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13 Things You Might Not Know about Startup Investments

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The combination of public market alpha opportunities decreasing and legislation making investing in startups more interesting to more people, means startup investing is on the rise. While there is a plethora of information regarding investment management, there is a lack of it specifically pertaining to startups. With that in mind, I put together a quick list of things to consider in order to help bring new investors up to speed quickly.

  1. You can’t just invest in any company you want. Unlike the public markets, startups companies aren’t always taking money. You have to find a company that is actively raising funds and then find a way to get into that deal.
  2. There is opportunity in the trade as well as in the investment. In the public market, the trade is established and the only variables are time and price. In the private market, there is value in the trade: negotiating shareholder rights, pro-rata follow ons, etc. Read my post “The Investment and The Trade.”
  3. The buy-side is easier than the sell-side. With crowdfunding, the JOBS Act and AngelList, it is getting easier to get into deals. Getting out is a different story. While the sell-side is starting to shape up, there is no dependable standard on existing an investment position in a startup yet.
  4. You probably wont know what you investment is worth. In the public market there are constantly trades happening, which provide price discovery. In the private market, price discovery only happens when a company raises another round or is acquired. This means that it is hard to tell how your investments are doing.
  5. No one will give you advice (legally). Most financial services firms shy away from allowing their advisors to give guidance on startup companies. They do this because the firms don’t have adequate information or coverage on startups to stand by a recommendation to invest or pass. This creates a gap in financial advice. As investors increasingly turn to startups and the private market as a way to generate true alpha opportunities, they are left to their own methods of evaluation.
  6. The good deals are hard to get into. The paradox is that the best company can likely raise money from whomever they want, leaving the lesser known investors to the perceivably less valuable deals.
  7. Just because you invested in the startup doesn’t mean you get to see its internal ongoings. There is something called Major Shareholder rights, and if you don’t negotiate it (as a small investor) you may not be entitled so see things like financial updates.
  8. You may not own the percentage of the company that you think you do. It’s wise to negotiate pro-rata rights — that is, the right to by more shares in subsequent rounds in order to maintain your ownership percentage.
  9. Most of the time, you won’t really be able to help the company succeed. A lot of Angel Investors try to pick investments where they think their sepcific experience can help move the needle for the startup — a logical way to invest. The reality is, though, that most of the time, there are way more factors at play which will marginalize such a phenomenon.
  10. It’s nothing like Shark Tank. As cool and easy as Shark Tank seems, it’s really nothing like real startup investing. Deals don’t get made in 10 minutes, they take weeks. With the best companies there is less room for negotiation and most of the time, Angels can’t move the needle as do the Sharks on TV.
  11. Diversification is expensive. In the public markets, you can diversify by buying a mutual fund with about 1k. While investment minimums are coming down in the private market, you still need about 10k to get into any deal. Standard diversification would say you need to own 15+ companies to diversify away non-systemic risk; in private market investing, that is at least 150k.
  12. Diversification is less effective. Private market companies are less proven and therefore by definition, much more risky. While owning 15+ companies does diversify non-systemic risk to an extent, it still doesn’t ensure that one of your deals will outperform others. It’s quite possible that all 15 of those deals don’t do squat.
  13. It shouldn’t be all about making money. There is no doubt that there is a true shift of the efficient frontier when you add startups to your asset allocation. In fact, it may be some of the only true alpha addition left in the market. That said, it’s still risky, and having more in mind then just making money will help you on your journey. Understanding how your investment is having impact on communities or industries is important.

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About the Author

This article was written by Brandon Gadoci.

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Entrepreneurship

Building Yelp: A History Lesson

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In the fall of 2004, Jeremy Stoppelman caught the flu.

He had just arrived in San Francisco that summer, so he jumped online in hopes of finding a recommendation for a doctor. Instead, all Stoppelman found were bare bones directories and useless information.

But this gave him an idea. He and Russel Simmons were in San Francisco working for a business incubator called MRL Ventures, searching for “the next big thing” on the internet. He met with Simmons over lunch.

The two were in the office of their boss, Max Levchin, pitching their new concept before dinnertime. They didn’t have a PowerPoint presentation or a specific revenue plan; just a sense that they could make something that would appeal to lots of people.

Early photo of Simmons (left) and Stoppelman (right).

Levchin hesitated. “I wasn’t sure if it would work. But the guys were really enthusiastic about it. And in my experience, when you have smart people who work well together, it’s foolish not to invest.”

Maybe he was feeling lucky because it was his 29th birthday, or maybe it was those tens of millions laying around from his recent exit from PayPal, but Levchin agreed. He invested $1 million in the half-baked idea and Stoppelman and Simmons got to work.

Yelp 1.0

So what were they building? The two founders realized from Stoppelman’s doctor experience that the best way to find a business was through word of mouth. But word of mouth hadn’t moved to the web yet. The question they were asking was, “How do we bring those in-person recommendations online?”

