date | theme

13. November 2018 | Legalbird: Investment of CHECK24 Ventures and tax consultancy of Kanzlei Meyers & Partner AG

25. June 2021 | The new § 19a EStG helps employees to participate in startups!

04. August 2021 | Startups and taxes: Secure advantages & avoid disadvantages

18. October 2021 | Employee participation at startups: Analysis of legal measures

13. July 2022 | Stratup Consulting: 3 rounds of financing with investors (this contribution)

If you want to start a startup, many startup entrepreneurs are looking for professional advice on a variety of topics. Among the most important points that start-up entrepreneurs are interested in regard to the inclusion of investors and the subsequent exit are the financing rounds with the associated dilution of the share ratios and the avoidance of strategies that make a possible exit difficult. For this, some eventualities can be determined in advance with corresponding regulations in the social contract. This can be done, for example, by including corresponding clauses for the exclusion of a blockage in an exit. In this way, it can be ensured that the entire company can be sold to the buyer in the event of an exit. For example, the majority of the voting rights are then decisive for the decision on an exit. But regulations that grant the original startup founders additional privileges in the co-determination of their startup are also conceivable.

1st Startup Advice on Financing Rounds – Introduction

1.1. Initial financing

Anyone who has a new business idea that shows that it will be successful often needs more than just a few motivated employees. Without an overdose of initiative and commitment as well as courageous determination, the undertaking sooner or later runs out of air.

But such a startup also needs financial resources to lead the idea to its due success. Of course, you can either equip your own startup with equity, provided that it is available in sufficient quantities, or with money that is raised via bank loans for the company. Occasionally, crowdfunding may also be an alternative. But in practice, all these forms of financing usually only allow a relatively modest initial financing. If you want to become a global player, then the moment of realization can occur, when you become aware that you should involve financially strong investors in your own startup.

1.2 Funding by investors

The fact that this moment could actually have come can be seen in the best case by the fact that potential investors express an interest in cooperation. Often these are large companies or even corporations with an industry-relevant relationship to their own businesses, which recognize the potential behind the startup’s business idea. Therefore, it is obvious that they either want to promote the start-up, because it is, for example, conducive to their own company as a supplement or they even want to integrate it completely into their companies, for example in order to release synergies. As a rule, this only happens after the startup has been able to prove its business idea. Ideally, it should then basically only be about financing. Occasionally, however, large companies also help a startup to grow further through know-how transfer and other forms of consulting.

In addition to financially strong large investors, whose interest in a startup is usually only awakened from a certain size, other smaller investors in relation to large corporations may already be interested in a cooperation. If this seems useful for advancing the startup, then a relatively early financing round may also make sense.

Ultimately, however, all financing rounds have a multi-layered impact. Therefore, we would like to explain in this article what we can tell a startup from our experience in advising on financing rounds.

Startup consulting: what a typical corporate structure looks like

First of all, we want to take a brief look at a typical corporate structure of a startup. We anticipate this because it is important for the later understanding of the impact that the financing rounds have on the startup and its shareholders.

2.1 Advice on the startup: the advantages of a holding company

If you start a startup, you should establish a holding structure immediately if possible. The holding company, which then heads the operating company as shareholder, performs several functions at once. On the one hand, it serves as a savings box for the shareholders. You can get the profits from it in the amount you want. In this way, it is also possible to influence the level of taxation over the personally applicable tax rate. On the other hand, the possibility of setting a managing director salary for the services vis-à-vis the holding company for tax optimization also helps. The same applies to the position at the operating company. Because a managing director salary counts as a business expense, so that this can be deducted tax-reducing in the case of corporate taxation. Fewer taxes at the company then also means more profit for the shareholders.

2.2 Advice on the startup: choice of legal form

Usually, such entrepreneurs set up both their startup and their holding company in the legal form of a GmbH. If the startup founded initially has to make do with less than half of the minimum share capital of EUR 25,000, you can consider a UG (limited liability) instead. Here a foundation is already possible from EUR 1. However, there are a number of conditions attached to this.

2.3 Advising on the startup: one holding company for each shareholder

This gives us a startup as an operating subsidiary of one or more holding companies. The plural holding company comes from this because each shareholder should have its own holding company. In this way, you can act individually with the profits now running there.

3rd startup advice on three rounds of financing with investors

In this chapter, we will now address a typical situation, as we have often seen in our advice on financing rounds at a startup.

3.1. Startup consulting: the first round of financing

The first round of financing usually involves an investor whose financial contribution on the one hand means a decisive boost for the startup, but on the other hand is still far from being able to turn the startup into a global player overnight.

3.1.1. How to Involve Investors in Startup

As an investor, one could hypothetically take over a share in the holding companies of the previous shareholders of the startup. After all, the operating company is also the property of these holding companies. However, this leads to the investments in the coffers of the holding companies. But they are of no use there. After all, the operating company should work with these funds.

Therefore, the participation of investors takes a different approach. The investment amounts are diverted against new shares in the operating company. In return, the previous shareholders do not lose their own shares. Only the percentage of their participation will be reduced.

3.1.2. Example of the first round of financing

An example:

Initially, four shareholders are equally involved in the founding of a startup. The share capital corresponds to EUR 25,000. A few successful years later, however, the value of the startup already climbs to EUR 500,000. At this point, a resourceful investor recognizes the opportunity that his own EUR 500,000 could mean for the further growth of the company. One negotiates and agrees that the investor invests his money directly in the operating company in exchange for new shares. But how high is the investor’s participation?

