Some Advantages of Founding a Startup in EU vs in the US (Pioneers Festival 2012 Talk)

(Slides available upon request)

At the Vienna Pioneers’ Festival in October 2012 I gave a talk during Investor’s Day.  I wanted let founders (especially local founders) know that it’s not always about moving to Silicon Alley as fast as possible. There are several advantages to founding and operating a startup in Europe.

My points were primarily:

1.    The extreme diversity of Europe can be very overwhelming for founders, and is indeed a huge obstacle to overcome for growth stage companies. But seed stage companies can use that diversity to establish niches and beachheads very quickly in their local markets, while their competitors struggle with legal and cultural challenges if trying to penetrate the same market.  This gives very early companies time to experiment and try various things, even in a winner take all market against larger competitors.

This can be especially advantageous for startups relying on Network Effects for growth (think, social network companies).  Such startups typically have a huge challenge early on, the chicken and egg problem.  Until the startup has a critical mass of users, it doesn’t bring much value for the new users who are thinking of joining.  A lot of startups try to get around this by spending tons on marketing (and forgoing any thought of revenue in the beginning).  This sometimes works, but is risky, especially with unproven teams.

Another approach is to shrink down the total “universe” of potential users so that the critical mass point is reached faster.  Best example is probably Facebook, which reached critical mass amoung it’s “universe” in only a few short weeks … with only a few thoasand users.  This was due to the fact that there was an initial limit of this universe only to Harvard students, meansing only a few thoasand users could still equal 70%+ of the undergrad class.

Europe’s diversity seems perfect for this kind of approach for such Networking Effects startups.  A company may struggle to reach 40% user base for Germany, which corresponds to 32 Mio. users.  But Austria shares many similair demographics as Germany (in addition to language and culture), and 40% there can be reached with only 3 Mio. users.  Or think smaller, only 40% Vienna at 680,000 users. Better subsets can be reached not only based on geography but on culture. Number of Christians in southern France (for a meetup web startup), number of secretaries in Berlin (for a distraction/user-content based web startup), etc.  I’ve heard that grocery chain Rewe uses it’s Austrian subsidiary Bipa to try out new technologies and methods, seeing how things look with an Austria only rollout before doing a potential rollout across much larger Germany.

2.     There’s alot less “noise” about startups in Europe right now than in the US.  (This is changing, however).  This means that with all other things concidered equal, odds are greater in Europe that that critical journalist or blogger will see your product; or a VC does get to your email sooner rather than later; or best of all: early adopters will see your product and decide to give it a shot. Think of the difference in ease of raising to the top page of Apple’s Appstore in France versus in the US.

3.     Average university students studying math, science, engineering, computer science in Europe: 13%.  Average in the US: 6%.  It’s no secret that engineers and developers are easier and cheaper to be had in Europe than in Silicon Valley right now.  I know of at least two startups that founded in the US, got US VCs to heavily invest in the companies, and then based themselves in Europe in order to get excellent talent cheaply.  Another interesting stat from  Riviera Partners in Q3 2012: average starting engineering salary in Silicon Valley (with under 3 years professional experience) at an early stage startup: $126T. Wow.

Again, this speech wasn’t about evangelizing europe as the best place to found a company, but rather an attempt to put into perspective that while there are many disadvantages, there are still many advantages which clever founders can use to remain globally competitive.

 

 

 

Fundraising and Financials, Part I of II

For my first true post I’d like to address a financial topic that a lot of seed stage founders struggle with: burn rate and the timing and size of seed stage fund raising.  I’ll be splitting this into two posts, the first dealing with some of the key terms and why this problem is not so easily solved as simply “constantly raising money”, the 2nd part covers what I believe to be the best timing along with an SAAS example with financials and timing requirements.

First, some definitions:

Monthly Burn Rate: this is effectively your monthly cash flow from operations.  However, since there is typically not a lot of revenue (again, cash basis) coming into a company in the seed stage, VCs will think of this figure as how much of their investment is being “burned” in efforts to get the company successful.  While technically Cash Flow from Investments (reminder: that is different from Cash Flow from Financing) also burns cash, these tend not to be reoccurring.  A monthly Burn Rate can spike if there are outlays for equipment or Intellectual Property and then level off again back to the operational average.  A typical Burn Rate is 35T€ for seed stage, though that can vary widely depending on the business model and sector  (hardware start ups will almost certainly have huge burns towards the beginning as they acquire the necessary equipment, software start ups can begin with almost no burn if it’s a guy coding in his garage, for example).

