In order for new risk capital structures to become common practice, we need to create a common way of discussing them.
Recent innovative financing structures from firms like TinySeed, Earnest, Indie VC, Womble Bond Dickson, or Purpose Ventures are designed to serve founder profiles left out of the equity paradigm. VC 2.0 widens the aperture of founders who can access risk capital.
However, for many founders and investors, parsing the similarities and differences between these funding structures can be overwhelming. These documents were drafted by brilliant lawyers, for brilliant lawyers.
Funding decisions now can have a profound effect on the business over the next decade. If new risk capital options are to reach mass adoption, founders and investors need simple ways to discuss these new instruments–easy answers to obvious questions like:
What is the difference between the SEAL’s Shared Earnings Payments and the Indie VC V3 Redemption Payment?
We propose a common vocabulary…
…which focuses on the economics first.
As investors, we believe our primary goal in a funding round is to solve for philosophical alignment by selecting the correct economic terms. We are not considering governance, legal, and tax implications, yet. Founders and investors need to know that they’re aiming for the same destination before trying to negotiate the nitty-gritty terms.
The goal is to identify the right Structure.
This places the Structure at the top of the hierarchy of terms. From there, we can deconstruct the ingredients of each Structure and abstract a common vocabulary from the legalese within each. This allows for 1:1 comparisons when each Structure uses different terms to describe the same event.
Structure — The manner in which investment terms, logic, and equations are aggregated to define the possible flow of funds between investor and company.
Since the term sheet summarizes the Structure in bullet-point paragraphs, we’ll call each new known Structure by the name of its term sheet.
A Structure is, naturally, defined by its building blocks.
The central building blocks of a Structure are the Instruments. Instruments define the different paths within a Structure to create investor returns. They take the logic behind an investment and put them into equations which will dictate the flow of funds for the life of the investment. This is the simple math both sides of the table are doing to see what an investment could be worth and the process to get there — “…if Company X sells for $100M, my 5% is worth…”
Instrument — the combination of the Return Variable and Return Mechanism which dictate the economics within a funding structure.
Understanding the Instrument relies upon two sub-concepts which define the economic drivers of an Instrument:
Return Mechanism — The contractual process which determines how return payments are executed from the company to the investor.
Return Variable — The variable by which investor returns are calculated. EG — share price, gross revenue, EBITDA, etc…
The Return Variable is the variable by which the investor and founder are aligning around. If this number goes up, so do absolute returns and visa-versa. The Mechanism describes how this Return Variable is translated into liquid returns. Funding documents can include a slew of clauses that may affect the economics for the investor and founder. However, the Instrument is the backbone of the investment’s economics. It can be thought of as simply the Return Mechanism applied to the Return Variable.
Instrument = Return Mechanism(Return Variable)
Here are equity and debt, the most fundamental investment instruments, broken into their Return Mechanism and Return Variable:
Structuring with Multiple Instruments
An investment Structure is not restricted to a single Instrument. The Convertible Debt Structure is a common startup funding Structure which uses two Instruments. While investors typically use this Structure with every intention of taking the Equity Instrument path to returns, Convertible Debt also offers the Debt Instrument as a path to returns too.
The new risk capital Structures hitting the “alternative capital blogosphere” typically retain the Equity Instrument (if the company sells, investors still get paid for the shares they own) and introduce an additional Instrument (or two) which allow for returns to be created before an exit event. While investors may still be crossing their fingers for an exit, these structures are “non-exit-required” for investors to receive some level of returns.
Periodic Variable Returns (PVRs)
Amongst most new risk capital Structures, the second Instrument (in addition to the Equity Instrument) utilizes a common Return Mechanism:
Periodic Variable Returns (PVR) — A type of Return Mechanism in which the investor purchases the right to regularly scheduled payments derived from a percentage of the Return Variable.
A PVR creates a contract for ongoing investor returns instead of waiting for an exit event. The investor knows a check will come at the end of each month/quarter/etc — the period. The risk is whether or not that payment is a percentage of ten dollars or ten million dollars (that’s the variable part).
For simplicity, when the PVR Return Mechanism is used, the Instrument is called a PVR Instrument. The PVR Instruments amongst new risk capital structures pair with company performance metrics for the Return Variable, keeping returns directly correlated with the company’s performance.
