The difficulty in identifying the next hot startup has lead many venture firms to employ a wasteful “spray and pray” strategy, sometimes making more than 1,000 investments in the hope of getting lucky with a wildly successful startup that more than pays off their other sunk costs. Spin-offs from known companies, in contrast, mean less risk, as investors have a clear view of the reputation, infrastructure, and credentials of the parent company. For founders, being at the helm of a spin-off rather than a from-scratch startup, has its advantages, too — you’re likely to get VC funding more easily and on more favorable terms.
How do spin-offs attract venture capital?
A spin-off is a new company formed from an existing one. They are common among enterprise businesses, with around 50 occurring in the US alone each year, and are known to often outperform other types of companies. They’re also popular in academia, when universities opt to commercialize their research innovations, and have a similarly successful track record — they’re 108 times more likely to IPO than other companies.
Yet in spite of this, they’re uncommon among startups. This isn’t surprising, given that startups are usually told to focus relentlessly on one idea, leading to a tendency to pivot to the single most viable one.
But spin-offs are often more attractive to investors for a number of reasons. Let’s consider what investors look for when considering startups, and how the spin-off model ticks all the right boxes.
1. They want big market opportunities. A spin-off can rely on the existing company’s expertise in the industry to judge where an opportunity lies, so the new team already knows whether a market exists for its product before the hard work begins. Take SitePoint for example. It’s an established community site for Web Developers (Alexa rank 1281) that produces content like online tutorials and printed books. While running the site, founders Matt Mickiewicz and Mark Harbottle noticed that the moderation demands for a forum thread about buying and selling websites had become too much. So much so that they started charging for listings. This counter-intuitively fueled its growth, and eventually they decided to spin off that thread as a standalone product. Flippa was born, and it is now the primary location online for buying and selling websites.
Subsequently, another popular SitePoint forum thread lead the founders to spin off design marketplace 99designs, which has raised over $45 million to date and is rapidly expanding internationally. Most recently, Mickiewicz’s experience in working with designers and developers led to the creation of DeveloperAuction, now known as the recruiting site Hired. Hired has raised $70 million and acquired three startups to accelerate its expansion. The insight into the market opportunities that SitePoint provided proved invaluable in kick-starting several successful, related startup spin-offs.
2. They want a viable product. Thanks to the reputation achieved by the company that created them, investors can more easily trust a spin-off to work. New products frequently start out organically as extensions of the original, meaning they’re rooted in tried and tested technology. They can also use the existing company’s resources to back product development until it’s proven out. Like AdWerx, which was spun out of ReverbNation, a fast-growing software firm in the music industry. Despite seemingly being a completely unrelated product, AdWerx, an advertising tool for real estate agents, used company resources to build, test, and refine its ideas before spinning off and going to market. One of its investors noted that seeing ReverbNation incubate this spin-off business encouraged him to invest in the parent company’s own Series C.
3. They want a strong management team. Investors always look for reliable and effective management teams before closing deals. Venture capitalist Mark Suster says, “I’m personally 70% management, 30% product. But for any investor, it takes a miracle to get investment dollars out of them if they’re not impressed with the team.”
Having the right CEO, respected workers in their field, and an office that functions like a well-oiled machine is priceless in making your business idea credible. This is certainly true of Quiet Logistics, a third-party logistics provider that ships over $1 billion worth of goods for brands like Bonobos, Ministry of Supply, and M. Gemi. This team spun off a warehouse robotics company, Locus Robotics, which raised $6 million from the same investors that backed Quiet Logistics, such was their faith in the management team.
An established company is able to negotiate on its own terms
But spin-offs are good for entrepreneurs too, not just investors. The more attractive a startup appears to investors, the more the company can negotiate its own terms. That was the experience at Fog Creek with our task management spin-off, Trello. On the back of the strength of past achievements like our $400 million+ spin-off Stack Overflow, we were able to return to previous investors following the creation of Trello and dictate our own terms. What’s more, backed by our own internal resources, we didn’t need to reach out to investors until a much later stage when we had gained more evidence of traction. The result was that, as Trello cofounder Joel Spolsky said, “We received so much interest that we were even able to limit ourselves to those who were already investors in Stack Overflow and still get the price and terms we wanted.” Trello earned $10.3 million in funding on the spot.
Startup spin-off success hasn’t gone unnoticed by big business
The success of the startup spin-off approach hasn’t gone unnoticed by established businesses. AOL, for example, is trying to incorporate elements of spin-off culture into its Alpha product group, which aims to spawn a series of experimental products: “Instead of making one big bet on one big idea, only to see it crash and burn, we want to take a bunch of smaller ideas, spend a few months turning each into a minimum viable product, and then just put them out there and see whether users take to them or not.”
As the climate for fundraising chills and VCs look to make fewer, smarter investments, the startup spin-off approach could prove invaluable for entrepreneurs who position themselves to take advantage of it.
Gareth Wilson is an executive at Fog Creek Software, a 15-year-old software development business that has created a number of successful spin-off companies, including Stack Overflow and Trello.