They thought the answer was email and that’s exactly what the earliest version of Yelp was. On the website Simmons put together, users could email their friends asking for recommendations on specific locations or types of places. Responses were logged on a communal site for everyone to see.

Their first review came in on October 12, 2004. Katherine W. gave Truly Mediterranean four stars and a simple, but convincing:

“dirt cheap, good falafels.”

Despite that promising review, their idea was a flop. It attracted few users beyond the founders’ friends and family and failed to impress the venture capital investors whom Stoppelman pitched at the end of 2004.

“We got the doors slammed in our face over and over again,” Stoppelman said. Things were starting to fizzle right before their eyes.

The Epiphany

Undeterred, the founders searched for a way to improve their product. One day, they noticed something.

The site had a link, buried somewhere in the footer, that you could click if you wanted to submit a review without being asked. While poring over their analytics, they realized that people were not only finding that link, they were beginning to use it — often.

They watched as users submitted unsolicited reviews more and more. It got even bigger than the email-requested reviews. People would write 5, 10, or 15 reviews in one sitting.

They knew they had stumbled upon something big. So in February 2005, the duo launched a brand new site, this time focused entirely on unsolicited reviews. Yelp 2.0 saw an immediate rise in traffic. It was a hit.

The Foundation

A 2005 version of yelp.com

To kick-start the process of building a platform for this new review system, they purchased a database of over 20 million business locations. This database was old and inaccurate, but it created the framework for what Yelp called “claimed business locations”.

The empty business pages functioned as an open invitation for people to submit reviews. It motivated people to, at the very least, write a few words about the business. In fact, many of the early reviews were just that: “this place is great”, or “this place sucked.” But as time passed, reviewers started to take the platform more seriously and write longer, deeper reviews. The framework paid off in dividends later.

Also, they didn’t subordinate the user’s contributions to professional reviews, as on Citysearch, or to directory information, like yellow-pages sites. Instead, Yelp motivated people to share reviews through praise and attention , something no one else was doing. Those social networking features were what made them stand out.

Getting Social

Now that they had the right direction, they needed to grow their user base. Without the cash for a national rollout, Stoppelman decided to first focus on making Yelp famous locally.

With the help of a buzz-marketing guru he hired on a whim, Stoppelman decided to select a few dozen people — the most active reviewers on the site — and throw them an open-bar party. As a joke, he called the group the Yelp Elite Squad.

A Yelp Elite event

Levchin thought the idea was crazy: “I was like, ‘Holy crap, we’re nowhere near profitability; this is ridiculous,’ “. But 100 people showed up to the first party, and traffic to the site began to increase. Since the parties were reserved for prolific reviewers, they gave casual users a reason to use the site more and nonusers a reason to join.

By June 2005, Yelp had 12,000 reviewers, most of them in the Bay Area. In November, Stoppelman went back to the VCs and bagged $5 million from Bessemer Venture Partners. He used the money to throw more parties and hire party planners — Yelp called them “community managers” — in New York, Chicago, and Boston. Community managers and the Yelp Elite Squad still exist today.

Stickers

The number of reviewers on the site grew to 100,000 by 2006. Stoppelman also raised several million more in venture capital. By summer 2006, Yelp had one million monthly visitors and they were slowly adding more cities.

Now that user counts were growing, they focused on their next problem: they needed to get merchants to play a much deeper role. A growing user base of reviewers was wonderful, but the other side of the coin was the businesses themselves. Not to mention they were Yelp’s only source of revenue.

They decided to begin an aggressive drive to get merchants to claim business listings, populate them (e.g. menus, hours, website, etc), and motivate their own customers to review their experiences on Yelp.

The Yelp sticker

One of the ways they did this was by using a sticker. It was a genius move.

Most businesses were already familiar with Zagat and Mobile stickers and the impact they had on awareness. But Yelp was more aggressive with it and even handed out extra marketing materials. This had a remarkable effect on the review count. Organic review counts shot up and more businesses got on board.

Yelp stickers became almost ubiquitous at famous restaurants in the Bay Area and continue to serve the company today. They stand as a daily reminder of Yelp to the potential reviewer, the potential visitor, and the merchant.

Yelp’s Legacy

Stoppelman, Simmons, and the rest of the Yelp team were persistent, humble enough to pivot, and savvy enough to see the real problems they faced and to use creative methods to overcome them.

Yelp continued to grow. The service kept adding cities and eventually went international. They launched a successful mobile app. Stoppelman gathered tens of millions in venture capital and then took it IPO. As of this writing, the company has a market cap of almost $3.7 billion.

They’ve made a few mistakes along the way, and some say they’re in the middle of a process of disruption. But Yelp — the original king of place reviews — spawned a score of apps and startups and changed the way consumers view their relationship with businesses.

