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

by Tom Taulli

  Once you feel comfortable giving your pitch, put together a fundraising plan that outlines the steps you plan to take—as well as the timeframe in which you’ll take them—to finance your company. Keep in mind that raising capital can be a time sink—a Series A round of financing alone can take anywhere from one to three months to complete—and your pitch is just the start of the fundraising process. You also need to allot sufficient time to engage in negotiations, perform due diligence, and finalize the transaction.

  But don’t give yourself too much time to complete your fundraising plan. Why? Because it is very easy to lose your focus on managing your company during the fundraising process. It makes sense, right? The more time you spend pitching VCs, negotiating terms, and signing contracts, the less time you have to commit to the essential day-to-day operations of your company. What’s more, VCs have a good sense of when a company is deteriorating, and they usually are not afraid to take advantage of the situation.

  A shortened fundraising schedule is also important because of the tight-knit nature of the VC community. When VCs see a deal they are interested in, they tell their friends at other firms about it, which helps build buzz for the company in question. Then, if word spreads that the company is approaching potential deals with a sense of speed and urgency, investors may jump on board simply because they don’t want to miss the train before it leaves the station. On the other hand, if the buzzed-about company spaces out its meetings and drags its feet on drafting term sheets for investors, the initial buzz and enthusiasm surrounding the company may subside, diminishing the company’s investment prospects in the process.

  So, how do you avoid creating a time-intensive fundraising plan? Easy: condense the time period you have designated for fundraising. Draw up a list of VCs you want to pitch to, and schedule your meetings with them during a short time period. The latter shouldn’t be too difficult to achieve, because many VCs in Silicon Valley (at least the ones that matter) are concentrated along Sand Hill Road. As much as possible, talk to lead investors, which are firms that manage the investment process for your company. If you have several lead investors at the table, you may be able to create a bidding frenzy, which will lead to a higher valuation for your company—not to mention a shortened fundraising period!

  Finding the Right VCs

  When it comes to finding the right VCs for your company, avoid using a “spray and pray” approach. Instead, target the VCs who are best suited for getting your company to its next level of growth. How do you do that? Go beyond the brand name of the firm and look at the other companies they’ve invested in, the stage of development they prefer a company to be in before making an investment, and what their investment successes have been. In other words, you should do a background check on a VC firm and its partners before requesting a meeting with them. You can start by doing a Google search on the firm in question and then asking your shared contacts about their experiences with the firm. Does the investor have a background in your company’s space? Can they bring strong contacts to the table? What about good advice? Or are they known to be a troublemaker? If the answers to these questions don’t meet your standards, don’t be afraid to walk away from the firm. It’s never easy to say “No” to someone who’s willing to write you a check, but in some cases, doing so may be the best decision.

  Once you have compiled a short list of preferred investors, ask your mutual contacts for an introduction. It may also be worthwhile to have a two-minute phone call with each of your potential investors before setting up a formal pitch meeting with them. On the call, give the VC your elevator pitch and see if they have any interest in your company. If the investor’s enthusiasm is lacking, well, that’s one less needless presentation you have to make.

  Data Room

  Data rooms are secure online portals with limited controlled access that allow investors to log in and view your investor materials, including your deck, executive summary, and due-diligence information. Although using a data room to store your company’s documentation may at first seem unnecessary, investors appreciate being able to access all of your company’s investor materials on one central hub. What’s more, constant e-mailing back and forth of documents can slow the investment process—or result in errors.

  If you’re looking for a secure data room for your company, you might consider using CapLinked, which caters to early-stage companies, is easy to use, and can be integrated with outside resources, such as LinkedIn. Perhaps the most important feature of CapLinked, though, is its ability to let you know that an investor has looked at your company’s materials. If an investor has indeed been reviewing your company on the site, you may notice, based on the specific documents they downloaded, that they seem to be interested in your company’s business model and product. This information can be extremely helpful to you when reaching out to the investor in question.

  Be Wary of the Fake VC

  It may be difficult to believe, but some VCs don’t have any money to invest. Consider that a typical VC fund progresses through several key stages in its lifespan, one of which occurs during the fund’s second to third year, when its partners start to raise capital for the firm’s next fund. If the returns on the prior fund have been lackluster, investors may not have any interest in joining the next fund—which means the fund won’t have any money to invest. So, if you notice that a VC firm hasn’t made an investment in a year or so, steer clear. This type of inactivity is almost always a sure sign that the firm has run out of investable capital.

  On a related note, you should also be wary if you discover that one of the top partners at a firm has stepped down or switched employers. Why? Because, often, investors and VC firms sign agreements stipulating that the fund’s investing activity will be halted if one of the firm’s main partners pulls out. A clause of this nature is perfectly reasonable; after all, investors decide which funds to invest in based on the skills and reputations of those funds’ main partners. Why, then, would they leave their money in a fund that is managed by someone they don’t trust?

