So is Earnest Capital more of a charity than a profit making enterprise? I really like what you are doing, serving the vast majority of businesses that don't want to be hyper growth.
But for the math to work out, with a 3x cap on earnings, you need 33% of the businesses to be successful just to get your money back. At 5x you still need 20%. And that is over however long it takes for those companies to reach payback, which could be measured in decades for some of the companies.
I think it's really altruistic, but I'm not sure how big this market segment could actually get.
I'm not OP, but it's worth mentioning that Earnest starts to recoup its investment as soon as founders take a salary. Its calculator [0] shows a percentage of 30% by default - if that's accurate, for the 67%-80% of companies that fail, Earnest would still recoup 30% of its investment (ignoring other expenses and time value of money) even if those companies never saw a penny of revenue.
Also, they list a starting point of $2k-$5k in MRR, and on a $150k investment with a 30% split, they break even as soon as the founder(s) have taken $350k in total salary (again ignoring time value of money), including any salary paid out of the original $150k investment. I don't want to trivialize the process of scaling a startup beyond $2k-$5k of MRR, but I bet more than 20% of companies with $2k-$5k of MRR are capable of reaching that point.
> Earnest would still recoup 30% of its investment (ignoring other expenses and time value of money) even if those companies never saw a penny of revenue.
How so? Who's paying that 30% if you have zero revenue?...did you mean "if those companies never saw a penny of profit"?
Based on my reading of their terms, it seems like they get back 30% of their own investment if the rest is entirely used to pay founders' salaries. So on a $150k investment, they have potential upside of $300k to $600k after they recoup their initial investment, while they can lose at most ~$105k when investing in businesses that have low expenses outside of founders' salaries.
We also have a residual, uncapped, % option if the founder ever sells the business. This keeps us aligned with the founders to keep helping them grow the value of the business for the long-term even after the Return Cap is paid back.
> I'm not sure how big this market segment could actually get.
> We also have a residual, uncapped, % option if the founder ever sells the business.
What exactly is a "residual stake"? In your spreadsheet this is set as 9.5%...where did that come from? Is this is a stock option, convertible note, or equity position?
It sounds to me like a critically important part of their model that they don't want you to understand or think about. There's nothing about it on their site from what I saw.
The residual stake is a factor of the investment amount, the Valuation Cap (negotiated at time of investment) and the terms of a sale. Note by "stake" we just mean an option to participate in a sale. You can run the business profitably forever without paying us a penny. There is a screencast here going over every term and a spreadsheet anybody can use to run the numbers. Not hiding anything :) https://earnestcapital.com/shared-earnings-agreement-digging...
By what instrument though? Are you offering a stock option at a strike price? Is it equity at a priced round? Or is a convertible note? Other? You can just say "if you sell we have the option to take a %"...
That is a tool for calculating the % of a sale that would go to Earnest depending on which year you sell the business in. It is set at year 6 in the default setting for the tool. Earnest's % of a sale goes down as Shared Earnings payments are paid back to us. In the base case setting in that model, the Return Cap is not fully paid back by year 6 so our stake at that point in time is 9.5%. If you change that 6 to year 10 our stake is reduced to 5%.
Just to reiterate all of these terms are negotiable at the time of investment too.
They don't explain it, but it sounds like the whole deal is effectively seed financing where they eventually get a 9.5% stake, but also with a 3-5x loan interest payment once you make money (which they're framing as "Shared Earnings").
I think it means we're on to something if we have folks in this thread arguing from boths sides that we're so founder friendly we'll never turn a profit AND that our terms are "predatory" and worse than a bank loan :)
The secret is there's a huge opportunity in between and tons of amazing founders and businesses we're excited to back.
Reminds me a lot of the Indie Fund in the game space, but slightly more profit-centered (which is not a bad thing).
How did you settle on a 3-5x return cap? Are you planning to tune that over time? Did you consider a graded return schedule? I don't know if you've published your profit share or if that varies by deal, but I'm curious if something like 25% up until 100% recoup, 10% up to 200%, 5% up to 3-5x target would compare to a flat 10-15% or whatever.
As a point of comparison, I used a portfolio loan to buy a business to run as a side project. The debt service on ~$125k is variable but roughly $500/month. At time of purchase that was about 20% of net, but that number will go down as the debt is paid and revenue grows. If I pay it off in ~5 years the total debt service will be in the range of $20-$30k... BUT that means almost all net is going to pay down the debt vs reinvesting in the business.
I know you're targeting more bootstrappers who want to go full time, but if this type of funding were available for side hustle acquisitions I'd probably consider it pretty strongly instead of taking on a bunch of personal risk (even though the rewards for me become less on paper).
Yes, very much consider this our next product. Will build, measure, learn, iterate as we go.
> I used a portfolio loan to buy a business to run as a side project
It's a useful comparison but not apples to apples. There are a lot more capital options to fund an operating business (ie SBA loans, IRA loans) than starting a new one. We are focused on the latter.
Our financial model might be a good fit for acquiring co's but it's not our strategy. Happy to help if anybody else wants to give it a shot.
If I read your agreement correctly, your terms are so that you invest $150k in what is or nearly is a bootstrapped business, on what essentially seems like a profit share basis, and expect to get paid for your doing so until you've made $3M? It's not entirely clear to me what the benefit is compared to a bank loan or VC money if you can get the latter.
