The most effective financing processes, like the most effective auctions, create scarcity. Of late, many founders have been triggering pre-emptive financing processes for their raises. This is my interpretation of their playbook.

Strategy

First, founders build credibility with investors. This can be done in many ways like cultivating a long term relationship with a handful of VCs or in less direct ways like brand building through social media and blogging. Founders have established credibility through referrals from people-in-common. And of course, business performance is the trump card. Walk in with great numbers and you establish your company as an expert.

Second, founders create the perception of scarcity, a great tool to seduce investors. There are many forms of scarcity creation. Trailing a fast moving processes is the most common form of scarcity I’ve observed. Once one investor is engaged, it’s much easier to engage others; ie, “We weren’t raising but someone became really excited and now you’re behind the process. Should we meet?”

Gameplan

How does a team build that momentum? One common gameplan: About 3 months before a fund raise, founders call a handful of VCs to provide an update on the business and indicate the company is contemplating a fund raising in about 3 to 6 months. They typically ask for advice on the process. What kinds of metrics and milestones excite investors enough to invest? What questions do they foresee their partners asking? What challenges to the business exist that the pitch must address?

A month or two or three later, founders follow up with an update to explain the progress on the key questions investors raised with the goal of triggering a meeting before the official process begins. By asking for expectations and then beating them, founders establish the business’s momentum and reaffirm credibility with an investor. With the first meeting down, and others in the pipeline, it’s a race to the finish, with the goal of getting to term sheets and closing as fast as possible.

Every once in a while a business is growing so quickly, or is just such a wonderful idea that no effort is required on the part of the company and investors pursue pre-emptive rounds actively. In that case, this playbook is moot.

Pros and Cons

There are many advantages to entice investors to engage early. Startups aren’t expected to have prepared as many materials as those engaging in a “formal” process. An early process has the potential to eliminate financing risk much earlier than expected. Founders can steer the financing to investors of their choice with more control than a standard process. And founders can always point to the pre-emptive nature of the financing as a bargaining tool for better terms. The most common refrain is effective: “You can invest now and get a bargain or I can raise in 6 months at a much higher price as my business continues to grow.”

Of course, there are trade-offs. First, like any financing, these processes are time expensive. Second, if the process takes too long to engage any investors, it can be perceived as a failed financing, so timing perceptions must be actively managed. Third, it may not work. Investors may not be receptive because of seasonality (summer doldrums), or macro-economic factors, or business risks/stage.

Like Mentos and Diet Coke

Preemptive financings don’t happen for every company, but when they do it can be well worth the effort.