How to use Information Cascades to get your Start-Up Funded
Especially for first-time founders, closing a fundraising round is a difficult task. There is the uncertainty of knowing which investors and venture capital firms to reach out to coupled with the low response rate for any cold contacts. Of the 500,000 companies started in the US each year, VC firms only invest in 1,000 and Angels only invest in another 30,000 (Fundera). This means that less than 6% of start-ups are funded through these traditional routes.
This past summer when I was working at a startup and helping them manage their seed round, a repeated tidbit of guidance from our advisors was to “secure the first investor.” They stressed that after one investor, the rest would follow. I wondered, what is the real value of one investor who is only contributing 1% of the money needed to close the round. Why would this be such a big deal?
After learning about information cascades and herding, it became much more clear why these few early investors were so significant. The cascades happen for two reasons: direct benefit and information effect. In this case, the direct benefit would be that by knowing someone already has invested in the company, you know that any money you invest after that person would be going towards a company that is able to use more money than just your own to develop their product. More importantly, the information effects play a huge role, especially in the worlds of venture capital and angel investors.
Getting one reputable VC firm to invest in your startup means that they trust you and are willing to risk their reputation because they feel that this is a sound investment. Any other investor or VC firm would observe that Firm A is confident in your startup (and has the information to do so) and would assume that investing is the “right” decision. Given the close-knit nature of the entire VC industry, word travels when one company adds a new start-up to their portfolio. This signals other firms to look at the same startup. Especially in early stages of startups before they even have a Minimum Viable Product (MVP) or any revenues to report, a shortage of information is the main barrier stopping people from investing. Even if the information publicly available might not be compelling enough to warrant investment, being able to observe other people’s choices can overwhelm the private information available and lead to investment which might not have occurred otherwise.
After the first investment, and even more so after the first 2-3, future investors are much more likely to follow others’ choices. This is why, after overcoming the hurdle of the first few investments, information cascades lead to the funding round closing more quickly.
Fundera: https://www.fundera.com/resources/startup-funding-statistics