Six weeks ago Earnest Capital soft-launched by posing the question: could we build a funding model for bootstrappers? We had been working for months 1 on the technical details of an early-stage investment structure that aligns an investor with a founder who wants to build a sustainable, profitable, calm company and doesn’t want to raise traditional venture capital. Here is what we learned.
A few things we learned
There is an unbelievable amount of interest in this. We received excellent, positive, constructive, and at times thoughtfully critical feedback in places like Hacker News, Indiehackers and even directly in the comments of the Google Doc of the draft term sheet we published2. We also received hundreds and hundreds of emails from founders, investors and interested bystanders.
Our small team is not set up to handle the volume of inquiries coming in and we needed a structured way for founders to reach out. You can now “apply” here and expedite the standard follow-up questions we would ask every founder via Airtable.
We have to be incredibly transparent about how this new model works and give founders a way to crunch the numbers and run scenarios themselves. There is more coming on this theme, but we started with an open source simplified spreadsheet and detailed video walkthrough here.
People love pointing out when things are oxymorons. Yes “funding for bootstrappers” is one but we believe that bootstrappers has come to embody a broader set of goals, values, and priorities than the narrow definition of “never raised a dollar of capital.” Searching for a better term, that encapsulated those values, without the implications around fundraising or not, is actually how we arrived at Earnest. Maybe we’ll just start calling them earnest founders from here on out. Or we’ll just see what the founders want to call themselves.
I learned that I (Tyler) am going to need a heck of a lot more help with this thing. I’m extremely happy to welcome Ben Tossell, maker extraordinaire and former head of community for ProductHunt/AngelList, who will head our platform and build the connective tissue between our partners, advisors, investors and founders.
What we learned about the term sheet
That’s what we learned broadly about the idea of Earnest Capital and funding for bootstrappers. Here are a few things we learned about the specifics of the funding model we proposed and how we have incorporated the feedback so far.
The big discussion, which was also the major outstanding question we posed, was whether investors should keep some kind of long-term stake after the Return Cap was fully repaid4. I was pleasantly surprised that the majority of both founders and investors had the same critique of the original terms, arguing that our default position should be some kind of long-term skin in the game, but let’s explore both sides.
The case against Earnest (or other investors) having a long-term stake of some kind looks like this:
- Founders at the earliest stages have a specific pain point now (lack of runway) and no idea how big their business could ultimately get. It’s very difficult to make the right decision to solve this short-term problem with something that has very long-term consequences. Giving the payback to the investors a firm cap gives a finite horizon to the consequences of not getting this decision exactly right.
- Many founders really like the idea that at some point in the future the business reverts back to being essentially bootstrapped, with zero obligations to outside investors.
- In years 5, 8, 10, 15, if the founders are still making payments of some kind to the investors who backed them a decade ago, will there start to be resentment. Will the investors feel they need to continually add value in perpetuity to justify it? Is this a recipe for a bad long-term relationship. 5
The case for Earnest having a long-term vested interest in the companies we back goes like this:
- Founders primarily do not view working with Earnest as purely a transactional discussion. The network of experienced founders that will be invested in their success is valuable and having them long-term aligned is something many founders really want.
- Because a Shared Earnings Agreement does not involve ownership, you get the long-term incentive alignment of an investor/advisory who has equity, without the ownership, complexity or board seats normally associated with it.
- Investors have serious FOMO about backing a company early on that turns out to be the next Atlassian, bootstraps the rest of the way to a $1B valuation, and all they saw was 5x their initial investment.
- Trading a lower Return Cap for a long-term stake seems likely to be a win-win for most founders and investors.
Our response and resolution to this discussion
- Our default terms now include a residual “stake” for Earnest after the Return Cap has been fully repaid.
- This takes the form of an option to participate in a sale of the business or follow-on financing which is exactly the same option Earnest has before the Return Cap is fully repaid, just at a reduced percentage6.
- After the Return Cap is paid, there are no further cash payments to Earnest as you continue to operate your business.
- However, because we would still get a % of the proceeds if you ever sell the business, Earnest and its investors are still incentivized to help you grow the business.
- If and when the founders do decide to sell the business, they will have an all star team of advisors ready and waiting to help them navigate and maximize the process.
- All of the above is technically optional. We will likely still offer and do deals that have no residual stake after the Return Cap is repaid, but that will likely entail a higher total Return Cap to compensate for the lack of residual stake.
Some other things we learned
Founders really don’t want to feel like they are being nickel-and-dimed. Terms that were essentially boiler-plate from VC docs, like that the legal closing costs are paid out of the funding that is raised, really rankled founders. We heard you loud and clear and are reevaluating every term from first principles.
There are a lot of questions around “is this debt” and what happens if the company fails or doesn’t become profitable. The answer is that we view a Shared Earnings Agreement like equity. There is no personal guarantee, no fixed repayment schedule that forces you to pay even when the business is not doing well, and fundamentally no personal consequences if the business fails. We expect some % of investments will fail and that’s perfectly okay. In fact, you can count on us to be helpful and supportive with the process and figuring out your next move if the business fails ✌️
What’s up with salary caps? We really screwed the messaging up on that one. They are not caps. Founders can pay themselves whatever salary they want. There is a threshold of salary, below which Founder Earnings do not apply. So in the early days if you can only pay yourself a $20k salary from the business, we’re not going to take a % of that, only amounts that exceed the threshold that we agree on as part of the investment closing process.
We had hours and hours of discussions, pages of notes, and learned a ton more but we’ll leave it at that for now. In general we’re happy with the latest version of the Shared Earnings Agreement and very excited with the level of interest and discussion around it.
…and thinking about it for years ↩
Note: this term sheet is now deprecated with some slight modifications based on what we learned↩
the point at which Earnest no longer receives a % of Founder Earnings↩
This btw is a much more compelling critique of more “normal” equity where the investor is owed an uncapped profit share in perpetuity. ↩
See the Equity Basis section of the SEA term sheet.↩