The managers of investment funds or family offices as well as the corporate venture departments of medium-sized companies are increasingly faced with the difficult question of which young companies and start-ups are to be regarded as having strong growth potential and promise a high return. Dr. Matthias Wallisch of RKW, based in Eschborn, recently stated at a workshop event, that the number of start-ups based in Germany can be estimated at 70000-80000 [1]. Accordingly, identification and acquisition can be demanding and time-consuming.
Why invest in start-ups at all?
There are two good reasons to invest in start-ups: Knowledge and money. For medium-sized companies, the main focus is the transfer of knowledge. Investing in start-ups can give companies a competitive edge over rivals by identifying and developing future technologies at an early stage. For investors from the private equity sector, on the other hand, the focus is on the growth opportunities of a start-up. Scaling quickly and as strongly as possible promises high returns in the event of an exit.
Where are the decision-making tools?
In the case of the CVC, these have been few and far between. Previous investments by well-known investors or strong interest from the respective industry could be identified as indicators for a young company or start-up and its positive prognosis. At the same time, however, it is still true that about 90% of all start-ups fail[2], often because of their own expectations and the market, which increasingly resembles a shark tank. So how can we judge what actually cannot yet be predicted?
A study by the RFH Cologne[3] tried to identify factors that can be used to make a better assessment of start-ups, which should be of particular interest to corporate ventures. The first important factor of the 4T scoring model is the composition of the team. In addition to the greatest possible diversity, it is important to ensure that the team members bring specialist knowledge and expertise in their respective areas of responsibility. If important skills are missing - such as in the area of finance or in the legal field - it is relevant whether the team seeks external advice or employs interim managers to compensate for their lack. Also, start-up experience in one or more team members should not be neglected. The second factor, Tech & Product, deals with the business model. It should be clearly defined and satisfy customer needs, i.e. address "pain points". Surprisingly, two other factors were partly even more important for the success of the start-up. Firstly, timing plays a decisive role. To arrive at an assessment here, it is advisable to look at the market in which the product is ultimately to scale. If it is in a growth market or serves a niche, this is of course an advantage, but equally important is the question of whether the market is ready for the product. This can be measured by recommendations, likes and similar markers, which can be summarised under the term "virality". If virality is high, a company has good prospects for the future and is more likely to scale. The fourth factor, traction, looks at how well a start-up uses its budget. Surprisingly, even start-ups with a smaller budget can be successful if they are capable of using it creatively in order to realise the company's goals. Business management parameters are also included in the evaluation.
The factors collected are often more difficult to assess than "hard numbers", but they nevertheless have a clear added value: they help to make a well-founded growth forecast, especially with regard to high-tech start-ups and start-ups in the B2C sector.
How much should it be?
After identifying high-growth companies, the question inevitably arises as to how much money should be invested in them. Should it be a small amount or in the double-digit millions? There is no general answer to this question. Too many different environmental factors have to be taken into account: The industry in which the start-up is located, the financial possibilities of the fund or company, the risk appetite of the backers and the phase the startup is currently in. When an investor is thinking about the size of his investment, ideally an industry expert should be involved who knows the "DNA" of startups well and has a feeling for how high the potential is in the environment of the industry.
Prepare and execute transactions
As soon as the conditions are clear, nothing stands in the way of an investment. However, a large number of formalities and documents are necessary to create legal certainty. The most relevant are a term sheet, an investment and shareholders' agreement and a partnership agreement[4].
A term sheet is a legally non-binding declaration of intent that lays the foundation for negotiations between investor and start-up. The framework conditions laid down are usually transferred into an investment and shareholders' agreement after minor adjustments.
The investment agreement includes the amount of the investment and the shares that the investor will receive in return. The modalities of the payout are also regulated in the agreement. Additional agreements, which above all contain the various rights of the investor as a shareholder, such as the possibility to intervene in the operational business or veto rights, are included in the Shareholders Agreement.
The memorandum of association, also known as the articles of association, is a document that is publicly accessible in the commercial register and contains more basic information about the company and the new ownership structure. In terms of content, it is subordinate to the Investment and Shareholders' Agreement. In contrast to the Term Sheet, both are subject to strict formal regulations and in almost all cases require notarisation. If necessary, the above-mentioned documents can be supplemented by other documents, e.g. contracts with the management or contracts of employment for managing directors. From both the investor's and the start-up's point of view, it is advisable to have legal experts at your side so as not to unwittingly make concessions that you will later regret.
After the investment is before the investment
Just as a company's R&D department does not stop working after a successful product innovation or development, there should be no time to sit back and relax after a successful transaction. Taking into account that most start-ups and new businesses fail within a few years, it is necessary to keep looking. Companies that do not want to miss out on the next groundbreaking development in their industry should invest in a variety of start-ups in order to be able to participate in the transfer of knowledge. Moreover it is also appropriate for investment funds not to put too much money on one horse, but to diversify their investments and show foresight.
Venture capital means risk capital. Accordingly, every such investment involves a risk. In the worst case, the capital invested could be lost; in the best case, all participants heavily profit. The alternative, however, which would be to always rely on security and the tried and tested, is not an alternative. Because if you don't take any risks, you have nothing to gain - and in the worst case, you lose the future.
Authors: Robert Bauer, Yannik Rediske, Christian Wewezow
[1] „Startup-Kooperationen systematisch entwickeln“, 27.10.2020
[2] https://www.manager-magazin.de/lifestyle/artikel/start-up-szene-new-work-arbeitswelt-ist-oft-eine-schoene-neue-scheinwelt-a-1264963.html
[3] https://www.rfh-koeln.de/e380/e1184/e46696/e21828/e25046/StudieLangversion_4T_Start-upRFH_ger.pdf
[4] https://www.cmshs-bloggt.de/venture-capital/die-vertragsdokumente-einer-venture-capital-beteiligung/