How To Start A Startup Studio: Design Choices Studio Founders need to take.
Hello again from STARTegy! For new readers, STARTegy is a startup studio building fintech companies in Mexico. A few months ago, I published an article that explained what startup studios are, how they compare to traditional models of innovation (VC, incubators, single startups, etc), and when the time is right to open a new studio.
I am now writing this second article to explain some of the design choices that you will need to make if you are thinking about launching a studio of your own -e.g. How will the studio be funded? Should the studio focus on a particular industry? When is the right time to engage entrepreneurs and integrate them into the studio model?
These are the sorts of questions that we at STARTegy needed to answer before opening our doors. I hope that by sharing our thoughts with the world and explaining why we made certain design choices, we can help the next generation of studio founders prepare for the road ahead.
Figure 1: Summary of design choices
Source of funding
One of the first questions you will need to answer (if not the first) is how to fund your studio. There are generally three sources of funding available for these types of ventures. The most common one is the founder’s wealth. After having one or more successful exits, an entrepreneur may use his or her own funds to open a studio and build multiple startups at once. A nice benefit of the studio model is that a seasoned entrepreneur can leverage both his or her personal wealth and operational expertise to support startups at scale.
Another option is corporate funding. A corporation may choose to launch a startup studio internally as a means of spurring innovation. In this scenario, the corporation will fund the studio directly.
In the absence of both corporate funding and personal wealth, studio founders may opt to raise money from outside investors. This is how we raised the necessary funds for STARTegy. When we started this journey, we didn’t anticipate how hard fundraising externally would be. We learned the hard way that VCs rarely invest in these models because they prefer to invest in individual companies as opposed to another fund. On the other hand, the typical Mexican investor invests in traditional businesses and just a very few do invest in startups. On top of that, the startup studio model is not well known and we had to work hard to explain why it is a good model for innovation. Our investors, however, valued our focus on fintech, the synergies created in the studio and how we can de-risk the investment through our ideation methodology and the possibility of recycling teams and ideas easily.
Studios that are funded internally (with the wealth of the founders or with company resources) typically adopt a legal structure with two investable levels: the builder itself and the many startups that pass through its doors. The benefits of this two-tiered approach are that the model is simple and that the builder accumulates the value of the shares it owns from its startups over time. At STARTegy, however, we did not believe this model would hold up if we raised money externally. With two levels only, we foresaw our cap table becoming overly complicated, which we knew would create more issues for us down the line. Thus, our solution was to adopt a three-tiered legal structure that would prevent the cap table at STARTegy from becoming unnecessarily complicated.
Figure 2: Types of legal structure
Here is a breakdown of the three investable levels at STARTegy, how we decided to fund each level, and why a three-tiered approach worked well for us.
- The studio is the entity through which we provide shared services to our startups and, as such, it accrues operating expenses that must be financed. If STARTegy were a traditional venture fund, investors would expect to pay in accordance with the traditional “2 / 20” fee structure — i.e. STARTegy would receive 2% of the principal invested plus an additional 20% of the carry. However, this is not a model that we think is adequate for startup studios as the 2/20 approach incentivizes raising a large fund to maximize the management fee. As a studio we would rather have a smaller fund and provide higher support to fewer startups. For this reason, we abandoned the 2/20 arrangement and, instead, receive our income from the shared services that we provide to our startups plus a share of the investment profits.
- The next investable level at STARTegy is a revolving door of special purpose vehicles -one new vehicle for each subsequent batch of startups we create. This is the level that we added in order to prevent the cap table at STARTegy from becoming unnecessarily complicated. If we were to have one continuous batch of startups, we would need to continuously add new investors to the studio. This would require constantly doing valuations of the studio and dilute the equity stakes of prior investors, thus making it much more difficult for us to fundraise. By creating a new special purpose vehicle for each batch of startups, we are able to reset the cap table, avoid the need for valuing the studio and start fresh with a clean fund. As an added benefit, we are able to raise money from investors that feel more comfortable with the “theme” of each batch and therefore can contribute more to the success of the startups. This way we can target those investors who not only provide funds but are also willing to contribute.
- Startups represent the third investable tier at STARTegy. These are seed stage startups that grow within the studio for one or two years and, in that time, gain enough traction to raise their series A. Once they do, they increasingly become more independent from STARTegy. Prior to series A, we prefer that investors do not invest directly in these startups because it would create a conflict of interest within the studio when determining how best to allocate resources amongst the different startups.
Regardless of who invests what into which tier, all studios ought to be structured in a tax efficient manner. Some structures can create double or triple taxation which of course can create a burden on the returns to investors, but these considerations would highly depend on the jurisdiction studios and investors are in.
Focus of the studio
Another important decision for studio founders to make is whether to specialize in certain industries, geographies, emerging trends in technology, etc. Specialization will allow for a greater number of synergies to be created between companies. Adopting too narrow a focus, however, can be a limiting factor on your studio’s diversification. With these principles in mind, we at STARTegy chose to focus our efforts on building fintech companies in Mexico, with potential of expanding to other Latin American countries. While Mexico is home to the world’s 15th largest economy and 2nd largest banking industry by volume in Latin America, the infrastructure that supports Mexico’s financial system is lacking. For this reason, we chose to set up shop in Mexico City and work to revitalize this antiquated industry with 21st century technology. At the same time, the level of financial inclusion that Mexico has is much lower than it should be for an economy with its size. About 60% of the population don’t have a bank account and only 20% have access to formal credit. And this was one of the key motivators for us, as the solutions that we build can have an impact in the level of financial inclusion in Mexico.