Specific to the funding model, we both do a kind of profit-share, with the main difference being that Earnest's repayment will usually happen earlier (assuming the business is successful) but is capped, Tinyseed payments would be smaller in the earlier years and keep growing over time perpetually. Neither one is "better" and I probably wouldn't advise founders to choose between an offer from both on the basis of just the funding model. If you're successful with either model you definitely won't be upset about the details of which model you went with.
No criticism from me. Love the concept and I hope there are more ventures like yours. Quick question: what is your investment criteria? Is a revenue of around $500 but a growth of 5% weekly good enough?
If there was a checklist online that we could tick ourselves before we start talking to you, it would be awesome.
Tyler, I've been very interested in this development and I have a somewhat fundamental question to you.
I've seen a number of VCs and other pundits recently say things of the form "there's a reason why for decades, there were only bank loans and VC and not much in-between". Eg Jerry Neumann (a NY based solo investor) has a nice twitter rant about it here: https://twitter.com/ganeumann/status/1093961051425697794
If I follow the math in his linked blog posts well (eg [0]), he's basically putting down the hypothesis that there's 3 categories of companies (determined by the alpha value of the power-law distribution they're in):
1. Companies where the risk and the upside potential are small. This is where bank loans are focused.
2. Companies where the risk is enormous but the upside potential is "meh".
3. Companies where the risk is enormous but the upside potential is also enormous. This is where VC is focused, and it's why they're all about finding those few big hits because this covers all the losses (or mediocre performance) of the rest.
Neumann appears pretty confident about this hypothesis; not because he can explain the underlying phenomenon, but simply because until now he's not seen much successful funding for companies that's neither VC nor bank loans. And if his hypothesis is right, then you're targeting companies of type 2: investments with enormous risk (comparable to that of a high-growth startup) but at the same time you're hard-capping your upside at 5x. That seems madness.
I don't think you're mad, however, so you must believe that his hypothesis is wrong. If so, why now? What changed in the world, or in the investment landscape, or in technology, that suddenly multiple people (you, indie.vc, etc etc) believe that a low-capped profit sharing scheme for startup investments is a good idea, when nobody did before? Did the risk go down? How did it? Why? Why now and not 10 years ago?
Super interested in any insights you might have on this. Great job, hope you succeed (i.e. I hope to be proven wrong)
* disclaimer: I'm a founder, not an investor and I don't spend a lot of time thinking about this stuff. Ergo I probably misinterpreted a lot of what Neumann is saying. If someone (or Jerry himself) reads this and thinks they know better, I'll be happy to stand corrected.
I like Jerry's work a lot but come to a different conclusion. My basic thesis is that we're in the deployment age of the internet/web/mobile era and there is a whole new wave of a lot lower risk and a bit less reward opportunities for companies to bring the "peace dividend" of the software areas into markets that are not winner-take-all. The upside is these businesses are much more capital efficient, can scale and potentially produce much higher returns than SMBs from previous eras. The downside is they have no collateral and are thus completely unbankable for traditional small business lending. We need a new default form of capital for entrepreneurs and we are trying to build it: https://tylertringas.com/a-new-default-funding-for-tech-comp...
pre-orders? That gives them cash to build what (pre)buyers showed they really want? It doesn’t have to be Kickstarter, per se, could be an academic grant, or a pilot project with an enterprise customer. I have seen this work well - from idea to V1 product without selling any equity. It’s a very efficient filter.
traditional VC model is great for generating scale and creating barriers to entry/competition, but few businesses warrant that kind of scale and fewer use the capital to create real barriers.
Lending is for cash flow businesses - you can have zero hard collateral (eg PPE) but if you have historical steady cash flows, you can get loans, no problem (in my experience). The problem here is few startups focus on cash generation. They are enamored with growth at all cost, aspiring to the VC model when it isn’t appropriate.
The "power law" / all-or-nothing form of VC is really just one flavor of tech investing. It is certainly the most widely discussed, and maybe its the best, i dont know, but there are other successful models.
For ex, many growth equity funds focus on a "doubles and triples" strategy where the risk / return profile is somewhere in between that of a bank loan and VC. They're looking for high probability of 5-7x returns, and low probability of capital loss, for each deal. Theoretically, this "bootstrappers' VC" model can be thought of as a scaled-down growth equity model: revenue-generating businesses in growing markets with potential for near-term profitability
Biotech VC is another good example of a "singles and doubles" strategy generating outperformance. Until the last few years, it was rare for a biotech startup to get to a $1B+ valuation in a 5-7 year venture timeframe, and considered impossible for a biotech startup to become a decacorn in that time period. A successful exit was a ~$500M outcome that returned a 5-10x. These funds have outperformed tech in many cases. See 37:46 here [0]
To build a fund that can return 3x in an environment with constrained exit sizes, you need to focus on consistent doubles and triples: 1) low loss rates, 2) capital efficiency, 3) modest valuations, 4) disciplined investment decisions. I don't know whether the fund math works for this particular "bootstrappers VC" model, but it is certainly possible for a disciplined "doubles and triples" venture fund to perform well
Defer to OP but that feels like bit lazy apologist framework for status quo.
