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

by Tom Taulli

  Assuming your presentation to the angel network goes well, a member of the group acts as the “champion of the deal,” typically ushers you through the rest of the angel round of financing, helping you target other potential investors and improving your pitch to investors. Your deal champion also conducts due diligence on your venture by performing reference checks and reviewing your intellectual property. Last, the angel network draws up a term sheet, which looks similar to those used during venture rounds of financing, and includes a bulleted list that outlines the terms and conditions of your business agreement with the group. For more on term sheets, check out Chapter 6.

  AngelList.com

  AngelList.com has become the key portal for matching startups with angel investors, and its members include such entrepreneurial heavyweights as Reid Hoffman, Fred Wilson, Brad Feld, Dave Morin, Chris Sacca, and Marc Andreessen, to name only a few. When you join AngelList, you are asked to create a profile for your company that details basic information about your company, describes why you are joining the site, and outlines who your core team members are. You are also asked to list a “referrer,” who, ideally, is a well-known entrepreneur or angel investor who is willing to provide some credibility—and hopefully funding—to your venture. If your referrer is not willing to invest in your company, well, you better be prepared for when the other angels on the web site ask why. Of course, you also should make sure that your referrer knows that you’re listing him as such on the site!

  After you’re all signed up, angels can follow your company and make comments on your business and its progress (which can be extremely helpful). For this reason, it is important that you upload a rock-solid executive summary and investor deck to your profile, which is the slide presentation. You should also take advantage of any visual collateral your team has developed, such as screen shots or video demos, because all these items can grab the attention of potential investors. Furthermore, make sure that you include the specific amount of funding you want to raise, as well as your company’s valuation, and it certainly doesn’t hurt to mention the type of security, such as convertible debt or common stock, that you will issue investors in return for their investment.

  To get your company off on the right foot, it helps first to contact angels you already know and ask them for introductions to other angels on the site. Investor leads should start materializing in no time, but make sure that you are quick to respond to investor interest as much as possible, lest potential investors go cold and lose interest in your venture, which can happen easily. Often, founders ask potential investors if they want to schedule an online video chat, which can be a time-efficient, high-impact way to meet interested angels and to continue building your company’s momentum. If it turns out that a contact made through the site does not result in an investment, you may find that the introduction is beneficial nonetheless if that angel becomes a valuable advisor to your company.

  Old-Fashioned Networking

  In all seriousness, if you want to raise money from angels—or VCs, for that matter—you need to be in close proximity to them, so move to Silicon Valley or New York City or perhaps even Los Angeles. All these places have tech ecosystems and are filled with angel investors who understand how startups work and, more important, have the funds to finance your business. Try to frequent the restaurants and bars where these investors are regulars. However, if you’re looking for a more authentic environment in which to meet potential angels, you can also attend investor and tech conferences, because these types of gatherings are a favorite haunt of investors. Over time, you’ll start to get to know some of the major players in the world of angel investing.

  Another good, old-fashioned networking possibility is to find an advisor who has gone through the startup funding experience himself. Zuckerberg’s funding advisor was Sean Parker, an entrepreneur who had developed extensive contacts in Silicon Valley while he was in his mid 20s and who made the necessary contacts to arrange for Facebook’s angel round of funding. Last, if you’re truly serious about starting up your own business, you can gain an enormous amount of experience and contacts by first working at a hot startup or top tech company, such as Facebook or Google. If you choose to go this route, you may not only get to know investors but also to develop crucial relationships with possible cofounders and engineers. Take Ben Silbermann, for example. After first working at Google as a product manager, Silbermann went on to cofound Pinterest in 2010. The site is now the No. 3 social network in the United States.

  Accelerators

  Similar to angel groups but often boasting their own office space for the ventures they decide to back, accelerators tend to provide ongoing advice and mentorship to fledgling startups, not to mention all-important seed funding. Some of today’s top startup accelerators include YCombinator and Techstars, and these programs typically provide seed funding in an amount ranging from $50,000 to $200,000, which really is enough for a small team to develop a proof of concept and determine whether it has enough promise to go on to receive venture funding. Some notable startups that were accepted and funded by accelerators include Instagram, Dropbox, and Airbnb.

  Crowdfunding

  Crowdfunding involves leveraging a public web site to raise funds for a venture from the public. Until the passage of the Jumpstart Our Business Startups (JOBS) Act in early 2012, it was illegal for business ventures to seek equity funding via crowdsourcing. Now that the act has been signed into law, however, startups can fund their operations using one of three types of models:

  Peer-to-peer lending: If you have a good credit score, peer-to-peer lending sites will help you borrow money from a number lenders, each of whom may contribute $100 or so to your cause. Although peer-to-peer lending is actually a well-developed approach to crowdfunding, the maximum amount that most sites allow you to borrow is usually around $25,000.

  Donation: With donation-based crowdfunding sites, people contribute a small amount of money to your project in return for a small perk, such as being named in the credits of your movie or receiving a t-shirt. A big player in this market is Kickstarter.

