Fractal - A Case Study in Studio Design

Business Insider’s recent article “Founders From the Venture Studio Fractal Say They're Being 'Blacklisted'” (Pioneer’s Perspective’s, non-paywalled version) has brought the captable challenge of studios in to the forefront of discussion. Social media, as well as my inbox, lit up over the last 48 hours. Critics of studios see the Fractal story as proof that the model is horribly flawed, and unworthy of consideration by serious investors or entrepreneurs. Studios see this as proof of the headway they have made, under threat.??

For a studio design expert, like me, Fractal becomes a perfect studio design case study. A case study where red flags abound.?

1) The pace of creation is several times higher than most studios, implying limited studio support for each company.

?2) The studio thesis of finding unicorn opportunities within boring markets was not shared by follow-on investors.?

3)Founder-market fit seems missing in founder selection, potentially even founder capabilities.?

4) Looking at earlier role positioning, Fractal was targeting Series A follow-on investors after only 12 months, less than half the average time studio companies can raise a Series A and 4x faster than most startups.?

5)? Studios play the founder role and get founder equity, not 2-3 portions or founder equity.

The captable challenge for studios has been a known issue in the industry. Studios take a founder share, but VC’s don’t count them as founders, but rather dead equity. This leaves most VCs to pass on studio companies without taking a look at the company. Often missing the fact that the founders in the studio company have greater individual ownership stakes than the non-studio companies in their own portfolio.

Studios can, and do, provide founders with greater ownership than the traditional founder journey. At an individual level, not a collective level. Founders are people, and no founder makes their personal long term decision to stay with the startup they founded based on how much equity other people in the company have. They focus on their own share.

Make no mistake. Studios do take a founder equity stake. It’s when they take more and/or fail to deliver as a founder that this becomes unsustainable, and the promise of a studio becomes a poison pill. The flexibility of the studio model makes good design a major challenge. You can’t out execute poor design, a truth that Fractal seems to have encountered first hand.

Big Disclaimer: I have never seen the inside of Fractal Software, their deal terms, or company creation approach. My analysis is based off the Business Insider, related articles, and my knowledge of venture studio design as a partner at Venture Studio Associates, creating a Universal Framework for Studio Design, frameworks for studio operations, an upcoming whitepaper on investing in startup studios, and my personal experience working with studios and building Savvy Tinkers Studios.??

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Good Studio Design is Not Optional

Fundamentally a studio is designed to improve the success of building new businesses. These can be venture funded SaaS startups like Fractal Software targeted, biotech companies like Flagship Pioneering builds, such as Moderna Therapeutics, one of the major COVID vaccine makers, consumer goods companies like Dollar Shave Club or Liquid Death from Science, or even cash flow based consulting businesses for local economic development like Insight Management. By its nature, a studio is designed to be the right support structure to build specific types of businesses. There is no one way to design a studio, but there are lots of ways to mess it up.

Solid design begins with understanding the design constraints. Broadly these constraints fall into a few distinct categories.?

1) The studio’s thesis and ecosystem it will operate in,?

2) the founding team of the studio,?

3) the founder role(s) the studio will take on as the build companies, and?

4) the customers of the studio. Each shape core elements of a studio are often impacted by other factors, and not all are controllable by the studio.

The studio thesis, ecosystem it operates in, and the founding team set the basis for the studio. The thesis has to attract investment and create suitable companies for follow-on investors. The ecosystem the studio operates in will set expectations for performance, investment amounts, and captables. The team brings the build capabilities, network needed to raise funding, and influence the founder role(s) that are a good fit for the studio. However, the single biggest factor for studio design constraints are the customers that it serves.

Studios must serve all four distinct customers. Studio investors, studio staff & partners, entrepreneurs, and follow-on investors. The needs of these customers form hard design constraints that directly impact studio operations, acceptable deal terms, and investment economics. One of the most critical design constraints is driven by the needs of follow-on capital.

While VC follow-on capital is the most common, it is not the only follow-on capital option studios use and is only fitting when building startups with unicorn potential where investors see not just a 10x return but a glimmer of 50x or 100x. An area where Fractal Software’s portfolio companies reportedly struggled in the eyes of investors.

A VC Analysis job ad suggests that Fractal targeted a Series A for its portfolio companies next funding round 12 months from founding. Working backwards from this assumption several red flags emerge.

1) 12 months is less than half the average time GSSN reports that studio portfolio companies raise a Series A and more then 4x faster than most startups. This would require an exceptional process and significant hands-on build support to meet the traction, product, and company progress Series A investors expect. Requirements that are at odds with Fractal’s weekly pace of company creation.

2) The captable has to be acceptable to Series A investors.? With ~15% ownership for each founder before raising outside capital, this is a huge red flag. Seed investors are looking for founders and staff to own ~50%. At Series A this can drop to 35-40%. Note this is collective ownership across founders and investors, not individual ownership. Studios can provide founders with greater individual ownership than if they took the traditional approach to building a startup. When founder ownership in studio companies is lower than the traditional approach, it must be acceptable to follow-on capital. Factors such as industry, how much the studio invested and built before the entrepreneur joined, if IP or a company was acquired as part of creating the company have significant influence, and the pedigree of the studio play a role here.

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CapTable Sidebar

Studios can and do provide founders with better equity stakes than if they take a traditional route to building their company. This is delivered primarily through three mechanisms. 1) They fully replace the need for at least one founder on the captable and take a cofounder share of equity. 2) Studios take the place of early investors, infusing initial capital to see the company through to an outside round. 3) They setup an options pool immediately.

