In addition to a good, feasible idea, the raising of capital is the largest part of every business plan: Founders have a substantial number of options to obtain money for their start-ups. Dr. Dorian Proksch, Director of the Center for Entrepreneurial and Innovative Management (CEIM) at HHL Leipzig Graduate School of Management explains the maze of financing.
Before actually raising funds for the implementation of a business idea, founders have to ask themselves some fundamental questions; How much money is usually required to start a business? What are the exceptions? When does one need more, or less, money? Dr. Dorian Proksch, an entrepreneurship expert, knows that the capital requirements strongly depend on the industry. “Starting a pharmaceutical company often requires several million euros to fund the clinical studies. An e-commerce business, however, could be launched with relatively low capital resources, depending on whether the founders themselves need a salary or have other ways of supporting themselves.”
According to Proksch, technological companies often require higher investment, e.g. for special machines or equipment. In many cases, these companies take longer to reach market maturity and therefore must bridge longer gaps until they make their first sales. In the field of software, costs are mainly limited to human resources. “If the founders have other income, the costs for starting a business might approach zero – the famous example of a garage start-up,” says Proksch.
The options listed below are all very common, according to the expert, and rank among the standard forms of start-up funding.
When self-financing, all shares remain with the entrepreneur. If the company is sold, it generates maximum profit for the founders. They also maintain full decision-making power in business matters. Proksch adds, “Being fully autonomous in decision-making is also accompanied by the full financial risk for the founders. In a worst-case scenario, they lose their own investment and, for instance, their private assets.”
Grants, state funding
Similar to self-financing, grants or state funding do not require the entrepreneur to transfer shares. Dr. Dorian Proksch knows that this type of financing gives an important sign for the success of the company, therefore potentially increasing the chances of receiving investment. He also states that grants are only available to certain, mostly technological, concepts, with high competition and long application periods. The waiting then also has to be bridged financially.
“Business Angels represent a good opportunity to obtain initial funding at the start of the venture,” explains Proksch. Great advantages are quick decision-making, additional consultation by the Business Angel and access to their network. According to Proksch, this type of financing is not as important in Germany just yet as the network of Business Angels is still relatively small. The founders have to transfer shares in their business. At the beginning, the company’s worth is often not very high. Consequently, the shares are transferred for relatively little money.
Venture capital allows for monetary amounts on a completely different scale. “They often represent the only chance to receive investments over one million euros. For the founder, venture capital comes at a low risk as the money does not have to be repaid,” says Proksch. The founders benefit from consulting services through the venture capital funds and there is also the possibility of accessing the Business Angel network. Proksch sees disadvantages in the transfer of shares and therefore of potential profit as well as decision-making authority. Moreover, the company must be sold if the venture capital company asks for it. Depending on the contract, the founder might be let go. Additionally, the documentation effort is higher as a monthly report needs to be prepared for the investor and other bureaucratic tasks must be completed.
For bank loans, Proksch views the benefits in the quick decision-making processes while the founder maintains all shares and full authority. On the other hand, the founder will be held liable if he or she fails to pay back the loan taken out. Moreover, collateral has to be provided in many cases to qualify for a loan.
Proksch views crowdfunding as a “quick and easy possibility of raising funds”. However, problems often occur regarding continued funding depending on the platform/process: venture capital companies only want a small number of shareholders in a business while crowdfunding often only works for concepts which are popular with a large number of people.
Maintaining a balance
“Transferring shares in company cuts down on the potential profit, e.g. when selling the start-ups,” says Proksch. Founders should also bear in mind that by transferring shares they are no longer the sole decision-makers, possibly preventing them from shaping the company in the way they intended to.
For venture capital investments, the goal is always to sell the company. For founders, this also means that they might not be allowed to work in their own company because the new owner might want to have his or her own people on the executive board. “Founders should be aware of this fact. Generally, the founder swaps a reduction of his or her own risk against a part of the potential profit when transferring shares,” concludes Proksch.