  Don’t Get Too Excited

  I often hear entrepreneurs say something like: “I talked to this VC the other day, and he was really excited about my company.” Not to be rude, but so what? VCs are smart and calculating individuals, which is why they generally refrain from saying “No” to any deal. What if that company becomes the next Facebook? Saying “No” to a company takes VCs out of the game, and they always want to make sure they are in the game—just in case.

  You also must realize that there is an important pecking order in the VC world, and titles matter. If you talk to a director, a principal, an associate, or a research analyst about your company, you aren’t talking to a decision-maker. People in these types of positions almost never say “No” because they are mostly keeping track of the players in the market, not making crucial decisions about which companies get what amount of funding. But if you do manage to talk to a firm’s managing director or general partner, congratulations: you are talking to a decision-maker. What’s more, they have little time to spare, so the fact that they are willing to meet you is a very good sign. In this case, you can get a little excited!

  Thick Skin

  Unless you have developed a super-hot product, expect to be rejected by VCs. Any company that is attempting to pioneer a new approach should expect its fair share of rejections. And when those inevitable rejections start trickling in, chin up: investors passed on Facebook in the belief that it was overvalued or a fad. Remember, raising money is like any others sales process. You have a target audience, and there is a hit rate. If things go well, several VCs will compete for your deal.

  Let the World Know

  When you close a round of funding, draft a press release that features quotes from some of the VC partners who have invested in your company; this will add credibility to your venture. You should also add an “Investor” section to your company web site that includes information about the company’s funding as well as a contact name, a p
hone number, and an e-mail address.

  Next, typically several days prior to your company’s official funding announcement, reach out to some of the typical blogs in your sector and alert them to the news of your funding. Reporters generally hold off on announcing such news before the predetermined announcement date you set for them, but be aware that embargos may be broken. Sure, this may be a bummer, but at least you are getting exposure for your company.

  Leverage Your Investors

  Many entrepreneurs have little idea how to enlist their investors’ help. In some cases, entrepreneurs may see their investors as adversaries, especially if funding negotiations were contentious. But this is a big mistake. Angels and VCs generally have a tremendous amount of entrepreneurial and business experience, so get your investors involved in your company as much as possible. If you are having trouble finding ways to make the most of your investors’ skills and talents, try these strategies:

  Ask for their advice on the new iteration of your product.

  Request that they help you lure in new hires.

  Propose that they put you in touch with companies with which you are interested in forming partnerships.

  Suggest that they give you feedback on your company’s new marketing campaign.

  You don’t have to involve every investor in every decision you make. Instead, segment them into their areas of expertise, which should help streamline the advice-gathering process—and maximize your results.

  Summary

  As you can see in this chapter, you need to display a tremendous amount of sales savvy when dealing with investors. In fact, being a skilled salesperson is critical if you want to achieve success as an entrepreneur, because you are, in parallel, selling not only to investors but to potential employees and customers as well. Selling yourself, your company, and your product may be a somewhat uncomfortable experience, but you don’t have much choice in the matter. When in doubt, repeat to yourself: “Sales is not evil!”

  In the next chapter, we look at the nitty-gritty of negotiating an offer from investors. It’s an intense process, but I’ll show you some ways to get your footing.

  Deal Terms

  My father said: You must never try to make all the money that’s in a deal. Let the other fellow make some money too, because if you have a reputation for always making all the money, you won’t have many deals.

  —J. Paul Getty

  When an angel or VC wants to make an investment, they issue a term sheet. This is a short document—one to four pages or so—that sets forth the amount to be invested and the valuation. There is also an array of protections that are heavily legalistic and technical. Often these are the most critical part of the document, yet investors tend to focus instead on the valuation. It can be a huge mistake.

  Mark Zuckerberg agreed to his first term sheet back in 2005, which came from Peter Thiel. Mark had the help of counsel and key advisors like Sean Parker, who understood the nuances of the deal terms. Although the valuation was important, it didn’t become an obsession. Consider that an important focus was for Mark to maintain control of Facebook, which would prove critical for the company’s success.

  All this required hefty legal fees, which were the company’s responsibility. And did you know that general practice is for the company to also pay the VC’s fees? It’s true. But these come out of the financing.

  This chapter shows many of the types of provisions you see in a term sheet and how to negotiate them. After this, you will look at how to manage the due-diligence process, which can have its own landmines. But first let’s cover some time-honored approaches to smart negotiation.

