The Cost of Raising Earnest: A Review of Earnest Capital’s Shared Earnings Agreement (SEAL)
I borrowed $40k from a friend to bootstrap Stormpulse (a profitable SaaS business with 2,000 subscribers and 6 million visitors) from 2006–2012 and then raised $3.3m through convertible notes and priced rounds of venture capital to pivot to enterprise SaaS with Riskpulse, where I served as CEO from 2013–2018. The following is my review of the first version of the Shared Earnings Agreement (or SEAL), a new structure for startup financing authored by Earnest Capital.
Earnest Capital, a source of “early-stage funding for bootstrappers, makers, and indiehackers,” has released the first version of their term sheet, affectionately coined the SEAL. You can read the latest version online. Since the latest version is likely to change, I’ve made a copy to capture the version I’m reviewing today. You can find it here.
While there has been a small flurry of coverage and conversation about Earnest Capital to accompany the document, there hasn’t yet been a deep critique or comparison between the SEAL and other forms of capital. I’d like to offer this as my own critique by looking at this financial instrument in terms of its cost to the entrepreneur in two ways: dollars, and equity.
This approach — of separately examining dollar cost, and then equity cost, is a tightrope because of the SEAL’s hybrid debt/equity nature. But if we’re going to understand the whole of this instrument, we need to make sure we thoroughly understand its parts. Once we do, we can reconstruct the whole and understand how it works.
One final note: Earnest Capital has authored the SEAL structure, but they have also open-sourced it, such that other investors can adopt it if they wish, for their own investments. This pattern of open-sourcing an investment structure is similar to what YCombinator did with the SAFE. What does that mean for this review? Throughout this article, I will refer heavily to Earnest, but that does not mean they intend SEAL’s to be exclusive to their firm. My own intent is that this analysis is helpful to any founder that sits at a negotiating table with a SEAL on top, independent of the investor on the other side.
Before we dive into the terms and costs, an overview of the structure:
- Investors don’t initially take equity through a Shared Earnings Agreement (or SEAL), but it does have equity clauses, so it can create ownership for the investor later.
- A SEAL isn’t a loan: it does not have an explicit interest rate or payback timeline, but it is a liability in the sense of stipulating an obligatory payback.
- The payback occurs as a minimum percentage rate of “Founder Earnings”, which, assuming the founder’s salaries are below a threshold, are equal to Net Income. The boilerplate of the term sheet states 30%.
- SEAL’s do not require personal guarantees and carry no foreclosure clauses — if you fail to pay it back, there is no recourse for the investor.
- The payback amount is set upon signing the agreement and is based on a multiple (generally 3x, 4x, or 5x) of the original investment. The product of the original investment multiplied by this 3x-5x is called the Return Cap.
- Similar to a Convertible Note, SEAL’s define a Valuation Cap, effectively setting the highest price per share that an investor will be exposed to in any future financings.
- SEAL’s are a seed instrument, aimed at serving founders that are post-revenue but still early-stage.
- As a hybrid structure for lending and investment, SEAL’s fall in the same general category as Convertible Notes and SAFE’s.
“The whole point of all of this structure is to re-align us with founders.” — Tyler Tringas, Earnest Capital
On the surface, this sounds interesting. So how should founders decide whether a SEAL can work for them? Let’s think about the cost of accepting capital through a SEAL through the lenses of dollars (cash) and equity (ownership).
Though a SEAL isn’t a traditional loan, it is a kind of liability, albeit a kinder one. Lacking any requirement of a personal guarantee, it’s more founder-friendly than a student loan. It also lacks any repayment schedule. Payment timing is entirely up to you; there is no concept of early or late. Though as we will see, these concepts do relate to the cost of SEAL-based capital.
These timeless features and the lack of a personal guarantee make comparisons to traditional venture debt or bank loans difficult, even unfair.