To prevent investors from becoming an everlasting line item expense (think 5% of revenue forever), PVR Mechanisms usually come with a Return Cap on PVR payments.
Return Cap — the maximum aggregate return owed by the company to the investor through PVR payments, typically expressed as a multiple of the initial investment (EG 2- 5x).
When using a PVR Instrument in a funding Structure, the investor and founder must agree upon a) the Return Variable, b) the Percentage, c) the Schedule for payments, and d) the Return Cap.
The Percentage of the Return Variable that is paid to investors each period is based on financial projections. While rooted in pure financial speculation, investors and founders are tasked with identifying the Percentage of the Return Variable which, when paid according to the Schedule, will provide competitive investor returns without hamstringing the company’s financial health. Adding in a Holiday Period to the PVR Instrument can afford the company time to reinvest revenues to reach a more profitable state before the PVR Mechanism is live and payments begin.
Holiday Period — a period of time (EG 18 months) from the investment before PVR payments are due.
With a PVR Instrument, rather than gambling on the odds of reaching a high-priced acquisition or IPO, the investor’s risk lies in whether or not the company can pay the investor back up to the return cap in a reasonable amount of time, if at all. Both a fantastic return (EG 3x in 2 years) and a dismal return (EG 3x in 20 years, or complete loss of capital) are possible outcomes, explaining why the PVR Instrument still falls within the “Risk Capital” bucket.
Discretionary Variable Returns
Unlike a PVR Instrument, where founders are obligated to make PVR payments according to the schedule, DVR Instruments provide “non-exit-required” returns to investors, but they are only triggered at the founder’s discretion.
Discretionary Variable Returns (DVR) — A type of Return Mechanism in which the founder has the option to make payments to the investor in an amount derived from a percentage of the Return Variable.
The TinySeed Structure is the only one currently using a DVR Instrument. This Structure keeps the Equity Instrument and adds two more DVR Instruments. One is triggered when investors raise their salary over a predetermined salary cap (based off of a local median salary), providing the investor a percentage of the total salary raise amount (EG — founder’s raise their annual salary by $20k/year, and the investor is entitled to 20%, or $4k, of this per year). The other TinySeed instrument uses net revenues as the Return Variable. When net revenues are produced in a calendar year, the founder may either reinvest them into the company (as “retained earnings” on the balance sheet) or make pro-rata distributions to investors (a la “dividends”). With the TinySeed Structure, and any Structure utilizing a DVR Instrument, it is important to understand that the founder may elect to never trigger payments, placing more emphasis on the Equity Instrument for returns.
Comparing PVRs: Diverging Return Variables
Within the term sheets, the PVR Return Mechanism goes by many different names, but is consistently defined by a) a percentage and b) a schedule. However, the Return Variable varies across PVR Instruments, making it one of the most important distinctions in identifying the right Structure. It defines the investor and founder’s economic alignment.
Digging into the Docs: RBI and Other Return Variables
The most common Return Variable for a PVR Instrument is gross revenue. When revenue is used as the Return Variable, it is known as Revenue Based Investment (RBI). The Indie VC V3 term sheet creates periodic “Redemption Payments” based off of a percentage of gross revenues. WBD’s Performance Aligned Stock also creates PVR payments derived from gross revenues (which they call D+R payments for tax reasons), and the SHARE simply calls them “Revenue SHARE Payments.”
Meanwhile, the SEAL uses “Founder Earnings” for regular investor payments according to an agreed-upon percentage for the investor. Lastly, Purpose Ventures’s “Redeemable Preferred Stock” uses Free Cash Flows as the Return Variable, delaying PVR payments until the company can reach profitability. This is just a snapshot of the varying use-cases and incentives driven by different Return Variables.
Understanding the differing incentives created by each PVR’s Return Variable is key to understanding the philosophy of each Structure.
The Instrument Interaction
When combining two instruments into one structure, understanding the interaction between them is critical.
Instrument Interaction — the method to account for payments to the investor from one Instrument when another Instrument is employed.
