How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (23 page)

An underwriter also has a
letter of intent
(LOI) with the company, setting forth compensation and other terms. It’s not binding until a day before the IPO. At this point, the underwriter is required to write a check to the company even if it can’t sell shares to the public.

After the S-1 is finished, the underwriter submits it to the SEC. After a month or so, the federal agency sends back questions to the company (known as
comments
). These can be contentious, as happened with Groupon. The company pushed back hard on several questions about its accounting. In the end, that turned out to be a big mistake, because the company had to restate its earnings for its first quarter as a public company. It was a huge embarrassment.

Facebook had a smooth process. It helped that the company took a conservative approach to its financials and accounting principles. This strategy is good for any company.

The choice of an exchange is usually between the NYSE and the NASDAQ. The tradition is for early-stage tech companies to list on the NASDAQ.

But this has been changing: the NYSE has snagged top listings from companies including Pandora and Yelp. The trend may accelerate as a result of the NASDAQ’s botched IPO of Facebook.

There are some trading platforms you should avoid, including the OTC Bulletin Board and the Pink Sheets. These are mostly quotation services that provide much less oversight. The trading volume is usually thin as well.

During the
road show
, also called the
dog-and-pony show
, senior management spends one to two weeks making presentations to investors. For the most part, they are in major US cities like Los Angeles, Boston, New York, Dallas, and San Francisco. But in some cases, management may make presentations in Europe and Asia.

Facebook’s road show mostly included Ebersman and Sandberg. Zuckerberg attended only two presentations, and he caused a media stir when he wore his hoodie and sandals.

During the road-show process, the lead underwriter gauges investor interest. This helps to establish the price range of the offering. If demand is strong, the underwriter may increase the price range as well as the number of shares.

If there are any changes to the prospectus during this period, the company files a
free-writing prospectus
(FWP on the SEC’s web site). Facebook filed one on May 5, 2012; it disclosed some weakness in the business due to the rapid shift to mobile. The disclosure may have been a key factor in some of the loss of enthusiasm for the deal and was also an ominous sign that the first quarter report would be relatively weak. But Facebook had little choice about making the filing—the SEC always demands disclosures of material changes in the business.

A couple of days before an IPO, the underwriters send an
acceleration request
to the SEC, which declares the S-1 to be
effective
. The company can now sell its shares to the public.

On the night before the day of the IPO, the underwriter and the company decide on the offering price. This can be a heated discussion. The company wants to raise as much money as possible. The underwriter, on the other hand, wants to make sure investors get an attractive return. Facebook’s pricing meeting lasted only about 10 minutes because there was already a consensus on $38 being the best price for the IPO.

Once the price is set, the underwriter notifies investors and allocates shares to them (usually fewer than the number requested). The reason is that there is generally more demand than there are available shares.

On the day of the IPO, the CEO often rings the bell on the NYSE or opens the NASDAQ. There are also lots of media interviews. An IPO can be a great branding event.

If you’re in your 20s and worth millions, will you be motivated to keep working hard? Perhaps not. This is a huge challenge for any highly successful company that comes public. Facebook’s IPO created more than 1,000 millionaires.

The challenge for the company is to find ways to maintain the passion and enthusiasm. This is why Facebook had a hackathon on the night before the IPO. It was a strong reminder that the company needed to focus on the future.

But maintaining the hacker culture could be Facebook’s biggest challenge. A concept called
vesting in peace
(VIP) describes a top employee who works just
enough to not get fired and give up their options. This is common in Silicon Valley.

Another issue is the disparities in wealth. Recent employees don’t share in the riches, but they see others buying big homes and nice cars. This can cause envy, which hurts productivity.

There are no easy ways to deal with these cultural issues. The key is for the CEO to be a strong leader and show that they’re committed to the long term. So far, Zuckerberg has not backed off from this commitment.

