Raising VC Money

Funding Social Networking Companies

Raising money for a social networking venture? Before you spend too many cycles pitching venture capitalists, you'll want to read this article.

It's mid-2008. Should venture capitalists still be investing in social networking sites or is Bubble 2.0 about to burst?

How about the flip side of the same coin? Should entrepreneurs be pitching their businesses as "the next big thing in social networking" or has that become a turnoff for investors?

The popular Tech Bubble Video makes it seem easy enough to get rich in the new Web 2.0 world.

The video satirically instructs would-be superstar entrepreneurs to gather up a bunch of trendy buzzwords, pick two industries to revolutionize, find a talented engineer and feed him pizza, give him beer. From there, it's easy street. You're on your way to billionaire status!

It's a very funny video. But the reality is that there has been a window of opportunity in recent times to get rich quick, even if your business isn't making much money.

Social networking and social media have been big drivers in that trend. YouTube sold for $1.7 billion. Here in Chicago, FeedBurner's founders snagged $100 million. FaceBook is valued at $15 billion based on Microsoft's recent investment. MySpace sold for $580 million.

We're just getting started. Other recently acquired Web 2.0 companies include Bebo, Blogger, Bloglines, Business.com, Compete.com, Cork'd, del.icio.us, Dodgeball, Dotspotter, Flektor, Flickr, Grouper, Jaiku, Jumpcut, Last.fm, LiveJournal, MeasureMap, MySpace, Newsvine, Oddpost, Picasa, Pluck, Rojo, Skype, Sphere, StumbleUpon, Upcoming.org, WebJay, Weblogs, Webshots, Writely and ZYB. We're probably missing another 50 or so Web 2.0 acquisitions.

Arguably, the companies on this list of Web 2.0 acquisitions are not all pure-play social networking sites, but social networking is certainly where much of the action has been in terms of merger and acquisition activity.

So, should the VCs be investing in social networking? If you've got a great idea for a social networking company, will the VCs throw money at you?

Social Networking Is Not Like the Movie Business

The short answer to your question is that venture capitalists are not going to pay much attention to a startup social networking company that wants to raise millions of dollars but doesn't yet have much traction.

That's because a social networking superstar typically can be identified before they need much capital. By definition, successful social networking sites grow quickly in terms of users and notoriety. There's no need for billboard advertising or full-page, four color magazine ads to get the words out. If the site is worth going to, word spreads quickly.

It's very different from, say, the movie business.

In the movie business, you have to spend a ton of money to create a film and then you have to spend a ton of money to market it. Finally, you put it in the theaters and only then do you know whether you've got a hit or not.

A great social networking business, in contrast, can be built on a shoestring. A few smart developers getting ahead of the curve with a good idea.and then their idea catches on like wildfire. Suddenly, everybody is talking about it. It jumps to the top of the Alexa rankings. Newsweek and Time write cover stories about it, even though the startup never has hired a PR firm. The growth is exponential.and it's all viral.

So, if you are really onto something big, do you need money?

You certainly don't need much money. Most of the VC money that goes into social networking is to buy server bandwidth to accommodate the rapid, ultrafast growth that precedes (and is a prerequisite to) the VC round.

If you are asking for VC money, it means one of two things.

First, it's possible that you just don't get the way things work. In other words, you don't realize that you need to show a lot of traction in the marketplace before a VC will be seriously interested in talking to you. So, by asking a VC for money too early in the process, you are basically shouting "I am naive!"

Second, if you ask for VC money early in the process, it could also mean that you do get it, but you are trying to hedge your bets because you're not too sure your concept is going to work. In other words, just in case traffic to your social networking venture is only a trickle after launch, it sure would be nice to have a couple million in the bank, so you can buy time. In this scenario, you are effectively shouting "Give me money because I am not very confident that this is going to work!"

It's like the venture capital industry aphorism about Kleiner Perkins: You only see the Kleiner guys when they are out walking their dogs.

In other words, if Kleiner is trying to syndicate a deal to you, your spider senses should be tingling. If it were really a high-potential deal, they wouldn't be talking to you. Rather, they'd do the entire deal.

It's the same thing with entrepreneurs, VCs, and social networking sites. An entrepreneur that calls on VCs to raise money for a startup social networking venture is effectively wasting time, both for the entrepreneur and for the venture capital firm.

So When's the Right Time to Hit the VCs for Money?

Venture capital used to be high risk, high return. That's no longer the case. VCs these days are more like mezzanine financiers. If something is already on its way to greatness, VCs are happy to jump on the coattails, throw in a little money and make a lot of money in return.

In other words, if you've achieved superstar status through organic and viral growth without spending much money, call up the VCs and you will get a meeting.

That's because the potential isn't a question mark anymore. You've proved there's real demand for what you've created. Your technology works, so there's no technology risk. There's no market risk. The market is embracing your offering.

There's very little risk at all. That's when the VCs are ready to write checks. They'll take meetings long before that time, but the checks get written after the major risks have been obliterated.

Exceptions to the Rule

If VCs believe you've got the Midas Touch, they will fund you a little earlier in the process.

Netscape founder Mark Andreesen, for example, can contemplate starting Ning in the social applications space and immediately get funded just by making a few calls.

