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The Residual Income Model
3 min read

The Residual Income Model

An Alternative to the VC Model

Startups by trait are monopolies of the future. Oftentimes, establishing that monopoly requires an upfront loaded cost - either for research, development or to prove the viability of it. One way to offset that is by raising Venture Capital at the future value of the company (also known as valuation). But if you are a startup in deeptech or an idea where the path isn't all that clearly visible, it can be hard to convince the future value of the present state.

That often means lower valuations, and if you do have to go down that route, it means heavy dilution in the part of the founders and initial stakeholders.

There is an alternate model - the residual income model.

I heard this term recently in an interview with Gwynne Shotwell, the COO of SpaceX. If you haven't heard about her, It is worthwhile reading up and listening to her talks. She is an all-out operator - and a star blazer in that (pun intended).

While Elon is the one tweeting out about the possibility of a rocket blowing up, Gwynne is the person behind the scenes that dots the Is and the Ts to ensure that it doesn't.

She mentions in her interviews about this residual income model where SpaceX had no credibility as a space agency - and was the only viable option.

Residual Income is defined as the value and income an asset can generate post the income generating activity has ended.

Truth be told, this model is not new to Elon Musk though. And it is not new to Silicon Valley either.

Back when Elon Musk was trying to build a car company - and had no experience in the industry, he couldn't find backers. So the first product that the company came up with was the Tesla Roadster. They priced it at $200K (+50K for the founders' edition). The current model of Teslas start at $39K

You start with a premium version of the product, where the early adopters are essentially paying for the investment that you need to make into your production process. And to prove the market, to raise more capital.

Side Note: The smart ones are perhaps the ones that used the 200K to buy Tesla Stock rather than a depreciating asset, the car.

This is also in line with the Space Tourism model that Jeff Bezos is doing, where they launch billionaires into space - and the cost of the ticket makes the cost of the experiment break even, but in return what they get is 1000s of launches which in turns helps them to optimise and tweak the machinery to extreme precision to do longer-range missions.

VCs might scoff at taking their money to do 1000s of test launches, but this model keeps the company at the edge, and also gives it a path to excellence.

All tech startups that succeed do so with that one element - excellence. But that has an upfront sunk cost.

When it came to SpaceX, It was Gwynne Shotwell that executed the playbook of signing up partners such as NASA to foot the bill of developing the infrastructure, which in turn helped SpaceX push the envelope on every single aspect of Space - that was assumed as default.

This is not an earth-shattering idea though - there have been time and time again, when a software development company, took on this audacious project for a client, retained the IP on the software and productized it. Not fully, but at least in part. And through a series of customers, perfecting the product.

MS-DOS was a project for IBM, that was then productized. And that is how Microsoft was born. The Microsoft Solutions Team makes 10x more money than the product team building custom solutions for their partners, but it is also their pathway to gain insights into features that will eventually become part of the product.

If you are building a deep tech company, one way to think about this is to break down the project into key components and find a partner for whom it would mean a disproportionate advantage and ask them to upfront the cost of development, with a perpetual license agreement with them that they get the latest version of that module. You can work out a royalty based fee structure for that.

Find a few such clients, and by the end of it, put it all together and you'd have a product that is cutting edge. And you'd also have garnered so much insights on a module level working with the partner - details, that you didn't think about, that makes the solution elegant.

The Residual income in a model like this is two parts - a) the Intellectual Property that you get to develop and b) the ongoing royalties you get from the partners you developed the modules with.

Don't however make the mistake of tying up with one partner to develop the whole product, as when you productise it, they are going to feel like they got the short end of the deal - and a potential lawsuit could follow.

The only other caveat is that it really has to be a leapfrog and not an iteration. In a way, it has to be a moonshot.

The other way to think about this is that, while you are pursuing excellence as a startup, doing an inventory of assets you have that could be monetized in part to generate revenue to fund further development.

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