A New Way to Create and Manage Software Innovation
When people first interact with us here at Frost Data Capital, they have fundamentally the same questions, which go something along the lines of “What exactly are you? An incubator? A VC?” The high level answer is that we have elements of both, but we are distinctly different to classic VCs and traditional incubators.
So, while a venture capital fund is part of our operation, it is entirely dedicated to the companies we are creating and we NEVER look at outside deals – we don’t have that slush pile of business plans waiting to be read. Also, while we may appear to operate as an incubator, we go far beyond the traditional ‘boot-camp’ approach of most incubators and, critically, we are the founders of the incubated companies in our portfolio.
At first glance, these differences may not seem all that important. However, they are part of what we believe is a reinvention of the way software startups are created and operated. Our approach is called the FROST MODEL and it consists of the following key threads:
Unlike most other incubators who chase the latest hot startups across multiple areas, we are very strongly focused on Big Data analytics. This still gives us a lot of scope – after all, Big Data is impacting just about every area of human activity. Yet it also means that all our companies operate in a similar way and use the same or closely related technologies.
Our portfolio companies have similar business models and sell to the same kinds of customers. The result of this focus is that the core incubator execs don’t have to context switch when talking to the various companies. In addition, it means we are creating one of the biggest ecosystems of related Big Data startups anywhere in the world.
If we’re going to truly change the way startups get created, we have to start more than a few companies. Otherwise, we won’t move the needle for our major partners. This simple fact has all kinds of implications for our operation. For example, if you imagine being the founder of tens of businesses, and trying to stay closely involved in them as they develop and grow, then you can see how rapidly you would run out of available time (and sanity).
The Frost Model recognizes that scale is vital, and builds this into the approach from the start. We do this through the use of Parallel Entrepreneurs, and by creating teams, and processes (along with the underlying technology backbone) that can scale. We’ll cover Parallel Entrepreneurs in a future post.
Finding the right leadership team for each company is critical. We need to find people who will quickly take ownership of the founding concept, with the experience and skill to develop the idea into a compelling company. In the traditional Silicon Valley startup model, success is perceived to rest on the shoulders of the ‘Superhero’ CEO. This individual typically has to come up with the initial idea and take huge personal risks in order to bring a product to market, while demonstrating incredible leadership skills as the team grows.
In the Frost Model, we don’t believe this is scalable or predictable. We take a very different approach. For one thing, we don’t expect our CEOs to come up with the founding ideas – we already have those in abundance (more on that in a moment!). We also don’t expect our CEOs to take significant personal risks, since we have capital available. As a result, we can attract and retain a different type of leader. Rather than the classic entrepreneurial young kid from Stanford or MIT, most of our CEOs & CTOs are in their forties and have young children. They have extensive experience in forming relevant startups and/or building/taking similar products to market, along with proven leadership skills.
When combined with the extensive experience and capabilities of our shared incubator team, all of the above makes our Frost Model far less of a risk, and also more scalable. In fact, we have become a magnet for leadership talent, to the extent that we no longer need to headhunt.
Most people struggle to come up with one compelling startup idea in their lifetimes, so we get asked how the Frost Model can produce ten or more great ideas each year? Part of the answer lies in our focus – Big Data is all we think about, pretty much 24/7. This focus has enabled us to build an incredible ecosystem. As of this writing in early 2014, we have 12 companies in the portfolio, all with their own CEOs and CTOs discussing Big Data ideas and opportunities with strategic partners and customers.
We also have a shared team of highly experienced business development staff, who are talking about Big Data on a daily basis with senior execs at Fortune 100 companies, strategic partners like the major software vendors and leading system integrators. As a result, we generate a significant number of new ideas. Recently we’ve added a more intentional program to generate ideas in conjunction with a small number of strategic partners. Let’s look at this next.
Working closely with strategic partners is a key element of the Frost Model. Our partners are a source of ideas, validation, funding and channels to market. Most importantly, they are also potential acquirers of our companies. We understand from our own experience that large companies often struggle to develop disruptive innovations as part of their overall product strategy.
Typically, this results in them acquiring relatively small startups to fill in the gaps. This can be a somewhat random process, with mixed results. After all, a high quality startup may simply not be available at the right time and price, and even if found, integration into the organizations product architecture can be a challenge.
