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

by Tom Taulli

  Much easier to structure than preferred stock, and with legal costs that top out at maybe a few thousand dollars, convertible notes are an attractive alternative to preferred stock for founders for yet another reason: Their value is not tied to the company’s overall value. As a result, convertible notes allow founders to avoid a potentially contentious conversation about company valuation with their angel investors. Might as well “kick the can down the road,” right? Actually, it is rather smart for an early-stage company to put off valuation discussions because it is difficult to determine the fair value of a venture that has not yet had the time to prove its worth.

  When a company is ready for a Series A round of financing, its valuation should be much easier for the founders and angels to agree on. As soon as they come to a consensus on the value of the company, the angel investors will convert their notes into preferred stock. However, convertible note holders want to receive special treatment during the Series A round in exchange for their willingness to make an initial investment in the company. You can reward your convertible note holders in one of two ways. The first approach is to put a cap on the premoney valuation of your company to ensure that note holders are cited a valuation that is no higher than a fixed amount. For example, suppose Jane invests $500,000 in XYZ. In 5 months, XYZ is funded at a premoney valuation of $20 million, but because her convertible note has a valuation cap of $5 million, Jane is cited this price when she purchases preferred stock during the company’s Series A round. The second approach you can take is to give your note holder a discount, typically anywhere from 20% to 30%, on the share price of preferred stock that is issued during your Series A round.

  Although it may seem unfair that you’re expected to offer certain perks to early-stage investors during your company’s Series A round of financing, in the long run it makes sense to keep your investors happy. After all, without a cap in place, your early-stage investors actually hope that the Series A valuation of your company is low! If they’re hoping for a low valuation, what would be their incentive to help out the venture? Furthermore, because a discount or a valuation cap offered during Series A financing functions as the upside to your investors’ early-stage investment, you should be able to avoid negotiating and issuing warrants, a process that can add substantially to your company’s legal costs.

  However, as with any financial structure, there are inherent risks involved when issuing convertible notes. After all, what if your venture doesn’t get around to seeking a Series A round of financing before the note comes due? Because the note is a debt, the holders may be able to take control of your company’s assets. If you find yourself in this unfortunate situation, try to renegotiate the loan terms with your holders and find out whether they are willing to extend the notes’ payment date to give your company more time to seek Series A financing.

  Seed Series

  During the past couple years, more and more angel investors have begun using a series seed approach to the angel round of funding, wherein they streamline the process—and expense—of issuing preferred stock by using a standardized set of financing documents rather than situation-specific legal paperwork. Be wary of this approach. Because of their fill-in-the-blank nature, series seed documents can cause you to rush the negotiation of key terms, like board seats, liquidation preferences, and so on, which is probably not the best idea in the long run. A better approach, as mentioned earlier, is issuing convertible notes.

  Securities Laws

  The federal government has extensive laws in place regarding the issuance of securities. If a company violates any one of these numerous laws, the federal government may require it to rescind its financing. In rare cases, the government may even impose fines and/or possibly jail sentences on the violator. Unfortunately, it is a common myth among entrepreneurs that only large companies are subject to securities laws. In reality, securities laws must be followed by any company that issues stock. Again, make sure that you hire competent legal counsel to guide you through the many legal complexities that arise when starting a new venture.

  Know When to Raise Funds

  So, when should you start the fund-raising process? Start now. In a way, a founder should always be fund-raising. After all, you simply do not know who you will run into, and it’s surprisingly common for a casual conversation to end with someone writing a check toward your new venture. Even if you do not need the money, you should still be fund-raising constantly. Having lots of money in the bank makes it easier to avoid getting squeezed financially during those inevitable stretches of time when your company’s funding dries up. Plus, you never know when the entire funding market will freeze up, as it did from 2001 to 2002 and from 2008 to 2009. During these periods, it was almost impossible for tech startups to raise sufficient capital, at least on reasonable terms. It should come as no surprise that angel investors and even professional VCs can get spooked easily, especially if the economy is in a downturn.

  On a related note, never let your venture get to the point where you only have the cash to fund it for 6 more months. VCs can smell desperation and will string you along, demanding even more draconian terms in return for cash infusions. Worse yet, you may just run out of money altogether and have to close down your company’s operations. Last, keep in mind that the funding process is seasonal by nature. There are two times of the year when it is almost impossible to close a funding deal: August and December. Investors are often on vacation during these months and will probably not respond to a pitch unless the deal is hot.

