We should be very careful with getting into cahoots with service partners who offer to build our product for us. It might sound sweet to have someone else build the product for us, but this is the path to the dark side! But why is partnering with a venture builder such a big no-no for a tech startup?
Years ago I participated in the first Antler cohort in Stockholm. And their message was clear. No tech startups were funded unless they had a CTO on their team.
This article is for all the hardworking founders out there. Those of you who have come up with a great idea. And are working hard night and day to create something great. If you already are or want to build a tech product, but don’t have a technical cofounder, you should read this.
And if you are running a venture studio or venture builder you should read this too. But be prepared to blow your tops. I will not go lightly on your business model. I will make some rough generalizations. The venture builder concept is pretty new and it means different things to different people. For the sake of clarity when reading this article, I will use this definition:
“An external company charging a startup a fee (cash and/or equity) in exchange for services with to accelerate the growth speed of the startup.”
The focus will be on building software together with a venture builder partner as this is my expertise. But this should generalize to other parts of a startup’s operation too. Like sales and marketing for example.
So, let’s dive into it. Why is the venture builder business model broken by design?
Reason 1: Venture builders look for billable hours for their employees
Many problems start with miss-aligned incentives. Charlie Munger, who works with Warren Buffet, once said: “Show me the incentive, and I will show you the outcome”. How does this apply to our situation then? Think about it.
A venture business is basically a consultancy business. But with a tweak to their business model to also accept equity as payment. Their business model is to invoice us for the time they spend on building our products for us. And it does not matter much for their business if it is for equity in our startup or if it is for pure cash. They just need to handle the increased risk that comes with getting paid in equity.
“Show me the incentive, and I will show you the outcome.”
Charlie Munger
But what about the incentives then? It might look like our incentives are aligned if they do it for equity. But the thing is, many venture builders have sprung out of traditional consultancy companies. And they have consultants they need to put to work. This is their most important priority.
I’ve spent a fair share of my professional life in consultancy companies. Both larger and smaller ones. On top of this, I’ve also been on the buyer side of consultancy services many times. So let me briefly explain how a consultant agency work so you better understand their incentives.
And why this becomes a problem for a startup.
Reason 2: You might be given idle hours from your venture builder
A consultancy agency hires professionals. They hope these people have skills they can sell to clients for a markup. But no matter if the consultants are working on an assignment or not the agency has to pay for their salaries. This makes the utilization rate one of the most important metrics for a consultancy agency. It is the % of the total working hours, for all the people that they can charge a customer for. Also called billable hours.
This makes it very attractive for agencies to take on projects where they can put idling unutilized people to work who are not on a long-term assignment. But for you as a startup, you will end up having people new people coming and going to build your product. People who have not been part of the earlier part of building your product. They have to spend time getting up to speed with the platform, getting to know your people and your way of working. Lead times are one of the biggest time drains when developing. So this will be very ineffective.
Reason 3: The venture builder will give you advice that keeps their invoices coming
Some agencies might argue that they will not replace people in their team working with us. They might even accept to have their people working in our office. That is one step forward.
However, the incentive model is still broken.
As we talked about previously in the article, the venture builders’ main goal is to send invoices to us for work done. While we as a startup want to build a product and take it to the market as fast and cost-effective as possible. Our incentives do not align. The cash flow the agency gets from the startup is too much of a temptation for them.
And it does not matter if it is equity, cash, or a mix thereof. It’s still put in the accounting books as revenue for them.
If they can, they will stay on as our tech team indefinitely clawing more and more equity away from the founders and the other investors. All while charging us market-rate prices for their services. Seasoned investors know this. The chance is high that they will see your startup as uninvestable. As they would get diluted along with your founders when the invoices keep coming.
On top of this, they will assume a position as our trusted partners and advisor. Maybe even sit on our board.
Once again we face a problem. The advice they give us will be tainted by their incentives to keep sending us invoices. Trust me, we will never see them put forward a plan to phase themselves out as the product team. Even though this should be our startup’s priority.
An early-stage startup does not need this much politics.
Reason 4: The tech platform might not be built in a good way
There are many things to consider when building a tech platform. If you make the wrong decisions you might end up having to rebuild it from scratch sooner than you hoped. If you do not have a good CTO on your team, you will not be able to vet the decisions your tech partner makes for you.
One mistake I’ve heard stories about is the tech partner building the platform on their bespoke framework. And when the startup wants to move away from the partnership they can not find developers with knowledge of, or that want to work with that framework. Furthermore, the startup could be stuck paying licensing fees to the venture builder to use the framework.
Also, remember that developers tend to be a bit picky why how to architecture software. When you finally go out and look for a CTO, they might not like the way it is built. They might not want to come and work with you unless they can rebuild the whole thing from scratch.
It takes skill, experience, and the right incentives to know when to take on tech debt and when to build for the long run. Read more about tech debt in my article “Leverage Tech Debt To Get Insights Faster“.
Situations do exist when you should consider a venture builder as tech partner
I can come up with a few situations:
- Our product is not digital at its core. Maybe we just need a website to market our cleaning services. In this case, it might work. However, I don’t think any venture builders would want to own equity in a cleaning service as this is not a good venture case. On the top of my head, I can come up with one space where this setup might have 100% aligned incentives between the startup and the agency and this is the Life Science space.
- If we need to get going quickly and have a person on our team with experience running product teams. This person can then make sure to keep the venture partner honest. And can run the team with the tech partner’s people as an integrated piece of our team.
- If we need specialist skills for a specific area for a specific project. Like the graphical design, rebranding, or senior management people. The key here is to make sure the agency does not have the incentive to make themselves single points of failure in your organization. And no, putting the MVP of your digital product on the market is not such a suitable project.
As a rule of thumb, if we expect to be continuously building our product, we should not let someone else build our product for us. Probably not even the MVP. Spend this time to find a co-founder who is technical instead. You need to have a CTO on your team.
What to do if you already have a tech partner building your product
So you ended up here anyway? The temptation to get going with building your product was too much for you? It might not be the end of the world. If you act now.
But be prepared for some rough seas ahead. Your tech partner will probably hold your tech platform hostage. They won’t say it to your face. But you will have trouble negotiating with them for better rates as they already are an equity holder. Furthermore, as they build the platform, they know it best, and handing over this to another team will make us lose precious time and resources.
But you need to make a plan to phase them out as soon as possible. Recruiting your own team. They might advise you it will be too costly to hire people. But let me assure you, it’s even more costly to pay those invoices. It doesn’t matter if it is in equity or cash. That equity or cash could be spent on getting in-house tech people on board.
Sit down with them and declare your intentions. And get support from someone you trust when going into this negotiation. Someone with experience in building tech and products. Sure, it will be costly to have this conversation. It will seem like there is never a good time for this. And it will take some courage.
Conclusion
If you don’t start owning your in-house product development in time you might miss the chance to make your company a breakout company. Once you bleed too much equity into a venture builder, the later-stage VC will not fund you. You will have become too diluted as founders.
I wrote this article so that founders out there would not miss their to make it big. I’m sure all the venture builders and tech firms out there will hate me for this. Talking down on their business model. Saying they provide immense value to the ecosystem. You are welcome to prove me wrong.
There might be outliers who made it with this model. But as an investor, having a venture builder building your product is a huge red flag for me.