The only way to decrease the burn rate is less cash out (cut expenses) or more cash in (increase revenues, on a cash basis).

Runway: This is how much time is left before the company dies from running out of cash (“liquidity crisis”).  The calculation is easy: average burn rate divided from remaining cash on hand (i.e., the seed investment).  A 35T€ burn rate divided into a 500T€ Investment gives the company a 15 month runway.

The only way to increase the runway is to decrease the burn rate (see above) or increase the “remaining cash on hand” (fundraising).  Cash Flow positive essentially means you have an unlimited runway.

Cash:  It’s essential for founders to understand intuitively the difference between cash-in and revenue.  This is not easy for some first time entrepreneurs, since we are used to thinking of our own personal monthly budgets as cash based, but most of the business world deals in revenue.  In the US, according to GAAP, cash-recognition is simply when the money is in your bank account, while revenue recognition is when the benefit of the good or service is realized (that’s an over simplified version).  I tend think of the cash flow as how healthy the business is and P&L statements as how successful the business is.  There is a strong correlation over the long term, but if we look at a specific period, like a month or a few months, these two numbers can be widely divergent.  I’ve seen companies, who hold contracts with large customers worth hundreds of thousands of Euros in revenue, but the customers were given good credit terms (90 days to pay, for example), so while the start-up has a successful and market-validated product, it becomes nearly insolvent since it doesn’t receive for a while the cash to pay its bills.

So let’s say you’ve just started a company.  You are putting together your pro forma financials, making assumptions on revenues and costs, and you’re beginning to think about talking to investors.  What kind of investment do you ask for?   I’ll address the typical amounts for various profiles elsewhere (and has been done exhaustively by others for the US market in other blogs), but let’s just say you’re talking to a seed stage or angel investor.  You may calculate that in order to reach long term profitability you need 5 Mio. €.  The odds of finding an investor for that are low (although as I am writing this in August 2011 the start up market is certainly hot), and especially low in Germany.   You would need to find probably more than one VC, since in the seed or early stage a 5 Mio.  € Investment would be an exception for an unfinished product or not-yet market-validated business.  Building a syndicate is possible, but very time and effort consuming.  So a better strategy is to calculate what you need right now, and go back to the VCs later for the rest.  Going back later has several advantages, namely you will have more credibility so it will be easier to raise money, and since the business will be validated in the meantime, you can command a higher valuation.

The question of what you need to raise to get started is also a bit tricky.  On the one hand, you don’t want to constantly be doing fundraising – you want to be running your business.  So raising 100T€ every three months is a losing strategy long term.  On the other hand, the larger the amount, the longer it will take to raise and the harder it is to convince investors.

A good compromise is “sufficient capital to reach a convincing milestone plus at least 6 months buffer”.  We’ll be looking at that closer in part II of this series on the timing and volume of seed stage financing.

Fundraising and Financials, Part II of II

In the previous post, I looked at how problematic it is to decide on the size and timing of fund raising, in particular for the seed stage.  A company can’t typically raise all the money it needs at the very beginning (nor should it), and it also can’t be constantly engaged in “the next round” for in some perpetual fund raising cycle.

A good compromise is “sufficient capital to reach a convincing milestone plus at least 6 months buffer”.  Let’s break that down:

         “A convincing milestone” can be anything which interests additional investors to come on board.  For A-Round investors, it could be a finished product (if the technology was hard to develop), existing and growing revenue (if market validation was hard to develop), a growing user base (if there’s a lot of competition for the users’ time), etc.  Really anything that proves that your company is special (as opposed simply to how you claim it is special).  This varies widely, for a dot-com a finished and live website probably isn’t impressive, for example.

