Long-term investment capital for early-stage businesses (aka funding for bootstrappers)
1/ Shared Earnings: Investors earn when founders earn
The core idea of a SEAL is that investors make an upfront capital investment and then are entitled to receive a percentage of what we call Founder Earnings.
What are Founder Earnings? Most business owners see revenues come in, other expenses go out, and whatever is leftover is a sum of money that founders can chop up into one of three things:
1) founder(s) salaries
3) retained earnings (which are kept in the business but can be converted into #1 or #2 at any time)
Traditionally, equity investors are entitled only to a percentage of dividends. But founders who own all/most of their company are entitled to draw arbitrary lines between salary, retained earnings, and dividends. This doesn’t make a lot of sense and can devolve into proxy battles over what is a “fair” salary, should investors get a board seat that approves salaries, etc. Instead we decide to lump it all together into Founder Earnings which represents the economic value going to founders. SEAL investors get an agreed upon percentage of that, called Shared Earnings, which creates more clarity and better alignment.
But wait, what about the early days when the founders are barely paying themselves just enough get by, do the investors start taking a piece of that right away? No, a Founder Earnings Threshold is agreed to (typically defined as $X per year per founder) and the investor percentage only kicks in once Founder Earnings exceed the threshold.
Note: this is not revenue-based financing. SEALs are often grouped in with revenue-based debt products which are repaid as a percent of top-line revenue. But by using Founder Earnings plus a threshold, a SEAL is much closer to a profit-share and investors should typically expect a growth period after the investment before any Shared Earnings begin to be paid.
But the Shared Earnings are not paid in perpetuity. A SEAL defines a Shared Earnings Cap that is a multiple of the initial investment. In our deals and others experimenting with SEALs a Shared Earnings Cap can be anywhere from 2-5x the initial investment. Once the Shared Earnings Cap is paid back, Shared Earnings stop, and the founders can continue operating the business as is, in perpetuity without paying another dollar to investors. However, the next section creates long-term alignment for founders and ensure investors’ total potential returns do not have a hard cap.
2/ Long-term Alignment and Optionality
One of the core strategies of Earnest Capital is to bring together an incredible group of experienced founders who are both mentors to companies we back, and literally invested in their success. We wanted to ensure there was long-term alignment with the success of companies who raise capital on a SEAL. Also, let’s be honest, every investor backing companies at the very early stage wants to have some chance of a huge uncapped return if they back the a billion-dollar business.
The SEAL includes an Equity Basis (the numerator) and a Valuation Cap (denominator) which defines a percentage of the company that investors are entitled to if the founders decide to either a) sell the company or b) raise a priced round of equity like a Series A from a traditional VC. That Equity Basis is reduced over time as Shared Earnings payments are made, but there is a residual Equity Basis that remains after the Shared Earnings Cap is fully repaid, so investors are still incentivized to help founders keep building the company. At that point, investors have already gotten a decent return on their capital and won’t be clamoring for a “liquidity event” so they can get their money back. This allows investors to be supportive and in most ways indifferent between either a strategy of a) grow fast, reinvest every dollar in growth, and sell the company b) grow sustainably, build a massively profitable business and never sell it or c) anything in between on the spectrum.
The convertible piece operates much like a SAFE and if founders decide later that they want to raise a round of venture capital, our investment converts to equity without any issues. We like to think of a SEAL as a convertible financing structure that actually makes sense even if you don’t raise more capital and convert it. Weird right?
If this seems a little complex, well we agree, although everything in finance seems complex until it doesn’t1. One reason for wanting to handle every possible outcome is that we are committed to a SEAL not having any control over the business: no equity, no shares, no board seat, no preferred voting rights. This means we have to create investor/founder alignment with almost any possible scenario for the business. Every word added to the SEAL was part of a public process we kicked off trying to collaboratively create funding for bootstrappers.
- Is there an easy way to run the numbers on this? Yes! There’s a public spreadsheet (make yourself a copy) and a gratuitously long video explaining how to use it.
- Is the accounting going to be a pain here? No. It’s fairly straightforward to calculate founder earnings. At Earnest we have a great relationship with Bench bookkeeping where they will include Founder Earnings for free as part of their bookkeeping service.
- Net Income, do I need to do GAAP accounting to use a SEAL? No, in our definitive documents we say roughly: cash accounting is totally fine, but if there is a dispute then we’ll fall back to GAAP definitions to resolve it.
- Is there a salary cap? Nope! The whole point of Founder Earnings is to make the demarcation between founder salary and dividends irrelevant. Founder set their own salary based on sensible things like their cost of living and what their accountant recommends for tax purposes. We go through every permutation of that question here.
Why use a Shared Earnings Agreement
A SEAL aligns incentives of both founder and investor to build a healthy profitable business that goes the distance. If you want to build the next Basecamp, Buffer, Wistia or Wildbit or a $25m/year profitable, growing, calm business with happy customers and healthy employees, a SEAL makes that a success for founders and investors.
A SEAL creates zero pressure for founders to raise further rounds of financing or sell the business, while also keeping those options on the table if the founder chooses.
The Shared Earnings Threshold explicitly acknowledges that founders and employees have a livelihood, family obligations and a life outside of their business, without also letting investors set your salary. This is business, we’re investing and need to earn a return, but we believe that stress, burn out and overwork are more likely to kill your startup than not having your customer acquisition funnel fully optimized.
We hope it provides clear intuitive terms that maximize options for the founder. We want to avoid perverse incentives for founders to make any weird decisions because a poorly thought out investment structure incentivizes them to do something that isn’t what they determine is best for the business and team.
Sometimes at the early stage of the business, you don’t know if you want to build a billion-dollar rocket ship, a world-class company that dominates a niche, or an amazing lifestyle business—a SEAL leaves all options on the table while providing smooth transitions if the plans change.
We are really happy with our version of the SEAL but sometimes founders or other investors approach us wondering how it might work with a few tweaks. The most common changes are 1) what if there was no Shared Earnings Cap, so Shared Earnings was a perpetual percentage and 2) what if there was no residual Equity Basis, so that once the Shared Earnings Cap was fully paid back, that’s the end of the relationship.
In our opinion there is no fatal flaw in either of these and if you are experimenting with a variation, we’d love to hear from you and help however we can. However we don’t take these approaches for the following reasons.
1) In our continual hunt to stamp out misalignment, we noticed that founders and investors tend to value the profits from a business venture differently. Investors are more sensitive to ROI or IRR, because they have lots of other opportunities to reinvest the returns into new investments, whereas founders tend to be more concerned the total cumulative amount of profits they get because they are all-in on their one company. If you run the numbers on various successful outcomes for a business with (a) a 10% perpetual Shared Earnings vs (b) 30% Shared Earnings with a 3x cap you find that (b) provides much better IRR by shifting the cashflows to the investor in time, while also taking much less in total dollars from founders over a 10-year period. Whereas (a) provides an inferior ROI to investors because it is unlikely to pay out much for years, but if the business becomes really successful the founder is stuck paying a huge perpetual dividend in exchange for a comparatively small amount of seed capital provided many years ago.
2) This is much more a matter of opinion. All things equal the Shared Earnings Cap should be higher if there is no residual Equity Basis and it’s purely a question of whether the founder really wants a future in which they “return to bootstrapped” and the investors walk away, or both parties want to create long-term alignment. Either variation is fine and even Earnest is open to this in theory.
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