Have you heard of social proof?

In case you haven't, "social proof" is a shortcut that investors often use to make decisions. If an investor asks for a "lead investor" to have validation that someone else likes the company, they're asking for social proof.

If you're a startup applying for your profile on AngelList, "social proof" is even an actual form you can fill out on your profile.

And, in case you haven't guessed, it can be pretty important when you're fundraising.

Here's a real story of a founder who learned the importance of social proof -- and who learned the hard way that if you understand how social proof works, you can be more successful in fundraising.

Trying to capitalize a startup from the ground up

As a 23-year-old, Lutheran was making six figures as a Project Manager with a Massachusetts-based startup. He became passionate about resource efficiency of agriculture and energy, and left that job to join EFK Group, an African startup that has identified dozens of uses for the croton tree, a pervasive bush that grows on otherwise worthless farmland across Africa. He started as an intern, and within a year, he was CEO.

EFK had solid revenues and good profit margins, and needed to raise capital to scale. Lutheran had an idea: if they owned more of their own supply chain, they'd be more profitable. They would raise $50,000 to build a processing facility.

Striking out raising $50K

EFK had solid profits, and great impact. They were raising the wages of farmers who gathered croton nuts across rural Africa from $1/day to $5/day.

Lutheran thought--how hard could $50K be?

First, they pitched banks, but learned that loans in Africa are basically nonexistent. IFC estimates that only 16 percent of the lending-worthy offerings in Africa get banked.

Then they started pitching investors. Lutheran found that most investors have higher minimums than his $50,000 raise. "Most people wouldn't even look at less than $250,000," he said.

Then he pitched a group of foundations and individuals interested in investing in Africa, and found this group pretty demanding. "One investor," Lutheran said, "made me pitch their board three times for a $50,000 investment--and still said no!" A few other investors said that they were interested, but "wanted a lead investor" because they "did not do deals alone."

Lutheran was at the end of his rope. He saw other startups in Africa raising $5, $10, $20 million, and he couldn't find $50K. "I finally realized," said Lutheran, "that I had to raise at least $1 million to be taken seriously."

Succeeding raising $1M

Lutheran went on a road show--this time to raise $1M. He first pitched a very well-respected hedge fund manager in Boston. Before meeting Lutheran, this investor had researched the futures of everything from chicken feed to biofuel--and liked the business.

He made the first $250,000 commitment, which got a matching commitment from another investor who had been previously interested but wanted "a lead." The round closed in two months.

"When we went out for $100,000, we got nothing," says Lutheran. "And when we went for $1 million, we got $1.4 million. That's the way the market works."

What did Lutheran learn?

1. Social proof can be a curse--and a blessing.

If an investor says they "need a lead investor," or "don't do deals alone," said Lutheran, don't waste your time with them until you find a lead. You won't convince them or change their mind.

Say "thanks, I'll come back when I have a lead"--and do it!

2. Investors back visions rather than projects. Share your vision first, then your budget.

For the $50,000 investment, Lutheran proposed a small-scale processing facility.

Trying to raise $1 million, Lutheran said, pushed him to develop a vision for what $1 million would do--which ultimately gave investors a much more exciting proposal.

3. Understand the market realities when fundraising--you might have to play the investor game if you want to grow.

Lutheran says that when he raised his amount from $50,000 to $1 million, he felt a moral dilemma.

"It felt crazy," he said, "telling my staff who made $150/month that we were raising $1M."

But then he discussed the fundraise with an advisor, who said, "Myles, what hill are you willing to die on? You can play the investor game, and grow big, or you can decide not to take outside capital and either stay steady or wither and die. There's no perfect choice."

Lutheran understood what the market was willing to buy. If you decide to raise money, recognize that investors have very specific preferences, and you may need to meet the market where they are.

(You could, of course, decide not to raise money--and keep control--but that's another column!)

Published on: Oct 17, 2016