Startup Studios are also known as Venture Builders and as both of these names suggest, they are companies that create other companies. The goal of a Venture Builder is to use the same internal team and set of internal resources to crank out as many high-quality startup ventures as possible. To learn more about Startup Studios and how they work, read this article.
At Studio Upstart- Build, the first and only membership community for entrepreneurs and leaders across the Startup Studio industry, we talk a lot about how to fundraise for Startup Studios. As many of our members are emerging Studio creators, there are questions on everything from legal to accounting. In this episode on our YouTube channel, I outlined the steps an emerging Studio must undergo in order to get ready to raise funding.
At a high level, one must:
- Develop a kick-ass team
- Identify your niche and mission,
- Set up your Studio as a legal entity
- Design your branding- which includes launching a website- and
- Decide on your funding mechanism (bootstrap or investment)
Once you’re set on those tasks, yous Studio is in good shape to move on to the next step: fundraising.
After conducting research and surveying existing Studios, I’ve come to the conclusion that there are two main structures Studios use to finance their operations and startup creation efforts. This is not to say that the financing can’t be set up in other ways, but in general, these two structures are the most frequently used for new and emerging Studios with little to no funding of their own to offer up. Additionally, most often VC firms are the backers of Startup Studios, but Angel groups, governments, and even private corporations can also contribute funding to a Studio.
Structure #1: The Fund Model
Essentially, Studio founders each hold an equal amount of equity in the Studio and they collectively launch a fund to raise money to build ventures. They’ll settle on an amount that will give them 24 months of runway because that is the minimum amount of time it will take to create a new venture and get it to “spin-out” scale. Venture Capitalists contribute to the fund as LPs and the Studio oversees the fund as a GP. For this, the Studio gets to keep 2.5% — 5% of the fund amount raised to help cover operational costs such as team salary, office space, and overhead.
Most often VC firms are the backers of Startup Studios, but Angel groups, governments, and even private corporations can also contribute funding to a Studio.
It’s important to note that the VCs are not investing in the Studio directly, they’re putting this money into a fund for the Studio team to use to create new startup ventures.
So, the Studio can only use the fund’s money to create new startup ventures and, once these ventures are created, the equity in them is held by the VCs who financed the Studio. To be clear, this means that the Studio itself doesn’t own equity in the startup ventures they create. On the flip side though, they still own 100% of their Studio which will become valuable over time.
The last piece of this puzzle is called carried interest. If you’re unfamiliar with the term, you can think of it like this: if the Studio has no equity in the startup ventures they create, why would they care if the startups are any good or if they have an exit at all? They’re not going to profit from the exit, so why should they care? This leads to a very poor incentive fit between the Studio and the investors who funded the Studio. To mitigate this, 20% carried interest is typically worked into the contract which means the Studio receives 20% of all dividends and profits from each startup venture. This helps align interests and ensures everyone is working as a team to be successful.
Structure #2: The Holding Entity Model
The second type of financing structure is called The Holding Entity Model. As you can see from the visual above, this model is a lot simpler than the Fund Model. Essentially, the Studio founders (who each hold an equal amount of equity in the Studio) announce that they are looking to raise funding for their Studio. However, instead of creating a fund, the Studio is asking VCs and others to invest directly in the Studio.
VC firms invest in the Studio and in exchange receive equity and become a form of business partner with the Studio. While the VCs won’t be executing and may not choose to provide any resources aside from capital, (other potential resources might be connections and access to infrastructure) they will get a say in the direction of the Studio’s thesis, the Studios operational strategy, hiring, and which projects/ startups the Studio invests in.
The Studio owns a percentage of equity in the startup ventures they create and the investors own a percentage of equity in correlation with their equity agreement with the Studio. For example, if the VC firm owns 10% equity in the Studio, they own 10% of all startups to launch from the Studio.
When there are dividends or profit from an exit to be distributed, the investors take priority over the Studio until they are fully paid back. This is a concept known as Preferred Returns and it’s often used to show good-will on the side of the Studio as the team and methodology are often unproven.
So, which model should you choose? When I advise emerging Studios on this matter, I almost always suggest going with The Holding Entity Model.
This model allows Studios to keep most of the equity in the ventures they create and ensures the Studio has funding for creating startup ventures and internal operations like hiring new talent, maintaining office space, and paying for tools. Once your Studio has matured and you start seeing returns on investments, more options for financing become available.