After company launch, many start-up founders are faced with the question of initial financing. In addition to their own funds and the so-called “FFF” – Friends, Family, Fools – many founders are eligible for grants and scholarships such as the EXIST Scholarship or the NRW Founder Scholarship.
Once the initial funds have been used up or are simply no longer sufficient, the question of further financing arises. The basic distinction is between debt and equity capital, whereby debt capital is not available for most early start-ups.
Debt capital or credit business is the traditional business of banks. For loans and credits, especially larger ones, banks need collateral to reduce risk. This is understandable and follows a simple mechanism: weighing risks against opportunities. Especially in times of low interest rates, it is increasingly difficult for banks to make money with the traditional lending business.
These limited opportunities result in a required risk profile that is equally low. To assess the risks of a company loan, banks consult ratings and ask for key business figures such as company age, turnover, profits and profitability. If these values fall within a certain range, the risk of default for the bank is statistically lower. In this case, it is possible and often advisable to finance a company with external capital by taking out a loan, as this does not dilute the founders’ shares. In the case of debt financing, the company or founder does not sell any shares. The loan amount is only repaid plus interest. Debt capital is protected in a particular way – in the event of insolvency, it is settled first.
In most cases, early-stage start-ups are young companies without significant revenue, but with losses. In addition, they have no or only little credible history. From an objective point of view, the risk of a total loss is therefore much greater than with established companies which often have significant, real assets. Debt financing for start-ups by banks is therefore rarely possible, with the exception of special promotional loans.
This is why financing through equity capital comes into consideration. Equity capital is the capital that you as founders have brought into your company, or will bring in. An equity financier or investor (e.g. a VC fund) participates as a regular shareholder in the capital of the company and thus takes full entrepreneurial risk.
As with a bank, a VC fund also balances opportunities and risks. As a shareholder, it can fully contribute to the development of a company. The VC fund does not receive a fixed percentage but a dividend, profit distribution or – and this is the real aim – proportionate sales proceeds in the event of an exit. Due to this large upside potential, the fund is prepared to take on a higher risk by investing in early-stage start-ups. If the company does not develop in the right direction, its investment is lost.
Interesting side effect: in their lending decisions, banks often factor in the equity ratio of a company. A high equity ratio is generally regarded as healthy. By raising equity capital, creditworthiness can also increase or it becomes a prerequisite debt financing.