Milestones that Matter: Elevating Investor Perception of Your Business Value Proposition
Think of the capital raising process as a series of challenges that must be overcome one by one before getting your money - the journey begins with first impressions followed by investor scrutiny in each of the above milestones, roughly in the same sequence of consideration.
Build a Strong Customer Validation Before Fundraising
Success of a business comes down to how well it can sell its products or services. So, your funding presentation must include information about your target markets and why customers in those markets will be interested in what you have to offer. The less you talk about ideas and guesses, the better.
Most investors are interested in businesses that will be the market leaders in their specific niches. They are less likely to invest in a company just like everyone else. If you want to become a PLC or future acquisition target, your target market segments must be big enough to let you get revenue of $100 million or more with only a small share of the market penetration.
For example, target market segments that are worth more than a billion dollars and explain how to get 5% to 15% of the market within 5 years - That's about $100 million a year.
Another way to look at this is that VCs who invest in early-stage companies usually want to get 10 times return in 5-7 years. If the investment is at a later stage, like in the last round before an IPO, the required returns may drop to 3 times because it will take less time to get back the capital plus a profit.
These metrics can only be met if you have strong evidence that a lot of people are likely to buy your products.
Getting strong customer validation and showing that you have "traction" in the market should be one of the first steps you take when making your pitch to raise money. Spend some time with your team to figure out who your best target really is before you start. Most of the time, the first "customers" are the easiest ones to get, but they may not be the best ones to grow your business.
Investors generally look for these types of validation in the following order:
Early Adopter (free)
However, not all types of validations are the same. For example, weak customer validation is hard to get around, even if all the other groups are positive. So, focusing on getting at least a few early adopters or paid customers of your product / services before reaching out to investors, that helps a lot.
Identifying a Huge Market
Assuming you have enough customer validation, next, investors will want to know how many more customers you could potentially get? In other words, what is your market size?
This includes an analysis of your products' / services' Total Available Market (TAM) and Served Available Market (SAM). For instance, the TAM for an online bookstore could be all of the people who buy books and the SAM might only include people who buy books in English.
Once a SAM is found, it is common to reduce the size even more by limiting the projected market penetration (also called Share of Market or SOM) to say, 5% to 10%. Higher % estimates tend to get more scrutiny and skepticism, it's best to make a modest penetration rate on a large, well-defined market instead.
Investors usually want to see a SAM of $1 billion or more and penetration projections that show the company will make $100 million in revenue within 5 years (for high-risk technology companies). Investors will be happy with lower returns that aren't as risky or investments that give them a steady stream of income (dividends). Investors will also usually look at the internal rate of return (IRR) of an investment opportunity.
Steps to determine the market size that attracts investors:
Make a simple spreadsheet with the expected income, expenses, and net profit over the next 5 years.
Find out how much capital you need from outside sources to run your business until you reach "break even."
Assume that your company's value in the 5th year will be 4 times its gross sales.
If necessary, change the income so that investors can get back 10 times what they put in after 5 years.
Multiply the income from the 5th year by 10 to get a rough idea of how big the market needs to be (assuming 10% market penetration) for investors to get the returns they want.
This is a very rough sketch of what you might need to do to figure out who your target market is and whether or not your business will attract investors.
Information about similar companies that have successfully gotten investments is also a good way to do something related to this. If your market already has competitors and other investments that are similar to yours, it's likely that market studies have already been done, which could help you make your case to investors.
Talk to analysts and business writers in your field to get better ideas. Investors will want to know that your projections have been checked by a third party, so it's important to start building relationships with trustworthy business analysts outside of your firm as soon as possible.
Construct a Defensible Business Model
One of the first things that investors look at a company is whether it offers a feature, product, or business. Features don’t make a product and can be copied easily. Similarly, a product doesn’t make a business.
Attractive businesses have a slew of products, and a road map for how to get clients. Attractive businesses also have an appropriate talent pool including software developers, sales, customer support, designers, finance, operations, and logistics talents etc.
