Startup studios are a relatively new breed. They’re not incubators, not accelerators, not venture capitals, and definitely not your typical company.
And — like any other venture — to get it off the ground and running, you need to finance it. This article focuses on the first funding options available to a studio.
The startup studio is a capital intensive model whose core aim is to create new startups. In its first years, all the cash raised by a studio will serve to take on all the costs to run the studio (HR, Admin & Legal, Tech, etc) and build its first ventures.
When the studio matures, and the startups launched become independent, the role of the studio evolves from being solely a venture builder to also being a continued investor. If the studio wants to maintain its pro-rata rights, it will have to take on the role of an investor.
In our article, I will not focus on studio financing in relation to the investment role of the studio but to its role as a startup builder. If you want to have a look at the investor aspect, I wrote a previous piece here which focuses on the different models.
Studio Structures at Inception
When starting off, there are three main startup studio structures:
Fund Model — In this model, the studio sets up as a fund. The studio ‘team’ (acting as a GP) is financed through the fund’s management fees. The equity owned by the studio in each created venture is owned by the fund (and therefore the LP’s). The studio team (GP) will enjoy a performance fee (Carried Interest) based on the IRR brought back to the LPs. Atomic VC is an example.
Holding Entity Model — The startups are financed through the studio itself as a Holding Entity (eg C-corp). The equity owned in each venture is on the balance sheet of the Holding Entity. eFounders is an example.
Dual Entity Model — A mix of both options above: the studio is a Holding Entity (financed to cover its operations) but is also GP of an affiliated Fund. The equity of each venture is then usually owned by both the studio Holding Entity and the Affiliated Fund. High Alpha is an example.
Each of these models has a different set of specificities. And not all of them are optimal when getting a studio off the ground.
The Fund Model usually operates under the industry-wide 2/20 model. GPs typically charge 2% management fees and an additional 20% carry fees dependent on the fund’s performance. While this is a proven model for VC & Buyout funds, the math doesn’t add up when creating a startup studio. The 2% management fees need to cover all of the studio’s expenses, and the initial Fund size will not be large enough. The capital-intensive nature of the studio limits this model’s success. So you’ll need to:
Increase management fee — Although most investors will not accept non-market conditions.
Increase fund size — The fund will be “scoped” to invest at early-stage and to also continuously invest at later stages. Here, the fund will take into account the dual role of the studio being both a startup launcher and an investor. However, when you’re just starting out and building your studio from scratch, investors will be reluctant to believe that you will create ventures in which you’ll have an investor's role down the line. This assumes that you will build highly successful ventures and without a track-record, getting investors on board will be tough.
Given these limitations, it is clear that this model is not the best suited when first launching a studio. And that’s not it, we believe that the Fund Model blurs the role of the studio in its initial phase. Studios are usually built and run by entrepreneurs whose main goal is to launch new startups. In this model, the Studio owners are paid and rewarded as GPs. Their role as co-founders in the startups they build isn’t as clear-cut and thus might not appeal to them. From our experience, only Atomic.vc has succeeded with this model to date.
In the Dual Entity Model, both the studio and the fund play a role in financing. This hybrid model is a great alternative as it solves the limits of management fees. In this set-up, conflicts of interest can be mitigated, the fund can invest in the studio itself or an investment committee can be established to approve the fund’s investment in a startup built by the studio.
However, this structure is still not ideal when starting out. If the studio founder(s) don’t have a solid track-record or if they don’t invest large amounts in both the Fund and the Studio to mitigate the conflicts of interest, the structure will be perceived as too complex to start. And investors hate complexity.
If you’re interested in finding out more, John Carbrey from FutureSights comprehensively mapped the sub-types of this particular model here.
Now, let’s dig into the Holding Entity Model. This structure combines two key benefits: simplicity and alignment of interests between the studio founders & investors. But it can be tricky to convince investors to get involved. Let’s say that you need $2M to build your first four ventures and only want 20% dilution. Investors will automatically make the connection to the GP / LP setup of funds where there is no “goodwill value”. The goodwill value of your studio is its ability to create a lot of value and generate above-average returns. The only way to show your goodwill is to have a successful track record, but since you’re only starting out — you hit a wall.
Over time, we’ve identified mechanisms for investors to accept a goodwill valuation at the launch of a studio. The principle is to imitate the 1x preferred non-participating liquidation preference, adapted to the studio model. The model has to be tailored because the goal of a studio isn’t to have only one exit — but a lot of smaller exits.
The first investors need to avail of a preferred payout or dividend for the firsts exits. Ideally, until their investments via preferred payout/dividend have been fully paid back.
It’s relatively easy to articulate in a shareholder agreement, eg:
-a- An all exits, 50% of the money proceeds will be paid out to the shareholders
-b- On all first exists and until the investors are fully paid back, investors will enjoy a privileged payout and be paid back before a studio founder gets a return from the first proceeds.
-c- Once investors are paid back, proceeds of exits flow to shareholders following traditional cap table percentages.
With this principle in mind, it’s relatively easier to ask for a $5M investment to back your studio. Investors will get 20% equity of the studio and therefore “lifetime” 20% of the studio’s shares in the built ventures. More importantly, they get a guarantee that if their $5M creates any value, they will be the first ones to get it back.
Studio founders will own 80% of their studio and of the studio’s shares in the startups they’ll create over time, even if that means leaving the investors the privilege of the first returns. This structure is therefore particularly attractive for entrepreneurs who naturally want to retain a majority of the studio equity. The Fund and Dual Equity models on the other hand should be more suited to studio founders with a strong financial mindset as their role will be more similar to the ones of GPs.
It should be stated that this is not how we financed eFounders at the beginning, but we’ve invested in startup studios and from our experience, we believe that it’s the perfect mix of simplicity, alignment of interests and rationale. The Holding Entity Model ultimately enables studio founders to retain the majority of the equity and allows the studio to get funding, hire above-average talent and build amazing companies.