Our goal is to invert this process and make it much more intentional. We work with our partners to identify disruptive ideas that they would like to pursue. If our validation process indicates there’s a large enough opportunity to justify a startup, we will go ahead and form a company. One or more of our strategic partners will be involved in the initial funding rounds, and more importantly, they help us develop the new company via ongoing validation and access to their customers.
Throughout, the corp dev unit of the partner stays very close to the startup as it develops. The end result is that the partner is presented with an opportunity to acquire a startup that fits nicely into its own product roadmap, when it is ready to do so and at a sensible price.
Most acquisitions of enterprise software companies occur at valuations between $75m and $150m, with a typical return to a VC investor of around $25m. Unfortunately, this reality is at odds with the needs of most large VCs. If a fund has raised $1bn, it must return at least $3bn to be deemed a success. Which means it would need to invest in 120 successful companies with an average exit value. This implies that the fund would need to make several hundred investments overall, which is simply impractical.
As a result, large funds are driven to ‘swing for the fences’ on every investment. In our opinion, this sets them at odds with market realities and is a key driver of the low success rate of Silicon Valley startups. Our goal with the Frost Model is to achieve a much higher success ratio, partly by ensuring our companies are built such that a $100m exit is a great outcome for all concerned.
Key elements of this include limiting the amount of capital invested and also making sure that other investors share our vision of what constitutes a successful outcome. Consequently, we maintain a relatively small fund. We also believe this promotes good practice, as our growing portfolio companies require outside capital, and therefore validation – although we are still careful to ensure we pick the right investors.
The hardest aspect of our operation to scale is what we call ‘Startup Mojo’. Some of this is simply having the cojones to go out and validate your vision with partners and customers, but most of it comes down to two points:
- The ability and willingness to make high quality decisions with very limited data
- The occasional intuitive leap.
While people with cojones can be hired and coached, world-class intuition is much harder to find and teach. It remains the highest barrier to scaling what we do. We will discuss this in more detail in a later post, but I will say that with the Frost Models we guide our companies using a process that helps us to identify when and where (and sometimes even how) those intuitive leaps can be made.
All of our companies go through the same process, which was created at our inception in 2010, and has been continually refined. At the core of this process is Eric Ries’ work on Lean Startups, adapted to enterprise software. We’ve also added ideas from Crossing the Chasm by Geoffrey Moore and Clayton Christensen’s The Innovator’s Solution, together with many nuggets from our own experiences in building enterprise software startups over the last couple of decades.
Critical concepts include:
- Hypothesis validation
- The business model canvas
- Minimum Viable Segment (MVS) (“Looking for bowling alleys”)
- Minimum Viable Product (MVP)
- Frequent stand-up meetings to share information
Another important aspect of our process is that we like to create companies in batches of 4-6. This allows us to put all of the new leaders through the process at the same time so they can learn from each other as well as getting input from the core incubation team. Our shared ownership structure helps greatly in this process, via the collegiate atmosphere that it creates.
Unlike traditional VCs at Frost Data Capital we are involved in mentoring our companies on a daily basis. In most cases, our leadership teams are in the same office as our incubator execs. This means we can give much more relevant advice as and when it is needed, instead of just being involved in board meetings and ad hoc calls.
The key is to ensure we don’t end up micro- managing the CEOs, since that would undermine their authority and reduce the chance of success. Micro-management is also not scalable. The collegiate atmosphere also means there is assistance and mentoring available between company teams.
At a high level, the cap tables of our companies would be familiar to any VC on Sand Hill Road. We have common stock, an option pool and our funds & investors own preferred stock. Where we differ is that the common stock is not broken down in the typical way. There are three fundamental ownership pools:
- Founding stock for the incubator exec team.
- A competitive stock package for the CEO & CTO. At first glance, this portion looks smaller than usual for the ‘founding team’. However, it is important to remember that the CEOs and CTOs of our companies are not like typical founders – they didn’t come up with the idea and they didn’t take any personal financial risks. Even so, we like to maintain their ownership at competitive levels to ensure motivation.
- A shared pool for the CEOs and CTOs of the other portfolio companies. This element is key. If one of our companies succeeds, all of the senior staff of the other companies gets a small, but meaningful piece of the action. This creates a very powerful culture, where opportunities and challenges are freely shared.
The Frost Model is woven from these threads and creates a strong climbing rope for our startups to scale the heights. We look forward to sharing with you more detail on these strands of our approach in future posts, and revealing more about each company’s journey. We hope to provide inspiration and insight to your own challenges!