  As described in this chapter, the funding process has many moving parts and involves many different types of investors, stages of financing, and investment structures. It can certainly get unnerving, but this is how startups have secured financing for decades. Deviating from the process is most likely a big mistake. In the next chapter, we take a look at another crucial piece of the startup puzzle, one that goes hand in hand with raising capital: the pitch. With thousands of entrepreneurs looking for capital, you need to stand out from the crowd. I’ll show you how.

  The Pitch

  And one more thing.

  —Steve Jobs

  More than anything else, Mark Zuckerberg liked coding breakout apps. But as CEO of Facebook, he was forced to become intimately involved in the business side of the company, which meant he had to spend huge chunks of his time pitching—to investors, potential customers, and partners, as well as new recruits. Zuckerberg does not have the charisma of someone like Steve Jobs; he is naturally shy and a man of few words, and these qualities initially were liabilities when he attempted to pitch his company to key stakeholders. But he did not allow his natural inclinations to prevent him from getting better at pitching. In fact, Zuckerberg, recognizing his need to improve, dedicated countless hours to working on his speaking skills, and he even sought the help of speech coaches. True, he still is not as compelling a speaker as Steve Jobs was (who is!) and can seem awkward when he is giving company presentations. But when you compare Zuckerberg’s early (and, it must be said, painful) interviews with the media to those he gives today, you can see how far his speaking abilities have come.

  In this chapter, you will learn how to effectively pitch your deal to investors—a skill that involves more than just sounding great and convincing. You will read about the nuts and bolts of putting together key pitch documents, like your company’s executive summary and slide presentation (also known as your pitch deck or deck). And you will discover how to plan your company’s funding process so as to avoid common problems and errors that can kill your chances of getting a “Yes” from an investor. Let’s get started.

  Elevator Pitch

  Even if you don’t know anything else about presenting, you probably know that an elevator pitch is named as such because it should take you no longer than a minute or so—the length of an elevator ride—to give this quick description of your venture to a potential client or investor. Practice your elevator pitch as much as possible, until it becomes second nature. The m
ore comfortable you are with your elevator pitch, the more likely that you can maximize each and every opportunity you get to speak with potential investors, no matter whether you meet at an event or, yes, in an elevator!

  Legendary entrepreneur and angel investor Peter Thiel has a great way of expressing how an elevator pitch should be structured: Problem + Solution = Money. Thiel cites SpaceX’s elevator pitch, which conforms to this model, as an example worth following: “Launch costs haven’t come down in decades. We slash them by 90%. The market is worth $10 billion.” The pitch is incredibly simple, but it has proven to be equally compelling. After all, SpaceX has raised hundreds of millions of dollars from some of the world’s best investors, including Thiel.

  The Deck

  As mentioned previously, when pitching to potential investors, you are expected to provide them with a set of slides, also known as a deck, that illustrates and augments your formal verbal presentation. Because your deck will be a key focus for investors, plan on spending quite a bit of time putting the deck together. But before you jump into the deck creation process just yet, be sure to avoid the following deck mistakes commonly made by entrepreneurs:

  Clutter: Keep the text in your deck to an absolute minimum. Practice giving your pitch to your co-founders and employees and ask them to help you identify text-heavy slides that would benefit from pruning. VCs don’t have time to review a deck that is filled with prose, so wherever possible, try to use visuals and pictures to make your points.

  Don’t assume: Although it is generally true that VCs are smart people, you should never assume that they understand everything about your business. If a specific aspect of your business is too specialized or complex for the average businessperson to grasp, then it is a good idea to spell out that component for your VCs as well. The last thing you want is for your VCs to lose interest or patience in your venture simply because they don’t understand one of its features.

  Hollywood: Over the past few years, many entrepreneurs have begun using Hollywood-style pitch techniques, wherein they say something like, “Our app is like Facebook . . . but for businesses.” Although this approach can be somewhat helpful in explaining your product to investors, it comes off as unoriginal.

  PDFs: Avoid presenting your company’s financials on PDFs, which are static files that cannot be modified. You should instead use Excel files, because investors will want to play around with your financial model and check its underlying assumptions.

  The exit: When you are ready to wrap up your presentation and explain your exit strategy, avoid saying something like, “We plan to sell our company for $100 million in 2 years.” Contrary to what you might expect, VCs aren’t necessarily interested in a quick cash-out; they realize that five to ten years will most likely pass before a viable exit option presents itself. So instead of telling your VCs what you think they want to hear, show them that you are committed to the venture for the long haul. Otherwise, they may begin to fear that you won’t stick around to see your venture through to fruition.

