Some startup financing structures are needlessly restrictive or place a significant amount of pressure on startup founders and investors alike. A shared earnings agreement is a financing structure that can provide all stakeholders in a financing relationship with a solution that aligns with their goals.
A Shared Earnings Agreement is a novel financing structure for startups and early-stage businesses that operates very differently than traditional venture capital, accelerators, or traditional finance.
These structures offer bootstrapped startups, early-stage startups, or other business models that don’t necessarily align with the venture capital model in all cases, often optimized for business outcomes that would otherwise be considered a failure for VC or misapplication of funding tools such as convertible notes or SAFEs.
Outcomes can include “small” exits of less than $20 million after raising a small amount of initial capital and selling a business, or building a business with no intent to sell in order to generate reliable, scalable profit.
A Shared Earnings Agreement is designed to align with these outcomes while building a framework that allows for other options, such as priced venture rounds to additional growth capital raises.
What is the Purpose of a Shared Earnings Agreement?
A Shared Earnings Agreement functions as a replacement or substitute for the traditional equity structures used by startups and new businesses, such as SAFEs, convertible notes, or equity agreements. Shared Earnings Agreements are not debt, and don’t operate with a fixed repayment schedule — nor do they require a personal guarantee.
The primary purpose of a Shared Earnings Agreement is to create an agreement that aligns the interests of both founders and investors to achieve a broad range of different outcomes while allowing founders to retain full control over their business. Shared Earnings Agreements establish a framework that allows for diverse optionality but represents a long-term commitment that typically lasts as long as the business itself.
How Do Shared Earnings Agreements Work?
In simple terms, Shared Earnings Agreements involve an upfront capital investment from investors, who receive in return a percentage of founder earnings. The key point of difference between traditional finance options and Shared Earnings Agreement is the definition of founder earnings.
A typical business operator captures revenue, accounts for expenses, then distributes revenue across founder salaries, the distribution of dividends, or assigns it to retained earnings that can be converted to either of the former at any time.
In traditional investment models, investors are, in most cases, entitled only to a percentage of dividends. Founders that retain full or almost complete ownership over their company, however, are able to define the line that separates salary, dividends, and retained earnings.
This lack of clear definition can often create disagreements over “fair” salaries, resulting in friction between investors and founders over whether or not investors should access board seats that approve salaries.
The Shared Earnings Agreement model, however, takes all earnings and assigns them the definition of “founder earnings,” which represent the economic value that is directed toward founders. Investors that participate in a Shared Earnings Agreement are provided with a predetermined, agreed-upon percentage of this value, which minimizes friction between all parties involved in startup finance and provides greater clarity.
What Makes Shared Earnings Agreements Unique?
In the earliest days of a startup company, a founder may not pay themselves a high wage. To prevent this structure from negatively impacting early-stage startup founders, a founder earnings threshold is established, typically defined as a specific amount of income per year per founder. Once the founder’s annual income reaches this threshold, the founder earnings percentage activates.
It’s important to note the difference between a Shared Earnings Agreement and revenue-based financing. While Shared Earnings Agreements are similar in nature to revenue-based debt products in which repayment occurs as a percentage of top-line revenue, the founder earnings percentage mechanism places Shared Earnings Agreements significantly closer to profit-share. For this reason, investors typically expect a growth period after the initial investment, after which shared earnings are distributed.
Shared Earnings are not paid in perpetuity. Within a Shared Earnings Agreements, a shared earnings cap is defined, generally as a multiple of the initial investment. In most cases, a shared earnings cap ranges between 200 percent and 500 percent of the initial investment. Once the shared earnings cap is paid in full, shared earnings cease.
After the shared earnings cap is paid back, founders are able to operate their business without further disbursements to investors. There are, however, a number of opportunities to create long–term alignment between investors and founders, or ensure that the total potential of an investment made via a Shared Earnings Agreement doesn’t have a hard limit.
There is no salary cap within the context of founder earnings — a shared earning agreement renders the demarcation between dividends and founder salary irrelevant, allowing founders to determine their own salary based on accountant recommendations and cost of living. In simple terms, investors earn a portion of the earnings of the founder through the founder earnings mechanism, functioning in a similar manner to a small non-controlling co-founder.
Creating Long-Term Alignment and Optionality With Shared Earnings Agreement
Investors invest in companies in order to profit in generate profit from their potential success. While Shared Earnings Agreements allow founders to access capital without long-term repayment commitments outside of shared earnings cap, it’s important to recognize the importance of long-term alignment in investor/founder relationships.
A Shared Earnings Agreement includes a number of factors that include an equity basis, as the numerator, and a valuation cap —the denominator. The valuation cap defines the percentage of a company that investors are entitled to in the event that the founders decide to sell their company or raise a priced round of equity, such as a series A from traditional venture capital.
The equity basis in a Shared Earnings Agreement decreases over time as shared earning payments are made. There is, however, a residual equity basis that remains subsequent to the full repayment of the shared earnings cap, which ensures investors are incentivized into assisting with the development and growth of a company.
Once the shared earnings cap is repaid, investors will receive a quantifiable ROI on their initial investment and are less likely to seek liquidity events in order to recoup capital. This mechanism encourages investors to support and nurture the businesses they invest in, and is indifferent to strategies that involve either rapid profit re-investment to secure a sale of the business or a slow, sustainable scaling strategy focused on building a large-scale, highly profitable company.
Should founders decide they want to raise a venture capital round, the Shared Earnings Agreement can be converted into equity through a simple, streamlined process. Put simply, a Shared Earnings Agreement is a flexible, convertible financing structure that remains effective regardless of whether additional capital is raised and converted.
A Shared Earnings Agreement establishes alignment between investors and founders without the need for equity, shares, preferred voting rights, or board seats.
What Happens in the Event of an Exit or Priced Round?
If a company raises a priced round of equity, a Shared Earnings Agreement can be considered similar in nature to a SAFE or a convertible note. The whole instrument either converts to equity alongside the new investors, or participates in the proceeds of the sale.
Should the founders of a company pursue a priced round, the investment made by investors is converted in full equity alongside new equity investors — any shared earnings elements are removed.
The most important point of difference in this scenario is the way in which the investor’s percentage is calculated. Rather than calculate investor share as a function of the initial investment size and found validation in the same manner as a convertible note or SAFE, the percentage is calculated in a manner that can be reduced over time through shared earnings payments.
Why Use a Shared Earnings Agreement?
Shared Earnings Agreements provide both investors and founders with incentives to work together to build a healthy, profitable, and scalable business that will succeed over the long term. By removing the pressure placed on founders to either raise further funding rounds or to sell a business, the structure will minimize friction between parties while leaving these options open to founders to pursue if they choose to.
By establishing a shared earnings threshold, a Shared Earnings Agreement acknowledges and supports the financial requirements of both founders and their employees without requiring approval for salaries from investors.
Shared earnings agreements can help broaden the number of options available to a founder and prevent the founder’s decision-making processes from becoming clouded by poorly designed incentive structures. As a highly flexible financing solution, shared earning agreements allow the long-term development of a business open to several different strategies while establishing a simple architecture which can appear to help align the interests of all stakeholders.
Determining which financing approach to take when building your startup can be a complicated process. If you’re an Australian tech founder considering a shared earnings agreement, reach out to Fullstack for guidance today.