• They have a limited amount of time they can devote to looking at new opportunities because they are very busy people.
• They often receive dozens of funding requests per month. 
• Every entrepreneur has a business plan and a private placement memorandum, but the format and quality of these documents vary wildly.  There is little consistency, and as a result, it takes longer to find and digest the key information they are looking for. 
• Investment decisions are rarely made without first developing a personal level of trust with an entrepreneur.  When starting from scratch, this takes valuable time. 
• Business valuations and deal terms offered by entrepreneurs are rarely what
• After investing all the time to sort through and finally find an attractive deal and develop a level of trust with the entrepreneur, it may take another 40 hours to conduct proper due diligence on a deal. 
• Due diligence also costs money for background and credit checks, legal review and document preparation, and much more.   
• After funding a deal, the statistics for success are not encouraging.  5 out of 10 businesses invested in will fail.  4 out of 10 are likely to survive but provide little return on investment.  Only 1 deal in 10 is likely to be a home run.  That home run has to make up for all the other losses incurred, and still provide a reasonable overall return.
• A down economy adds a whole new layer of risk, as successful exits through acquisition or public offering become fewer in number.

Even with all of these challenges, accredited investors still invest in deals.  Smart entrepreneurs recognize that the key to capitalization success is making it easy for investors to address all these challenges.

How about having customers provide all the necessary capital. 

While this scenario may not be realistic for most startups or existing businesses, within the concept resides a nugget of truth that can find practical application for many companies in their approach to capital and customer acquisition. 

The primary question is: 

How lean can a company start and operate in order to attract paying customers with an early version of its products or services, thereby demonstrating viability, scalability, and fundability? 

After a business has demonstrated these characteristics, it’s a lot easier to get funding, because the investment is a lot less risky. 

This idea is not new or uncommon.  For many years 3-M has fostered a culture of intrapreneurship whereby small teams of technical and business people come together on a limited budget to develop and market new products.  Some industry experts estimate that 30% of all large companies provide seed funds to finance internal entrepreneurship today. 

Many entrepreneurs could take a page from this playbook for their own companies.  In other words, start making money from a small investment in product development and marketing, consistently improve the product based on market demand and reasonable economics, and raise growth capital after establishing a respectable product, delivery and support team, customer base, and growth plan.

One of the key elements to this lean approach is focusing on the creation of “minimum viable products,” and then building a base of paying customers.  This approach has also been around a long time.  In the automotive industry, both Honda and Hyundai came to market in the United States with cars that could easily be classified as minimum viable products.  They sold a lot of these cars at low prices, which provided revenue and a growing customer base on which they could continuously improve.  Both car companies have a much better reputation today than they originally did, and they are still going strong, even amid global economic challenges. 

During the past five years, I’ve worked with many startups that wanted to hit the market with a knockout product or service from the very beginning.  Few have achieved their fully realized vision out of the starting gate.  Many find that the perfection curve can be a real business killer for tender young companies with limited financial resources.  I’ve experienced this brand of misery firsthand with one of my own startups, and don’t recommend it to anyone!

Venture capitalists and other investors are coming around to this way of thinking again – spend less upfront to develop products and customer bases, and then fund the winners that emerge.  It’s a simple lesson with major implications.  It’s also a mindset and a strategic approach that can help you quickly and economically sift through many good business ideas to find a really great one customers love to pay for.

The New York Times also ran an article on the subject, which you can read here.

When raising money for your business, you have control over the truths you tell, and therefore the ability to earn trust from investors by demonstrating integrity.  But there is at least one truth that’s difficult for entrepreneurs and investors to candidly discuss, even though it’s a vital factor in the decision-making process of most investors. 

Investors won’t write a check to your company if they don’t like you or find you credible. 

Some may tell you to your face (particularly if you live in New England), but most will either simply stop communicating with you, or will offer a less offensive reason for not investing.  In either case, it can be difficult to know what really went wrong.

The best way to address this problem is through preparation, presentation materials that invite discussion, honesty, and humility.  Here are several tips for each of these issues that can help increase your likeability, credibility, and capital raising success.  They’re not meant to be comprehensive, but rather to point you in the right direction.

Preparation Highlights

• Be thoroughly familiar with the way you have developed the financial projections for your business.  Build your revenue model not on capturing some percentage of the market, but rather on specific activities that should result in the revenues you project.  Be conservative in your assumptions – it’s better to underpromise and overdeliver.  Find external data to show that your assumptions are reasonable.  Don’t lead with this data, but keep it handy to show if asked. 
• Identify a significant and painful problem your business will solve, be prepared to give a few “real world” examples of how your solution is or will be better than other alternatives available to customers.  You’ll always have competition, and you need to be able to convincingly explain why customers will choose your solution over those offered by competitors. 
• Be highly conversant in the “secret sauce” aspects of your business – those things that give you a significant competitive advantage.  While you won’t give the recipe to investors, they will have to get enough of a taste to validate your claims of competitive strength. 

Presentation Materials

• Your presentation materials will perform several critical functions, which include demonstrating professionalism, communicating specific information, and providing a framework for dialog. 
• Your materials should be professional in appearance and content.  Typographical and grammatical errors, sloppy formatting, and faulty data must be eliminated. 
• Investors are not the federal government, so they usually don’t want to be buried under a mountain of research and projections from entrepreneurs.  You need to say the right things in the right way in the right amount at the right time to efficiently and effectively move investors through the decision-making process. 
• Lastly, your documents should lead investors to ask you questions about those subjects they are most interested in.  If you are properly prepared, this is one of the most effective ways to demonstrate both your likeability and your credibility. 

