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Hackernoon logoThe Retreat of Venture Funds and The Emergence of Venture Studios by@golubev

The Retreat of Venture Funds and The Emergence of Venture Studios

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@golubevGolubev_Od_UA

Crynet.io (project manager), EU structural funds, ICO/STO/IEO, NGO & venture, marketing projects

Honore de Balzac:

«Those who are looking for millions very rarely find them, but those who do not look for them never find them!».

Problems and mishits of venture business

In countries with technology-oriented economies, production growth and industrial development mainly depend on successful innovations, which means that the results of research and development are effectively commercialized (moving into the stage of commercial production).

At the same time, access of technology companies to financial resources is becoming a key factor in the innovation process. Venture capital plays an important role in this regard. The participation of venture capital is a fundamental factor in the innovation process. For various reasons, large companies find it difficult to implement a risky project.

Such projects have a greater chance of success if undertaken by small technology firms. This is confirmed by the fact that the technological revolutions that led to the transformation of industrial manufacturing in the 20th century were led by companies backed by venture capital.

For example, the firms that were leading in every new generation of computer technology (PC, software) were funded mainly by venture capital alone. The ability for a company to raise funding is a critical part of the commercialization of research and development activities. The goal of any investor is to generate income from investments.

Venture capital, as defined by the European Venture Capital Association (EVCA), is equity capital provided by professional firms investing in and jointly managing start-ups, developing or transforming private companies that demonstrate the potential for significant growth. There should also be noted such a significant element as the growth in the value of the company, which occurs in the long term and leads to an increase in the value of the equity share of the venture investor as well.

This is where the investor's jackpot is cached. In successful startups, this capital gain is higher than the ROI on alternatives, which compensates for the risk and liquidity of such investments. Younger companies in partnership with venture capital funds and professional experience make more progress. Today, venture capital usually has the following:

• the venture capitalist shares the risk with the innovative entrepreneur;

• long investment horizon, from 3 to 10 years;

• In addition to investments, relationships are also maintained with the management of the company to provide support based on the experience and contacts of the investor;

• the return of funds is carried out in the form of the sale of the increased in price of the investor's equity in the company at the end of the investment agreed period

But in reality, different situations and relationships occur. Most venture capital schemes are independent funds that raise capital from financial institutions before they invest in small and medium-sized enterprises. However, some financial institutions have their own venture capital funds, and in some countries, there is an informal market for venture capital (private investors) and large companies (corporate venture).

These are venture funds from large financial institutions that mostly fail today and often cause reputational damage to venture funding itself. It often turns out that such funds are just advertising puppies of large Transnational institutions, whose task, if you look at the effectiveness of the results from the outside, is simply to employ their consultants, lobbyists, experts in warm places to work in vain or to write off losses in principle through such gaskets, without pushing start-ups into the light, not seeking to finance them, or helping purely scams and projects of a dubious nature. In addition, they justify such a structure for their activities at a loss by the fact that, sorry, we are engaged in venture financing, and this is always high risks.

Or, what else can you see on the venture capital market - such funds are simply enrolled in collecting information about projects, innovations, the purpose of which is simply to harm and bring down a project or innovation that can harm the financial and operational results of the parent structure of such funds (it can be not only financial transnational institutions, but also industries, suppliers of energy resources, and so on).

Today, unfortunately, most venture capitalists are simply intermediaries for a percentage between financial large institutions that provide capital to them and companies that use these funds (mostly start-ups). In principle, we can state the fact that the main role of the venture capitalist today is falsified. You can rarely find out objective goals - the search for innovative breakthrough points and technological development of the economy and society, including the subjective desire to make excellent profits in the long term.

The role of a venture capitalist should be to look at investment opportunities in most innovations, structure a deal, invest, and directly achieve capital gains by selling a stake, either in the stock market, or company management or outside management. Financial institutions are unable to perform these functions on their own. The reward for an independent venture capital fund is a profit share and a flat rate. But this is in ideal. While for a venture fund the main stages are raising, placing and withdrawing funds, the process of venture financing of a project can be conditionally subdivided into the following stages:

• Search,

• selection,

• transaction execution

• and capital output.

