Starting your own business is challenging. No matter how unique your idea is, it’s unlikely to get off the ground without proper funding. Securing the necessary funding to start and sustain a business is one of the biggest hurdles that every aspiring entrepreneur faces.
Within Northeast Ohio, there is a significant and growing number of investors and organizations dedicated to helping local entrepreneurs succeed. However, finding the right investors for your business will take careful research and an unwavering commitment to growing your venture.
Below is a perspective on a few of the questions you should be asking yourself as you prepare for raising outside money. My experiences as an attorney, investor pitch coach, business advisor and entrepreneur shape much of this perspective. This perspective is also shaped by resources developed by existing and former JumpStart Entrepreneurs-in-Residence.
Do I have the right product/market fit?
It should go without saying, but an excellent product/market fit is crucial if you want your business to succeed. By product-market fit, I mean that there is market demand to pay for your product. This demand should exist because your product solves an urgent problem better than existing means do. An entrepreneur’s focus should be on getting into the market where you can have the most impact today, instead of waiting years for conditions to be perfect.
For this reason, it is critical to start the customer discovery process before you go to market, not after. Customer discovery is the process of determining your value proposition by testing assumptions about your business. This process helps you identify where the market demand is and why that demand exists. This understanding allows you to make more informed decisions about designing your product and business model. Until you validate demand, there is no reason to provide any supply. Investors will not invest until you do.
Validation can come in many ways. The key is to talk to your target customers. Ways to do this include focus groups, interviews, and beta testing.
And remember, the simplicity of the story is critical. The best products help people save time and make or keep more money. The best pitches emphasize product values and not features. Thus, focus on how your product will make your target customer more money while reducing the amount of work they have to do.
Am I solving the right problem?
It’s common for early-stage companies to be pulled in the wrong direction because often, opportunities present themselves that tempt you to attempt the task of solving many problems at once. Instead, solve one problem and do it right.
The key to identifying the right problem is to study what problem is most significant to your desired customers. By significant, learn what problems are most urgent and mission-critical for them to solve right now. Then understand why it is urgent and mission-critical, how they are trying to address those problems now, and why current approaches are inadequate.
With this understanding, you’ll be able to create a high-quality product that they are willing to use and buy. Additionally, gaining commitment from beta customers who are eager to test your product speaks volumes about your product’s efficacy.
How am I going to make money, and What Is My Total Available Market Size?
Investors are in the business of making money through investing in high-risk ventures others either will not or cannot invest in. When evaluating any pitch, investors want first to understand how you are going to make money.
An investor wants to know you have identified a target customer that is willing to pay for your product. That investor will also want to see …
- how you reach that customer
- how much revenue you can generate from that customer
- how many of these potential customers exist in the world
- how much is your business worth per year if all these potential customers bought your product (i.e. Total Available Market Size)
Investors will also care about the unit economics-it is nice to have revenue, but they want a pathway to profitability and free cash flows that can be used to pay the investors back.
The answers to these questions will determine if an investor will invest in your business. For example, many equity investors will not invest in a product whose Total Available Market Size is less than $500M.
As an entrepreneur, the burden on you is to make the business case for why someone should invest in your business. The evidence should justify this business case. This evidence is obtained from the customer discovery, market research, competitive analysis beta testing, and initial sales and user traction you acquire. Based on the business case, you should target investors accordingly.
How do I know I am ready for (and need) outside funding?
The first question you need to ask is if I have a validated need for outside funding over the next 12-18 months. By validated need, here is what I mean. First, based on market research, and customer discovery, you have established there is a large potential Total Available Market($) for your product. Second, you either have one of two issues. Either you have demonstrated user traction and need funding to scale to meet demand. Or you need to acquire equipment, personnel, intellectual property, or other assets to grow your business after testing an MVP.
Investors do not want to take giant risks. For this reason, investors often do not fund many startups in the pure “idea stage,” no matter how great the idea may be. That’s why the best way to be successful in raising outside funding is to demonstrate proof that customers want your solution before you ask for the money.
Assuming you can demonstrate a validated need for funding, there are additional questions you need to figure out. As part of this, ask this question, is there a way I can do this without spending money. For example, many times, one can work with local University students and classes to get many tasks done at no cost to them. Or, one can work with organizations like JumpStart to get access to services and resources at reduced or no cost to them. Finally, a good advisor can help you focus on prioritizing what to spend money on now versus what is not a priority in the next year.
It helps to approach things as if investors are looking for reasons not to fund you, not the other way around. You will have an easier time getting supported when you eliminate any reason for them not to invest in you. Showing an investor that you have customer validation, traction, repeatability and predictability does this.
How do I evaluate different funding opportunities?
Not every source of capital is equal. When it comes to specific deal terms, it’s very critical for an entrepreneur to have experienced legal counsel and financial advisement to help protect your interest. With that said, here are seven key elements you should pay close attention to when evaluating your various funding options.
