This is Part 2 of the four most common questions I am asked by entrepreneurs seeking to grow their businesses.
- What do I need to do to get ready for external financing?
- How do I persuade the investor my business is viable?
- How much should I ask for initially?
- When should I ask for more?
To seriously consider an investment, an investor must be satisfied that there are no basic flaws in the business. Surprisingly, more than 85% of the opportunities seen by investors have a critical flaw that causes them to be rejected in less than ten minutes. Understanding the evidence that the entrepreneur must present about each of these eight potential critical flaws is vital:
- Customers in target market will adopt product or service
- Features and benefits designed around customer needs
- Sufficient overall market potential
- Sufficient barriers to entry to discourage competitors
- Evidence that technology can be made cost effectively
- Available route to market
- Sufficient entrepreneur experience
- Financial forecasts realistic and venture can be profitable
After deciding not to reject an opportunity due to a critical flaw, the investor will evaluate each in more detail, along with four other factors, to determine the long-term likelihood of venture success, and the chance of earning a sufficient return on his or her investment.
We provide an outline of the types of evidence the investor will look for in each of these factors to be persuaded that the business is viable:
A new product or service should be designed with a specific customer in mind. The investor is likely not a typical customer, so he or she requires evidence that a customer will buy the product or service, by:
- Actual sales, even on a small scale
- Orders, or conditional orders from a customer
- Market validation study, focused on showing reactions to your proposed product or service
Many inventors develop products with little evidence that each feature is required. Even where there is evidence that basic features are essential, inventors often continue to add features and their associated costs, when the costs exceed the customer’s perceptions of the benefits. The entrepreneur must show the skeptical investor, that each feature meets a potential customer’s need and price point.
The entrepreneur must persuade the investor that the overall market in which the product or service competes is large enough for them to achieve forecast revenues. If the product or service replaces one that already exists, then the entrepreneur must be clear on why people will switch to the new product or service, and how they will stop existing suppliers from retaining market share. If the market is new, then the entrepreneur will need to justify the creation of the overall market size and its sustainability.
Barriers to Entry
The entrepreneur must show that they can achieve long-term profitability by discouraging others from competing on price. Typical ways of creating a barrier to entry this, include developing a brand, filing a patent or capturing a strategic long-term customer.
Investors are not interested in opportunities at the early stage of the development process. They want to see evidence that the product is reliable, will work, and can be made cost effectively.
Route to Market
In certain cases, getting a new product or service to customers can be challenging and often require distribution partners. If the entrepreneur cannot show that such partners are both available and interested, their likelihood of receiving investment is limited.
The investor must be convinced that the entrepreneur has the capability to run the company, either based on related external experience, or direct entrepreneurial experience. In some cases, an entrepreneur can attract investment without such experience, but in this case, he or she must demonstrate the ability to learn quickly, and are willing to rely on the investor’s guidance.
The entrepreneur must show realistic financial forecasts that provide the investor with evidence to support top-line revenue numbers and bottom-line profit numbers, which can be achieved while managing cash flow.
What other factors does the investor consider when making an investment decision?
The four other main factors that the investor considers are:
- Will the amount of cash required allow the venture to grow as forecast without running out of cash
- Will the value of the venture forecast, and the percentage of equity offered, provide sufficient return
- Is there a viable exit strategy, such that the investor can take out his or her money
- Can the investor trust and work with the entrepreneur over the long-term.
We will provide more details on each of these questions, in the next blog.
Andy is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.
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