Honesty

• The tendency for entrepreneurs is to maximize business strengths and opportunities while minimizing weaknesses or problems.  This is both naïve and dangerous when raising capital.  Investors will usually see through the smoke and mirrors, hurting your chances to get funded.  If investors let you slide on these issues and make an investment, you will likely be unable to achieve your projections, opening a whole different can of worms that can put the future of your company in jeopardy.   
• A balanced discussion of strengths and weaknesses is a far better approach.  Show that you understand the risks, know where the company is weak, and have appropriate strategies for addressing these issues. 
• If you cannot answer a question asked by an investor, don’t bluff.  They’ll know.  It’s better to recognize the validity of the question, promise to get back with an answer, and follow through on your commitment.

Humility

• Investors like smart people, not smart alecks.  So don’t act like you know it all.  Be confident, but be receptive to input.  This does not mean that you have to implement all input, but you should at least express thanks for and appropriately consider it. 
• While there are certainly some arrogant business owners, the majority of those I’ve encountered are approachable and open to the ideas and concerns of others.  In my capital raising experience, arrogance on the part of entrepreneurs is a deal breaker. 

How would you respond? 

• Smart money, of course!
• Dumb money, that’s why I’m talking to you.
• Which kind can I get from you?

The question is ridiculous, yet the issue comes up a lot.  Money is inanimate, and is neither smart nor dumb in and of itself.  The way entrepreneurs or investors manage and invest money can be smart or dumb, and this gets more to the heart of the matter.  But before delving into this issue and its implications for entrepreneurs, let’s take a quick look at some definitions. 

The term “smart money” is often used to describe investment capital from sources that also provide valuable expertise and contacts that will enable businesses to become more successful.  This sounds like a smart idea, and I believe the principle is a good one.  But the term is also used in other less useful ways, and not always explicitly.  For example, a venture capitalist or angel investor may deem their investment as smart money, and infer that others who invested in your business at an earlier stage on an informal basis provided dumb money.  

There are many elitists in the capital markets.  But ultimately this doesn’t matter, and I’ll tell you why.  I’ll also tell you what’s far more important as an entrepreneur looking for capital. 

First, many of the “smartest” financial people in the world helped create the current global economic meltdown.  And even today, whenever they talk about the future, the only truth is “we don’t really know . . .” 

Second, $18 billion (the same amount angel investors and venture capitalists each invested in 2009) was entrusted to Bernie Madoff by thousands of smart people. 

Third, let’s compare the failure rates of companies that received angel investment, those that received venture capital, and the whole gamut of U.S. start-ups that survive at least 5 years. 

 
While different studies report varying failure rates, these numbers reflect a reasonable average.  

What does the data indicate about the value of so-called smart money? 

Taken on the whole, it doesn’t seem to make much of a difference. 

So what does matter for you, the entrepreneur? 

YOU being smart. 

Here are some tips to help guide you along.  

Smart entrepreneurs surround themselves with advisors, strategic partners, board members, employees, subcontractors, customers, vendors, etc. who bring expertise and contacts to the business.  When you look at the big picture, you can get vastly more support from these resources than you are likely to get from your investors, though good participating investors can be very helpful members of your team.

Investors who are also well-known and successful figures in your industry could be very helpful, if they take an active role in supporting you.  There are many anecdotal tales of high profile experts that promised to help for a premium, but never did.  Find out how active such investors will really be for you (check their references) before you take their money.

Don’t take money from investors that are likely to become a problem for you later on.  You can conduct due diligence on them by asking to talk to the owners of other companies they invested in.   

If investors are too “smart” you could end up in a dangerous situation where they can take over your business if you don’t meet certain performances on schedule.  While this a a major concern for entrepreneurs, the reality is that it doesn’t happen very often.  Most angel investors don’t want your business, don’t have time for it, and would rather support it with help from time to time rather than taking it over.  Onerous terms and conditions proposed by an investor should flag you to perform due diligence on the investor, and talk to your trusted business advisors before committing to do a proposed deal.  This is the path of the smart entrepreneur.

Develop a strong financial model of your business built on leading indicators that will help you manage the business from the beginning of the marketing and sales cycle.  Show it to experienced advisors you trust.  Refine it until you completely believe in your ability to achieve these numbers.  Don’t start trying to raise money until after this has been accomplished.

Expect that you’ll have to do a major overhaul of your business model within a few years in order to ultimately succeed. 

Know that a smart entrepreneur can make just as much with so-called “smart money” as can be made with “dumb money.”  So focus on being a smart entrepreneur.  That’s something you have a lot more control of.

Don’t be a smart aleck, that’s not the same thing as being smart.  You’re unlikely to succeed with Tip #1 if you’re a jerk.  I’d like to be able to say that jerks are also more likely to fail, but I haven’t seen any reliable numbers on that issue yet . . .

Data Sources:

SBA Office of Advocacy FAQ updated September 2009; Kauffman Returns to Angel Investors in Groups study 2007; 2005 Sand Hill Econometrics Report by Susan Woodward; http://www.reuters.com/article/idUSTRE58Q2SE20090927; http://knowledge.wharton.upenn.edu/article.cfm?articleid=2397