Startups Use Four Catalysts to Win Funding

It turns out there is a roadmap to venture-fundraising
success. My research with Stanford University’s Kathleen
Eisenhardt, which will be published in the February edition of
the Academy of Management Journal, identifies four hallmarks of
efficient prospecting for money. By efficiency we mean attempts
that take less than two months of formal, almost full-time
fundraising, while yielding offers from desired investors.

Our conclusions are based on extensive fieldwork, tracking
nine Internet-security startups as they sought multiple rounds
of venture capital over their first five years. We sampled
companies in Silicon Valley and across the U.S. that had already
raised at least one investment round before entering our study.

Conventional wisdom holds that successful fundraising
requires introductions to investors, a clear pitch and the
ability to signal the presence of a high-quality founding team.
We found these practices aren’t enough, especially for the
majority of entrepreneurs who haven’t previously been backed by
or worked with targeted investors. Rather, efficient fundraising
also depends on four catalyzing strategies.

Casual Dating

Step 1: Casual dating. Efficient entrepreneurs meet
informally, but deliberately and repeatedly, with a few
investors a couple of months before formally seeking an
investment.

At one startup, the entrepreneur strategically courted
venture capitalists by seeking their advice on his business
model over a series of casual lunches.

“You’ll talk about the business and stuff,” he told us,
“but you won’t pitch. And you won’t go to the partner meeting
and you won’t let them do diligence on you.”

These occasional lunches continued for several months until
one day, the chief executive officer announced he was raising a
round. Within 10 days, a courted investor made an offer. Others
followed.

Consistent with social-psychology research, casual dating
is an effective, but subtle, form of ingratiation. It flatters
investors, while focusing their attention on a business’s
prospects. Moreover, investors become psychologically invested
in ventures that follow their advice.

Step 2: Timing around proof points. It’s wise to time
formal requests for investment around a signal indicating
accomplishment of a proof point, or a critical and externally
validated milestone. One early such signal in our sample
involved the arrival of the first paying customer.

Efficient entrepreneurs recognize that proof points are
vital for fundraising, yet occur relatively infrequently.
Accordingly, some entrepreneurs with a recent proof point, but
without an immediate need for capital, still went ahead and
sought investments earlier than they otherwise might.

Other entrepreneurs we observed were in the more difficult
situation of lacking a recent proof point and running out of
capital. These scenarios required tough decisions, such as
delaying or temporarily cutting entrepreneurs’ own salaries so
as to postpone fundraising until the next proof point was
reached.

Research in behavioral economics suggests that timing
around proof points is effective because it provides a simple
signal of progress that is credible and easy to understand;
engages psychological biases that overweight immediacy; and
keeps investors from asking, “What have you done for me
lately?”

Scrutinizing Interest

Step 3: Assessing potential funders’ interest. Just because
a venture capitalist voices interest in a business idea doesn’t
mean an investment is in store. Efficient entrepreneurs
recognize that talk can be cheap; they don’t simply take a
venture capitalist at face value.

One CEO we interviewed said he scrutinized interest during
a venture-financing lull by calling well-connected acquaintances
and asking if they had knowledge or “could fish around about
whether or not a firm was still doing deals.” Another
entrepreneur looked at venture capitalists’ actions following
their meetings. Notable signals included how long it took the
investor took to call again or to schedule a technical expert to
meet with her engineering team.

Why are these actions important? Many venture capitalists
left the door open for any startups that they found even
somewhat interesting. While these investors knew they were
unlikely to make an offer, they still voiced interest and told
entrepreneurs they wanted to get together next month. Skillful
scrutiny helped entrepreneurs to avoid such teases and to focus
more intently on likely investors.

Step 4: Crafting alternatives. Efficient entrepreneurs
establish multiple routes that can lead to fundraising success.
This is important because potential investors tend to be
hesitant. As one financier told us: “There is no incentive for
me to act too soon. I would rather give the company plenty of
time to either prove to me that what they said three to four
months ago was correct, or prove it was incorrect.”

One entrepreneur whom we studied threatened to abandon his
initial financing round and instead fund his startup through
product sales if investors continued to delay.

Another entrepreneur pressured two casually dated, high-
status investors by also approaching three lower-status ones
known for their speed. When these latter investors rapidly
launched due-diligence reviews of the business, the entrepreneur
used their interest to pressure his desired investors. One
quickly made an offer.

Psychology research suggests that crafting alternatives is
effective because it capitalizes on the allure of scarcity and
the perception of urgency to motivate greater risk taking in
decision makers. One investor told us that the emergence of an
alternative “was a good strategy. It was real and credible and
it probably got me off of my rear end.”

Because many entrepreneurs fail to utilize catalyzing
strategies, they may be sabotaging their access to investments.
Looking beyond the context of entrepreneurship, we believe our
research begins to unlock the mechanisms by which less-
privileged and less-connected individuals and companies
compensate for a lack of strong personal and firm connections.

(Benjamin L. Hallen, an assistant professor of strategy and
entrepreneurship at London Business School, is a contributor to
Business Class. The opinions expressed are his own.)

Read more opinion online from Bloomberg View.

To contact the writer of this article:
Benjamin L. Hallen at bhallen@london.edu

To contact the editor responsible for this article:
Max Berley at mberley@bloomberg.net