  Being a Dealmaker

  Before getting into the negotiating process, make sure your team is on the same page. This includes not only your co-founders but also your advisors and attorneys. Decide on things like the ideal term sheet you want, deal killers, the minimum levels on key points, and terms that don’t matter much.

  You’ll be glad you vetted these issues. Keep in mind that VCs are pros at negotiation—it’s part of their job description—and are not afraid to pounce on inexperienced entrepreneurs.

  Let’s say one co-founder blurts out that an anti-dilution clause is important, but a few days later another co-founder mentions the opposite. The VC will smell an opportunity to kick out the clause.

  Yes, it can be brutal.

  Negotiating Tips

  It’s common for entrepreneurs to talk too much in negotiations. This may be due to nervousness, or it may be a way to create rapport.

  Don’t fall into this trap. You may talk too loosely about certain terms, such as inadvertently volunteering your minimum deal points on the valuation or the liquidation preference. It’s almost impossible to undue such a move.

  What about Zuckerberg? By his nature, he is a quiet person. He reflects much on ideas and what people say. The silent approach has also been a great negotiating technique. Despite his young age, he was able to effectively go up against some of the world’s best dealmakers.

  If you read the literature on negotiation—and there are many books on the topic—you’ll notice myriad approaches. One is to be Mr. Nice Guy and not get too aggressive. The belief is that you’ll reach a better deal if you’re collaborative.

  There are merits to this technique, but it has its problems. Investors want to know that an entrepreneur is tough and willing to fight hard on material points. If you roll over on major issues of the financing, you’ll probably lose the confidence of your potential investors. They will wonder: Are you too wishy-washy? Will you be up to the task of getting strong terms from customers and vendors? Probably not. Consider that investors, such as Peter Thiel, have passed on investments because the entrepreneurs were not willing to get aggressive on their negotiations.

  On other hand, some entrepreneurs go to the other extreme, taking a no-prisoner’s approach. The premise is that a negotiation is a war, and every point must be won.

  The most notable example is Steve Jobs, who was a relentless negotiator. Somehow he was able to get his way with mega companies.

  But of course, Jobs was an outlier. He had an innate sense of timing and immense charisma. Chances are you don’t. So if you are too hostile in your negotiations, you’ll likely wind up with little to nothing to show for it. It’s also important to remember that during the negotiation process, you are in the early stages of building a relationship with the VCs. They will be part of your company for years.

  The best negotiating approach is to maintain a balance between collaboration and aggression. It’s not easy, but it gets better with experience—and as an entrepreneur, you will have many opportunities for practice. It’s key to be mindful of the balance and keep finding ways to improve.

  You should also be wary if the VC uses hostile tactics. Is this approach the typical way they conduct business? Might this bode ill for a long-term relationship?

  One bad sign is if the VC offers an exploding term sheet, which means you must agree to it within a short period of time (say, 24 to 48 hours). This high-pressure technique is a major red flag. Probably the best thing to do is walk away.

  You also should not agree to a “representations and warranty” clause that makes you personally responsible for the company’s results. This could be devastating to your personal finances. It also shows that the VC is overreaching and you should probably look elsewhere for an investor.

  Get Some Thick Skin

  If a VC gives a low-ball number on your company’s valuation, it feels like an insult. You may want to lash out or tank the deal. Don’t they know this company has huge potential?

  This may be the case, but you need to realize that VCs are taking a big leap of faith. Most early-stage ventures fail for a host of reasons, such as timing, competition, and bad execution.

  It’s amazing that VCs are willing to invest in such ventures. Doesn’t it seem nuts to put $5 million into a company that has only a prototype, no sales, and a young management team?

  S
o when it comes to the valuation of your company, you need to have thick skin. Expect the low-ball offers—and don’t be surprised if the valuation goes even lower as the negotiation progresses! It’s all part of the not-so-glamorous journey for an entrepreneur.

  A big fear of entrepreneurs is a massive dilution of their ownership stake. It could mean the difference between being mega-wealthy or moderately wealthy or merely content. But there is no way around dilution; it’s part of the game. As for Zuckerberg, he had only 28.1% of Facebook’s ownership when the company came public in May 2012. But it was still enough to make him one of the world’s richest people.

  Valuation Is an Art, Not a Science

  There are several approaches to valuing a company. They include looking at comparable transactions, coming up with the market values of the assets, and evaluating a company’s cash flows.

  But for early-stage ventures, none of these methods work. Even if there are similar transactions, they won’t have been disclosed. An early-stage company has few meaningful assets, and cash flows are years away. So throw away your Excel spreadsheets—they’re useless and will muck things up.

  Perhaps the only quantitative standard is that an investor generally takes a minority stake in an early-stage company, say 10% to 40%. By doing so, they make sure the entrepreneurs have enough incentive to create a breakout company.