A key takeaway from Facebook’s public offering is the importance of getting the valuation right. It’s a difficult topic, even for a well-established company like Facebook, primarily because the technology industry involves tremendous uncertainty. Once-towering companies like Sony and Yahoo! can eventually become laggards. Many disappear or are bought out.

Although Facebook went public with strong financials, there were still worries about the future business. For example, an executive provided lowered revenue and profit guidance to an analyst at Morgan Stanley. The analyst then lowered his own projection and told several major investors about it. There was nothing illegal about this, but it spooked investors.

At the heart of the analysis was the rapid shift from desktop traffic to mobile devices. This change seems like a good thing, but Facebook didn’t anticipate it and failed to develop advertising systems to monetize its mobile apps.

At the same time, another piece of news created more uncertainty: GM planned to cut off all its advertising on Facebook. The company is number three in terms of ad spending in the US, so its drastic move was noteworthy.

Investors began to get skittish. Was Facebook’s growth decelerating? When would it find the right business model for mobile? Was the GM problem just the beginning of more defections? In light of all this, it seems reasonable that the company should have been more tempered with its valuation.

It’s important to realize that public markets have different kinds of investors. Many of them don’t necessarily understand new-fangled technologies and try to avoid paying premium valuations for stocks. Facebook should have seen this poor performance in prior offerings, such as for Zynga, Pandora, and Groupon.

In addition, many top Wall Street investors still have fresh memories of the dot-com era. They don’t want to get trapped in another bust that could tank their returns.

Facebook and Morgan Stanley apparently ignored these signs. They instead focused too much on the high valuations in the secondary markets, where Facebook’s stock routinely traded in the low to mid 40s.

But the secondary markets are much less liquid than public markets, and the investors are different: many of them are deeply bullish on the prospects for tech. So it makes sense that they would pay premium prices for the shares.

Valuation was not the only problem. Zuckerberg was too lackadaisical about the IPO process. He got married a day after the offering! It was a brazen move and did little to encourage confidence from investors.

Going forward, Zuckerberg may change his approach. If he wants to have a thriving business, he needs to be mindful of Wall Street. Other standout companies have done this, including Microsoft, Google, and Apple. It does seem as though Zuckerberg has learned his lesson: an example was his active role on Facebook’s first conference call with investors.

This chapter looked at the key steps of an IPO and ways to help improve your chances of success. Even though the regulations are less onerous than in the past, only top-notch companies can be successful in the public markets. Investors ignore companies that fail to show consistent growth, which means a poor stock price.

The next chapter examines wealth management. It’s a topic that entrepreneurs may ignore, which can be a big mistake.

I am not so much concerned with the return on capital as I am with the return of capital.

—Will Rogers

Mark Zuckerberg is the second youngest billionaire in the world, with the number-one spot going to his co-founder Dustin Moskovitz. (He’s only eight days younger than Zuckerberg.)

But unlike other tech billionaires—such as Oracle’s Larry Ellison and Microsoft’s Bill Gates—Zuckerberg doesn’t have multiple estates, yachts, and other nice toys. He lives in a $7 million home in Menlo Park, which seems kind of underwhelming for a billionaire. He had to get a loan from Moskovitz for the down payment!

Wealth doesn’t seem overly important to Zuckerberg. When he had a chance to sell Facebook and walk away with a huge payday, he said no. He was on a grand mission to change the world, and this would not be possible if he sold out.

Zuckerberg is mindful of sound wealth management. During the IPO, he sold $1.15 billion of stock to handle the exercise of his stock options and pay his taxes. He also set aside millions to make sure he can pay his bills.

This chapter looks at the unique financial needs of entrepreneurs and how they evolve as a company grows. Some of the topics include secondary markets, core financial planning principles, asset protection, and philanthropy.

Chances are, you’ll have little money when you launch your venture. To keep afloat, you may even need to have a part-time job and live with a roommate.

A key trait for success is to live on an extremely low income. To help things along, it’s a good idea to track every penny and use a service like Mint.com. It also helps to learn about some of the fundamentals of personal finance. The good news is that there are many great sites to help out, such as Money.com, Kiplinger.com, and BankRate.com.

