Alternative Funding Calculus: A Quant Comparison of Tiny, Indie, and Earnest
Previously, I described the new wave of funding sources that are emerging for bootstrappers. Today, we’ll place a fictional startup named “Array” under the microscope, consider a fundraising strategy, and compare the financial outcomes of raising money from three alternative funds based on publicly-available term sheets.
NOTE: This post was revised on May 23rd, 2019 using a new version of Summit that corrects the previous calculation of Earnest Capital’s “Founder Earnings” term. Thanks to Tyler Tringas of Earnest Capital for the clarification.
Imagine you have your very own startup: Array, a video conferencing tool for distributed teams. You have a real passion for the problem because you (like every other human), knows that every existing web conferencing solution sucks. Even better, you’ve already solved the real crux of it, which required rewriting part of the standard WebRTC library using C++. That means this idea is way out-of-bounds for most web dev kids-these-days. Which is nice, because you’re not interested in going faster than you want.
So you have a real product with a technical moat. What else is great about Array? Let us count the ways.
You’re so stoked about the design and UI/UX breakthroughs that you plan to charge a premium for the service compared to other solutions like GoToMeeting. $299/mo per team (up to 10 users) has a nice ring to it. That said, you don’t plan to sell to enterprises because they will ask for things you don’t want to do, and for you, custom is loathsome.
You and your co-founder are both technical, but you don’t consider marketing a dirty word, so you spend a fair amount of time shielding your brilliant Woz from any such distractions.
Product? Check. Positioning? Check. Team? Check.
Early response to Array has been positive. You have just over 150 prospects visiting your site each month and signing up for your newsletter. Early access customers (who are enjoying a free trial) have written testimonials for your next home page. And you just wrote a killer content marketing piece that succinctly explains in 8 hand-crafted pages why distributed teams are the future because distributed teams of futurists literally distribute the future more evenly. And your, product, does, that. Wow! People love it.
Life is good, but given that your goal is to become free to focus full-time on this venture, you feel a bit stuck — Array isn’t earning the $200k-$300k per year (ARR) it would cost to feed, clothe, and shelter you and your co-founder and your families. So you’re giving some of the new, bootstrapper-friendly funding options like Tiny Seed, Indie.vc, and Earnest Capital some serious thought.
But before you engage, you wonder — what will it really cost you, and what will it take to break free? Are you better off bootstrapping? Would one set of terms work better for you than another set? Knowing there’s always some amount of give and take, what terms deserve your focus?
To decide on the best form of funding for Array, you consider two factors: your speed to market, and your profitability.
Speed analysis: Taking money would allow you to go faster, no question. On the other hand, you’re not sure you have to go faster to achieve your dreams. Your arcane, low-level moat is wide enough that an upstart can’t easily come along and steal the opportunity. That said, a large, innovative incumbent like Slack — whose video tools are used widely within the kinds of organizations you’re targeting, might have the chops and means to launch something killer if they take the initiative.
Speed verdict: We may have a strong defense from weekend upstarts, but we should move into the market with Array before an incumbent includes this as a killer feature in their in-market platform.
Second, you consider profitability. If you were intent on pushing the incumbents out of existence, you’d need to spend a boatload of cash of marketing and PR at scale. This would keep profits thin until you were dominant. You’d also need a more powerful competitive advantage — something that attracted users by the millions and took them away from the incumbent services. Something more powerful than a better experience, perhaps? You’re not sure what that is, but is it possible? Sure, maybe. And if so, a larger product team with a growth hacker or two sprinkled in, would be necessary … and expensive.
On the other hand, the nature of this market isn’t winner-takes-all, at least not now. Should you spend millions trying to make it that way? You could, but do you have to, to achieve your dreams? Could you build something exciting that was profitable instead of acquiring customers at the highest possible rate? Could you balance these and be content?
Profit verdict: Your software is going to be at a premium price point, which means your unit economics will be healthy if you’re successful. With this assumption, and the speed verdict (you don’t have to go ludicrous speed), you decide that taking a modest profit — not investing every dime back into the business to grow as fast as possible, could make sense.
With this strategy in mind, you compare funding options by creating a 2-year growth forecast using your current monthly mailing list signups (155), estimated conversion rate (5–15%), team size (2), current MRR ($2,400), inherent product virality (k=1.0), and target price points ($99-$499/mo, billed annually 20% of the time, 80% monthly). Rather than open Google Sheets or Excel, you use Summit to do the heavy lifting.
The first question you want to answer is how much cash you should raise. You set “Bootstrapping” as your funding model, which will assume you only have your current cash balance of $10,000 to work with.
Your 24-month cash forecast based on those inputs:
This forecast contains 10 runs, representing a range (ensemble) of market timings and momentum (because things never go according to plan). The 3 runs in this image represent a weak-median-strong spread.
To interpret this chart: if you and your co-founder were to go full-time next month at $100,000 pre-tax salaries, your bank account would bottom out at roughly negative $70,000 in approximately 8–10 months. And that’s assuming none of your assumptions are rosy.
Your net income, meanwhile, for these scenarios shows break even occurring somewhere between months 9–12 (purple areas shifting above $0):
The tall green bars are dividend payments to your team, monuments of hope on the horizon.
Lastly, revenue, showing all 10 runs to illustrate outliers vs. consensus:
Not a hockey stick, but you’re just above $600k ARR in the best case scenario — and not doing terribly at $360k ARR in the weakest case. The average is ~$400k. In the strong case, you’ll have profit to pay dividends, or hire help. In all cases, you’re alive and growing — if you can make it that far.
