 percent on their overall investment portfolio.^[26]

3.1.5 Crownd funding & Crownd investing

Crowdfunding counts to the most popular form of financing in recent years. In particular, through portals like Indiegogo and Kickstarter crowdfunding has become famous. According to recent figures crowdfunding platform have collected 5.1 billion US dollars that is more than twice as much capital as last year. The funding form "crowdfunding" uses the mass of internet users first to collect enough money in order to realize a project or business idea and second as a marketing multiplier. In contrast to the often high capital investments by venture capital firms or angel investors, crowdfunding only collects small amounts of money by a large mass of people. The idea is that StartUps promote their product idea on a crowdfunding platform and rename the necessary financing to promoting its business plan and the expectable (tangible and intangible) compensation in exchange for votes. The internet users pay attention mainly through marketing campaigns on social networks, blogs and media over a crowdfunding campaign. If the specified amount is reached within a certain time, the money goes to the founders, and the idea is implemented. Through this kind of financing founders can quickly increase the equity and stay at the same time independent of banks and commercial investors. Also it is a good chance to increase to perception of the company or product and receive feedback form potentiell costumers. Nevertheless this kind of financing is not been fully established in Germany and causes high care costs.^[27]

The latest trend is crowd investing. Unlike the crowdfunding the investor benefits from the positive business development because the investor receives shares from the capital-seeking StartUp. Even the amounts of the individual people can be very small, multipilated by the large number of people arise large sums of equity. Examples of Crowd Investing platforms in Germany are Seedmatch, Mashup finance or Innovestment.^[28]

3.1.6 Government Grants & Public support programs

Federal and state governments often have financial assistance for young businesses. Special types of equity are grants that serve to encourage start-ups. Although the level of subsidy is usually relatively straightforward, but often there is no need to pay interests and to repay the money.^[29]

3.1.7 Incubators

An incubator combines elements of a business angels and venture capital firms. In addition to equity financing the start-up is supported by the incubator also operational and personnel. Incubators are accordingly often called Company Builder as the company is being developed.^[30]

3.2 Debt financing

3.2.1 Bank loans

Banks and other commercial lenders are important sources of young businesses. It existing many different types of loans. Loans may be short term or long term in their repayment schedules. Generally, short-term debt is used to finance current activities such as operations while long-term debt is used to finance assets such as buildings and equipment. The conditions and the maximum volume depend on ratings of the company and the founders. Most lenders require a solid business plan, positive track record, and plenty of collateral. These are usually hard to come by for a StartUp business.^[31]

3.2.2 Government Grants & Public support programs

Public fundings can be granted in different forms. There are three approaches: first, the low-interest loans to optimize interest expenses, secondly, the loan to compensate the lack of collateral and third the loan to strengthen the equity ratio. In Germany the 16 regions offer next to the KfW different funding programms. The KfW is the biggest national developing bank of the world and has among other things the task to provide entrepreneurs, small and medium-sized companies with investment loans. Thus, the KfW granted specifically for entrepreneurs micro-loans, the so called “StartGeld”, the company capital and the coporate credit. All these funding programms offer next to the financing spezial conditions and support or coaching to the founders.^[32]

3.3 Mezzanie financing

Besides the classic financing mix of equity and debt the mezzanine capital has established itself in the financial market. Instruments which count to this kind of capital are subordinated loans, convertible bond, silent company and participation certificates. Overall, it should be noted that high demands are made on mezzanine capital and therefore the use in founding the company is usually limited.^[33]

4 Categorisation of StartUps

Companies can be segmented according to many criteria. Thus, the categorization may relate, for example, to the gender, age, number and education of the founders or to the type and size of the company. However, in order to find the appropriate form of financing for the particular business model, the segmentation by industry in combination with the segmentation by capital requirement seems to be the best way. There are three main industries or sectors: service, trade and production. According to current numbers with around 70% the by far biggest part of foundations take place in the service sector, followed by 16% trade and 14% manufacturing and production.^[34]

illustration not visible in this excerpt

Figure 4: Financial requirement for business founding.^[35]

According to figure 4: “Financial requirement for business founding” almost half (45%) of all business foundations start with 5,000 € and less of material and financial resources. Even 79% of all business foundation have a capital requirment of less than 25,000 € and only about 15% have a financial need between 25,000 € and 100,000 €. In contrast, only about 6% of the company founders have a central demand of more than 100,000 euros.

[...]

---

^[1] There are also used other spellings (such as "Start-up" or "Start-Up").

^[2] cf. Dr. Georg Metzger, KfW Bankengruppe (2014), p. 2.

^[3] cf. Reichmann, Richter (2006), p. 472 ff.

^[4] Own graphic based on Wagner, Schulz (2011), p. 47 and Boué, Kehlbeck (2012), p. 48.

^[5] cf. Wolf et al. (2003), p. 3 ff.

^[6] cf. Rudolph, Prüher (1999), p. 572 ff.

^[7] cf. Blank, Dorf (2012), p. XXVII.

^[8] cf. Investopedia

^[9] cf. Mensch (2002), p. 2.

^[10] cf. Götze, Bloech (2004), p. 5.

^[11] cf. Hans Paul Becker (2013), p. 103.

^[12] cf. Ermschel et al. (2013), p. 117.

^[13] Own Graphic based on Hans Paul Becker (2013), p. 129.

^[14] cf. Hans Paul Becker (2013), p. 242.

^[15] cf. Hans Paul Becker (2013), p. 247-250.

^[16] cf. Ermschel et al. (2013), p. 142-143.

^[17] cf. Ermschel et al. (2013), p. 136-137.

^[18] cf. Ermschel et al. (2013), p. 118 ff.

^[19] cf. Hans Paul Becker (2013), p. 183.

^[20] cf. Hans Paul Becker (2013), p. 233.

^[21] cf. Boué et al. (2012), p. 50-51.

^[22] cf. Portisch (2008), p. 74 ff.

^[23] cf. manager magazin (2007).

^[24] cf. Boué et al. (2012), p. 49.

^[25] cf. Ag Decision Maker (2013).

^[26] cf. Ag Decision Maker (2013).

^[27] cf. Daniel Hüfner (2013).

^[28] cf. Eigenkapital: Quellen für Ihre Existenzgründung im Vergleich (2014).

^[29] cf.Eigenkapital: Quellen für Ihre Existenzgründung im Vergleich (2014).

^[30] cf.Boué et al. (2012), p. 49-50.

^[31] cf. Portisch (2008), p. 96-104.

^[32] cf. KfW Bank aus Verantwortung (2014).

^[33] cf. Portisch (2008), p. 109-113.

^[34] cf Dr. Georg Metzger, KfW Bankengruppe (2014), p. 5.

^[35] Own graphic based on Bundesministerium für Wirtschaft und Technologie (2013), p. 20.