But 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.
I think it's really altruistic, but I'm not sure how big this market segment could actually get.
Also, they list a starting point of $2k-$5k in MRR, and on a $150k investment with a 30% split, they break even as soon as the founder(s) have taken $350k in total salary (again ignoring time value of money), including any salary paid out of the original $150k investment. I don't want to trivialize the process of scaling a startup beyond $2k-$5k of MRR, but I bet more than 20% of companies with $2k-$5k of MRR are capable of reaching that point.
[0] https://docs.google.com/spreadsheets/d/1h_L7oa3rbV8P-ZnMM-l1...
edited for clarity
How so? Who's paying that 30% if you have zero revenue?...did you mean "if those companies never saw a penny of profit"?
> I'm not sure how big this market segment could actually get.
Keep following along and see :)
What exactly is a "residual stake"? In your spreadsheet this is set as 9.5%...where did that come from? Is this is a stock option, convertible note, or equity position?
By what instrument though? Are you offering a stock option at a strike price? Is it equity at a priced round? Or is a convertible note? Other? You can just say "if you sell we have the option to take a %"...
Just to reiterate all of these terms are negotiable at the time of investment too.
And they're trying to hide the 9.5% part.
The secret is there's a huge opportunity in between and tons of amazing founders and businesses we're excited to back.
How did you settle on a 3-5x return cap? Are you planning to tune that over time? Did you consider a graded return schedule? I don't know if you've published your profit share or if that varies by deal, but I'm curious if something like 25% up until 100% recoup, 10% up to 200%, 5% up to 3-5x target would compare to a flat 10-15% or whatever.
As a point of comparison, I used a portfolio loan to buy a business to run as a side project. The debt service on ~$125k is variable but roughly $500/month. At time of purchase that was about 20% of net, but that number will go down as the debt is paid and revenue grows. If I pay it off in ~5 years the total debt service will be in the range of $20-$30k... BUT that means almost all net is going to pay down the debt vs reinvesting in the business.
I know you're targeting more bootstrappers who want to go full time, but if this type of funding were available for side hustle acquisitions I'd probably consider it pretty strongly instead of taking on a bunch of personal risk (even though the rewards for me become less on paper).
Yes, very much consider this our next product. Will build, measure, learn, iterate as we go.
> I used a portfolio loan to buy a business to run as a side project
It's a useful comparison but not apples to apples. There are a lot more capital options to fund an operating business (ie SBA loans, IRA loans) than starting a new one. We are focused on the latter.
Our financial model might be a good fit for acquiring co's but it's not our strategy. Happy to help if anybody else wants to give it a shot.
We have a Return Cap which is negotiated on a per deal basis but we guide toward 3-5x the initial investment.
Besides the no equity position of Earnest, could you do a quick compare/contrast with TinySeed, of similar ilk and recency?
If there was a checklist online that we could tick ourselves before we start talking to you, it would be awesome.
I've seen a number of VCs and other pundits recently say things of the form "there's a reason why for decades, there were only bank loans and VC and not much in-between". Eg Jerry Neumann (a NY based solo investor) has a nice twitter rant about it here: https://twitter.com/ganeumann/status/1093961051425697794
If I follow the math in his linked blog posts well (eg [0]), he's basically putting down the hypothesis that there's 3 categories of companies (determined by the alpha value of the power-law distribution they're in):
1. Companies where the risk and the upside potential are small. This is where bank loans are focused.
2. Companies where the risk is enormous but the upside potential is "meh".
3. 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. And if his hypothesis is right, then you're 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.
I don't think you're mad, however, so you must believe that his hypothesis is wrong. If so, why now? What changed in the world, or in the investment landscape, or in technology, that suddenly multiple people (you, indie.vc, etc etc) believe that a low-capped profit sharing scheme for startup investments is a good idea, when nobody did before? Did the risk go down? How did it? Why? Why now and not 10 years ago?
Super interested in any insights you might have on this. Great job, hope you succeed (i.e. I hope to be proven wrong)
[0] http://reactionwheel.net/2019/01/why-do-vcs-insist-on-only-i...
* disclaimer: I'm a founder, not an investor and I don't spend a lot of time thinking about this stuff. Ergo I probably misinterpreted a lot of what Neumann is saying. If someone (or Jerry himself) reads this and thinks they know better, I'll be happy to stand corrected.
traditional VC model is great for generating scale and creating barriers to entry/competition, but few businesses warrant that kind of scale and fewer use the capital to create real barriers.
Lending is for cash flow businesses - you can have zero hard collateral (eg PPE) but if you have historical steady cash flows, you can get loans, no problem (in my experience). The problem here is few startups focus on cash generation. They are enamored with growth at all cost, aspiring to the VC model when it isn’t appropriate.
For ex, many growth equity funds focus on a "doubles and triples" strategy where the risk / return profile is somewhere in between that of a bank loan and VC. They're looking for high probability of 5-7x returns, and low probability of capital loss, for each deal. Theoretically, this "bootstrappers' VC" model can be thought of as a scaled-down growth equity model: revenue-generating businesses in growing markets with potential for near-term profitability
Biotech VC is another good example of a "singles and doubles" strategy generating outperformance. Until the last few years, it was rare for a biotech startup to get to a $1B+ valuation in a 5-7 year venture timeframe, and considered impossible for a biotech startup to become a decacorn in that time period. A successful exit was a ~$500M outcome that returned a 5-10x. These funds have outperformed tech in many cases. See 37:46 here [0]
To build a fund that can return 3x in an environment with constrained exit sizes, you need to focus on consistent doubles and triples: 1) low loss rates, 2) capital efficiency, 3) modest valuations, 4) disciplined investment decisions. I don't know whether the fund math works for this particular "bootstrappers VC" model, but it is certainly possible for a disciplined "doubles and triples" venture fund to perform well
[0] https://lifescivc.com/2019/02/our-year-in-review-annual-talk...
