How A Russian Billionaire Is Changing The Way Startups Grow Up

Starting in the summer of 2009, Russian holding firm Digital Sky Technologies (DST) began taking huge stakes in successful American startups. 

First it plowed $200 million into Facebook at a $10 billion valuation.  Then it dropped $180 million into Farmville-maker Zynga, setting its value between $1.5 billion and $3 billion. Finally, last week, DST invested $135 million in discounts-for-group-buyers site Groupon, setting a $1.2 billion valuation.

So what the hell is going on, right?

It's all part of DST CEO (and billionaire) Yuri Milner's clever strategy that's changing the way tech companies grow up.

Here's how it works:

There exist profitable, late-stage startups that are run by people who believe their companies could stand a little seasoning before going through the hassle of an IPO to face the quarter-by-quarter scrutiny of the public markets.

The problem for these patient entrepreneurs is that often times, their startups have investors and employees who are not as patient. These employees and investors have stock in a company that they can tell is doing well, and they want to sell it to the public and make a lot of money.

DST solves this problem for entrepreneurs by coming in and buying stock from these early investors and employees at very high valuations. DST also buys some new stock from in the startups themselves.

The really smart thing DST does in these situations is buy "common" stock instead of just buying "preferred" stock.

Venture capitalists will usually only invest in startups if they can get "preferred" stock. That's because one of the advantages of owning preferred stock is that preferred stock holders get their money back before "common" stock-holders in the case of a fire sale. In this way, owning preferred stock is kind of like insurance against a startup's failure. Of course this advantage doesn't come free, and preferred stock comes at a premium.

DST, figuring there is less risk that the type of late-stage, profitable startups it likes to invest in, gobbles up this cheaper, common stock (along with some preferred, too.)

It's brilliant, because Facebok isn't going bust anytime soon and pre-IPO common stock and preferred stock become the same thing after an IPO.

Another advantage in buying non-voting common stock, is that it is very entrepreneur-friendly. It signals to entreprenuers that it wants the them to keep doing what they're doing. DST doesn't even ask for a seat on the company board. This makes DST a more attractive source of funding than typical VCs and the public markets.

So, what kind of startups will DST invest in next?

The firm looks for late-stage startups that should be generating hundreds of millions of dollars in profits within the next five years.

Investing in Groupon, which shares its deals through Facebook, and Zynga, which gets most of its users from Facebook, DST has shown a preference for startups that are piggy-backing on DST investment Facebook's increasingly enormous scale. (DST CEO Yuri Milner is a scientist by training and it seems he views Facebook as a catalyst he'd like his portfolio companies to touch.)

The one major draw-back in DST's strategy is that there aren't many late-stage startups in the entire world -- maybe 20 -- and even fewer that fit DST's thesis.