Funding Rounds for Startups: Preparation and Process

According to surveys conducted by the Startups Association for the German Startup Monitor, 1,384 startups were founded in the first half of 2024, representing an increase of about 15 percent compared to the second half of 2023. This upward trend is evident across nearly all industries throughout Germany. As early as 2023, two-thirds of newly founded startups planned to raise external capital in the coming twelve months to meet their funding needs. However, according to the EY Startup Barometer, the amount of available investment in 2023 decreased by about 39 percent compared to 2022. Compared to the record year of 2021, the decline in investment volume amounts to as much as 65 percent. This trend stands in contrast to the growing number of startups that are facing increasing challenges in raising capital. The reasons for this decline are varied. Among other factors, rising interest rates and a weak economy are causing investors to act more cautiously.

What are funding rounds?

Funding rounds are periods during which startups seek investors to raise capital. This infusion of capital allows them to secure their liquidity, enabling them to finance their growth plans and strengthen their market position. Startups typically go through several such rounds as they develop. 

Various types of investors participate in funding rounds, all with the goal of achieving the highest possible returns on their investments. By injecting capital into startups, they have the opportunity to share in the growth and success of young companies. If a startup is successful, the value of their investment can increase significantly.

Bootstrapping vs. Debt Financing

Not all startups seek external financing from outside investors. Some founders instead opt for bootstrapping, a strategy in which they build their company using their own financial resources. Both financing options have different advantages and disadvantages.

With bootstrapping, founders retain complete independence. They don’t have to involve investors in their decisions and are free to shape their business strategy as they see fit. In addition, the time-consuming process of seeking investors is eliminated, allowing founders to focus more on strategic planning. However, when a startup is self-funded, it can usually only grow slowly, as the budget is very limited and may not be sufficient to implement an effective marketing strategy or hire qualified staff. This can lead to a competitive disadvantage.

External financing from investors enables companies to invest in key resources at an early stage, thereby accelerating their growth. In addition to financial resources, some investors also provide access to extensive networks and expertise, which can support companies in their development. This is often referred to as “smart money.” However, external financing also entails a degree of dependence on the investors. Depending on the terms of the agreement, they may have a say in decisions, which can limit the founders’ freedom to make their own choices. Furthermore, both the preparation and execution of funding rounds are time-consuming. In the early stages of a startup, however, personnel and time resources are often severely limited. 

Ultimately, the choice between bootstrapping and external financing must be made on a case-by-case basis, taking into account the company's specific goals and market conditions.

External Sources of Funding for Startups: Venture Capital and Business Angels

According to DMS, when looking at the distribution of external funding sources used by startups in 2023, government grants account for the largest share at 45 percent. Business angel investments are chosen in 32.6 percent of cases, followed by venture capital at 18.6 percent.

In venture capital, investors—in this case, venture capital funds—provide startups not only with financial resources but also with strategic advice. In return, they receive equity stakes in the company. Venture capital is primarily aimed at startups with high growth potential. Since these companies have little collateral to offer at the outset and a low credit rating, such investments are referred to as venture capital financing. The goal of venture capital funds is to generate substantial profits by selling their shares after a few years, primarily through an initial public offering (IPO) or the sale of the company.

Business angels are wealthy individuals who also provide financial support to startups in exchange for equity in the company. They offer more in-depth advisory services than venture capital funds. They often have experience from having successfully founded their own companies and have a wide network of relevant contacts in the industries of the companies in which they invest. They can leverage these connections to benefit the startups, for example, by helping them acquire customers. Business angels often invest at an earlier stage than venture capital investors—sometimes as early as the initial phase—which increases the risk of losing the invested capital. For this reason, they typically invest smaller amounts, usually ranging from 25,000 to 100,000 euros. For startups, this can mean that, unlike with venture capital, they must rely on additional sources of funding.

How do funding rounds work?

Choosing the right source of funding is just one small step in the funding process. The exact process can vary depending on the type of investment and the relationship between the investor and the founder, but it typically involves the following phases:

Funding Cycles for Startups

Funding rounds for startups are divided into several cycles, which are based on the company's current stage of development:

Early Stage

The early stage refers to the initial phase of a newly founded company, during which no revenue is yet being generated. During this period, the focus is on developing the business model. Therefore, the first round of financing—the seed round—is fundamental to building a company. The capital raised is needed for production and strategic planning. Investments at this stage involve many risks, making it particularly challenging for startups to attract investors during this funding round. However, many business angels are willing to invest at this stage if the business plan is promising.

