As I discussed in my previous few blogs, there is a lot of fuss being made of online community. In a previous blog, I defined online community – at least how I see it – I would like to start a discussion on the business purpose of online community and social networking.

In Mark Cuban’s blog, blogmaverick.com, he came up with a pretty good definition of a business model for online community in the context of video and youtube. And with a little editing, can be generic to all online social networks.

“A video based social network, in order to be sustainable, has to reliably be able to generate revenues from the uploaded video content. It has to be able to market the brilliance of its members and the product of their work to advertisers and sponsors. It has to be able to market its members video content online and offline.”

In addition, Peter Theil and Bambi Francisco have started company, vator.tv. Vator.tv targets “InnoVators” to upload their video “EleVator” pitch to the site. I find it very interesting to view the videos and analyze the trend of the uploads, in terms of business model viability. Theil points out a fundamental question that I mentioned a few months ago in Commercializing Web 2.0 which dramatically impacts the approach to the business model. Theil’s point is that there is a fundamental difference between a technology application versus a stand alone company. I argue that this fundamental difference dramatically impacts the short-term business model in terms of the type of infrastructure in which to invest.

Furthermore, it is my belief that a social networking application is not a social networking business. In Episode 2 of vatornews.com, Theil points out that:

“The basic idea [of social networking sites] is to learn more about their users and tell their users things about other people in their network that are interesting and relevant.…It’s at the core of the business model of these web 2.0 companies.”

Again, I would draw a further distinction between product and viable business. Social networks are not about technology product, they are about connecting users and sharing the users’ knowledge and information. They are essentially media companies for user-generated content. Therefore, in evaluating business plans that purport to be social networks, I find that they are in fact product companies. In fact, I tend to believe that social networking and online community, in-and-of-itself is not a business model – but has the ability to dramatically enhance a business model.

So with that said, what is the business purpose of online community and social networking in enhancing an existing business model? To start, social networking and online community affords businesses the following advantages:

• Build customer loyalty: Connecting users to each other by sharing opinions, knowledge, and experiences deepens brand loyalty. If it’s a product or service brand, then allowing customers to communicate about product experiences adds tremendous value. If it’s a fan-related network, such as sports or entertainment, then providing a space for fan interaction reinforces the positive experience with the franchise.

• Mass Market of One: The more customers visit and communicate, the more information the sponsor of the network has about the customers. Therefore, the more targeted and relevant the advertising and sponsorship can be in serving up related networking and product recommendations.

• Increasing Revenue: Of course, building a business model is all about building a base of revenue, increasing customer loyalty, brand recognition, and relevancy, will ultimately increase revenue. Depending on the approach taken, this connection can be tightly integrated or loosely integrated. Either way, there should be metrics in place to measure the impact of the social impact of networking on the business.

In addition to the business model benefits, there are some fundamental product functionality of social networking that enables these business benefits. These include:

• User ratings and comments: These are relatively commonplace at this point on such Amazon and ebay. This enables users to rate and review product. In addition, you often see a reputation system attached to this to get quantify the percentage of readers who felt that review was helpful.
• User-generated solutions: These are typically knowledge bases that are manifested in a simple message board. It is simply a community where users can post questions about a product and the community answers support-related questions.
• User-created complimentary product: This typically occurs with products that support or require customization, such as uploading custom user-generated ring tones for mobile phones.
• User-uploaded content or editorial: On fan sites for music, movies, or sports, fans thrive on building community, commenting on a performance, or critiquing a game. All of which ultimately builds fan loyalty.

And for all of the above types of online functionality for community, if a company does not support, encourage, and sponsor it, the company will lose out on the opportunity to build brand recognition, customer loyalty, and revenue – simply because customers are conducting these activities already online, and if there is not a sponsored location for community they will build it themselves.

All businesses today must be more creative than ever before when it comes to marketing, getting the attention of the media, and reinforcing its brand.  The need to do this is certainly great for a start up, and a high tech start up must approach marketing and the media even more creatively.  After all, high tech implies 2.0 communications. There are many terms and buzz words today that deal with ways people and organizations are communicating — social networking, social marketing, web 2.0, viral marketing, word of mouth marketing, blogs — and receiving information — RSS feeds, podcasts and more.

Today, I would like to discuss the online communities that have sprung up online everywhere (this is springtime after all). Everyone’s heard of MySpace, Tribe and Friendster in the social networking space. Well, there are equivalent networks within the business community.

Fast Pitch (www.fastpitchonline.com) bills itself as “the fastest growing online business community in the world.”  There is also LinkedIn, where I am listed, and Meet Up. In preparing this article I have discovered many more networking opportunities for business professionals.

Wikipedia describes a business social network like LinkedIn as “a network that connects businesses by industry, functions, geography and areas of interest.” It goes on to mention a similar one in the UK—Bizmeed, “an emerging online networking service” with “similar tools” that is “developing a live video conferencing feature, as well as actively promoting Bizmeed members through search engine optimisation.”

These networks are either free or have a very low cost of entry.  As mentioned earlier, they are especially beneficial for

high tech startups and entrepreneurs that need to expand their base, build and manage relationships, find referrals, get introduced to other business professionals, promote themselves, drive prospective people to their website, and find capital, benefactors and customers.  Furthermore, it goes without saying that these networks have no boundaries and are worldwide.

