Y Combinator: When Raising Money, How To Convince Investors

From Paul Graham's blog:

August 2013

(This is one of a pair of essays on fundraising. The next one, on fundraising tactics, is coming soon.)

When people hurt themselves lifting heavy things, it's usually because they try to lift with their back. The right way to lift heavy things is to let your legs do the work. Inexperienced founders make the same mistake when trying to convince investors. They try to convince with their pitch. Most would be better off if they let their startup do the work—if they started by understanding why their startup is worth investing in, then simply explained this well to investors.

Investors are looking for startups that will be very successful. But that test is not as simple as it sounds. In startups, as in a lot of other domains, the distribution of outcomes follows a power law, but in startups the curve is startlingly steep. The big successes are so big they dwarf the rest. And since there are only a handful each year (the conventional wisdom is 15), investors treat "big success" as if it were binary. Most are interested in you if you seem like you have a chance, however small, of being one of the 15 big successes, and otherwise not. [1]

(There are a handful of angels who'd be interested in a company with a high probability of being moderately successful. But angel investors like big successes too.)

How do you seem like you'll be one of the big successes? You need three things: formidable founders, a promising market, and (usually) some evidence of success so far.

Formidable

The most important ingredient is formidable founders. Most investors decide in the first few minutes whether you seem like a winner or a loser, and once their opinion is set it's hard to change. [2] Every startup has reasons both to invest and not to invest. If investors think you're a winner they focus on the former, and if not they focus on the latter. For example, it might be a rich market, but with a slow sales cycle. If investors are impressed with you as founders, they say they want to invest because it's a rich market, and if not, they say they can't invest because of the slow sales cycle.

They're not necessarily trying to mislead you. Most investors are genuinely unclear in their own minds why they like or dislike startups. If you seem like a winner, they'll like your idea more. But don't be too smug about this weakness of theirs, because you have it too; almost everyone does.

There is a role for ideas of course. They're fuel for the fire that starts with liking the founders. Once investors like you, you'll see them reaching for ideas: they'll be saying "yes, and you could also do x." (Whereas when they don't like you, they'll be saying "but what about x?")

But the foundation of convincing investors is to seem formidable, and since this isn't a word most people use in conversation much, I should explain what it means. A formidable person is one who seems like they'll get what they want, regardless of whatever obstacles are in the way. Formidable is close to confident, except that someone could be confident and mistaken. Formidable is roughly justifiably confident....MORE

HT: Abnormal Returns