
Reviewing the SEAL: A new form of bootstrapper funding - wensing
https://medium.com/swlh/the-cost-of-raising-earnest-a-review-of-earnest-capitals-shared-earnings-agreement-seal-2cf68c099ddc
======
louisswiss
>> 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.

This is just plain wrong. By binding the payback to profit (not revenue) and
giving the entrepreneur a lot of flexibility in defining when to allow the
(successful) business to become profitable, the investor will only have access
to cash when it isn't scarce.

The author seems like a really competent person so, unless they have a bone to
pick with the Earnest Capital team, I can't understand how/why they got this
so wrong.

~~~
wensing
Thanks for the nod to competence.

Re: "By binding the payback to profit" \-- but it isn't bound to profit. Re-
read the terms. It's Founder Earnings, which is profit PLUS any founder salary
above a 'low but fair' threshold. You can be breakeven or below zero and still
have shareable earnings with a SEAL if you are making a market rate ( _not_
low but still fair).

I spent days thinking this through and would be happy to explore your
objections in a higher-fidelity forum or longer-form format than HN comments.

For now, suffice to say I have no incentive to mislead founders.

------
revorad
Very interesting analysis. As a bootstrapping founder, I am thinking about
possibly raising funding at some point. So it's good to see new options coming
out and some way of comparing them with existing options.

To the author - I wonder if you could use the data from the Open startups
(sharing their numbers on Baremetrics) and see how different funding options,
including Earnest capital's SEAL, would work out for them.

~~~
wensing
Yes, absolutely. The key question in my mind still (after finishing the
article) is what startups actually WOULD be smart to take money on these terms
(what kind of business model, unit economics, and growth trajectory would they
have to have for it to make sense).

My guess is it's a narrower slice of the startup population than Earnest
intends. And my prediction is they will update their terms to broaden the
slice.

------
tylertringas
The section on "Cost of SEAL Capital, in Equity" is mathematically correct,
but omits a few key points that make the example unreflective of what would
happen in reality. The whole point of the Equity Conversion terms is to keep
open the option to raise VC if the founder wants to do so.

If after a SEAL, the business decides to raise a priced round at a valuation
higher than the Valuation Cap, then the investor has the option to convert to
[any unpaid amount of the Return Cap] / [Valuation Cap].

If at the time we are negotiating a SEAL this simple math shows the investor
would own a giant % that would make a VC round impossible, then it closes down
that option and defeats the entire purpose. It's very easy to plug in numbers
that generate a result that is extremely founder-friendly ($100k, 3x, $5m cap
= 6%) or ridiculous ($250k, 5x, $2.5m cap = 50%).

As part of the upfront negotiations, any honest investor would make sure the
founders understood how these numbers play out in a variety of scenarios and
agree on terms that are fair to both parties.

The example in the post is $250k, 4x, $3.5m and with the implied 28.3% the
conclusion is "the terms will work out so poorly for you and your new
investors that the most likely outcome is new investment never happens" \- But
by changing the cap to $5m, it becomes 20% (not an unreasonable ownership
stake for a very early seed/pre-seed investment). If the return multiple is
3x, we get to 15% which can be further reduced by any payments that might have
been made prior to the fundraising round.

There are plenty of fair ways to structure these terms. Though I would agree
that for founders that are dead set on raising a round of VC in the near
future, they should use traditional products like a SAFE or convertible note,
which are built for this purpose.

------
tylertringas
Hi all, I'm the GP of Earnest Capital and I'll add here the comments I gave to
Matt privately before this post. The terms we use for our Shared Earnings
Agreement are the result of a transparent and honest discussion with the
community via this post ([https://earnestcapital.com/funding-for-
bootstrappers/](https://earnestcapital.com/funding-for-bootstrappers/)). I
received 100s of comments about our investments structure from founders and
investors, 99% of which were along the lines of "how will you build a
successful fund with such founder-friendly terms."

I would encourage folks who are interested to read the very good discussion:
Here on HN:
[https://news.ycombinator.com/item?id=18338665](https://news.ycombinator.com/item?id=18338665)
On Indiehackers: [https://www.indiehackers.com/forum/help-us-design-funding-
fo...](https://www.indiehackers.com/forum/help-us-design-funding-for-
bootstrappers-and-indie-hackers-eb92f5e179) And directly in the term sheet
draft that we posted with comments open on Google Docs:
[https://docs.google.com/document/d/1HoZ94eWTctYQM5O5RXDeQQ_h...](https://docs.google.com/document/d/1HoZ94eWTctYQM5O5RXDeQQ_hU36Pk-
UM8_pO8--_-MQ/edit)

A Shared Earnings Agreement is not debt and comparisons based on interest
rates are academically interesting, but misleading because you cannot go to
any debt lender with a side project with $2k MRR and get a loan to take a year
and grow it. A SEAL has no fixed repayment schedule, no personal guarantee, no
mechanism to foreclose on the business if it fails, and critically and unlike
any form of debt __the investor only gets paid when the business is doing well
__(repayment is a % of the economic benefit the founders choose to pay
themselves: Founder Earnings).

We designed it to be a substitute for equity (where seed VC is really the only
real alternative most founders at our stage would have) but equity that
doesn't force the company to continually raise capital or sell the business. A
SEAL can still have a successful risk-adjusted outcome for the investor even
if you build a nice profitable business (literally the "nice Italian
restaurant" example quoted from DHH in the post).

You may as well also include the effective interest rate on every VC
investment that returns 50x or 100x their investment and say "Woah what a high
interest rate. Should have used a credit card." Like equity, the implied
"interest rate" on a SEAL looks higher in scenarios where the business &
founders are more successful (thus paying back more Founder Earnings faster)
and is a nice, low 0% APR if the business fails

That said, if anyone has constructive feedback to share I would love to hear
it: [https://earnestcapital.com/contact/](https://earnestcapital.com/contact/)

~~~
louisswiss
> You may as well also include the effective interest rate on every VC
> investment that returns 50x or 100x their investment and say "Woah what a
> high interest rate. Should have used a credit card." Yeah,

This. The author seems to completely miscomprehend/discount the risk involved
for both parties in his calculations.

It's important to remember that the payback is based on profit, not revenue.
The author does note this, but a lot of his reasoning around the founders'
hypothetical motivations only make sense if you assume the reverse is true.

For example:

> 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.

This misses the point because you _don 't_ really owe money like a mortgage.
With a mortgage if you don't pay it off today, lose your job and can't make
future repayments, you could lose your house.

With this SEAL, if you don't pay back the investors today and suddenly can't
afford to pay anything next month, there are no negative consequences. You
won't be fired, lose your house/additional equity or end up paying back more
(eg due to interest).

