What follows is a public draft of the investment memo for Earnest Capital’s second fund with as few redactions as possible. This is an extension of our experiment in radical transparency, beginning with our open-source process designing our funding for bootstrappers investment strategy and Shared Earnings Agreement investment structure.
Update: Earnest Capital Fund II is now live and accepting new LPs every quarter. Fill out the form here for more information.
If this is interesting and you would like to continue following our journey, I’d recommend our For Investors page. Feedback, critiques, and discussions are highly encouraged.
If you’re not familiar with Earnest, here is a very brief primer on who we are and what we do. If you’re already familiar with Earnest, skip to the next section.
Earnest Capital is a fund launched in 2019. We do “funding for bootstrappers,” which is a strategy to back founders and businesses that most people would associate with bootstrapping: capital efficient, often focusing on niche markets, balancing growth with the sustainability of the business rather than growth at all costs.
For founders, we offer a bootstrapper-aligned financing instrument we created called the Shared Earnings Agreement (SEAL). The SEAL retains all the flexibility of other early-stage instruments (converting to equity in the event of a next financing equity round or participating in an exit) and aligns the investor with a strategy of building a profitable ongoing business through a profit share arrangement called Shared Earnings.
Beyond investing Earnest, brings an incredible group of successful founders and operators as mentors who have skin in the game by being investors in the fund. We run a remote community of founders and mentors and run our fund and investing process entirely remote-first.
On to the thesis…
1/ The Macro Momentum: Software is entering the Deployment Age
Candidly, Earnest began without a solid macro theory as the product of a practitioner just looking for a solution for founders like me. I built, bootstrapped, and eventually sold a niche SaaS business. Along the way, I was fortunate enough to meet many many founders currently building or aspiring to build a calm, profitable, software business. But at the earliest stages, enough capital to quit your job, stop freelancing or make your first key hires has still been a constant struggle for this rapidly growing 1 category of entrepreneurs.
But relatively quickly into developing the principle ideas of Earnest, and solidified over thousands of conversations in the last two years with people smarter than me, it has become clear that this is far more than a search for a niche alternative to VC. We are in a search for a new default form of funding entrepreneurial ventures that should be substantially larger than the entire early-stage VC market.
Earnest is leaning into a powerful macro trend that I think is best explained by this post from Jerry Neumann that builds on the widely read work of Carlota Perez to argue that software is transitioning into what both would call the Deployment Age.
Both Perez’s work and Neumann’s analysis are very in-depth, so I’ll only briefly cover the relevant points. Perez argues that technological revolutions follow distinct long-term waves with different characteristics in each phase. Jerry claims that software is transitioning from the “Installation Phase”—which consists of frenzied adoption, financial bubbles, winner-take-all opportunities, and spectacular failures—to the Deployment Phase, which consists of more steadily and incrementally (at least incremental compared to the previous phase) spreading these new technologies to every aspect of the economy. A key characteristic of this phase is that new forms of capital are needed to fund the deployment process.
A new kind of default funding for startups is needed.
The consequences of this transition are numerous, but the most important one for our purposes is that a new kind of risk capital is required to fund businesses in the Deployment Age. The terminology used is a transition from “financial capital” to “production capital.” The post takes a somewhat more pessimistic view on the new “production capital,” which takes on less wild risk and is more calm and methodical, but I very much agree with the assessment of “financial capital” which in our current phase is essentially traditional VC investments in software.
Financial capital invests in innovation because it thinks it can earn a good return. It is primarily controlled by agents that are external to the means of production, financiers. Production capital invests in innovation to add to and make more efficient its production resources. It is controlled by the management of companies. Financial capital has a casino-like mentality: nine losing bets and one that pays 12x is a good year. Production capital has a planning mentality: a failed investment is a failure of management, almost a moral failing.
When financial capital pulls back, both because of decreased opportunities for massive exits because of the new regulation and because of the new conservatism that fear teaches, production capital takes over. Production capital is not looking to create entirely new markets and disrupt incumbents–they are the incumbents–it is looking to improve the means of production through innovation. Production capital funds predictable innovation: classic sustaining innovation, not the riskier exploratory innovation. This period, when production capital starts to take control, is a period of synergy, with less technological volatility, fewer business failures, more (and longer-lasting) employment, and less income inequality.From http://reactionwheel.net/2015/10/the-deployment-age.html#rf4-1586
I agree with much of the assessment here except for the implied prediction that the transition to production capital means that this capital will come from entirely large established incumbent businesses. As Alex Danco points out, we are seeing a form of production capital coming in the form of merchant advances from Stripe/Shopify/Square, but these same dynamics also create an opportunity for new kinds of funds to provide this kind of capital.
Shift to Production Capital
A good analogy is that the Installation Phase of inventing and manufacturing the machines of the modern industrial age (cars, radios, televisions) required the creation of consumer credit (store financing, credit cards) and commercial leases to fund the widespread deployment.
For a few decades now, venture capital (or angel investors deploying a very similar strategy) has been the default/only form of funding for software and software-enabled companies for two key reasons:
- For a long time, software companies perfectly fit the profile of venture capital. They had high startup costs of racking servers and hiring developers and designers for 1-2 years before even launching and often had highly scaleable winner-take-all outcomes in huge markets as yet untouched by software.
- These companies lack entirely the collateral and other characteristics needed for underwriting and accessing the traditional business banking options.
If this ever was true is a matter of debate, but certainly now, venture capital not the best source of early-stage capital for the vast majority of all software/software-enabled companies. Note: this thesis is not an outright indictment of the venture capital asset class, I just believe that the opportunities that fit the risk profile of VC are leaving pure software and increasingly found in other markets like hard tech, machine learning, synthetic biology, and other areas well outside the scope of my expertise.
It’s easy to take a pessimistic view of this transition by thinking that “less risky” ventures in software will mean “less ambitious and impactful.” But I believe this is not the case. The opportunity to make people’s lives better with software is vast. We are fortunate to be entering a phase when entrepreneurs do not have to “go big or go home” to build something meaningful and ambitious.