While many new risk capital Structures are uniquely “non-exit-required,” a company may still decide to exit or commit to an exit by raising an equity financing — both known as equity events. With DVR Instruments, since pre-equity event payments are unpredictable and possibly nonexistent, the Instrument Interaction is defined much more lightly. With a PVR Instrument, following an equity event, the Equity Instrument takes over as the sole pathway to investor returns and the PVR Instrument becomes inactive. The Share Price becomes the Return Variable that investors and the company are aligning around, so continuing PVR payments often cannibalizes the company’s ability to grow share value.
Today’s PVR Structures differ in how they account for PVR payments when the Equity Instrument takes over.
Redemption — Accounting for PVR payments by reducing the investor’s outstanding ownership (contractual or actual) in proportion to the Return Cap with each payment.
Andre’s Awesome Artichokes raises $100k from Amy (borrowing from Adam Huttler’s example for congruity) using a Structure which includes a PVR Instrument (a 5% revenue share, paid quarterly, up to 3x) and an Equity Instrument which grants Amy 10% ownership of the company at the time of investment.
After two years, Andre has paid back a total of $200k (or 2x) through PVR payments (the 5% revenue share) and Amy has 3.33% (($300k — $200k)/$300k*10%) in outstanding ownership.
Scenario A — Next Financing: At this point, Andre decides to raise $5M in equity financing from Alex Ventures, which ceases PVR payments to Amy. Amy’s remaining return potential lies in her 3.33% ownership and is now subject to the Share Price of Andre’s Awesome Artichokes in a subsequent exit event.
Scenario B — Exit: At this point, Andre accepts an acquisition offer from Antoine’s Awesomer Artichokes for $10M in cash, which ceases PVR payments to Amy. Amy receives $333k in distributions for her outstanding 3.33% ownership.
Stock Purchases and Redemptions
Redemptions are a longstanding technique which allow companies to repurchase their equity from investors following the original investor stock purchase. Performance Aligned Stock and Redeemable Preferred Shares both define share prices at the time of investment, as well as a Redemption price-per-share. Therefore, each PVR payment’s amount is also the “Purchase Amount” for the company to the investor. The share price for the company’s Redemption purchases equals the investor’s original share price multiplied by the Return Cap.
Redemption Share Price = Investor’s Share Price x Return Cap
For example, with a 3x Return Cap and $1 original share price, the redemption share price is simply $3. This stock repurchase and the investor’s real-time ownership can simply be tracked by an up-to-date cap table.
Contractual Rights to Equity and Redemptions
A Redemption with a contractual-right-to-equity Structure has the same exact economic implications as a Redemption using a share repurchase.
In the case of Indie VC, the investor’s initial “Percentage” is defined in the term sheet, even though there is not an actual stock purchase occurring. This implies a valuation, much like an actual share purchase, and makes outstanding ownership calculations similar to a stock purchase. As PVR payments are made, called “Redemption Payments” in the Indie VC V3 term sheet, the investor’s implied post-money ownership can be tracked by a simple pro-forma cap table.
With the SEAL Structure, the Redemption concept is transposed onto the investor’s purchasing power in a conversion event (typically an equity event). This borrows from the Convertible Debt Structure (again, here’s a refresher on Convertible Debt), using a Valuation Cap (and no discount) to define the investor’s share price for conversion into equity ownership. At the initial time of investment, the investor has a balance that can be converted into stock which is equal to the Return Cap multiplied by the investment amount.
Conversion Balance = Investment Amount x Return Cap
If Amy’s $100k investment uses a SEAL with a 3x Return Cap, Amy will have $300k outstanding for conversion into Andre’s Awesome Artichokes’s equity — before PVR payments reduce this balance.
Notice how the “Conversion Balance” is calculated in a similar manner as the Redemption Share Price. Rather than multiplying the share price by the Return Cap, the SEAL simply multiplies the investor’s balance, and therefore purchasing power in a conversion event. This accomplishes the same thing, in economic terms, as a Redemption using a stock repurchase, though the investor’s post-conversion event ownership is subject to the terms of the subsequent conversion event.
Founders can track the investor’s outstanding purchasing power in a conversion event and project the investor’s post-conversion ownership, much like Convertible Debt notes (try this modeling tool), though ownership will ultimately be determined by the terms of the converting equity event.
