How to become an investor at Earnest Capital

This is a post about how to become an investor—someone with the authority to write checks— at Earnest Capital.

We like to build in public, so there are unfinished parts of this roadmap. I’m hoping smart folks will weigh in and help us figure them out.

The on-ramps to investing (or lack thereof)

There are essentially no on-ramps to becoming an early-stage investor. This is a problem. Venture Capital is notorious for the fact that all jobs—analysts, associates, principals, and a wide variety of other made-up titles—that aren’t “General Partner” or GP (a) don’t have any actual authority to write checks and (b) having no pathway to go from any of those roles to a GP that can write checks.

GP roles are almost always filled via closed networks. Open spots are almost never publicly announced. This year one prominent fund made the (hailed as ground-breaking) decision to publish that they had an open role for GP. It was… an event in the industry, with Twitter erupting in applause for the progressive thinking of just posting the job opening.

This lack of accessibility of roles that actually make investing decisions is a root cause of a lot of the problems in early stage funding. We can do better.

Funds as personality cults (or not)

Some investment firms are cults of personalities. The quality of the fund is all due to a few brilliant partners who make all the decisions and generate all the returns. Usually, this goes hand in hand with a pseudo-mystic investment thesis where the partners are trusting their finely tuned gut instincts by looking in a founder’s eye and assessing the confidence of their handshake.

That’s… not at all what I want for Earnest Capital.

In the long-term, I want Earnest to be powered by more than my own decision-making. Earnest should be a platform that can outlast and outgrow my own particular point of view.

But recruiting folks to come and join the fund and giving them the keys to the check-writing kingdom seems incredibly difficult for a number of reasons.

  • First, it’s kind of like recruiting a co-founder 2 years into the business. Starting-up a new fund is an incredibly long-term venture. The pay sucks for GPs and the carry is all many years into the future. So you’re starting off with the challenge of finding someone super-talented who wants to work for peanuts plus the upside in your original vision.
  • Second, it seems very difficult, and honestly, I haven’t figured out a way, to just interview for the skills that you are looking for in someone with ultimate investing authority.
  • We are at a unique disadvantage here because essentially nobody is investing using our thesis, so there are no angels out there with a lengthy track record of personal successful investments as proof points.
  • So the only thing I’ve been able to come up with also happens to be my favorite way to hire folks: create a structure for them to just do the actual work of the job, and pick the ones who prove they’re good at it.

How to become an investor here

One of the main reasons we publish our thesis in such level of detail is to turn it into a toolkit that others can use to assess companies as possible investments. We’ll be refining these in more detail but you can already dig into:

In 2021 we’ll be launching a super-charged scout program (cool name TBD) to allow anyone to apply our thesis and make a strong recommendation for a particular investment. To date we haven’t had a formal scout or referral program because honestly we get enough inbound from founders and don’t need any email intros. But I don’t just want introductions. I want well-vetted opportunities with a well thought out investment memo.

We’ll provide an investment memo template and a dedicated way to submit them.

In the short term, we’ll give you meaningful upside in the companies you scout that we approve investment in…

< Here’s where we need some help and your input >

I’m looking for suggestions on exactly how to structure this. There seem to be three broad approaches, and none of them are all that great. So the typical Earnest approach when there are some default options that we don’t like is to think it through from first principles, in public, with the community. The three basic approaches are:

  • 1) Cash incentives. 

The challenge here is to offer something that is high enough to be a real incentive to motivate real diligence work, but that could scale to a meaningful amount of our investments coming via scouts without us going broke. Many folks I’ve talked to have said 10-15% of the investment amount seems fair (so on a $250k investment, $25k – $37.5k scout fee). This seems about right in terms of incentivizing scouts, but it creates an incentive not to scale it up since, at the limit of 100% of deals being scouted, we would be looking at a substantial majority of all our management fees (currently 12.5% of capital) going to scout fees

  • 2) Co-investment.

We could also offer room on the cap table to co-invest, or invest directly on behalf of the scout, so that scouts get the upside of the investment they recommend. This is definitely something we want to support but it has the same drawbacks as cash incentives and additionally we are constrained by accredited investor rules that probably would not allow non-accredited investors to invest.

  • 3) Deal-specific carry-sharing. 

This is an arrangement where instead of getting any direct benefits at the time of investment, the scout gets a slice of the “carry” or upside/profits that come back from that specific investment. The big upside here is that this scales really nicely, since it doesn’t have an upfront cost, and also is the best alignment of long-term incentives. The downside is these arrangements are complex to structure and difficult for scouts to understand what they are actually getting. The main challenge is a fund cannot share carry it doesn’t have and carry is calculated at the fund level. Specifically, a particular scouted investment could do well, while the overall fund does not generate substantial carry (returning all of the investors’ capital and then multiples of that in profits). There are big questions about who bears that risk, the fund or the scout, how to structure any kind of catch-up payments, as well as how to prorate the scout’s proportion of the carry (proportional to the initial investment, magnitude of the success, or something else?).

If you have strong thoughts or good examples to share, I’d love to hear them at tyler@hey.com

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It’s important that we get the incentives right here, but the point of this program is not just to incentivize scouts to send us more opportunities, it’s about building a track record of making real investment recommendations.

In the long term, this is how we will empower more people other than me to write checks from Earnest. Sourcing and vetting opportunities, and making the compelling argument to invest in them is doing the work, so scouts who do this consistently well will be the ones we prioritize to allocate a portion of the fund for them to invest directly under a specific thesis.

We will start building allocations into our funds allocations to be deployed in batches to the most promising scouts to start part-time GP’ing, serving as and a roadmap to full partner status. That’s it. No special tricks, just an opportunity to do the work, get upside in some companies you feel strongly about, and mutually decide if being an investor at Earnest Capital is the right move for you.

Some practical details

The best way to stay in the loop as we roll this out is to subscribe to our investor-focused email list.

Subscribe to the Investor email list here

Scouting will be available to all Earnest team members and investors. Beyond that, we will need to pre-approve scouts to submit deal memos so we’ll be sending a short opt-in/application form to that investor list above.

We are targeting Q2 2021 to open the pilot version of this program with scout allocations starting to come out of our Fund III which kicks off the first quarterly subscription window in Q3 2021.

There’s no way around this, and I apologize to unaccredited folks, but being even a small LP in our funds and getting the behind the scenes look at our investing decisions, will be an unfair advantage, so that’s something to consider.

Here are some areas where I’m especially interested in seeing investment memos:

  • highly technical products that would be difficult for me to personally diligence (developer tools, next-gen programming frameworks, practical applications of machine learning)
  • software or other capital-efficient businesses in highly regulated industries. We have mostly shied away from products operating in highly regulated industries due to the extra diligence required to understand the regulatory risk. If you bring particular experience in a regulated industry and can help us more effectively diligence those regulatory risks and frictions, I want to hear from you.
  • e-commerce, marketplaces, and other non-SaaS business models. The center of gravity in Earnest has been B2B SaaS, in part because I think it most strongly aligns with our thesis, but primarily because it’s where my personal circle of competence is strongest. I’m certain there are great opportunities in non-SaaS businesses that I’m missing but will need a partner with deep experience there to help me think them through
  • content & creators. I think folks building paid and ad-powered newsletters, online courses, communities, and other membership products can become phenomenal and profitable businesses. Earnest should be backing a lot more of them.

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