Startup Studios- also called venture builders, company builders, and startup foundries- are a relatively new vehicle for launching ventures. You can read about the history of them here and learn about their business models here.
The focus of this article is to take a look at how Studios make money and dissect the various ways Studios get money (from fundraising and other efforts).
How Do Startup Studios Raise Money?
Before we can discuss how Studios make money, we have to look at how they get money. It wasn’t obvious to me when I first began researching Venture Builders that they weren’t using their own funds. I assumed the internal Studio team was made up of founders who have sold their startups and had money to invest in a Studio so they could continue creating and launching startups. Or, I thought, perhaps the funds to run the Studio come from the fundraising efforts of each individual startup venture created within the Studio.
On both accounts, I was wrong.
While there are examples of Studios founded by entrepreneurs who have sold their startups and have money to spare, the majority of Startup Studios are financed by Venture Capital firms and Angel Investment groups.
These groups get their funding from a variety of sources like endowments, grants, pension funds, big corporations, and private funds. Once these funds are invested with a VC or Angel firm, the firm invests a portion in Startup Studios- either directly or indirectly through a sidecar fund. When the dust settles, Venture Builders have the funding they need to operate.
As discussed in my YouTube video on the topic, all Startup Studios fund the initial stages of product development. The Studio pays engineers, designers, growth hackers, and covers all raw material costs (including office space) for the new venture. But, once the project moves from the “testing phase” to the “validation phase”- it begins to look a lot more like an independent startup company.
When the Startup and begins to find market traction, the Studio is faced with the choice to either formally spin-out the venture (where they may invest in the initial seed round of funding or decide not to participate in the round).
Statistically speaking, over 70% of Startup projects that a Studio generates will be killed off due to lack of demand, bad timing, poor business model, or a variety of other factors.
The gray circles on the graphic below indicate the “killed off” startup venture projects.
According to Madrona Venture Labs, a Startup Studio based out of Seattle, they fund only a fraction of the hundreds of ideas that they evaluate.
Our ideation and concept validation approach is refined from running hundreds of ideas through and funding only the precious few that make it through our rigorous process. — Madrona Venture Labs
These precious few MVL is referring to are indicated on the graphic above by yellow circles. These are the projects that move forward and, if all goes well, eventually spin-out of the Studio as independent ventures.
To borrow again from Madrona Ventures, here are a few of the next tests that Startup projects have to pass if they are to continue being worked on:
If a Startup makes it through these rapid testing and traction phases, it has a great chance of being launched. The launch process involved the Startup Studio hiring a CEO and founding team (COO, CTO, and early employees) to come in and run the Startup as an independent venture. The Studio keeps the majority of the equity in the venture, but the newly established founding team is awarded equity as well. This keeps the incentives aligned.
As with most Startups, the big payoff comes when there’s an exit. This is not to say that Startups making a profit and operating in the market are not valuable, because they are, but the goal of a Venture Builder is to develop, launch, scale, and spin-out startups with the intention of having those startups exit resulting in a big cash payday for everyone involved.
This Forbes article breaks down exactly why an exit is so important for Venture Capital firms and, as such, why exits are so important to the success of a Startup Studio:
VCs make money on management fees and on carried interest. Management fees are generally a percentage of the amount of capital that they have under management. Management fees for the VC are typically around 2%.
The other side of making money is the carried interest. To understand this concept, carried interest is basically a percentage of the profits. This is normally anywhere between 20% and 25%. It is normally in the largest range if the VC is a top tier firm such as Accel, Sequoia, or Kleiner Perkins.
In order to cash out and receive the carried interest, the VC needs to have the portfolio of each one of the funds making an exit, which means that the company is acquired or will through an IPO where investors are able to sell their position.
— Forbes: How Venture Capital Works (2018)
So, in order for VC firms to cash out on their owed percentage of profits, the Startup has to be sold, acquired, merged, or offered for Public stock (IPO). This is why it’s crucial to quickly discontinue any Startup that doesn’t have a bright future. No one can predict what may happen, early signs of a struggle are not indicators of good things to come. Studios need to be willing to cut ties with the project and move on.
It’s a numbers game that has produced some of the world's most innovative companies like Hims, Dollar Shave Club, and Tumblr. But in order for these incredible Startups to have emerged, plenty of others had to die. This is a critical part of the process. As each new Startup is killed off, lessons are learned by the Venture Builder team and new connections to outside resources are made. This allows the Startups that do succeed to do so on a massive scale.
Why Some Startup Studios Fail
Clearly, there are a number of different ways Startup Studios can fail. They could run out of money or never get enough in the first place. They could hire the wrong mix of people creating a dysfunctional team atmosphere. The list goes on but a serious and avoidable problem that kills a lot of Startup Studios is losing sight of the mission and the model.
As we’ve discussed, Startup Studios need to vet hundreds of ideas, try out a fraction of those, and ultimately move forward with only a handful.
If a Studio gets too focused on one Startup, it can begin sucking all of the Studios resources including people and capital into that one company project.
This is what has happened with a few prominent Studios and they have since shut down as a result. For example, Twitch co-founder Justin Kan started and a Startup Studio but then dropped it to pursue the building of one venture. There are more instances of this happening often, but they aren’t very public about these transitions so it’s hard to get data on the specifics.
The bottom line is that Startup Studios are, in my opinion, the best vehicle that has ever been designed for innovation. Each Studio’s business model is unique but they all have the same six elements in common. If you remove one of those elements (in this case it would be “volume of projects”) you break the frame and the entire thing falls apart.