← Mark McGranaghan

Alt VC Math

2019-08

As a company founder, I want the option to build a business that is healthy, profitable, and independent over the long term. With bank loans not an option for most early tech companies, bootstrappers often fund the early stage of their product development with loans from family members, credit card debt, or consulting work on the side. But all of these introduce their own difficulties and distraction from trying to get a product to market.

So I’m excited to see a new category of early-stage financing now available from firms like Indie.VC, Earnest Capital, and TinySeed. These alternative venture capital (aka “alt VC”) funds offer seed-level financing like traditional VC, but with more options for what constitutes a successful business. The best parts of bootstrapping with the best parts of VC. Sounds great!

But founders should know the incentives of any investor they are considering bringing into their business. Part of the pushback against VC funding is unfair to venture capitalists: a VC’s job requires them to push every company to be a unicorn. It’s nothing personal, just math.

So what are the financial incentives of these alt VCs? In this article I’ll examine the Earnest Capital case by modeling a number of scenarios under their investment terms.

My conclusion is that Earnest’s alt VC structure is indeed compatible with many portfolio companies remaining “small and profitable” indefinitely. However, such a structure does require some companies get acquired or raise venture funding for total returns to reach target levels. It doesn’t require huge breakouts like Atlassian or Notion to work, though those would be welcome boosters.

If that’s the case, Earnest Capital is less of hits-driven business than traditional VC. It’s compatible with a wider variety of company outcomes and with companies not shooting to be unicorns. That’s good if your company is looking for funding but isn’t a candidate for traditional VC. There are lots of important details here though, so let’s dig in to the math.

Modeling approach

Several articles model alt VC from the perspective of funded companies (e.g. here, here, and here). But to our knowledge nobody has published a quantitative model from the perspective of the investor. Such a model would answers questions like:

Earnest Capital gets high marks for being open and transparent with their deal structure. In particular they have published their Shared Earnings Agreement (SEAL) which documents exactly what happens in all scenarios with your company: making a little money, making a lot of money, or later in the game deciding you want to be a moonshot after all and take venture funding. Hence I’ll use SEAL for this modeling exercise.

This article is structured as follows. I start by outlining why it’s important for founders to understand investor incentives and briefly review IRR as a standard metric for these investors. After sketching baseline assumptions for the model, I simulate various company-level and portfolio-level outcomes from the investor’s perspective, including companies that stay profitable indefinitely and those that either sell or raise equity financing. Based on those results I speculate on the overall incentive structure these investors face and what that could mean for entrepreneurs.

The investor’s perspective

When considering a funding approach for a business, it’s important to think about how the approach will work for you and for your investor.

Why your investor? The most obvious reason is that they’re only likely to offer you a deal that’s good for them. You need to understand what makes an investment appealing to them, ensure your company fits that profile, and negotiate terms with an understanding of what matters to them.

Later, once you’ve taken their money, the financial incentives of the investor will influence their behavior in high-stakes situations. Years from now you might, for example, be considering an acquisition offer that will be a life-changing amount of money for the founders and employees, but your investors want you to turn it down and keep going for their potential bigger exit. Investors have a fiduciary duty to their limited partners (LPs) to return as much money as possible. You should know what that means for your business.

The startup community now understands the implications of traditional venture capital (VC). The key result from modeling VC funds is that they’re highly dependent on huge winners. What matters to these funds is 1 or 2 huge IPOs or acquisitions. If a fund has those, what happens to the rest of the companies in the fund doesn’t matter that much. And even if a lot of the companies in a fund do “OK”, it will do poorly overall if it doesn’t have big winners.

Those conclusions are not obvious if you don’t actually model out a VC fund. But once you do a model it’s clear. Because of this dynamic, VC funds a) only invest in companies that have the potential to become huge winners b) push companies to try to go huge wherever possible (even if it means forgoing an “OK” outcome that would still be life-changing for the founders.)

