How venture capital studios turned the investing upside down — and why startups do better this way

Oleksandr Davydenko, Chief Innovations Officer of the TECHIIA holding

Photo: Oleksandr Davydenko, Chief Innovations Officer of the TECHIIA holding

About the phenomenon of startup studios and how they affected venture capital investment.


Last time, I explained why the traditional approach to venture capital investment was ineffective. Just to quickly remind you: there is a hole in the market when early-stage startups are not given enough money and support, then they go into the "valley of death" - and only a few of the survivors get the money and time of late-stage investors, those who invest in working businesses with lower risks.

In this article, I will explain how venture capitalists got out of the impasse they created and what this gives to today’s startups in a world that is increasingly losing predictability.

Studios boost you to create a project faster

In the early 1990s, it became obvious to some that distributing investments to various startups based on the "at least one of them will succeed" statistical logic was not the most productive approach. But the desire of innovators to launch projects was still there. Investors' fear of losing money was still there also.

A new model appeared in 1996 in the Idealab project. Its founder is Bill Gross, a graduate of UCLA.

In his youth, Gross has been working on various projects: he was opening arcades, launching the production of acoustic systems, and developing software.

Mike Tyson once said that everyone has a plan until they get punched in the mouth. “Not only does this phrase apply to boxing, but also business: the main task of a manager is to be ready for the punch in a mouth by the consumer," argued Gross. He analyzed a ton of business projects and concluded that the investors’ traditional approach, when the originality of the idea and the funds invested in the project is the core, is incorrect.

According to Gross, the two most important factors that affect the success of a startup are timing (the time it takes to create a product and bring it to market) and management. Bill assigns them 42% and 32%, respectively. He left a 28% success rate for ideas and only 14% for funding.

Gross' proposed approach to financing startups turned everything upside down. He decided to create a company that would independently synthesize ideas for startups and develop several projects in parallel, evaluating and selecting the most viable ones.

Idealab managers themselves sought funding and helped form project teams. Gross's idea worked. Idealab implemented 150 projects with 45 that went public.

Differences in various investment model approaches

Differences in various investment model approaches. Source: medium.com

Studios remove irrelevant projects

Idealab is called the oldest startup studio, but in the 90s such a concept simply did not exist. Gross called his enterprise a "technology incubator."

In the vocabulary of venture investors, the term "startup studio" appeared in 2007. Then in Berlin, Rocket Internet, the first venture builder in the Old World was launched.

The founders of Rocket Internet - brothers Marc, Oliver, and Alexander Samwer - are called “clone” kings.

In 1998, after traveling to the States and discovering the eBay service, the brothers decided to create a similar one in Germany. The copy — Alando's online auction — was so successful that within four months eBay bought it for $43 million.

The next project — Jamba, a service for downloading Internet content to mobile phones — the brothers sold for $273 million. After that, they decided to engage in venture investing and created their own startup studio. They took the same tactics as Billy Gross — recruiting a team and attracting funding to launch startups.

As before, the brothers borrowed ideas for projects from successful startups. One of the biggest successes of Rocket Internet is the Zalando e-commerce service, whose revenue was almost €8 billion last year.

Today, nobody remembers that Zalando is a clone of the American online retailer Zappos.com. Although in the middle of the 2000s brothers were considered impudent and incapable of creating an original project. The thing is that the Samwer brothers did not search for originality. They were not looking for a breakthrough idea, but simply successfully copied those that existed. This is how the brothers solved one of the main problems of startups — poor Product-Market Fit.

This indicator does not assess the revolutionary nature of the business idea, but its relevance. The brothers kept their fingers on the pulse and launched startups, carefully calculating market capacity and competition. That is, they made sure that the project’s PMF was relevant.

Today, Rocket Internet is the largest venture capital fund in Europe. The approach the brothers created is used all over the world, especially in countries where there is no full-fledged venture ecosystem — and this is almost the entire planet, except for centers like the Valley and New York. Where access to venture capital and the ecosystem is severely limited, startups can only count on the help of venture capital studios.

This approach to investing is effective. In 2020, Global Startup Studio Network discovered that 84% of startups developed in venture studios reached the seed stage. Among them, 72% were able to go to Series A. Among traditional startups, only 42% managed to do the same.

Studios offer more objective conditions

The success of Rocket Internet immediately led to a startup boom in Europe, and in 2011 in the rest of the world. Then Nova Spivack, an American venture capitalist, the founder of the startup studio Magical, and a business theorist wrote the article The Venture Production Studio Model.

“The production approach to venture creation is quite different from the “fire and forget” or “spray and pay” (or “pay and pray”) model that many VC’s and angel investors are engaging in," writes Nova. — Instead of spreading lots of fairly hands-off bets across dozens of companies, in the production model I really focus and get deeply hands-on with a pipeline of projects of various stages. This is the opposite of the index fund or hedge fund approach that some funds are taking in the Valley. And I think it is a much better fit for the needs of early stage companies."

Spivack describes in detail the concept of a venture studio. He notes that the new approach to creating startups is very similar to the film production process in Hollywood when a huge company deals with many projects.

Following Bill Gross, Spivack says that the main advantage of a venture studio is a much faster launch of a startup. Why? Because, unlike venture capitalists, studio managers get involved in a startup at the concept stage, even before the project team is formed.

Based on the experience of the studio, startups also bruise while forming a team, raising funds, and creating a product, but they do it much faster and cheaper - they have a ready-made team for product development and partners for financing or they invest their own funds. Having entered the market earlier than competitors, they already get a huge advantage.

Thus, the studio becomes a long-term partner and not a sidelined player on the totalizer. This is its key difference.

Spivack breaks down the creation of a startup into the following stages

1) Discussion of the idea with the developers. No money is invested at this stage.

2) The team refines the idea and creates a proof of concept. At this stage, the team receives the first grant and continues to work on the idea - as Hollywood screenwriters, after consulting with the producer, add to or revise the script.

3) Work begins with the technical and product groups to understand whether they will be able to create a working prototype with the allocated funds.

4) In case the team copes with the previous task, the studio concludes an agreement with it, which implies gradual funding. The entire amount necessary for the implementation of the project is never transferred at once.

5) While work on the project is underway, the studio helps the startup conclude agreements with the best suppliers for the services it needs, engages legal and patent firms, PR and marketing teams, as well as accounting and HR services. This saves businesses time and money and protects them from early mistakes.

6) As soon as the finished product appears, the studio, together with other angels and venture funds, attracts funds for its deployment.

More objectiveness — this is what Spivak singles out as one of the advantages of working with the studio. Entrepreneurs who partnered with him ended up with larger stakes in their ventures than if they had worked with traditional angels and venture capitalists, he said.

And this approach results in statistics that I hear in meetings with colleagues and on the sidelines: in 2020, for every million dollars invested by foundations, there was $5 million from studios.

What's next

The cases of Rocket Internet and Magical demonstrated the capabilities of such a business model, and as the result, startup studios started springing up like mushrooms. In particular, in Ukraine, almost all service and product IT companies have their own studios, which have the resources to invest and are trying to find startups on the market.

This approach is very different from the usual startup rock and roll with night pitches and contests. It definitely takes some of the romance out of it, making the creation of new businesses something measured and predictable.

But as we know, there is enough uncertainty in modern life that creating new products, businesses and companies is still a high-risk endeavor.

Original article on ain.ua.

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