Know Thy Investor
Make your pitches pitch perfect. Use this practical guide to determine the type of risks your private investors can handle.
When raising money for your business, it makes good sense to categorize the types of private investors you're pitching. This will not only increase your success rate with fundraising, but it will allow you to develop a funding strategy that's consistent with your business model. My column this month outlines a method for categorizing private investors to help entrepreneurs tailor their fundraising pitch.
Who Makes Private Investments?
After you've tapped your personal savings and maxed out your credit cards for business capital, the next step is to consider attracting funding from outside investors. Who are these investors? One of the most comprehensive studies on this topic is the Global Entrepreneurship Monitor, which has surveyed more than 9,000 individuals to discover how entrepreneurs raise money for their businesses. According to their yearly study, the vast majority of private investments in startups comes from close family (42 percent), relatives (10 percent) and friends (29 percent) of the entrepreneur. Only 9 percent of private investments come from strangers, such as professional angel investors and venture capital firms. (Additional sources include work colleagues--6 percent--and other sources--4 percent.) Despite the media hype about venture capital, it's still an option for very few entrepreneurs.
Financial Risk vs. Emotional Risk
Investing is about risk. The risk that you'll lose your money or not earn a decent return is the most obvious risk faced by private investors. But for most entrepreneurs, raising money is about managing emotional risk in addition to financial risk. It's a daunting task to approach your family, friends, work colleagues or neighbors to ask for money.
But you can lower your risks if you understand how your investors' motives and investment sophistication can impact the type of investment proposal you make to them. And it's important to remember that if you approach multiple investors, they'll have different motives and you'll want to tailor your proposal to those different concerns. To begin, consider each potential investor with regards to comfort for financial risk and emotional risk.
In the area of financial risk and familiarity with private investing, you need to determine the answers to these questions:
- Is the potential investor able to lose their investment in return for a chance for a significant upside? If so, their comfort with financial risk is high, and you can consider them savvy.
- Does their enthusiasm for you or your idea overshadow their investing experience? If so, their comfort with financial risk is low, and you should consider them supportive.
In the area of emotional risk and concern about mixing money with relationships:
- Would the investor withhold their money if they thought it would damage a relationship? If so, their comfort level with emotional risk is low, so consider them worried.
- Are they far enough removed that the emotional risk feels low? If so, their comfort level with emotional risk is high, and you can consider them distant.
Using your responses to these questions, place your investor in the quadrant below that you think best fits their comfort level:
Savvy & Worried
A savvy and worried investor will tolerate some financial risk--such as a substantial investment in a risky business--as long as the emotional risk is low. For example, your mother may have both the means and the will to help you get your enterprise off the ground. While she would hate to lose her money, she's really more concerned that the loan not hurt your relationship with her or with other family members. Your primary job for this kind of investor is to alleviate their concern that an investment would jeopardize their relationship with you. One way to do this is to assure this investor that you intend to formalize the investment like a business transaction with legally binding documentation. In my experience with advising entrepreneurs on raising money, formal documentation and a repayment plan are critical ingredients for reducing the emotional risks of transactions between relatives and friends.
Savvy & Distant
The savvy and distant investor will tolerate both financial risk and emotional risk. For example, your neighbor is a serial entrepreneur and dabbles in angel investing; he's known you since you were a kid and likes your business idea. As long as you can make a professional pitch and offer a respectable return, he'll be comfortable with the financial risk and won't think twice about the emotional risk. In this case, your investment proposal should include a business plan and professional investment terms.
Supportive & Worried
A supportive and worried investor is enthusiastic about your idea and your ability to follow through, but is nervous about both the financial and the emotional risks. For example, your older brother wants to help but has kids entering college and only limited resources to lend you. In addition, you suspect he wouldn't make an investment if he thought it might jeopardize your relationship. With this type of investor, first and foremost, you need to make sure your request is within their means. Don't ask someone who supports you for more than they can afford because the refusal will be painful for both of you. This is also the type of individual who might offer you the investment on a handshake. Without hurting their feelings, explain that you want this to be a properly documented business transaction. You may need to remind them about the tax benefits, legal benefits and credit-building benefits of formalizing the investment.
Supportive & Distant
A supportive and distant lender will want to avoid financial risk but can tolerate emotional risk. For instance, a family friend of modest means loves your idea and thinks you're a great manager. She expects to get her money back, but the personal relationship is distant enough that she has no strong sense of emotional risk. Take a guess at what this investor can afford, since you may not know, but do be ready to negotiate up or down. This type of lender will probably also benefit from a business-like explanation of the proposed terms of the investment agreement.
Entrepreneurs rarely devote as much systematic thought and energy to fundraising as they do to building their products and services (for good reason). Given that more than 90 percent of all private investments are from people you know rather than strangers, such as angel investors and venture capital firms, I urge you to think strategically about categorizing private investors so your fundraising pitches are successful.