5 things entrepreneurs should think about when seeking investment
Seeking investment is a constant battle for the entrepreneur. But if it’s the first time, the entrepreneur needs to work on finding answers to some crucial questions like what about the business makes it attractive to an investor. What scares an investor away? What should be in place in order to make the business attractive for investment? In considering these issues, I have prepared five basic guidelines that an entrepreneur should keep in mind as they go to market:
The basis of all business is the core product being taken to market. In today’s economy, investors will expect some level of entrepreneur’s understanding of how the product serves the market. Unfortunately, the days of large rounds of institutional finance for an idea on a napkin are long gone; investors are far more demanding and need to see the value of the offering very clearly before considering their participation.
There are some basic questions that an entrepreneur should address: Does the product serve a ‘want’ or a ‘need’? Is the offering disruptive? Does it make a difference? Do you have a first-mover advantage? Are there barriers to entry?
Entrepreneurs should also note that they will likely need a working MVP (minimum viable product) and be able to demonstrate validation in the market by showing adoption from targeted early adopters and some initial signs of traction.
Market size /opportunity
It is extremely important that the entrepreneur can illustrate to investors a deep understanding of their target market and how to serve them best. Investors might expect the entrepreneur to be a part of the target audience, following the adage that to truly know your market you need to be a part of it.
Demonstrating market size always represents a dichotomy in the pitch. The TAM (Total Addressable Market) needs to not only be large enough to give the business the potential to become a unicorn, but should also have a realistic SAM (Segmented Addressable Market) that can be targeted as the entry point with a realistic targeted focus. Entrepreneurs are always struggling to find the perfect balance between opportunity and realism that an investor can buy into.
Entrepreneurs need to clearly understand the alternatives available to the product or service they are offering. Even if there is no direct competition, the question remains how target customers are currently solving the problem (and how much benefit your offering provides to compete).
The financial model should be driven primarily by revenue or engagement projections that illustrate the potential of the business. With a defined TAM and SAM in early models an investor will likely only buy into a SOM (Share of Market) of less than 10 percent over the early years. Therefore, the extended opportunity does need to be very large in order to make the projections attractive while maintaining realistic expectations.
However, even with reasonable growth predictions, the entrepreneur must also demonstrate that the target audience will utilise the offering as expected to generate the engagement/ revenue predicted. This happens as part of the validation of the MVP as referenced earlier. The validation will not only show that customers will adopt the offering, but also how they will use it. From this, entrepreneurs must define the KPIs (key performance indicators) that drive the hypothesis and expected growth. These will be tracked alongside the financial performance.
Finally, it is important to ensure that short-term expectations of the business are accurate and achievable. The investment process can span over a few months, during which time the business will be judged against the numbers it is generating. This process allows an investor to truly evaluate if the entrepreneur understands their business and is realistic about their targeted expectations going forward. Be sure to have an accurate view on performance for at least six months to avoid falling into the trap of over-promise and under-deliver.
Often, investors will say that they are investing in the people even ahead of the business. This illustrates that the founding team presented to investors is extremely important. Entrepreneurs must consider the macro needs of the business and build a team of founders that can carry the business’ core needs forward. It is somewhat different for each individual case, but the general considerations might be: Who is going to drive product/technology? Who is going to drive customer-facing efforts? Who owns operations and finance? And who maintains the investor/stakeholder relationships?
It is rare that all founders will be the right leaders for every stage of the business going forward, but the investor should be comfortable that this is the right team to build traction and start to scale the offering being presented.
Investors also like to understand the story behind the business and what motivates the team. How was the idea birthed? How did the team come together? How does the team see itself working? All of these considerations allow an investor to get a feel of how the business will operate as the company grows, and where the gaps exist that might need to be filled in the future.
Knowing your ask
The final consideration for this short review is centred around the amount of investment the entrepreneur is looking for and the level of dilution they might expect in an early investment round. Entrepreneurs have to know how much money they need. Ideally, a financial model is built that would allow 12-18 months before more funding would be required (or the business becomes cash flow-positive). How much investment is necessary for product development? How much on marketing and sales? How much on operations etc.? This is sometimes confusing, especially when building a revenue generating business, but the focus of the use of funds needs to be clearly outlined for an investor.
Entrepreneurs should be careful not to ask for too little, as this could cause problems down the road when money runs out before achieving the set goals On the other hand, don’t ask for too much, as an under-subscribed round of investment can often fail to close due to over-asking. A common strategy would be to ask for just enough and push for an oversubscribed round where it’s possible to expand the offering to include additional investors and increase the cushion.
Valuation is also an art and not a science at this stage of the business. Often dictated by market conditions, valuation is also driven by the amount being raised. Expect to dilute by about 20-30 percent in early rounds: however, if the ask is too much and the valuation becomes too high, then the round might fail to close due to unrealistic expectations. So, consider market figures of other investments in your space, stage and geography and use those as a guideline to set expectations on size of round and ultimate dilution/valuation. But be sure that projections can carry the business through its initial targets based upon the level of investment sought.
With these considerations in place, entrepreneurs should be well-positioned to initiate discussions with the investment community. The hardest part of the effort is always to find the first investor (aka 'the lead'). Once a lead is secured, follow-on investors will become more engaged, and often entrepreneurs find that as demand grows, everyone will seem to want a piece of their business. So get that first committed lead and then put together the best team of investors possible to help build the business and drive towards future rounds of additional investment.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)