Nevertheless, throughout the rest of this section I will intentionally make several such apples to oranges comparisons, not to suggest that something like a personal credit card could or should be substituted for a SEAL, but rather to provide you with a familiar reference point with regards to the dollar costs of various forms of borrowed capital. You should not choose a wolf over a husky as your family guardian just because you learn that a wolf is larger. But if you want to understand the anatomy and genetics of dogs, you can learn a lot by comparing their physical features — not to judge a winner, but to understand why nature has designed them the way it has, to explain their place in the food chain, and to predict whether they will thrive in new environments.
Similarly, we can learn a lot about the nature of borrowed money by comparing its various form factors and traits, and we can ask ourselves whether new instruments like the SEAL will perform well in the new bootstrapper funding environment.
Once the number of funding options in this space increases, the terms of the SEAL [in terms of cash] will need to become more favorable.
Cost of SEAL Capital, in Dollars
As far as dollar cost comparison, accounting has already invented a metric that can be used to measure the cost of various forms of capital over time: interest. Conveniently, for our purposes, we can use Annual Percentage Rate (APR) — the same measure as you see on your credit card statements and mortgage rates (and yes, wisdom would say you shouldn’t refinance your house to fund your startup either).
SEAL’s don’t have an explicit interest rate, let alone an APR, but that’s not because the capital is free, or even cheap. Rather, the terms of a SEAL are silent with regard to interest rate because it is de facto variable, not fixed. In other words, there’s no way to express the interest rate of a SEAL as a single number that is true overall points in time or universal across SEAL instances.
This isn’t really unusual. Most founders should be familiar with the idea of a variable rate mortgage. The interest rate bounces around over time, based on the market. Here’s how interest rates moved in the U.S. from 1963–2015:
So what about SEAL? In practice, when we plot the APR of a SEAL-based financing over time, we see something very different than the chart above. Rather than the rolling hills and valleys, we see a curve that starts at infinity with a long tail that approaches 0% as time continues (but won’t get there in your lifetime).
For a SEAL with a 4x Return Cap, the APR by day looks like this:
The y-axis is in terms of whole numbers. To get the more familiar percentage form, multiply the y-value by 100 — i.e. 20 = 2,000%, 80 = 8,000%, etc. As you can see, the longer the payback horizon, the lower the APR.
However, ‘low’ is only relative to itself; in fact, SEAL-based capital, as compared to other forms of capital with obligated payback, is extremely expensive. To continue the example, if you were to take $150,000 on a SEAL with a 4x Return Cap, the chart indicates that the APR is still 200% just under 2 years later (the 728th day, blue dot). Other benefits of the SEAL aside, the cost of this capital at year two is still 10x that of most credit cards (15–25% APR). It isn’t until the 20th year that the APR crosses into credit card territory (20%). And to match the interest rate of a typical Convertible Note (10%)? Year 40.
While these other instruments are not substitutes or equivalents, a founder would do well to wrap their head around the weight of a 3x-5x multiple.
But the most personal dollar cost of SEAL capital for the founders is the notion of of “low but fair” Founder Salaries. This term enables the SEAL investor to draw a line above which founder salary will be considered a part of Founder Earnings — i.e. added to Net Income, and therefore subject to a shared earnings percentage for the investor.
How low is fair? As of today, there’s no guidance in the boilerplate term sheet, but this term may disqualify founders who are stuck in the corporate world with elevated standards of living that are very hard to change — costs like car payments and mortgages and tuition tend to be fixed. This is another term where funding source competition should drive “higher but fair” numbers into SEAL term sheets.
Are We There Yet?
Realistically, how long might it take for a SEAL-funded startup to pay back the Return Cap? This SimSaaS chart shows the fortunate future of a startup with solid in-market momentum. Let’s assume they accepted $250,000 in SEAL-based financing when they had $3,000 in MRR (Month 0 on the chart):
The $250,000 enabled the founders to go full-time and endure an initial period of negative Net Income (the purple below the $0 line) until getting to profitability (on a P&L basis) at Month 27, when their revenue hits $50,000/mo. Why that number? According to the simulation, they had to hire a few additional team members to support their growing customer base and business.
