How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (9 page)

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.

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.

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.

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.

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.

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
.

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.

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.

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.

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.