Are You Crazy, Unrealistic Or Just Naive?

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How Can You Possibly Assume The Returns Will Be 31 to 139x for InsightStudios? 

We recently started a second raise for InsightStudios, a startup studio that is developing startups using a proven methodology for finding product-market fit. Our initial raise was largely self-funded and we’ve been pretty modest about the capital we’ve brought in so far. But this has changed with our goal of raising $7.5MM in the second round to help fund six startup spinouts. We'd like to attract this capital because we would like to go faster and capital is a great accelerator for our proven business model. 

I feel grateful we have had the opportunity to engage with hundreds of investors from all walks of life in the past 30 days. Hundreds of investors have requested a pitch deck and many of them have engaged in detailed discussions as they have considered investing. Along the way, I’ve received feedback from skeptical investors that our financial projections are unrealistic. Here's a copy of an email I received from Bill Bennett, Founder & CEO of Level Office and an entrepreneur I respect. He was direct. 

From: William Bennett <{redacted)>
To: Dave Linhardt <(redacted)>
Date: Thursday, June 14, 2018 at 11:01:11 AM
Subject: Re: InsightStudios investment opportunity
The below math suggests you are saying less than 1 percent of yc companies are successful, and that you will be 100x as successful as an example of a firm that is considered very successful.  It just comes off as naive, Dave.

Bill, thank you very much for your honesty! Insight like this gold. I'm glad you shared your reasons why instead of just saying you'll pass. Knowing the reasons why is helpful. Normally this means other investors are thinking the same thing. 

If you consider most venture funds return 1.0 to 2.5x cash-over-cash returns, then these investors may have a point. In addition to a 100x success rate, we are showing expecting returns at 31x after the third round of funding and 139x over the next 21 years. That's nuts, right?

I acknowledge these assumptions seem to be naive on the surface. I think these investors should look deeper at what we are doing. After all, this isn't our first rodeo.

So the key question becomes, how is InsightStudios going to generate returns that are so much higher than the industry average?

I think what investors like Bill are missing is that InsightStudios is NOT a seed fund. We are NOT a venture fund. We are NOT a startup accelerator. We are entirely new asset class.

We are a startup studio. If you look at what we are doing, InsightStudios simply isn't comparable to seed funds or accelerators like YC. To compare our startup studio to a traditional seed fund is simply a fundamentally misunderstanding of our model and a flawed comparison. Our business models are just not comparable at all. 

Here are the four primary reasons why our startup studio model is not a seed fund and why it will outperform funds and accelerators in a big way. 

1. Our startup success rate is much higher

Y-Combinator, arguably the most successful startup accelerator in the world calls itself a seed fund. Business Insider performed an analysis on the YC portfolio defining success as an exit of $40 million or higher. Using this standard, only 7% of YCs companies are successful. That number is shockingly low. It also happens to be true. 

Using this same standard, Idealab, which is the largest, oldest and most prolific startup studio, has a success rate of 47%. This success rate is 100x higher than YC. Just from an empirical perspective, Idealab is not comparable to YC even though some consider them both to be startup incubators. One is a startup studio based on internally-generated ideas and the other is a seed fund that invests in startups. If you look at how these two companies operate, they are completely different animals. This is a distinction that jumped out at me even though many investors fail to see the difference. 

In our first startup studio, all five of our startups were profitable. That's a 100% success rate and a 0% failure rate. Still, we aren't using 100% in our forecast and have instead adopted the Idealab success rate metric for planning purposes. Assuming 100% success would be crazy.

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Please note that these figures do not come from me. They are not assumptions. They are facts about YC's failure rate as reported by Business Insider. The comparative results from Idealab are also sourced in the following article. Sorry but I'm not making this stuff up.

Isn't it surprising that Idealab's success rate is 100x higher than YC's? It was to me. That's one of the reasons I designed InsightStudios to be more like Idealab. If the reverse were true, I'd be building a startup accelerator and seed fund instead. 

1.1. InsightStudios experiences failure more quickly, more efficiently and with less waste. 

One of the differences lies in how failure is experienced and handled in a studio versus in a seed fund. Both models experience failure. However, in a studio the early failure happens while the idea is just a “project” and before it becomes a startup. At InsightStudios, we have a idea, and we immediately start validating the problem before building product or writing code. In fact, we follow a disciplined seven-stage validation process testing all business model assumptions with customers in a certain sequence designed to minimize waste. Instead of creating a startup right away, we wait until the entire business model has been validated. Projects must earn the right to become startups based on evidence from customers. Along the way in our testing process, there are many insights, lessons learned, failures and pivots before we decide to spin out the project as an independent startup. With YC, entrepreneurs have an idea, start their companies outside of YC and then they build an MVP. Sometimes, this is enough to get into YC. In almost all cases, there is still a lot of failure ahead for YC-backed companies. 

This is a significant difference in the two processes. As a result, the outcomes are dramatically different. Idealab is a much closer comparable to InsightStudios as our process is closer to theirs than to Y-Combinator's. In contrast, YC is working with inexperienced, newbie entrepreneurs who don't follow a proven methodology in general and don't have deep entrepreneurial judgment. As a result, they experience a much higher failure rate. 