         “A 6 months buffer” is important since no one (excluding some outliers from boom periods) get a check for millions after their first pitch.  The reality is your first pitch is a win if you get invited to a 2nd pitch with the other partners.  And that’s a win if you involved in due diligence, and so on.  A round can be fast (2 months), but the reality is that you need to plan for it taking at least 6 months (9 months is smarter).  Pitches, evaluation, internal discussion, another pitch, another internal discussion, term sheet preparation, term sheet analysis, due diligence preparation, due diligence analysis, due diligence questions and feedback and further preparation, investment contracts, your attorneys’ feedback, other attorneys’ feedback, etc… you get the picture – it always takes longer than you expect and the less runway you have, the more desperate you become and the less negotiating power you enjoy at the table.

A good example would be an SAAS company that does [insert earth shattering technology here] for [insert largest growing demographic here].  In this example, the founders are three recent university graduates bootstrapping their idea from a CompSci project into a real company.  5T€/Month takes care of a small office, telephone, web server and hosting, etc.  Another few thousand for attorneys’ costs, travel, misc.  .  Finally, the two founders need to live, so at a about 4T€ brutto X 3 plus some interns for another 1T€, we have expenses of about 20T€/month.  When the company starts ramping up, it’ll be closing to 35T€ when they hire a few more people, need a slightly bigger office, servers which can handle the expected loads, a bit of marketing, etc.

For such a company, being able to demonstrate paying customers over several months would be a pretty convincing story for investors, especially when these are showing good growth.  The assumptions are that the company will launch in 4 months, so if it takes a month to find its feet and then start generating revenue.  Three months later the company can talk to an investor, point back, and say “look at the revenue we are generating; it may be small, but it is growing; with another investment, we could jump start it into another order of magnitude by doing [insert strategy here]”.

Although the founders are probably talking with VCs the entire time, when the can say the above is when they first start to become seriously on the VC radar.  In this example, that is in month 8 (4 Months development, 1 month “live” but not yet significant, 3 months proven traction).

When you consider that the decision + Term Sheet negotiations + Closing will take 6-9 months, this means the company has to have a total of at least 14 months runway and 17 months would be smarter.  In the SAAS example above, this corresponds to an initial capital need of 280T€ to 340T€.  If we were talking about a company with closer to 45T€/Mo. Burn, then the initial capital would be 630T€ to 756T€.  Which do you think is easier for the three recent graduates to raise?

So What is a “Concrete Milestone”, anyway?

In my previous post we talked about the timing for raising capital, and how a “significant milestone” is when a deal can become serious enough for a VC to start looking at it more closely.  As discussed, this does NOT mean that you shouldn’t be trying to get on their radar before that – I believe establishing a relationship is critical, especially when we’re talking about seed and early stage investments.  Rather, while a deal might be known to a VC, it suddenly gets a lot more attention when the company appears to be on the way to success; a concrete milestone reached is a strong argument for that.

So what exactly is a significant milestone?  Well, that depends on your industry and technology.  Below is a chart known to most entrepeneurs, which breaks down the challenges a start up faces in the early years.  There are certainly exceptions, but I believe it captures the general steps fairly well, which is while I’ll use it for this discussion.

(You’ll notice that “Idea” is farthest and smallest to the left.  I wanted it to be included, but couldn’t make it so small you couldn’t read it – but basically the “idea” itself is worthless in terms of value to the company.  Execution of the idea is the big value driver).

Valuation vs Time at Stages

Valuation vs Time at Stages

(By the way, I invest in tech deals in the seed stage, so my focus is nearly always on the technology part of a start up.)

Technology-Product Milestone:  These are often the hardest to evaluate, since the potential revenue is so far in the future. On the biggest extreme would be pharmaceutical deals, where the benefit from the technology could be 10 years away.  In these cases developing and completing the technology into a product is possibly the biggest break thru for the company.

Product-Market Milestone: Most of the deals I see are new products based on existing technology.  Since the technology already exists, making it into a product is typically not impressive.  There are many reasons for this, not the least of which is the IP on the deal.  What can be impressive, however, is finding a market for that product.  This is demonstrated most easily thru the elusive traction that VCs often are seeking in a deal.  What “traction” means can itself also depends on the product.  It could be that some LOIs (Letters of Intent) are sufficiently convincing, but typically an established revenue stream is what the VCs will want to see. Here you need to show not just revenue, but month over month growth, etc.

