On the Viability of the Startup Studio Model
What is a startup studio?
The studio approach to company building, otherwise known as parallel entrepreneurship, portfolio entrepreneurship, or a lab, is becoming more and more prevalent.
The most recently announced big one is Expa, started by Uber and Stumbleupon Founder, and funded by some impressive names like Richard Branson, Meg Whitman (CEO of Intel), First Round Capital, and Tim Ferriss. Some of the most well known studios are Betaworks, Obvious Corp (Twitter), Idealab, and Science Inc. (Dollar Shave Club). I was part of the founding team of a studio called Casual Corp.
Each studio has a slightly different approach, but the common ground is that they start companies from scratch. The specific approach to “starting” can vary, but a studio is different than an incubator, accelerator, or VC, in that it doesn’t invest in existing companies.
In this post, I will discuss some of the pros and cons of the studio approach to company building, as well as some more detail on how studios actually operate.
Startup studios have some advantages over single startups, or even VCs. Namely:
a. Diversification. As opposed to starting one company (“traditional” entrepreneurship), a studio starts multiple companies. Startups are very risky. The earlier they are the riskier they are. Working on multiple startups allows the team to diversify their risk.
b. Higher risk = higher return. A company’s valuation is at it’s lowest point when it first gets started. Investing in a public company is typically much less risky than investing in an early stage startup. Therefore the studio (or entrepreneur) gets a more significant chunk of equity.
c. Shared resources. The studio’s companies can share resources such as data, recruiting, funding, sales, expertise, etc. Studios also typically have in-house staff that operate the companies (at least at the early stages).
d. Built to scale. A startup studio may not face the problems that many big companies are facing right now because all businesses are completely independent from the outset. If/when a studio grows, it’s organization structure would be one that is sustainable. In fact, some large companies are starting to replicate this organizational design by setting up their own startup studios or “labs.”
e. Enabling entrepreneurship. Depending on the specific approach the studio takes, the studio is often enabling the founder(s) of the studio to start more companies or enabling other people who might have otherwise had trouble starting a company.
While startup studios have advantages, they also face challenges, above and beyond standard entrepreneurship or investing. In the section below this one, I describe how startup studios and their companies are typically structured…reading that section may help you understand these challenges.
a. Capitalization Tables
The way teams are structured and equity is distributed can lead to principal/agent problems and insufficient incentives.
The earlier stage a company is, the lower its valuation is, therefore more equity will be granted to the equivalent sweat equity or capital of a later stage company. If the studio starts a company from scratch, it will have to replace itself, which means additional shareholders. Additional shareholders means less equity per shareholder. A couple rounds of financing later and everyone has less equity, including, and perhaps most importantly, the team who will be scaling the business.
One of the reasons why startups can compete against large companies is because the team members have equity, and therefore upside, and/or have invested their time and/or money, and therefore downside. I believe lack of incentive and separation between principal and agent are one of the biggest reasons why large companies fail, or fail to innovate.
It requires a unique personality, and incentive structure, to “hire” a “founder.” I think people who would work as hard without the equity as an entrepreneur with equity are hard to come by. Not impossible but hard to come by. There are probably rare cases where the “safety net” of a salary may help the entrepreneur perform better, but in general I think someone who has their finances tied to the performance of the company will be more motivated to succeed.
Having more smart people on board may seem great, but in practice it might not be. Everyone’s a little involved but no one’s really involved. Like a “party round” of VC funding. Or building a product that’s attempting to solve everything for everyone but really not solving anything for anyone.
b. Team Dynamics
“Manufacturing” teams by recruiting on their behalf, matching co-founders, etc. can result in teams that may not not work together so well. Sure, big companies do it, but it’s probably a problem they face too as compared to a traditional startup.
It can take months or years to get to know someone well enough to know if it’s right to start a company together. A co-founder relationship requires a lot of trust. The traditional startup team that has known each other for a little while, worked together, quit their jobs together, etc., and chosen to work together may be more effective than a team that’s placed together.
Having team members (or the studio team) who are working on multiple projects can create similar problems to if your husband or wife was also seeing three other people: time and trust. In the cases of both a startup and a relationship, time and trust are not impossible to overcome, but it definitely presents challenges. As weird as it may sound, a startup is like a band, a sports team, or a relationship.
As discussed above, the highest amount of risk in the earliest stage. Therefore, compared to a VC, a studio is taking on significantly higher risk.
d. Deal Sourcing
The actual logistics of how companies are started vary from studio to studio. I will go into different ways they can function later in this post. If the studio starts companies by way of either partnering with or investing in people who haven’t yet started, or very recently started their company, “deal sourcing” becomes a shit show.