A few (unsubstantiated) guesses at reasons to counter:
1 - Medium risk medium reward opportunities exist (a currently unprofitable but otherwise promising startup addressing a 25m niche can't get bank debt or venture funding)
2 - Could decrease risk holding reward (avg. multiple of investment) constant by having small funds with managers that have deep knowledge of particular niche deploy smaller checks in markets they are better at evaluating (v. large fund managers needing to cast net wider than their "lane")
3 - Size expectation can be correlated with risk. Can decrease risk holding reward (avg multiple of investment) constant by just having smaller funds writing smaller checks for smaller companies that be happy with smaller exits or alt. upside capture (v. forcing companies that could work with small exits into chasing big inflexible exits). Sure no 100x-ers but theoretically could see higher blended fund returns
4 - Opportunities generally continuous on risk and reward calling for equally diverse approaches to capitalization
> 1 - Medium risk medium reward opportunities exist (a currently unprofitable but otherwise promising startup addressing a 25m niche can't get bank debt or venture funding)
I think one of the main arguments in favor of a bimodal distribution of VC and Bank (or high and low risk) funding is that if you are in that middle "medium risk medium reward" zone it can be really difficult to defend your position for any stretch of time. You will be attacked from both bigger players to whom you've proven a market, and smaller players who are willing to take bigger risks to see if they can blow that market up (or bite off a smaller piece of it).
In order to maintain a medium risk medium reward business you need something approaching a monopoly, but also you need the market in which you have a monopoly to be growing and not attracting new players. Maybe some of these exist, but they are very rare and I suspect identifying them is not significantly easier than identifying startups with high growth potential.
So I think skrebbel's question is pretty fair, though I suspect OP has heard it a lot. I would predict that this fund passes on WAY more deals than even a standard VC fund, and will be required to determine the risk of the investment even more effectively. That's a tough problem, and I do really wish them luck!
I've worked at a lender that did loans to small businesses somewhere in between categories 1 and 2.
The major thing that's changed is the availability of data. A $100k loan used to take several hours of expensive analyst time to process manually, and since most would be rejected, it wouldn't be worth it. Now a business can, e.g., securely share real bank account data.
That makes the whole process much faster, which reduces the cost per loan, which makes smaller loans profitable.
I imagine something similar can apply for small business equity.
^^^ Wondering the same. Read the FAQ but still interested in the risk management philosophy.
Also interested how you guys get paid. Did you raise a fund? Are LPs mostly HNWs? Any institutions? Is the investment horizon of the fund similar to a typical VC fund?
And finally, I would imagine your SEA gets negotiated on a deal by deal basis if a portco raises more traditional VC? I'm curious what a series A looks like when there's a SEA in place that hasn't reached its return cap.
It's a fund. Our basic bet is that way fewer companies will fail than a traditional seed VC portfolio (tons of reasons but not forcing them to hit growth targets that they need to show to raise the next round is one). A portfolio of this kind of businesses should be in the top quartile of venture funds (not actually that hard of you look at the numbers) with lower concentration of risk and faster liquidity.
Cool, thanks for the reply. Doesn't look like you have any professional investment management experience. What was the most difficult part of raising the fund? How long did it take?
Full disclosure: I (unsuccessfully) pursued something similar and have exchanged a few emails with Tyler. I’m obviously biased toward being bullish on this as an idea. That’s because:
The usual story and rationale around VC focus and outcomes no longer makes sense (if it ever did). By their own statistics (Cambridge Associates) they’re pretty bad at their job. The power law returns aren’t just applicable to the companies they invest in but to the funds themselves. Mobile atm so I don’t have all the research to hand but up to circa 2011, it is something like 90-95% of funds did not even manage to return the fund to investors. The success of the entire industry came from the same 5-12 firms, who were largely syndicated into the same handful of investments (Yahoo, Google, LinkedIn, etc.). If you were in the breakout success story for that cycle you were a winner.
I’m pretty dubious about the generally accepted wisdom from a group who have a couple of lottery winners among a bunch of losing bets.
That’s all changed in the current cycle. I don’t think that’s because VCs suddenly got better at what they do. I think it’s because the economics of launching a company changed, as did the expectations around traction to raise your first rounds. There are exceptions in some verticals (hardware, med/bio tech, etc) but then vast majority of startups no longer have huge capital outlay just to prove technical viability. They’re not building a fab facility to produce silicon, they’re not trying to iron out how to do that at scale, they’re not dropping $40K for a single SGI server they need to rack. They’re paying very low opex, and depending on access to credits from vendors maybe not even that. For a team with tech capability they need little more than time to actually build the product to actually have something in market. Plug in Stripe or similar and they’re able to prove revenue too.
The net result is VCs are not investing in anywhere near the same level of risk as they were 10-15 years ago. There’s very little investment in a deck full of ideas (you’d need a team with previous track record) and a lot of investment in scaling working products. “Is this technically possible?” risk is largely non-existent. “Can this team build it?”/execution risk is heavily discounted. “Can this scale?” has been reduced to “worst case we can probably throw money at this with a cloud vendor to weather rapid growth”. What’s left is doubling down on sales and marketing.
What’s happened is a period of riches for VCs because founders & teams have leveraged tech advancements to reduce the risk of failure. But the investment industry hasn’t reacted and have instead captured an outsized upside. And I think the 10 year feedback loop for funds probably isn’t helping them to see it (also, what’s the incentive? Why leave money on the table as an investor?).
I see Earnest and similar initiatives as being the competitive response to correct this imbalance. In 10 years you’ll no longer have VC as an expectation to achieve a unicorn (or whatever we’re calling them then) valuation, and whatever investors you have will have an appropriately risk adjusted return.