Growth and Competition are typically outside of my focus in seed stage investments, though of course they are examined.  However, if you are bringing a deal to a VC which no new technology, no new product or new market, and are instead trying to take on existing players in an established market, you will need to be very, very convincing on your competitive strengths.  For example, nearly every week I see Facebook and Groupon clones.  These clone-deals are using existing technology, existing products, in an existing market, which has already shown high growth.  So the question is, what distinguishes these deals from the crowd?  Normally not much.

So the thing to remember when making your narrative and pitch, is to keep in mind what stage you are in and what milestone you need to reach or show that you are able to reach.

Confusion on Break Even and Cash Flow Positive Points

I’ve had a few conversations with founders lately about Cash Flow positive and Break Even points, and I realize there is often some confusion about what these two terms actually mean. Many times a founder will plot out his cash flows and assume his break even point is when these flows start trending positive.  But that’s not Break Even, the Break Even point is when the company has turned a sufficient cumulative profit (or more specifically, the cumulative cash) to cover the initial investment.  The Cash Flows are simply the “difference on monthly basis” (1st derivative) of the cumulative cash,  ie, the change in your monthly bank statement.

Although the topic is a relatively simple one, I think it would help to look at these concepts visually.  The diagram below shows the relationships between cumulative cash, cash flows, cash flow positive, break even, and investments.

Cash Flow Diagram

Let’s start with the monthly cash flow, since that’s what we  look at to see how quickly the company is burning cash in the early stages.  As we discussed in the last post, the cash flow is the cash basis (as opposed to GAAP or accrual basis) of money coming in and going out of the company. The net cash flow is simply the total of all cash transactions for that month. For this discussion I’ve further used the SAAS example from the earlier post. While unrealistic, we’re assuming the product is ready to launch immediately and that a few people are immediately ready to pay, and that costs are remaining constant.  The product gets launch in October 2011 and there’s barely any revenue. The total cash flow for that month is about minus 40T€.  The next month costs remain the same but a few more people use the product, so there is more revenue (assuming they pay in the month they use the product) and total cash flow is a bit shallower, now maybe minus 37T€.  Next month same story, but more users, so about negative 34T€.  In this example this continues in a more or less linear fashion (no hockey stick – for simplicity) for the next year, until the estimated 40T€ in monthly costs start becoming more and more covered by the monthly revenue, until around the end of 2012 when they equal each other.  As monthly revenue minus monthly costs reach zero, the company has achieved a very significant milestone of cash flow positive (which means it can basically survive even if there are no further investments and can begin plowing revenues back into the company to further spur growth).

At this point every euro the company earns is considered a profit (on a monthly basis). However, this is not break even! NPV and time value of money make the calculations a bit trickier, but basically if the company hasn’t generated the same amount of cash as the original investment, they are still just paying back the original investment.  The blue line of the diagram represents the sum of all the cash flows. For you calculus minded, this would be the integral function of the cash flows; while the cash flows represent the derivative function of the cumulative cash.  As the cash flows turn positive, the cumulative cash stops going deeper into negative and begins to turn around (inflection point), just as we’d expect of a company who is suddenly no longer burning thru the investment each month but instead beginning to pay it down. Once it is paid (when the blue line is at zero again), then the company has finally hit break even.   (This happens here at about three years after the investment, which for a low-cost company as in this example is quite a long time.  This is when it would be nice to see the hockey stick from revenues, in which case break even would be hit much faster.)

Since it is not possible to have a negative bank balance (without debt or some sort)- since that makes the company insolvent the total cash on hand is actually the sum of the cash flows plus the investment. What investment is needed? Quite simply, just look at the deepest point in the cumulative cash curve. What does it take to bump that above zero? That’s your investment target, giving you the green curve, which is the total cash including financing.  (In this example the needed cash was about 230T€, keeping in line with the earlier posts’ assumptions).