When signing up for a Structure that includes an Equity Instrument, it is important for founders to understand how much of the company they are giving up, or putting up for possible conversion. Redemptions make this an ongoing calculation as PVR payments are made.
There is a simpler approach to account for PVR payments when the Equity Instrument takes over — subtracting payments made to date from the investor’s conversion value.
Subtraction — Accounting for “non-exit-required” investor payments in an equity event by subtracting the sum of PVR payments to date from the resulting share purchase or distributions in an exit event.
The SHARE Structure is the only prominent new risk capital structure which currently utilizes this method with a PVR Instrument.
TinySeed’s Structure also uses Subtraction (though not with PVR payments) to provide investors with a net 1x return should an exit event not provide at least a 1x in pro-rata, akin to a 1x preference.
The simplicity of Subtraction to account for earlier investor payments (especially with PVR payments) is worth distinction. As it is used in the SHARE, Subtraction is essentially a Convertible Debt Structure, except aggregate PVR payments (“Revenue SHARE Payments”) reduce the investor’s conversion balance in a conversion event.
Adam Huttler’s example (originally here) explains the SHARE’s subtraction method in an exit scenario.
Scenario B — Next Financing: Had Andre decided to raise equity financing at a pre-money $100M valuation, the $300k would have been subtracted from Amy’s purchasing power in the conversion, again resulting in $1.7M of stock, now waiting for an exit.
Compared to a Redemption, the Subtraction method provides simplicity in exchange for the ability to repurchase ownership from the investor.
Adding A Residual Stake to Redemptions
To avoid missing out on this exit potential with a Redemption, many new risk capital Structures will include a Residual Stake.
Residual Stake — a portion of investor ownership in a PVR Structure with a Redemption which remains intact regardless of PVR payments.
Residual Stake Exit Example: Had Amy and Andre included a Redemption instead of Subtraction, Amy’s ownership would be fully redeemed at the 3x (in three years!) and she would not have any ownership in the company at its $100M exit (or equity round). Amy’s funds helped launch a $100M company very early on in its trajectory, but Amy didn’t reap any of the exit value. Her 3x in PVR Returns is still admirable, but just 15% of the maximum $2M in ownership she could have ended up with. The Subtraction method ensures the investor has a stake in the company in an exit.
The Indie VC V3 Structure includes a Residual Stake as a portion of its original ownership “Percentage,” per the following language:
The Company may redeem 90% of the Percentage (for ex., if the Percentage is 10%, then the Company may redeem 9% of the original 10%) by making the redemption payments described below.
Earnest Capital has indicated that they may include a residual stake in their Structure as well.
Residual Stake Exit Example — Amy invests $100k into Andre’s Awesome Artichokes using a Structure which includes a PVR Instrument (a 5% revenue share, paid quarterly, up to 3x) and an Equity Instrument which grants Amy 10% initial ownership of the company at the time of investment, subject to a Redemption, with a 1% Residual Stake.
After three years, Andre has paid Amy $300k through PVR payments (the 5% revenue share), hitting the Return Cap. Future PVR payments cease.
Five years later, Antoine’s Awesomer Artichokes purchases Andre’s Awesome Artichokes for $100M. Amy’s 1% Residual Stake becomes liquidated for $1M (1% * $100M), and Amy ends up with $1.3M from her initial $100k investment.
Whether it is through a redemption or subtraction, stock purchase or contractual-right-to-equity, and includes a residual stake or doesn’t…..
Think of the Instrument Interaction as a third psuedo-Instrument, defining the math and relationship of the two Instruments.
Comparing Instrument Interactions
The funding Structure is the operating system for a relationship that can last more than a decade. It is critical to understand what this operating system is optimized for.
While Structures are each written in their own term sheet’s legalese, today’s new risk capital Structures all build off of the same economic principles and mechanisms. By using a common vocabulary between Structures, investors and founders can more effectively communicate and discover economic alignment.
Download the complete vocabulary and all diagrams HERE.
And let us know what you think of this vocabulary in the comments below. It’s only as good as the practitioners using it.
Huge thanks to Brad Bernthal and Zachary Mueller at CU Boulder’s Silicon Flatirons Center for helping us refine and explain this vocabulary.