Start-Up Business Investment: The Case of Mongolia

Abstract

Innovation and technology-based startups are crucial for converting knowledge into wealth and boosting economic development. Many countries are investing heavily in science, high technology, and innovation to strengthen their national innovation capacities. In Mongolia, there has been a recent increase in capacity-building initiatives and programs for startups. However, investment-related issues remain unsolved and significantly hinder the further growth of these businesses. This study aims to provide an overview of the present condition of startup businesses in Mongolia and the challenges they face. Secondary data is used to analyze the limited funding opportunities and the traditional methods used in fundraising that prevent businesses from growing. The major challenges faced by these businesses include recruiting new employees, fundraising, attracting customers and increasing sales, developing teams, developing new products and services, and penetrating the international market. To overcome these challenges, there is a need to create a legal environment that supports startup economic development and enhances the enforcement of the Law of Innovation through developing sound policy instruments. This chapter concludes by highlighting the need for sustainable funding sources for startups and the importance of establishing a supportive legal environment to ensure the smooth implementation of policies that promote startup growth in Mongolia.

1. Introduction

A start-up business is unique as it has specific features that are not common in other types of businesses like high social impact, high reliance on technology, and out-of-the-ordinary solutions that bring significant contributions to society and the economy of the countries. In the digitalized era, the development of a country can be recognized by the technology sector, the number of unicorn companies, and the startup ecosystem advancement.

Startup businesses have specifics not common in any other businesses as it brings a strong impact on society through their unique solutions based upon high technology that contributes significantly to the economic and social development of any country. It serves as a solid foundation for innovation since all activities of the business intensely deal with innovative solutions [1].

A startup is a temporary organization designed to look for a business model that is repeatable and scalable [2].

Startup businesses are most concerned with the creation of a business model that focuses on the development of innovative, unique products and services or processes, as well as businesses around the platform to bring them to the market making them desirable for the customers [3]. It has become notable in creating jobs, boosting innovation as well as competition and the financing of startup businesses grow persuasive in the economy. Financing decisions are crucial in recognizing the potentiality of the businesses to survive and prospect and risks [4].

Financial decisions generally depend on the choices available to businessmen. The potential funding is significant in the launch, survival, and expansion of any startup [5]. Raphael et al. noted that attracting investment is one of the key skills of the businessman [6].

Typically, startups require a heavy investment in the initial stage for developing new products and services and earn limited incomes as they lack expertise and additional investment to sustain the businesses. Fundraising remains the major challenge for most businesses and a key success factor. Furthermore, they make substantial efforts to differentiate their businesses from their rivals to take a better position in the market. The typical problems encounter among startups due to lack of capital and business experience. The most challenging issue among local startups is financing that has not been resolved yet and that prevents them to expand their operations.

2. Literature review

The meaning of startup is perceived as the initiation or start of any processes or activities. The terminology was used by Forbes magazine in 1976 to describe small companies with high growth potential, especially, an increase of information technology businesses in early 2000 like Dot com bubble in Silicon Valley served as the origin of the term. The technology-based competition allowed these businesses magnificently compete in the market yielding immense profits and attracting numerous angel investors. Startup businesses are developing progressively not only internet-dominated businesses but also entering through technological solutions to the industries like banking, finance, insurance, commerce, logistics, and real estate.

Therefore, for any person who pursues transferring his/her idea into a real business activity attracting funding or raising the fund is a long way to learn and experience the real world. The knowledge and skills in funding technology are getting essential ever in a rapidly transforming business environment, particularly for the younger generations who often choose a free-lance professional career path that often ends in launching new startup businesses.

The funding of startups is tricky but provides diverse alternatives that make the businesses select the most appropriate ones. To better understand the alternatives of funding, the following part will guide you to the best options that exactly meet your needs. One of the key aspects of startup development is the funding opportunity that plays a crucial part in the initial stage. The appropriateness of financing startups depends on the development stage of the businesses and the other essential aspects like return on investment, loan conditions, financial capital as well as any other types of support for the beneficiaries.

