Last week I read about the new Share Ventures startup studio and realized we might be at a tipping point for this newish type of venture. Startup studio is the modern name for what was called an incubator back in the dot-com days. Thankfully, the tech infrastructure and scale of Internet users make startup studios more viable now, 20 years later.

For startup studios, the big idea is to have a core team help create and grow multiple companies at the same time using shared resources and expertise.

I’ve followed startup studios for years and have personally been doing a form of it for 13 years now (see Atlanta Ventures). Today, the largest and most well-known in the SaaS world is High Alpha out of Indianapolis. High Alpha has already launched dozens of companies and has built a tremendous team.

Locally, I’m excited to see more entrepreneurs launch startup studios. Here are two of the newest:

Rule 1 Ventures – Founded by serial entrepreneur Todd Erlich (FactorCloud, Kill Cliff, Triserv), Rule 1 focuses on B2B SaaS, an area of local strength. Todd and his team have a background in SaaS, FinTech, and consumer. Look for a number of new startups to emerge from Rule 1.

Outlander Labs – Founded by Leura and Paige Craig, Outlander Labs positions their firm as an investing incubator with a hands-on program. Leura and Paige have long startup backgrounds with investments in over 100 startups. Look for a broad range of startups to emerge from Outlander Labs.

My prediction: startup studios are going to be even more prevalent as it costs next to nothing to test ideas and entrepreneurs realize more at-bats will increase their chance of homeruns.

Startup studios are an excellent advancement in the startup world and will have a major impact over the next 10 years.

Over the years I’ve invested in a number of venture funds as a way to learn about venture in general, dive deeper in selected startups, and see what’s out there. One topic that’s popular now in VC fundraising decks, but was non-existent five years ago, is the firm’s historical loss ratio.

A historical loss ratio is represented as the number of previous investments that the venture firm has lost money on, most commonly going to zero (an investment that’s completely worthless). I’m not an insider in the venture and limited partner industry, so my guess is that a paper became popular arguing that the better venture returns came from firms that didn’t lose money very often on individual deals (update: here’s a paper). Venture capitalists that have to work hard to raise money from LPs (most firms!) have glommed on to this theory and worked hard to paint themselves as good at not losing money.

Of course, more focus on limiting the downside can be inverted as more focus on limiting the upside. The greatest returns in venture don’t come from limiting the downside, they come from the positive outliers — the power law of distributions.

Personally, it’s more interesting to attempt something with a 1 in 50 chance of succeeding as opposed to something with a 9 in 10 chance of succeeding, assuming the upside is correspondingly larger. Yes, we want to control our own destiny, but we also want to take big risks that have the opportunity for big impact.

Humans are conditioned to feel more pain from losing money than gaining the same amount of money. Losing hurts more than winning.

As an entrepreneur, it’s important to understand where a potential investor stands. Is the investor more oriented towards maximizing upside, or minimizing downside? Don’t know? Just ask.

There’s nothing wrong with having a low or zero loss ratio — there are many paths to success. I know a number of excellent investors and entrepreneurs than minimize the zeros and execute incredibly well.

Ask investors how they think about zeroes and you’ll understand a critical part of their core psychology.

In the past few weeks I’ve talked with several startups that are severely impaired by the pandemic. Before the pandemic their companies were doing well enough to raise venture money, but not well enough to be obvious winners in meaningful markets. Then, the pandemic hit and it exposed their businesses in a way that showed they weren’t great businesses to begin with, and raising money wasn’t the appropriate route to go. 

Now, the founders are in the honorable zombie startup trap.

These founders aren’t willing to shut down their companies and move on. No, they’re too honorable and are going to do everything in their power to at least return the investors’ money. Only, the startup is a zombie.

There’s enough revenue and gross margin to keep the lights on, but with revenue declining there’s no clear path to reverse course and accelerate growth. Unfortunately, with declining revenue and a suffering business, if they were to raise money, it’d be a down round, if at all possible. Down rounds are almost always the kiss of death, due to a number of reasons.