Now I’ve kept this example intentionally simple so that we could look at the graph without a lot of complex curves. In reality, there are a few things which will greatly complicate how your cash flow planning looks:

  1. There is probably going to be a period of initial “cash flow from investments”, in which computers, office, etc are acquired.  This doesn’t impact the cash flow from operations but most definitely will impact your total cash on hand.  (Remember, there are three types of cash flows: Financing (get a loan or investors), Investment (acquisition of equipment, etc –don’t confuse with financing cash flow!!!), and Operations (the real driver, this includes the operational revenues and expenses).
  2. As discussed in the previous post, sometimes the initial investment is not enough to break even or even to reach cash flow positive. In these cases, there will be additional “troughs” in the cumulative cash curve, each one representing a new financing.  Their dept from zero will likewise correspond to what financing is needed that round in order to survive further.  This applies also to investment models which are dependent on milestones and tranches make sure that those match the liquidity situation!
  3. The Cash Flow from Operations line should rarely be linear (which would imply a lack of scalability).  This example used a typical subscription based model, in which a user signs up and then pays on a monthly basis. That makes forecasting relatively easy, along with cash flow management. Other revenue models, like sales, will require a much more detailed understanding of the drivers in order to accurately forecast.  In real world situations, the revenue curve itself is non-linear, as viral marketing and scalability impact the growth rate.
  4. This may be too obvious to need saying, but obviously the lower the burn rate, the faster cash flow positive is reached and the less investment is needed (and therefore the less equity you have to sell). There are some situations in which bootstrapping simply cannot work (like hardware-based, long development-cycle companies), but when you can do it, it’s normally a very good idea, at the very least in the beginning.

Threats of Reseller-based Sales Channels for Startups

Sales channels for startups can be tricky, especially when dealing with the question of direct or indirect channel strategies. It can be very tempting for founders to want to start with an indirect strategy, since if they get some resellers on board it can instantly lend credibility to their product and brand, increase revenue potential through more customer exposure, and act as a multiplier for further brand expansion.

But in this post I want to highlight a few negative things that often go unseen by founders when considering how they will sell their products.  Both channel strategies are correct, depending on the type of business and age of the company, but below I outline a few things to take a hard look at before engaging in an indirect strategy.

What to keep in mind about a reseller channel strategy:

1. You will largely loose pricing flexibility.

Resellers are entirely dependent on their mark ups for revenue. In order to minimize their risk they will insist that the Channel Agreement have a minimum price.  This basically says that while the start up is still allowed to sell their product themselves, they pledge not to sell below a certain threshold. This prevents the start up from becoming a price competitor with its own resellers.

This restriction can be very harmful for a startup, especially very early (as in, right after launch), since the pricing strategy and price positioning (premium, low cost, etc) may not yet be validated by the market.  If you go for a premium price positioning, but end up having to compete on price in order to get noticed in the market, then you have to retain the flexibility to alter your price.  A restrictive channel agreement can hurt this flexibility.

2. Avoid Exclusivity when possible

Sometimes it makes sense economically to accept a reseller’s insistence on exclusivity.  For example, if you aren’t present in a city and there are legitimate reasons for a geographic limitation (if your business model is based on city by city expansion, for example), then if the price is right (there has to be a premium to justify accepting such a restriction) some type of limited exclusivity is OK.

However, if you just launched you product and a company gets excited about it and wants to be the exclusive reseller, then this is probably a bad deal.  The reseller likely has a lot of information on the sector and experience on what is needed, while the startup is negotiating from a weaker position.  Basically, if a company demands exclusivity in your primary target market, then you don’t really have any markets after you let the reseller take over.  That’s identical to an acquisition, and should be priced accordingly!

Final thoughts on Exclusivity: be sure that it can’t be used as a cheap way to simply eliminate you from the market. Insist that there be minimum purchases of XX € per month or year, or the exclusivity is forfeited.  For example, you must avoid the possibility that a reseller forecast purchases of 100T€ a month, so the founder gets excited and grants exclusivity for that city.  Then the reseller looses all interest and doesn’t sell a dime worth of product, but without the minimums the founder is prohibited from pursuing other resellers or even selling his own product in that city, shrinking the startup’s addressable market.

3. The distance to customers and feedback is increased

This is probably one of the most important on the list but often gets over-looked: if your customer is only dealing with resellers, you aren’t talking to them.  If you aren’t talking to them, you are forfeiting one of the most valuable assets for a just-launched product: the feedback from early adopters.  This feedback SHOULD be having a disproportional impact on the direction future products take. But without it, you are just swinging blindly.  The whole product-market fit aspect of business is essentially defined by these first customers, so you better have a clear channel of communications open with them at all times.  This includes negative as well as positive feedback.  Where do they go if they have technical support issues?  This is especially important for revolutionary products, since they may not understand it 100% from day one and need to be talked thru the usage process.  Absent that, they will simply all return the product en masse to the reseller, who will reward you by cancelling the reseller agreement.

