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Glossary: the “Startup”

by Paul Creech on Tuesday, April 29, 2014

In order to understand what is going on in the news, in life, and in your phone it is important that you have a basic understand of where technology companies come from, what they want, and how they are funded.

Startup is a generic term to describe a new firm. In the technology industry a startup generally is a one trick pony, created for one specific product. Think: Dropbox, Evernote, WhatsApp, etc. One product. Do one thing, do it really well. In the 90s we talked about starting your own website, now we talk about apps. But startups can be a restaurant, a well fracking engineering firm, or a some other service company. Many create hardware, such as 3D printers, specialized computer components, and air-bags for bike riders. Others exist to create specialized technology to sell hard/software companies but that aren’t retail products: voice recognition, motion sensing, mapping technology companies. Startups generally denote small groups of people, founders working for nothing, in a garage or loft to launch a new product–the startup will live or die by the success of that one product. Of course, they can start out as well funded, corporate, fully mature companies. For as many people as there are in the world, and the variety of interactions, ideas and relationships shared between people, there are as many ‘forms’ of startups.

Initial public offering (IPO)  success drives the funding of startups because that is where early investors can realize their incredible returns. Almost,  every startup’s long term goal is a huge IPO. Capital firms and startup founders want to occupy Wall Street, and then leave it like Steve jobs and Bill Gates as the .0001% of the 1%, the neighborhood of  Mr. Zukerberg–where you can pick up a phone call and complain about your pet issues directly to the President of the United States because you swim around in Scrooge McDuck piles of money.

The secondary goal of any startup is to attract the attention of a corporate buyer who will acquire them at a premium(for control), make the founders rich and allow them to go off and create another startup.  In the 1990s a startup wanted to be bought by Microsoft or have a big IPO, in the last decade Google was the company startups were hoping noticed their shop and wanted their intellectual property. The payout can be huge, billion dollar WhatsApp kind of coin.  Route 1 for those that want be industry titans–“the CEO bitch;” and Route 2 for the idea guys, a company for every idea, a serial startup ‘founder’ or lottery winner.

First, you and a girl named Donna start a company that creates software for app developers (other startups) called Small Corp Easy App Maker 2.0 software. The plan: You build the software, while Donna creates the buzz by going around giving away the product to developers. The catch: you and Donna have no money ((or would rather risk someone else’s) even if that means sharing the future returns when developers start paying for your products, updates, and cool stickers.

Now-a-days there are many places to advertise a startup’s need of a capital infusion. Several websites act as dating services matching the right investor(s) with the right startup, trade shows allow startups to try and catch the venture capitalist’s eye, and nothing beats old fashion industry ‘buzz.’ Capital infusion can come from an established capital firm, other companies, individuals, or an ad hoc investment vehicle created for the purpose of investment. First floor investor profiles can take as many forms as the startup. The angel, floating down from heaven with buckets of cash, but wanting no control, is the most heralded.

Second you must decide how you want to structure the capital infusion.  One way is the straight stock sale, not very common for capital firms as there is little backside protection. A good model is a convertible debt instrument and the gradual vesting of founder’s stock.  In English, a convertible debt instrument is a promissory note or promise to pay a debt (repay the investment plus some huge interest rate) but is set to convert into stock at a pre-determined event rather than be paid back in cash.  If the business fails then the investor has the rights of a creditor to claw back as much of the investment as possible in default/bankruptcy, but if things go well the investor gets large amount of stock at some later point (usually a later round of investment, when the business reaches a certain value point, or at IPO).  It is important to keep founders motivated, since they aren’t putting their own money on the line and creative people tend be poor finishers, so incentivizing staying power is important.  To this end, the founder’s own ownership interest is generally not given over all at once, but ‘vests’ gradually over time as they earn their equity in the company with their sweat (usually at a percentage per year over two to four years).

If you follow technology news you will hear all about startups. You may hear about when they raise some money. Hopefully, this brief overview will cause you pay attention and ask more questions about the business side of the tech industry (in case you are wondering, that’s the side that drives innovation, awesome products, and people).

Believe it or not startups, specifically tech startups, may be over-funded and heading towards another tech bubble (lets hope not). Reasons for this surge of startups are plentiful, including overvalued public markets, fears about rising public debt, and an aversion to startups in traditional industries that continue to struggle in the Obama economy. There is a plentiful supply of cash on the sidelines of the economy, which needs to be invested and put to work.  A driving force for technology investors is the return of huge IPO numbers by recent market entries and high dollar acquisitions by cash flush Apple, Facebook and Google.  The rising tide of this never-ending  boom is lifting all boats, floating the good and bad.

When their are few alternatives for investors, and a sector is enjoying a boom, there are many effects.  First is that projects that need funding and deserve it (can return on investment), get it.  Second, projects that cannot return on investment and would otherwise not receive it, get it. Third, everyone that gets too much funding .

The investor loses more than they otherwise would because they sunk more into a project in the competition to get into a startup get in early. The return is not high enough, given the higher required investment, creating a failure where their would be a success.  Deserving projects are not recognized because the market place is crowded with too many investors and too many startups.  When every competing platform/language/etc. is fully funded the competition lasts longer than it should, innovation is slowed for lack of an industry standard or consensus, and money is wasted on projects in this competition in projects that would be toast but for a big pile of money yet to burn. Larger than necessary investments means the startups burn more (investor’s) cash on wasteful or boondoogle projects, facilities, and flash–spending more for the same result. The long term effect will be bursting of the bubble, the thinning of the herd, the realignment of the industry, but only after big piles of money have burned and time wasted.  Lucky for the wider tech sector and the consumer that technology will continue to shape our world and some of today’s startups will be tomorrow’s Google and Facebook.

 

These materials have been prepared for general informational and entertainment purposes only and are not intended as legal advice.

Paul Creech
Paul Creech is an attorney living in Houston, Texas. Paul has baccalaureate degrees in philosophy and political science from Utah State University, and a juris doctorate degree from Houston College of Law. He is a former U.S. Marine. Besides the law, Paul's interests include sports, art, and food.

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