Think about company building like a conversion funnel…x# companies start, a percentage of those get seed funding, a percentage of those raise venture funding, a percentage of those go public or get acquired. The problem is that the number of “companies” at the top of the funnel is massive! And a large percentage of them are not strong and will not receive funding. The universe of companies contending for series b financing is a lot less than the amount of companies contending for angel or seed capital. The massive number of potential people for the studio to screen is a huge time challenge.
If the studio is not seeking to partner with people at the earliest stage, it will have to operate the companies themselves. That’s really hard to do! It’s hard to shift back and forth between projects. It’s hard to commit enough time to each project. Starting one company is hard enough hah. Some amazing entrepreneurs are able to make this work, but it can also result in a whole bunch of projects without any getting enough attention.
Money scales, time doesn’t. Investing in additional companies is only a marginal additional time commitment. Starting additional companies is an equal additional time commitment.
If the studio plans to replace themselves as operators, that creates an additional recruiting hurdle, and additional dilution.
If the startup studio is funded by an investor with a portfolio of investments, such as a VC, the studio may end up starting a company that is in some way competitive to one of the investor’s portfolio companies. This would either be a conflict of interest for the investor, or a restriction to the startup.
g. Capital Intensity
A studio requires more capital than a VC or incubator. A studio needs full-time staff. Y-Combinator only needs only mentors, most of whom are unpaid volunteers.
h. More Hurdles
An entrepreneur has to overcome many extremely challenging hurdles when starting a company. For example, finding a technical co-founder, acquiring customers, building, product, fundraising, hiring, etc. A startup has some statistical chance of failing at each step along the way.
A studio has to face all the standard challenges of starting a company, in addition to some potentially added challenges. For example, finding “co-founders” over and over again, replacing themselves as founders/operators, in some cases fundraising for each company, and/or fundraising for the the start of the studio (before even starting a company).
Adding hurdles increases the potential for failure. If the upside increased according to the added risk, it would make sense, however I’m not sure why a scaling company that came out of a studio would be more like to succeed than a scaling company that started “organically,” all else equal. If the studio were to reduce the challenge of some of the hurdles (i.e. building product, recruiting, etc.), that could be valuable, but it would have to for less equity value than the value of time/money it would take for an entrepreneur to solve those problems on his/her own.
Structures and Logistics
It sounds really cool to be a startup factory or lab that just spins up startups. It sounds simple on the surface. But in the background it’s actually quite complex and challenging. Below are a few ways studios can operate and be structured. For each the “logistics” are a little different, but the outcome is very similar (for example, what’s the difference between starting a company and then finding partners vs partnering with a pre-traction company).
a. Hiring founders – a wealthy individual either has too little time or energy, or simply has enough money to be able, and (essentially) “outsources” a company he wants to start. He hires people to do everything that needs to be done to start the company.
My take: you can’t “outsource” entrepreneurship. It takes drive, passion, and upside.
There are too many scenarios where either the investor or the team get screwed. For example, if the company starts doing well, the company will want more equity, despite not taking on the same risk as a the investor because they were getting paid a salary.
b. Investing “pre-company” – investing at the earliest stage of a company. Team is pre-seed, pre-angel, pre-significant traction, and maybe even pre-product. Investor invests at a low valuation and takes more equity to account for the risk.
My take: similar to above, there are many scenarios where someone gets screwed. The investor takes on a tremendous amount of risk, and the team has to give up more equity to account for it. It’s gotten cheaper and easier to get a company off the ground so I’m not sure why a startup would want to take on investment at such a low valuation. It creates problems after future fundraising when the founding team gets overly diluted.
c. Starting and building multiple companies from scratch. The studio’s team does everything themselves. From identifying a problem, to figuring out how to solve it, to solving it, and so on. Eventually if the studio wants to scale as a studio, so they either have to replace themselves as operators or partner with or hire co-founders/managers at the onset.
My take: This doesn’t scale. Not even a little bit. Either the team has to operate multiple companies at the same time (which means everything would take longer), or it has to recruit a team to replace itself. Working on multiple companies at the same is extremely hard, if even just from a focus and workflow perspective.
Recruiting a team to replace the studio team is a hurdle. As discussed above, hurdles are risky. Also more people = less equity per person = less incentive. In addition, the studio becomes dependent on other people to execute in order for their equity to increase in value.
d. Work for equity. This can come in the form of “high touch advisorship,” more active operational support, such as building a product, business development, recruiting, etc., or even serving as a “co-founder.”