Even when you raise capital, your salary will likely be modest, because investors want to make sure you are motivated by equity. Peter Thiel believes that a CEO should make no more than $150,000 a year. In many places this may seem like a lot, but definitely not in tech hotspots like Silicon Valley and New York.

After several rounds of capital, your company may be worth over $100 million, and that means you are officially a multimillionaire. Although this is a big achievement—and kind of surreal—you have a problem: until you sell the company or go public, you can’t turn much of this wealth into cash.

But there is a way to get some liquidity: through secondary markets. These are online platforms, such as SecondMarket and SharesPost, that let founders and employees sell some of their privately held shares.

It should be no surprise that Facebook was the most popular stock sold in the secondary markets from 2008 to 2011. The sales helped employees to diversify their wealth into other investments and to even fund their own startups.

But before you do a transaction, talk to your investors. They should understand your needs and realize that it’s important to reap the rewards of your success. The investors may also be interested in buying the shares or know other value-add purchasers, which can keep the equity in friendly hands.

If you decide to use a secondary exchange, the process takes anywhere from 30 to 45 days. The first step involves getting numerous bidders, who should undergo background checks. Once a qualified buyer is located, there is some paperwork, such as drafting a purchase agreement; it’s a good idea to have a qualified attorney review everything. The buyer sets aside money in an escrow account that won’t be released until the stock certificates are sent to the buyer.

For the service, a secondary exchange usually charges a fee that represents a percentage of the transaction, such as 1% to 5%. But as with anything in business, you can negotiate this payment.

How much of your stake should you sell? There are no clear-cut rules. From a financial planning standpoint, it makes sense to sell at least two to three years’ worth of your salary. It’s common for founders to eventually leave a company due to burnout or to pursue another early-stage venture. If you have a considerable amount of money set aside, you aren’t under pressure when you decide to make a big change in your career path.

Early-stage ventures are extremely risky—look at the case of Digg, which was a social media darling but could not keep up against rivals like Facebook. But the company’s co-founder, Kevin Rose, was able to sell enough of his shares to pursue other ventures. He also had enough to invest in breakout companies like Twitter and Zynga.

If you have a chance to get some liquidity from your venture, it’s probably best to do so.

Back in the late 1980s, John McAfee launched McAfee Associates and pioneered the fast-growing market for antivirus software. His distribution model was pathbreaking at the time: it involved giving away the product. If customers liked it, they paid for a subscription. McAfee Associates saw explosive growth, and the company went public in 1992.

This would have satisfied many entrepreneurs, but not McAfee. Bored with the corporate life, he left McAfee Associates a few years later and cashed out about $100 million. He went on to invest aggressively in real estate and tech stocks. He even put his money in high-yield bonds from Lehman Brothers!

McAfee’s strategy worked well until the financial system nearly collapsed in 2008. In the aftermath, he had only about $4 million remaining.

This tale is common in the tech world. A key reason is that entrepreneurs love to take risks. This may be fine when you’re creating a new venture, but it can be the worst approach when managing your personal finances. The global markets have seen considerable volatility over the past decade, including the popping of the dot-com and real-estate bubbles.

When looking at your personal finances, it’s important to have a realistic and balanced approach. To help things along, here are some things to consider.

If you want the potential for high returns, then you need to take risks. This is a truism in investing. So if a financial advisor pitches you an opportunity that can generate large gains but says the risks are minimal, move on. It probably has tremendous risk!

Over the past few years, there has been a surge in big-time scams. The most notorious example is Bernie Madoff, who pulled of a $65 billion Ponzi scheme. Always remember: If it seems too good to be true, it is.

Mutual funds and exchange-traded funds (ETFs) offer tremendous advantages for building your wealth. They provide exposure to the main asset classes, such as stocks, bonds, and real estate. A rule of thumb is to have more than half of your liquid wealth in these types of investments.

