How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO

by Tom Taulli

  Start up Lite

  The costs of starting up a company have declined substantially during the past few years, at least for those in the web and mobile app spaces. After all, most mobile or web products can be hosted, launched, and distributed easily and inexpensively on cloud services such as Amazon Web Services, thereby eliminating the hassle and potential expense of self-distribution. You can start easily with a small amount of storage and bandwidth, and, as your business begins to grow, pay for additional capacity as the need arises. This pay-as-you-go approach is the hallmark of cloud computing and makes life much easier for the startup entrepreneur.

  So, for the most part, then, the “cost” of a tech startup is the time it takes for the team to code the product. Your out-of-pocket expenses will likely be well under $25,000, much of which will go toward your company’s legal fees. This is in stark contrast to the dot-com boom of the 1990s, when it took $5 million to $10 million just to obtain vital components of tech infrastructure, such as Oracle databases, licenses to servers, and hardware. All of this is to say that although you may think you need to raise millions of dollars to launch and develop your product successfully, odds are that you will need far less capital than you might expect.

  If your product gains momentum, then you are in a much better position to pique the interest of investors whose cash infusions will help you scale your company, which means to accelerate the growth rate. You should also be able to get a better valuation on whatever funding deal you strike with them. Don’t think that you have to draft an executive summary or a business plan when you are still in the early stages of developing your product to draw in investors. Rather, focus on speed and on developing some critical features that will solve your customers’ problems. In many cases, success is the by-product of pursuing a project that solves a specific problem you have. As was mentioned in Chapter 3, Zuckerberg created Facebook because he wanted a better way to connect with his school friends, and things turned out pretty well for him.

  Know the Types of Investors That Are Out There

  If your product is getting traction in the marketplace, then the time has come to seek out investors. Keep in mind that there are many types of investors you can approach, each of which specializes in a specific phase of the financing cycle of a new company. Read on to learn about the main players.

  Angels and Superangels

  Angel investors are those who invest their own money in early-stage ventures. For the most part, angels are wealthy and meet the U.S. Securities and Exchange Commission’s requirements to act as accredited investors. In addition, many angels have started their own companies or are executives; so, as an added bonus, they often bring incredibly valuable business experience to a venture. Don’t be alarmed if you encounter angels who wish to make their investment in your company through a legal structure, such as a trust or an LLC. Angels use such structures because they lower taxes and provide liability protection, not because they’re trying to scam you.

  You may also talk to so-called superangels, or high-profile entrepreneurs, who carry a lot of clout within the startup community and become serial investors in early-stage ventures. It’s not unheard of for superangels to invest upward of $1 million in the ventures they decide to seed. In many cases, superangels invest money on behalf of other angel investors by creating a micro venture capital fund. Some examples include Jeff Clavier’s SofTechVC and Chris Sacca’s Lowercase Capital.

  Venture Capitalists

  Although venture capital is thought of as a fairly new industry, its roots go all the way back to the 1940s, and it started gaining momentum as early as the late 1970s, when VCs funded breakout companies such as Genentech and Apple (keep in mind that VC is a broad term and refers to both a firm and the partners). It was during this time that some of today’s most iconic VC firms, such as Kleiner Perkins and Sequoia, got their start.

  Many of these operators set up their offices along Sand Hill Road in Menlo Park, California, which to this day remains the epicenter of venture capital. It is a boon to budding entrepreneurs that Sand Hill Road runs along Interstate 280, which connects San Jose and San Francisco, and is in close proximity to Stanford University. Furthermore, because so many firms are concentrated in such a small area, it is relatively easy and inexpensive, travelwise, to pitch to VCs. An entrepreneur can easily pitch to four or five VCs in a single day!

  Unlike angels and superangels, VCs invest money on behalf of their investors, who are known as limited partners and include institutions, such as endowments, insurance companies, and pensions, as well as wealthy individual investors (usually, former entrepreneurs). In this respect, a VC is essentially a money manager; any given firm has several partners that seek out investment opportunities, structure investments, and provide follow-on funding.

  Every few years, a VC firm will invite several of the firm’s investors to combine their capital into one large fund to invest in an array of startup companies. Each fund that a VC firm creates lasts for 10 to 12 years, which, ideally, is just enough time for the firm to sell all its equity stakes in its portfolio companies. However, because it is now taking much longer for companies to go public—in part because founders want to retain more control over their ventures, but also because it is very expensive to pull off an IPO—more and more VCs are extending their funds’ lifetimes.

  The partners in a venture fund generate income from two sources. First, they charge a management fee, which can range from 1.5% to 2.5%, and is based on the size of the assets in the fund and is paid every year until the fund is closed down. For the most part, the management fee is meant to help the partners with their overhead costs. For a large fund, however—say, $1 billion or more—management fees can turn into lucrative compensation for the partners.

