Entrepreneurs looking for investor funding often fail to realize that all money comes with strings. For example, if you have watched the Shark Tank TV series, you probably noticed that the Sharks always ask the entrepreneurs for their intended “use of funds.” Those who respond with one of the wrong answers, such as “I want to pay myself a salary,” usually go home empty-handed.
You may think this question is just an artifact of good television, but let me assure you that in my experience as an angel investor, it’s a standard “make or break” inquiry posed to every entrepreneur. Here are some guidelines that will help you with the right answers, not only in closing your next investment, but in planning when and how much money to ask for:
Investors are most interested in helping you scale the business. That means they normally only invest in startups with a working product that has already been sold to at least one customer for full price (beta tests, giveaways and best friends don’t count). They are willing to cover marketing, inventory and scaling, but not product development.
Make your focus and priorities clear. A long list of everyday expenses is not helpful here. I recommend that you simplify your use to no more than three items or categories, with a percent allocation to each. An example might be 50 percent for marketing, 30 percent for inventory and 20 percent for staffing. Have backup charts for investors wanting more detail.
Funding for founder salaries at this stage is a red flag. Investors expect you to “bet on the future” with them. You may pay salaries to your team, but your salary should come from earnings, when they occur. Taking your cut before earnings exist implies that you are not willing to take the same risk of no return, as you are asking of investors.
Make sure allocation amounts are reasonable. These days, even viral marketing requires real money, for events and promotions. Startups whose marketing budget is trivial lose credibility and most likely the investment. Conversely, a huge marketing budget implies an intent to “spray and pray,” in hopes that something works.
Use of funds must be tied to projected cash flow negatives. If you ask for a million dollars, your financial projections better show a negative cash flow approximating that number (with a 20 percent buffer). Investors are not interested in giving you money to keep in the bank for backup, for investing in real estate or a fancy new car.
Tie use of funds to real traction milestones. A valid milestone might be closing a specific big-name customer or channel, such as Walmart, or it might mean getting your first 100,000 social-media followers, by a given target date. Building a huge inventory before you have a confirmed customer is not a convincing strategy.
If you are really looking for research and development money, and you didn’t sell your last startup for $800 million, professional investors are not the place to start. Hopefully, you can find some friends or a rich uncle who believe in your potential. The other alternative is to find a strategic partner who knows the space well and will benefit from your solution.
Professional investors always look for a proven business model and an existing revenue stream to minimize the risk. Then they look at the people behind the model, the execution status and how they might get their money back. Your proposed use of their funds will be seen in these three contexts. They will look to your business plan for cash flows and specific return on investment projections.
In all cases, your goal must be to explain how the investment will help you scale up the business and become more profitable sooner. You should always be prepared to mention a plan B, if possible, to grow more slowly by reinvesting initial earnings over time. Confessing that you are in survival mode, desperate for money now, will not improve your odds with investors.
Whether it be in the context of a five-minute elevator pitch or a more formal presentation to professional investors, the projected use of funds should be summarized and prioritized into three “chunks.” These must remain focused on scaling the business.
Investors want to be convinced that your use of their money will maximize their returns in the first five years, as well as yours. After that, all you have to do is make it happen. Have fun!
*** First published on Entrepreneur.com on 5/22/2014 ***