How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (15 page)

A company may want to put restrictions on potential buyers. Do you want to have an employee sell shares to a competitor? Or what if they cash out a huge amount of stock and have little incentive to work for the venture? These are real concerns, and investors want to try to deal with them up front.

Perhaps the best way to do this is with a
resale restriction
—or the
right of first refusal (ROFR)
. It gives the company the right to buy shares at the current valuation. Or it can select its own buyer. This is something Facebook did; for example, one of the approved buyers was Digital Sky Ventures.

It’s tough to negotiate a resale restriction. Then again, it’s an effective way to help a company’s growth by trying to avoid the disruption of unmanaged sales of securities.

A VC may also request a co-sale agreement. This means that if a founder wants to sell shares, other investors can do so as well. This is a standard
clause and doesn’t necessarily harm the company. Thus there is no reason to waste time negotiating it.

This clause shows who has the right to inspect the company’s financials and other key disclosures. Investors always request this, and it’s not a major negotiating problem. They deserve to understand the progress of their investment, right? Of course they do.

But there is a wrinkle. With the emergence of secondary markets, smaller outside investors may get shares. In this case, it’s a good idea to limit their ability to gain access to sensitive information about the company.

Once the term sheet is signed, the next step is to put together a variety of legal documents, such as the shareholder agreement. At the same time, the investors engage in a due diligence of your venture.

Due diligence is often fairly quick and straightforward for an early-stage company. There often isn’t much operational history to scrutinize.

Despite this, you need to show your potential investors that you run a clean shop. Make sure all the company’s affairs are in order. Some of the main things include having vesting of founder’s stock, invention agreements, fully reviewed contracts, and a proper Delaware C-Corp.

The due-diligence process is intrusive and may feel uncomfortable. And yes, there are probably some things you don’t want investors to know. But don’t hide them. They will eventually come out. Hiding issues may not tank the financing, but it could create distrust and mean a lower valuation.

As you’ve seen in this chapter, the negotiating process for a funding is far from easy. It requires strong negotiating skills as well as an understanding of the key elements of a term sheet. Having a highly qualified team is a huge help.

The next chapter looks at something that often doesn’t get enough attention: the go-to-market strategy. Even if you have the world’s best product, it doesn’t matter if your potential customers don’t know about it!

Google actually relies on our users to help with our marketing. We have a very high percentage of our users who often tell others about our search engine.

—Sergey Brin

Your product can be a great sales tool as long as it is super-easy to use and provides instantly high value to users. They will usually spread the word about the product, creating more and more growth.

But there needs to be more. To reach breakout velocity, a company must solve the tricky issue of distribution. Yet many entrepreneurs devote too little attention to this subject.

Mark Zuckerberg has always understood the importance of distribution. All his apps have involved some level of sharing, which helped greatly to spread their adoption.

Zuckerberg also used creative approaches to supercharge growth. One ingenious strategy—which cost virtually nothing—was to allow new members to import the contacts from their Hotmail, Yahoo!, and Gmail accounts. Facebook also created profiles for users who had not even signed up—called
dark profiles
—that were based on tagged photos. It was another way to help make it easier for those people to become real members. All these efforts had a cumulative impact, making it possible to end-run rivals like MySpace.

This chapter looks at some of the main strategies you can use to boost distribution of your product. This doesn’t mean you should use all of them or even a few of them. Keep in mind that products often have one prime distribution mechanism. It will likely take some experimentation to figure out the optimal approach for your situation.

Back in 2005, Chan Kim and Renée Mauborgne published the path-breaking book
Blue Ocean Strategy
(Harvard Business Review Press, 2005). The premise was that huge opportunities exist to create new markets that have little competition and customers with significant unmet needs. One of the examples in the book is Cirque du Soleil. By blending elements of opera, ballet, and the circus, the company was able to create a new, highly profitable category.

Facebook is also an example of a blue ocean opportunity. Although it was not the first player in the social-networking space, it was the one that got two critical things right. The first was timing. Facebook came at a point when the world was ready for a way to create an online identity and openly share status updates, photos, and videos with friends. Facebook also realized that it was critically important to focus on a few key features, which included the News Feed, tagging photos, and the developer platform.

