State finance

Main methods of startup funding used in European countries and their features

There is no European central register of startup businesses and national registries commonly do not consider the degree of innovativeness, the aim to grow, or the sources of financing during the business creation. This makes it difficult to find data on these specific types of businesses.
Access to finance for small businesses has long been a point of contention among economists and researchers. Although there are no precise definitions for what constitutes a startup, various metrics such as the number of employees, annual sales, and net profit are some of the dimensions that can help distinguish between large and small startup firms. Startup businesses can be divided into two categories.
The first form of startup is defined in the "Entrepreneur" scenario, which "describes a person who thinks, reasons, and acts to turn ideas into commercial opportunities and create value." This phenomenon refers to the stage of the firm lifecycle just before the birth or startup stage, where the owner prepares to transform an idea into a lucrative opportunity by deciding to start a firm. On the other side, the second type explains the startup firms which are already carrying their operations and are in their working phase; however, they are yet to achieve the status of a small developed and operating firm.
Various types of funding solutions are available for startups at various stages of the firm's life cycle. The financing styles are determined by the startup's level of growth from the first to the last stages of the firm's life cycle, as well as their growth and output size. Since various types of financing are used at different stages of a company's life cycle. These types are classified as followings: Seed financing, Startup financing, First round financing, Second round and Mezzanine finance. The importance of the types of financing can be explained by the findings that about 23.7% of startup firms disappear within the first 2 years and further 52.7% are vanished in a time span of 4 years and the major reasons behind their failure are the bankruptcy, owner’s health, and access to financing options.¹⁹ For any firm in the startup stage it is necessary to make sure the availability of finance exists in order to meet the initial needs by the entrepreneurs. In the initial stages when an entrepreneur decides to convert an idea into a business opportunity, he/she might lack financial resources to cover up the requirements. At that point, Seed financing is required in order to help the entrepreneur to develop the business concept. It is important for both types of startups. It comes under the category of the insider financing, where needs for finance are fulfilled by the startup team comprising of entrepreneur’s own assets together with finance from the family, friends and colleagues. Seed financing stage investing is important for the good beginning of the startups. However once the initial phase is successfully reached, Startup financing is deployed in order to meet financing needs of the entrepreneur. Like the seed financing, startup financing is also important for both types of startup.
Funds are needed for a startup firm to progress from an existing market opportunity to the initial stage of development and sales. Significant sources of this form of funding include "Business Angels" and "Venture Capitalists." Another form of funding is first-round financing, which is essential for the second type of entrepreneurs to determine whether or not they can survive in their lifecycle. By definition, a first round is formal, and equity is given externally to cover shortfalls in necessary funding for startups to meet their expenses. Making sure the availability of first round finance, the options include commercial banks, suppliers and customer, and grants from the governments.
The main sources of startup financing are:
Owners’ Capital. When the opportunities for external funding are small for start-up companies in their early stages, owner's capital is viewed as "Seed financing." It is regarded as the most important source of funding for new businesses. Owner capital, which includes owner's equity, loans, and credit cards, is a type of insider financing that is the most common source of informal finance for startups. Finance from family members, colleagues, and associates of the firm are the most common sources of insider finance.
Insider finance refers to funds raised by the startup team, which includes the owner's family, associates, relatives, and coworkers. Insider financing is a viable choice for startups because they lack collateral and a track record. Because of their uncertain future prospects, startups have a hard time securing external financing and signalling their creditworthiness. However, the amount of owner's capital may be questioned; this may be justified by the fact that the owner may use some of the retained earnings to fund their startup venture. However, in the majority of cases, especially for startups that are still relatively new and therefore unable to reap any income, they turn to insider finance. Furthermore, outside sources are hesitant to provide funding during the early stages of a startup's growth unless the entrepreneur can effectively demonstrate to investors that there is a profitable opportunity. If an opportunity has been identified and taken advantage of, funding for startups becomes available.
Banks. After owner's money, banks are the most well-known sources of funding for startup companies. Banks are financial institutions that lend money to all types of businesses, regardless of their size. Banks play a major role in any bank-based system in facilitating the movement of money between different investors and organizations, as well as the surplus cash that they need.
Countries with a bank-based financial system have very large banks that are active in the strategic decision-making of the sector and have a major role in monitoring companies. Banking finance is crucial for startup companies because they seldom receive long-term debt or equity, and they must rely on bank credit as a major source of finance because they obtain much of their external capital from the entrepreneur's own funds, as well as informal investors such as family members, associates, and colleagues.²⁰
The decision to use banking finance by a startup depends on a variety of factors, including time period, credit availability, degree of intervention, and supervision, all of which differ from one company to the next. Since the financial situation of startup firms appears to be very opaque to investors, it is critical for them to rely on bank financing. Without the involvement of a financial intermediary firm like the banks, it is too expensive for investors to obtain information in order to offer credit to startup firms.