4. Following up with leads becomes trickier

Qualified Leads are gold to a startup that just launched their V1.0 product.  By qualified I mean leads that have a high probability of conversion. Like the guy who randomly calls you after your first press release and says he’s needs your product, and how can he buy it?  Unqualified leads are what I think of as everything else (ie, meeting a guy at CeBit who says the product looks interesting, so you ask him for his card).

The qualified leads are going to be your early adopters. As first customers, they will be more willing to put up with the bugs and give you feedback when you ask for it.

The problem with resellers here is similar to point 3 above.  When you get a qualified lead, the temptation is to forward him to your reseller.  This shows how serious a company you are that you have sales partnerships, right?  And you won’t have to worry about handling the transactions yourself, right? Which is important for when you scale, right? Well… No.  You aren’t scaling yet. You may only have 2 or 3 customers so far, and you are desperate for 100 more before the end of the month in order to meet revenue targets.  So why would you send a customers that says “I want to buy now” to someone else, who may or may not be able to give them attention?  Resellers have lots, and lots, and lots of SKUs.  The odds that they are giving their brand new startup partners’ products attention and priority are minimal.  They are concentrating on their large ticket partners; the ones that help them move thousands of units and product a month.

So there are two ways most founders will send a willing customer to a reseller:

The founder takes his contact info and send it to the reseller. (Who may or may not call him back).

Or he simply tells the customer to go to the reseller (because he doesn’t want to / can’t do the transaction himself), in which case the customer may or may not continue to be interested a few days later when/if he remembers.

Both are bad.  If a customer is willing to open his wallet to give you cash for your product, let him do it right away!  This is doubly important for B2C products which could be arguably “impulse buys” from early adopters.

5. Brand building and market positioning can suffer

Sometimes the business is built for a good reason around a white labeling model. If that’s the case, this point doesn’t apply.  For everyone else, use you own selling platform (even if that is you on the phone taking a credit card number) as a way of building your brand.  Increase the number of people who know what the name of the company behind their cool product is.  Social and viral marketing for B2C is also important and much more complicated if you are only known thru a reseller. Let’s put it this way- which way is easier for you to control your reputation? When you talk to people directly or if they only hear of you from someone else?

6. Terms can be very dangerous for liquidity

This point can probably be made better through negotiations or even factoring, but most resellers will insist on at least 30 days credit terms and probably closer to 90 days net credit terms.   This means that if you only have two months runway left in the bank and sell millions in products through a reseller that has net 90 days terms, you are still insolvent.  As with most other points in this post, this is not so big a deal when a company begins to become a bit more established but can be deadly for a brand new, just-launched startup.

The conclusion is not that a reseller strategy is bad, only that there is a time and place for it, and that time and place is likely not at the beginning.  Resellers can be very useful when scaling.  For a company that is starting to show a bit of traction, and is starting to hit its capacity limits, then resellers can help further push the product while the company starts trying to scale.  But until the startup reaches that point, it’s better to stay as close to the customers as possible.

US/ German Startup Differences – Legal Differences during Founding Phase

Having started and operated a startup in the US and assisted (and invested) in multiple startups in Germany, I recognize that there are some important differences in the two countries.   Most of these differences are a consequence of the variations in legal structures, but there are also some important cultural differences which need to be understood.  I’ll be splitting these topics into multiple posts.  (These posts are principally applicable only to GmbHs, AGs have some differences).

——

Some of the biggest differences are simply in getting a corporate entity founded and up and running.  In the US this is rather easy, after deciding on a name, you have your attorney draft the Articles of Incorporation (assuming a C Corp), Bylaws, etc, and file with the Secretary of State and receive a Tax ID Numbers.  Total costs can be as low as $1,000 and takes a few days or weeks.

