This post will answer some common questions from investors looking to use a SEAL themselves or considering co-investing with us. If you are a founder looking to raise capital you will probably find the main Shared Earnings Agreement page more helpful.
Relevant excerpts from our public term sheet are pasted inline but the full document is viewable here.
Why does the Shared Earnings Agreement exist?
The SEAL was designed transparently with a community of entrepreneurs that might call themselves bootstrappers, indie hackers, makers, and a variety of other names, typically building businesses that do not fit the venture capital model. One of the primary ways this category of entrepreneur differs is they are often optimizing for two types of business outcomes that would be a failure for venture funds and a misapplication of the typical venture toolkit (SAFEs, convertible notes). Those outcomes are broadly 1/ raise a small round of capital and then sell the business for a life-changing but “small” exit (ie $20m) and 2/ build a business they never intend to sell that grows predictably and generates several million a year in net profit.
In both the structure of the SEAL and the terms we offer (which vary on a deal-by-deal basis), our goal is to align ourselves with these kinds of outcomes, to support the founder and high-five when they happen, and also not close out other options like raising additional growth capital or a priced venture round.
What are Shared Earnings?
Put simply, it is a modified profit share. Investors are entitled to a percent of what we call Founder Earnings, which is Net Income + Founder(s) compensation. This eliminates the arbitrary delineation between founder salary, owner draws, and profits.
We set a Founder Earnings Threshold, so that investors are not taking a % of founders’ meager early salary, but anything above that, whether its founder comp or profits, gets apportioned to investors as it is generated, on a quarterly basis.
The Shared Earnings are articulated as a fixed percentage of Founder Earnings and calculated quarterly. Multiple investors in the same round would share that total amount on a pro rata basis.
Shared Earnings typically has a cumulative lifetime cap defined as a multiple of the investment.
Why cap Shared Earnings?
We believe there is a misalignment between investors, who are IRR-sensitive, and founders, who are more sensitive to the total quantity of money they’ll have to return to investors in exchange for initial capital. So we ask for a larger percentage of Shared Earnings, but put a lifetime cap on it. Which seems to be a win-win.
As an example, if a founder and investor would be willing to do 15% perpetual Shared Earnings, you will probably find that a 30% Shared Earnings with a 3-4x lifetime cap is actually better for both parties. The higher percent pulls cashflows forward in time, providing a better ROI, while the lifetime cap better matches founder preferences.
We are not dogmatic about this though and have done deals with an uncapped Shared Earnings.
Is the total return capped?
No. The amount of Shared Earnings that can be paid to investors from the operations of the business is capped (usually). In theory the founder could then operate the business profitably in perpetuity without further payment to investors.
However, in all cases, and even after the Shared Earnings Cap is repaid, investors retain the option to participate in an exit or future priced round of equity.
The calculated percentage of that participation does interact with how much Shared Earnings has been cumulatively paid to investors already (more on that below).
What happens in the event of priced round or exit?
If the company goes on to raise a priced round of equity (above a threshold defined in the definitive docs but typically 1m) a SEAL works much like a SAFE or convertible note. The whole instrument either participates in the proceeds of the sale or converts to equity alongside the new investors.
In event of a priced round, the investment is fully converted to equity alongside the new equity investors and any Shared Earnings aspects go away.
The main difference in this context is how the investors’ percentage (of the round or exit) is calculated. It is not just a function of the initial investment size and round valuation (as in a SAFE or convertible note) but also can be reduced over time by Shared Earnings payments through a simple term we call Equity Basis.
What’s the Valuation Cap and How is percent ownership calculated?
The Shared Earnings Cap is a multiple of the investment. For round numbers let’s say
- $100k Investment
- 3x Shared Earnings Cap = $300k
Equity Basis is the greater of (i) any unpaid portion of the Shared Earnings Cap, or (ii) the Amount of Investment ($100k).
The implied ownership of investors in the event of a sale (for an amount greater than the Valuation Cap). Is simply [Equity Basis] / [Valuation Cap]. In our scenario, the numerator here starts at $300k and can be reduced to $100k. So at a hypothetical Valuation Cap of $5 million, we start at 6% and can be reduced to 2% by repaying at least $200k of Shared Earnings over time.
Yes, this means that the numerator for the calculation can be a multiple of the initial investment amount, so Valuation Caps should be set accordingly relative to SAFEs or other instruments.
Investors using a SEAL may vary here, but with Earnest, we try to set Valuation Caps with a slightly higher than market starting % than can reduced to substantially below market % by repaying Shared Earnings. So if you could raise the same amount with 5% equity, we might target 6-7.5%, which can be reduced (in this case) to 2%-2.5%. Thus if founders repay Shared Earnings and then sell or raise, they’ve gotten substantially lower cost of capital, but otherwise, we have received a slight premium for keeping those options open.
Is this founder/investor friendly compared to SAFEs?
We get this question a lot and to me it feels like an apples to oranges comparison. Either can be more or less founder/investor friendly depending on the specific numbers and terms you plug into them for a given deal and a given company context.
In Earnest’s case, we tell founders candidly that if your goal is definitely to raise a Series A in 12-18 months, we are not likely going to be the cheapest or most aligned source of capital for you. If you want to take your business in a different trajectory, or at least want to maximize your options at the earliest stages, we are likely a great fit. But that is primarily a function of the specific terms we offer within a SEAL rather than the structure itself.
Is this all set in stone? Do you invest using other financial instruments.
Not set in stone. We have already made modifications to the SEAL on a deal by deal basis and are constantly tweaking it based on founder and investor feedback.
Yes. We invest using other instruments in the right circumstances.