The principal conclusions of all this are:
- Fewer software businesses have genuine winner-take-all market dynamics, and most are increasingly not a fit for VC.
- The opportunities of the Deployment Age are in niches with smaller total addressable markets, lower risk of failure
- We need a new default structure of funding for software businesses
2/ The Lever of Change: The Peace Dividend of the SaaS Wars
One property of the Installation Phase is the bubble dynamics often leave substantial physical and intellectual capital available for the next wave of entrepreneurs to build upon. The UK Railway Mania of the 1840s led to a massive bubble in the shares of railroad companies, leading to an inevitable financial collapse. However, the result was 6,220 miles of railroad tracks were built in a short time 2 and were thus available for the rest of the economy to make use of during the Deployment Phase.
From Geocities to Salesforce and Shopify, vast sums of money have been poured into software companies enabling, among other things, the building of substantial capital stock that today’s entrepreneurs don’t have to waste time and money reinventing. I call this the Peace Dividend of the SaaS Wars.
The Peace of Dividend of the SaaS Wars includes:
- Quick start open-source development frameworks (Ruby on Rails, Laravel)
- Scaleable server infrastructure (Heroku, AWS)
- A full-stack suite of tools for the basic operations of software businesses (SaaS for help desk, email & social media marketing, FAQ, billing, analytics)
- Free distribution networks from piggy-backing on fast-growing app stores and platforms
- No-code platforms allowing entrepreneurs to reduce their engineering costs to get to market (Zapier, Webflow, Airtable, Shopify)
- Battle-tested methodologies for finding and validating businesses (Lean Startup, Traction)
The net effect is that it’s easier, cheaper, and faster than ever for a solo founder or small team to get a software product live and creating real value for customers with little to no outside investment.
This has two principles effects:
1/ It is economically viable to build a software business targeting a smaller, more niche market than in the past.
The amount of capital needed to get a business to positive unit economics and sustainable profitability is a fundamental driver of whether a business plan targets a sufficiently large market. Businesses that will consume $30m-100m+ in investment capital before getting to profitability must tackle huge multi-billion-dollar markets. But, we believe that profitable software businesses with mature products, thousands of customers, and margins enabling growth through free cash flow can be built with $100k-$500k of either founder sweat equity or outside capital. This fundamentally changes the scale of what challenges it makes sense for a software business to tackle.
There is still a vast ocean of problems currently solved with sticky notes, spreadsheets, and human labor that become viable targets for software entrepreneurs building with this level of capital efficiency.
2/ Businesses built in this environment should have a fundamentally lower rate of failure than the preceding wave.
When you speak to people who have been investing in early-stage companies for the last decade or so, either professionally or as an active angel investor, you will often hear a variation of the following: “80-90% of startups fail, so you need the ones that don’t fail to be huge winners to make up for all the failure.” Leaving aside the substantial data challenges of validating the underlying claim, this is simply not true in a Deployment Age enabled by the Peace Dividend.
Founders can find a niche market3 with a problem that is widespread within that market and with no existing solutions, build an initial version of a product that genuinely solves the problem, and get initial validation from customers before they ever need to involve investors. It is probably still true that a very high percentage of startup ideas still fail, but bootstrapping the early phases allows entrepreneurs to quickly iterate through those failures and get to a substantially de-risked and validated young business. With this methodology, a significant portion of the conventional risk associated with a “software startup” is taken out of the business before the founders ever speak to outside investors.
3/ The Opportunity: A Tidal Wave of Earnest Entrepreneurs
Software is transitioning from the frothy Installation Phase to the more steady Deployment Phase with fundamentally less risky ventures pushing into every niche in the economy, fueled by the Peace Dividend of the SaaS Wars. What does that mean for the economy and entrepreneurship?
One thing we know is that despite billionaire startup founders dominating culture, any way you measure it entrepreneurship is in decline in the US. The full diagnosis for this decline is probably a broad combination of factors. Still, I believe one component is that the central area for new entrepreneurship, software, and software-enabled businesses, has no default form of aligned funding.
Just like it is eating everything else, software is eating entrepreneurship. If you grew up in a small/medium-sized American town like me, the wealthy entrepreneurs you knew or heard of got rich building businesses like a successful regional chain of health food stores, a large auto dealership, or multiple franchises of retail mattress stores. Those same entrepreneurs in this generation are building software CRMs for auto dealerships, software-enabled networks to track and deliver the freshest possible produce to health food stores, and direct-to-consumer e-commerce businesses for sleep products.
These businesses are:
- Great businesses! They have higher margins and are more scaleable than their generational predecessors. They can launch from home with a team distributed around the world.
- Typically completely locked out of the traditional banking and capital due primarily to a lack of collateral and other physical trappings of a business. Most of these businesses are launched by founders scraping together savings, working on nights and weekends, or funded by credit cards.
These are Earnest Businesses, and the next phase of the modern economy is going to be powered by millions of them, but they need an efficient source of funding like the small business loan and commercial leases that funded a previous generation of retail entrepreneurs.
The New American Dream: Earnest business ideas are attracting incredibly talented founders
Earnest Businesses are differentiated from what many think of as traditional technology startups in a few key ways:
- They often balance the sustainability of the business with growth. Growing more slowly means spending less on marketing, hiring carefully, and ensuring an otherwise good business doesn’t collapse under the pressures of hyper-growth
- They are acutely wary of the venture capital model that they associate with founders building billion-dollar companies, owning just 2% of the equity, and losing control of the business to an over-bearing board of directors.
- They are ambitious but value work-life balance, sane work hours, often embrace remote work and expect their businesses to serve the founders, employees, and customers.
I wrote recently that “building, owning (and possibly someday selling) a profitable remote software business is the New American Dream,” and I firmly believe it.
