July 20, 2023
Startup Studios hold immense potential for innovation and growth but if you are looking into Studios as an investment opportunity, you need to know the main advantages and disadvantages of their main financial structures:
Among various models, the Dual Entity model stands out as a powerful approach that brings together the benefits of a Venture Builder and a VC fund. By understanding the advantages of this model, we can appreciate how it fosters collaboration and maximizes the potential for success in Startup Studios.
Before delving into the Dual Entity model, let's briefly examine two other financial structures commonly found in Startup Studios: the Single Studio (Hold-co) and Single Fund models.
The Single Studio Model or Startup Studio Holding is the simplest : the Studio creates new startups and finances them as a holding entity. The Studio provides resources to the startups and it receives back equity. Founders and Studio’s investors own the Studio; no carry or management fees are applied. The Studio’s investors fully pay the capital upfront at subscription.
The Studio and the Fund are a single entity. The Studio team is the General Partner (GP) or Fund manager. The Studio gets liquidity through management fees applied to the invested capital. The Studio has some equity in each startup created; then each startup is owned by the Fund, which is the Studio itself. The Studio’s team (GP) applies a management fee and a performance fee (Carried Interest) based on the Fund’s performance for the investors (Limited Partners - LP).
The Dual Entity Model represents a unique convergence of the Venture Builder and VC fund models, combining their strengths to create a mutually beneficial relationship. In this model, the Fund's first investment is in the Studio, which finances the creation of startups and covers operational costs. Let's explore further the advantages of this model in detail.
The model involves the combination of a Venture Builder and a VC fund, so two different operating models come together and operate symbiotically, generating benefits for both parties.
The fund’s first investment is in the Studio and aims to finance the creation of startups and thus cover the operational costs of production. The fund acquires stakes in the Studio and, indirectly, stakes in each startup created by the Studio itself. Moreover, the fund directly invests in the startups created by the Studio year after year, choosing only the best among them.
A VC fund usually spends time and resources to select and search for the best startups on the market and carry out due diligence activities to identify those startups in which it is worth investing. In this process, a VC fund has to share the market with other VC funds to get the best deals on which there is often competition. In some cases, competition may cause upward movements in-purchase prices and investment terms.
Conversely, a Studio needs to raise money to finance the production of startups and raise funds to finance the startups it has created. These activities take time and resources and the Studio is thus forced to interrupt the flow of its operations to focus on fundraising, thus losing ground and part of the competitive advantage gained up to that point.
The Fund/Studio combination, namely, the Dual Entity Model, creates a mutually advantageous “relationship” in which both players enjoy the benefits analyzed below.
The fund first invests in the Studio, in which it acquires a minority stake (ranging from 10% to 30%); this allows the fund to diversify its portfolio with one single investment. In fact, by investing in the Studio, the fund indirectly acquires stakes in all the startups that will be created, and this is the first benefit.
The startups generated by the Studio have a lower failure rate than the market average (40%, just as those in the Series B round). The fund also has an exclusive pre-emption right to invest in every startup created by the Studio upon advantageous and predefined terms and price.
Funds and Studios share the same management: a fund’s management has access to first-hand information and metrics on startup performance and can thus evaluate the startup correctly and efficiently. The decision to invest is therefore based not only on precise data, but also on direct observation of the work carried out by the entrepreneur until that time. This also dramatically simplifies legal and business due diligence.
Moreover, as the Studio does not have the funds to finance startups in the subsequent rounds, it assigns the pro-rata rights in the stakes held in startups to the fund, thus ensuring greater strength for the fund in the case of double down.
Thanks to the investment received, the Studio can promptly fund startup generation, covering the operational costs without the need to waste time raising the necessary funds.
Given good results and good metrics, founders of the startups have access to almost immediate funding subject to previously agreed conditions. They thus avoid losing time in a lengthy fundraising process that would require 6 to 12 months of intensive Work.
Like in any winning relationship, in this context as well, there are safeguards. To encourage the Studio to continue to focus on greater Exits, the VC fund relies on the liquidation preference on the investment made in the Studio itself. This is an incentive for the Studio to stay focused on startups that can generate a significant return in a short time.