Formally organizing a startup (or any company) in Germany is very different.  Deciding on the corporate form involves the same concerns as a US company (limiting liability, ownership structure, etc), but also involve some regulatory hurdles which must be overcome.  Assuming a GmbH (more or less like a LLC), which is the most common form for a startup, then the following must be kept in mind:

  • A GmbH has a minimum capital cash reserve requirement (“Stammkapital”) of 25T€.  This must always be kept in a bank account somewhere untouched, and the company cannot formally organize without at least this amount being paid in. So if you are thinking of creating a GmbH entity, remember you must have at least 25T€ cash on hand just to get started.  (In recent years there was an attempt to lower the barrier to 10T€, but that failed.  However another corporate form, and called the “UG” is an exception and can be founded under more strict controls with only 1€).

 

  • Just like in the US, the company must draft and accept Bylaws, incorporation agreements, shareholders agreements, etc, along with deciding on the corporate officers.  But another big difference is reporting requirements to the government. In Germany, a company is not officially a legal entity until it is recognized as such by the “handelsregister” (basically registry of commerce).  These are operating at the state or city level and must be informed of details on the company, including: names and birthdays of officers, corporate address, number of outstanding shares (“stammkapital”), list of shareholders, and the bylaws.  If any of these changes, the company must inform the handelsregister.  Also, this information is public!  So if you close a financing round, all it takes is for someone to look at the change in the number of outstanding shares or a new addition to the shareholder list, for them to see that you just received an investment.

The time it takes for the handelsregister to officially recognize a change and publish the results can vary widely depending on the city or state. Some only take a few days; others can take up to two months. This is important to understand because many investors will only initiate the final wire transfer for the paid in capital after they have officially the handelsregister publishes that they are listed as a shareholder.  This is for the protection of the investors, since it is possible the handelsregister finds a problem in the documents which prevents an investment.  In that nightmare scenario, the investor would have wired the money without having received any shares.

  • Shares of a German company are also very different than in the US.  Although in both countries there exists the concept of the par value and premium of a stock share, the par value number in US startups are most often set just above zero, while in Germany they are a minimum of 1€.  In both countries, the legally required amount they must keep in reserve (depending on the state) is:

Number Outstanding Shares multiplied by the Par Value.

So if a US company sells 10T shares (assuming a $0.01 par value as required by some states), the legally required amount they must keep on hand is 10T X .01 = $1,000 (which basically any company has).  If you are based in the US and this is news to you, don’t worry, the par value requirements are so low I think most US entrepreneurs don’t ever even know about it.

Where it gets interesting, however, is in Germany where the par value requirement is set by law at a minimum of 1€ (and the number of issued shares must be an integer).  That means in the example above, the 10T outstanding shares corresponds to 10T€ capital reserves which the company must always have on hand somewhere.  Given that all GmbH’s have a minimum paid in capital amount (see above) of 25T€, that means all GmbH’s have at least 25T outstanding shares and must always maintain a minimum cash on hand of 25T€.

This has the side effect that in Germany there is no distinction between outstanding and issued shares.  While in the US a company may authorize 1 Mio. Shares, with perhaps only 100T issued, such a construction is impossible with a German GmbH.  (That also has a HUGE impact on subjects such as Vesting and Stock Pools, which I’ll write about another time).

US/ German Startup differences– Legal Differences in Startup Contracts and Agreements

As part of the ongoing series on in US and German Startup/VC processes, laws, and culture, I’ll be addressing some of the most glaring differences I’ve observed regarding shareholders’ agreements, startup contracts, etc.  It should be noted that most of these observations are relevant only to GmbHs.  While many of the same differences apply to German AGs, I’m limiting this post to GmbHs, where I have more experience.

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Under German law, any contracts which deal with the transfer or sale of shares must be notarized.  This is not as in the US, where the process can take only a few minutes and most law firms’ secretaries are also state certified notaries.  The situation in Germany is quite different.

For one, there is a set number of notaries in the country (“Notar”) who are allowed to notarize documents, so it’s not a question of just asking a secretary or paralegal to do it.  Notary positions are highly sought after in Germany, with only the most highly qualified legal specialists allowed to become one.

Notaries assume personal liability for the documents they are certifying.  For example, in a 100T€ transaction, the notary can be liable for the 100T€ if he fails to verify that the details of the transaction are all permitted.  For example, if someone signs a contract for someone else without having a proxy or power of attorney, the notary is liable for any damages that arise from this.  This leads to a situation where the notaries are basically paid to go thru every detail of what is permissible in a transaction with the parties, verifying everything, and only then will he notarize the transaction.

The process can be very long.  For a typical seed investment, for example, there is a shareholders agreement, new bylaws, IP and Software assignments, etc.  To verify the agreement of all the parties, the Notary will ask everyone to come together, and then he will read EVERY SINGLE WORD of all of the contracts.  After finishing that (which can take many hours) everyone agrees to them and prepares to sign the contracts.  Now the Notary must verify that everyone present is actually able to sign the contracts.  If someone is representing the startup, or the VC firm, or someone else, then the Powers of Attorney must be checked.  This becomes even more complicated with the Powers of Attorney documents are also linked to entities which also are given by Powers of Attorney.  The Notary must verify all the parts of the chain, make sure they are correctly done, and then check the identities of the people present (passports, etc).  Then and only then can he notarize the contracts.

Since the Notary is personally liable for any problem he may have missed, he is of course very thorough.  His costs are also representative of his liability (and standardized across the country, so don’t bother trying to shop around).  A 500T€ Seed Investment notarization can be many tens of thousands of Euros, a signification portion of the attorneys and transaction costs.

I’ll leave the relative advantages and disadvantages of this system to another post; for now any US-based VCs or Entrepreneurs who are participating in a financing round based in Germany should be made aware that the transaction itself can be more complicated and formal and expensive than simply getting together around a conference table and signing.

US/ German Startup differences – Legal Differences on Founder Liability

Similar to in the US, officers and directors of a German GmbH can also be held personally liable for their actions or for the liquidity of the company.  The penalties, however, can be very different from those to which a US entrepreneur is accustomed. As before, I offer this information informally and I strongly recommend checking with a German attorney on the finer points.

The Managing Director of a GmbH can in some situation be personally liable for his or the company’s actions.  D&O insurance and the corporate shield are of little protection in many of these situations.  A CEO taking on a leadership role (and officially becoming Geschäftfuhrer) in a German Start Up needs to inform himself of the liabilities to which he is exposed.  The issue of bankruptcy is course likely the most relevant for entrepreneurs, though there are a few others (including fraudulent activity and not respecting the minimum capital requirements for a GmbH).  For example, when the cash on hand drops below half of the minimum required capital reserves (“stammkapital”), the CEO is required to inform all the shareholders.

At the most extreme, founders can be held criminally liable.  Even if criminal activity hasn’t been committed, in some situations the officers may be officially barred from participating in management of a company for a period of time.

The German Law Journal has a great treatise on the subject which can be found here.

US/ German Startup Differences – Accounting

It should come as no surprise that Germany has different accounting and financial requirements than the US.  As neither an attorney, nor CPA, nor tax consultant, I try to limit this post to a general background on some of the issues that Americans will experience with German accounting which may differ from their previous experiences with GAAP.

Generally speaking, the culture in German is much more oriented towards Managerial Accounting (“Controlling”) rather than financial accounting.  Midsized companies have shown a greater willingness to invest in controlling mechanisms like ERP and more detailed analysis of cost centers than their American counter parts. (Source)

To understand the actual differences in the required financial principles, we start with a short background of the key components in Germany. The basis of German commerce laws is the Handelsgesetzbuch (HGB—the German Commercial Code).  Section 243 (1) of the HGB declares that financial statements must be setup following the Grundsätze ordnungsmäßiger Buchführung (GoB—German principles of proper accounting).  However, the standards are not explicitly defined within the GoB, but rather assembled based on multiple sources and principles, including statutory laws on tax and corporations, as well as external sources like the IFRS.

Some examples:

  • Revenue recognition can be a key difference between US GAAP.  For example, under IFRS, if a company has a contract with a customer but there is not a guaranteed payment, then revenue recognition is differed until collection.
  • Customer Loyalty programs are another area of difference.  For example, if free samples or gifts are recognized as marketing expenses, and when.

Extensive analysis from PWC available here.

KPMG also has a good guide of the differences between the IFRS and the HBG here.

And finally, a handy translation guide for some accounting key terms:

acct