IRR as metric

To talk about investor behavior around SEALs, we need a unified way to assess investor returns. Internal Rate of Return (IRR) is a standard metric for venture capitalists and other investment managers that will suit us here.

IRR shows how well the investor’s investment grows over time. It does this in a way that accounts for money being invested in and paid out at various times and in various amounts across multiple investments.

IRR is the annual rate of return needed on invested money to produce the observed investment returns. For example, if you invest $100 and 5 years later get $300 back, your IRR is 24.6%, because 100×1.2465 = 300. But if you get the same $300 back in 4 years, your IRR is 31.6%: 100×1.3164 = 300. This shows a dynamic we’ll see throughout our analysis: IRR depends both on how much money is returned (the more the better) and how quickly it is returned (the sooner the better). Obviously these are also the things funds and their LPs care about.

So what’s a good IRR for a SEAL investor? I’ll use the following benchmarks:

SEAL IRR benchmarks
IRR Evaluation
≤ 9% Poor
10% - 19% Iffy
20% - 29% Solid
30% - 39% Excellent
≥ 40% Bonanza
Figure 1: Benchmarks used to evaluate IRR of SEALs or SEAL portfolios, from the investor’s perspective.

These are based on a few reference points:

As suggested above these IRR are all gross and nominal: they don’t account for management fees or inflation. We’re also ignoring drag from holding cash. That said, the gross numbers still provide a useful benchmark; we just need to keep these caveats in mind when evaluating them.

Now that we have a sense of what good results are, let’s see what it takes to get them with SEAL-based investments.

Base assumptions

For this modeling, I’ll use with the excellent materials published by Earnest Capital:

The base case SEAL parameters come from their Public Calculator. As Earnest stresses there is no standard SEAL offer and the terms will vary. But we have to start somewhere and this seems as good an option as any. Later I’ll test sensitivity to these parameters:

Base SEAL parameters
Investment amount $ 150,000
# of founders 2
The percentage 30%
Return cap multiple 3
Return cap $ 450,000
Valuation cap $ 3,000,000
Founder earnings threshold $ 50,000
Figure 2: Base SEAL parameter values. Models in this article use these terms unless otherwise noted.

We also need financial trajectories for the companies being funded with the SEAL. Initially we need example net income streams, and eventually we’ll need acquisition value and equity financing terms.

Net income trajectories

My colleague Adam Wiggins has collected some examples of successful independent companies that have publicly shared their revenue. While profit margins vary substantially by business, we’ll use an assumption of 50% margin to turn revenue into net income:

Financial references
Company Net income guess,
5 years after funding
Pinboard $ 96,000
WorkFlowy $ 200,000
Ghost $ 550,000
Gumroad $ 1,000,000
Figure 3: Some reference companies and their estimated net income in year 5.

As we can see from the examples in the spreadsheet, the possibilities for revenue growth curves are endless. But for this modeling, I’ll simplify into three basic trajectories, labeled “Low”, “Middle”, and “High”:

Base net income trajectories
Year Net income trajectory
Low Middle High
1 $ 30,000 $ 30,000 $ 100,000
2 $ 50,000 $ 60,000 $ 200,000
3 $ 80,000 $ 120,000 $ 400,000
4 $ 120,000 $ 180,000 $ 800,000
5 $ 170,000 $ 300,000 $ 1,200,000
6 $ 210,000 $ 500,000 $ 1,600,000
7 $ 280,000 $ 900,000 $ 2,000,000
8 $ 380,000 $ 1,300,000 $ 2,400,000
9 $ 480,000 $ 1,600,000 $ 2,800,000
10 $ 580,000 $ 1,900,000 $ 3,200,000
Figure 4: Base net income trajectories used throughout this analysis.

This mapping of spotty real-world data (note the survival bias) to our low/middle/high scenarios is clearly speculative and subjective. Readers will have to judge for themselves how realistic these and my other assumptions are.

