Earnest is introducing a plan to share at least 20% of carry (profits) with our team, early investors (LPs), and other stakeholders who help us succeed. This is Earnest so we’re doing it differently and we’re going to tell you how and why we’re doing it that way. I’d also love thoughts and suggestions for how we can make this better before we finalize it.
What is Carry?
Carry is the primary incentive for the owners of funds in venture capital, private equity, and new weird investors like Earnest. Our business model is to raise money from other investors (LPs), invest that money in entrepreneurs’ companies, get money back from the companies via profit share (Shared Earnings) or a portion of a sale of the business, return more money back to our investors than they gave us and take a slice of the profits: the net amount of money we returned to our investors above what they originally gave us. The typical amount of this slice (and the one we use) is 20% which, fun fact, dates all the way back to the financiers of risky whaling voyages who used to take their cut as 20% of the returning whale… blubber, I guess?… which they “carried” off at the docks.
While funds do take management fees to cover their cost of operations, and sometimes those fees do get outrageously high, the primary incentive for funds of our size is the potential for millions of dollars in carry if we do our jobs right and our portfolio companies succeed.
Carry, or the right to receive it, is essentially the “equity” of the funds business.
Why share it at all?
The way most funds are structured is there is a management company owned by the Managing Partners or General Partners (GPs). The management company is the actual business that manages each fund, pays payroll, etc. Each time a new fund is formed, the management company is the one that gets any carry (profits) from that fund, which is then split among the owners of the management company. In our case, Earnest Capital LLC is the management company and it’s owned just by me as the sole founder. So by default, and from the start of Earnest, all carry from all funds goes just to me [insert scrooge_mcduck_swimming_in_money.gif]
So technically, I (and other fund owners) don’t have to share the carry with anyone but there are some really good reasons I want to:
- Growth Trajectory: Earnest is a lot more like a startup than a traditional established fund. We’re doing new ground-breaking stuff and if we do it right there is a huge market of entrepreneurs who want to build modern, profitable, technology businesses to invest in. To do that we’ll need to break through successive bottlenecks which include building a bigger team and getting a ton more capital to invest in entrepreneurs. By giving folks a slice of the total long-term profits of Earnest Capital, they become incentivized to help us grow and meet that trajectory.
- Long-term Alignment: With everything from the Shared Earnings Agreement to ‘skin in the game’ mentorship, we are obsessed with creating a strong alignment of incentives. Sharing carry helps everybody look beyond just this moment and just this fund toward our larger vision. I recently tweeted our 10-year vision and I want everybody in our orbit on board to make it happen.
- Reward those who bet on us early: Getting a new fund, let alone an entirely new model of investing, off the ground is very hard. It takes early backers who believe in your vision and put their money in your hands to build a fund. But those early investors (or Limited Partners/LPs) only see the upside of their actual investment in the Fund 1, Fund 2, etc. If they end up being the catalyst that gets Earnest Capital to managing $100s of millions and backing 1,000s of entrepreneurs per year, they don’t see any benefit. Giving them a slice of the carry (I think appropriately) rewards that bet they made on us. We’re offering carry sharing retroactively for our Fund 1 as well as for our current Fund 2. Future funds are TBD at this point.
Structuring the carry sharing
It works like this:
1/ I’m committing at least 20% of the carry/profits from all Earnest funds to a pool (code-named Carry Corp, though it’s not actually a separate entity). It’s 20% now but could increase over time.
2/ Various stakeholders can generate credits for doing certain things that we will lay out shortly in specific detail. Examples would be working one month in a certain role might earn you so many credits each month, investing in Fund 1 or Fund 2 as an LP might earn your so many credits per $10k of investment.
3/ These rates are reset by Earnest management each year and will change. So working in a given role this year might have a different credit rate than 3 years from now. Generally doing the same thing but earlier will generate more credits
4/ You keep these credits indefinitely (there is some chance we may have to have some kind of cut-off date for administrative purposes but call it 20+ years)
5/ Whenever Earnest Capital starts to receive carry, we do some simple math. 20% goes in the pool and then everyone gets their proportional slice based on their credit ownership in that year. So in each year:
Total carry to Carry Corp * (your current total credits / all credits outstanding) = your carry share check.