Hey Glenn. I don't think there's anything wrong with VC per se, but it's no longer a fit for most software businesses (why the best firms are moving to crypto, robotics, AI, etc). We have an outdated association with software company needs capital = VC. https://tylertringas.com/a-new-default-funding-for-tech-comp...
Any idea the total number of investments you are looking to make a year? Handful, dozens?
Is there a limit on the term? Let's say you invest $100,000 in a $3k MRR business. Unfortunately it does not grow, or maybe even MRR declines. What happens to the investment obligation?
There's no limit. If the business stalls at $3k MRR (ie no Founder Earnings) it can go on running forever or shut it down. We would get a % if it was ever sold.
Thanks for the reply. So if after accepting investment, if the company does not work out and has to shut down, is there a personal liability owned back to Earnest Capital by the founders?
Second, can you explain the valuation cap in terms of acquisition. Let's say I take $100k in investment, and 5 years later I sell the company for $10M. What is the max amount Earnest Capital will receive?
Don't think we have the legal infrastructure to invest in Indian companies right now, but definitely could invest in a company that used Stripe Atlas to form a US entity: https://stripe.com/atlas
Hey Tyler! I'm actually super interested in Earnest. One thing I was thinking is, the traditional VC model works in cycles - founders raise some money, build & sell, raise some more, build & sell - by the time they raised $100M hopefully they are at least close to profit.
How does that work with bootstrappers? Ideally they'd only have to raise money once (from you), but what happens after the $100k (example) run out and the business is only generating, let's say, $2k/month? Back to 9-to-5?
Well, yes in some cases. Our goal is definitely for founders to get to personal break-even, where they can pay themselves enough to work on the business full-time, by the time our investment runs out. Some percentage of these will fail (startups are hard) and we're expecting that.
Hopefully, you meet a ton of cool people along the way and we can sort out something cool as a next step that isn't 9-to-5 drudgery tho.
In principle this seems pretty cool, but the gap between what's communicated on the website, and what's actually contained in the 'Shared Earning Agreement' [1] makes me concerned this might be good marketing on a fundamentally predatory investment agreement. This could very well be a completely unintentional idiosyncrasy, so I don't want to be too accusatory, but the implication of the terms needs to be laid out more clearly on the website, if this is simply an oversight.
The single biggest red-flag is the fact that the equity stake vests in company sale or priced-raise as unpaid return cap (a multiple of 3-5X investment) over valuation cap. What this essentially means, is that in the scenario that you raise more money or sell the company before you've paid off the 3-5x multiple of the investment, then the investment essentially vests as if the valuation cap was 3-5x lower than what it was actually set at.
This probably seems abstract, so I'll make it vividly clear with an example. Let's say you raise $200k on a $2 million valuation with a 5x return cap on an SEA. Business goes well, a year or two goes by, and you either sell the company or raise more capital at a $10 million valuation, having in the interim say paid off $200k of the agreement from earnings. With 4x still outstanding. Suddenly, likely to your surprise, that $800k (4x investment amount) vests into equity—at the $2 million cap from the original agreement. In other words, Earnest Capital suddenly, to your surprise, owns 40% of your company. If you hadn't monetized at all and paid any off, this could be a full 50% stake.
Even if you run the numbers with the more conservative numbers in their document—is it clear to people that a $150k investment at a "$3 million" valuation could convert to a 15% equity stake in your company?
I'd love to see how this could be revised to address this issue, and I'd love to see the website more clearly communicate the equity implications. As of now, I can't help but feel that this is double-dipping, predatory investing, that is getting heaps of praise on HN due to clever marketing around tapping into the trend of anti-VC and indie-hacking, that will ultimately lead to some very frustrating experiences for first-time entrepreneurs that didn't fully comprehend the terms they were agreeing to.
Tyler—please prove me wrong and fix this thing. Or, since IANAL I may have completely misunderstood the document, in which case—screw me, my apologies—but please explain how it actually works :)
FWIW, there are other alternatives for entrepreneurs to get financing without giving up equity. MainVest offers Revenue Sharing Notes (RSN) and Equity-alternative Revenue Notes (EaRN) through Reg CF crowdfunding. Here are some examples of how they work:
RSN:
A $200,000 RSN that matures in 5 years and 5% of revenue is paid back quarterly until a total 50% return (i.e. the "cap") has been hit. In this example, the business is expected to pay back a total amount of $300,000 by paying 5% of their revenue to investors over five years. If at the end of the 5-year period, the $300,000 has not been paid, then the business has to pay the remaining balance at that time.
EaRN:
A $200,000 EaRN that matures in 10 years and 5% of revenue is paid back quarterly until a total 25% return (i.e. the “cap”) has been hit. Upon reaching the “1.25x cap”, the company then pays a smaller percentage (e.g. 2%) on revenue until the maturity of the EaRN is reached.
The entrepeneurs set the terms of their offering and investors in their community decide whether they would like to invest.
Some comments below are talking about a 9.5% "residual stake". But I don't have a clear understanding of how it works, and would definitely appreciate some clarification before I apply.
I'm strongly considering TinySeed, Indie.vc, and now Earnest Capital. It's hard to navigate all of these terms and weigh the pros and cons. At the moment I'm leaning towards TinySeed because of the mentorship and community in the accelerator program. It sounds like Earnest Capital is more "hands-off", but it also doesn't take any equity (unless you raise more money or sell the company.)
All the exact terms are negotiable. We make a spreadsheet available for any founder to run these numbers before doing a deal. Hyper committed to transparency and educating founders to make sure they know what they're getting into.