While this desire to eventually return investors’ money is in fact honorable, it actually makes all parties worse off. From a time perspective, investors are better off moving on and focusing their energies elsewhere. Startup investing in its purest form is a game of maximizing upside, not minimizing downside. Some investors would struggle with recognizing the loss if they have limited partners or are trying to raise a new fund, but that shouldn’t be an issue with successful investors.

Founders are often better off shutting the startup down, or going into harvest mode, so as to return some capital to investors and prepare for their next endeavor. Time and energy are two of the most important components of successful founders, and running a zombie startup for years beyond what makes sense depletes both.

Look out for the honorable zombie startup trap, and ensure all parties involved are aware of what’s happening. The best path forward is often moving on from the startup.

During my time trying to raise money in the early 2010’s, investor term sheets were expected to have a number of strings attached — the questions were how many and how onerous were they. Now, with a much more entrepreneur-friendly market and a long bull run, investors have come up with a variety of ways to sweeten the term sheet in an effort to increase the chance of selection by the entrepreneurs.

Here are a few of the sweetener strategies:

• Give the Founders New Stock Options – Every round of funding comes with dilution, often a heavy amount (e.g. 30%+ when an expansion of the stock option pool is factored in). One strategy is to write into the term sheet some level of new stock options for the founders (similar to a refresher grant) such that the financing round dilution is slightly less painful.
• Buy Founder Common Stock – Founders often have the majority of their net worth tied up in the startup. By buying some of the founder’s common stock, the founder gets liquidity and the investor gets a larger ownership position. Win, win.
• Buy Existing Shareholder Common Stock – If certain shareholders have been in the business a long time and/or there’s a substantial step up in valuation, there’s often an appetite to sell a portion of the holdings (much like dollar cost averaging out). The new investors will buy all preferred equity, then have a portion of that new capital buy common stock at 15-20% discount, and retire it. The retired common stock is an effective increase in ownership for all shareholders — common and preferred — such that the new investors gets a larger ownership percentage and existing shareholders don’t get diluted as much (the ones that don’t sell any of their holdings).

As expected, money and ownership percentages are the drivers of these sweeteners. Thankfully, entrepreneurs now have more options and investors are more creative at getting deals done. The next time you see a term sheet, look for the sweeteners.

Back in the Pardot days, we had exactly one alternative financing option to venture capital: bank venture debt. While that was a great option, and we maxed out our line, being a bootstrapped startup we didn’t qualify for venture debt until we had millions of recurring revenue — an extremely high bar.

Today, there are a number of interesting alternative funding sources that are very different from venture capital, and available for startups at much earlier stages. The big driver here is entrepreneurs want to maintain optionality and/or don’t have a business that fits traditional venture capital (e.g. too small a market). Let’s take a look at a few providers:

• Lighter Capital – Revenue financing for subscription businesses, Lighter Capital typically collects 2-8% of monthly revenue to pay back the loan until some cap is reached (e.g. 2x the loan). This model is better for a lower payout over time but requires making payments immediately.
• Earnest Capital – A profit-sharing model where the more profit shared, the lower the equity percentage in the event of an exit with an overall higher target return (e.g. 4x the investment). Profit is defined as any salaries above some modest amount for founders as well as standard distributions/dividends. This model is better for using cash flow to grow in the near-term (payments are only required if profit is distributed) but more expensive in the long term if everything works out.
• Indie.vc – A hybrid that can be equity or revenue financing where it’s equity if a traditional round of funding is raised but defaults to a revenue based financing model after 12-36 months where 3-7% of revenue is paid monthly until a target return is met (e.g. 3x the investment). This model provides the most direct optionality benefits but could be more expensive depending on the path taken by the entrepreneur.

Ultimately, these are all great market developments for entrepreneurs as historical venture capital was only suited to a microscopic percentage of startups striving for billion dollar outcomes. More providers serving a larger variety of startups will help grow the number of entrepreneurs that raise money, and, hopefully, help them achieve a greater level of success.