When a company effectively executes on a blue ocean strategy, the results can be astounding. The company almost doesn’t need a go-to-market strategy because word of mouth catapults it into the stratosphere. This is why Peter Thiel’s famous advice to Zuckerberg during the early days was, “Just don’t f**k it up.”

The problem is that blue ocean opportunities are exceedingly rare. The typical scenario is instead to attack an existing market, which is usually dominated by several entrenched players.

How does a tiny company pull off a David-and-Goliath move? You need to come up with a way to disrupt the market. And yes, this has been set forth in another game-changing book: Clayton Christensen’s
The Innovator’s Dilemma
(Harvard Business Review Press, 1997). His playbook is fairly straightforward. It involves focusing on the low end of a market, which the major operators don’t care about. An upstart company can use agility and innovation to make the market profitable. This can then be a launching pad to move into higher-end segments.

An example is Yelp. Co-founders Jeremy Stoppelman and Russel Simmons firmly believed that the multibillion-dollar Yellow Pages business was vulnerable to disruption. But it needed an innovation to upend the market. As the founders studied the landscape, they realized that customers relied on referrals from trusted people when going to a restaurant or selecting a service provider. So why not allow anyone to post reviews on a web site?

It was a big idea, but Yelp did not immediately set out to create a national platform. The founders wanted to start in San Francisco and focus on the
nightclub scene. The approach was something the Yellow Pages industry considered a waste of time with little profit potential. But for Yelp, the move allowed it to refine its business and build a solid foundation.

Keep in mind that it took Yelp a few years to get traction as the Yellow Pages industry began taking notice. This is typical for market disruptions, because it is painstakingly difficult to get consumers to change their habits, even if the new approach is far superior. To push things forward, the founder needs to constantly talk about the mission—and decry the evils of the incumbents. But in the end, it can be an effective way to create a billion-dollar company.

The rest of this chapter looks at some go-to-market strategies that can help you, whether your company is pursuing a blue ocean opportunity or a play to disrupt a market. But before diving in, let’s first look at the fundamentals of marketing. They’re crucial if you want to build an enduring company.

During the dot-com boom of the 1990s, companies used a large amount of their capital for marketing. Companies like Pets.com sponsored major events, advertised aggressively across the Web, and even produced Super Bowl commercials. Although these efforts resulted in massive traffic, they proved to be inherently unprofitable. When the venture capital markets shut down, thousands of dot-coms evaporated.

It’s true that marketing is not an exact science and that there will certainly be wasteful expenditures. But startups can use some basic concepts to improve the odds of success.

At the core is understanding how to measure things. One metric is the customer lifetime value (CLV), which involves measuring the average revenue per user, the gross profit, and the average customer churn. Changes in any of these variables can have a big impact on your business, although the most significant is likely to be the average customer churn. If there is new competition or the product is languishing, you may see deep attrition in your customer base, and this can wreck your business.

Thus companies need to spend time on programs to improve retention. This means being responsive to customer needs as well as continuing to invest in the product.

The amount of the CLV ranges based on the industry. For a consumer Internet site, the CLV may be low—say, under $100. On the other hand, for some businesses the CLV is enormous, perhaps in the millions. This is typically the case for enterprise software companies.

Once you have a reasonable grasp of the CLV, you need to measure the cost to acquire a customer (CAC). It consists mostly of advertising and marketing costs.

For a company to be successful, the CLV must exceed the CAC. Speed is also critical; you should recoup your CAC within about 12 months. Doing so is a sign that a company has a strong business model and should eventually see healthy profitability.

One of the top players in understanding the CLV/CAC dynamic is Zynga. In the early days, the company already had games that were addictive and viral, spreading through users’ News Feeds on Facebook. But Zynga’s CEO, Mark Pincus, wanted to make his company the category leader—and this meant finding ways to boost distribution. With his rounds of funding, he invested heavily in building a core infrastructure that made it easy to test and measure the impact of online marketing. He also hired some of the industry’s top online marketing pros.

With a clear-cut understanding of each game’s CLV/CAC profile, Pincus was able to profitably grow Zynga at lightning speed. It turned out to be a huge advantage that his competitors could not match.