Therefore, it is no secret that the main issue for a company to receive investment is the consistency of a business idea and the ability of the company's management to transit it into profitable production. It is the project assessment that has recently ceased to be assigned a decisive role in making decisions on venture financing. This is a long process that completes the decision making process. The investor studies in detail the history of the company, the personality of employees, potential consumers, research of the competitive market, assessing demand and evaluating potential competitors. The next item, which they no longer pay attention to in detail, is the pre-investment assessment of the company - as if by investing in the company, the venture capitalist no longer strives to foresee a possible way out in advance, with the implementation of which it is possible to receive income. In fact, today, in most cases, it can be observed that venture capitalists forget that at any stage of the company's development, venture capital is increasingly competing with other sources of funding, which the management of a start-up seeking independence may find more attractive.

Part of the venture capital market is made up of private investors who have direct equity participation in unlisted companies. These investors are usually self-motivated wealthy investors, most of them successful entrepreneurs, although some have a background in business areas or experience in senior management positions in large companies. They often invest individually, but many invest as part of informal syndicates that usually include family, friends, or business colleagues. The informal venture capital market is also important because of the volume of funding it provides, being the largest source of external risk capital for small companies in the West. According to estimates in the world, the number of companies invested by private investors is 20 times more than those invested by institutional investors. But at the same time, private investors have not yet lost their professional acumen in finding and evaluating projects, compared to institutional investors. Although the risks are present here as well - a private investor at the most inconvenient moment for a start-up, can simply jump off your boat.

Let us describe the basic principles of the classical scheme for organizing a venture fund. The fund accumulates funds from several investors in order to diversify risks. These funds are managed by a professional management company. It acts as an intermediary between investors and recipient companies. As a rule, the management also collects funds for the VC fund. The main investment object of the venture is shares in companies at the start-up stage. The goal of the fund is to increase the capitalization of invested companies and make a profit from the sale of stakes in it:

• through the stock market through an initial public offering (IPO) - selling shares of invested companies on the stock exchange;

• through the sale of a venture investor's share to another investor (private equity fund or strategic investor);

• through the redemption of the investor's share by the management, including through the attraction of credited funds.

In order to share risks, venture capital funds invest in a large number of projects (10-30). This is natural, because a significant part of projects will be unprofitable or low-profit, but a small share of financed companies can bring hundreds and even thousands of percent of profit. A feature characteristic of venture capital funds is the active participation of the Fund's Management Company in the management of an invested company, “living with company”. This is a kind of training, because in its course the founders of the start-up acquire from venture capitalists the necessary knowledge in the field of business, accounting, marketing, as well as useful connections and contacts. Usually, investments in one company take place in several rounds. This helps to quickly identify unsuccessful projects at an early stage and stop funding them. Entrepreneurs receive additional incentives to improve their productivity in order to get more investment in the next round.

As I wrote earlier, the Achilles heel of many venture funds is the lack of a clear methodology for selecting projects! The selection of projects for financing is a complex and time-consuming process, within the framework of which the investor conducts a comprehensive study of a huge amount of information about existing companies and the selection of the best among them. Unfortunately, these processes have recently begun to cut off budgets. It is not worth reinventing the wheel here, the selection process consists of two successive clear stages: deal flow and due diligence. Search and selection of a company (deal flow) is the initial stage of searching for competitive venture projects. The main sources of information about companies are their CVs received by the investor. For his part, the investor himself seeks projects through analysis of press and advertising materials, exhibitions, venture fairs, databases of venture capital associations, personal contacts. Regardless of the orientation and preferences of investors, the general selection criterion is the answer to the only question: are the company and the market in which it is capable of rapid development and achievement of leadership positions. Here, the investor, in addition to violent fantasies about XXX profits, must have intelligence and intuition. The transition from searching to studying the company is the "first meeting" between the investor and company representatives, during which both parties look closely at each other for the possibility of future interaction. Some of them are accompanied by an investor's visit to the company, inspection of production and demonstration of products. However - this is all in ideal, in the end - only a few do this. Decisions are often made spontaneously and under pressure from profit.