To mature, the startup businesses undergo the following stages:

2.1 Development stages of startup business

• Seed stage–Various actions are taking a place in this stage including idea development, market research, product design, development of service concepts, development of the business plan, and search for funding sources.

• Early stage—This stage is mainly devoted to experimenting with business ideas and introducing the product and service to the market.

• Mid-stage—Businesses get stabilized and operations are maintained as a result of the increase in demand for their products and services, which enables the businesses to strengthen their market position.

• Last stage—the enterprise activities are fully stabilized and turn into a mature business that seeks an opportunity to sell shares of stock to the public.

2.2 Main investment sources of startup business

One of the success factors of startup businesses is financing opportunity that is critical in any stage of development, especially acquiring adequate funding in the initial stage is indispensable. The biggest challenge for many startup businessmen remains to find the initial capital to launch the business or expand it [7].

Despite accumulating working capital, the new businesses need funding real estate, which is often solved through utilizing international funding, but in later stages, external funding is sought for the expansion [8].

Depending on the stages of the development of the startups, it is essential to consider certain conditions including return on investment, loan condition, and nonfinancial support in selecting an appropriate type of financing. Moreover, attracting the funding technology differed slightly relying on the stages of the development [9] as it is shown in the chart (Figure 1).

Figure 1.

Stages of startup business development and financing cycle. Source: [10].

2.3 First stage of the financing life cycle (seed funding/capital stage)

Seed money is a form of financial means where an investor invests capital in a startup company in exchange for equity in the company. The term seed refers to the early investment to support the business until they stay confident or survive in the market until it is ready for further investments.

In the initial stage, seed financing is required for any business to transfer the idea into the business and it is often referred to as the initial investment. Technology-related businesses with a fast pace of development usually seek an opportunity to access the current financing to boost their growth and accelerate product development [11].

Seed financing options include [12]:

• Friends and family funding,

• angel funding,

• government schemes/grants,

• bootstrapping, and

• crowdfunding

  • Self-financing: It is frequently used as a convenient financial source in the initial phase of the business as it enables the creation and development of the establishment. However, further operations necessitate additional funding to expand the scope and scale of the business. The advantage of this type of financing is the owner’s ability to monitor the company business, but the disadvantage is the lack of prospects extending their network within the professional sphere and learning the best practices and expertise.

  • Friends and family funding: Based upon the credibility of the business project family members and friends of the business person invest in the business as support. The advantages of this type of financing are skipping red tape and diverse risk assessment and criteria for funding, which are the compulsory procedure in accessing the investment, however, the amount of financing is usually sufficient for the initial stage of the newly launched business. Large involvement of personal relations likely damaging due to the business-related risks, there is no guarantee to save their investment as well as close tie.

  • Business angels: This approach has been used since the 1900s. Angel’s meaning of exemplary conduct is exactly suited for its deed for the startups that sharply need the support to survive “Valley of death” in the initial stage. Angel investors or private persons are those who typically provide insignificant sums of investment for recently established companies to assist in implementing business ideas in exchange for share capital of the future business. The angels usually have business experience and expertise in corporate management and tend to invest in the familiar business [13].

  • Government financing: Government financing for startups is motivated by two factors - creating job opportunities and fostering a favorable socio-economic environment. For instance, if a company develops an innovative process, it not only generates income for the developer but also makes it easier for other businesses to replicate and implement the same, leading to community-wide benefits. Preventing investment in such startups could hinder access to these benefits. Moreover, proponents of government financing strongly advocate for investing in startups, considering the limited funding opportunities available in the initial stage of their development [13].

  • Bootstrapping: It is a convenient option to invest with no involvement of a third party, which is called bootstrapping. In reality, it is not an easy task for establishing the foundation of the business, but rather a strategic mode of financing [14].

Bootstrapping requires the business person to possess a certain income that is sufficient for funding startups unless third-party involvement is unnecessary [15]. The advantage of the approach is to enjoy full authorization to control the business, but if the owner lacks sufficient business experience, then it will be a disadvantage in the competition.

