Introducing the HERO

The most aligned form of funding for early stage start-ups

D2 aspires to be the most founder-aligned VC firm in the world.

Part of that is thinking about and trying to solve some of the negative unintended consequences of venture capital for founders. VC is a phenomenal tool, but it encourages binary outcomes (win big, or lose), which creates a lot of often needless risk and leaves a huge amount of value on the table for founder and investor alike.

Many VC backed startups don’t end up being venture scale ($1B+) but could otherwise become stable and profitable businesses. The founder equity value in these outcomes is often destroyed by endless raises and the desperate pursuit of growth at all costs. On the other end of the spectrum, companies that are growing fantastically are pushed to raise ever more ever faster, even if it doesn’t make sense, partly so that their investors can show a mark-up on their holding.

Introducing the HERO

In a nutshell, we set out to design a structure for funding early stage start-ups that addresses two problems:

1. How do we create more optionality for founders and avoid pinning them down to a set path for how they should build their company for the next decade?
2. Can we create a funding instrument that rewards efficient growth instead of celebrating dilution?

Our answer to that is the HERO. As well as sounding pretty epic, it actually means something. It stands for a ‘Hybrid Equity or Revenue Option’.

How the HERO Works

At its core, the HERO is like a priced SAFE note with an optional revenue share path. Another way to think of it is like a form of redeemable equity.

Using a HERO, D2 would invest in a company and receive the right to a stake in the business (e.g. 10%). If the company goes on and raises another round then the HERO converts ahead of the round and D2 ends up holding 10% of the shares of the company. So far, this is EXACTLY the same as a priced pre-money SAFE.

Here’s the difference: If after two-three years the company has not raised another round, then the HERO starts to convert into a revenue share. The revenue share usually ranges from 2–10% of revenue (the exact number is fixed in the HERO). Each year of rev share ‘buys back’ a slice of the HERO. After five years of rev share, ¾ of the HERO has been bought back and the rev share stops. There are no caps or minimum paybacks: if the company does well, the rev share will be higher and the HERO earns more for the investor, if the company doesn’t, the HERO earns less. The final ¼ of the HERO will remain in case the founder decides to raise or exit the business later. If the company raises a round or exits during the rev share period then the rev share stops immediately and whatever is left of the HERO converts into equity.

So what does this actually mean in practice and how does it solve anything? Lets look at some scenarios:

The HERO creates more options for growth and success

Scenario 1: Venture Path

D2 invests £500k at a pre-money of £4.5M and receives an option on 10% of the business. The company executes strongly and exhibits 30% M-o-M growth over the course of twelve months. To further build out the product, move into new markets and stay ahead of the competition the business decides to raise a Series A round 18 months after the HERO round. The company receives a term sheet from a Series A venture fund and the HERO converts ahead of the round into a 10% shareholding. At this point the HERO falls away and the equity issued by the conversion of the HERO is diluted by the new money coming into the business, exactly in the same way as a SAFE.

Scenario 2: Efficient Growth

D2 invests on the same terms as above. This time though the company is able to scale efficiently in the early stages and decides to put off raising a round until after they have hit profitability and a material size. After two years the rev share kicks; D2 earns a return and the founder is able to effectively buy back equity on the cheap. After five years the rev share stops and shortly after that the company raises a growth round. ¾ of the HERO has already been bought back via the rev share — the remaining 2.5% (¼ of 10%) converts into equity ahead of the round. In this circumstance the HERO has ended up costing the founder up to 70% less than had they taken equity instead of a HERO. Founder win.

Equity efficient champion Calendly would have saved 73% had they raised their seed on a HERO vs. equity

Scenario 3: Off-Ramp

Again, same investment terms as before. In this scenario though the company is growing, but at a lower level of say 5–10% a month. The founder ends up deciding that the market size is smaller than expected and starts to optimise for near-term profitability. Here the revenue share element of the HERO functions as an ‘off ramp’ that simply doesn’t exist in equity venture capital. This business has the potential to become a stable, profitable £10–20M company. That isn’t a great outcome for a venture fund, but for the vast majority of founders it represents a life changing sum of money. The rev share means that the investor recovers part of their investment and redeploys it elsewhere in their portfolio. The founder is then free to choose how to take their business forward without the pressure of an investor pushing for the company to artificially become something it’s not.

We know that the HERO won’t be right for every early stage round, and the majority of the rounds we do will continue to be conventional equity rounds. For the right type of ambitious start-up though, we think it’s a powerful tool that embraces the uncertainty of the early stage and aligns both investors and founders behind a larger set of outcomes without taking away what’s great about regular venture capital investing. If you’d like to learn more about the HERO, you can find the actual HERO agreement, a model to play with and other resources here. Our door is always open too, so come have a chat.