As for Due Diligence, today, unfortunately, it is from the world of fantasy. Institutional investors have stopped spending money on this, and private investors have recently begun to save on this as well. Due diligence is a process of "thorough analysis" of a company. This stage can last from several months to a year and ends with a final decision to start investments or refuse them. All aspects of the current state of the company and the market as a whole and their prospects are considered. In an ideal world, versatile specialists should be attracted here, but their services and experience are worth money, it's a pity that the venture world plunged into saving on them. Another acute problem of venture financing today is the evaluation of an innovative project and product. Here are the traditional problems - investors want to underestimate, and the founders of the project - to overestimate to the gates of paradise. In my opinion, it is at the stage of evaluating a venture project that most of the disagreements between investors and founders of the company arise, and at this stage up to 70% of transactions fail. A sign of reaching this consensus is considered to be a divergence of views on the company's value by no more than 30%. The main task of analyzing the value of a company lies precisely in this consensus, and not in an attempt to deceive or humiliate someone. Today, five methods of evaluating venture projects are most widely used. In all methods, one should distinguish between pre-money (before receiving investments) and post-money (after receiving investments) valuation of the company. A very good indicator is the approximate coincidence of company estimates by several methods.

Investors should not forget about these methods and, again, involve specialists:

- contractual method (consensus method)

- method of comparable estimates (method of market multiples)

- Discounted cash flow method

- Decision tree method

- Venture method

- Determination of the share of the venture fund in the company

Assessment of the company's value is the most important stage in the venture investment process, because when investing large sums in an innovative company, it is very difficult to predict the profitability or loss of these investments. Therefore, you should be very careful when assessing the cost and determining the share of the investor.

Another contemporary problem in venture capital financing is the manipulation of measuring investment performance. One of the most important tasks of a venture fund in the selection of projects is to determine the effectiveness of the project. The essence of this analysis is to compare the effectiveness of investments in a given company with alternative investment opportunities. Usually, problems between venture capitalists and project founders began to arise when assessing the current cost of a project and determining the internal rate of return. Due to disagreements in the valuation of companies, it often happens that the process of the transaction and decision-making is delayed. Since each side is trying to play on their side. So far, experience shows that about 95% of all innovative projects do not enter the market, stopping at the stage of development and research work or drowning in clarifying relations with investors. But the remaining 5% of profitable projects still pay off not only the funds invested directly in them, but also in those 95% that have not entered the market. World practice shows that large companies are engaged in their own research and development not in all possible areas, but only in some of them, where they have a solid foundation. However, such a model starts to fail, since two conditions are ignored: large companies are not very interested in innovations, and small ones - feeling this, are no longer sure that if they succeed, they will have a prize - money from large companies. Here you can already identify the following risk and problem: on the one hand, the institution of venture entrepreneurship itself is still allocating money for innovation - through venture funds. On the other hand, since there is no real demand for innovation from large companies, the market is deformed, allowing innovation to be carried out without focusing on demand, on the commercialization of results, on the capitalization of innovative companies. Today there are risks that innovation companies do not care whether the innovation finds a consumer or not: where the state gives money, and where there is just a game of venture financing. The main task to solve this problem is to strengthen and develop the initiative of the masses for innovation. Moreover, this initiative is not abstract; it will always be expressed in income. The task of the players in the venture capital market is to stimulate the initiative and creativity of the masses in all directions, and to help in the formation of small innovative companies. Simple mechanisms for stimulating innovation, such as the creation of infrastructure and the distribution of money, in fact discourage the innovativeness of the economy, since in the absence of demand and attention from large investors; they lead to false goals and non-economic criteria for investment decisions. There is a risk of excluding small and medium-sized businesses from these processes altogether.

