The process of raising capital is a difficult task for most entrepreneurs. Each stage of the process requires adequate preparation and the persistence to keep pushing amidst rejections from potential investors.
Founders who have tried to raise capital attest to the fact that it is difficult to get a penny out of an investor, as they carry out extensive due diligence and ask tough questions. This comes as no surprise at all in the face of startup post-mortem reports that show that 9 out of 10 startups fail. As a result, investors will only invest in startups that they believe will be profitable and sustainable in the long term.
Depending on their investment strategies, investors consider different criteria before investing in startups. As a starting point, no investor will invest where the founders are not themselves invested in time and equity.
Some of the factors investors look out for are indeed interesting. For example, Isaac Ho, a venture capitalist in Asia says that one quirky addition to the due diligence process is assessing how long it takes the founder to respond to his texts on WhatsApp. According to Ho, “If you take days to respond to me when you are seeking my finance, what will happen during the bad days? Do you take months to reply?”
Also, Taizo Son, another investor stated that his criteria to invest are the founders mindset and passion and that he would not check any business plans and projections.
While the factors differ, it is however important to understand the variables that make a startup attractive to an investor. This article highlights some of these and goes further to discuss legal and regulatory risks that can prevent investments.
Investors do not only invest in ideas, they invest in the people behind the ideas. It is important that you strategically constitute a marketable team. Investors consider matters such as the composition of the team, the complementary skills and level of expertise, relevant experience in the domain and the chemistry in the team.
Investors are also interested in seeing evidence that the team is flexible enough to adapt, as many organisations end up adopting a business plan or model different from what they started with, for example, companies like Facebook, Paypal, Google and Microsoft were flexible enough to change their business model.
Some investors even go as far as conducting due diligence on the founders history, re-visiting issues such as college reputation, relationships with vendors etc.
A definite red flag is a team that is constantly at war with each other and who are unable to agree on basic matters. There are other criteria that investors consider in the management team, so a founder must highlight as many of the strengths of the team as possible.
Investors are interested in products that are unique and difficult to replicate. Products that solve new problems or solve old problems in new ways will surely catch the attention of an investor.
A product that creates a more efficient way of doing things or offers a different/better price point also attracts an investor. The more features that differentiate your product from existing products, the better for your startup.
An investor is interested in how big the market is and how much of the market your product/business can capture within a reasonable number of years to yield a sizeable return on its investment.
Founders should therefore have adequate knowledge of the size of the market and have a plan on how to capture a large market share. This boosts investor confidence in your startup.
Investors are interested in seeing evidence of market demand i.e., that the business or product has a measurable set of users or customers and that there is sustainable growth for the business.
Investors want to know how much progress the startup has achieved to date and would need to see supporting data to prove the progress. Founders must present financial records showing generated revenue, results of operations, financial position and cash flow.
Founders that can show traction with their products early enough are better at arousing the interest of investors
Business Plan and Model
While investors understand that business plans and models are likely to change as the business matures, an initial business model and plan are necessary for making an investment decision.
A business plan should contain matters such as an analysis of the industry and the position of the business within the larger framework, the market opportunity; the company’s competitors, the competitive advantage and the differentiating features from its competitors; marketing and sales strategy; 3 to 5 year financial projections; the financial requirements of the company and the key use of the proceeds from the investment.
The business plan should also address the exit strategy for shareholders and the risks of the business. Investors want to know that the founders are fully aware of the risks (such as business, financial, operational, compliance and product liability risks) and how they intend to approach these risks.
The business model should contain matters such as how the company intends to make money, the pricing model and the long-term value to customers.
Having a business plan and model in place demonstrates that the founder understands what it takes to scale the business. It is therefore important that you let the investor know your vision through your business model and plan.
Attracting an investor is only half of the journey in many cases. Getting the investor to release the cash after due diligence is the other half of the journey.
Where a startup looks attractive enough to an investor, the next step is the due diligence process. It is at this point that certain factors can impede an investor from making that investment.
Risk exposure and liability
While carrying out due diligence, most investors request for the startup’s material contracts such as shareholders agreements, joint venture or partnership agreements, employment agreements etc. Investors also request for an overview of pending, threatened or settled disputes.
Indeed, startups enter into contractual obligations without legal counsel or thinking about the consequences of such contracts with these obligations leading to complications in the future.
Where any of these pre-existing obligations has the potential of adversely impacting on the business of the startup or the investment of the investor, then an investor is unlikely to invest in the startup. It is therefore imperative that startups seek legal counsel before entering into any contractual arrangement.
Corporate governance is the system through which a company is managed and controlled. Sound corporate governance principles are important for the long-term success of any business.
Most startups are formed by friends working together to build a product. As a result of the dynamics of the relationship, they may fail to establish systems for managing and controlling the business and neglect to draw a line between personal and work relationships.
Just like every other company, a startup should have a formal board structure and established practices that promote accountability and transparency to avoid the risk of failing.
Several companies, including startups like US based technology companies, Theranos and Zenefits have faced scandals due to lack of sound corporate governance practices. Therefore, investors prefer to invest in companies that have good corporate governance practices.
The roles and responsibility of each founder and officer of the company must be clearly set out, effective reporting lines established and a mechanism put in place for checks and balances between the management and the shareholders.
Furthermore, startups that carry on business in regulated sectors such as the financial, medical or insurance sectors need to ensure that they comply with the laws applicable in those sectors and obtain all relevant licenses.
Starting a business venture without knowledge of the regulatory framework is a huge risk that no serious entrepreneur should take. Failure to comply with the law has grave consequences ranging from payment of huge fines to imprisonment of the directors involved.
Investors want to see evidence that you are fully aware of and compliant with the laws that affect every aspect of your business. It is therefore important that founders seek specialist legal assistance. This is increasingly important for startups involved in emerging areas such as cryptocurrency and crowd funding.
These factors identified above are not exhaustive as there are several other factors that an investor may consider. For many investors, companies with solid intellectual property portfolio are attractive investment targets. Sometimes, the final deciding factor may be an x-factor such as similar education or work background, hobbies etc.
The goal of every founder intending to raise capital should be to tick as many boxes in the investor’s list as possible. Having the above factors and other positive factors in place will better position your startup and increase the likelihood of investment.
Most investors have an investment strategy, so it is worthwhile to find out beforehand if your business fits into this investment strategy. Founders should also consider engaging professionals such as lawyers who can assist with regulatory compliance, registering intellectual property, establishing sound corporate governance principles and reviewing all documentation, before approaching an investor.
Founders should also seek advice from those who have successfully raised capital as they are likely to have useful information.