  The second way in which the partners of a venture fund are compensated is via carried interest, also known as carry, which generally amounts to 20% to 25% of the profits from the fund and is paid out as a performance incentive. Again, a partner working at a large fund can command substantial fees from carried interest. For example, suppose a VC fund generates $1 billion in profits. In this case, the fund’s partners will divvy up $200 million to $250 million, which explains why many VCs drive fancy cars and have multiple homes.

  The VC game, however, isn’t exactly a surefire way to rake in heaps of money. It can be brutal. Because the majority of investments a VC makes will be wipeouts, firms need to invest in ventures that can ultimately become franchise companies, such as Facebook. The goal is that these huge winners will more than compensate for the many losers in a VC’s portfolio. Unfortunately, however, this isn’t always the case. Although tier 1 operators have been able to generate standout returns in recent years, the majority of firms have posted lackluster returns since 2000. As a result, there has been substantial attrition in the number of VC firms in operation throughout the years.

  Strategic Investors

  As companies grow larger, it can become more difficult for them to innovate, despite how essential it is for them to do so. Often, in lieu of hiring a chief innovation officer or trying to innovate from within, an established company makes what are known as strategic investments in early-stage ventures with the goal of gaining valuable insights into new technologies or markets. Strategic investments can even be used as a way to stifle the competition. For example, a key reason that Microsoft invested in Facebook was to prevent Google from taking a stake in the company; the investment documents that Microsoft drew up specifically prohibited Facebook from taking money from the search engine giant. However, Microsoft received other important benefits when it invested in Facebook. As part of the deal, Microsoft was given the green light to sell banner ads on Facebook outside the United States, splitting the revenue with the young startup. It also gave Microsoft the opportunity to learn the nuances of social networking. Oh, and the investment turned out to be a big gainer.

  So, why should a startup take money from a strategic investor? One reason is that valuation negoti
ations with strategic investors are usually straightforward, because strategic investors in general are looking for company synergies and not necessarily a substantial monetary return on investment. A strategic investment can also be a validator and vote of confidence for a young company, which can make it easier for the startup to attract new customers. Last, a startup can leverage its strategic investor’s infrastructure and distribution channels, potentially leading to wider exposure and more opportunities for growth. For a startup, it is important to establish specific deliverables—in other words, benefits that the strategic investor will provide, such as introductions or promotion assistance—when brokering a deal with a strategic investor to maximize the value received from the investment.

  No doubt, there are downsides to strategic investment, the most notable of which is exposing you to the need to navigate through corporate bureaucracy. It might be agonizingly slow to get much feedback or traction from your strategic investor; therefore, try to avoid giving your strategic investor a board seat or veto rights on major decisions. You should also try to avoid negotiating any exclusive partnerships with your strategic investor because these can ultimately limit your company’s growth potential.

  Venture Lenders

  To avoid issuing too many shares and running the risk of diluting their stock, which has the potential to wind up in the wrong hands, many startups seek out debt financing, which involves borrowing money. This may seem like a strange strategy for an early-stage company, but debt financing is actually a viable option for new ventures, thanks to recent developments in startup funding.

  During the past decade, a variety of top venture lenders have emerged whose financing provides startups with working capital and helps them buy equipment or meet their short-term needs. If you think only a desperate or flailing startup would seek out venture lenders, think again; Facebook actually borrowed money from venture lenders, such as WTI and TriplePoint Capital, as recently as 2009, when the company’s credibility and worth were already well established.

  Prior to signing a debt-financing deal with a startup, venture lenders establish the term of the loan, which usually ranges from 2 to 4 years. Then, in return for their willingness to front the startup working capital, the venture lenders gain competitive interest on the loan—perhaps 5% to 7%. However, venture lenders also want to acquire some equity in the startup as a condition of the loan. As a result, the startup issues its venture lender an agreed-on number of shares through a warrant, which is similar to a stock option in that it gives the investor the right to buy shares at a fixed price for up to 10 years. The worth of the warrant is usually expressed as a percentage of the overall amount of financing the venture lender provides. For example, if a company borrows $1 million from a venture lender and the warrant coverage is 10%, then the warrant allows the lender to buy $100,000 of common stock. For the most part, venture lenders only provide debt financing to startups that are backed by venture capital, because doing so provides some level of safety for the loan.

  Late-Stage Funders

  Private equity funds, hedge funds, and mutual funds, from time to time, provide late-stage funding for startups they deem to be promising. By investing in more mature companies, late-stage funders have the opportunity to gain strong returns from their investments, but with a significantly lower level of risk because the startups that survive to this later point have most likely achieved impressive sales and established their worth in the marketplace. On the flip side, for the company that is seeking it, late-stage funding is usually a way to generate secondary sales and to allow its existing shareholders—whether they are investors or employees—to sell some of their holdings to these funds. It is also a way to infuse liquidity into the startup without having to file for an IPO, which can be expensive and disruptive to the startup’s operations.