Among other problems that have emerged sharply for 10 years, is the actual disregard for the very essence of venture financing - helping to develop technologies and projects that can significantly redistribute and reshape markets in the future. Perhaps this is why. It's about motivating inventors to think further on their ideas. Everyone knows that there are the following stages of development of companies that can be financed by venture capital:

• "seed" - the company still does not exist, there are business ideas that still need to be worked on as, for example, additional research before releasing the product to the market.

• "start-up" is a newly formed company that does not have a long market history. To start sales and research projects, they need funding in this case;

• "early stage" - the initial stage. Companies that already have a finished product but are in the early stages of promoting it.

• "expansion" – scaling. Companies that may need additional funding for new market research, development of additional products, scaling of production volumes, etc.

Here I draw your attention to the fact that the trend of the last decade is no longer in favor of ‘’seed’’ and ‘’start up’’. So the share of the ‘seed’ in the US accounts for 3% of investments and 7% in ’start up’. And this is data from the US, where the venture capital market is the most developed and advanced. But what is most interesting - for the ''start up'' and ''early stage'' categories - in most cases, funds are invested in the development of projects previously funded by the state. This is done to reduce the risk of losing the invested funds. In fact, the venture business is no longer venture, that is, it is risky. Since in developed economies so far the state (and even in the US) at a very early stage applies programs of state support for small innovative companies. And the modern greedy venture capital already has a different task - to acquire at a preferential price (by manipulating the valuation) equities in newly created companies, in which taxpayers' money was initially invested, but not venture financiers, as required by their investment activities. Undoubtedly, there are differences, pros and cons in the development of venture capitalism in the US, in Europe, in Japan, in China and Asia, in the Middle East, but all of the above problems are now common to many venture capital firms, regardless of jurisdiction. By the very idea, a venture business should:

• Help countries acquire or strengthen their economies and obtain the status of producing countries;

• Promote an increase in the number of jobs;

• Assist in the creation and release of new, improved innovative products and services;

• Ensure the country's competitiveness and even monopoly positions in certain categories

Now just think, will the big capital of the global market really try so hard for someone? Of course not, Transnational companies, the developed countries are simply not idiots to raise their competitors at their own expense. Strong countries don't need competitors. The rich and bureaucratic Transnationals do not need competitors to destroy their monopolies. The world's leading technological research centers also do not need competitors, so the outflow of brains and ideas is motivated on a global scale.

In the aftermath of the 2008 crisis, the global venture capital industry began to suffer from another problem that is raging today, especially in the Corona crisis of 2020 (which has not gone away yet). It's about a failure of venture capital mechanisms or a cacophony of rules. Already, one can observe discrepancies between the list of conditions and the legal documentation required by investors. Often, even at the level of a single well-known venture fund, there are no uniform standards, one such private equity fund deals with at least three different groups of law firms, as well as with many partners within each firm, all of which use their own formats. Term sheets - an "agreement" between an entrepreneur and a venture capitalist, containing the terms that will later be included in the investment agreement - used to be designed to protect the shareholders of the venture capital, but now the emphasis is shifted towards protecting shareholders as creditors, as in leading jurisdictions, a firm can buy back its shares only if it has distributable reserves. Earlier in the venture capital industry, it was enough just to have money. Previously, venture capitalists were very straightforward about their involvement in the deal and tried to influence the company by participating through their representatives on its board. This approach was much more inspired with the spirit of partnership. Both sides took part in the work, and there were only two possible outcomes - either everyone makes a lot of money, or everyone loses a lot. Now, on the contrary, a different style of thinking dominates, associated with management buyouts. Among other things, this means that investors are less interested in working on the board. They are far more concerned with drafting complex investment agreements defining a relationship that is more like the relationship between a bank and a borrower. Regulatory clauses are of the “negative control” nature (they seek to maximize the number of opportunities when the venture capitalist could impose a ban). Previously, venture capital and leveraged buy-outs were two very different industries. Today, the prevailing approach is when venture capital began to structure their investments as loans with cheap equity capital.