The dark green shade represents 30% of net income paid to Earnest. It totals $43,596 by the 38th month of the simulation. Having taken $250,000 at a 4x Return Cap multiple, the unpaid portion to Earnest is $956,404. Assuming the founders plowed all of their newfound profit ($30k/mo) into payback, slowing growth for the sake of minimizing the duration of the obligation, the final payment to Earnest would take place in approximately two and a half years (~31 months).
This isn’t what founders should do, of course, because they need cash for growth, and the APR is actually declining the longer they wait. What they should do instead is pay the minimum, which will require just over 8 years to complete the payback at $10k/mo. While much shorter than a mortgage, eight years can feel like a long time to owe money, especially in startup land, where 1 year can feel like a decade.
Since most founders do not have access to capital that doesn’t require collateral or guarantees, does it matter that SEAL-supplied cash is so expensive? Perhaps not; but we can still use this fact to predict that once the number of funding options in this space increases, the terms of the SEAL along this dimension will need to become more favorable.
You take an introduction to the venture partners at Stripe who say they are willing to invest $1m at a $10m valuation.
Cost of SEAL Capital, in Equity
- Equity Basis: this is Earnest’s definition of their ownership. Predictably, it is, therefore, the greater of two calculations. One calculation is simply how much is left of the original investment amount. The other calculation is the Return Cap — the investment amount multiplied by 3x-5x (4x in they're current boilerplate). This definition will be substituted elsewhere.
- Equity Conversion: this allows Earnest to convert their Equity Basis (see above) into shares in your startup at the lowest available price per share. What prices are they comparing? First, they look at the share price implied by the valuation cap in the term sheet they signed with you. Second, they look at the price per share being paid by a new investor.
- Valuation Cap: this number puts an upper bound on the price Earnest has to pay for a single share of your startup. To compute, take this number (for example, $2,500,000) and divide by your number of shares (or units, if an LLC). Many startups begin with the issuance of 10,000,000 shares of Common Stock for the founders. If you then raised $150,000 on a SEAL with a $2.5m Valuation Cap, the maximum price per share for Earnest would be $0.25.
- Sale: this term states that, if your company is acquired, Earnest is entitled to receive the best available payout. This is determined by comparing the Equity Basis (for example, $600,000 if you took $150k at 4x) and the market value of shares purchased at the Valuation Cap price, using any portion of the Return Cap.
- Participation Rights: if you raise more funding, Earnest has the opportunity to invest a sufficient amount of capital to retain their stake (percentage ownership) without suffering dilution. So if they own 10% through the enactment of the Equity Conversion clause (#2 above), and you raise money, they must be given the chance to invest enough money to preserve their ownership percentage such that they still own 10% after the financing is complete.
- Residual Stake: listed on their website as a key attribute of the SEAL (but not yet defined in the terms) is another equity component. Earnest writes “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.’” Given that no calculation is available at the time of this post, it’s not possible at the moment to quantify the cost of this key attribute; for now, we’ll simply keep this extra slice of ownership in mind, and assume it’s a meaningful-enough size for the investors to bother including. Residual stake, the mystery meat.
If the cost of capital measured in dollars is best expressed by opportunity cost, the cost of capital measured in equity is best expressed by investor optionality. And, as might be expected, these terms maximize it for Earnest.
What is optionality? Optionality is retaining the ability to select the most rewarding outcome, especially after the revealing of new information. It is the opposite of being forced to accept a result. Remember flipping back to the last decision point in one of those Choose Your Own Adventure books and selecting page 23 instead of 101 because 101 said you didn’t get the treasure? That’s optionality at work.
In a term sheet, you create optionality for your side of the table by setting upper bounds on your risk and lower bounds on your reward and preserving those bounds for as long as possible. Even better, not only do these bounds not disappear, but they get reset based on calculations that run on new information — the sale of the company, a future fundraising, profits.
This is what’s happening in the Equity Basis, Equity Conversion, and Sale terms when it says “the greater of” or “the lower of.” Regardless of what happens in the future, Earnest always gets the greatest amount of ownership possible at the lowest price possible for the largest outcome available. This is a master class in optionality.