Freear et al. identified the prevalence of the following types of bootstrapping [16]:

1. Launch of product development,

2. business accelerator, and.

3. use of own resources to reduce the external funding needs

   • Crowd-funding: The term is used since 1890 and initially, it is used for fundraising from the public. The concept remains the same except for the use of the internet platform, which widely entered daily life in the new millennium. In the present day, it is regarded as a way of raising money for financing business projects and the user himself turns into a financer. Starting from a few people or a large number of people are involved in collecting the fund via an online platform. In the case of using this approach, warranting an equal return on the invested money is more significant than the credibility of the business project [17]. Three parties are involved in this financing approach: business project initiator, the public who seek a return on their investment, and public financing organizations or businessmen, interested parties involved with the financing mechanism [18]. Crowd-funding is executed on a voluntary initiative and contributes significantly to boosting the development of innovative products. Types of the Crowdfunding:

     • Reward crowdfunding: The project initiator conducts the promotional sale of a sample of products or services to attract the funding.

     • Charity crowdfunding: Public or private challenge that is solved with aid of the public and private fundraising.

     • Equity crowdfunding: similar to the traditional stock exchange, but an institution and a person have communication on raising funds. There is an option to involve more people in this transaction.

     • Lending crowdfunding: Public fundraising in an exchange for interest payments. Moreover, P2P and small loans are considered lending crowdfunding.

2.4 Second stage of financing life cycle (early stage/growth stage)

At this stage, the following options for financing are available [10]:

• Venture capital,

• private equity, and

• strategic alliances like:

  • Joint venture

  • Mergers and acquisition

Seed money and venture capital differ in certain characteristics. Seed money involves high risk as the investors do not require a well-developed business project proposal like in venture capital funding or significantly vary in the sums of investment they provide to the beneficiaries, while in seed funding only a small sum of money is invested to the new businesses as against venture capital investment can invest heavily and as a result, the risks associated with funding the businesses are different.

• Venture capital: it is a convenient financing mode that is used in the early stage of startups to support the current business operations that have been believed to their future growth potential in exchange for equity. It is a risky decision for venture capitalists to invest the new businesses with the hope that they will succeed in the future. The difference between venture capital and loan investment is that one does not require collateral like real estate and liquid assets. Businesses prefer accessing venture capital when traditional financial institutions reject financing the companies due to the risks. Investment in new companies that do not qualify for the loan criteria involves high risks for the investors and venture capital funds, but the return is high. The sources can be pensioning funds, insurance funds, company assets, private savings, and investors and public assets. Venture capital can be obtained at any stage of business development. The goal of the venture capitalist is to support the growth of the company with the investment and obtain a return through an initial public offering and trading. Moreover, the investors are most interested in businesses that have promising growth in a short period, subsequently, they necessitate the beneficiaries to have professionally developed business plans.

• Private equity (PEs): This means of investment remains popular in the financial market for more than three decades and it has grown fast in recent years due to technological innovation. It became one of the frequently used financial means for startup business funding in recent years. PEs primarily invest in mature companies using a method known as Leveraged Buyout (LBO). LBOs acquire companies by specialized investment firms with relatively small stakes and relatively large foreign debt funds [19, 20]. It refers to the investment partnership that buys and manages companies to sell them after they increase their value. Private equity firms manage the investment funds for the beneficiary institution and investors. Moreover, they invest in the fast-growing promising startup business with limited sums having a deemed to earn returns in the future. Private equity collaborates with venture capital and hedge funds as an alternative investment. The requirements for the lenders to access such capital are accessible to only successful businesses with long business history.

• Strategic alliances: Agreements to cooperate in the manufacturing, development, or sale of products and services or other business objectives involving a minimum of two independent businesses. There are three types of strategic alliances: joint venture, equity strategic alliance, and non-equity strategic alliance.