Debt-like scenarios

With some assumptions in place, we’re ready to start modeling scenarios. First the simplest case: when the funded companies are profitable but never have a sale or other financings and have no residual value after the 10 year analysis horizon. In these cases the SEAL has debt-like behavior.

The IRRs for a SEAL investor in companies on each of the three trajectories described above, on the base SEAL terms listed above, are:

SEAL basic IRRs
Net income
trajectory
Low 16%
Middle 24%
High 48%
Figure 5: SEAL IRRs under assumptions of baseline SEAL parameters and varying net income trajectories of the company, from low trajectory (IRR = 16%) to high trajectory (IRR = 48%). Assumes no sales, no other financings, and no residual value after the 10 year analysis horizon.

This and all other calculations in this article are based on the spreadsheet here. As an example, here’s an excerpt from the spreadsheet covering the Middle trajectory case:

Scenario: middle trajectory, no sale, no further financing
Year 1 2 3 4 5 6 7 8 9 10
Net income $ 30,000 $ 60,000 $ 120,000 $ 180,000 $ 300,000 $ 500,000 $ 900,000 $ 1,300,000 $ 1,600,000 $ 1,900,000
Founder earnings $ - $ - $ 20,000 $ 80,000 $ 200,000 $ 400,000 $ 800,000 $ 1,200,000 $ 1,500,000 $ 1,800,000
Founder earnings to SEAL $ - $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ - $ - $ -
Founder earnings to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 1,200,000 $ 1,500,000 $ 1,800,000
Total to SEAL $ (150,000) $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ - $ - $ -
SEAL IRR 24%
Figure 6: Example IRR calculation for the Middle net income trajectory assuming base SEAL parameters, no company sale, no other financings, and no residual value after 10y horizon. The resulting IRR is 24%.

To read this:

These initial IRRs look promising for the SEAL. Even in the Low case the IRR comes to 16%, and in the High case the IRR is 48%. These shouldn’t be too surprising though; after all this SEAL specifies that the company pay back 3 times the investment it got! But the large spread in IRR is our first sign of how sensitive SEAL performance can be to when that payback occurs.

An investor will make SEAL investments across a portfolio of companies. These companies will have variable outcomes: some might do great, others poorly, and some may go bust before they pay back any of their balance.

If we analyze some hypothetical SEAL investor portfolios according to the proportion of companies following our “Low”, “Middle”, “High”, or “Zero” (never profitable) scenarios, we get the following IRRs:

Simple SEAL portfolio IRRs
SEAL portfolio composition
(net income trajectories)
⅓ each Low, Middle, High 26%
¼ each Zero, Low, Middle, High 18%
⅓ each Zero, Low, Middle 12%
½ each Zero, Middle 6%
Figure 7: Portfolio IRRs given different proportions of company trajectories, using the base SEAL parameters with various proportions of net income trajectories. Assumes no sales, other financings, or residual values. “Zero” means the company never earns a return for the SEAL.

These portfolios paint a less optimistic picture for our hypothetical SEAL investor. In all of the portfolios accounting for some “Zeros”, the portfolio fails to achieve IRR at or above our 20% benchmark. An even in the perhaps optimistic case shown in the first row, IRR is a solid but not blowout 26%. On the other hand, the IRR is at least positive in all of these scenarios.

Our conclusion from this figure is that SEALs on the terms described above, with plausible distributions of portfolio companies trajectories, are tenuous for the investor if we only account for the debt-like (paying back the return cap) piece of the agreement. Even though “3x your money back” seems like a great deal for the investor, after accounting for how long that return can take, the inflation and illiquidity in the meantime, and the reality that some companies will fail, it doesn’t look as promising.

Sensitivities in the debt case

Let’s explore the sensitivity of SEAL outcomes to the instrument’s debt-like parameters.