For start-ups, this approach is much less attractive, but it is convenient for the administration of the funds. It seems that earlier such methods were not acceptable, since in the venture capital there were fierce competition between the funds themselves, today, in the pursuit of minimizing risks, venture activities have turned into lending, which conceptually strikes the very nature of the instrument itself. After 2008, venture capital firms began to introduce increasingly harsh clauses on the "condition list". This trend, which is detrimental to venture capital, is exacerbated in 2020. This trend has given rise to another problem - the monogeneity of the venture and the desire to invest in "their own kind". Venture capital funds today are looking for startups that suit them only and do not want to expand the scope of their ideas about markets, products and new opportunities, which is strange for an industry that is known for supporting the most brave beginnings and thanks to which we now have the Internet, smartphones, social media and 24/7 delivery of anything. If nothing changes, we risk in the near future a market for goods, services that will reflect the prejudices of those who decide which project will receive funding, and which will not.

What is the way out? Can Venture Studios (venture builders) give new life to innovation promotion?

As we can see from the material above, the high mortality rate of start-ups occurs not only through the fault of the startup teams themselves. Perhaps a venture studio (venture builder) as a tool will change the situation globally. The formula itself is not new, startup factories appeared thanks to IdeaLab (https://www.idealab.com) back in 1996. The essence of the 1996 model is the creation of infrastructure for the development of startups. The task of the studio is to systematically and quickly check ideas for innovative products with a minimum budget, develop successful projects and attract investments to modify them into independent companies. The model of a modern venture studio is autonomous organization that serially creates startups within one structure. Today it is a micro startup factory, in which up to 10 different start-up projects can develop in parallel. It is actually a corporate venture fund and a corporate business accelerator in a "one box". The second wave of hype in venture studios began quite recently, when it became obvious to many that accelerators had actually failed their tasks and goals, and start-ups wandering from accelerator to accelerator never matured and did not find the necessary venture capital investments, since globally, as I have already said, no one wants to engage in seed investment.

A venture studio is, first of all, not a podium for experts, but a ready-made expert infrastructure, where a venture builder helps entrepreneurs with project communication, procurement, management, legal support, marketing and PR, in fact, they establish business processes in the project and filter analytical information. In such a venture builder, an entrepreneur can only deal with his favorite brainchild - a product, and a venture studio outsources everything else that is not directly related to the creation of a product. Usually a venture builder accompanies a start-up for a couple of years. According to this principle, High Alpha (https://highalpha.com) began operating in the USA in 2018, and Vtorov Tech (http://vtorov.tech) will start operating on a similar principle in Russia at the end of 2020. A venture studio is a kind of platform with expertise, resources and infrastructure that allows you to generate and test business ideas, and then bring some of them to mind and bring them to market. The studio trusts its CEO to manage each project to turn it into an independent company, the lion's stake of which will belong to the studio. In addition, it is very likely that very soon this format will prove its effectiveness to the start-up community. After all, the main task of a venture builder (of course, in addition to capitalizing their stake in the project) is to create the right environment for the project. Unlike accelerators or corporate venture programs, which involve external companies for investment and consulting, the Venture Studios model is really designed to work with startups and connect with corporate partners from the inside in order to accelerate internal and joint cooperation. The income of venture studios is:

- Funds from managing operations with their corporate partners in selected start-ups

- Compensation from the division of capital between the Venture Studio and its partners (banks, investment funds, private investors, and so on) in the startups being created

Venture builder is a hybrid structure that first tests new products on the flow and launches new businesses, united in studios according to industry or technological principles, where project decisions are made based on synthetic skills. Thanks to the internal expertise of the team and cross-financing of partners, such a company format can significantly reduce the costs of testing hypotheses and product development, actually filling the gap in the venture capital market in seed investments and rounds. The studio has a central team with expertise in key areas, resources to develop multiple projects in parallel, and tools to validate working ideas. If accelerators focus on mentoring external teams, small investments in exchange for a share, and providing infrastructure, then studios create products, teams and ultimately companies - one after another, ideally.