If negative $70,000 is the nadir, raising $100k-$150k from an alternative funding source could make sense. Let’s compare taking $140k from each:
More cash should allow you to grow fast, but to stay conservative, you decide to keep almost of your growth assumptions the same, selecting TinySeed first and punching in $140k for 12% ownership. Their terms also make TinySeed eligible to receive dividends, just like your team. If, for example, you chose to pay $100,000 out as a dividend (better than income for [U.S.] tax purposes), you would receive $88,000 and TinySeed would receive the difference of $12,000.
The one change you decide to make: with the new cash, you will allocate 10% of your monthly budget (non-variable expenses) towards paid lead acquisition at an estimated CPA of $50 per, driving leads into the top of your funnel to boost ARR (and your own return on dilution):
Assuming you don’t pay dividends until you reach profitability, and assuming that you only pay dividends when you have more than 3 months in expenses, the future looks like this:
Using the above strategy — keeping the business well-fed with 3 months of cash even while profitable and gaining steam, in the average case you have paid $12,600 out to you and your teammates while sending $1,724 to TinySeed, which is 12.3% of their original investment. In the weak case — one in which you are still on your way to a $475k+ ARR business, you have elected to pay out $0 to conserve cash. And the strong case is a numerologically-satisfying 10x of the weak case.
And of course, your cash forecast is looking much better; in all scenarios, you survive “the dip”:
Great. So far so good. You run it again, using Earnest Capital as the funding source, like so:
Using the same logic for paying dividends, the box score results are:
And for illustration, here are the timings of payments to Earnest (dark green) against a Net Income backdrop:
You now see that, although launching in the same frame and marketing to the same audience, these two alternative-to-VC funding sources are quite different in terms of operational finance.
Painting by number:
- Your payments to Earnest in the average case are $34k vs. ~$2k to TinySeed.
- The balance of the 3x Return Cap ($140k x 3 = $420k) is $385k.
- Team dividends are small in an absolute sense but still noteworthy — $0k (Earnest) vs. $12k (TinySeed).
- Earnest has an ‘Equity Basis’ of $385k.
- Payments to Earnest have reduced their convertible ownership to 12.8% based on converting their equity basis into a $3 million valuation cap (pulled from vanilla term sheet).
How far will their equity basis shrink? Based on their terms, their stake would have a floor of $140,000 (their initial investment amount) divided by the Valuation Cap in their term sheet. Ergo, $140k as a floor for their Equity Basis would give them an eventual, residual stake of 4.6% after you pay the $420k cap in entirety.
With those trade-offs swimming in your mind, you turn to the Seattle-based pioneers of alternative funding models next: Indie.vc.
You consider raising $140k from Bryce and company, like so:
Playing out the future with the same growth assumptions again, the scoreboard looks like this:
Indie has received $8,453 in payments in the average scenario, while the team has received $14,705. The redemption element of Indie’s terms has shrunk their ownership to 11.7% vs. their original 12%.
And what about those redemption payments? They occur regularly, monthly, after an lapse of time specified on a per-deal basis, commonly 20–24 months post-investment, like so:
Because we are looking at a 24-month timeframe, the payments are only beginning to peek into the forecast. These will continue until Indie’s 3x return cap is reached, at which point they will retain a very small, residual stake of 1.2%.
Few, if any, of the thousands of founders that apply to these funds will have the luxury of choosing among multiple offers, but knowing the trade-offs between these offerings can help you decide what matters most to you.
In terms of equity —each is in the same zone, but headed in different directions. After their return caps are met, Indie will own 1.2%, Earnest 4.6%. Meanwhile, without a return cap, TinySeed’s ownership is constant at 12%.
In terms of cash, things are — counterintuitively, not entirely reversed: TinySeed is indeed the least expensive option in these first two years, receiving the fewest dollars as an investor while you capture more for your team than you would with the terms of Earnest or Indie. But Earnest, meanwhile, who was second in residual equity, has received the most cash out of all scenarios — $34k to Indie’s $8k.
Of course, given the same original investment and return cap, Indie and Earnest will cap out at $420k, while TinySeed will not. TinySeed’s cumulative receipts from their 12% stake will continue to grow while Earnest and Indie’s stay capped. If Array is the next Basecamp, this difference will be measured in the millions of dollars per year. This is a major trade-off.
But, will the additional payouts in the short-term required by Earnest and Indie hinder your ability to become the next Basecamp? Indie.vc navigates this by delaying repayments for 18–24 months. Earnest does not.
So what’s your decision? With valid legal tender and mentorship circles, all three funds are viable vehicles for getting Array where you dream it can go, but the differences are real: Indie.vc allows for a path to maximizing your ownership while delaying repayment, TinySeed requires zero cash repayments at the expense of the most long-term equity and cash in the case of profitable success, while Earnest presents a hybrid that reduces their ownership at the expense of the highest cash outlay in the early years.
For the scrappiest founders that don’t mind the additional cash up front, Earnest offers an ownership-reduction mechanism; for those that do, TinySeed and Indie.vc are strong options, as their cash draws are simply smaller early on, with salary triggers that are higher or non-existent. For TinySeed founders, this will come at the cost of cash in the post-seed, pre-exit phase. Meanwhile, if you plan to raise a single round of capital, Indie.vc’s redemption program provides the lowest long-term equity cost by a wide margin.
Your decision is made.
Thanks for reading. Summit, the tool used to run this analysis, is now available for free to founders.