Expectations: Investors

Not surprisingly, investors have a lot of questions about the studio model. If you’ve read any of my prior posts, you’ll know that I view startup studios and their startups as snowflakes; each one is unique and special. This leads to a lot of variation that confuses even the most experienced investors. I hope this post will help you understand the key differences between studios and how the studio model impacts the investor.

The Basics:

Studios spin up (and spin off) several startups per year in parallel. There are several advantages to investing directly in the studio and alternate advantages for investing in the spin offs. Many studios only invest in the ideation-to-validation stage. These studios require external investors to further validate their spinoffs at formation and beyond. Other studios discourage outside investment in order to retain a larger piece of the pie, which requires a larger internal fund. All studios require investment. Some studios only take initial investment to cover expenses until the first spin offs exit, with huge returns. Other studios also raise funds to invest in the spin offs at formation and again in follow-on rounds.

Slices of the Pie:

Each major stakeholder receives a piece of the pie, which can be divvied up based on IP, investment, sweat equity, leadership, C-suite experience, risk and size of the opportunity. The first question that many investors ask is, “How much equity will the studio keep?” Studios keep anywhere from 10 to 80%, depending on the deal and the studio model. The same studio may take 15% of one and 50% of the next. That is a staggering range. The next question is usually, “How much does the C-suite get?” Again, the range is wide: 10–70%. Many investors will then ask, “What’s left for me?” Below I’ll break down the percentages of the pie based on factors and explain why there is always room for more.

The Studio’s Slice:

Because studios provide such a widely varying menu of services, they retain a widely varying range of equity. A studio that provides the idea, does the validation, gains the traction, brings in a CEO and funds the startup through to exit will obviously retain a large chunk of the whole (50–80%). The studio that only provides the ideation and validation (not funding or ongoing support) will retain less (15–50%). Some studios act more like accelerators or incubators for the occasional startup (i.e. the CEO brings the idea to the studio and then goes to outside investors afterwards). In this case, the studio retains less (10–25%).

The CEO’s Slice:

As I explained in the last post, CEOs with more experience will demand greater equity. CEO’s that require more services and funding from the studio will receive lower equity. As a result, the slice that the C-suite retains is cut from the same percentage as the studio’s. Investors should want the C-suite to have a large portion of the equity because it will motivate leadership to exit large (which helps the investors). In some cases, C-suite dynamos may retain less equity for a larger salary (this is sliding on the scale from entrepreneur toward early startup employee).

The Option Pool:

As is standard for startups, a 15–20% option pool for all employees is set aside. This pool only varies by 5%, so there isn’t much wiggle room there. Again, investors should lobby for a large option pool in order to motivate the employees.

Investing in the Studio:

Investors that directly participate in the studio will benefit when the studio benefits. If the studio gets a larger chunk of equity, the investor gets a greater return on their investment in the studio. However, if the studio takes too much, they may dis-incentivize the C-suite to exit big (why wait for $100M in 2 years when I can exit for $10M now?). What all stakeholders need to remember is that a slice of watermelon is better than the whole grape.

Investing in Spin Offs:

Some studios allow investors to come in at all stages, while other studios won’t allow external investors. If you’re working with a studio that encourages or needs follow on investment, it typically works just like any other startup investment. If you’re early in (e.g., seed or series A), you should expect lower valuations (more bang for your buck) and the eventual dilution by later rounds. Of course these later rounds increase the valuation so you’ll end up with a smaller portion of a much larger pie. The concern, as always is negative rounds. There is no need to focus on the percentage breakdown between the studio and the founders because your investments will dilute the studio’s, not the other way around.

Investing in a Studio Fund:

Some studios have a separate fund for initial and follow-on rounds. If you invest in this pool, you’ll get returns based on your equity share of the fund. This is similar to investing in an accelerator fund. The studio will take a few basis points to cover management expenses. So, let’s say you own 10% of a fund, and the fund invests at various stages in 10 of the studio’s startups. By investing you diversify the risk compared to investing in a single spin off. In this case, your investment goals directly align with the studios goals (maximize returns for the ensemble while minimizing exposure due to a single failure). Most studios have fewer portfolio companies than accelerators, so their fund is less diversified than the typical accelerator. At the same time, the median success rate and exit size for spinoffs is often higher than those of accelerated startups, so the net risk is mitigated.

Studio — Investor Alignment:

It is important to know that the studio’s investment goals align with yours. Some studios focus on a narrow niche (mobile tech for millennial or programmatic advertising), while others diversify more (hardware, medical, natural foods and SaaS for mobile). Some focus on beating emerging competitors to market, whereas others focus on previously unexplored markets.

And Boulder BITS?

At the time of posting, we’re currently NOT taking on investors for Boulder BITS or the Boulder BITS fund. We do encourage early-stage and follow-on investment in our spinoffs. Please let us know if you’re interested in one of our portfolio startups. We grant generous equity to the C-suite in every startup. This helps us attract the best leadership team. Larger equity also gives them incentive to exit big. In late 2017 we’ll raise another fund to support our spin-offs. We feel that if we don’t double down, how can we expect others to?

Fun Bits:

  • To be a successful startup investor you should: create a budget, determine your portfolio size, determine your portfolio building timeframe, determine your investing frequency, and to get involved with others (join an Angel group). To learn more about these best practices visit: Best Practices to Get Started Investing In Startups
  • So now that you know a little more about startup investing, how do you determine which startups to invest in? Some quick tips are to invest in a domain you know about or have some experience in, know the people your investing in, and diversify, diversify, diversify!!!
  • As a general investor rule of thumb, you should never invest more than 10% of your net worth into a startup, this usually amounts to between $25K and $250K however these numbers are shrinking as startups need less and less capital to launch. (Bill Clark)

Next Up:

Now that we know what investors can expect we should also know what to expect from a mentor perspective. It’s important for a mentor to understand the studio or startup just as much as the investor or the entrepreneur. A mentor’s vast experience can help an entrepreneur or investor make the best decisions in the startup. The level of involvement from a mentor varies depending on the entrepreneur’s experience in startups or the investor’s experience in smart investing. In our next blog we will discuss exactly what a mentor can expect and how to be prepared.

Originally published on January 26th, 2016 on our previous blog.

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