Basically, studios take more of the project than accelerators or business angels, providing a small number of projects (no more than 3-5 per year) with dedicated teams and a large amount of financial and human resources, as well as a powerful platform in the form of tools, connections and knowledge ... Some studios come up with ideas themselves, and some prefer to work with external founders early on. Studio support can last for several years, and in some cases never ends, it all depends on the circumstances. A venture studio is building a business from scratch. This model creates a very good foundation on which to build a huge business. An important point is to correctly understand the expectations from this method, and what it can and what it does not. And apply this method correctly. According to experts, including the specialists of the first venture studio IdeaLab, the model of venture construction (venture studio) is 20% less risky than the classic venture or even corporate venture model of support and investment in start-ups. In the early stages, the mortality of projects is very high, so even a small decrease in this mortality at large numbers is worth it. Venture Studio has certain hallmarks:

- Constant and systematic search for new ideas;

- Development and launch of several projects at the same time;

- Developed infrastructure and sufficient human resources;

- Money for investing in business idea is taken either from the organization's own fund or from investors (partners of a venture studio). Combined financing options are most likely;

- Sharing resources and lessons learned. Each entrepreneur within a startup studio receives help from other members of the studio and general services - legal, accounting, personnel, marketing and sales experts, development, and so on.

Venture studios are the investors and owners of stakes in the companies they develop. The main difference from traditional funds is that they don't just invest. They are actively involved in all processes from design to strategic management. However, it should be noted that initially, venture builders did not take off in the West. The most successful ones today are Science (https://www.science-inc.com), Bleinheim Chalcot (https://blenheimchalcot.com), Founders Factory (https://foundersfactory.com). Venture studios have become the choice for entrepreneurs who are not ready to put everything on the line and start a business in a garage. But now, as I wrote above, the current structure of the venture world and its bureaucracy and risk minimization policies no longer give the majority of young companies a chance to survive. Everything that could be built quickly and easily has already been built, sold and resold. Startups of the new generation are left with either serious large-scale tasks, or very narrowly specialized ones, in which few experts understand and only intuition is able to see a great perspective. The cycle of their detailing and structuring is longer, they require more capital, but most importantly, they need more attention from both investors and partners. And all this is associated with risks and time.

The main advantage of a venture studio is resources. In addition to financial support, the studio startup receives comprehensive expert and technical support. The bottom line is that the entrepreneur can focus on solving the main task, namely, testing hypotheses and creating a product. The absence of the need to overcome unnecessary bureaucratic obstacles allows in many cases to outstrip competitors. Centralization of all services in a venture studio allows for lighter staff and lower costs per project. All this affects the final cost. It is cheaper than in the case when startups are forced to solve many issues on their own while in accelerators or business incubators. Venture studios operate in different directions, from IT to healthcare. But the main focus is on tech companies. With a well-functioning process of work, the methodology for "growing" projects is not very different, and a well-organized startup studio can create projects for different requests and needs of clients (as corporations, or individual customers).

Building a strong team allows a venture studio to conduct several projects at the same time, and in the event of a one-time failure, redistribute forces, retaining experience and debugging business processes. The venture studio model gives more chances to attract investors, since the latter are interested in retaining control over the development of the project and obtaining a stake in a ready-made company. For an investor, a successful studio turns into a stable source of good deals. The venture studio is also an ideal model for overcoming the “innovator's dilemma” and helps companies increase the quality and quantity of their innovation efforts by shaping startups right from the start.

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Sergey Golubev (Сергей Голубев)

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