Attracting private investors - 3

(eleventh of a series)

By Frank Demmler

Over the next few weeks I will provide you with a process that you can employ to plan your fund raising strategy. Many of the companies that have used this process have successfully raised money from private investors.

Last week I closed with a way that you should consider classifying potential investors in your business based upon how well they knew you and/or your business.

This week we’ll look at why this is important and how you can use it to your advantage.

PERCEIVED RISK

Taking a step back, how OTHERS perceive risk is the important point, as we’ve discussed in recent weeks. Let’s take a look at the perceived risk of the four categories of potential investors represented by the above table.

Don’t Know You – Don’t Know the Business

Think about it. If a complete stranger contacted you and asked you to invest in a business you didn’t understand, what would be your response? Why?

If you were like most normal people, your answer would be something like, “I will not invest in your company because I don’t know anything about you or your company, so it appears to be extremely risky. I would have to devote a lot of time and energy to be comfortable to even consider an investment.”

Why would people you approach respond any differently?

Without extenuating circumstances (and there are some we’ll discuss later), if this group were to be your primary focus of fund raising, the characteristics you might expect would include:

• long decision time
• highest return require, due to the perceived risk
• lengthy due diligence process

At the same time, though, it does represent the largest pool of potential investment.

Know You – Don’t Know the Business

This group of private investors that Jeffry Timmons noted professor of entrepreneurship and author calls the 3 F’s - Family, Friends & Fools. These are the people do not see a lot of risk because they know you and are often willing, or feel obligated, to invest you. Quite often their motivation for investing has little or nothing to do with financial gain. Some of the characteristics of this group include:

• quick decision
• lower economic cost
• highest potential psychological cost

The last point is worth commenting upon. The role of 3F investment is often hotly debated. Some investors won’t invest unless you’ve tapped that source. If friends and family don’t demonstrate their confidence in you, they’ll say, why should they? If you say that you haven’t approached them because you don’t want them to risk their limited capital in your business, the typical response from an investor will be to challenge your level of confidence in your own business.

These attitudes are next-to-impossible to change. If you are comfortable including friend and family investment, or welcome it, for that matter, then it’s not an issue. If you choose not to seek investment from this source, and another investor challenges you on it, thank them for their time and move on. You won’t change that investor’s mind.

Don’t Know You – Know the Business

Someone in this category is likely to respond in one of three ways to your business proposal: I don’t agree; Ho-hum; or “I get it!” If you get one of the first two responses, thank them for their time and move on. If you get the last response, you have reduced the risk significantly. Now you’ve only got to convince them that you’re the right person to exploit the business opportunity.

Some of the characteristics of this group include:

• moderate decision time
• great anchor & halo effect
• higher return expectations
• can add significant value

If someone from this group were to commit to an investment, their independent endorsement may significantly impact the risk perceptions of others, thereby motivating them to invest. Hence the reference to the anchor (locks in a deal) and halo effect (their participation, alone, impacts others favorably.

Know You – Know the Business

Again, the knowledge of the business is a very important distinction for this group. The interpersonal relationship, though, has its own implications. On the one hand, the decision making process may be shorter since both major risk areas are greatly reduced. On the other, the personal relationship may somewhat diminish the halo effect of this investor’s participation.

Some of the characteristics of this group include:

• quick decision
• good anchor
• halo effect
• can add value

Summary

Not all investors are the same. Analyzing their differing characteristics can provide you with insight as to how to approach each type and when. As we will discuss next week, you can, and should, use this knowledge for your benefit in fund raising.

Advice to Entrepreneurs

• A potential investor’s perception of risk will greatly influence whether he has an interest in investing in your company under any circumstances.
• To be able to manage the fund raising process to your greatest advantage, you need to categorize your potential investors by their perception of risk.
• Using their knowledge of you and your business can be a useful method for categorization.
• Surround yourself with professionals, mentors, and advisors who can help you level the playing field.

Next week we’ll look at the categorization of angel investors and how that can be used in your fund raising strategy.

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.