The seed phase is followed by the startup phase. During this phase, a company works toward establishing itself in the market and generating its first revenue. Among other things, this requires building marketing and sales structures and hiring additional staff. The increasing capital needs during this phase can be met through a Series A funding round. From this point on, the company also becomes attractive to venture capital funds.

Growth Stage

After a startup’s successful market entry comes the growth phase, the goal of which is to further expand the company and increase revenue. This requires expanding the team and acquiring new customers. The capital needed for this can be raised in a Series B funding round. To establish a foothold in the market, rapid growth is essential. As a result, the required investment volume in this funding round increases once again. Investors from previous rounds may participate again at this stage. However, due to the rising capital requirements, business angels rarely invest at this stage.

The Bridge Stage is the second part of the Growth Stage. At this stage, a startup has established itself in the domestic market and is aiming for an initial public offering (IPO) or expansion into international markets. To achieve this, additional capital is raised through a Series C funding round , in which venture capital investors are also frequently involved. If the company’s goals cannot be achieved with the funds raised so far, further financing rounds are necessary. These are named in ascending order according to the alphabet, but generally do not go beyond Series E.

Later Stage

The later stage is the final phase of a startup. In this phase, there are generally no further rounds of financing. By this point, a company has successfully established itself in the (international) market and can finance itself with its own cash flow. In the later stage, founders focus on executing a potential exit in the form of an initial public offering (IPO) or an acquisition.

The search for suitable investors

Many investors specialize in specific industries or investment stages. If founders actively seek out investors who are a good fit for their company’s circumstances from the very beginning, they can save time and increase their chances of success. 

Suitable investors can be found through various channels. An existing network offers the opportunity for personal recommendations, which are usually particularly effective. Alternatively, pitching events also provide a good opportunity to engage directly with potential investors. Social media can also be used to find startup investors. Platforms like LinkedIn make it possible to search specifically for investors in certain industries and contact them.

Proper Preparation for Funding Rounds

Once suitable investors have been selected, it is essential to thoroughly prepare for the pitch and the respective funding round. The following steps should be followed:

Determining the Required Investment Amount: Before the start of each financial phase, it is necessary to determine how much external capital is needed.

Preparing All Documents: Before making contact, all documents should be customized to meet the specific requirements of each investor. Some investors specify which documents they need. In some cases, there are also fixed deadlines for submitting these documents, which must be strictly adhered to.

Developing a Pitch Deck: A pitch deck serves as the basis for an investor pitch, in which a startup’s business model is described in detail. Pitches give investors a first impression of a company. If they are convincing, they can motivate investors to take a closer look at the business model and investment opportunities, which can ultimately determine the success of a funding round. An investor pitch includes, among other things, a market and competitive analysis, as well as a presentation of the unique selling points of the product or service offered by the startup.

Creating a Business Plan: A business plan enables investors to better assess a company’s prospects for success. It contains information on the business model, financial projections, and strategic plans. A financial plan is also part of a comprehensive business plan. It breaks down how much capital is needed and for what purposes.

Mistakes to Avoid During Funding Rounds

To stand out from other startups, founders should avoid certain mistakes during funding rounds. In addition to thorough preparation, this can increase their chances of successfully attracting external investors. Common mistakes include:

Bad timing: Preparing for funding rounds often takes months. All documents must be finalized, and suitable investors must be found. Even after an investment agreement is signed, it can take a long time before the agreed-upon capital is actually made available to a startup. To avoid financial bottlenecks, founders should factor these waiting periods into their plans.

Too narrow a pool of investors: Due to a lack of experience, founders often appear uncertain during their first pitches. If only a few investors are approached, the success rate tends to remain low, and dependence on individual potential investors remains high. Approaching a broad range of investors, on the other hand, strengthens presentation skills and improves the negotiating position.

Disproportionately high investment amount: The requested investment amount should correspond to actual needs. An excessively high investment amount can artificially inflate the company’s valuation, thereby making it more difficult to attract investors in later investment phases. Furthermore, investor confidence may decline if they realize, for example, that excessively high amounts are budgeted for founders’ salaries.

Unclear Use of Funds: Founders must be able to specify exactly what they need the capital for. Vague statements can deter investors and raise doubts about a startup’s prospects for success.

Incorrect Company Valuation: Before investors come on board, a company valuation is required to determine the value of the company’s shares. For startups, this valuation is based primarily on projections, since no historical financial data is available at this early stage and no revenue has yet been generated. Estimates are subjective and do not always reflect the company’s actual performance. If a company is overvalued, investors’ expectations also rise. This puts pressure on the founders to grow quickly in order to meet those expectations. Furthermore, overly high valuations can cause problems in later funding rounds. If a valuation cannot be justified, this leads to a “down round,” in which capital must be raised at a lower valuation than in the previous funding round. This can result in dilution of the founders’ equity stakes and a loss of confidence among existing investors.