For that, they get…

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About the Author
This article was written by Jordan Bowman of  jrdnbwmn.com.
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Experience

5 Important Reasons Not to Raise Capital for Your Startup

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I recently had dinner with co-founders of a startup who’d just raised quite a bit of money for their company, a deal which incidentally I’d passed on. The meal was fantastic: fresh salmon from the bay, washed down with a particularly good New Zealand pinot noir, while watching the sun go down over the water. Really you’d expect my mood to have been chipper… but it wasn’t.

The evening was spent with the founders congratulating themselves for raising money. I’m not being a killjoy but it felt like the end of the line, not the beginning. It felt like all the preparation had been done, all the work completed, all the sweat, tears and marriage breakups had already been had, and now finally they’d succeeded. Except of course that wasn’t the case. This was the beginning not the end.

All they’d done was raise some money. Money which, though it may be needed to fulfill their goals, stands as a liability. Now, I’m all for celebrating success but this attitude really worries me and here’s why.

VC culture has come to equate raising capital with success, where each successive round of financing successfully completed is denoted as success,but you know what, VC culture is wrong.

Success is success and raising money is raising money. Let’s not confuse the two.

Raising money amounts to taking someone’s hard-earned capital. Capital which has been acquired by sweat, savings, maybe even theft but it’s someone else’s nevertheless. That, folks, is a liability no matter which way you spin it!

Realise that even if the capital never came with strings such as board seats, preferred equity, liquidation preferences or any host of other typical “strings”, realise that capital ALWAYS comes with strings which I’ll get to shortly.

So in the event that you’re an entrepreneur, emboldened by the fact that most anyone in Silicon Valley today sporting a hoodie, some pimples, and professing to work out of his grandmother’s garage, can get funded and at eye-watering valuations, let me give you 5 reasons why raising money may be a bad idea for your business:

1. Lack of Focus

Multi tasking is rarely a great strategy for any business. If you doubt me, try rubbing your belly and patting your head.

37signals built one of the most successful businesses in their niche by remaining extremely focused on just one product. My point is that it’s next to impossible to be running around raising capital, while remaining focused on building your fledgling business.

Unless you’re sitting in Silicon Valley which stands as a distinct anomaly to the rest of the world, let me assure that raising money will likely take you far longer than you ever thought, will come with more distractions than you’ve even thought, and the progress in your business will suffer.

2. ROI Can Be Poor

Time has a cost. The time spent raising money can often be time poorly spent.

I little while ago I was pitched by a company which had developed a minimum viable product, cheap to produce, easily shipped and which when sold, netted a $10,000 profit. The founders were, however, trying to raise $250,000 and had been on a road show for 3 months already!

Consider that by focusing on building, marketing and selling that very product they needed only 25 products sold to reach their $250,000 they had spent the last 3 months raising. The sheer insanity of what they were doing forever precluded any investment.

3. It Can Be Expensive

Further to the above, as an entrepreneur you might consider paying brokers to raise you capital. While this is an option realise that in any financing round up to Series A, it’s not uncommon to have to pay up to 15% of capital raised, and sometimes even include some warrants, preferred stock or options.

In short, it’s expensive money. Really expensive.

4. Capital Comes with Strings

You should expect that incoming investors may want board seats and input in your company. Do you want that? Does the capital you’re looking for come with the kind of strings you are comfortable with?

You can take money from all sorts of sources.

  • Family and friends will invest because they like you, or maybe they hate you and want you to go away. Or they feel guilty and can’t bare the thought of the next thanksgiving dinner where they’re the only family member who haven’t backed your idea and aunt Marge will make a stink about it. These are psychological strings. Are you OK with them?
  • Angels will invest if they believe you’ve got a good chance at success and often, if they feel they can, add some personal expertise. These guys are not stupid though, and will likely structure deal terms including ratchets, liquidation preferences and so forth. Strings may be that the input by the angel(s) is not something you want. These guys can be of immense value but make sure interests and personalities are aligned otherwise you risk a lot of strife.
  • And venture capital comes with a set of different strings. This particular avenue of financing deserves an article in itself and I’ll write about it next week.

5. Too Much Capital Can Actually Be a Bad Thing

I’ve seen good ideas go to the wind when founders raise too much money. Money can certainly make people do daft things and I’ve learned that as well.

The fancy office space suddenly becomes “necessary”. Scrappy goes out the window in favour of “professional”.

You want to know what is really professional? A company that manages its cash flows, is scrappy as hell, is intensely, manically focused on building awesome value, and realises that when markets turn, as they always do, it’s the strong that survive and thrive. And the strong are always scrappy.

Make sure the money is aligned with your outcomes. Understand who you’re dealing with and what the motivations are. Most of all, don’t just follow the herd because the herd is rarely right.

If, after reading this, you’re not scared away and believe that your company has world changing potential, is less than $10M pre-money valuation and “needs to exist” then feel free to contact me. I’ll be happy to look at your pitch. I’ll almost certainly say no and be kind about it but maybe, just maybe that doesn’t take place.

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About the Author

This article was written by Chris of of capitalistexploits.at.

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