What are the exact numbers?
We’re still working on that. Since this sets something in motion that could have implications for 20+ years we want to make sure we’re modeling the numbers really well and aren’t missing any key considerations. Hence publishing this and discussing with the Earnest community first.
Why this is a good structure
Big tip of the hat to Michael Grosser for originally proposing this idea and helping me think through the math and incentives.
We think this is particularly good way to structure incentives in a fund (though if you think it’s bad, I want to hear it). here’s why:
- Early work is rewarded by the different credit earning rates. Backing us in Fund 1 for $100k counts for more than the same amount in Fund 2. Working 12 months in the same role in year 1 earns more than year 5.
- Built in dilution: many carry sharing agreements are structured as a fixed % of carry in perpetuity. This is weird because now you’re drawing down from a fixed 100% pool. The Carry Corp model recognizes the early contributions and you get to keep them indefinitely, but as the team grows or new LPs join, the pie automatically grows to accommodate the larger pool. Want to keep your proportional share of credits? You have to keep pitching in to earn more.
- Automatic vesting: by structuring credit earning as a monthly we don’t need complex vesting structure where we allocate you a big chunk and then claw back most of it if you don’t stay for 4 years. You come, you earn some credits, and if you leave you keep them. Easy.
- Liquidity: This model bypasses all the complexity of options. There’s no need to exercise them, no huge bill you have to pay to convert them when you leave, no ongoing uncertainty of whether they’ll ever be liquid. Profits come in and you get a check, the end.
- Just profits: this method is a lot simpler than actually giving a ton of people ownership in the fund which has all kinds of complexity. Everybody gets the upside in a straightforward way but ownership and management stays streamlined.
- Broadly Applicable: the credit structure can be used to reward all kinds of efforts not just team and LPs. We have some plans to expand that group in a small way below, although you of course have to be careful to have too many people splitting the same pot. Although it can easily be augmented by just allocating a greater percentage of total profits to Carry Corp.
Who gets this at Earnest?
1/ Everybody on the team including retroactively to past employees.
2/ All LPs in Fund 1 and Fund 2 (the earlier investors in Fund 1 get a better rate of credit earning which will persist into Fund 2). TBD on future funds.
3/ We’re also exploring how to use credit earning as a way to incentivize scouts, mentors who are unable to invest in the funds, and a few other roles.
What about founders?
The good thing about employee months worked or LP dollars committed is they are reasonably standard contributions to Earnest. Earnest investing in a company is… different and quite hard to connect to carry sharing in a way that feels equitable.
To state the obvious, any carry at Earnest will only be a fractional share of our portfolio founders’ collective success. So for founders who’s companies really succeeds financially, we’re just taking some of their success, running it through the fund, through Carry Corp and then back to them… they might as well just keep slightly more equity on the initial investment. The only founders for whom this would potentially move the needle would be ones who’s companies do less well, which quickly gets into the realm of ideas around portfolio founders swapping equity or otherwise “diversifying” their risk within the fund portfolio. We’ve thought about and modeled every permutation of equity swapping and carry sharing we can think of and nothing seems to be a standard and fair way to do it because each investment can’t really be compared in an apples to apples way. Fundamentally how many credits should each company get as part of joining the fund and do they even care about that?
For the moment, our offer to help founders diversify their exposure to other portfolio founders is simply to essentially remove the minimum LP commitment on our subscription fund structure for portfolio founders to allow them to invest as much as feels comfortable in Earnest funds (which several founders have taken us up on already).
We may re-evaluate this if we can find a carry-sharing approach that incorporates portfolio founders in a sensible way.
We’re sharing at least 20% of all carry/profits from Earnest Capital with our team and early investors via a nifty credit systems on the way to re-inventing modern funding for entrepreneurs. Let’s go!