These are the risks of the cash flood for the German start-up scene

A lot of money is currently flowing into German start-ups. That's not always a good thing, writes Bettina Engert.

At the moment, reports of record investments are pouring in. According to PitchBook, just under 80 billion flowed into Europe's start-ups last year in almost 8000 financing rounds. This increasingly includes generalists with deep pockets such as the notorious Tiger Global or those from Silicon Valley. In Germany, too, startups are currently being showered with almost unlimited capital.

Why? Interest rates remain at record lows, inflation is rising, and the digital and technology sector is currently the only area of the global economy that continues to grow and promises corresponding returns. More and more money is therefore flowing into venture capitalists, who in turn are competing to invest this money in the best ideas. Politicians praise great conditions for founders and Germany as a location for innovation. But is that true?

According to statistics, the number of VC-affiliated start-ups in Germany remains surprisingly constant, despite countless funding programs and the reported record sums. In other words, more and more money is flowing in, but despite the founder-friendly climate, this does not necessarily mean that more innovative companies are being created. A comparison with other countries also shows that Germany's high-tech exports have stagnated: Germany's high-tech exports are stagnating, and China has been outpacing the former inventor nation for two decades. Many argue with structural problems, a lack of growth capital from Europe for the really big rounds, but is even more capital really the solution?

The disadvantages of "higher, faster, further"

The fact is that unicorns - private companies with rapid growth and at least one billion in valuation - are currently multiplying faster than corona variants. By way of comparison, there were just 80 of these mythical creatures worldwide in 2015. In 2021, there were already more than 1000, 26 of them in Germany, twice as many as in the year before(Statista 2021). In the flood of records, when potential unicorns line up one after the other, the observer quickly loses track. The situation is similar for one or the other financier.

Due to the competition for the best investments, new power relationships have emerged. Meanwhile, the investor pitches to the start-up to be allowed to invest money. Founders like to put pressure on the timeline and VCs with absurd deadlines for the term sheet - i.e. the framework conditions offered. In order not to miss anything, VCs are making investment decisions faster and faster and sometimes completely remotely.

However, if the principle of "higher, faster, further" applies in financing rounds, the quality of the due diligence, i.e. the heart-and-soul examination of the business model, the market and the operating team, suffers. If it has to be done quickly, because otherwise another VC will get a chance, this is simply outsourced.

The higher the round, the higher the dilution.

The result: VCs know less and less about the companies in which they invest more and more money. Never met the founders and team? Doesn't matter, the main thing is to be there.

Conversely, this also applies to the start-ups that opt exclusively for the financier with the deepest pockets and the highest valuation.

With the prospect of a windfall, it's easy to forget that the higher the round, the higher the "dilution," meaning that the founder loses more and more shares and thus co-determination in his own company. Some people don't see a problem here - in the end, it doesn't matter who owns the thing on paper, as long as the idea is good - but similar to taking away piece by piece from your own home, the motivation to add a conservatory here also decreases, right? Especially in the early phases, the founder is usually the best owner. The more shares he/she loses, the lower is, according to experience, also the self-motivation to really push the company further.

Lack of substance and "natural selection" by the public market

Another disadvantage of the seemingly infinite availability of capital is that even highly loss-making business models without a unique selling proposition are promoted. These burn extremely large amounts of money in the fight for market share already in very early phases and not infrequently lack a concrete plan of how this should change after scaling. But if the substance of the business model is missing, the hyped startups are then brought back down to earth quite hard at the latest during the IPO. So natural selection in the public market - and alienated small investors.

It is said that the same thing happened during the financial crisis in 2008 and the dotcom bubble in 1999. But these are just the stories of veterans. Hardly any of the decision-makers - neither on the founders' nor on the investors' side - were of business age at that time.

Board meetings with peers nodding in agreement may be more relaxed - because criticism is seldom comfortable - but then there is also a lack of experience and the necessary overview when things don't go so smoothly.

Like child stars in Hollywood - when start-ups lose focus

"So what?" says the start-up spoiled by success on the financing wave. Different times, no crash in sight, the local ecosystem has simply grown up. More startups attract more capital and consequently higher valuations. Besides, my idea is worth the money, many think. But this is wrong.

Because as a result, some startups in a gold rush but also raise more capital far too early than they actually need. The maxim "a lot goes a long way" then usually comes at the expense of healthy growth and innovative ability. Comparable to child stars in Hollywood who later sink into the drug swamp, start-ups quickly lose their focus, take short cuts in scaling and take on risks in the early phase that they are simply not yet up to as an organization. If the perspective for the long-term development of the company is also missing, the consequence is that many - initially good start-up ideas - are soon on the brink of extinction again, despite record financing.

The good news at the end

Of course, the current windfall also brings many advantages. The shift in power means that founders are no longer in the position of supplicants. This means that VCs also have to think again about how they can create concrete and long-term value in the start-up process. There is also finally European capital for high-risk bets in the technology sector, i.e. future topics that investors in Germany and Europe would have given a wide berth to a few years ago (cue Isar Aerospace, Lilium, Volocopter and Co.).

It is now up to the start-up ecosystem to make the most of this windfall. We have it in our own hands.