First, let’s look at a range of return cap multiples:

SEAL IRRs
with varying return caps
Return cap multiple
2x 3x 4x 5x
Net income trajectory Low 11% 16% 17% 17%
Medium 16% 24% 29% 32%
High 33% 48% 59% 65%
Figure 8: SEAL IRRs for investments with varying net income trajectories (rows) and return cap multiples (columns). SEAL parameters are otherwise the base from above. Assumes no sales, other financings, or residual values.

As expected, higher return caps are better, all other things equal, for the investor. Interestingly, the trajectory of the company in this model seems more important than the return cap multiple, even across the huge range of caps from 2x to 5x.

Now looking at the percentage of founder earnings going to the SEAL within the return cap (here again fixing that cap at 3x):

SEAL IRRs
with varying percentages
Net earnings % to SEAL
20% 30% 40%
Net income trajectory Low 10% 16% 18%
Medium 21% 24% 25%
High 42% 48% 56%
Figure 9: SEAL IRRs for investments with varying net income trajectories (rows) and net income percentages due to the SEAL (columns). SEAL parameters are otherwise the base from above. Assumes no sales, other financings, or residual values.

Again this term matters to the investor, but at least in these ranges not as much as the trajectory of the company.

Finally let’s look at the investment amount:

SEAL IRRs
with varying investments
SEAL investment
$100k $150k $200k $300k
Net income trajectory Low 18% 16% 12% 6%
Medium 26% 24% 22% 20%
High 58% 58% 43% 36%
Figure 10: SEAL IRRs for investments with varying net income trajectories (rows) and net income percentages due to the SEAL (columns). SEAL parameters are otherwise the base from above. Assumes no sales, other financings, or residual values.

All else equal, higher investments result in lower IRRs for the investor on a given company, even in the case of a High net income trajectory. And again the trajectory of the company seems more important than this parameter given the other assumptions in our model. Note that while more investment in (say) a High trajectory company lowers the IRR for that investment, it may raise it for the portfolio overall (because the portfolio will be more weighted towards that relatively successful investment).

Note that the decrease in IRR for a given investment with increasing investment amount (again all things equal) is rather different from the behavior of straight equity investments in a traditional VC model. There a higher investment amount corresponds to proportionally more ownership in the company, which yields proportionally more proceeds on the eventual sale of the company. Again this brings us back to the SEAL dynamic of paying back a given return cap over a variable span of time.

Indeed, one can view all of the above sensitivity analyses in this light of payback time. The timing of the payback matters a lot for the eventual IRR. And the best way for the investor to get paid quickly (at least in a debt-like scenario) is for the company to highly profitable early in its life. Hence we often find the biggest factor in investor outcome to be the net income trajectory of the company.

The other side of this dynamic: the success of a company after it’s initial payback doesn’t influence investor returns, assuming it never sells or raises equity. As an extreme example, if a company goes on to eventually make $100 million in net profit a year, but never sells or raises equity, the SEAL investor gets $0 a year from that.

But paying back the return cap is only one part of the SEAL. It also comes with an equity-like component, which we’ll turn to next.

Equity-like scenarios

If a company funded with a SEAL is sold or decides to raise equity financing, the SEAL is convertible to equity in the company. Thus the investor can participate in the upside like a traditional equity investor. But this dynamic is complex: for example, the equity basis decreases as the company pays back their return cap.

Let’s look at some concrete scenarios to see how the SEAL equity component works.

Consider first a company on a “Middle” net income trajectory from above. Suppose it’s acquired after 8 years, after they’ve paid back their return cap. Further assume that the acquisition is on a multiple of the company’s net income, 5x. Here’s how that works out:

Scenario: middle trajectory, income multiple acquisition after payback
Year 1 2 3 4 5 6 7 8
Net income $ 30,000 $ 60,000 $ 120,000 $ 180,000 $ 300,000 $ 500,000 $ 900,000 $ 1,300,000
Founder earnings $ - $ - $ 20,000 $ 80,000 $ 200,000 $ 400,000 $ 800,000 $ 1,200,000
Founder earnings to SEAL $ - $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ -
Founder earnings to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 1,200,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ - $ -
SEAL equity basis $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ 150,000 $ 150,000
Sale proceeds $ 6,500,000
Sale proceeds to SEAL $ 325,000
Sale proceeds to founders $ 6,175,000
Total to SEAL $ (150,000) $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ 325,000
Total to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 7,375,000
SEAL IRR 33%
Figure 11: Scenario model for a company on “Middle” net income trajectory that is acquired on a multiple of their net earnings after 8 years, after repaying their full return cap.