Earnest Businesses are Real Businesses
For the past two decades, Earnest Businesses have sometimes been given another name: lifestyle businesses. Primarily VCs looking for the next Facebook or Uber, to their determinant, have dismissed business plans with an exceptionally high chance of building a $25m or $100m business with minimal capital by quipping “that’s a nice lifestyle business but, it’s not venture backable.” The time has come to put this kind of thinking finally to rest.
Not only are Earnest Businesses very attractive to talented entrepreneurs, but when done well, they are incredible investment vehicles thanks to very high operating margins, recurring revenue with predictable low churn, strong revenue per employee, and the ability to fund continued growth through free cash flow.
These businesses are almost all privately held, so comprehensive financial data is difficult to come by, though we can look to one category as an example.
Although Earnest Businesses encompasses a broader definition, the quintessential Earnest Business is probably the vertically-focused B2B SaaS. This strategy takes a particular industry (payroll processors, mortgage lenders, construction, hotels) and builds a custom software solution to systematize and automate manual processes, sticky notes and spreadsheets.
As one example of the quality of Earnest Businesses, Vista Equity and Constellation Software have both been some of the top-performing private equity funds of the past two decades with a model of acquiring and continuing to operate a portfolio of fully mature vertically-focused SaaS companies. Vista Equity’s 2007 fund was the top-performing PE buy-out fund of that vintage, and it recently raised its seventh fund of $16B for the same strategy. The public success has paved the way for a new wave of middle-market PE funds acquiring profitable software businesses like SureSwift Capital, who invested in Earnest Fund 1.
The demand from investors to acquire and own these businesses is mounting, as is the multiple at which they are willing to pay, shows us that many savvy investors have caught on to the quality of these companies, but who is helping to start the next wave of them? The number is certainly growing but not nearly at its full potential.
Many of the founders of Earnest Businesses have no intention of selling their business and are wary of investment terms premised on eventually exiting their business. However, having been in the situation myself and after having hundreds of conversations on the topic spurred by my widely read post on the subject, I believe many of them will ultimately decide to sell their business at some point. Founders want to found things. After building the preeminent product in a business niche and spending 5-10 years crafting the company and lifestyle they want, many founders will seek new challenges and the opportunity to collect a life-changing sum of cash, keep their current customers happy, and create new opportunities and challenges for their team is a great choice for many. Some of these entrepreneurs will build products and businesses they run for decades (some of Earnest’s mentors have built businesses like Basecamp and Wildbit), but for founders and investors alike, there will be immense liquidity for businesses that seek it for the foreseeable future.
What about business cycles?
As a final aside on the quality of Earnest Businesses as an investment opportunity, I’ll add that, while I’m certainly not hoping for a (some say long overdue) recession, this part of the economy is in many ways counter-cyclical. For new investments, a downturn in promotion opportunities and bonuses would likely be the nudge many would-be founders need to raise a small round, quit their jobs, and go full-time on the side project they’ve been working on for years. For companies that would be already in the Earnest portfolio, they are typically small enough that changes in the top line of the total market don’t affect their short-term outlook. By optimizing for sustainability most of them implicitly build substantial slack into their financial models, leaving plenty of room in the budget for a short-term revenue hit to do minimal damage. By focusing on niches, Earnest Businesses can build mission-critical software that customers will continue paying even when budgets come under pressure. Lastly, most Earnest Businesses’ capital plan involves never raising another round of capital, so they are entirely insulated from fluctuations in the funding environment.
4/ The Tools of the Trade: The Shared Earnings Agreement, Aligned Capital, Mentorship
Software is entering a new age of deployment, and the Peace Dividend of the SaaS Wars is unlocking opportunities for new software and software-enabled businesses in every nook of the economy. Talented entrepreneurs are seeking the New American Dream and looking to Build Earnest Businesses that become incredible financial vehicles for founders, employees, customers, and investors alike. Private equity funds are building up war chests to acquire these businesses even while the founders build calm sustainable plans that make both exiting and never exiting perfectly viable options.
So the question I found myself asking was: why on earth is there no source of early-stage funding aligned with these kinds of founders and business plans? Early in building my last SaaS business, I was inspired by a small movement of founders exploring radical transparency and decided to blog hyper-transparently about my founder journey in real-time. Through that, and the magic of the internet and Twitter, I met many other founders currently bootstrapping remarkably successful businesses and many more who aspired to the same. But while these businesses can fund themselves through cashflow once they reach a certain level of maturity, they often still need some amount of capital at the earliest stages to give the founders enough runway and bandwidth to get a first product launched or make a few key hires to get their minimal viable team in place.
When I began workshopping this problem with other founders, I heard the same horror stories over and over about the initial phase of bootstrapping:
I moved in with my parents, who also wrote us a check for $10k at several points to keep the business alive.
I wasted two years pitching VCs until I finally decided to just build it myself.
I was only able to build my business because my spouse had a high paying job with great insurance that covered our family’s costs while I bootstrapped for two years.
Or my own story that so many other founders share:
I burned through all my savings and lived off credit cards, eventually hitting $60k in debt before the business turned a corner and started covering my bills.
But despite the obvious upside of owning a piece of these very successful and profitable businesses, there was still no form of capital aligned with these founders who were:
- Aren’t a fit for venture capital either by targeting too small a total market or the founders were just not interested in the associated hyper-growth strategy.
- Too light on collateral to get a small business loan. The entire business often consists of a Stripe account with recurring billing, a Github account holding the code, and a distributed team working from their laptops.
- Too early for existing and emerging revenue-based financing options, which are only viable for businesses generating $25k-$50k in monthly revenue.
The Shared Earnings Agreement
So, along with several other highly supportive founders, I started pulling the thread and asking the question, could we design an investment structure that aligned with “bootstrappers” and a fund that brought the best parts of an accelerator–shared resources, mentorships, and a sense of community–without the unicorn-hunting baggage of the venture capital model.
One of the first problems we faced is that nothing in the existing quiver of investing terms (convertible note, SAFEs, preferred equity) was in sync with building bootstrapped profitable businesses with no intention of selling them. Success for founders might be raising a single small round and growing to a sustainable business that throws off millions a year in profit, while a convertible note sits unconverted waiting on a follow-on priced round that never materializes4.