• Joint Venture: For completion of new business projects or other business activities, the interested parties pool the resources in the current alliance. The parties are responsible for profits, losses, and costs associated with the activities. However, the venture is its entity, separate from the participants’ other business interests. A joint venture is established when the parent companies establish a new child company.

• Mergers and acquisitions: M&A have been a key in leveraged finance. There are three types of acquisition loans:

  • Leveraged buyouts: LBOs are backed by a private equity firm that funds the transaction with a significant amount of debt in the form of leveraged loans, mezzanine finance, high-yield bonds, and/or seller notes. Stronger markets usually allow for higher leverage.

  • Platform acquisitions: These are transactions in which private-equity-backed issuers buy a business having a deem that it will gradually lead to growth.

  • Strategic acquisitions: Strategic acquirers are usually corporations in the same or a related industry segment as the target company, allowing the buyer to leverage its expertise in the segment.

2.5 Third stage of financing life cycle (mid-stage/mezzanine Stage)

In the current stage, businesses reach their break-even levels and overcome the challenges in their path. Despite alternative funding, the new opportunity can be debt financing.

Debt financing: Debt financing refers to borrowing funds from creditors with the condition of repaying the borrowed funds including interest at a specified future time. The creditors benefit interests for the lending fund from the borrowers. Two types of debt financing are practiced including secured and unsecured. The secured debt has collateral but unsecured does not require collateral, which makes the creditor insecure to a certain degree if the lender fails to meet his financial obligation. By time frame, it can be long-term and short-term funding depending on the business needs.

There are various types of debt financing [10]:

• Term loans: Given for medium to long-term periods.

• Banks and other financial institutions

• Non-banking financial corporations (NBFCs)

• Loans from government/financial institutions.

• Loans for working capital

• Bank overdraft facility

• Short-term loans

  Term loans: A loan with term installments, is usually a short-term loan that is settled by installments. There are two principal types of term loans:

  • An amortizing term loan: A loan with a progressive repayment schedule that typically runs 6 years or less.

  • An institutional term loan (TLB, TLC, TLD, etc.) is a term loan for non-bank investors. This institutional category also includes second-lien loans and covenant-lite loans

• Banks and other financial institutions: Banks prefer to reduce their risk by requiring collateral from the lenders. Lack of record of reliable information or track on previous loan history, or outstanding debt of the lender prevents banks from financing startups and newly established businesses.

• A financial institution (FI) is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, and currency exchange. Various types of institutions are included under the umbrella of financial institutions including banks, trust companies, insurance companies, brokerage firms, and investment dealers, which are mainly engaged in the provision of financial services.

• Non-banking financial corporations (NBFCs) loans: The concept of microfinance involves small-scale entrepreneurs who are incapable of accessing bank loans or capital. Therefore, borrowers with poor credit ratings approach to NBCFs whenever they get rejection by banks.

• Loans for working capital: A working capital loan is a loan that is taken to finance a company’s everyday operations including payroll, rent, and debt payments. The borrowers cannot use the loan for purchasing assets.

• Business Overdrafts: It is a convenient payment option that enables businesses to settle their expenses having insufficient balance. The disadvantage of this funding is high-interest rates over conventional loans.

• Short-term loans: This loan is for supporting a temporary personal and business need and usually in a shorter term within a year.

2.6 Fourth stage of financing life cycle (last stage/public offering stage)

The last stage is where the business has grown to a high level and needs funds for its future projects. Sources of finance are [10]:

• Initial public offering (IPO)

• Follow on public offer (FPO)

• Right issue of share

  • Initial public offering (IPO): An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors [21] and usually also to individual investors [22]. An IPO is typically underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Discounted cash flow (DCF) analysis and comparable firms’ analysis can be used and a preliminary valuation may rely heavily on how the market is valuing comparable firms. In some cases, publicly-traded firms in the same line of business are easy to find. In other cases, it may be difficult to find publicly-traded “pure plays” to use for valuation purposes [23].