This model adds a few new rows from our simpler case above:

By the terms of our hypothetical SEAL, the investor retains some equity basis in the company after the return cap has been paid back. In this case, the equity basis ($150,000) pays out by dividing by the original valuation cap in the SEAL ($3,000,000), yielding effective ownership of 5%. Multiplied by the sale price, that means $325,000 goes to the SEAL. The total IRR (considering both return cap payments and sale proceeds) is 33%, a nice kicker compared to the 24% IRR for the same company with indefinite profitability and no sale. And the founders get the other $6M+ from the sale, so it works well for everyone.

On the other hand, founders probably wouldn’t sell their company very early for a multiple of income if they’re on a SEAL. To see why, consider a company that sells on a 5x net income basis in year 3, when net income is low so the price is low:

Scenario: middle trajectory, income multiple acquisition before payback
Year 1 2 3
Net income $ 30,000 $ 60,000 $ 120,000
Founder earnings $ - $ - $ 20,000
Founder earnings to SEAL $ - $ - $ 6,000
Founder earnings to founders $ - $ - $ 14,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000
SEAL equity basis $ 450,000 $ 450,000 $ 444,000
Sale proceeds $ 600,000
Sale proceeds to SEAL $ 444,000
Sale proceeds to founders $ 156,000
Total to SEAL $ (150,000) $ - $ 450,000
Total to founders $ - $ - $ 170,000
SEAL IRR 73%
Figure 12: Scenario model for a company on “Middle” net income trajectory that is acquired on a multiple of their net earnings after 3 years, before repaying most of their return cap.

In this case, the company hadn’t paid back much of their return cap, so the SEAL still had almost all of its initial equity basis in the company. The IRR is nice for the investor, but the founders don’t take much away from the sale. So investors shouldn’t count on outcomes like this in their portfolio.

Let’s now suppose that the sales are more strategic, with higher prices. Even in the case of early sale this can now make sense for everyone. Consider a price of $4,000,000 = $2,000,000 per founder:

Scenario: middle trajectory, strategic acquisition before payback
Year 1 2 3
Net income $ 30,000 $ 60,000 $ 120,000
Founder earnings $ - $ - $ 20,000
Founder earnings to SEAL $ - $ - $ 6,000
Founder earnings to founders $ - $ - $ 14,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000
SEAL equity basis $ 450,000 $ 450,000 $ 444,000
Sale proceeds $ 4,000,000
Sale proceeds to SEAL $ 592,000
Sale proceeds to founders $ 3,408,000
Total to SEAL $ (150,000) $ - $ 598,000
Total to founders $ - $ - $ 3,422,000
SEAL IRR 100%
Figure 13: Scenario model for a company on the “Middle” net income trajectory that is acquired for a strategic price after 3 years, before repaying much of their return cap.

This is a great outcome for the SEAL investor (and for the founders).

Here’s the case of a strategic acquisition later on, after the return cap has been paid in full, supposing a sale price of $20,000,000:

Scenario: middle trajectory, income multiple acquisition after payback
Year 1 2 3 4 5 6 7 8
Net income $ 30,000 $ 60,000 $ 120,000 $ 180,000 $ 300,000 $ 500,000 $ 900,000 $ 1,300,000
Founder earnings $ - $ - $ 20,000 $ 80,000 $ 200,000 $ 400,000 $ 800,000 $ 1,200,000
Founder earnings to SEAL $ - $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ -
Founder earnings to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 1,200,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ - $ -
SEAL equity basis $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ 150,000 $ 150,000
Sale proceeds $ 20,000,000
Sale proceeds to SEAL $ 1,000,000
Sale proceeds to founders $ 19,00,000
Total to SEAL $ (150,000) $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ 1,000,000
Total to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 20,200,000
SEAL IRR 44%
Figure 14: Scenario model for a company on the “Middle” net income trajectory that is acquired for a strategic price after 8 years, after repaying their full return cap.