The combination of the firm’s talent pool, the nature of its revenue model, and steps taken to protect its intellectual property is what converts it from something that can be easily copied into something that can be defensible.
What stops others from following and dominating the market you discovered?
Many attractive markets are full of established companies that have substantial resources and the ability to access and serve your firm’s target clients. So, how do you stop a large company that wants to move into your space?
Often you cannot. You are left with two scenarios. Either you have a structural advantage from being the first mover. Or you simply have the best execution, which can involve a decent amount of luck at the right time.
To establish that you have a defensible business, you need to have good answers to the following questions:
What is your unique intellectual property and how do you protect it? Do you have patents?
Can your service be easily reproduced by a competitor?
What defensible advantages do you really have? Algorithms? Data? Customer experience? Security?
What is the strength of your talent pool and key advisors?
What is your underlying asset? What happens if it becomes commoditized?
Tell a Good Equity Story
You need to begin the process of building your presentation by first gaining a thorough understanding of what your target investors want to see in both your investment proposal and what they expect to see in you as the CEO.
Realize that most investors are seeking to find holes in either your business model or in you or your team. In other words, they are looking for reasons to say “no.” Writing a check is an exception that comes only after all the possible reasons to say “no” have been exhausted.
Don’t be too quick to take investment from less sophisticated investors. Consider that every investment obligates you to that investor going forward.
Before you start pitching, make an honest appraisal of your shortcomings and your ability to successfully convince investors that you can lead your company. You may be better off being a successful second fiddle than a failed conductor.
Plan to make a significant investment in honing your presentation style. Once developed, good presentation techniques will last for the remainder of your career and beyond.
Develop an understanding of the hierarchy of business validators that investors look for, and focus your early marketing efforts on targeting strong referenceable and paying customers. Paying customers is your most important trump card in convincing investors.
Make sure your attainable market share fits the objectives of your target investors in advance of first meetings.
Be prepared to explain how and when investors will receive a return on their investment! Show such excellent returns in 5 years in your projections, even though investors will be giving you some slack and may be willing to wait longer to get the hoped-for returns.
A well-defined exit strategy with credible options, and a projected timeframe that meets investor expectations.
Why is an Exit Strategy Important?
Mitigating Risk: An exit strategy helps investors mitigate risk by providing a predetermined plan to exit the investment. It allows investors to minimize potential losses and avoid being tied to an underperforming asset for an indefinite period.
Maximizing Returns: An effective exit strategy ensures that investors can maximize their returns by providing a clear path to exit at the most opportune time. It allows investors to capitalize on market conditions, changes in industry dynamics, or a company's growth trajectory.
Investor Confidence: Having a well-defined exit strategy instills confidence in investors. It demonstrates that the entrepreneur has thoroughly evaluated the investment's potential and is committed to creating value for stakeholders. This, in turn, can attract more investors and potentially enhance the overall valuation of the investment.
Options for Exit Strategies
Investors expect firms they invest in to build something significant and to take it to exit. It is advisable to focus at least some of your strategy on identifying and cultivating potential acquirers of your business. Possible exit options including:
Initial Public Offering (IPO): Taking a company public through an IPO is a common exit strategy. It allows investors to sell their shares to the public and realize their investment returns. However, an IPO requires significant preparation, compliance with regulatory requirements, and market conditions conducive to successful listing.
Acquisition or Merger (M&A): Selling a company to another business can provide an exit opportunity for investors. This can occur when a larger corporation seeks to expand its market presence, acquire intellectual property, or leverage synergies with the target company. The acquisition or merger can generate substantial returns for investors if negotiated effectively.
Management Buyout (MBO): In some cases, the management team of a company may initiate a buyout, acquiring the shares held by external investors. This option allows investors to exit the investment while providing the management team with a chance to take full control of the company and execute their vision.
Strategic Partnerships or Joint Ventures: Collaborating with another company through strategic partnerships or joint ventures can be an alternative exit strategy. This approach enables investors to leverage the resources, expertise, and market reach of the partner company. It may eventually lead to a full acquisition or provide an exit opportunity through the sale of shares to the partner.