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On Venture Services

Venture, in all its forms, is the professionalisation of angel investing.

Angel investment has a bad reputation. One that is characterised by chaos, amateurism and exceptionally high levels of risk.

I once attended an investment seminar where a seasoned angel presented his view that one shouldn’t expect to make any money from angel investing and that it was more about having fun.

This seemed counter-intuitive. But when your company is you, a big idea and a slidedeck, it’s hard to convince others to back you (especially if you’ve never started a company before.) Given the obstacles, it’s a miracle first-time founders ever make it out the gate.

Institutional investors don’t engage until much later on. They are scaleup, as opposed to startup, investors. They enjoy the comparative luxury of a working product, market traction, even revenue from the companies in which they invest.

Venture services firms serve two sets of interests, those of early-stage founders and those of early-stage (‘angel’) investors. They facilitate transactions that align the interests of both towards the rapid creation of equity value.

For venture services firms, the bets are as follows:

Proptech. Lawtech. Connected Enterprise. Smart Cities. IoT. The tech-sector is diversifying rapidly. And so is the archetypal startup founder.

[*Important note: Mr Graham uses this term in a somewhat derogatory manner. We most definitely do not.]

And for “just some business person” with a vision but no technical experience, the challenge of building an initial product and finding sufficient capital to pay for it can be insurmountable. It’s a much greater obstacle to startup progress than is commonly acknowledged.

Historically, non-technical founders looking to start a company have had two options to choose from.

Either they find a technical co-founder / CTO and rely on them to build a product in exchange for a healthy slice of equity.

Or they reach further outwards to one of the many providers of software services (aka ‘dev shops’), typically located on the eastern edge of the European Union (think Poland, Czechia, Belarus, Ukraine, Russia), or in India and pay them in cash.

Venture services firms offer a third option to founders, one that sits between an invested employee and a detached supplier. And one which, ideally, offers the benefits of both.

These firms don’t create companies or lay claim to their ideation. They partner with mission-driven founders to solve a specific subsection of their needs: the need for working software and the need for capital to pay for it.

For startup founders, finding a partner willing to remove the two biggest obstacles to early-stage progress can be compelling. It’s common to hear founders talk of their desire for value-added capital. Done correctly, venture services should feel like an accelerator on steroids.

By trading in equity, venture services firms attain goal congruence with founders that suppliers are unable to achieve. This creates a partnership culture of trust and shared outcomes.

The percentage of startups who burn through their initial capital but fail to deliver an actual product remains surprisingly high. This usually occurs when CEOs unexpectedly part company with their CTO and find themselves with half a product that has little or no value.

Experienced angels will have witnessed this on multiple occasions. Having confidence that a product will be delivered, on time and on budget, is rare and appealing.

Investment decisions don’t exist in a vacuum. They occur within a complex macro-economic environment of financial incentives and opportunities, notably tax relief and grant-funding.

All governments seek economic growth. As startups are high-growth vehicles by definition, governments are increasingly trying to incentivise early-stage investment. Widespread awareness of the generosity of these schemes, combined with the explosion of interest in startups, has created a perfect storm of capital searching for a home.

“To say that the Seed Enterprise Investment Scheme, or SEIS, is incredibly generous is somewhat of an understatement. Of course we all hope our investments do well, but if you pay tax at 45% and make an investment of £10,000 that fails completely, you only lose £2,750 due to the tax relief.”

Wealthy individuals with high income tax bills have stampeded to find startups that will allow them to take advantage of the tax relief offered by SEIS. But few have direct access to qualifying companies or the time to find them.

Whilst the relief is an end in itself, investors also want to protect their investment and minimise downside potential. They’re not just looking for startups that qualify for SEIS tax-relief. They’re looking for the best startups that qualify for SEIS tax-relief.

Via access to select early-stage startups, venture firms are well positioned to broker these trades.

In Part One, I observed that the economic details of venture deals are rarely disclosed. It’s hard to quantify how much equity (and cash) really changes hands between founders and venture firms. The spectrum is very broad.

The very short summary is that venture services means building software in exchange for equity, syndicating part of the equity to cover costs, and retaining the remainder as margin. This aligns the firm’s incentives and upside with those of the founder(s) with whom they partner.

The slightly longer version is as follows:

Compared to other forms of venture capital, venture services remains niche.

This is primarily due to the complexity of the business model. There are more moving parts, and more factors to align, in a successful venture deal than a conventional investment. Most investors prefer to avoid the additional overheads and responsibilities of being a venture partner.

Additional reasons I have observed are as follows:

In Part One, we explored why venturing can’t be funded by profits from a services business; at least not long-term.

Services businesses generate revenue in the form of cash. Venturing is investing, which is deferred revenue. What makes the two irreconcilable is usually the cost base.

As software companies are asset-light, the lion’s share of their cost base is payroll. If you have a lot of salaries to pay at the end of each month then you need the cash to pay them. And, if all of your profits are funding ventures, then you are dangerously exposed in a downturn.

I have experienced services companies with large workforces all but go bankrupt trying to move into venture. The consequences were drastic and unfortunate, mainly for the employees.

So, how can venture firms build software without the overhead of large team of developers and designers? We solve for this at Pivot by mobilising teams on a deal-by-deal basis and working within a tightly managed, fixed cost environment.

We generally employ a mixed model, with CPO and CTO working ‘onshore’ (in our case, in London) and UX, design and engineering working ‘near shore’, typically in Eastern Europe. We always seek to build long term partnerships by working with the same individuals across a number of ventures. This creates bonds of familiarity and trust that generate real team effectiveness over time.

The costs for the team are rolled into the overall capital raised by the venture firm and then exchanged for equity in the company.

Finding startups that are good investments is hard. Finding startups that are pre-product, pre-revenue and a good investment is a treasure hunt of mythical proportions.

It’s hard to accurately size the market for venture services. It could be very small based on the ratio of deals we have done versus the opportunities we have passed on.

The downside of working at the highest risk end of the investment spectrum is that it’s, well, risky. Most investors prefer to see proof of market traction. It’s a giant leap of faith to invest in a market for something that doesn’t yet exist.

Pivot endeavours to de-risk this by backing founders who sell back into their primary network, at least in the first instance.

Ex-lawyers are well positioned to sell lawtech solutions to other lawyers. Ex-marketers selling marketing platforms to their former (marketing) colleagues is a reasonable bet. Unlike hackers, “just some business person” often has the edge when it comes to sales. And sales is the bigger challenge long-term.

Venture services firms combine expertise (and application) in two distinct fields: early-stage investment and software product development. Folks from these respective fields come from different places, have different mindsets and speak different languages.

Service providers are instinctively inclined to work with whoever wants to work with them. Investors are instinctively sceptical. Service providers are default ‘yes.’ Investors are default ‘no’.

I speak from experience when I say that the two are also treated very differently by founders and the startup community in general.

Investors are top of the food chain and get treated accordingly. They enjoy high response rates to their emails and meeting requests. They don’t sell or hustle as a rule.

Life is different for providers of software services. Much of their time is taken up writing estimates and proposals that go unacknowledged. Their communications are ignored. They have to hustle constantly.

Part of the achievement of a venture services firm is finding a common ground for these very different individuals to interact within. This alone is a barrier to entry.

That’s pretty much all I have to share, so far. As you can probably tell, I’m bullish about the potential of venture (and venture services) as an emerging category within venture capital as a whole.

Any other players (or aspiring players) within the space, I’d love to hear from you.

Here’s the TL:DR:

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