  • Follow-on public offer (FPO): Follow-on public offer refers to the issuing of shares to financial specialists by an organization that has been as of now recorded on trade [24]. FPO is a stock issue of supplementary shares made by an organization that has been now freely recorded and has experienced the IPO process. FPOs are known as a popular method for companies to raise additional value capital in the capital markets through a stock issue. Open organizations as a rule exploit FPO issuing, an offer available to be purchased by financial specialists, which is made through an offer document. FPOs and IPO are different one should not be confused between them as IPOs are the initial public offering of equity to the public while FPOs are supplementary issues made after a company has been established on an exchange.

  • Right issue of share: Offer of securities by a listed company to those who are shareholders of the company as on the record date fixed for the said rights issue. Rights issues give existing shareholders the option of purchasing new shares, normally issued at a discount to the prevailing market price to encourage participation in the capital raised over purchasing shares in the market.

Startup businesses need to identify the appropriate type of financing to prevent themselves from the risks associated with funding options as the necessity is compelling over rationality. The more the entrepreneurs are aware of the advantages and disadvantages of the funding options, the sounder funding decisions will result. Although time is always a scarce resource that makes everyone rush with no limit, going forward and backward learning the pros and cons will pay you double in the future.

3. Research results

3.1 Funding background of the startups in Mongolia

It is not a long time passed since startup businesses were introduced in the country and investment policies and legal frameworks for strengthening this type of business are far from accomplished. Even though, we have an opportunity to make a shortcut using the best practices of the countries who survived the hardships in strengthening the startup ecosystems.

According to the Startup Blink Global startup ecosystem index 2022, Mongolia is ranked 81 globally out of 100 best, increasing seven spots since 2021.

Ulaanbaatar is ranked 491 globally and showed a positive momentum increasing 19 spots since 2021. It also ranked 472 out of 1000 cities [25].

START has significance for venture builder as it contributes to creating startups and accelerating their growth. The startup ecosystem map is prepared annually for the public to promote and support the startup ecosystem (https://startco.mn).

The other stakeholders of the ecosystem are divided into 15 categories including accelerator programs, events, nongovernmental organizations, entrepreneurs, and investors (Figure 2).

Figure 2.

Map of startup ecosystem of Mongolia. Source: https://startupnews.mn/2022/03/30/startupmap2022.

In the map of the startup ecosystem 2022, 109 startup businesses in 19 clusters are presented by the multi factors including social impact solutions, business model, team structure, work methods, ethics of the founders, technological solutions, and dynamic features (Figure 3).

Figure 3.

Sectors startup businesses operate in the businesses included in the map. Source: https://startupnews.mn/2022/03/30/startupmap2022.

The ecosystem of the startups is comparatively immature, approximately 63% of the businesses are set up in the past 3 years. The technology-based companies are improving recently. Particularly, the pandemic served to the expansion of the digital economy and business environment, although no improvements were observed in the ecosystem of startups operation in other sectors. The reasons behind the holdup serve as a lack of envisioning and attitude that creates the ecosystem. Because of that, the expectations of investors and technology startups differ. The main setbacks for most startups are hiring new employees, fundraising, attracting customers, boosting sales, team development, and penetration of the international market via developing irresistible products and services.

3.2 Startup business financing condition in Mongolia

Recently numerous programs have been implemented to build the capacity of startup companies. The survey on the startups indicates that the total revenue of MNT 60 billion and 1318 jobs contributed to the economy [26].

Despite the progress, insufficient funding of the startups remains unsolved and it serves as the major challenge for further success.

Seed funding: In the initial stage, the founders launch and maintain their business operations with heavy internal investments like personal savings, support from family, friends, local angel investors, and other business incomes. A baseline study of the Mongolia startup ecosystem conducted in 2022 shows that 11.3% of the initial funding is made up of the project grant and 6.3% comprises accelerators, incubators, and loans. The local venture funds and international angels are less interested in the initial funding and only 3% of the funding is comprised of this type of financing (Figure 4).

Figure 4.

