Subscribe to Entrepreneur for $5
Subscribe

Know Thy Investor

Make your pitches pitch perfect. Use this practical guide to determine the type of risks your private investors can handle.

By
Opinions expressed by Entrepreneur contributors are their own.

When raising money for your business, it makes good sense tocategorize the types of private investors you're pitching. Thiswill not only increase your success rate with fundraising, but itwill allow you to develop a funding strategy that's consistentwith your business model. My column this month outlines a methodfor categorizing private investors to help entrepreneurs tailortheir fundraising pitch.

Who Makes Private Investments?

After you've tapped your personal savings and maxed out yourcredit cards for business capital, the next step is to considerattracting funding from outside investors. Who are these investors?One of the most comprehensive studies on this topic is the Global Entrepreneurship Monitor, which hassurveyed more than 9,000 individuals to discover how entrepreneursraise money for their businesses. According to their yearly study,the vast majority of private investments in startups comes fromclose family (42 percent), relatives (10 percent) and friends (29percent) of the entrepreneur. Only 9 percent of private investmentscome from strangers, such as professional angel investors andventure capital firms. (Additional sources include workcolleagues--6 percent--and other sources--4 percent.) Despite themedia hype about venture capital, it's still an option for veryfew entrepreneurs.

Financial Risk vs. Emotional Risk

Investing is about risk. The risk that you'll lose yourmoney or not earn a decent return is the most obvious risk faced byprivate investors. But for most entrepreneurs, raising money isabout managing emotional risk in addition to financial risk.It's a daunting task to approach your family, friends, workcolleagues or neighbors to ask for money.

But you can lower your risks if you understand how yourinvestors' motives and investment sophistication can impact thetype of investment proposal you make to them. And it'simportant to remember that if you approach multiple investors,they'll have different motives and you'll want to tailoryour proposal to those different concerns. To begin, consider eachpotential investor with regards to comfort for financial risk andemotional risk.

In the area of financial risk and familiarity with privateinvesting, you need to determine the answers to thesequestions:

  • Is the potential investor able to lose their investment inreturn for a chance for a significant upside? If so, their comfortwith financial risk is high, and you can consider them savvy.
  • Does their enthusiasm for you or your idea overshadow theirinvesting experience? If so, their comfort with financial risk islow, and you should consider them supportive.

In the area of emotional risk and concern about mixing moneywith relationships:

  • Would the investor withhold their money if they thought itwould damage a relationship? If so, their comfort level withemotional 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 canconsider them distant.

Using your responses to these questions, place your investor inthe quadrant below that you think best fits their comfortlevel:

Savvy & Worried
A savvy and worried investor will tolerate some financialrisk--such as a substantial investment in a risky business--as longas the emotional risk is low. For example, your mother may haveboth the means and the will to help you get your enterprise off theground. While she would hate to lose her money, she's reallymore concerned that the loan not hurt your relationship with her orwith other family members. Your primary job for this kind ofinvestor is to alleviate their concern that an investment wouldjeopardize their relationship with you. One way to do this is toassure this investor that you intend to formalize the investmentlike a business transaction with legally binding documentation. Inmy experience with advising entrepreneurs on raising money, formaldocumentation and a repayment plan are critical ingredients forreducing the emotional risks of transactions between relatives andfriends.

Savvy & Distant
The savvy and distant investor will tolerate both financial riskand emotional risk. For example, your neighbor is a serialentrepreneur and dabbles in angel investing; he's known yousince you were a kid and likes your business idea. As long as youcan make a professional pitch and offer a respectable return,he'll be comfortable with the financial risk and won'tthink twice about the emotional risk. In this case, your investmentproposal should include a business plan and professional investmentterms.

Supportive & Worried
A supportive and worried investor is enthusiastic about your ideaand your ability to follow through, but is nervous about both thefinancial and the emotional risks. For example, your older brotherwants to help but has kids entering college and only limitedresources to lend you. In addition, you suspect he wouldn'tmake an investment if he thought it might jeopardize yourrelationship. With this type of investor, first and foremost, youneed to make sure your request is within their means. Don't asksomeone who supports you for more than they can afford because therefusal will be painful for both of you. This is also the type ofindividual who might offer you the investment on a handshake.Without hurting their feelings, explain that you want this to be aproperly documented business transaction. You may need to remindthem about the tax benefits, legal benefits and credit-buildingbenefits of formalizing the investment.

Supportive & Distant
A supportive and distant lender will want to avoid financial riskbut can tolerate emotional risk. For instance, a family friend ofmodest means loves your idea and thinks you're a great manager.She expects to get her money back, but the personal relationship isdistant enough that she has no strong sense of emotional risk. Takea 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 willprobably also benefit from a business-like explanation of theproposed terms of the investment agreement.

Entrepreneurs rarely devote as much systematic thought andenergy to fundraising as they do to building their products andservices (for good reason). Given that more than 90 percent of allprivate investments are from people you know rather than strangers,such as angel investors and venture capital firms, I urge you tothink strategically about categorizing private investors so yourfundraising pitches are successful.

Entrepreneur Editors' Picks