Last week I detailed an example of how studios can provide founders 20% more equity. When a studio takes a 50% stake and a 15% preferred stake through a capital investment, a solo founder can end up with a 36% stake before outside investment, a 28% stake after the seed round, and a 22% stake after the Series A. More than double what founders of Fractal companies reported. At a guess this is due to the nearly 50% stake Fractal took, forcing two cofounders to join each splitting the remaining equity with additional significant dilution from early employees and advisors before setting aside an options pool. Effectively taking twice the equity of any individual cofounder. The excel model used for this analysis is available for free here.

The nuances of the studio model mean that there is no one right equity range for founders or captable structure that will consistently work. For example, a bio-tech where substantial resources are invested in creating or licensing IP, proving it out in lab testing and scaling that testing up to FDA evaluation may start with 100% of the ownership and approach equity distribution with a Private Equity or Search Fund mindset, rather than a venture funded software mindset. The industry itself also plays a major role in expected dilution, ownership, and exit options. Even software focused studios may take a similar approach when they own building the company from idea past product-market fit. At that point, they can hire a CEO who excels at scaling companies, rather than a founder who knows how to navigate a company to reaching product-market fit.

This is a major nuance of the studio model. The right deal terms for founders do look very different studio to studio. Industry, how the studio builds companies, the nature of the founders recruited, and the local ecosystem’s norms all play major roles in shaping what is acceptable for studio investors, studio staff & partners, entrepreneurs, and follow-on capital.?

Founder Role Impact

Studios act as founders, creating companies. How they take on this role has major operational and captable impacts for the studio and portfolio companies. The founder roles a studio can take on include Founder, where they come up with the idea and validate it before they bring on a cofounder or CEO, Cofounder, where they partner at or before the idea stage to validate and build out a company, Late Cofounder, where they join as a cofounder after a startup has a MVP and some level of traction, or Refounder, where they acquire IP or a company to use as the basis for creating a new company.

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The Founder and Refounder studios often invest substantial resources before considering bringing on an outside founder or CEO. This often translates to larger equity ownership by the studio, greater than a typical cofounder stake. When potentially millions of dollars are invested first, and the studio provides additional working capital, greater than a typical founder share is justifiable. Cofounder studios typically take an equal cofounder share and often limit the number of founders that can join. This helps to maintain a suitable ownership stake for each founder and protect the economics of the studio. Late Cofounder studios often demand up to a cofounder stake and provide a capital investment.

All of this is based on a fundamental assumption. That the studio is providing founder level value. When they don’t, the equity stake must adjust or the model risks breaking. Get too far away from providing founder level support and value, and you cease being a studio and become an agency or operational support investor.

Fractal seemed to play the Founder and Cofounder studio roles. They brought vetted ideas to the table and searched for founders to build them with the promise of $1 million in funding, teams to support sales, product, and recruiting, and a salary of $125,000 to start. These are not uncommon offers from a number of studios across the world. With a few exceptions. Most studios are not building one new company a week, nor do they take when amounts to the “the third through fifth cofounder” share. Launching one new company a week, assuming each company received studio support for only 12 months, and a staff size of approximately 100 at peak, this means that each company created received at most the equivalent of two full time employees supporting them. Support from the founding partners of Fractal would have been limited to a few hours of advice or mentoring every month. Fractal’s pace of company creation dwarfs most studios that have been around two or three times as long. Based on the estimated support, the equity stake taken seems high. Too high.

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Reflections

Designing, building, and running a successful venture studio is incredibly challenging. Take a VC firm, digital agency, and add in multiple startups simultaneously. If hardware startups are twice as hard as software startups, studios are exponentially more difficult than software startups. Laying the right groundwork is essential to ensure the foundation is sound and founder level value can be delivered and delivered every time.

The Fractal situation is disheartening and absolutely devastating to entrepreneurs stuck in the middle. The startup world is known for actively learning from failure and a deep appreciation for those that rise again wiser from the experience with the courage to get back in the ring. For those considering getting in the ring, here are a few takeaways:

For Entrepreneurs – Evaluate studios as a cofounder and harshly. Committing to a cofounder is often compared to getting married. Don’t jump in. Do some solid due diligence. Check if their deal terms enable future fundraises or completely block them. Talk with investors or their portfolio company founders that raised and those that did not. Does the support they provide pass a sanity check on what it will take, including the delays and pivots, to set the company up for success and to raise in the next round? For what is provided, does the equity deal make sense??

For investors in studios – Review a studio’s design within the industry, ecosystem, and follow-on expectations. The economics of a studio must work for everyone. The studio, the entrepreneurs, follow-on investors and studio investors. Dive into how a studio will operationalize their founder role in company creation. Ensure studios are providing founder level support, value, and have experience in the company creation roles they are taking on.

For follow-on investors – Look beyond collective equity ownership to the individual ownership level. Hold studio portcos to a high standard. Studios bring advantages to the table in building companies. Studio portfolio companies should be performing better than their peers.

For emerging studio founders – Sanity check your studio design. Perform customer discovery with each type of customer you will serve. Design iteration is a fact of life for early studios. Check your deal, support plans, and investment approach with each customer.

Studios may be creating new markets and companies, but they operate in an established market. Violate market expectations and everyone involved will pay the price. Balance those market needs and the impact to entrepreneurship, the economy, the mission, and investor returns is enormous.