Volume of Startups
Once we decided to focus on financial technology, we had to decide the right number of startups for us to build at one time. We believe that this decision depends on the type of industry you are in. There are industries where the need is very clear, for example, finding a cure for cancer or finding a cheap source of renewal energy. These are typically highly capital intensive industries and success depends on how you build that solution. Some other industries, such as gaming or movies, require much more effort into discovering the what, which means that startups will require a lot of iteration with the initial concepts. Studios that are in this last group, might focus investing minimal resources on creating hundreds of different concepts to then narrow it down to a few. We believe that fintech falls in the category where iteration is required but less so in the what, but more in the how. For this reason, we at STARTegy decided that, with the resources that we had, we could focus on 3 problems in our first batch for the next 2 years.
Intensity of Shared Services
Regardless of the number of startups that a studio supports at one time, a key characteristic of all studios is that they provide those startups with a range of shared services. It is up to the studio, however, to determine both the breadth of services provided and whether those services come at additional cost to the startups.
Some studios are extremely hands on with portfolio companies and employ a plethora of technical teams to help founders develop all facets of their business; everything from core product to peripheral needs like accounting, HR, and legal services. On the other end of the spectrum, there are studios that operate more in line with the traditional incubator model and provide more in the way of financial resources and shared office space. At STARTegy, we believe it’s best to be in the middle of these two extremes. We try to be hands on with startups, but in a way that will allow them to fully own and develop the core competencies of their business. We believe this is fundamental to startups becoming fully self-sufficient once they leave the studio. If we were supporting the next Google, for example, we would not want to be responsible for developing their flagship search algorithm. We would rather want they develop this core competency for themselves, so that they can continue to drive their product forward once they leave STARTegy. For this reason, STARTegy, beyond funding, provides startups with supplemental services like office space, accounting, legal expertise, and the type of initial dev work that any fintech company would need to build their basic infrastructure.
A startup studio must also decide whether these services will be provided pro bono or at an additional cost to portfolio companies. If startups are charged for these services, they would naturally shop around for lower-cost alternatives and sacrifice the quality of services provided and not taking advantages of economies of scale. Spending less time seeking out service providers also means that founders can spend more time focusing on product and developing the core competencies of their business. On the other hand, charging startups for these services can become a steady source of income for the studio. In any case, once startups raise external funds and leave the studio, charging for these services provides a nice incentive for startups to own all aspects of their business and become fully independent at the right time.
Another important design choice for studios to consider how long they can continue investing in their startups At STARTegy, we invest at the seed or angel/pre-seed stage only. There are other studios that, in addition to getting involved at the seed stage, provide later rounds of financing through a traditional venture arm. We believe this is an ideal and more profitable model as you are able to double down your investment in stages where the risk is reduced. Studios that follow this model though, need to have two separate investment committees to avoid conflict of interest. It is important for the venture arm to make objective investment decisions and not invest in a startup solely because it originated from the builder. With this division in place, we believe the combination of studio and fund can be a powerful catalyst for startup growth. We hope to someday adopt this model at STARTegy but, for the time being, we must focus our time and attention on building the basics of the studio.
How Startup Founders Are Engaged
Another important design choice is the manner in which the studio engages founders from the local startup ecosystem. There are several key factors for studios to consider at this juncture, like how much equity to offer their entrepreneurs in residence and to what degree those entrepreneurs should manage the strategic vision of their respective companies.
At STARTegy, our main goal is to ensure that entrepreneurs feel a strong motivation to grow their business. The first thing we do to achieve this goal is engage entrepreneurs early on. Ideally, we bring entrepreneurs into the mix before the idea for a business is fully formed. This way, the entrepreneur plays a pivotal role in the ideation process and is not solely brought in to execute on others’ ideas.
We also view founders’ equity and the manner in which capital is delivered to those founders as important tools for instilling motivation. First and foremost, we provide a level of equity that balances risk/return well. Secondly, we deliver funding to founders in the form of capital calls as opposed to actual rounds of investing. By taking this approach, we are able to provide a sizeable pool of money but still be milestone-oriented. There is also the added benefit of limiting the amount of time spent on tangential matters like valuation, which maximizes time and energy spent on growing the business.
How Studios Evolve
I would like to end this post with some brief thoughts on the long-term prospects for STARTegy and for startup studios in general. Studios combine elements of both single startups and traditional venture capital funds. Over time, however, there are many real-world instances of studios reverting to one of these bookend models for innovation. In some cases, a studio may have one startup that achieves extremely rapid success and decides to abandon all other operations in pursuit of growing that one business given that profits will be higher if resources are invested there as opposed to spread through multiple startups. This is the studio reverting back to a single startup. In other cases, a studio might add a traditional venture arm to their operations and ultimately make venture investing the focal point of their business. It may be too early to say, but we foresee STARTegy operating dual arms of studio + VC in the long run. For now though, the plan is to go full steam ahead with the studio and see what sorts of exciting new companies we can spin up!
About STARTegy Venture Builder
At STARTegy Venture Builder, we create high growth fintech startups for the Latin American market. We are a group of entrepreneurs, designers, engineers, marketers and fintech experts that create startups from scratch. Want to join us? Reach out to us at firstname.lastname@example.org!
Victor Noguera is a Founding Partner at STARTegy. Prior to that Victor worked at Google and he was also at The Boston Consulting Group in New York and Barcelona, where he advised large financial institutions in strategy and innovation.
Thanks to Ross Palley for his help in drafting and editing this article.