Startups and Funding (A Cautionary Tale)

I am thinking about the Microsoft/Facebook deal and the absurd valuation it places on Facebook. Then I started thinking about my experience with start-ups. The previous start-ups I worked for I am not familiar with how the financing worked exactly, but my current employer I have been with since before the beginning so I am intimately familiar with all of the details.

What strikes me the most is how an unscrupulous investor totally screwed us over by formulating a deal which would allow him to pocket millions while screwing us. He had obviously been planning this since the beginning since the terms of the deal contained many bizarre terms that, to me, screamed out "I am going to screw you over!" But I guess the "founders" were too blinded by the site of a couple million dollars to really think about the future. This guy's plan was to "financially engineer" an artificial valuation for our company, and everyone thought he was the bee's knees until he screwed us over, except for me - I never really trusted him at all.

Once the plan put in place by this investor (who has a reputation for doing this with companies) and the company and stock structure was in place the "founders" went out and started finding other investors. They did the whole dog and pony roadshow thing, at a ridiculous valuation for our company of $600 million. But they raised a good amount of money - most of which went right back into their pockets. It seems that the "founders" were not quite as stupid as one might have thought, and had arranged for themselves to be owed money by the company, payable either in monthly installments or once $x million had been raised. Some of the founders went even further and did their own private placement, the proceeds of which were ostensibly to pay off debt from their old company, but which actually went directly into their pockets.

So the "founders" made millions of dollars, in addition to their high salaries and ridiculous severance packages, right off the bat. I should have gotten 5% of those millions but they kind of screwed me out of that. Nevermind though, because they ended up giving me .5% of the company instead of the 5% I had originally been promised, which under the initial ridiculously high valuation of the company was worth several million dollars.

The plan put in place by this devious investor involved bypassing an IPO and becoming public through a reverse merger which allowed us to bypass FCC regulations and become public way before we were ready. We became public well before our stock was even registered to be able to be traded, which kept the valuation artificially high. Once the registration statement went through the price immediately dropped as 99% of the shares became tradeable.

Since then the price has dropped to 0.0167% of it's original price, the price which had been used for the first round of financing. A bunch of people lost a lot of money, including me, because I foolishly held on to 95% of my stock hoping it would go back up after the initial dive. I wish to god now I had sold more of it, even 10% would have made for a nice cushion and savings that would come in really handy now, but no, I just sold the bare minimum I needed to pay off my credit cards and other loans. The only people who made money were the initial investors and the founders, who had to defer their fat salaries as the company started to run out of money and the creditors came knocking. The problem was that since we were public, and so thinly traded that anyone can move the stock price around with a few hundred shares to trade, and the stock price was so low, they couldn't raise money anymore. If we were private I am sure we would have a high valuation and VCs lined up out the door as we have a great idea and a great product. But being public, and having this first investor holding the share price down, we would have to sell 1/2 of the company to raise even a couple million dollars.

The next chapters in this book are yet to be written. The company recently got its main new backer to extend the terms of the deal which we used to borrow money from them. Other people have been interested in the company but the terms of the deal with this new backer make it ridiculously stupid for anyone to invest in us. As far as I know the "founders" salaries are still deferred, though they may have paid themselves once the new deal was put into place.

This makes me think that they way to get rich is to start a company and make sure you have deals in place that ensure you get paid no matter what happens with the company. It might scare off some investors (I nearly peed my pants when I read the first 8k and finally learned about all of these backroom deals) but as long as you can get someone to invest you can still make money without having to do anything. Of course the people who lose are the people who invest in your company, but they presumably have enough money that it's not going to hurt them too badly.

As soon as I come up with a salable idea this is exactly what I am going to do.

Social networking and Netflix

Netflix is apparently adding some social networking / community features including:

1. Latest reviews stream that continually loads movie reviews in real time as people post them to Netflix
2. “Members’ Top 10 Lists” widget that displays user-generated movie lists based on what Netflix thinks you will like
3. “Unique in…” area that shows the movies that are uniquely popular in your hometown
4. Selection of strangers on Netflix who share your interests or are most “similar to you”
5. List of your friends’ recent activities with Netflix (what movies they have requested, whether they have been returned, etc.)
6. “Friends’ Quiz” that generates simple questions to test you about your Netflix friends’ movie-renting behavior
7. Friends’ Love/Hated area that shows the movies your friends loved or hated (pretty self-explanatory)

This is what I like about social networking. Forget Facebook, MySpace and Friendster. The really important things going on right now are Wikipedia and stuff like this. There is an entire book ("The Wisdom of Crowds") about how markets are much better at making decisions than individuals. One recurring example in the book is about a "guess the number of jelly beans" jar. The average of everyone's guess is usually pretty close to the correct number, sometimes even closer than any single persons guess.

When Netflix put out their challenge to come up with a new algorithm to recommend movies I thought about it. Being a bit of a movie buff I have some problems with their recommendations. If I said I like "Raging Bull" they would be more likely to recommend "Rocky" than "Taxi Driver" or "Mean Streets," both of which are much more similar to "Raging Bull," thematically and visually, than "Rocky" is.

My thoughts about how the recommendations should be determined was that the user needs to specify some criteria - like what they look for most in a movie. I look at the director, my wife looks at the actors. As far as I am concerned I don't care who is in a Scorsese movie because I know Scorsese will do a good job. My wife doesn't care who directs a Nic Cage movie because she likes Nic Cage. My wife is concerned with what the movie is about, I don't really care what it's about because I see movies as works of art to be experienced while she sees them as stories.

If we each said we liked the same movies Netflix would recommend the same movies to both of us, at least I think it would, while we would actually be interested in widely different films.

To account for differences like these we either need a pretty complex algorithm with lots of user-inputted data, or we need some sort of social network. Ideally would be a combination of both. People who gave similar answers to the questions as you did are likely to like similar movies as you do. Or if not you can at least see what connects the choices of the two people and make an inference based on that. This can get extremely complicated which is why I never went ahead and wrote this, although I have most of it planned out in my head.

My wife suggested that a good idea for a site would be a gift recommender. For example all of the kids out here in NY are crazy about Webkinz. Her family back in California has not heard of them. So punch in 6 year old, boy, and a location and you get customized suggestions for what such a person might like. This would obviously require a strong social component and would need to learn from the results it gives.

Anyway this Netflix idea is great. This is where the power of social networking really lies. Not in stuff like MyFacester, but in learning from crowds and applying that knowledge. This is the core of Web 2.0 in my opinion. The Wisdom of Crowds. Check out the book if you haven't already.