As a result, banks play an important role as traditional financial intermediaries, solving problems for startup firms by generating knowledge about them and setting loan contract terms to increase the startup firms' incentives. Obtaining bank finance opens up many opportunities for a startup company seeking funding, as banks offer a variety of financing options such as credit trade, low interest loans, interest-free loans, lower transaction costs, cover against credit crunches, and credit risk insurance.
Banks support startup companies by renegotiating contracts and diversifying risks through a number of small business credits while they are experiencing financial difficulties. Banks act to form long-term relationships with startup firms, and as the working relationship between the two matures, it results in lower interest rates and less collateral requirements in terms of more financial assistance. Banks, on the other hand, may impose "migration restrictions" on these startups to prevent them from turning to other sources of funding.
Furthermore, banks ensure that funding is available to startup companies on a continuous basis, with no interruptions or discontinuities. Another benefit of using banking finance is that it needs fewer oversight and control rights than other types of financing. They are not interested in the ownership of the firms.
Angel Investors. It is important for a start-up company to seek out readily available sources of capital. Angel finance, unlike the conventional financial industry, is an unregulated market for direct financing in which individuals can invest directly in small businesses or start-ups via an equity contract. Angel investors are affluent people who act as informal or private investors, providing venture capital to small business startups. As the name implies, angel investors are high-net-worth individuals, and the amount they wish to invest in small businesses is usually the same as the amount needed by the business.²¹ The amount of money given by angel investors varies by person and is determined by the firm's need. The majority of contracts between business angels and entrepreneurs are drafted with the protection of their investment in mind. It is the contract that outlines both parties' rights and responsibilities in terms of who will do what and when. The primary goal is to balance the owner's and investors' incentives based on results and control measures.
According to the National survey for small company financing conducted in 1993, angel investors funded an estimated 3.59 percent of small businesses in the United States. Though it may seem insignificant, angel investors are high-net-worth individuals who provide direct financing to start-up companies in their early stages.
Angel investors and small start-up companies interacting is a fascinating phenomenon. Qualified angel investors will look through the data of startup companies to find the one that attracts them. The angel investors and entrepreneurs are then seated at a table to negotiate investment opportunities as well as terms and policies of engagement.
Business angels not only offer financial assistance to start-up companies, but also “human capital” in the form of skills and competencies to assist newly formed start-ups as well as existing small businesses in various scenarios.
Venture Capital. Moving on to other sources of funding, venture capital is another important consideration in this group. For high-tech companies, venture capital is the primary source of funding (both small and large).²² Venture capital is a form of investment capital made available by venture capitalists to companies in the early stages of their growth, which often entails a high risk of complete loss or failure.
Individuals who join informal and organized companies (startups) in order to raise and allocate venture capital to new and rapidly expanding new projects and business opportunities are known as venture capitalists. The majority of venture capitalists tend to invest in startups in order to help them compensate for their initial negative cash flows and fund their expansion plans. As a result of the increased scale of production and turnover, startup companies need additional funding in the early stages of their growth.²³
The literature offers an overview of venture capitalists' funding priorities by discussing the types of industries in which they invest. Despite the fact that venture capital is available for startup businesses in the form of pension funds, trusts, private investors, and joint ventures between small and large businesses, venture capitalists prefer to invest in small businesses. As compared to the pre-startup process, when owner capital and banks are the primary sources of finance, startups have a better chance of obtaining venture capital once they are founded.
Trade Credit. It is an additional source of funding for entrepreneurs that is mostly focused on personal relationships. As the company expands, it may become less reliant on informal sources of funding and more reliant on formal sources. Since it is available later in the firm lifecycle, it can be another source of funding for the second form of startups mentioned in this article. Trade credit becomes an essential source of working capital as the startup progresses through the phases of the firm lifecycle. Trade credit is primarily provided by banks.²⁴ The accounts payable at the end of the previous year are used to calculate it. For startups, a small amount of trade credit is sufficient in terms of transaction costs, liquidity, and cash management.
Another form of “asset-backed” financing is leasing. Apart from trade credit, it is another formal type of external financing option. Lease finance is a more refined type of financing that is uncommon in low-income countries. Leasing is the process of a landlord or lessor buying a fixed asset.²⁵ It is a popular way for banks and leasing companies to finance equipment and real estate in many countries. After buying the fixed asset, the borrower enters into a rental agreement with the provider, which defines the payment schedule. In certain contracts, there is a risk that the borrower will be able to buy the asset at a pre-determined price at the end of the contract. Overall, startup founders choose the appropriate source based on their company's level, short-term objectives, and form of market.