A new legal form for startups, an English focus and an EU-wide business framework – what we need for startups to succeed

Europe
Europe

According to the directors of the programme “European Digital Agenda” at the Berlin think tank stiftung neue verantwortung, Germany has a while to go before it can become a startup haven. Read on to discover what steps they think need to be taken to give German startups the edge they need to truly compete internationally…

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We’ve been hearing the mantra that Germany needs a culture of entrepreneurship for years now. The coalition treaty of the newly formed German government – which sets the agenda for the years ahead – focuses on founding new businesses. It also praises the German government’s investment arm High Tech Gründerfonds as an effective tool to help tech startups get seed funding. The treaty also announced the new government’s intention to make German tax laws in regards to VC internationally competitive.

Both points are important. But a startup agenda must be more comprehensive – Germany needs more people to start businesses, no doubt. But without a broader approach, which also puts an emphasis on growth and internationalisation, chances of success are slim. Thousands of new startups doesn’t mean much if none become viable businesses.

What German startups need to succeed

We need to develop concrete policy proposals that go beyond cheap political rhetoric. Too often, the government focuses on what it can do rather than what startups really need. The point is not to find new tasks for the government, but to identify the obstacles that prevent startups from growing. Such an analysis will either lead to specific policy proposals or provide us with greater understanding of the market forces that are better left alone.

It is a huge challenge for the government to determine where and how to intervene as well as when to leave the market to itself. You can only tackle this challenge if you not only talk to startups, but also engage with the startup ecosystem as a whole and include investors, social entrepreneurs, legal experts, and established companies in this discussion. This is exactly the approach we took when we brought together different stakeholders in the Forum Digitale Agenda. The Forum is a multi-stakeholder group of technology policy experts that we host at our think-tank, the stiftung neue verantwortung in Berlin.

Together, we discussed how we can improve the ecosystem for startups. The result is our Startup Agenda, which provides government officials with concrete policy recommendations. It is a starting point for practical steps that can be taken right away, with growth and internationalisation as the main themes. The core of our proposal presents a new idea to create a legal category for startups that exempts them from inhibiting regulations and provides them with new incentives and opportunities for growth.

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We have taken the regulatory framework for VC as our starting point. It is the grease that oils the startup-sector. New businesses can neither get started nor grow without it. Regarding their opportunities for growth, many entrepreneurs struggle with regulations that make sense for large corporations but have discriminating effects on startups. For example, German tax law makes it difficult for startups to take advantage of loss carryforwards, which make it possible to count current losses against future profits on tax returns. The law restricts loss carryforwards when large shares of the ownership are transferred to third parties. Startups usually produce large losses and typically have an exit, in which large parts of the ownership are transferred. Startups should be exempted from restrictions on loss carryforwards when investors buy a large share of the company so that they can also benefit from this important tax regulation.

A new legal category for startups

Another example. Sometimes startups are not financed through equity investments, but by loans – in particular convertible loans. Under a convertible loan, the lender is entitled to convert its repayment and interest claim into shares at a certain ratio. When converting, the lender is “waiving” his claims for repayment and interest, getting the shares in return. However, in the event the startup would not be able to repay the loan at the moment of conversion, the nominal amount of the loan is taxed as a gain for the company. Since the startup lacks the means to repay the loan, it probably also lacks the means to pay such a tax bill and becomes insolvent. This is clearly counterproductive. The investor has simply chosen a different way to finance the startup. He later waives his claims and gets equity in return, resulting in a tax burden that would not have occurred if the investor had invested in equity immediately.

These regulations fulfil important purposes. They are supposed to prevent abuses of the tax system by large companies. This is why we are not calling for their abolition. Instead, we’re calling for the creation of a unique legal category for startups. As long as new businesses meet the criteria of a startup, they would be exempt from regulations such as those outlined above. When a company no longer fits the characteristics of startups – such as small size coupled with high growth – the exemptions, as well as other regulations designed with the needs of startups in mind, no longer apply.

The introduction of what we call a “startup phase” into corporate law would be proof that German policy makers understand the unique challenges and risks that distinguish startups from large companies. Our proposal does not even mean that the German government will have to forego tax revenues. If the introduction of a “start-phase” translates into higher survival and growth rates among startups, tax collections are more likely to increase than decrease in the long run.

A second major point is growth beyond Germany. Sustainable growth is impossible to achieve without internationalisation. We thus need a policy approach which also takes into account international growth potential for startups in Germany. Attracting more international attention to the startup scene in Germany is a good start. But it is hardly sufficient. In addition, German local and state governments need to offer more English-language information and services in order to make it easier for foreign investors, entrepreneurs and engineers to come to Germany.

An EU-wide business framework

Along with language barriers, different regulatory frameworks pose great challenges for German startups that are keen to expand quickly within the EU. We need a single framework for how to set up and register a business across the entire EU. The EU is a great marketplace for German startups, but we are still far from realising its full potential. Basic common standards such as an EU-wide framework for data processing and protection would decrease uncertainties and costs for German startups seeking to expand their business across Europe.

Better conditions for EU-wide expansion would make German and other European startups more attractive for foreign investors. Better growth opportunities would also help to prepare German startups for the US market. In the end, success in the US is still the gold standard for global competitiveness. Only those startups that survive the fierce competition for capital, clients, and technology in the US can aspire to become global players. From this perspective, the ability of German startups to internationalise would also benefit from a transatlantic trade and investment partnership, if it makes investments in European tech companies more attractive for US VCs and lowers market entry barriers to the US for European businesses.

Startup is the new buzzword. The potential of startups as engines for growth and innovation is undisputed. The ICT industry is one of the few sectors in the European economy with significant growth rates. But the government needs to act so that the potential can be fully realised. This requires that government officials seriously study and seek to understand the startup ecosystem. Based on a comprehensive analysis of the problems, the needs for action can be identified and policy solutions can be developed. Our startup agenda provides a valuable starting point for this process. If German government officials take this advice, startups will thrive and, with them, the German economy.

To read the full report, click here.

Image credit: Attribution Some rights reserved by woodleywonderwork

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