Here the outcome is also good for the SEAL, though at least in terms of IRR not as good as the earlier sale above. While the sale price is 5 times higher in this scenario, the SEAL’s equity basis has been reduced by the payoff of the return cap. Also the sale proceeds come in year 8, suppressing IRR relative to the quick payoff of the earlier acquisition.

Key SEAL parameters determining acquisition outcomes for the SEAL are the unpaid return cap (when that’s the binding term for a given sale — in earlier and lower value acquisitions) and the investment amount relative to valuation cap (for later and higher-value acquisitions). The sale price is also critical. For example, here’s how IRR varies with valuation caps and sale prices (assuming fixed investment amount) for the last scenario modeled above:

SEAL IRRs for late
strategic acquisition
Valuation caps
$2M $3M $4M
Sale price $20M 49% 44% 40%
$40M 61% 54% 49%
$100M 75% 66% 61%
Figure 15: SEAL IRRs gives various values for the sale price and valuation cap. Parameters are otherwise as described in Fig. 14 above.

There’s a huge spectrum of acquisition outcomes possible — in terms of timing, pricing, SEAL terms etc. — so it’s hard to draw overall conclusions about their impact on SEAL investors. High-premium and/or later stage acquisitions can work very well for SEAL investors. Very early, modest sales look good in terms of IRR but in practice are unlikely because founders will avoid them. In general much higher IRRs seem possible in cases of acquisitions than in even very optimistic scenarios for companies that remain profitable indefinitely. If companies sell at sufficiently high prices, the returns could become critical to the investor’s overall portfolio return. Given all of these I expect SEAL investors to seek high-value acquisitions, and perhaps even to count on them in their portfolios.

Another important set of scenarios is when the company takes external equity financing. In these cases presumably the company is converting more towards the traditional VC model — with investors willing to put in straight equity on the belief that the company has a return profile compatible with that form of financing (i.e. high upside but with high risk).

Here’s what might happen if this conversation happens early on, before any of the return cap is paid off:

Scenario: middle trajectory, equity investment before payback
Year 1 2 3
Net income $ 30,000 $ 60,000 $ 120,000
Founder earnings $ - $ - $ 20,000
Founder earnings to SEAL $ - $ - $ 6,000
Founder earnings to founders $ - $ - $ 14,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000
SEAL equity basis $ 450,000 $ 450,000 $ 444,000
Equity investment pre-money $ 8,000,000
Equity investment amount $ 2,000,000
Equity % to SEAL 14.8%
Equity % to new investor 20.0%
Equity % to founders 65.2%
Equity value to SEAL $ 1,480,000
Total to SEAL $ (150,000) $ - $ 1,486,000
Total to founders $ - $ - $ 14,000
SEAL IRR 215%
Figure 16: SEAL performance in the case of an equity conversion upon fixed-price financing before much payback has occurred. Note that the IRR figure combines cash investment, a small cash repayment, and the paper value of a large equity conversion.

At least on paper this is extremely favorable to the SEAL investor. The investor only put in $150,000 initially, but because of the low valuation cap of $3,000,000 they can convert to about 15% of the equity in the new company. With a $10,000,000 post-money valuation this stake has a nominal value almost $1,500,000. Because this conversion happened relatively soon after the initial investment, the IRR is huge at 215% (though again this is only on paper, not cash).