A few (unsubstantiated) guesses at reasons to counter:
1 - Medium risk medium reward opportunities exist (a currently unprofitable but otherwise promising startup addressing a 25m niche can't get bank debt or venture funding)
2 - Could decrease risk holding reward (avg. multiple of investment) constant by having small funds with managers that have deep knowledge of particular niche deploy smaller checks in markets they are better at evaluating (v. large fund managers needing to cast net wider than their "lane")
3 - Size expectation can be correlated with risk. Can decrease risk holding reward (avg multiple of investment) constant by just having smaller funds writing smaller checks for smaller companies that be happy with smaller exits or alt. upside capture (v. forcing companies that could work with small exits into chasing big inflexible exits). Sure no 100x-ers but theoretically could see higher blended fund returns
4 - Opportunities generally continuous on risk and reward calling for equally diverse approaches to capitalization
I think one of the main arguments in favor of a bimodal distribution of VC and Bank (or high and low risk) funding is that if you are in that middle "medium risk medium reward" zone it can be really difficult to defend your position for any stretch of time. You will be attacked from both bigger players to whom you've proven a market, and smaller players who are willing to take bigger risks to see if they can blow that market up (or bite off a smaller piece of it).
In order to maintain a medium risk medium reward business you need something approaching a monopoly, but also you need the market in which you have a monopoly to be growing and not attracting new players. Maybe some of these exist, but they are very rare and I suspect identifying them is not significantly easier than identifying startups with high growth potential.
So I think skrebbel's question is pretty fair, though I suspect OP has heard it a lot. I would predict that this fund passes on WAY more deals than even a standard VC fund, and will be required to determine the risk of the investment even more effectively. That's a tough problem, and I do really wish them luck!
The major thing that's changed is the availability of data. A $100k loan used to take several hours of expensive analyst time to process manually, and since most would be rejected, it wouldn't be worth it. Now a business can, e.g., securely share real bank account data.
That makes the whole process much faster, which reduces the cost per loan, which makes smaller loans profitable.
I imagine something similar can apply for small business equity.
Also interested how you guys get paid. Did you raise a fund? Are LPs mostly HNWs? Any institutions? Is the investment horizon of the fund similar to a typical VC fund?
And finally, I would imagine your SEA gets negotiated on a deal by deal basis if a portco raises more traditional VC? I'm curious what a series A looks like when there's a SEA in place that hasn't reached its return cap.
Thanks!
The usual story and rationale around VC focus and outcomes no longer makes sense (if it ever did). By their own statistics (Cambridge Associates) they’re pretty bad at their job. The power law returns aren’t just applicable to the companies they invest in but to the funds themselves. Mobile atm so I don’t have all the research to hand but up to circa 2011, it is something like 90-95% of funds did not even manage to return the fund to investors. The success of the entire industry came from the same 5-12 firms, who were largely syndicated into the same handful of investments (Yahoo, Google, LinkedIn, etc.). If you were in the breakout success story for that cycle you were a winner.
I’m pretty dubious about the generally accepted wisdom from a group who have a couple of lottery winners among a bunch of losing bets.
That’s all changed in the current cycle. I don’t think that’s because VCs suddenly got better at what they do. I think it’s because the economics of launching a company changed, as did the expectations around traction to raise your first rounds. There are exceptions in some verticals (hardware, med/bio tech, etc) but then vast majority of startups no longer have huge capital outlay just to prove technical viability. They’re not building a fab facility to produce silicon, they’re not trying to iron out how to do that at scale, they’re not dropping $40K for a single SGI server they need to rack. They’re paying very low opex, and depending on access to credits from vendors maybe not even that. For a team with tech capability they need little more than time to actually build the product to actually have something in market. Plug in Stripe or similar and they’re able to prove revenue too.
The net result is VCs are not investing in anywhere near the same level of risk as they were 10-15 years ago. There’s very little investment in a deck full of ideas (you’d need a team with previous track record) and a lot of investment in scaling working products. “Is this technically possible?” risk is largely non-existent. “Can this team build it?”/execution risk is heavily discounted. “Can this scale?” has been reduced to “worst case we can probably throw money at this with a cloud vendor to weather rapid growth”. What’s left is doubling down on sales and marketing.
What’s happened is a period of riches for VCs because founders & teams have leveraged tech advancements to reduce the risk of failure. But the investment industry hasn’t reacted and have instead captured an outsized upside. And I think the 10 year feedback loop for funds probably isn’t helping them to see it (also, what’s the incentive? Why leave money on the table as an investor?).
I see Earnest and similar initiatives as being the competitive response to correct this imbalance. In 10 years you’ll no longer have VC as an expectation to achieve a unicorn (or whatever we’re calling them then) valuation, and whatever investors you have will have an appropriately risk adjusted return.
Is there a limit on the term? Let's say you invest $100,000 in a $3k MRR business. Unfortunately it does not grow, or maybe even MRR declines. What happens to the investment obligation?
There's no limit. If the business stalls at $3k MRR (ie no Founder Earnings) it can go on running forever or shut it down. We would get a % if it was ever sold.
Second, can you explain the valuation cap in terms of acquisition. Let's say I take $100k in investment, and 5 years later I sell the company for $10M. What is the max amount Earnest Capital will receive?
% of the sale would be roughly $100k / Valuation Cap (which is negotiable at time of investment).
2. How big is your fund?