So I sat down, drew up a bunch of personas of different bootstrapped founders and the kinds of successful business trajectories they could take, and from essentially a blank slate built the first version of the investment structure we now use. After getting a first version worked into a term sheet (with the generous help of Joe Wallin) I decided to open-source both the term sheet (in a Google Doc with comments left open) and publish our thinking behind it in a post called “help design funding for bootstrappers.” The response was overwhelming. We were deluged with interest from founders, criticisms, and suggestions from investors and other industry professionals, and above a refrain from all corners of “this needs to exist, how can I help?”
After a few iterations, we have settled into a production-ready version that we call the Shared Earnings Agreement (or SEAL for short). A SEAL is differentiated from traditional early-stage investing agreements by the following:
- It takes no board seat or control of the business but goes to great lengths to align investors’ and founders’ interest in every scenario.
- It receives a percentage of what we call Founder Earnings (roughly profit + founder compensation above a certain level) as the business generates it. We get paid out of the business only when the founders do too.
- It has several provisions that enable the founder to control whether they want to run the business optimizing for profits, maximize reinvesting profits into growth, sell the business, or raise more growth capital in the future.
- It gets repaid only as a percentage of either a very profitable business and a sale, giving it equity-like characteristics of being aligned with the founder and having an uncapped upside for the investor.
You can read more details about the SEAL here, download a spreadsheet to calculate how it works here, and view a comparison between it and a SAFE or convertible note here.
How can I be helpful? Mentors and Community
It’s become a common twitter refrain to echo Vinod Khosla’s sentiment that most VCs add negative value to the companies they invest in. Some have turned this into a meme-ified claim that investors can’t and indeed shouldn’t even try to add value to their companies beyond writing a check. I find this genuinely baffling.
It is self-evident to me that there is immense value in experienced mentors who help founders plan long-term and see around corners with their decisions, a community that solves shared problems collectively, and shared resources and best practices that save founders from reinventing the wheel on the basic operations building a business.
The Earnest Mentors
The centerpiece of our “value-add” at Earnest is a group of 40 or so mentors, all of whom have skin-in-the-game by also being investors in the fund. Bootstrapper Heroes like Natalie Nagele and Chris Nagele from Wildbit, Jason Fried and DHH from Basecamp, Sahil Lavingia of Gumroad, Rich Thornett of Dribbble (see the full list) as well experienced founders and operators with a lower profile, have stepped up to help Earnest a reality and dedicate time and energy to helping the next generation of founders succeed. We thought deeply about how to structure our mentorship program (read our guide to mentorship), and the results have been an ego-free community that works together to solve problems and learn.
Despite the firepower in the mentor network, the founders in our portfolio consistently rank the remote community (leveraging Slack, Basecamp, and a suite of no-code tools) of the portfolio founders themselves as the most valuable aspect of working with Earnest. Our approach to the community has been one of consistent experimentation and iteration, humility, and acknowledging that we do not need to optimize for “engagement” since everything we provide for founders is secondary to their actual goal of building a healthy business and team.
As Earnest grows, investing in our mentorship and community will remain a top priority.
In the works
The current iteration of the Shared Earnings Agreement is relatively optimized for high margin recurring revenue businesses like SaaS. There’s no fundamental reason it couldn’t work for a DTC e-commerce company or another business model, but it’s not quite as tightly scoped to those use cases as I would like. We are closely monitoring other experiments with financing terms and may introduce some new variations in the future… which is about all I can say about that at the moment.
5/ The Strategy: Early-Stage Value Investing & Heresy on the Laws of Startup Physics
Some have looked at this market and thought this just a different flavor of unicorn-hunting. They look at Atlassian, MailChimp, Qualtrics, and GitHub that all basically bootstrapped to multi-billion-dollar status and think our plan is an “alt-VC” strategy to find those companies on a slightly different path to unicorn land.
I’m here to tell you Earnest is not in this camp.
While the odds are fair that—if we continue to execute on our strategy for many years and if we are able to grow the number of companies we back each year—we will someday end up backing an eventual billion-dollar company, it is not a primary goal of ours nor is estimating that likelihood part of our investment criteria.
This is tantamount to heresy in the early-stage investing world. I’ve had thousands of conversations about Earnest and almost inevitably I will hear the recitation of the basic axiom of investing in startups: “90% of startups fail, so you need the ones that don’t fail need to be billion-dollar companies to make up for all the failures.” When pressed on this, a surprising number will double-down and argue that a high failure rate is genuinely an immutable law of startup physics and the only option to adapt your portfolio strategy to that reality by trying to get at least one home run investment. I believe this is a huge availability bias from people who spend too much time in the company of venture capitalists.
The following thought experiment is illustrative. It can’t be true that every single portfolio of early-stage investment into entrepreneurs will result in a “power law” distribution of outcomes made up of mostly total failures and a small number of huge wins that represent all the returns. If I had a fund that wrote equal-sized checks into entrepreneurs opening McDonald’s franchises in mid-sized American cities, you would absolutely not expect that portfolio to result in the same distribution of outcomes as an angel investor in Silicon Valley. Earnest is not building a portfolio of McDonald’s owners, but we are betting that the filtering and selection process of an investor, the incentives of the investment agreement, and the nature of the post-investment mentorship, can change the distribution of outcomes in an early-stage portfolio.
Earnest is making a bet that the very high failure rates of venture-backed startups are at least in part self-fulfilling prophecies. Founders raise a seed round encouraged to spend aggressively within a defined runway period and are coached by their current investors about what kind of growth rates they will need to achieve to raise a subsequent round of funding. This leads to a go big or go home mentality that may in fact increase the likelihood of the startup becoming a unicorn, but also increases the chance of the business failing. Specifically this could manifest in the form of:
- Early-stage venture funds are primarily incentivized to achieve “markups” in their portfolio when companies raise a new round at a higher valuation. This makes raising another round the default path for venture-backed founders and discourages reaching profitable self-sufficiency.