I will readily admit that if founders intend to raise multiple rounds of follow on equity (VC style) we will not be the most competitive form of capital for them.
That sounds good. So long as founders are aware of all the implications, then there's nothing wrong with any particular arrangement. I would be careful about a structure potentially disincentivizing growing a business faster, though. One really simple consideration that requires no tweaks on the current agreement I think is just setting a higher valuation cap, that's still around where if one was to raise additional capital due to rapid growth, they would expect to raise at. For example, on a company worth $3 million perhaps the cap should be more like $8 million. Alternatively, change the terms so that the equity basis cannot be greater than the invested amount at the valuation, which I think is the intuition most founders would have, while still providing substantial upside and downside protection to investors—who get both a loan-like repayment multiple, and in the event of a rapidly growing startup, a normal seed-valuation-based level of equity. Having the downside protection of the return-cap re-payment, as well as an equity conversion of potentially multiple times a normal seed valuations on the upside, seems to be inherently bad terms to me. Of course, if it's the only capital you can get, and you'll die without the capital, it's better than nothing. But, there's a lot of offerings out there, as well as the option to not raise, so I'd be concerned as a limited partner that the only entrepreneurs willing to accept such terms were self selected in an unfavorable way, and thus despite the aggressive terms would quite likely still receive poor returns as an investor.
There's also seems like there may be a bit of contradiction of messaging here. The messaging is like, "Take this capital, grow a business at your own pace and pay us back a multiple of what we give you as you can.", yet in the case that a company is doing very well and growing fast, and can utilize more capital or sell, instead of having normal equity terms on invested capital, the agreement turns around and says, "Oh, and by the way, we own a huge multiple of the investment as equity now." This seems highly inconsistent to me, as if you're really expecting the majority of your returns to come from these 3-5x return caps being paid off from earnings, why would you have a provision to take such an aggressive equity stake in the companies that end up doing particularly well and go on to raise or sell? Like, it seems to me such terms suggests you expect to make the majority of your returns from equity, which is not what's being communicated. I could also be over-estimating your interest in startups that may ever go on to raise more capital or sell, but I think there's so much uncertainty in starting a company, that it's not really reasonable for a founder to know if at some point in the next few years that the best thing for the business might be to raise or sell, as it depends on the state of the company and the market. This agreement as currently drafted, without proper high-cap or other considerations mentioned above, could too easily disrupt future optimizing for the best outcome for a business.
Just wanted to thank you for doing a deep dive into this with all your comments. This certainly changes equation and potential payout of their perhaps oversimplified messaging of simply getting 3-5x returns, but not knowing that the founder is in a gridlock situation if it makes sense for them to raise more money. I can understand how if a business required more money just to sustain business and keep it alive, then converting to equity makes more sense for additional perceived risk that more money was required to sustain, however it's odd that that mechanism would also then more act as a penalty for the more successful businesses - and definitely is turn off.
3-5x return cap sounded super refreshing - and almost like a dream come true, however assuming they're good judge of characters and select well, then I could see them pulling off a very successful investment protocol. I may still contact them to see what their intentions are and what expectations/agreement may be possible.
Would it be legal for the startup to take a loan of $800k and just pay off the remaining balance? Then EC gets their 5x, and you keep your equity? (Probably the new investors would see the advantage of this)
IANAL, but it's ambiguous from my reading—leaning towards no, not without them accepting. The reason being that the reduction in the 'Return Cap' is through a quarterly pay-off-mechanism as a percentage of earnings, set out in the agreement. There may be case law or general legal precedent that requires them to take your money if you wish to pay them off, but a literal reading of the agreement in a vacuum doesn't suggest to me that they have to take your early payment. There is precedent for things like car loans or mortgages or w/e, where there's a penalty for paying off early (They want to keep milking you for interest). So, without an explicit provision I would assume you cannot pay off the return cap, except through the set percentage of earnings per quarter.
It's relatively easy to write terms that (a) allow something like this to adversely affect us if done on good faith over the normal course of business and (b) prevent founders from doing this maliciously to engineer more equity in the event of a sale. Our final deal docs go into this.
I just read through the terms in the SEA, and I think you're right about how it works out.
I guess this is an "escape hatch" for companies that start off independent, but then change their mind and decide to pursue traditional VC funding.
YC invests $150k for a 7% stake, with the expectation that you will raise 7 figures and aim for a billion dollar exit. You won't get accepted to YC unless you can convince them that you're aiming for a unicorn. =
I think it might actually be fair to penalize a company if they say they are going to build a sustainable, profitable business, and then they change the rules by aiming for a unicorn. Earnest Capital would be taking on a lot of risk that they didn't ask for, because moonshots are extremely risky compared to a small profitable business that can grow at it's own pace. The founder gets to go for a moonshot and spend all of the money, and they'll likely go bankrupt because moonshots are extremely risky. And if they succeed, then Earnest Capital only gets a $450k return from a billion dollar company. A VC expects a 10x to 30x return for this kind of risk ($1.5M - $4.5M.)
Also the return is capped at 3-5X, so I think these terms are pretty good for the founder. A business loan would be better, but it doesn't come with any mentorship or accelerator program, and I personally won't be able to get one because I live in Thailand (although I have a US company.)
This would be give me a really good boost so that I can pay for a few big projects that I couldn't otherwise afford (redesign, increased marketing budget for ads and newsletters, audits and certifications, and a few features where I could hire some contractors.)