How much should be in each category? It’s a matter of your goals, family situation, and age. A reputable financial advisor can provide some helpful advice on asset allocation. There are also some great web services, such as Wealthfront, which is focused on the needs of tech entrepreneurs.

This usually means buying gold. I recommend that this asset make up 5% to 10% of your portfolio. The good news is that it’s much easier to own gold—compared to five or six years ago when you had to find a place to store it—such as with the purchase of SPDR Gold Shares (GLD). It’s an ETF that is backed by gold bullion, which is stored in vaults in London.

Gold has historically been a safe haven during times of distress. And if the future continues to see volatility, this precious metal should be a stabilizing force in a portfolio.

These are simply investments that are not stocks or bonds. They are diverse, including things like commodities, timber, and currencies.

One way to get exposure to alternative investments is through hedge funds. The money managers usually have wide latitude, such as the ability to engage in short selling. This makes it possible to make money when an investment falls!

But hedge funds have high fee structures. The money managers usually have a 2/20 approach: this means they get 2% of the assets under management and 20% of the profits generated.

There may even be
lock-ups
, in which an investor isn’t allowed to sell their position for a couple of years. This can be agonizing during times like the 2008 financial crisis.

When selecting a hedge fund, make sure you do a lot of homework. Get referrals from existing investors, and do background checks on the money managers. A top financial advisor can also provide help.

As you get rich from your startup, there’s a good chance you will begin engaging in angel investing. It can be a lot of fun, but the risks are substantial. For the most part, these investments go bust. And even for those that are successful, the returns may not be realized until three to five years down the road. As a result, you should have a low percentage of your net worth in angel investments—probably less than 5%.

This is a critically important factor. Saving 5% or 10% on taxes can be a big deal. Services like TurboTax are excellent, but they generally are not best for wealthy entrepreneurs because there’s little time to keep up with the constant changes in the tax law. The best approach is to seek out an expert who understands the matters that impact entrepreneurs.

When you become rich and famous, you find that you have lots of friends. Of course, they hope to get a piece of your wealth! This is not to say that you have to distrust everyone you meet. But the fact is that wealthy persons attract unsavory people, so it’s important to be cautious.

You should look at something called
asset protection
, which is a way to shield your wealth from potential lawsuits. It’s true that the techniques aren’t necessarily foolproof—Zuckerberg has been a defendant in many lawsuits—but you should be able to avoid many problems.

Here are some things to consider:

• Don’t sign a personal guarantee:
  With this, you are pledging essentially all of your assets to back a potential liability.
  
• Have adequate insurance:
  You need to periodically inventory your assets, determine their values, and make sure you have enough insurance.
  
• Set up protective entities:
  These are usually corporations that can own assets. Doing this makes it more difficult for creditors to get access to them. A common entity is a trust. For example, Zuckerberg holds his shares as the trustee of The Mark Zuckerberg 2008 Annuity Trust. He probably structured this for asset protection as well as to get tax benefits.
  
• Pay attention to corporate matters:
  Read the contracts you sign. Are there areas where you may have personal liability? Your company should also have enough directors and officers insurance. Shareholder lawsuits are common.
  

In late 2010, Zuckerberg pledged to donate at least half his wealth to charity. It was part of Bill Gates’ “Giving Pledge.” Others who have joined include Steve Case, Warren Buffett, Larry Ellison, George Lucas, and Michael Bloomberg.

Zuckerberg has already made donations. The most notable was a $100 million gift to the Newark, NJ, public school system. According to Zuckerberg:

People wait until late in their career to give back. But why wait when there is so much to be done? With a generation of younger folks who have thrived on the success of their companies, there is a big opportunity for many of us to give back earlier in our lifetime and see the impact of our philanthropic efforts.

It’s great advice and shows that money should not be an obsession. It’s better to focus on things that matter, which has always been the driving motivation for Zuckerberg. And of all the things covered in this book, that’s perhaps the most important lesson to keep in mind.