- Building and exiting a multi-billion company in less than ten years requires the very top tier of “10x” talent, so venture-backed companies still strongly prefer to co-locate teams in high cost of living cities and pay top tier salaries, substantially increasing the overheard of the company
- Companies are incentivized to utilize high risk expensive growth strategies at the expense of margins and unit economics
At Earnest we take specific steps to counteract these failure loops at two levels. First, our filtering and focus on Earnest businesses, tackling niche markets without winner-take-all dynamics, leveraging the Peace Dividend to bootstrap a product and de-risk the business make our portfolio on average less inclined to shut down in the short term.
Second, our messaging and mentorship encourage founders to take a path of slower more sustainable growth. For example:
- Our model assumes that generally an early-stage investment from Earnest is the first and last round of dilutive financing. We are not interested in mark-ups and walk founders through a simple forecasting model showing that path from the point of investment back to break-even sustainability.
- Earnest strongly encourages capital efficiency and maintaining strong margins.
- We advocate for the Basecamp model of “hire when it hurts” so founders hire slowly and carefully.
Why are failure rates so important? The rate of failures in our portfolio is an essential question because again, Earnest is not a VC and we are not unicorn hunting. If we expect to generate a reasonable overall rate of return from single, doubles and triples (rather than mostly strike outs and a few home runs) we need to see fewer strike outs.
Specifically we are betting that, even if we don’t back a single unicorn, we can see a low enough failure rate across our companies that we will generate a competitive risk-adjusted return for our investors.
Earnest is built on a fundamentally different investment hypothesis: can we consistently generate a great risk-adjusted return by maximizing the percentage of founders that we invest in that succeed, rather than assuming most will fail and maximizing the scale-of-success of the few that don’t fail.
To reiterate, Earnest is successful if as many of the founders we invest in go on to succeed as possible. I think this better aligns with founders, versus our incentive being for the few that succeed to be as big as possible, though opinions may vary.
The Envelope Math
Our strategy to make the math work, and challenge the law of startup physics, is two-fold.
First, we seek to slightly flatten the distribution of outcomes in our portfolio through filtering and selecting companies and founders with lower outright risk in the business model, in markets with less competition and winner-take-all effects, where the founders have an unfair advantage and niche expertise. The distribution should have more successes even at the expense of a lower chance of backing a massive outlier success.
Second, we seek to make substantially more of the spectrum of outcomes a success for both the founders and the fund by helping founders grow through cashflow or with non-dilutive capital. Many of the “zombie” firms (eg $5m ARR, profitable, growing 20% per year) in funds mis-applying the venture model to good SaaS business plans would be successes for Earnest, even as they have been practically written off as “fund-makers” never to be.
In our first fund, our approach to the math looks like this. For each investment opportunity we structure our terms based on a very simple model that shows a range of results for the business from typically 3x to 7x our investment for outcomes that we think would represent success for the founder, team, and investors. These scenarios are based on fairly conservative projections that the business gets back to default-alive with just it’s current capital raise, grows to profitability and we see a return through a combination of Shared Earnings, proceeds of a sale of the business, or a secondary transaction of our interest if the business is still growing strong toward the end of our fund life. We completely ignore the chances that the business catches lightning and decides to raise a monster round of VC (on their terms, having put themselves in a position of not needing the additional capital) or an out of the blue strategic acquisition for a huge multiple; any of those would be gravy in our forecast. This means we need to see a 50-65% success rate (meaning companies that don’t outright fail and at least return some of their investment) to have a fund that returns >3x our investors’ money. Despite the constant discussion of grand slam 50x investments, fund-level returns in early-stage venture are fairly underwhelming where the median venture fund simply gets investors their money back over ten years (or worse). Despite doing something fundamentally different from early-stage venture, we know that most potential LPs will benchmark us against it and be considering making an allocation out of their capital ear-marked for VC. So at Earnest we are striving to consistently generate 3x or better returns, which would put us in the top decile or so of venture firms with a much lower concentration of returns in the portfolio and much faster liquidity (via Shared Earnings) in a world where venture-backed companies are increasingly staying private longer and longer.
I believe that this entire thesis—from the macro level winds at our back, to the specific choices we have made around around investing structure and strategy— makes a compelling case that we can do this, but it is fundamentally a bet without a huge compelling body of data to support it.
Except for the late-stage private equity firms mentioned previously, nobody has built a portfolio of bootstrappers nor had any vested interest in reporting the results of failure rates, sizes of successes or total potential return from investing in a basket of these companies at the early stage… at least until now. We are starting to see early, promising results, but the fact remains that, like nearly all investors who generate outsized returns, we are taking a fundamental bet into uncertainty in this one core way.
But what general evidence do we have that this could work?
Early-Stage Value Investing
While some have called what we are doing “Alternative VC” (or alt-VC) I don’t approve of the label. Unicorn-hunting is not the only known way in the investing universe to earn a return by backing entrepreneurs companies. Public markets and later-stage private equity have long held that there is a spectrum of investing methodologies with growth investing at one end and value investing at the other. Growth investing is based primarily on the expectation that the business will grow fast and be valued more highly by subsequent investors and gives little heed to whether the business is expected to generate profits at any point, whereas value investing builds a model of the expected stream of future profits from the financials of a business and attempts to put a present value on it. Neither is universally better and both are considered valid ways of investing in companies in the public markets and in later-stage private equity.
But at the early stage, where businesses are valued at $10m or less and the investment checks sizes are below a few million dollars, value investing has traditionally been ignored. Competitive seed rounds have made valuation a function of supply and demand (how high can founders raise the valuation before investors start dropping out) and it has been presumed that there just isn’t enough information, when it may be just a few founders and a prototype, at this stage to bother doing a fundamental analysis. Unicorns like Slack, that started as completely different products and companies before a major pivot, have taught investors to ignore the actual underlying business and just back smart founders who will “figure it out.” I won’t speak to whether these are rational developments in the world of venture, but I will argue that it has made early stage investors miss a relatively new opportunity.