This optionality means that the equity cost of SEAL-based financing for the founder is high. How high? Of course, it depends. Let’s think through one scenario:
- You sign off on a $250,000 cash infusion using a SEAL at a $3.5m Valuation Cap and a 4x Return Cap.
- After the ink is dry, the expected return for the investor is $1,000,000 ($250k * 4x).
- You quit your day job and get to work growing your business.
So far, this matches the same scenario as the above. However, this time, you realize that things are really taking off; growth is faster, and your valuation as a reflection of this growth rate is tempting. This SimSaaS chart shows an estimated $10m venture valuation around the two-year mark (before your current growth inevitably begins to slow):
You take an introduction to the venture partners at Stripe who say they are equally impressed by your vision and traction and are willing to invest $1m at your preferred $10m valuation.
You’re thrilled and accept.
What does Earnest get in this scenario? How does the pie get sliced?
In this scenario, you’re approaching breakeven and haven’t hit profitability yet. The full $1,000,000 of the Return Cap remains. Excited by the growth, Earnest elects to use their rights under the Equity Conversion term to turn the $1m into ownership. If they were using the valuation set by the new round ($10m), their ownership would be the same as Stripe’s: 8.3% ($1,000,000 divided by $12,000,000 post-money valuation). But they don’t have to. Instead, they use their Valuation Cap of $3.5m, and their post-round ownership stake is 28.6%.
Earnest, who risked $250,000, is now your largest investor shareholder by a factor of 3.4x.
How expensive was this relative to other investment types, strictly in terms of equity? If you had used a common, seed round Convertible Note with 8% simple interest and the same Valuation Cap of $3.5m, their Equity Basis for the new round would have been $290,000 ($250,000 + 8% * 2 years), translating into a rewarding — but still palatable, ownership stake of 8.2%, in the range of a pre-seed investment from YC.
Instead, your first investors now own almost as much as you and your co-founder. The Return Cap calculation worked out well for Earnest … less well for you and your new investors. Given that their stated preference is to return cash to their LP’s, one could argue this outcome is less than likely, but it is a clearly stated term. If they do take their 28.3%, and Stripe takes their 8.3%, the 50–50 split between you and your co-founder will shrink to 31–31. Combined, you still a majority (50%+) but no longer a super-majority (67%+).
Equity cost verdict: enabled by the Equity Basis and Valuation Cap, Earnest is the equivalent of multiple co-founders slicing deeply into your ownership pie at the best time for them. Unfortunately, the terms will work out so poorly for you and your new investors that the most likely outcome is new investment never happens. Under the current terms, the best growth-stage investors will choose to pass on investing SEAL-funded startups. For this reason, bootstrappers that wish to preserve the option of a rocketship ride should think twice (or more) about SEAL-base financing.
Many funds promise to be more than money to their portfolio companies; for investors that take a cut of profits, delivering on this promise will be mission-critical.
Cash & Carry
Now that we’ve tallied the dollar (debt) and equity (ownership) costs independently, we can bring them back together again, and ask ourselves: what is the strategy that would cause an investor to bring these terms together?
To answer, let’s first consider what happens when a seed investor makes a traditional equity investment: they give the founder cash in exchange for stock. The entrepreneur agrees to this exchange because:
- unlike their penny stock, the cash has the power to make people (including themselves and people who do not even yet believe in the founder’s vision) do the work that needs to be done to grow the value of their business; to use Warren Buffett’s words, each dollar bill is a “claim check on society” that can be used to marshal resources and point people in the founder’s desired direction; and
- the founder knows that if they are successful, their business will be worth an immense fortune, which will enable access to loads of cash through future financings or liquidity events. At that point, cash will no longer be a scarce resource, and the investor can take their portion of the harvest without it materially affecting the founder’s new position on the wealth curve. The difference between having $5 million and $7 million is not as valuable as the difference between $0 and $2 million. Cash has diminishing marginal utility at the personal level.
To summarize: in a traditional seed investment, the founder is giving up that which is not scarce, and which has a nominal value (stock) for that which is scarce and has immediate value as legal tender (cash). The consequence of this transaction is that he must also accept sharing some percentage of the cash that will come later if he or she is successful. However, at that later point, cash is much less scarce and has less value to the entrepreneur and the business than it had previously.
