The focus of this article is to take a look at how Studios make money and demonstrate what happens when a Studio messes with that model.
How Do Startup Studios Get 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 it was money from the sale of a company reinvested into a Startup building business. Or, I thought, perhaps the investment funds come from the wealthy backers of the Studio. On both accounts, I was wrong.
As it turns out, the money used by Startup Studios to invest in promising new projects comes from the traditional Venture Capital funding pipeline. As you can see from the graph above, Startup Studios have two main sources of financial backing: Venture Capital firms and Angel Investment groups.
These groups get their funding from a variety of sources like endowments, grants, pension funds, big corporations, insurance companies, and charity. Once these funds are granted to a VC or Angel firm, they invest it in Startup Studios directly. From there, the Studios have the funding they need to operate.
As I discussed in my YouTube video on the topic, all Startup Studios fund the initial stages of product development. They pay the engineers to build the apps. They pay for the raw materials that go into production. They even pay for the space it all gets built in. But, once the project turns into a Startup and begins to find market traction, the Studio is faced with the choice to either formally invest in a Seed or Series A round, or to look for outside VC funding.
How Do Startup Studios Make Money?
Statistically speaking, more than 70% of startup projects that a Studio generates will be killed off (that’s the gray circles in the graphic below).
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
The “precious few” that Madrona is referring to are represented by the Orange circles in the graphic above. These ventures go through the rigorous testing phase and make it out alive.
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 gets launched. The Startup Studio hires a CEO and founding team to come in and run the Startup while maintaining the majority ownership of the Startup. Essentially, they pay themselves in equity for all the hard work that went into getting it off the ground.
As with most Startups, the 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 big cash payday comes from an exit.
This Forbes article breaks down exactly why an exit is so important for Venture Capital firms and as such, why it’s 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 seriously discontinue any Startup that doesn’t have a bright future. No one can predict the future, but at signs of a struggle, 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.