The Peace Dividend of the SaaS Wars and the ability of founders and small teams to ship real products means you can now frequently do fundamental value investing level analysis of companies even when the check sizes look like a seed round. We frequently find ourselves looking to write a $150k-250k check, which will be the entire investment round, and doing diligence on a company built by one or two founders that, without raising any capital, has 100s of customers, a reasonable understanding of their customer acquisition funnel, a year or more of metrics on monthly recurring revenue growth, customer churn, expansion revenue, and lifetime value. This is still “early” so we do still have to heavily evaluate the founders, strategy, and target market. But you can also evaluate the actual business!
Essentially you can now get to the level of uncertainty in a later-stage private equity round at a stage and investment size typically associated with seed-stage uncertainty. This is our unfair advantage. Please don’t tell anybody else about it.
Our Investment Criteria
Like all investors, our investment criteria is not a set of iron glad rules that I rigidly follow. I have probably broken each of the following rules with at least one investment already which can reviewed in this series of “why we invested in…” posts.
but this does represent the center of gravity that I try not to venture too far from in multiple ways in the same investment.
Our public FAQ page lists out the three main buckets we evaluate for whether a company is the right stage for an Earnest investment. Simply put we expect the company to already have some evidence of 1/ the team as it currently exists has built a working version of the product that is useful to customers 2/ customers are paying a reasonable price (not deeply discounted/free) for it and 3/ they have at least one channel for acquiring new customers beyond their personal network.
We believe recurring revenue is the lifeblood of an Earnest Business and focus most of the portfolio with explicit subscription revenue models or recurring use cases (and early evidence customer stay subscribers for the long haul or come back as repeat customers).
A linchpin of what makes the Shared Earnings Agreement work is the potential for the business to grow through free cashflow and eventually throw off very substantial profits. This requires “high” operating margins. We don’t have a specific number, but do benchmark against the kind of margins you see in SaaS businesses.
Earnest is one of the very few remote-first investment funds. The team is remote, the community of founders and mentors is remote. Our investment and diligence process does not require an in-person meeting. We do believe that building businesses remote-first is a long-term competitive advantage. It is absolutely not a requirement that companies we invest in be remote teams, but nearly all of the companies we have invested in to date are.
One of the conclusions of our macro view of the world is that opportunities in interesting business niches are now numerous and it now makes sense to build products for these industries and use cases. But distribution can still be challenging. This is not a hard requirement, but we find the best solution to this is investing in a founder that has had a career in or otherwise deeply understands this market niche and has an unfair personal advantage in distribution and product intuition.
I am often asked how our evaluation process differs from VC/growth investors from metrics perspective. My simple answer is that we evaluate and prioritize metrics in the customer lifecycle bottom-to-top while growth investors prioritize top-to-bottom. Growth investors are primarily concerned with top line growth, customer growth, growth in pageviews and trial signups; and while churn is not ignored, it’s something that can be fixed later with product iterations, new features, or expanding into adjacent markets. We take the opposite approach and strongly prioritize low (or ideally “net negative”) churn where customers stick around effectively forever, a high average revenue per customer where the product adds mission critical value to the customer, a high percentage of conversion of free trials to paid customers meaning the product deeply resonates and acquisition campaigns will be very efficient. Top line growth is not ignored of course, but it’s much further down the priority that metrics that indicate the products deeply resonates and solves a core problem for the target market.
The Canonical Earnest Business
What we have learned after evaluating 1,000+ businesses in year 1 of operation is that the canonical business for Earnest looks like this:
- A founder works in a specific industry, trade, or segment of the economy and identifies a pain point still being done by hand with spreadsheets, email, or sticky notes.
- The first order total addressable market, while large enough to build a real profitable business, is too small for VCs to back or for tech giants to serve.
- She learns to code or finds a technical co-founder and builds a specific SaaS or software-enabled solution. The pain point is large enough, and with no direct tech-based competition, they can charge a substantial average revenue per customer of at least $100s/mo or $1,000s/year
- Potential customers are well known and the target market well-defined (“film production studios” and not “people in leadership roles”) and the founder can find their first 25-50 customer manually through founder-led sales.
- The product quickly becomes the no-brainer default solution in the industry. Non-revolutionary customer acquisition strategies like long-tail keywords, attending industry trade shows, and customer referral programs have a strong ROI due to tight product-market focus and efficiency in the funnel from free trial conversion to churn.
- Of course this is early-stage investing so we frequently make investments that look nothing like this, but a little more than half of our initial portfolio looks very similar to this in most respects or has characteristics that achieve the same results.
6/ The (Early) Results: It’s working
This is the one section where I don’t feel I can comfortably share the precise details of the performance so far. I’ll be preparing a more detailed analysis later this quarter but it will have to remain private and by request for now.
Recognizing that the data here is very early, the headline is that our funding for bootstrappers model is working extremely well. The portfolio so far is performing well above our median expectations. We have taken some genuine risks, in many cases investing in founders that had only built products as side projects while working full-time or freelancing and writing the check that allowed them to go full-time on the business. And we are getting rewarded adequately for that risk with very substantial performance from the companies and talented founders post-investment.
Earnest went live at the end of February 2019 and made 13 total investments in the year. So to reiterate, we are only just approaching 12 months of data for our earliest investments and some investments are only a few months old. We are still being extremely cautious about drawing any overall conclusions.
Of the 13 investments, nearly all of them have reached break-even default-alive status, getting there in a very rough average of 6-9 months. None of the businesses have failed. Other than the general axiom that “some businesses have to fail” we don’t see any indications that 100% of them won’t at least reach a simple level of founder-break-even, where the company generates enough revenue to cover the existing team and pay the founders a sustainable salary. Some are seeing slow and steady growth, while others have seen 5x, 7x, and 11x MRR growth in less than a year, showing our model not preclude fast growing businesses.