  Now that we’ve covered what you shouldn’t do with regard to deck writing, what are some common features of winning decks? First, good decks are short, containing no more than 12 slides. (By way of comparison, Facebook’s original deck was only six slides long!) But if your current deck is 25 slides long and you think you can shorten it simply by jamming content drawn from 5 of your slides onto 1 using a miniscule font, think again. Any text that appears in your deck should be typed in a font that is at least 30 points in size. Your deck should also focus heavily on your company’s proof points, or the major, tangible signs that suggest your business has a lot of potential. Facebook’s deck, for example, showed that the company had achieved massive growth in users, but it also demonstrated that the company had been able to foster a high level of engagement on the site, given that about 65% of users were returning to Facebook on a daily basis. And you better believe that this stat grabbed the instant attention of Facebook’s VCs!

  Your presentation should last about 30 to 45 minutes, but don’t be alarmed if you are cut off with questions before you’ve had the chance to present all of your slides. Questions are an indicator that the VCs in the room are interested in your company and are already starting to think about its potential and possibilities, so try to refrain from interrupting the natural flow of questions and answers to return to your slides. There’s nothing like an energy-charged brainstorming session to increase your potential investors’ enthusiasm in your company.

  As for what types of slides you should include in your deck, the following are a few to consider.

  Mission

  To get your deck off to a powerful start and immediately grab the attention of your investors, think about launching the deck with a slide that outlines your company’s mission and reveals how your product will help change the world. You may want to supplement the text description of your mission with a visual. This could be a graphic of your product or something that shows the growth rate, such as an upward-sloping chart.

  Product

  If your deck focuses too much on features and delves too deeply into the technology that underpins your product, you run the risk of losing your audience’s attention. Investors don’t care what type of server you use to host your product; instead, they want to know what kinds of problems your product will solve. Will it help users cut their costs? Increase their revenues? Gain access to better information? Facebook, for example, makes it possible for users to instantaneously and continuously connect with their friends and colleagues, no matter how geographically separated they may be. As most Facebook users would agree, the site sure beats old-world communication solutions, which tend to be slow and difficult to maintain.

  When describing your product in your deck, you should also answer the following two questions:

  Question #1: Why is your approach superior to others that are currently in use or development?

  Answer #1: It helps if you are focused on solving just a couple of people’s most pressing problems. Facebook, for example, had the single-minded goal of making it extremely easy for users to connect with their friends and share information and photos. As a result, Zuckerberg launched only a handful of major features—like the News Feed and Photos—every year or so. He also refrained from cluttering the site with advertisements, which would have detracted from the user experience. This approach was in stark contrast to Facebook’s competitors, such as MySpace, which were scattered web sites that often confused users and annoyed them with offers and even spam.

  Question #2: What prevents your competitors from copying your product and killing it?

  Answer #2: You need to be able to show potential investors that you have unfair advantages over your competition. Facebook had a top-notch technology infrastructure, which allowed users to rapidly download pages, photos, and videos. Meanwhile, Facebook’s competitors—MySpace and Friendster—had fairly weak technology foundations that detracted from the user experience, and as a result, these sites eventually faded away. Keep in mind that most companies’ unfair advantages are behind the scenes, hidden from users’ view. What Zuckerberg realized is that users don’t care how the technology works; they just want it to work, and they want it to work quickly—which explains why Facebook spent so much time recruiting top-notch software engineers.

  Spend a lot of time thinking about these two questions. VCs want to understand your thinking process and strategic ability—and with good reason! After all, they are about to shell out millions of dollars to fund your dream, so it’s reasonable that they want to have a firm grasp on what sets your venture apart from the thousands of others out there.

  The Opportunity

  As a general rule, VCs will not fund a product unless it has at least a $1 billion target market, so if your end product is only meant to fit the needs of a smaller market, you probably won’t get much interest from VCs. This is not to say, however, that you should abandon your work on a product that is initially intended for a niche audie
nce and start the product development process all over again, this time with an emphasis on creating a product that is targeted to everyone and their mother. Although it may seem counterintuitive, it actually is a smart idea to focus on a small part of the market when you are first launching your product. Doing so allows you to test the product and get user feedback prior to a larger product rollout. What’s more, due to its size, your test market is likely underserved, and so your product may gain much more traction than it would if you released it to your eventual intended user base all at once.

  Think about how Facebook handled its product rollout. Initially started at Harvard, Facebook caught on quickly in its first small target market. Word about a new online social network spread organically from college to college, and eventually students from colleges and universities around the country began lobbying the site for access. In response, Facebook started to slowly roll out the site to more and more schools, continuously testing and refining the concept with each new school that was added to the network.