Experts in product development will tell you to understand your user.
Some people are naturals at this, most have to learn. Raising money is
no different. Some people understand it intuitively, but most aren't so
lucky. Learning what investors care about and how they think is critical
to knowing when and how to fundraise for your venture.
As an entrepreneur, you are thinking about the upside, opportunity,
and the excitement. Rightfully so, as thinking about these things will
carry you through the "valleys of death" that may open up in front of
you on your entrepreneurial journey.
Investors also care about these things, but only because they want to
answer a yes/no question: does the startup in front of me present a big
enough opportunity to consider investing? Investors know startups are
inherently high-risk, and a high-risk investment darn well better have
the potential for a very large return.
So, assuming you can clearly articulate to the investor that your
venture has the potential of a high return, the investor now begins to
analyze the risks. Here are the types of risks they consider:
The foundation of any venture is the team
behind it. If the team is not the right team, then the venture will
fail. The right team starts with a founder who investors believe has the
qualities necessary to navigate through the challenges of a
fast-evolving product, organization, and market. Core and extended team
skills and experience are evaluated to create a perceived risk profile
of the team. Having a complete core team with all the relevant skills
and experience is the best way to mitigate this risk. Surrounding your
core team with an extended team of high-quality mentors and advisors is
also helpful in reducing team risk.
Your team may have members with the
right skills and experience, but there is still a risk that you can't
work together effectively, that some needed skill is missing, or that
something doesn't gel; and then your startup fizzles. The best method to
reduce your execution risk in the eyes of an investor is to get things
done. Planning is not good enough - building a prototype or launching a
basic version of your product are both great ways demonstrate that your
team can execute.
One Risk to rule them all, One Risk to find them,
One Risk to bring them all and in the darkness bind them.
Reducing market risk trumps all. If you can demonstrate that people
are using or buying your product, then investors will overlook many
minor and sometimes major blemishes and weaknesses that a startup
appears to have. And that makes sense, because if you have customers, or
if you have significant usage, then you've shown that you can build
something that people want. (Side note: If your company is in a highly
regulated industry, then eliminating the regulatory risk that your
company faces is akin to reducing market risk.)
Intellectual property is
often a red herring that startups can be lured into. Companies without
significant IP risk should avoid being dragged down a rabbit hole by
investors who use IP concerns to delay or compound commitment decisions.
But some companies really do have significant IP risk and founders will
be far more credible with prospective investors if it’s clear that they
understand and have taken steps to reduce those risks.
I've found the framework above to be a useful way for startups to
catalogue and understand their risk profile from the perspective of
investors. Once assessed, a startup--sometimes in conjunction with their
lead investor--can create a plan that mitigates risks and increases
their attractiveness to investors, as well as their valuation (because
reduced risk translates directly into higher valuations, but that's a
topic for another time).
Understanding how investors think is an important step in preparing
to raise funds. The process of understanding your risks may seem
obvious, but too often I meet founders who don’t work to understand and
mitigate their risks, and as a result, lose precious time, momentum, and
often burn warm leads. Know thyself and thy company, and you can avoid
many of the pitfalls of fundraising.
Owen Johnson is a co-founder and managing partner of Betaspring. You can find this post, as well as other content on the Betaspring blog located here. You can also follow Owen on Twitter (@owenjohnson) by clicking here.