Although we did not have a fully rigorous system to track all of our inbound deal flow (something in the roadmap) the simple answer is that we saw way way too many good opportunities to invest. We saw at least 1,000+ investment opportunities (a mix of formal applications, cold outreach, and referrals) and many more than 13 met the investment criteria for our portfolio construction model, allowing us to be exceptionally picky.
The volume of dealflow and overall interest directly led to perhaps our worst performing part of the fund: communications with founders… especially ones we choose not to invest in. My personal bandwidth was a key constraint in this regard and in many cases I was not able to follow up with founders at all, something I regret and would like to improve in the future.
Broadly we are almost never competing with other funds or financial products and most founders we speak to are exclusively considering either bootstrapping or working with us. We have been able to agree on Shared Earnings Agreement terms that believe make our financial work well and are fair to founders.
Skin in the game Mentorship is working. The community is striking the right balance between support and motivation and over-bearing “here’s the formula for how we did it that you must follow” curriculum approach. Lots to build on and improve but happy with early results.
Readers of my monthly investor letter will know I’m highly cautious with projections and not one for overly optimistic projections but there is effectively no other way to interpret the results so far.
The basic strategy we are deploying is working, quite well in fact.
7/ The Future: A sustainable advantage in funding for bootstrappers
So far this thesis has primarily made the case for investing in Earnest Businesses, but what’s the case for Earnest Capital itself?
I tell every investor I meet that I want there to be dozens more firms investing in these kinds of businesses… I just want to run the firm that is the best at it.
We are still in the very early days of exploring this strategy but I believe Earnest Capital is laying the ground work for a sustainable long-term competitive advantage in backing the best founders at the vanguard of an explosion in this part of the economy. We invested in 13 companies in our first year, built a network of 40 skin-in-the-game mentors, launched a private (investors and founders-only) podcast and several newsletters. We did hundreds of good tweets and launched the first in-real-life extension of our remote community in the Founder Summit. I believe the opportunity here is immense and the plan is start adding zeroes to the end of all of those outputs and back 100s and ultimately 1,000s of entrepreneurs per year.
The core of our long-term competitive advantage comes from three simple principles:
- Create alignment (through empathy)
- Tell the truth (transparency)
- Don’t take ourselves too seriously (have fun)
From day one (and continuing to the publishing of this draft memo) Earnest has experimented with a level of transparency virtually unheard of in the investing world. I tell everyone that I am one-trick pony when it comes to marketing—long-form radically transparent prose—but that this turns out to be exactly the one trick needed for this venture. This has been a phenomenal advantage for Earnest in the form of earned media, brand recognition, and word of mouth referrals that have allowed us to punch far far above our weight from the beginning.
Everything about Earnest is designed from first principles and we have made several very opinionated decisions—from the way we structure our investments, to our approach to mentorship, to being completely remote—with potential for backlash and some amount of controversy. But by and large these decisions have consistently been lauded by founders and there’s a reason for it: listening to founders about what they need to be successful and deeply empathizing with their challenges and goals. I don’t consider Earnest “founder friendly” because it implies to me a zero-sum scenario in which investors are trying to beat out other investors by giving up more of something (equity, control, protection, who knows) to the founder. I strive for Earnest to be founder-aligned, where we relentlessly refine every aspect of our process, strategy, LP base, terms, team and community to be as aligned with founders’ interests as possible.
What we’ll continue to do
Earnest will always be built on radical transparency. We believe this critical earning and retaining the trust of founders and keeps us accountable to our goals of being founder-aligned.
We will continue with first principles thinking and experimentation with an open dialog with the founder community.
We will continue to grow a network of skin-in-the-game mentors and our broader network of values-aligned founders. If you are interested in joining as an Earnest mentor, please start by filling out the interest form here.
What we’ll start doing going forward
Expand the investing team with Earnest Operators. Some investing firms are built on the individual exceptionalism of the investing founders… that’s not the road I want Earnest to go down. If we are going to back 100s and 1,000s of founders per year and fuel a huge expansion in Earnest-style entrepreneurship it is imperative that we quickly move beyond me making 100% of the investment decisions. I’m giving a great deal of thought about to expand the investing team beyond me and we will start by opening a small number of roles modeled after the “venture partner” role in VC called Earnest Operators. These positions would be a bridge to a true investing role with each partner staking out an area of focus (by industry, business model, geography), have an allocated portion of the fund, source and vet their own deals, collaboratively come to an investment decision with me, and get carry (a portion of the profits of the investment) in their deals and overall. More to come on this later in the year, but for those interested the best way to start it is to request to be mentor.
Tools to systematize our process and simplify the experience for founders. Early-Stage Value Investing needs a better toolkit and we intend to spend significant time and energy building them. Much of the fundamental analysis we do from analyzing and benchmarking key business metrics, finding and evaluating the competitive landscape, reference checking founders and customers, could be better systematized and automated. Ultimately I believe we are operating in an area of risk that cannot be fully underwritten in an a largely automated fashion in the way some revenue-based financing products seem headed. Well trained and experienced investors will still to make the final bets, but there is much we can do to make the process faster and more efficient for investors and founders alike.
Expand our shared resources & in-house experts. One of the easiest wins at Earnest has been founders comparing notes on solutions to the ubiquitous challenges of running any business: payroll and benefits, bookkeeping, accounting, taxes and financial modeling, planning team retreats and building culture. As we grow, Earnest will move from simply having good recommendations for these problems to having professionals on hand for the entire portfolio to leverage. I consider this quite different from the focus on design, PR, and head-hunting that some funds have tried along these lines.
8/ The Bets: What questions will Earnest Fund 2 seek to answer
To generate attractive returns, any venture, including a new fund, needs to be making a fundamental bet into some amount of uncertainty. I try to be explicit about what those bets are both for the long-term arc of Earnest and each individual fund within the journey.
Our first fund, which I called our Pilot Fund asked a three distinct questions, two of which we have answers for and one we only have early positive indication on:
- Would the bootstrapper community react positively to the SEAL structure and could we close deals with great founders on SEAL terms that make our fund economics work?