My take: what’s worth more to an entrepreneur, sweat or capital? Capital can be used to buy sweat, or anything else the entrepreneur wants, while sweat can only be used as is (what’s worth more, a gift certificate to Target, or cash for the same amount?).
This model also presents challenges later on one when studio has to move on from the company to focus on it’s other companies. As a result, the remaining company has less equity. If the studio is working on that company while simultaneously working on others, the company and it’s team may not get the attention it needs.
I think a startup with a fully committed and incentivized team is more likely to succeed than one with a larger team that’s less committed.
e. Testing out multiple companies, then picking one. The individual or team does customer development and tries to get traction on multiple products at once. Most experiments fail, hopefully one succeeds, they may raise money for it, and the individual or team operates that company solely. This is different than starting and building multiple companies, as listed above, in that the studio approach discontinued after a company has traction.
My take: At the earliest stages, it’s great to diversify. Everyone knows startups are risky and that most will fail. Running multiple experiments is like having a mini portfolio. But eventually either focus or incentives will be sacrificed. Obvious Corp took this approach…they were working on a few things, but when Twitter started taking off, they piled in. I’m actually also taking this approach right now.
This model provides the benefits of diversification without added hurdles and/or dilution. It implicitly doesn’t scale, however that’s just yet another challenge an entrepreneur faces. I’m not sure risk/diversification can be solved without limiting upside disproportionately.
f. Funding. Depending on which of the above approaches the studio takes, the studio can be funded in a few different ways. Companies can be funded by individually by the founder(s), they can be individually funded by outside investors, or the studio as a whole can be funded by outside investors (i.e. Betaworks, Expa, Science).
Many investors claim to not fund “pre-companies,” however funding a studio essentially the same. In addition, studios have the potential to produce companies that are competitive to a VC’s portfolio. In fact, what the studio produces is not known. Which is why I was surprised to see a couple VC firms on Expa’s investor list. I guess the benefit is you get a portfolio of ideas instead of having to source each one. Two old saying also come to mind: “no one ever got fired for buying IBM,” and “bet the jockey not the horse.”
Will startup studios be successful?
Here are a few (somewhat rhetorical) questions I have about the studio approach:
a. What problem does a studio solve?
For the studio, it solves diversification/risk and allows them to pursue multiple opportunities at once. For the teams/founders of the studio’s companies’ (whether recruited in, invested in, partnered with, etc.), it’s intended solve, funding, operations, recruiting, and/or advice, etc.
Finding a technical co-founder is really hard for some people. Funding the initial stage of a startup, or simply forgoing salary, is hard for some people. However I think it may create more problems than it solves. In addition…
b. Does solving this problem lead to $$?
What type of person has the above problems starting a company? Will solving those problems for those people lead to big profits for the studio? I’m not so sure. “Those people” being people who get hired to execute on someone else’s startup, who are willing to give up that much equity to partner with a temporary or part-time team, and/or generally have that many problems starting a company.
A lot of the best founders probably want more equity and upside, have/have access to capital, have/have access to partners/hires, and/or generally don’t need as much help with company building. I’d probably rather have equity in those companies. Therefore the best opportunities would come from solving problems for those companies. What do the best companies need? Probably cash, but that’s pretty abundant now, and therefore more difficult to try to compete on supplying. Maybe some advice too. Distribution? maybe.
It seems like the problems the publishing industry is facing right now…the authors that publishers want don’t want them and the authors that want publishers aren’t wanted by publishers.
I think the studio approach may create more problems than it solves. It may be unlocking opportunities, but they might not be the best opportunities. It results in a lack of incentives for teams. It creates additional hurdles to starting and growing a company. The studio becomes overly dependent on outside forces. And for investors, it’s very risky.
I don’t completely buy in to the whole belief that entrepreneurs must be obsessively focused on solving one problem. I think it’s actually irresponsible and too risky at the earliest stages of a company. VCs have a portfolios, so why shouldn’t entrepreneurs. However I also think there aren’t many scenarios where the studio approach works out for all shareholders (studio, founders, investors, etc). I think it’s great at very early stages, but eventually the team should focus.
The best way to make money is to solve a problem or deliver to some customer. To an entrepreneur, that means starting a company and selling a product or service. For an employee or advisor, that means work for a company. For an investor, that means trading cash (and potentially some advice, introductions, etc.) for equity.
Starting and growing a company is really hard. But I unfortunately don’t think there are many better ways to do it.