Investment rounds are like trips to the theater: you might not expect much of the performance, but you'll be glad that you went.
When the word "ticket" is mentioned in start-up circles, it usually refers to the size of an investment. "Ticket" also reminds me of the stubs you purchase to see a movie or a theater performance, so I will use it as a metaphor to explain a few investment dynamics.
What determines the size of an investment? Among other things, the size depends on how much revenue can be generated in a certain amount of time. During the first round of investments when a company isn't operating quite yet, entrepreneurs use estimates whose plausibility depends on the business model and on comparisons with the revenue of similar companies. Figuring out expected revenues can be a very complex process. Complexity and uncertainty help to explain why initial investments are much riskier than later investments. Either the company prospers and proves the validity of its business model (in which case the risks are manageable), or it goes bankrupt (and thus renders additional investment cycles unnecessary).
Let's assume that a company is valued at one million dollars and aims to raise 100,000 dollars from investors to begin its operations. In return, investors receive ten percent of the company's shares. This is called "seed investment," and it is usually followed by several rounds of investing to increase the company's capital as it grows and prospers. Seed investors can invest again or the company can look for new investors (or both).
If the company can increase its value over the course of two or three years because of its revenues and profit margins, more money will be required to keep it growing. Let's say that our imagined company is now worth five million dollars: the second round of investing needs to raise more than the original 100,000 dollars. Some seed investors will decline to participate in another round of investing either because they lack the necessary money or because their margin of profit would likely decline.
If you invest in a company valued at one million dollars, a fivefold increase in value also increases your share in the company by the factor five.
Thus, it only makes sense to invest again if you think that the company will continue to grow significantly, say, from five million to 12 or 18 million dollars. If this seems like a plausible scenario, another investment might be worth the risk.
Some business models require large amounts of capital. This is where venture capitalists enter the picture. They are only interested in investment opportunities of more than five million dollars. Our little company wouldn't be too interesting to them. Smaller investments in the range of 100,000 dollars aren't worth their effort.
The reason I am telling this story in all its details is this: we frequently hear rumors about a start-up bubble. Berlin's start-up industry has been growing quite quickly in recent years, and people are beginning to question whether the industry is really worth its price tag. But whenever I talk to entrepreneurs, they always say that there's not enough investment money. Or, to be more precise: there are not enough investors in the range between 200,000 and one million dollars.
Let's return to the metaphor of the theater. Tickets at a well-known venue are generally more expensive than tickets to a small chamber theater. Some investors focus on small companies in their initial stages (i.e. small theaters). Big players concentrate on big business (i.e. large opera houses). This doesn't mean that one is better than the other -- they cater to different markets. It doesn't make sense for an investor to give 100,000 dollars to one company, 15,000 to another and two million to a third. Companies often demand investor support, and small companies might have different demands than bigger companies. Investors might all invest in theaters, but their demands differ. A large venue requires more money than a small theater -- hence the price difference between the two.
What Germany lacks are investors in the middle between initial seed investors and venture capital firms.
One reason can be found in a crucial difference between Germany and the United States, where venture capitalism has a longer history. In Germany, companies frequently employ between 20 and 50 people and pursue a business model that is geared towards long-term success. They don't expect to be bought by a big technology company for hundreds of millions of dollars after a year or two.
This is a new incarnation of the famed German "Mittelstand," the world of medium-sized businesses. But why can't new and old form an alliance: established entrepreneurs could provide the funds necessary to help new companies grow. Family-run businesses and funds come to mind, but also those who run medium-sized companies or who made a fortune in that industry.
I suspect that start-ups are still seen by many of these potential investors as an American import (indeed, there's no German translation for the word "start-up." The industry has embraced English as its native language). Established entrepreneurs hesitate to invest into an industry that seems foreign and that they don't fully understand.
But remember when your wife of husband dragged you to the concert or the performance that you didn't really want to see? Remember how skeptical you were, and how much you enjoyed it in the end? The next show isn't sold out yet -- maybe you should act on the opportunity.
Newconomy is the new weekly column for the start-up industry. It focuses on the intersection of classical and new economies and of politics and entrepreneurialism. Newconomy is sponsored by Factory, the new start-up hub in Berlin.
www.factoryberlin.com@factoryberlinThis piece originally appeared in The European Magazine.