TinySeed invests $120k in exchange for 8-15% equity. So that's like Earnest Capital + immediate Equity Conversion.
The equivalent for Earnest Capital might be a $75k investment with a $3M valuation cap. (75000 * 3) / 3000000 = 7.5% equity if you sold or raised more money without paying anything back. 2.5% if you have less than $75k remaining, and 0% as soon as you reach the return cap. I think that cliff is a bit weird. Earnest Capital would have 2.5% equity even if you only had a single dollar remaining until you reach the Return Cap, then it immediately falls to 0%. I think it would be better if there was a gradual drop from 2.5% to 0% as your remaining payment amount goes from $75k - $0. If I apply, I might ask them to change this term.
I would also like to know if it would be possible to buy back shares from the TinySeed investors. I didn't see anything about that. But for a small sustainable company, I'd honestly be happy to just pay myself a reasonable salary, and pay some dividends from time to time. 8% wouldn't be too bad.
EDIT: Just thinking some more. It would take so long to pay back this Earnest Capital loan! If your company gets to $10k Founder Earnings per month, you'd be paying back $3k * 3 = $9k per quarter, or $36k per year. Even if you only took a $75k investment, it would take you 6.25 years to reach the $225k cap. It's sort of like golden handcuffs, where you can't sell or raise any more money without giving away significant equity (and you would be better off with the TinySeed deal.) On the other hand, if you can get to $10k by the first year, and $100k by the second or third year, then it would be repaid very quickly. ($360k per year).
I think I'm leaning towards TinySeed. But it's hard to weigh all the pros and cons.
I was very excited by Tinyseed. However, I didn't quite like the model. I inquired about a model similar to this and it was declined. Fair enough I thought.
Now this comes along. Definitely sending out an email! Pretty excited to be honest.
The thing is, this category of "not VC" is actually like 99% of all businesses. There's going to be a ton of diversity of viewpoints and alignment and I think it's good lots of folks are trying out different models. Not even clear to me that there will end up being one "best" approach over time.
Anyone helping early stage startups is doing god's work as far as I'm concerned. Technology is what pushes the world forward and anything that helps that is, with limited exceptions, a very positive thing.
My questions/comments/criticisms after a brief look, please correct me if I'm wrong:
1. It funds startups that already have growing revenue, which is fine, but that's the hardest part by far. So it might filter out all of the best startups who can just choose to grind it out a few more months, having already overcome the biggest hurdle. Taking the calculated risk of funding startups that are pre-product/market fit is where the real magic happens.
2. It's legally complicated which means a smart founder would definitely want a lawyer (unlike SAFE), which could be quite costly. It could (potentially) scare off future investment as well.
3. It converts to equity (optionally, which seems scary) to a hefty ~10% valuation, which is more than YC takes in exchange for a much, much better deal because they all but guarantee successful startups will raise a large amount of money at a very high valuation. In effect this costs a startup maybe 3-10x more than YC on the VC route.
4. Like TinySeed, I think it also ignores the inescapable fact that startup investing is a hits-based business regardless of what anyone wants it to be. One out of 50 investments is going to be worth more than the other 49, so it makes sense to align interests with reality. By focusing on getting paid from the biggest winners, you can afford to be much more generous and high-minded with the rest.
5. Also like TinySeed, it doesn't seem to account for just how high living expenses can be for founders with families, etc. Having to negotiate with your investors about paying rent is going to feel a lot like having a boss, which could be very demoralizing for founders. YC is extremely careful not to make founders feel like employees for good reason.
6. Having to negotiate the amount of investment also seems less then ideal. Knowing exactly what the deal is would be much better than having to haggle as the start of the relationship.
7. Wildcard: have you considered evolving this into an ICO-funder for startups? Equity crowdfunding with an initial seed investor seems like a huge idea.
I applaud the effort and hope it becomes huge. I wouldn't bother commenting if I didn't!
Unfortunately, after further analysis, my suspicion that this is a very bad deal for founders seems to be true. A founder would have to be desperate and ignorant to take this deal, and no one deserves to have years of hard work wasted by taking a predatory deal like this.
I hope they fix their terms but based on how misleading they've been, I would never personally do business with this person.
I always feels it's disingenuous to say you don't take equity if you ask for warrants or other % of the upside - it's essentially a proxy for equity. When you factor in a 3-5X cap, PLUS warrants - this doesn't seem like a better deal than something like Lighter Capital which has a smaller cap and zero warrants.
Not necessarily, equity and loans both have conditions around them. Sometimes loans are more punitive than equity. Taking common stock has almost zero downside for instance, it's when you get in to preferred equity and the rights that come along with it that you can get in trouble.
"In most cases, we’ll agree on a long-term residual stake for Earnest if you ever sell the company or raise more financing. We want to be on your team for the long-term, but don’t want to provide any pressure to “exit.”"
This seems to imply that they get a % of an exit or future financing even once the cap has been reached. That is functionally warrants right?
Once Return Cap is fully repaid the founder can run the business profitably forever and not pay us anything more. We do typically prefer an option for a % only if the business is sold but can do a deal (with a higher Return Cap) that excludes this easily.
A "minimum viable product" can raise the range of capital discussed on the FAQ via crowdfunding (Kickstarter, etc).
Not every product category is suitable for crowdfunds, but for those that are, a successful Kickstarter campaign is also an effective marketing launch, worth a small fortune by itself.