  Prepurchase and equity: When you use the prepurchase model to fund your venture, your funders receive your product for free in exchange for their early-stage investment. Although initially the prepurchase model was frequented by those who were selling a physical product, such as a cool shoe or a new-fangled mobile device, the JOBS Act has made it possible for companies to issue stock in return for their funders’ investment, with a limit of $1 million in aggregate funding per year. For example, suppose you have already raised $200,000 in funding for your venture from a couple of friends. In this case, the JOBS Act only entitles you to raise an additional $800,000 from a crowdfunding site.

  Since the adoption of the JOBS Act, there has been a proliferation of crowdfunding sites with the main purpose of helping companies gather the necessary documents for their funding efforts and seeking out potential investors. In exchange for their services, these sites charge a fee to the ventures that use them, which usually amounts to a percentage of the total funds raised. Because this industry is in its early stages, there are no clear-cut standards yet regarding the sites’ fee levels; however, they will probably round out to at least 10% of the total funds raised.

  According to the stipulations of the JOBS Act, investors who make less than $100,000 per year can make crowdfunding investments in an amount that is the greater of $2,000 or 5% of their income or net worth each year. For those over this threshold, the limit is the greater of $100,000 or 10% of their income or net worth each year. On the other side of the equation, if a company raises less than $100,000 using crowdfunding, its CEO must certify that the company’s income tax returns and financial statements are true and complete. If it raises from $100,000 to $500,000 using crowdfunding, a certified public accounting firm must vouch for its financials. If it raises more than $500,000 using crowdfunding, it is subjected to an official audit.

  Be wary. Many crowdfunding operators are smal
l and may not necessarily be legitimate. When it comes to companies that handle investor money, there is always the temptation for fraud, so before using a crowdfunding site, look at the backgrounds of the site’s principals. If there is even a hint of a shady past, do not partake of the site’s services. At all times, focus on using those crowdfunding sites that have broker–dealer licenses, which is an indication that they can sell securities to the public legally.

  Even if you find a reputable site, I still caution that crowdfunding is not a particularly good route to take for ventures seeking early-stage funding. Interestingly enough, receiving upfront crowdfunding money could make it more difficult to obtain follow-on investment from VCs later on. Why? When you crowdfund your venture, you are giving scores of individual investors early access to your shares and, generally speaking, VCs are reluctant to jump in on a deal with baggage that includes many small investors who, collectively, can cause a litany of administrative headaches. If anything, VCs try to find ways to buy off smaller, crowdfunding investors, but even this process could prove to be too trying for them in the end. Furthermore, when you gain new investors from crowdfunding, you are required legally to provide some level of ongoing disclosure to them about your company’s progress, despite the fact that such a requirement is atypical for most private rounds of financing.

  Herding Cats

  It is often said that managing your angel investors is about as easy as herding cats; it is a statement that has persisted because it’s usually true. It can be tough to deal with a large number of angels. They have egos and some may be easily distracted. As a result, I recommend that you try to limit the number of angels your company signs on to no more than five. Any more than that and you may find it tough to put together a round of funding.

  Free Equity

  Wait a minute, free equity? It sounds crazy, huh? Why would an entrepreneur issue shares to someone who does not pay anything for them in return? This scenario actually happens quite often when an entrepreneur brings on advisors and pays them in company shares in exchange for their expertise. Advisors can certainly be incredibly valuable, as was the case with Sean Parker, who advised Zuckerberg during Facebook’s initial round of funding. Without a doubt, Parker deserved the equity he received (which, by the way, has made Parker a billionaire). However, an entrepreneur needs to be careful. There are many advisors out there who make outlandish claims about their abilities and may even lie about their backgrounds, so conduct some due diligence before bringing an advisor onboard. Another option is to ask a potential advisor to join your company on a trial basis to determine whether she can really deliver before you fork over your equity.

  Venture Capital Funding

  Venture Capitalists as Seed Investors

  Some major VCs have begun participating in seed rounds of financing, which probably seems kind of strange. If a venture capital fund has $1 billion under management, how does it have the bandwidth to invest in many smaller deals? Don’t VCs have to focus on startups that need substantial rounds of financing, such as those requiring $25 million or more? Although it is true that VCs have traditionally been involved in larger investment transactions with more mature companies, some VCs have begun trying to lock in deals with ventures while they are still in their early stages of development. To this end, VCs take a “shotgun” approach to the funding process, which means investing in as many deals as possible without doing much if any research.

  Obtaining early-stage venture capital funding can be an attractive proposition for many entrepreneurs. First of all, when a VC invests in a venture early on in its development, the company’s valuation tends to be higher, because the VC typically is investing only a small amount of capital and, as such, does not spend an enormous amount of time negotiating valuation figures. And, of course, when VCs are involved in early rounds of financing, a startup can potentially receive upward of $1 million in its seed round alone.