From experience, we know that investors measure the value of their shares in the share that their investments contribute to the value of the startup. In our example, this means that the investor is entitled to just as many shares in the startup as the original shareholders also own. In proportion, this brings the investor a participation of 50% in the startup. For the founders of the startup, on the other hand, the amount of own participation in the operating company shrinks pro rata to the same extent as the investor is entitled to. So where every startup founder initially had 25% of the company shares, he comes after this financing round only 12.5% of the shares.

3.2. Startup consulting: the second round of financing

Some time later a second investor comes to the shareholders. He offers an investment of EUR 3,000,000 for the now EUR 5,000,000 valued company. Again, this is only possible through a participation in the startup in the ratio of the investment to the company value of 1 to 1 per euro. This gives the second investor a share of 24 %. The original shareholders, including the first investor, share the remaining 76% in proportion to their previous holdings. This means that the first investor is entitled to half, i.e. exactly 38%. In contrast, the original founders now have a shareholding of 9.5% each.

3.3. Startup consulting: the third round of financing

The third round of financing now dwarfs everything so far. The value of the startup has grown to EUR 12,000,000 over time. At this time, our six shareholders receive a foreign investor who is convinced of the success of the company. He would like to contribute to this himself. His proposal is therefore that he would like to support an expansion abroad with his investment of EUR 8,000,000. Of course, this idea is a very pleasant one for the shareholders. For some time now, an internal consultation between the shareholders about this next logical step for the startup has been ongoing. So there is a quick consensus on this too.

What is the participation structure? After successful negotiations on the future of the startup, the third investor receives new shares in the company, which grant him a 40% stake. Of the remaining 60 % of the shares, the second investor will account for 14.4%, the first investor for 22.8% and the start-up founders for 5.7% of all shares.

4th Startup Advice on the Impact of Financing Rounds

4.1. Dilution of investments after each financing round

The first phenomenon we encounter here is called dilution of participation relations. This means that the original startup founders and every other investor who sits at the negotiating table as a shareholder on subsequent financing rounds to negotiate with a new investor have a smaller share in the company with each addition of further investors. It may sound paradoxical at first glance that the inclusion of new investors with each round of financing reduces your own share of the company and yet this serves your own advantage. But you have to point out that the cake you now share has also become larger.

If we look at this concretely in figures, i.e. in euros, using our example shown above: While the original startup founders initially had a share of 25% of EUR 25,000, this made a value of the respective shares of EUR 6,250. This is then also the share capital that the four founders have paid into their startup. This is offset by a 5.7% share of EUR 20,000,000 at the end of the third round of financing. In terms of figures, the value of their shares amounts to EUR 1,140,000. The shrinking of their shareholdings from 25% to 5.7% has led to a 182.4-fold increase in the money originally invested in their startup – the current profits of recent years are of course added.

However, the dilution of the shareholding also affects the voting rights of the original founders in their formerly own company. Now investors with their majority of votes can significantly determine the fortunes of the company. This concerns, for example, the time for an exit. We'll go into that a little bit more in the next section.

Startup Advice: The Power of Minority Participants in Exit

Based on our example, we want to assume that after some time a buyer wants to buy the startup. Of course, a potential buyer would like to buy the whole company in such a situation. The mere fact of potential co-determination by other shareholders is reluctant to many interested buyers. But the possibility of integrating the startup into an already existing group usually works much better in practice without the original founders and their subsequent investors. Finally, sole management in any case means the exclusion of competing interests.

So let’s assume that the buyer proposes a price of EUR 50,000,000 for the startup. Of course, this is a very attractive offer, so you can assume that all shareholders should be interested in it. But in order to organize such an exit, everyone involved in the startup must also agree to the deal. But what if the first investor, who invested only relatively little in the company with EUR 500,000, sees this as an opportunity to maximize the personal profit from the exit? For example, he could demand twice the amount for his shares. After all, with his participation of 22.8%, he has a significant share in the startup; Only the third, most recent investor has even more voting rights with 40%. Should the other shareholders therefore absorb such a disproportionate claim by assigning part of their own right to the price to him?

5th Startup Advice on Financing Rounds – Conclusion

When consulting on the topic of startup, there are many different questions to discuss right from the start. But there are also suitable solutions that can be regulated for the individual eventualities. For example, the inclusion of co-shareholders and even the founding of the startup can be organised in accordance with the social contract so that minority shareholders are subject to a co-sale bid in the event of a majority-capable exit. Similar provisions can also provide for the inclusion of new investors in the social contract.

What may also be important for many startup founders, who laid the foundation for later success with a lot of enthusiasm and personal commitment, especially in the often difficult, labor-intensive early days, is that they continue to retain a significant voice despite dilution. One can therefore consider whether the original founders should be granted a right of veto in certain respects.

In each of these exemplary references, this is of course a matter that you have to represent to investors. In any case, it should be clear that a technically sound advice, beyond purely tax matters, is very important for a startup for the future – right from the start. Many new entrepreneurs who raise their startup without consulting are then dependent on learning from their own experience. What, on the other hand, a successful exit can look like, may show the example of bottle post.