  Yuri Milner, who operates Digital Sky Technologies (DST), was one of the first innovators in late-stage funding—and an unlikely one, at that. Born in Russia, he went to school at Wharton and then returned home to buy a macaroni factory, which turned out to be a tremendous cash cow. When the dot-com bust hit in 2001, Milner purchased the e-mail service Mail.ru for $100 million and, within a few years, it became the No. 2 Internet company in Russia. Flush with cash, Milner then contacted Facebook and said he wanted to buy shares in the company. His timing was perfect; when he got in touch with Facebook, the world economy was still in the throes of the financial crisis of 2008, making his offer extremely attractive to Facebook. The company eventually agreed to the deal, and DST invested $200 million in the social networking giant while taking a “hands-off” approach to the investment. In a sense, DST’s late-stage investment in Facebook was almost like an IPO, because the investment gave the firm no ultimate control over the site. Since then, Milner has made late-stage investment plays in other well-known companies such as Twitter, Spotify, Zynga, Groupon, and Airbnb.

  Late-stage funding has become a common part of the startup landscape. These investments make it possible for founders to defer filing an IPO and provide liquidity to early investors and employees. The funding also provides substantial resources to help accelerate a venture’s growth and position it to dominate new markets. However, it isn’t exactly easy to attract the interest of late-stage investors. A company must have the potential to become a franchise player—complete with a global brand and substantial barriers to entry, such as with its customer base, technology, and distribution—before late-stage investors give it a second glance. The good news, though, is that such attributes are obvious in the marketplace and late-stage funders often approach worthy companies to inquire about making an investment.

  Understand the Stages of Investing

  In general, a startup goes through four different types of rounds of financing: seed, angel, venture capital, and IPO. Let’s take a look at each one in detail.

  Seed Funding

  Seed funding, which is often a company’s first round of funding and generally involves fairly small amounts of capital, from perhaps $1,000 to $100,000, allows a startup’s cofounders to test their hypothetical product. This testing usually entails creating a beta version of their product and seeing whether it gains any traction with potential investors, who may include the company’s founders, friends, family, and maybe angel investors. One of the more popular sources of seed funding is through the use of the founders’ personal credit cards, which is exactly how Facebook survived the first year of its existence. However, investments can also be drummed up creatively, such as when the founders of Box financed the company with $20,000 they made from playing online poker!

  Generally speaking, for most startups the seed stage is a mess. Founders who are enmeshed in the seed funding stage of their company’s development tend to give little thought to legal matters or business formalities. They probably will have issues with a lack of communication, as well. Facebook suffered from these classic problems, too. Like many first-time entrepreneurs, Zuckerberg had no experience with business and legal matters when he first launched Facebook, but this is no excuse for you to do the same. It does not take much work to build a solid foundation of business and legal knowledge. As we talked about in Chapter 2, there are some legal moves, such as incorporating a C-Corp in Delaware, protecting your intellectual property, and exercising an 83(b) election, you can make to position your startup for success. Sure, concerning yourself with the business and legal minutiae of starting up a company isn’t fun and may delay your speed a bit, but it will be well worth the effort in the end.

  Angel Funding

  Compared with the seed funding stage, angel rounds of financing typically involve much larger investments, which can range in size from $100,000 to $1,000,000. In the case of Facebook, Zuckerberg raised $600,000 in its first angel round, including $500,000 from Peter Thiel and $40,000 from both Reid Hoffman and Mark Pincus. The remaining $20,000 was contributed by several other individuals.

  So, how do you find angels? Doing so takes a lot of work and is certainly not
the easiest endeavor in the world, but the following sections provide several helpful strategies to make your search easier.

  Angel Networks

  Angel networks are organized groups of angel investors consisting of anywhere from 20 to 100 members that meet up about once a month to look at new startups in which to invest. When angel networks decide to strike a deal with a startup, the investment amounts can be large—say, more than $1 million.

  There are several reputable angel groups in many large cities across America and they usually have web sites that detail the process by which they select startups for investment funding. However, angel networks typically become aware of your company because you either get a personal introduction to a member or you submit an executive summary for the network to review. If your deal meets the network’s initial criteria, you’ll be invited to make a presentation to the group, which—heads up—may be quite small. Some angel networks require you to pay a fee before presenting to the group, but I’d avoid networks with this type of requirement. After all, the best investors want to find early-stage investment opportunities, not draw in additional income from cash-strapped entrepreneurs.