Initial funding sources of the Mongolian startups. Source: Baseline survey of the Mongolia startup ecosystem, 2022.

Follow-on funding: Enterprise venture funds, international venture companies, and crowdfunding platforms are available for local startups in follow-on funding in Mongolia. Major investment companies like MCS Investment, Shunkhlai, and TECO are getting influential players in the market (Figure 5).

Figure 5.

Follow on funding sources of startups in Mongolia. Source: Baseline survey of the Mongolia start-up ecosystem, 2022.

The typical challenges that prevail among local startups are the lack of skilled human resources and funding. According to the study, the most challenging issues for startups include investment funds (61%), improved tax regulations (54%), subsidies/grants (40%), intellectual property and regulations to protect innovations (39%), and loans (31%). Moreover, the most expected support for the startups was accessing incubators/startups (20%), innovation hubs (13%), co-working spaces (11%), and awards (8%) [26].

In sustaining the national startup ecosystem, hiring and retention of highly qualified professionals to contribute to the businesses are the utmost priority for the novel businesses. Hence, education reform in science, technology, engineering, and mathematics (STEM) is the highest priority of the education sector to the resource with competent professionals who can support the innovation.

Although an increase of local angel investors supporting startups observed in recent years, at any stage of the development of the startups, personal savings, family, friends, other business income, and project grants and bank loans remain the major funding sources. The government may serve as the major player in attracting foreign investors. Moreover, there is an opportunity for developing the startup ecosystem based on the experience and expertise of the private sector.

3.3 The legal environment for startup business

It is essential to construct a favorable legal environment that encourages attracting investment and capital growth for startups. There is a need for a legal framework that ensures the protection of copyrights and the rights of startup businessmen. Furthermore, social infrastructure, collaboration, and political and legal environment-related concerns remain to hinder the startup ecosystem in the country. The baseline study conducted in 2022 concluded the establishment of the economic and legal environment in the startup ecosystem of Mongolia.

4. Conclusion and discussion

It has not been a long time since startup businesses were introduced in our country and numerous questions remain unsolved effusively in terms of investment policy and the legal environment. Nevertheless, there is an opportunity not to recurrence slip-ups of startup businesses in different countries. It creates noteworthy contributions in developing startup businesses in the country, increasing productivity, creating jobs, and boosting the country’s economy.

According to the research, we identified the following findings:

• The initial investment sources of startups in Mongolia are personal savings (73.8%), family members and friends (25%), and other business sources (17.5%). Although an increase in the interest in the funding of startups among angels, still personal savings, family and friends’ investments, and other sources like financing with the other business’s income, project funding, and bank loans still remain dominant.

• Recruitment of new employees, fundraising, attracting customers and increasing sales, developing teams, penetrating into the international market, and developing products and services are the main challenge for startups.

• Business operation-related challenges among startups are poor production equipment (29.4%), human resources (23.5%), insufficient current assets (20.5%), and missing business planning and formulation of future aspirations (14.7%). It reveals that there is a need for professional consulting and support for the startups to build capacity among startups businesses and the involvement of professional association and business initiatives to support startups still remain vital for them. Additionally, the study shows that providing quality education that nurtures the knowledge and skills to develop business mindsets remains essential.

• Constructing the legal environment that supports economic development and enforcement of the Law of Innovation through the development of policy documents as well as legal instruments the enforcement.

Promotion of the startups through financial and nonfinancial support and advocating their activities especially, those who introduced innovative approaches of financing as well as the investors who contributed to the progress of startups will have a substantial impact. The participation of large local companies in a solution of the startup business investment and care of the implementation mechanisms of this type of business could be the potential solutions to address the challenges.

The study has limitations as it has relied on secondary data. We admit that there is a need for research based on primary data that will be beneficial to fully address the challenges that prevail in the businesses and have practical significance for the stakeholders of the startup businesses. Moreover, a comparative study will be significant for businesses to better learn about the startup opportunities and challenges that exist within startups around the world.