Selling Too Many Shares Too Early: Founders should make sure to retain enough company shares for themselves in the early stages of funding. If a high percentage of shares is sold off as early as the first funding rounds, this can deter investors. On the one hand, because there may not be enough shares available for additional investors in subsequent funding rounds. Second, because a small founder stake can give the impression that the founders’ motivation and commitment are insufficient to ensure the company’s long-term success.

What to Keep in Mind When Drafting Investment Agreements

Once investors and founders have agreed on all the key terms of the financing, the terms are finalized in an investment agreement. These agreements are often complex and may contain provisions that are disadvantageous to founders. It is important to thoroughly review investment agreements before signing them in order to identify any risks.

For example, some clauses result in the founders losing control. An investment agreement may stipulate that certain decisions require the consent of investors. While this provides investors with greater security, it can, depending on the scope of these provisions, restrict founders’ ability to manage day-to-day operations. Similarly, provisions that guarantee investors seats on various corporate bodies can strengthen their influence and further limit the founders’ decision-making authority. However, both provisions can also enable investors to have more opportunities to contribute their expertise and thereby increase a startup’s chances of success. It is therefore important to carefully weigh how much influence should be granted to investors.

Many investment agreements contain anti-dilution clauses that ensure investors’ percentage ownership stakes in the company remain protected even if the company’s valuation decreases in future funding rounds. However, these clauses can expose founders to a higher risk of dilution of their own shares. Anti-dilution clauses, such as the “pay-to-play” mechanism, are designed to protect startups from this. This mechanism grants existing investors anti-dilution protection only if they also participate in the subsequent funding round with a specified minimum amount.

Exit provisions must also be carefully reviewed. A partnership agreement may stipulate that investors can sell their shares without the founders’ consent. This can result in changes to the group of shareholders against the founders’ will. To counteract this, restrictions on the sale of shares can be implemented. Provisions regarding tag-along rights, buyback obligations, and the distribution of proceeds from a sale can also significantly influence the consequences an investor’s exit has for the affected founders.

Trends in Startup Financing

Over many years, funding from investors has become the norm for startups. However, factors such as the increasing frequency of crises have led investors—including business angels and venture capital funds—to adopt a more cautious approach. This makes it more difficult for founders to raise capital. As an alternative source of funding for startups, venture debt financing has gained prominence in recent years. According to a survey by KfW, the deal volume for debt financing reached an all-time high in 2022, exceeding 20 billion euros.

Venture debt is a form of debt financing through which startups receive capital to fund their growth. Unlike venture capital, where investors receive equity in exchange for shares in the company and thus share in the company’s success, venture debt is based on the full repayment of the borrowed capital, plus interest. The lenders are usually venture debt funds or commercial banks. Unlike with traditional bank loans, venture debt providers do not base their financing decisions on existing assets or current cash flow; instead, they evaluate a startup’s future growth prospects. This increases their investment risk. As a result, founders face high interest rates with this form of debt financing.

Crowdfunding is another financing trend that has emerged in recent years. With this method, capital is not provided by individual investors, but by a broad base of people. Founders first present their startup in order to convince as many people as possible of their idea. This is done primarily through specialized crowdfunding platforms. They set a funding goal and determine whether backers will receive a reward in the form of products or whether the contributions will be purely donations. Once founders reach their target amount, the money is disbursed to them. 

Another alternative form of financing is revenue-based financing, in which investors receive regular shares of revenue. A total amount is defined in advance. Once the investor has received this amount through payments of their revenue shares, the mutual obligations between the investor and the company end.

Conclusion

The conditions for startup funding rounds have changed in recent years: The investment climate has become strained due to factors such as geopolitical conflicts and energy crises, and the amounts invested have decreased. To still be able to convince investors and stand out from other startups, it is all the more important for founders to thoroughly prepare for funding rounds. With the onset of the interest rate turnaround in 2022, alternative forms of debt financing have also gained importance. As a precaution, startups should additionally consider these financing options so they can always adapt to changing market conditions.

The results of the German Venture Capital Barometer for the first quarter of 2024 underscore these trends: Venture capital funds’ willingness to invest declined slightly during this period. However, investor sentiment has recently rebounded moderately. Combined with expectations of an interest rate cut in the coming years, this could be an indicator that investors’ risk appetite is increasing again and that the total amount invested will rise slowly in the coming years. However, it remains unclear whether new crises will slow this development. Founders must therefore remain flexible and adaptable.