How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (8 page)

Yuri Milner, who operates Digital Sky Technologies (DST), was one of the first innovators in late-stage funding—and an unlikely one, at that. Born in Russia, he went to school at Wharton and then returned home to buy a macaroni factory, which turned out to be a tremendous cash cow. When the dot-com bust hit in 2001, Milner purchased the e-mail service Mail.ru for $100 million and, within a few years, it became the No. 2 Internet company in Russia. Flush with cash, Milner then contacted Facebook and said he wanted to buy shares in the company. His timing was perfect; when he got in touch with Facebook, the world economy was still in the throes of the financial crisis of 2008, making his offer extremely attractive to Facebook. The company eventually agreed to the deal, and DST invested $200 million in the social networking giant while taking a “hands-off” approach to the investment. In a sense, DST’s late-stage investment in Facebook was almost like an IPO, because the investment gave the firm no ultimate control over the site. Since then, Milner has made late-stage investment plays in other well-known companies such as Twitter, Spotify, Zynga, Groupon, and Airbnb.

Late-stage funding has become a common part of the startup landscape. These investments make it possible for founders to defer filing an IPO and provide liquidity to early investors and employees. The funding also provides substantial resources to help accelerate a venture’s growth and position it to dominate new markets. However, it isn’t exactly easy to attract the interest of late-stage investors. A company must have the potential to become a franchise player—complete with a global brand and substantial barriers to entry, such as with its customer base, technology, and distribution—before late-stage investors give it a second glance. The good news, though, is that such attributes are obvious in the marketplace and late-stage funders often approach worthy companies to inquire about making an investment.

In general, a startup goes through four different types of rounds of financing: seed, angel, venture capital, and IPO. Let’s take a look at each one in detail.

Seed funding, which is often a company’s first round of funding and generally involves fairly small amounts of capital, from perhaps $1,000 to $100,000, allows a startup’s cofounders to test their hypothetical product. This testing usually entails creating a beta version of their product and seeing whether it gains any traction with potential investors, who may include the company’s founders, friends, family, and maybe angel investors. One of the more popular sources of seed funding is through the use of the founders’ personal credit cards, which is exactly how Facebook survived the first year of its existence. However, investments can also be drummed up creatively, such as when the founders of Box financed the company with $20,000 they made from playing online poker!

Generally speaking, for most startups the seed stage is a mess. Founders who are enmeshed in the seed funding stage of their company’s development tend to give little thought to legal matters or business formalities. They probably will have issues with a lack of communication, as well. Facebook suffered from these classic problems, too. Like many first-time entrepreneurs, Zuckerberg had no experience with business and legal matters when he first launched Facebook, but this is no excuse for you to do the same. It does not take much work to build a solid foundation of business and legal knowledge. As we talked about in
Chapter 2
, there are some legal moves, such as incorporating a C-Corp in Delaware, protecting your intellectual property, and exercising an 83(b) election, you can make to position your startup for success. Sure, concerning yourself with the business and legal minutiae of starting up a
company isn’t fun and may delay your speed a bit, but it will be well worth the effort in the end.

Compared with the seed funding stage, angel rounds of financing typically involve much larger investments, which can range in size from $100,000 to $1,000,000. In the case of Facebook, Zuckerberg raised $600,000 in its first angel round, including $500,000 from Peter Thiel and $40,000 from both Reid Hoffman and Mark Pincus. The remaining $20,000 was contributed by several other individuals.

So, how do you find angels? Doing so takes a lot of work and is certainly not the easiest endeavor in the world, but the following sections provide several helpful strategies to make your search easier.

Angel networks are organized groups of angel investors consisting of anywhere from 20 to 100 members that meet up about once a month to look at new startups in which to invest. When angel networks decide to strike a deal with a startup, the investment amounts can be large—say, more than $1 million.

There are several reputable angel groups in many large cities across America and they usually have web sites that detail the process by which they select startups for investment funding. However, angel networks typically become aware of your company because you either get a personal introduction to a member or you submit an executive summary for the network to review. If your deal meets the network’s initial criteria, you’ll be invited to make a presentation to the group, which—heads up—may be quite small. Some angel networks require you to pay a fee before presenting to the group, but I’d avoid networks with this type of requirement. After all, the best investors want to find early-stage investment opportunities, not draw in additional income from cash-strapped entrepreneurs.

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 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.

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.

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 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:

1. 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.
   
2. 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.
   
3. 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 small 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.