(tenth of a series)

By Frank Demmler

This week we will continue the discussion about private investors. Last week’s primary takeaway was that there are significant differences among private investors and it is incumbent upon the first-time entrepreneur to understand that, first, and then use it to his advantage to conduct a successful fund raising effort on reasonable terms.

This week I will share with you a way to divide potential investors into different categories and how to use those categories in the fund raising process.

PERCEIVED RISK

Revisiting some of the issues from last week, different classes of outsiders will look at the risk of your enterprise differently.

A bank will want to see profitable operations, positive cash flow, and sufficient assets to provide collateral for any loan it is going to provide. As such, banks may fund your growth, but they won’t fund your start up. According to this method of evaluating risk, your start up is “too risky.”
Alternatively, venture capitalists may not be put off by your company’s financial performance to date. In fact, they would probably be surprised if you satisfied any of the bank’s criteria. They will want to evaluate the financial return potential of your enterprise and the inherent risk associated with your ability to realize that potential. They will do this evaluation in the context of their experience, their existing portfolio, other deals they are looking at and the investment criteria of the fund. The net of all this will be to come to a decision about the risk-adjusted return expectations of your venture.

These two examples represent the two poles of the financial sources scale. They share the characteristics that they are reasonably predictable with regard to their requirements for your ability to access their capital. The same could be said for other identifiable sources, economic development funds, technology grants, etc. They have stated criteria and an honest evaluation of your firm will help you determine whether you have any chance of qualifying for their funding. Too often, first-time entrepreneurs don’t do their homework and/or don’t have the sophistication to properly assess their qualifications. This can lead to disappointment, and sometimes anger, that could have been avoided.

Entrepreneurs have to gain the sophistication to understand what sources are viable for them and which aren’t. The competition for those funds is often quite intense, and the people responsible for making the funding decisions have extreme time pressures placed upon them. You are not doing yourself any favors by aggressively pursuing a source of capital for which you don’t qualify. Similarly, creating ill will by venting your frustration when you are inevitably turned down is not smart. Don’t shoot the messenger, particularly when the source of the problem is your mistaken belief that these programs are set up for “you” and you are “entitled” to them. You are not entitled to any of these funds. Get over it. Compete for funds for which you are qualified, and compete well and from an informed base.

Private investors are not so predictable. That’s why you have to manage the process.

Sources of Risk

The first step in attracting private investment is to recognize how others will react to the risk of your enterprise. While risk can have an almost infinite number of dimensions, there are two core sources of risk: the business and the people.

Business Risk

The types of questions that a typical private investor might ask include:

Is there a market opportunity worth pursuing? Is the business at hand a reasonable way to exploit the opportunity? Who are the competitors and how are they addressing the identified opportunity? Can a start up or early stage business realistically establish itself in such circumstances? Who are the customers? How are they accessed? How do they make purchase decisions? Can the venture successfully close sales?

What is the role of technology in this venture? Does the company have proprietary intellectual property? Is the technology invented, or in a lab? Have customers used it and endorsed its value? Can it be effectively protected?

I could go on and on, basically providing a full list of due diligence requirements that an institutional investor will use to evaluate such a deal, but you get the point. Evaluating business risk can be quite daunting for the typical private investor.

People Risk

Similarly, the types of questions that a typical private investor might ask about the people include:

Is the venture’s team the one that will successfully exploit this opportunity and provide a desired financial return to the investors? Do they have relevant industry experience? Have they done it before? Can they grow to meet the venture’s future needs? Will they accept advice and guidance? Will they attract quality people to the team and let them do their thing? Do they understand the value of a dollar in an entrepreneurial concern?

Are they good people? Do I want them to win? Do I want to work with them? Do I like them? How do I know if they have integrity? How can I go beyond superficial impressions and really get to know them as a person?

Evaluating risk

Just as risk has many dimensions, evaluating that risk can go in many, many directions. In the private investor arena, the potential investor is unlikely to have the resources, time, or motivation to go a “professional” due diligence process. The private investor is rarely making investments in companies such as yours as his primary occupation. If it’s “too hard” to evaluate your business, they will pass and move on to the next deal. Remember last week’s advice:

If you approach a potential investor prematurely or inappropriately, you will lose that investor unnecessarily and for the wrong reasons.

This discussion is why I gave that advice.

What are you to do then? How do you influence the perception of risk? For lack a better way to express it, you need to evaluate how well potential investors know the business and know you. If a particular individual knows something about your business, he will either “get it” of not. If he “gets it,” then his perception of risk will be significantly reduced relative to someone who doesn’t know the business. Similarly, someone who knows you and thinks well of you will perceive lower risk than someone who doesn’t.

Advice to Entrepreneurs

Many sources of capital have defined criteria and processes for attempting to access that capital. It is the entrepreneur’s job to learn what’s what, and to honestly evaluate whether his company qualifies for consideration.
Private investors are less predictable than institutional investors. The entrepreneur needs to understand and categorize potential private investors according to their perceptions of risk.

Do they know anything about the business?
Do they know you?

Surround yourself with professionals, mentors, and advisors who can help you level the playing field.

Next week we’ll take a look at how you can use these insights in your fund raising efforts.

NOTE: I would like to acknowledge Tom Canfield of Equity Catalysts (www.equitycatalysts.com) for his contribution to these articles. Much of what I’m sharing with you was developed by Tom and me when we worked together at The Enterprise Corporation of Pittsburgh, a predecessor organization that was merged with others to form Innovation Works in 1999.

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh.