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85 Knots: Introduction and Day 1 - The Oriental

The Anatomy of a Tech Startup

by Paul Creech on Thursday, December 1, 2011



Believe it or not startups, specifically tech startups, may be over-funded and heading towards another tech bubble. Reasons for this surge of startups are plentiful, including overvalued poor performing public markets, fears of public debt default, and an aversion to startups in traditional industries that are struggling in the Obama economy. There is a massive supply of cash on the sidelines of the economy, which needs to be invested and put to work, but is being held back from other sectors out of uncertainty.  A driving force for technology investors current funding spree is the return of huge initial public offering (IPO) numbers by recent market entries, and an anticipated blockbuster IPO for Facebook next year. The front page of the Wall Street Journal recently claimed that Facebook would value at $100 billion, the IPO would raise $10 billion, and would a defining moment in the “latest Web investing boom.”  The rising tide of this Web boom is lifting all boats, the good and bad.

When there are few alternatives for investors, and a sector is enjoying a boom, there are many effects on that sector’s startups.  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 losing project. The return on another project is not enough given the higher investment, creating a failure where there would otherwise 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 then competition lasts longer than it should, innovation is slowed for lack of an industry standard or consensus, and money is wasted on projects based on other projects that would be toast but for a big pile of money yet to burn.  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.

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.

IPO success drives startups because that is where early investors realize their incredible returns.  Every startup’s goal is a huge IPO. Capital firms and startup founders want to Occupy Wall Street like Steve Jobs and Bill Gates as the .0001% of the 1%, a neighborhood Mr. Zukerberg may enter early next year. The secondary goal of any startup is to attract the attention of a corporate buyer who will acquire them at a premium, make them 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 they were hoping noticed their shop and wanted their intellectual property. 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’.

First, you and a guy named Dave start a company that creates software for app developers (other startups) called Small Corp Easy App Maker 2.0 software. The plan: You create the buzz while Dave goes around giving away the product to developers. The catch: you and Dave 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-fashioned 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 downside 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 half the stock rather than be paid back.  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 for 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).


Next startup post: Common terms of Angel investment, trade-offs, and the first questions you need to answer before the decision to seek funding.


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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