But for your average Joe Entrepreneur, that dog don't hunt.

Timing Is Everything

The other factor working against your raising money for a social networking startup is Bubble Paranoia.

There's a sense that Social Networking has started to become a commodity business. With everybody heading in that direction, the odds of your hitting a grand slam get much smaller. VCs are worried the bubble is about to pop.and, as such, they are getting a little gun shy in allocating funds to even the most promising entrepreneurs.

Kleiner Perkins even said it publicly: We are no longer investing in Web 2.0 companies. We aren't even looking at them.

If you are starting a social networking company now, it's a bit like starting a dot com venture in early 2000. You're two or three years late to the party.

Instead, you should be figuring out what the next party is going to be after social networking and jump on that one ASAP. What's the next big boom? Go there.

Niches are Key

Odds are you won't be creating the next MySpace or FaceBook. The biggest social networking sites have been created and it will be hard to displace them.

Sure, we all know that companies like AltaVista and Excite dominated the search industry for a short period of time, and then Google ate them as an appetizer for lunch.

Can you do the same thing in social networking? Maybe, but it's a tall order. There's more luck if you focus on smaller niches.

For example, real estate social networking sites, travel social networking sites, financial planning social networking sites, senior citizen social networking sites, pet lover social networking sites and other niches have some promise. If you are aggregating leads that somebody else would love to sell to, that's a good sign that your niche will one day pay off.

Take a look at Gooruze.com as an example niche social marketing site. It's a well done social networking site for online marketers.

The key is to find a niche that has not already been conquered but that has a high value/valuation creation potential.

You can also focus on other countries if you've got the right skills and connections. For example, Google invested $1 million in Comsenz, a Chinese provider of social network software. FaceBook has expressed a lot of interest in buying Chinese social networking company Zhanzuo, a Chinese FaceBook clone that has become quite popular.

The big acquiring companies are, and will definitely be for some time, on the lookout for good international social marketing sites to buy.

Another piece of advice is to think outside of the box. In this case, the box we are referring to is the rectangular web brower. Social networking is moving away from site-specific mode and it's becoming more invisible, more infrastructural.

These days, it's more about widgets than websites. Can you build something that facilitates social networking but that doesn't require somebody to visit your website? There's big money in that.

Things like Twitter, for example, are becoming a way to connect with other people who are of interest to you. Messages connect the dots.you don't have to go to a site. That's a trend that VCs are watching.

Remember when Microsoft's Steve Ballmer suddenly realized that email was the web's killer app. That's the idea. There are killer apps out there that don't look like apps at all. They just quietly connect the social networking dots, and they are slowly taking over.

Revenue Models and Business Plans

Sure, VCs like to see revenue models. They like to see business plans. But with social networking all of that is a little bit fuzzy.

Advertising click through rates are horrible on popular sites like MySpace. People are there to socialize, not to shop. So, MySpace leverages pay per impression ads that make money even if the end user ignores them. How long can that last?

These days you can get away without a good revenue model, but having one will certainly help you raise money.

The weird thing about startups these days is that the value proposition of the company often isn't known until years after the company is formed.

Take Feedburner as an example. It started with a belief in the value of RSS feeds. But Google's Adwords model made relationships with publishers extremely valuable. At the end of the day, Feedburner's connections to all of its publishers led Google to buy them out. Sure, the technology was great, but the value came from relationships.and that took the founders by surprise.

The moral of the story is that you need to learn as you go and adapt as you go. Be close to the market and see where things are headed.then get there ahead of everybody else.

So What Do You Do If VC Money Is Not an Option?

OK, we know what you are thinking.

You're thinking:

I'm ahead of the curve with this idea. I think I can get to the point where my idea will be worth a ton to a lot of companies. But to get there I need money to start things up and kick things into gear. Are you serious? I shouldn't be pitching VCs? What should I be doing then?

Forget the venture capitalists. Pretend they don't exist.

If you're in the early stages of your social networking startup and don't yet have superstar traction, then your funding alternatives are bootstrapping up (i.e. run up those credit cards), friends and family or angel investors, or cash flow from the business.

Bootstrapping and angel investing are well documented financing mechanisms, but you should really think long and hard about the last option: getting the business to generate enough revenue to cover your costs.

Along those lines, we know a company that folded here in Chicago. They had a property valuation website and they couldn't figure out how to monetize it. Offering functionality similar to that of Zillow, they were reasonably popular. They wasted a lot of time calling on VCs who were not interested, and then closed after they could not raise VC money.

However, in my estimation, they could easily have covered their burn rate by search engine optimizing a ton of content related to real estate and putting AdSense and other ad network revenue generators on their site.

If you only need say $350,000 to $500,000 of investment money, you should be able to easily generate this through online advertising or something similar. If you can't do that, you probably don't have what it takes to succeed in the long run. (Hey, don't shoot the messenger!)

Raising VC Money for Social Networking Companies

So, social networking entrepreneurs, take heed of this advice. Venture capitalists are not the easy money targets you thought they were. You can waste an enormous amount of time courting them and wind up with nothing.

Our advice is to talk to them only have you have demonstrated some initial success and have had at least 15 seconds of fame in the marketplace.

More importantly, always have a Plan B and a Plan C that presumes that the VCs will not be there for you when you need them.

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