Yesterday, Tyler Tringas, co-founder of Earnest Capital went live on Hacker News to answer questions. For those not aware, Earnest Capital provides funding and mentorship for bootstrappers, indie startups, and hackers mostly in SaaS, e-commerce, and scalable online education.
Earnest Capital has been receiving a lot of attention because of their different investing structure than traditional VCs or accelerators. They have a novel Shared Earnings Agreement investing model.
Key attributes of a Shared Earnings Agreement by Earnest Capital
- We invest upfront capital at the early-stage of businesses. Typically (but not always) after a product has launched, but before the founders go full-time.
- We agree on a Return Cap which is a multiple of the initial investment (typically 3-5x)
- We don’t have any equity or control over the business. No board seats either. You run your business as you see fit.
- As your business grows we calculate what we call “Founder Earnings” and Earnest is paid a percentage. Essentially we get paid when you and your co-founder get paid.
- Founder Earnings = Net Income + any amount of founders’ salaries over a certain threshold. If you want to eat ramen, pay yourselves a small salary, and reinvest every dollar into growth, we don’t get a penny and that’s okay. We get earnings when you do.
- Unlike traditional equity, our share of earnings is not perpetual. Once we hit the Return Cap, payments to Earnest end.
- In most cases, we’ll agree on a long-term residual stake for Earnest if you ever sell the company or raise more financing. We want to be on your team for the long-term, but don’t want to provide any pressure to “exit.”
- If you decide you want to raise VC or other forms of financing, or you get an amazing offer to sell the company, that’s totally fine. The SEA includes provisions for our investment to convert to equity alongside the new investors or acquirers.
The Hacker News conversation was a big hit, with Tyler mostly answering questions and offering pieces of advice to upcoming entrepreneurs while also explaining their novel strategy. Per Tyler, Earnest Capital works like a “profit-share + a SAFE”. The primary function is for them is to share in the profit (or more specifically “founder earnings”) of the business alongside the founder(s). If later a business owner decides to sell the business or raise a big equity round later, Earnest converts into a SAFE.
On how it is different from a Venture Capitalist Investment
A user asked, “If I read your agreement correctly, your terms are so that you invest $150k in what is or nearly is a bootstrapped business, on what essentially seems like a profit share basis, and expect to get paid for your doing so until you’ve made $3M?” Tyler’s response, “$3m?! No. We have a Return Cap which is negotiated on a per deal basis but we guide toward 3-5x the initial investment. This post walks through each of the terms in detail.”
Traditional VC model usually works in cycles. The founders raise some money, then they build and sell, raise some more, build and sell. This cycle continues by the time they have raised enough money to be at least close to a profit.
“How does that work with bootstrappers? Ideally, they’d only have to raise money once (from you), but what happens after the $100k (example) run out and the business is only generating, let’s say, $2k/month? Back to 9-to-5?” asked another user. Tyler argued that this is true only in some cases.
Earnest Capital’s goal is for founders to get to “personal break-even, where they can pay themselves enough to work on the business full-time, by the time our investment runs out. Some percentage of these will fail (startups are hard) and we’re expecting that”, he added.
On comparison with TinySeed
People also appreciated the novel non-VC funding space asking Tyler to do a quick compare/contrast with TinySeed, (TinySeed is also a startup accelerator designed for bootstrappers) of similar ilk and recency.
Tyler commented, “Specific to the funding model, we both do a kind of profit-share, with the main difference being that Earnest’s repayment will usually happen earlier (assuming the business is successful) but is capped, Tinyseed payments would be smaller in the earlier years and keep growing over time perpetually. Neither one is “better” and I probably wouldn’t advise founders to choose between an offer from both on the basis of just the funding model.”
On their 3-5x return cap
People also had concerns regarding the 3-5x return cap. Some called Earnest Capital “more of a charity than a profit-making enterprise?” to the extent of calling it altruistic. A Hacker news user observed, “For the math to work out, with a 3x cap on earnings, you need 33% of the businesses to be successful just to get your money back. At 5x you still need 20%. And that is over however long it takes for those companies to reach payback, which could be measured in decades for some of the companies.”
To this, Tyler said, “We also have a residual, uncapped, % option if the founder ever sells the business. This keeps us aligned with the founders to keep helping them grow the value of the business for the long-term even after the Return Cap is paid back.” He added that they are preparing to fine tune the return cap model building, measuring, learning, and iterating as we go. Basically, he added, “By default, we don’t take equity (shares, a board seat, none of that). If you decide to raise a round of equity financing (ie VC) we could convert into equity alongside them and if you sell the company we get a % of that.”
A user countered it saying that “This return cap is stated as 9.5% in the spreadsheet. But, where did that come from? Is this is a stock option, convertible note, or equity position?” Another user added, “They don’t explain it, but it sounds like the whole deal is effectively seed financing where they eventually get a 9.5% stake, but also with a 3-5x loan interest payment once you make money (which they’re framing as “Shared Earnings”). And they’re trying to hide the 9.5% part.”
Tyler offered no comments on this thread.
On being asked why return cap is better than just taking out like a 20-30% APR business loan, Tyler said, “At the risk of not answering the question, I’d say no form of capital is “better” than any other. Capital is a tool and the job of the founder is to find the option (both on payments term and other aspects like mentorship or personal exposure) that best aligns with their goals.”
On his thoughts on Jerry Neumann’s theory
Jerry Neumann, who is a Venture Capitalist at Neu Venture Capital has a theory about why “there’s a reason why for decades, there were only bank loans and VC and not much in-between.”
Per his theory, there are 3 categories of companies (determined by the alpha value of the power-law distribution they’re in):
- Companies where the risk and the upside potential are small. This is where bank loans are focused.
- Companies where the risk is enormous but the upside potential is “meh”.
- Companies where the risk is enormous but the upside potential is also enormous. This is where VC is focused, and it’s why they’re all about finding those few big hits because this covers all the losses (or mediocre performance) of the rest.
Neumann appears pretty confident about this hypothesis; not because he can explain the underlying phenomenon, but simply because until now he’s not seen much successful funding for companies that’s neither VC nor bank loans.
A hacker news user points, that “if his hypothesis is right, then Earnest Capital is targeting companies of type 2: investments with enormous risk (comparable to that of a high-growth startup) but at the same time you’re hard-capping your upside at 5x. That seems madness.”
Tyler comments, “I like Jerry’s work a lot but come to a different conclusion. My basic thesis is that we’re in the deployment age of the internet/web/mobile era and there is a whole new wave of a lot lower risk and a bit fewer reward opportunities for companies to bring the “peace dividend” of the software areas into markets that are not winner-take-all.
The upside is these businesses are much more capital efficient, can scale and potentially produce much higher returns than SMBs from previous eras. The downside is they have no collateral and are thus completely unbankable for traditional small business lending. We need a new default form of capital for entrepreneurs and we are trying to build it.”
Overall people were generally appreciative of Earnest Capital and wished the company success. Here are some positive responses.
“Hi Tyler, this is amazing! Going through the FAQ it seems, you’re not investing in India right now! Would love to know if and when you do!”
“Very cool, Tyler. Just applied. 🙂”
“Congratulations on launching! Sounds like a nice compliment to IndieVC and TinySeed. I’m glad to see innovation here, interesting times!”
“Awesome to see innovation from capital providers on the instrument in the wild. As a niche market founder wish option like Earnest existed when we were raising early financing.”
We recommend you to go through the entire thread on Hacker News. It makes for a very insightful conversation.
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