1.2. Our proven methodology mitigates market adoption risk

Because we boldly run experiments with real customers in the real world, and often before we've built product, our process inherently mitigates market adoption risk. Because of they way we've designed the Insight-Driven Iteration process, it's simply not possible for a project to leave our startup studio without finding product-market fit and a scalable path to customers. This means when we do spin out, all of the business model questions have been answered with rigor and with evidence. 

In contrast, many newbie entrepreneurs shy away from boldly testing their assumptions with customers for fear they will be proven wrong. They often delay pricing experiments which is really the ultimate way to measure what customers value. Because of this reluctance, many newbie founders spend months or years developing MVPs (Minimum Viable Products) and full-blown products without any evidence at all that anyone will pay for their novel solutions. This leads to failure and waste virtually every time. It's a mistake we used to make when we were newbies. Now it just pains us to watch almost every young entrepreneur make the same mistake over and over again. 

1.3. We use experienced entrepreneurs who have better judgment

It's been said good judgment comes from experience, and experience—well that comes from poor judgment! That is certainly true when building startups. 

The most difficult part of building startups involve decisions on whether to pivot, proceed or kill the project. Sometimes, the data from experiments are pretty clear, making the decision easy. But most of the time, the data are not clear at all as most ideas kind of work and kind of don't work in the early stages of figuring things out. It takes tremendous judgment to make these calls. Well-intentioned people can disagree vehemently on these questions and often do. While we can teach the skills required to run experiments using our methodology, we cannot teach entrepreneurial judgment. Judgment can only be learned over time and through experience. 

YC normally works with young, newbie entrepreneurs. In contrast, all of our project team leaders are 3x founders at a minimum. This is a big difference and it's a conscious choice in our studio design. 

2. We are stingy

Because I've spent so many years as a bootstrap entrepreneur, I'm not really used to having a large cash cushion behind my ideas. As a result, I'm in the habit of being extremely careful with money. When you are trying to achieve profitability while being extremely capital efficient, this is a good habit to get into. 

We like to keep customer engagement, revenues and profits behind our capital investments. In our view, if a customer won't pay in advance for a screenshot, he is unlikely to pay for the finished product. This is a really high standard. It's not a standard most startups accept or adhere to. We embrace this higher standard because we know the greatest risk is not that we can't build it, but that no one will buy it once we do. 

We are extremely conservative with investment, and ideally, we like customers to pay for product development. And if they don't, we just don't build it and move on to another idea that resonates more.

3. We don't have General Partners and we don't have management fees. 

According to a 20-year historical analysis of their venture fund investments, the Kauffman Foundation concluded 67% of fund managers' income comes from management fees. In other words, most managers are so bad at managing their venture investments that the carried interest part of a 2/20 deal doesn't amount to very much. This is an embarrassment. It's a mystery to me why Limited Partners would continue to give these General Partners any capital at all considering 86% of venture funds fail to outperform comparable public market funds. Just put your money in the public market at a much lower risk.

At InsightStudios we've completely eliminated the middle-man between entrepreneurs and investors. We don't have any General Partners (GPs). We don't have any management fees. We don't need these guys because in all honesty, they don't add much value in our early-stage process. 

When you consider cash-over-cash returns net of management fees, InsightStudios has a much better chance at beating comparable public market funds without any management fee drag or overhead. 

4. We recycle returns

To help fund future projects in the studio, we added an automatic recycling mechanism to our equity purchase agreements. Return recycling allows the studio to re-invest 20% of the returns after the investors have made their money back. On average, we are developing series A startups for $1.5MM and exiting for $78MM to the studio at a 50% failure rate a number that comes from Idealab's 25 year history. With 20% recycling rate, every successful exit generates funding for ten new series A startups.

This adds up quickly. In fact, by round three, we are 7.5 years into the studio business plan and we will no longer need any additional capital. The first 30 startup exits pay for the next 120 startups, which generate additional returns to investors without requiring any capital at all. When this happens, InsightStudios becomes a perpetual money machine. That's how our returns get ridiculous in the later years with a 139x cash-over-cash return. It's not magic or naive. It's a higher success rate and 20% returns recycling. 

Yes, that's a lot higher than the average seed fund at 2.5x. The reason is that we are not a seed fund, as I've stated above. We don't operate like a seed fund and we don't behave like one either.

We are an entirely new asset class. Our model is just more efficient. We are not venture capitalists who are picking winners and losers in a market that is impossible to predict. Instead, we are a group of experienced entrepreneurs who run well-crafted experiments with customers to figure out what to build and how to scale. In turns out that makes all the difference in capital efficiency and cash-over-cash returns as we bring a more scientific methodology to picking projects. 

Summary

While we understand the reasons why investors compare us with traditional startup portfolios, seed funds and accelerators, we just disagree that any of these models are comparable to our startup studio model. Our historical and comparable success rates are at least 100x higher using the most conservative comparable. We are stingy and more capital efficient. We don't have any GPs and we don't charge any management fees. Finally, we recycle returns to build more successful startups that generate incremental returns to investors without requiring them to invest any additional capital.

If we don't walk like a duck, swim like a duck or quack like a duck, then we aren't a duck. We are a new animal. The fact of the matter is that we are something entirely new. Maybe we are a golden goose.

We are a startup studio that is building 150 startups with experienced entrepreneurs using a proven methodology for finding product-market fit and scalable, repeatable business models. 

Learn More

If you'd like to invest or learn more about InsightStudios, please contact me to set up a time.