They can help you find former colleagues as well. You can either reach out directly to others to ‘link’ to you (think degrees of separation), or, if you pay a premium on LinkedIn, you can have much more flexibility in terms of tracking people down and connecting or re-connecting with them. For instance, I am now ‘linked in’ with current and former Lucent Technologies, AT&T and Avaya professional managers.

These services make it easy to get started and interact and usually involve creating an online profile for yourself and your business and building your online network. Your profile looks a lot like a resume, bio or CV. You can use tutorials and get helpful advice with instructions, including video assistance. For instance, at Bizmeed, you can: create and search boards, create and attend events, create and join groups, engage in live chat networking, send and receive email, and create, read and contribute to blogs.

In my research, I’ve discovered many other networks and have a feeling I’ve just scratched the surface. At Ryze Business Networking (www.ryze.com) members get a “free networking-oriented home page” and can go to location and industry related bulletin boards.

There’s Xing (www.xing.com) which is German-based, bills itself as the “first ‘Web 2.0’ company to go public,” is operated by Open Business Club AG and has two main points of entry on its website—professional contact management and business accelerator.  Xing has recently purchased eConozco (www.econozco.com), which launched in 2003 and is said to be Spain’s “second biggest professional network,” with “around 150,000 members in Spain and Latin America.”

To learn more about these, you can read an article about LinkedIn on http://www.infotoday.com/online/nov04/bardon.shtml or visit some of these websites. You’re likely to find at least one that’s very valuable for you.

Earlier in the week, one of the entrepreneur members of the Amplifier Network reached out to me for some advice.  He had an “angel” investor who was ready to invest some money in his company.  He wondered how to structure the deal so that it would be appealing to a professional investor, or at least wouldn’t discourage an investment by an institutional investor.  As I spoke with him I realized (much to my surprise – well, not really) that I had some strong opinions on how he should structure his deal.  So, as we ended our call, and he went off to do his deal, my parting comment was that I was going to do a blog entry on our conversation.  Names won’t be used, to protect the innocent: we’ll call him “George” here.

Anyway, George started the conversation by saying that he and his investor had agreed to an equity investment, and that they needed some guidance on valuation.  That was a reasonable enough request, but it was really not as simple as he was hoping.  Merely providing guidance on valuation wouldn’t solve George’s problem, it would, in fact create more issues.

Here’s the basic issue: if you sell equity in a company, you must value the business.  This has two major implications. 

Firstly, if you attempt to value a business without professional input (i.e., from a professional investor) you run a serious risk of not getting the valuation “right” when you later approach professional investors.  As I have mentioned in an earlier blogs, venture valuation is a process that is arcane, and usually VCs value a business below where an entrepreneur will.  This matters because if you sell equity to an angel and then a subsequent professional investor determines to invest at a lower valuation you have a real problem on your hands.  It’s just not a good thing when an angel investor finds out that the stock he paid $1 per share for is only worth $.25 to the professional investor. 

You might say, well, that’s just a market. But, the reality is that no professional investor happily goes into a situation where earlier investors are going to be unhappy.  It often ends badly.  Perhaps your reaction to this is to say, “sure, but couldn’t the entrepreneur get the valuation wrong on the downside?”  That’s possible, but it’s just not the way human nature seems to work with start ups.

Secondly, if you value your equity by selling some to an investor, it then becomes practically impossible for you to provide equity to others at a lower price (i.e., your option grant price, or the value of stock you give to other founders or employees, has to approximate the value of the stock paid by your investor).   One of the most valuable things an entrepreneur can provide to early stake holders is “cheap” equity – indeed often that is the best currency he has.  So, doing anything to make a start up’s equity more expensive, should be undertaken very carefully.

So, after I told him all this in answer to his seemingly simple question, George asked, perhaps more patiently than I might have, “so if I can’t sell stock, what should I do?”  Here’s what I told him:

If you are going to raise money from non professional investors, your default position should be to structure deals that postpone valuation as long as possible.  How do you do that?  By issuing debt instead of equity.  Borrow the money.  Well, that was easy….. so obvious.  Of course, it’s a little more complicated than that.

People invest in start ups, particularly in the early stages because they want a high return possibility – 50 to 75% per year (that’s the equivalent of an interest rate of 50 to 75%). Well, who wants to pay that much interest? And, more to the point, what start up can afford it? So, if an investor wants a start up rate of return for his investment (which, by the way, he is generally entitled to for the risk he is taking by financing an early stage business where the risk of business failure is large), the only way an entrepreneur can provide it is to sell equity, because in equity substantially all the return is generated by the difference between the purchase price and the ultimate sale price.  Remember – “buy low, sell high.”

So, an angel investor should want equity, and indeed that is what he should get.  What the entrepreneur should do, however, is postpone the valuation of his company until it can be done by a professional investor as part of a professional financing.  However, George needed money now so what to do?

Do a convertible debt deal that has the following terms:

• A market interest rate.
• A maturity date some reasonable period of time in the future, say a year.
• An obligation on the part of the investor to convert the note into the first equity investment priced by a professional investor (usually referred to as the “first institutional financing”).
• Provide that the investor gets an economic advantage for basically pre purchasing the equity offered in the first institutional financing.  There are many ways to do this – the most customary being to provide the angel with a “discounted” purchase price for the equity obtained in the conversion.

The point of this structure is that it provides the earlier angel investor with two economic advantages: (i) the ability to participate in a professionally structured investment downstream, an investment opportunity that might otherwise not be available to the angel investor and (ii) a better purchase price in the round than the professional investors.