- Would we be able to work with the most talented founders operating with a bootstrappers mindset, or would there be adverse selection where the best bootstrappers do just fine without investment and only the ones who struggle to get traction show up looking for investment?
- Does our basic bet on portfolio construction work? Can we make early stage investments and see a high percentage of those companies go on to succeed?
The answer to the first two questions has been a resounding “Yes!” I believe in part because of the collaborative and transparent way we designed and rolled out the Shared Earnings Agreement, the overall response has been very positive. Most founders I speak to assess it as a reasonably fair way to align incentives between investors and founders who want to focus on building a profitable sustainable business, while keeping their options open. We are also finding that there is very little adverse selection. The best founders, much like the many successful ones we spoke to during the process, can still make good use of capital in the very early stages of building their business and Earnest is operating at a phase of the business where literally the only capital alternatives are seed VC, friends and family, or credit cards. Even founders who don’t technically need the capital are excited to work with us, seeing the benefits of the mentor network, shared resources, and community of other founders. Indeed most of the businesses we have invested in could have executed on their business plan without the capital, though it would have taken enough extra time that the capital becomes a sensible choice. Of the few deals where we offered terms and didn’t close, the majority of those came from founders who were excited about the prospect of working with Earnest, but decided to continue bootstrapping “for now” and re-evaluate in the future.
Question #3 is the fundamental bet at the heart of Earnest and we won’t get definitive answers until the portfolio reaches somewhere around 5-7 years of maturity, however the (admittedly very early) data on the quality of founders and businesses we’ve been fortunate to invest in and their post-investment performance is very promising.
For our Fund 2, we’ll continue asking question #3 from Fund 1 and won’t have definitive answers until the portfolio matures in several more years. This is partially the reason for this open source investment thesis. We simply can’t point to a dataset of any significant size to argue that a portfolio of “bootstrappers” will have a higher rate of success, or more importantly how much higher, than a basket of similar companies pursuing venture-scale growth. To make Earnest work, we have to rely on a mix of theory and the gut intuition of the many many bootstrapping founders whose direct experience concurs.
We’ll also be making few new bets with the second fund:
- Can Earnest scale its investing capacity beyond just me? If we are to reach our goals of backing 100s and then 1,000s of entrepreneurs per year, Earnest must be able to empower more people with investing decision-making. As explained above, we’ll begin experimenting with a few roles that source and vet investment opportunities and use those collaborations to build best practices around teaching (and iterating) our unique investing point of view.
- Are there enough founders in enough niches for this model to grow rapidly? Earnest Fund 1 was inundated with investment opportunities from before we even launched, but I firmly believe that the opportunity here is larger than the entirety of the venture capital asset class. For that reason our current long-term plan is to scale up Earnest much more quickly than you would expect of typical VC franchise. In committing ourselves to deploy more capital, we’ll test whether there is enough demand… although that this point this seems like an incredibly low-risk bet.
- Do the fund economics actually work? Earnest Fund 1 was a micro-fund and unsustainable for forming a long-term platform. Fund 2 will be our first attempt and running the full math on whether we can build the team we need, vet the opportunities, service a growing portfolio on a fees and carry structure that is market competitive.
- Can we expand beyond our B2B SaaS comfort zone? Fund 1 has several bets outside of B2B SaaS but candidly this subset of business models has dominated our approach to date. It seems to be the most maximally aligned approach with our economics and happens to be the area I personally know best. In collaboration with our partner roles, we will look to run a few small tests that are clearly outside of the B2B SaaS arena to see how well our approach resonates there.
The plan to ask these questions
As mentioned at the top, this is a draft of ideas for a second Earnest fund, but here is currently the way we plan to answer these questions going.
Earnest’s second fund will be larger than our pilot fund, though still quite small by seed fund standards. The plan is $25-30m. We’ve updated our fund strategy to double down on building Earnest with entrepreneurs, angels, and real people. Learn more about our quarterly LP subscriptions approach.
We’ll continue roughly the same investing pace over a longer period of time (we expect to fully deploy our Pilot Fund in 18 months). In addition to a longer deployment period, the larger fund will enable us to do two things:
- Write slightly larger checks of up to $500k. For our pilot fund our check size was $50k-250k and we have been deploying with an average of about $150k. But we often meet entrepreneurs with a credible plan to raise more in the $250k-$500k range. On a few of our deals we have successfully led and syndicate a small round allowing angels to co-invest alongside us on SEAL terms, but the process is time-intensive and I believe it makes sense for us to at least have the option to take the whole round ourselves when the situations warrants.
- Run several Earnest Operator experiments. There are many talented entrepreneurs and investors with their own expertise and sources of dealflow. I have made it clear from the start that empowering more people to make investments in Earnest Founders is one of our top priorities and Earnest Operators, who will have a real seat at the table including an official designation as “our point person on X” and will work closely with me on investment decisions, will be our first foray into empowering more investors in this space. The long-term plan is to bring the most successful Operators on as full investing partners to help Earnest scale horizontally and do more investments per year.
Although we will still keep a very lean team, we will begin making more investments in systematizing our process in a toolkit for Early Stage Value Investing.
Above all we’ll continue our commitment to helping entrepreneurs build calm, sustainable, profitable businesses and making sure every step we take keeps up as aligned as possible with those founders. It’s been amazing to see the response to Earnest so far and I can’t wait to see what we can build together if we keep at it.
Feedback and Ways to Get Involved
This is a draft so I’d love to hear any and all feedback directly at email@example.com or on Twitter @tylertringas.
We are fortunate enough to have an incredible group of folks working with us and more broadly helping to move the mission forward, if that sounds like your crowd, consider joining us in the Founder Summit Remote community.
Accredited investors who want to see a little more behind the scenes should check out our For Investors page.
Thank you so much for reading 🙏
the modern UK railroad system consists of only 11,000 miles↩
Here I use niche in the ecological sense meaning roughly: sufficiently specialized to the point of acquiring a comparative advantage, rather than simply “small”↩