We have yet to find a funding model where products don’t turn to shit after the companies that raised hundreds of millions of dollars don’t meet their promises made to VC.
MongoDB is a great example of a company shooting itself in the foot because they don’t meet the promises of growth and profitability the market is expecting.
This fund is a great potentiel for dev tools and deep technology that needs only a tiny amount of capital at start and then can remain profitable with SaaS or Consulting.
This model would be somewhat unacceptable for VC because they expect every company they fund to go public and cash out right after with 100% YoY growth , otherwise you’re not a good investment.
Wow, I don't think I heard that MongoDB had an IPO and that they were worth $5 billion. Maybe I was on vacation when the IPO happened, so I wasn't checking Hacker News, because I'm sure I would have remembered that. All I see on HN is horror stories about MongoDB, or posts about migrating from MongoDB to Postgres.
Awesome to see innovation from capital providers on the instrument in the wild. As a niche market founder wish option like Earnest existed when we were raising early financing.
Curious - to extent you're willing to share - what dynamics are like for LPs (assuming raising outside). Since median vc fund return is barely 1x, and traditional VCs sometimes blow up otherwise good niche companies by forcing them to go big or bust, targeting 3-5x returns with way faster liquidity for investors a super interesting alternative.
And if the niche market turns out to be a massive market, can still go in with eyes wide open!
> As a niche market founder wish option like Earnest existed when we were raising early financing.
Can't tell you how often I hear this.
> what dynamics are like for LPs
Can't really say much on this because SEC. But yes, being better than the average VC fund (not to mention better liquidity and lower concentration of returns) is not a high bar IMHO.
Do you believe there will be an industry of similar funds 5 years from now? If you're able to share, what is Earnest Capital's return profile? Do you have LPs?
Because very few lenders will lend to a business at this stage (relatively little revenue and short operating history), and the few who do will require a personal guarantee and/or personal collateral.
That is, if the business fails, or does okay but doesn't become large enough to service the debt, the founder still needs to pay the loan back. For all intents and purposes, a business loan with a personal guarantee is a personal loan.
That's not true of these terms. If the business fails, the founder doesn't personally need to repay the investment. If the business grows but very slowly, the founder still decides how much to re-invest in the business.
(Also, at the interest rates you mention, such a loan would be no different than taking out $100k in personal credit card debt to fund your business. Yes, someone could do that, but it has some very significant downsides.)
From a quick read of their agreement, it seems like the payments are only made when you are actually making a net profit, whereas a traditional loan would require mandatory payments or interest would accrue.
This seems like a middle-ground that is better suited to starting up companies that most likely won't be unicorns. They only get paid once you get to a "comfortable" spot, financially.
Another consideration may be that in the event of business failure, you'd still owe money on the loan but the Shared Earnings agreement would essentially go away since the business is no longer viable. Not sure about this, but this is what I'd imagine would be the case.
But it seems likely to me that their 'investment decisions' are going to be made based on a run-of-the-mill small business credit model which will be heavily revenue focused.
We're more of a substitute for seed equity. Or at least that's the lens through which we have structured our terms and strategy. Most of the co's we are looking at would not be able to get a small business loan (zero collateral, very limited financial track record by debt standards, etc)
If the loan in to the LLC then the loan would also go away if the company fails. The difference is primarily the deferred payments in case of non-profitability.
Acquiring a commercial loan to your LLC with reasonable rates without a personal guarantee is extremely difficult. In all likelihood, a small business is going to have to make a personal guarantee to borrow money.
The business loan is slowing down your business no matter what.
Earnest only takes their return once you're in the position to pay yourself a salary. If you reinvest everything in the business, they don't get anything.
Yeah, sure. Just seems like paying a bank 20-30% per year is a way better deal than slowly bleeding 200-400% back to Earnest. You're paying WAY more money (read: 10x) for a more flexible payment schedule.
I don't think you understand how interest rates work.
If you look at the repayment schedule in the model, you'll find that Earnest ends up being CHEAPER than 20-30% without the personal guarantees required by a bank:
At the stage in which they're investing, a bank loan will generally be secured against your personal assets, whereas the money from Earnest is not. If you raise money from Earnest and your business fails, Earnest loses their investment. If you raise money from a bank and your business fails, you may lose your house or declare bankruptcy.
At the risk of not answering the question, I'd say no form of capital is "better" than any other. Capital is a tool and the job of the founder is to find the option (both on payments term and other aspects like mentorship or personal exposure) that best aligns with their goals.
Sure, I mean different forms of capital are better in different circumstances. So in which circumstances is the form of capital you're offering better than a 20-30% APR business loan?
We are mainly focused on the early stage when a business loan (ie no personal gaurantee) isn't an option. I went the route you described (racking up $50k credit card debt) to launch my SaaS business and it sucked. That said a business loan could be a great option for more mature businesses with solid cash flow (hopefully at much less than 20-30%!)
The short answer is if your financials are good enough to qualify for a business loan without a personal guarantee, which means you have revenue high enough to service the debt, then that's great.
My guess is that Earnest is investing more money, at a much earlier stage, than when a business loan without a personal guarantee would be available.
Rob Walling is launching something a bit similar (cannot remember the name right now). But it's aimed at bootstrapped starters who aren't planning a unicorn billionndollar exit.
Why is this now a model? Too much cash chasing too few unicorns ? Too much money lost on unicorns that cannot fly or a realisation that chasing unicorns leaves herds of perfectly good horses untended?