  Despite these perks, receiving venture capital funding early on during your company’s development could be a bad move. Why? Because unless your startup starts showing breakout momentum, your VC will probably have little or no time to devote to your venture. Furthermore, collecting early-stage venture capital funding could potentially make it more difficult for your company to raise investments during the Series A round of financing (which I discuss in the next section). How so? If your company’s original VC passes on the opportunity to infuse follow-up funding into your venture during a Series A round of financing, other firms could read your VC’s disinclination to invest as a sign of its lack of confidence in your venture. It’s even worse if your original VC is a tier 1 firm and it provided your company with a decent amount of seed funding, such as $500,000 or more. True, maybe your VC is passing on the opportunity to invest in your company via Series A financing because it has already made major financial commitments to other companies, but prospective Series A investors won’t necessarily know the true motivation behind your VC’s decision to pass.

  Venture Rounds

  Generally speaking, founders seek out venture rounds of financing to evolve their product and to start building their company’s infrastructure, which entails hiring engineers and perhaps business development people. As discussed briefly in the previous section, the first round of venture financing a founder pursues is referred to as a Series A round.

  The total amount of financing a startup raises during a Series A round can range from $1 million to $25 million or more, but the typical amount is around $5 million to $10 million. To raise so much capital, fledgling companies generally select one lead VC whose purpose is to facilitate the financing process and bring other VCs into the round to distribute the overall risk of the investment among several parties. Keep in mind, however, superangels may also be involved in a company’s Series A financing efforts. In Facebook’s case, for example, Accel Partners was the only VC involved in the company’s $12 million Series A round of financing in May 2005. Angel investors Marc Pincus and Reid Hoffman also participated in the round.

  The Series A funding round typically lasts for a year or so. If it looks like the company will achieve longer term profitability at the conclusion of this financing process, then the company will launch a Series B round of financing to provide fuel for its growth. At this point in time, the company will probably also start exploring expansion into global markets and may bring on even more professional management to help take the venture to the next level. In some cases, the company may even acquire other ventures to help bolster its growth.

  During a Series B round, a company may raise $50 million or more in financing from investors who, again, are usually VCs but may also include strategic investors. (Facebook, for example, raised $27 million from investors [including Greylock Partners, Meritech Capital Partners, and The Founders Fund] during its Series B round of financing in April 2006.) Then, when a company reaches the Series C level of financing, its investments often trickle in from several large investors over the course of several months. Typically, a startup continues raising funds in this manner via subsequent venture rounds until it is ready to go public. Or, if an IPO is not a viable option—perhaps because the market opportunity proves to be less than expected—a company may instead look to sell the company to a larger operator. This latter option, however, is not as attractive, because the returns on a company sale are generally less than they are on an IPO.

  IPO Funding

  When a company is ready to issue shares to the public, it undergoes a process known as an initial public offering, or IPO, and its shares are made available to the trading public via a major stock exchange, such as the NYSE or NASDAQ. Many tech companies raise upward of $100 million to $200 million during their IPOs. Facebook raised a whopping $16 billion! We look at IPOs in more detail in Chapter 14.

  Types of Stock

  The total number of shares available for a company to issue is referred to as authorized stock whereas the total number of shares that a company has already issued is referred to as
outstanding stock. Now, let’s say that company XYZ has authorized the issuance of 10 million shares of its stock, and of those 10 million shares, 1 million have already been issued. In this case, if you own 100,000 shares of XYZ, then you own a 10% stake in the company. As XYZ cycles through the various rounds of funding that a company undergoes in its development, it issues more and more of its authorized stock to early-stage investors in return for infusions of capital, which usually means that your 10% ownership stake in the company likely becomes diluted over time.

  A company will issue different types of stock to different types of investors, depending on the stage of funding it’s in. Common stock, for example, which represents a form of equity ownership in a company, is issued to founders, early-stage employees, and seed investors. It is also distributed, when applicable, to the startup accelerator that helped to launch the company. Angels and VCs, on the other hand, are interested in a different type of security: preferred stock. Like common stock, preferred stock bestows upon its holder equity ownership in a company, but it also confers an assortment of additional special rights, which are spelled out in the term sheet and shareholder agreements and can include liquidation preferences, veto rights, and board seats. We take a look at some additional preferred stock deal terms in Chapter 6.

  To continue our current discussion, however, an angel round of financing predicated on preferred stock can be time intensive (taking 2 to 4 weeks to finalize) and expensive (given that the legal costs of this process can easily soar to more than $25,000). In other words, for what amounts to a small infusion of capital—–say, $500,000—preferred stock can create some big problems. To avoid the delays and expense of issuing preferred stock during the angel round of financing, founders often distribute convertible notes instead, which essentially are loans with fixed interest rates (such as 5% to 10%) that mature within 1 to 2 years of issuance. As an added bonus, interest payments are not due on accrual. Rather, any interest that accrues prior to maturity is added to the notes and can be paid off when the notes mature or are converted into equity.