With a SEAL, things are quite different. The investor is providing the founder with cash when it is scarce, but their own access to cash (through payback) comes to this side of the non-linear payout of an acquisition or exit. This means that cash is still a scarce resource. While it is true that the founders themselves are also partaking in cash in the short term, it is because they are actively working on the business and creating more value than they are taking out in the form of cash.
The investors, meanwhile, are collecting rent, and a lot of it. I say rent, not dividends because their claim is based on a legal agreement, rather than equity. At 30% of profits, until the Return Cap is met, this is the equivalent of a full partner or more.
This will feel unfair if this partner is absent operationally. Many funds promise to be more than money to their portfolio companies; for investors that take a cut of profits, delivering on this promise will be mission-critical to maintaining positive founder relationships.
This rent is ultimately what de-risks the investment for the investors, who are not in the business of enterprise value; to say it another way, when they make an investment, far from betting on an exit, they aren’t even calculating the odds of such liquidity event; thanks to their optionality, they don’t have to. Instead, they will accept a share of profits as partners, despite the scarcity of cash, because it has proven economic value in the external world. That is, until and unless it becomes apparent that your stock is the more valuable thing, at which point they will shift tracks to capture the value of equity instead.
The high cost of SEAL-based capital in terms of dollars and equity likely won’t come as a shock.
SEALing your fate?
Now that we understand the costs, parts, and whole strategy of a SEAL from the investor’s perspective, what about the utility of a SEAL for founders? When is a SEAL a good financial product for the entrepreneur?
Earnest hasn’t given any concrete examples (yet) of startups that would be an ideal fit for their product, but we can imagine the traits of such a business: when certainty exists around time being absolute of the essence, cheaper sources of capital are unavailable, and your business is about to be so cash rich by next year that frankly, the costs of that cash don’t matter. At the same time, you’re quite certain that growth after next year will be flat, such that growth-based investors won’t be interested anyway, so the cost in terms of equity also doesn’t matter — you don’t plan to raise.
In other words, a SEAL would be great for the startup that gives off a predictable, constant stream of cash; a small bubble of money supply inflation that counteracts the de facto APR of the SEAL and makes you forget about that Return Cap and the Valuation Cap. Venture capitalists gaze dumbfounded by your lack of ambition, but you’re too busy soaking in a bath of boring dollars to notice.
The amount of certainty required to walk this line is high. Most founders aren’t sure what they have, how big it will get, how profitable it will be and when, and what it might be worth one day. To quote Earnest:
Sometimes at the early stage of the business, you don’t know if you want to build a billion-dollar rocket ship, a world-class company that dominates a niche, or an amazing lifestyle business — an SEA leaves all options on the table while providing smooth transitions if the plans change.
Yet, as we’ve seen, in practice the suggested terms of the SEAL will require those founders to close the doors to some of those options, something an early-stage founder shouldn’t have to do.
So is early-stage venture the answer — SAFE’s, convertible notes, priced equity rounds? No. To quote DHH, “there are too few people trying to make just a nice Italian restaurant in the web space.” (I highly recommend his whole talk).
Which brings us back to the question of what’s a SEAL for: SEAL’s were created to take advantage of a hole in the market, the empty lot where that Italian restaurant would fit just perfectly. Unfortunately, while enticing, under the current terms, many founders could find themselves in future scenarios where ‘taking advantage’ is exactly what these terms feel like.
A Better Way?
This post is an intentional critique of the first version of the SEAL, which aims to provide amazing founders with the capital they need to build “profitable, sustainable companies” to use Tyler Tringas’s words. This is a noble goal, and I hope this post can help those founders weigh the trade-offs.
Whether or not it arrives as a future version of the SEAL, a financial product will come along that connects founders with investors eager to partner in a way that is symmetrically risky and rewarding. The opportunity is too great for both sides for this not to emerge. In a future post, I will attempt to sketch what a new financial product for this space might look like, using SimSaaS to simulate the deployment of that capital along the way, while keeping an eye on costs and optionality.