I'm a (tiny) LP in TinySeed (Rob's fund), another effort with similar thesis, and am broadly supportive of these experiments generally.
Speaking solely for myself, but gesturing in the general direction of my peer set: there exist some software entrepreneurs who have substantial operational expertise and have made some money, but who do not feel like they'd add much value in the unicorn hunt, partly due to access reasons and partly due to different skills. There's a distinct body of practice between e.g. the things a YC partner would tell you to do about fundraising, the things a growth stage VC fund would tell you to do about organization building, and the things a self-funded software founder would tell you to do about e.g. testing AdWords copy. There is a certain degree of overlap, in the same sense that all of them overlap someone whose business model is buy-and-hold apartment buildings in Chicago, but there is a reason none of them buy-and-hold apartment buildings in Chicago.
By comparison, I feel reasonably confident that "six figure SaaS business trying to get to seven" is somewhere I understand pretty thoroughly, would almost always enjoy a conversation with that founder, and (napkin math) looks plausibly mutually interesting.
Why now and not five years ago? It feels like a generation-of-business thing: the reason everybody who made money at Google / Facebook didn't invest five years before they started investing was because they hadn't made money at Google / Facebook. Did the opportunity exist five years ago? Probably, as evidenced by the successes from that generation. Is the opportunity better now? Plausibly yes, as demonstrated by all of the people who were successful writing down what they did, doing technology transfer on that to new operators (often for free), the ecosystem radically improving (inputs, platforms, employees, exit options all got a bunch better), etc.
probably a loaded question (so I apologise?) but why are you reasonably confident for growing a 6 -> 7 figure businesses? what about 7 -> 8 figure busineses?
context: i ask because i have this problem right now and find this is a harder hurdle (trying to double a 7 figure business without VC money)
My history is 3x 7->8 and 1x 8->9, 3 with VC, 1 with no VC...we definitely found it easier to go 6->7 in all four as the “early adopter” set all talked to each other and that was enough to get momentum and small enough that bigger players take no notice. 7->8 you start to get noticed which is both good and bad. Convincing enough buyers to “cross the chasm” and not go to a competitor is an entirely different org challenge. Also the expectations of the larger buyers adds cost and complexity (ie channel sales vs outbound vs inbound)
If you are in SF area happy to host 7->8 beers/coffee meetup!
interesting background you have there and yep, i agree on that it is an entirely different challenge trying to restructure the business to handle the bigger spending customers.
If anyone is looking for a blog post writing prompt, I would love to see something written from a founder's perspective breaking down when one should consider this form of funding, vs. YC/VC, vs. "grinding it out" and continuing to bootstrap. Or taking personal loans, etc. This could include some analysis of the total cost of each option, the benefits, etc. Specify numbers about you should use X amount to pay your own salary, Y to hire people, Z for marketing/other spend, etc.
I think the YC/VC pre-market-fit-hoping-for-billions model is well understood. But I find it difficult to understand when a bootstrapped cashflow positive business should consider any of these options. If one has a bootstrapped side business making $X/mo and a job making $150k+Y per month, when should one go all in on the business?
They do take an equity stake but it only converts in a future funding round or acquisition. If you stay independent forever they can't provide any pressure. This is basically like normal equity but a weaker form I guess.
Yes, by default we don't take equity (shares, board seat, none of that). If you decide to raise a round of equity financing (ie VC) we could convert into equity alongside them and if you sell the company we get a % of that. There's a spreadsheet here that lays it out: https://earnestcapital.com/shared-earnings-agreement-digging...
Honestly, this looks perfect for my case, I am too early for Indie.vc for example, but overall, I love what is happening in this space. Pretty much, you get to prove your business model somewhat and you will get support. Most of the time, this will result in much better growth and focus, and few of times things don't work out, it will not be as often as it would be without business being proven.
I really like this concept. First Investors often face the follow up dilemma when they cant join a follow up round and get squeezed out with much a lower valuation. Am I right that this wont happen to you because your earning share is basically just a position on cost side? Or could that even be an obstacle for follow up rounds?
Do startups that raise from you tend to have other investors come on at the same time? If so, do they use similar terms or something completely different? If this doesn't happen now, would you hope that it would in the future (that is, that people would want to follow a round led by you)?
Income Sharing Agreements are super interesting. Definitely an opportunity to building a SaaS for managing agreements from contract to facilitating the payments over the lifetime of the agreement...
Not really either of those. A closer version would be profit-share + a SAFE. The primary function is for us to share in the profit (or more specifically "founder earnings") of the business alongside the founder(s). If you sell the business or decide to raise a big equity round later, we convert a lot like a SAFE.
Founders should def consider all their options. It's very much not a loan though. There is no repayment schedule (we get paid as the founders generate Founder Earnings) and there's no personal guarantee. On average I think it's more likely that we would fund a business earlier that might use a number of cool new debt products to continue growing once it hits a level of revenue and business maturity.
Thanks a lot for mentioning OnDeck and Kabbage! I hadn't heard of these, and I didn't realize I had some other options for loans. I'm working remotely on a US startup, and some additional capital would be really helpful, to pay for a redesign and some contract work.
EDIT: Ah, I live in Thailand, so I probably won't be able to get a business loan through these companies. (Even though my company is a US C-Corp.) Also I probably don't have enough revenue yet.
Both of those require 1+ year in business and significant revenue. So yes, this is definitely a loan and it has relatively bad terms but it's targeted at businesses with no credit.