- Length of process: Know how long the process will likely take from first engagement to funding. You can’t rush an investor’s timeline, but you do need to understand it.
- Clarity of process: Gain a handle on the steps and mechanics of how the organization/individual decides to fund.
- Clarity of milestones: Even with a clearly defined process, things can drag out if you don’t have the significant milestones clearly identified.
- Complexity of the process: If the process is too complicated, it can often drag out longer than you’d like or anticipate. Make sure you have enough runway to make it to the close of the deal.
- Accessibility: How accessible are your potential investors for coordination, collaboration, and relationship building? An open line of communication is essential for a successful entrepreneur/investor relationship.
- Expertise: Are your funders investing the necessary time and resources to learn about different industries—including yours?
- Track record: Does the investor have a reputation for doing what they say they’ll do?
For a more detailed discussion on How to Identify and Target the Right Investors, please check out this blog post here.
How does Debt vs. Equity factor in here?
Outside funding comes in the form of either debt or equity.
Debt financing involves borrowing a fixed sum from an investor, which one must pay back with interest within a set amount of time. Typically, this form of financing requires the commitment of some collateral that can easily be liquidated into cash to help cover the debt. Equity financing is the sale of a percentage of ownership in the business for a certain amount of capital. This form of funding is typically subject to less legal protections than debt and is less senior to debt.
These definitions provide the following implications for businesses. Debt financing is not patient capital and creates revenue pressure on a company. Obtaining debt financing often requires businesses to have consistently strong and steady revenue flows that can satisfy the debt without hurting the business. Further, there needs to be some collateral that can be sold for cash if necessary. Intellectual property can serve as collateral. However, for early-stage startups, there is typically insufficient proof that the developed Intellectual Property can cover debts. Remember, you are still trying to prove out the business. This pathway for collateral is better suited for more mature companies.
This is not to say an early-stage startup cannot use debt financing. For example, if you have a purchase order and a relationship with a manufacturer to produce those products, a purchase order can be used to obtain a loan. Additionally, for paying for initial marketing around your MVP, microloans can help cover initial expenses.
Equity financing is more expensive capital that debt because there is a greater risk to these investors of losing money. It also is more often utilized by startups because of the lack of tangible collateral and strong revenue flows to support a debt-based investment. However, these investments put more pressure on startups to grow at scale rapidly. This is why these investors care about significant TAM sizes, Go-To-Market strategies, and user traction.
Ultimately, an entrepreneur looking for funding should consult with an advisor to determine the right type of outside financing for their business.
Where do sales fit in the equation?
Generally, a startup will not get funding without proving they can generate sales. The reason being is that an investor wants evidence that you can make money and repay them. There are a few exceptions to this rule, such as startups in the healthcare and life science spaces. The reasons being are these are highly regulated and development intensive spaces where an investor is willing to provide more flexibility subject to other reference points.
If there is nothing else you learn from this post, remember, investors need to manage risk and return. Your job as an entrepreneur is to de-risk an investment opportunity before presenting it to an investor. It does not mean you need to get rid of all risk. That is impossible. However, it does mean that you need to address the risk which is directly in your control. By showing you can sell the product and have a predictable and scalable revenue stream, you are de-risking the investment. This makes it easier to secure funds.
At this point, you, as an entrepreneur, are probably wondering how to get sales without a completed product. You don’t necessarily need a finished product to begin selling. Below are some ways that you can go about generating sales that will be respected by most investors:
- Pre-Sales Based on Your Proof of Concept
- Sales Based on Your Proof of Concept
- Results from Reward-Based Crowdfunding Campaigns
- Purchase Order Letters of Intent
- Early Commitments to Acquire Product
What are some final pieces of advice I need to know or do before closing a deal with an investor?
First, do not let desperation or excitement for cash lead you into a bad investment for you and your business. When I was a practicing attorney, I saw many bad investment deals. A common denominator behind these deals was an entrepreneur’s excitement or desperation that led them to ignore the details and ramifications of a potential agreement. For this reason, go through the details and seek legal counsel and financial advisement from people with experience in the investing space. The wrong deal can ruin your credibility as an entrepreneur and destroy your company in the process.
Second, make sure you understand an investor’s evaluation and due diligence process, especially as a first-time founder. This understanding will help you know what you need to do and what to expect from an investor to close the deal.
Relatedly, make sure you both are clear on post-closing expectations for you and the investor. Ultimately, investing is really about relationships. For this reason, an entrepreneur’s focus should be on building a relationship with an investor and learning more about them.
Finally, remember you are not alone in your entrepreneurial journey. Throughout Northeast and Northwest Ohio, there are phenomenal networks that provide various levels of business assistance and funding to help entrepreneurs. Much of this support will come at no cost to you.