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4 Steps to Beating the Odds and Winning Startup Capital

4 Steps to Beating the Odds and Winning Startup Capital
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While people who found companies may be willing to work without pay, a startup's suppliers only accept cash on the barrel. How can an entrepreneur pay suppliers without profits?

The answer is to convince other people to give their money in exchange for a piece of a startup's equity.

Doing that is very difficult. When I was researching my book, Hungry Start-Up Strategy, I talked with dozens of investors. One of them, Peter Bell of Highland Capital Ventures, told me that he talks with 1,000 companies a year and invests in at most two.

Bell also told me that in the first three minutes of meeting with an entrepreneur, he decides whether he would like to end the meeting or schedule four more hours to get to know the startup better.

How can an entrepreneur be that one in 500 that gets the cash instead of being mentally -- if not physically -- dismissed by the investor in the first three minutes?

An answer to this question came to mind recently. On March 10, I reviewed the so-called rocket pitches that five student teams delivered the week before in my Foundations of Entrepreneurial Management class at Babson College.

Related: 8 Questions That Will Help Set the Right Expectations With Investors

To beat the odds of winning capital, entrepreneurs should follow four steps.

1. Get a warm introduction

Investors do not often respond to cold contacts -- such as emails sent to them directly to introduce an entrepreneur's venture.

Entrepreneurs should instead get what I call a warm introduction. That means that the warm introducer -- an individual who knows the startup CEO and the investor -- connects the venture with the investor (perhaps through email).

To get a warm introduction, an entrepreneur should talk to someone they know who is well connected. That could be a family member who is an investor, executive, banker, accountant or lawyer who has been successful and knows many people.

For a warm introduction to work, the entrepreneur should help the warm introducer by explaining why the introduction will benefit the investor -- and by extension the introducer.

To that end, entrepreneurs should make sure that the potential investor knows the startup's industry and can offer skills that will help the venture succeed.

The desired outcome of this process is for the investor to agree to meet with the entrepreneur to listen to a rocket pitch.

2. Deliver a great rocket pitch

A rocket pitch should answer an investor's most important questions in three minutes. These questions might be:

  • Does the venture address real human pain? To address this, founders should tell a compelling story of an individual who is suffering because of the problem that the venture aspires to solve.
  • Is there a big enough market for the solution? An entrepreneur should deliver conservative statistics on the potential revenues in the market for the venture's product, the market's growth rate, and estimated profit margins.
  • Will the startup's product relieve the human pain? To address this, founders should explain how the features of the venture's product will alleviate each of the specific pain points revealed in its customer research.
  • Can the team turn this idea into a significant business? Here an entrepreneur must describe the skills required to make the venture a success -- such as product development and sales -- and explain why the team members excel at the needed skills.
  • Will an investment deliver an attractive return? Finally, startup CEOs must explain how much capital the venture requires, how it will be spent and how and why that investment will help build the company into an attractive acquisition or initial public offering candidate.

If this step goes well, the investor will proceed to due diligence -- a process that could take a few weeks.

Related: Steve Case on Angels, Tech Bubbles and Caution

3. Provide an honest account of your life

Due diligence is the process of investigating a business plan and a team with the intent uncovering hidden problems that will make the investor want to stop before writing a check.

To avoid such unpleasant discoveries, entrepreneurs must assume that they will not be able to hide any embarrassing details about their conduct -- such as speeding tickets, bounced checks, lawsuits, rocky business relationships or failed business ventures.

By talking with people who have worked with a venture's team, conversing with potential customers for its product, investigating competitors' strategies, reviewing the team's credit history, checking for any criminal records and perhaps even hiring a private investigator to look into their past, those investors will probably find out everything about the venture's risks and opportunities and any embarrassing secrets about the team.

Due diligence will discover unpleasant secrets. So it is best for entrepreneurs to disclose problems during the rocket pitch.

If due diligence does not uncover any deal-killers, the investor will ask for a term sheet.

4. Offer compelling investment terms

The final step in getting investors to write a check is to offer compelling investment terms.

First, decide how much to value the company before the investment -- the lower the so-called pre-money valuation, the higher the percentage ownership that the investor will get in the venture.

If the venture offers a bond that converts into stock -- so-called convertible preferred -- investors will care about whether they will receive a quarterly yield and if so, how much.

Whether the investor receives a periodic cash payment, the entrepreneur must decide how many common shares the investor will receive if the venture is acquired or goes public.

Ultimately, entrepreneurs can beat the odds and persuade that investor to write a check if these terms are at least comparable to those offered by the venture's peer companies.

The most important test that will get investors to write a check is whether they believe that a venture can get a decent share of big and growing market so they can get an attractive return on their investment.

These four steps can help entrepreneurs get that investment.

Related: 4 Steps to Help You Prepare for the Fundraising Process