Keep in mind that a company’s CAC is one of the largest expense items on a profit and loss (P&L) statement, if not the largest. Because of this, VCs want to see that you have thought about low-cost approaches to marketing and advertising. Some of the common strategies include partnerships, viral distribution, search-engine optimization, meetups, PR, and, yes, the use of celebrities. Let’s look at each in more detail.

When you look back at some of history’s legendary companies, an early partnership often propelled distribution. A classic example is Microsoft, which teamed up with IBM in the early 1980s to provide the operating system for the PC. The relationship made DOS a global standard, which led to tremendous cash flows. These financed other franchise products like Windows and Office. Eventually, Microsoft was worth more than IBM.

Another example is Google. It always had its own destination site, but the distribution strategy was to strike partnerships with portals. A critical deal was made with Yahoo!, which allowed Google to refine its search algorithms at scale. The company also got lots of exposure because the search page was co-branded. And yes, Google was eventually worth more than Yahoo!.

So, partnerships should be a major consideration for any startup. They may be indispensable for success.

Yet they must have a strategic purpose. Before seeking out partnerships, you need to think hard about which companies would be your ideal partners. This means doing extensive research on the market so you understand which companies have the most promising futures.

The next step is to make it as easy as possible to get a partner on board. Consider that it can take months—if not years—to get a deal done. Large companies are often resistant to spending time and resources dealing with a small operator.

To help accelerate the process, you should create your infrastructure to make integrating a partner straightforward. This is much easier nowadays thanks to application programming interfaces (APIs), which are code modules that allow third parties to hook into a web site or a mobile app. But an API is more than just good coding. It must be easy to use and, most important, it must not fail. Big companies are risk averse and don’t want to jeopardize their hard-won reputations.

Even with a strong API, there are still challenges. To land a mega-partner, you need to be persistent and find the decision-makers in the organization with which you wish to partner. You also must to be prepared to make a standout presentation that addresses the risks and shows the immediate opportunities. If you can demonstrate that a partnership will create new revenues, your chances of success increase greatly.

One of the masters of creating partnerships was Steve Case, who turned AOL into the dot-com era’s version of Facebook. When he merged the company with Time-Warner in 2000, the combined value was over $350 billion.

But in the early days of AOL, there were other major players in the market, such as IBM and CompuServe. To be a winner, Case realized that partnerships would be important in supercharging his growth. And he saw Apple as a key.

Case went from Virginia to Cupertino, California and lived in a hotel for months while trying to form a partnership with Apple. He vowed not to leave until he had a deal. In the end, his determination paid off, and the Apple relationship turned out to be critical for AOL’s success.

Despite all this, partnerships are not cure-alls. The dependency can prove fatal for a company. There are many examples, such as what happened with LookSmart. A pioneering online search engine, the company relied on
Microsoft for its distribution. The problem was that LookSmart did not seek out ways to diversify its revenues. By 2003, Microsoft accounted for a whopping 65% of revenues. As online search marketing became more profitable, as demonstrated by the growth of Google, Microsoft wanted its own platform. As a result, the company did not renew the partnership agreement, and LookSmart’s stock price collapsed. Since then, it has not been able to recover.

All distribution strategies have a cost, but the expenditure for one is extremely low: viral marketing. In fact, the cost is often near zero. The reason is that your users get other users to join.

When a product is viral, growth is usually explosive, and the company almost inevitably becomes a mega-player. Examples include Hotmail, Skype, YouTube, Dropbox, and, yes, Facebook.

To determine whether a product is viral, you need to understand the
viral coefficient
, which shows the conversion rate of a user to the number of invites. For example, suppose a person signs up and invites ten friends. With a conversion rate of 15%, the viral coefficient is 1.5. Keep in mind that if it’s greater than 1, you probably have a viral product.

But you need something else: a quick conversion cycle. If it takes six months for a user to send out invites, then your product won’t reach breakout velocity. For a truly viral product, users need to send out invites within 24 hours of signing up.

The problem is that few products are viral. But don’t despair: there are things you can do to bring viral magic to your product. One of the simplest approaches is to place buttons on your site that allow users to send messages to their friends via Twitter or Facebook. This is a no-brainer.

Or you may want to provide rewards for referrals. This has been the case with Dropbox, which provides free storage for each new user who joins. It’s a great incentive and has resulted in a huge number of sign-ups. Dropbox now has more than 50 million users.