If instead the equity conversion happens later, after the return cap is paid off:

Scenario: middle trajectory, equity investment after payback
Year 1 2 3 4 5 6 7 8
Net income $ 30,000 $ 60,000 $ 120,000 $ 180,000 $ 300,000 $ 500,000 $ 900,000 $ 1,300,000
Founder earnings $ - $ - $ 20,000 $ 80,000 $ 200,000 $ 400,000 $ 800,000 $ 1,200,000
Founder earnings to SEAL $ - $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ -
Founder earnings to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 1,200,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ - $ -
SEAL equity basis $ 450,000 $ 450,000 $ 444,000 $ 420,000 $ 360,000 $ 240,000 $ 150,000 $ 150,000
Equity investment pre-money $ 40,000,000
Equity investment amount $ 5,000,000
Equity % to SEAL 5.0%
Equity % to new investor 11.1%
Equity % to founders 83.9%
Equity value to SEAL $ 2,250,000
Total to SEAL $ (150,000) $ - $ 6,000 $ 24,000 $ 60,000 $ 120,000 $ 240,000 $ 2,250,000
Total to founders $ - $ - $ 14,000 $ 56,000 $ 140,000 $ 280,000 $ 560,000 $ 1,200,000
SEAL IRR 56%
Figure 17: SEAL performance in the case of an equity conversion upon fixed-price financing after payback has occurred. Note that the IRR figure combines cash investment, cash repayments against the return cap, and the paper value of a large equity conversion.

Again this looks very positive for the SEAL investor. They enjoyed a full 3x payback on their initial investment in cash, and then convert their residual equity basis into a stake worth more than $2,000,000 on paper. Because the repayment and conversion happen a while after the initial investment, the IRR is still very big at 56%, but not as eye-popping as the case above.

Even with only a couple models, it’s clear that an equity conversion can be valuable to the SEAL investor. If a company changes course from a focus on profitability to fueling growth with equity funding, the SEAL investor gets to participate in the future upside very cheaply. As with acquisitions, it seems that investors would be happy to see companies convert like this.

Given these incentives, SEAL investors may be tempted to encourage companies to sell or raise financing, especially after their return cap has been repaid and the investor has no incentive to encourage profitability. It’s hard to say without more data from investors and experience in the wild.

Venture-level outcomes

Just for fun, let’s see what happens if the investor is in a company that does an equity conversion and ends up achieving a true venture-scale exit.

Consider a scenario in which an equity conversion happens before payback of most of the return cap, the company then spends ~7 years growing on a venture trajectory including taking several rounds of additional venture funding, and then sells for $1 billion:

Scenario: middle trajectory, equity investment before payback, venture exit
Year 1 2 3 10
Net income $ 30,000 $ 60,000 $ 120,000
Founder earnings $ - $ - $ 20,000
Founder earnings to SEAL $ - $ - $ 6,000
Founder earnings to founders $ - $ - $ 14,000
SEAL unpaid cap $ 450,000 $ 450,000 $ 444,000
SEAL equity basis $ 450,000 $ 450,000 $ 444,000
Sale proceeds  $ 1,000,000,000
Equity % to SEAL 14.8% 8.88%
Equity % to new investor 20.0% 50.00
Equity % to founders 65.2% 39.12%
Sale proceeds to SEAL $ 88,800,000
Sale proceeds to founders $ 391,200,000
Total to SEAL $ (150,000) $ - $ - $ - $ 88,800,000
Total to founders $ - $ - $ 14,000 391,200,000
SEAL IRR 103%
Figure 18: SEAL performance in the case of an equity conversion upon fixed-price financing after payback has occurred, followed by a large sale years later. We assume the equity holders as of year 3 are diluted a further 40% by funding rounds between the converting round and the exit.

In this model, the SEAL investor has a 14.8% equity stake as of the funding round that triggers the conversion. We assume several funding rounds dilute that position down to 8.88% on account of the venture-style growth over 7 years. Even so, a sale of $1 billion yields about $90 million in returns for the investor!

Indeed a small number of outcomes like this could carry a SEAL investors fund, much like a typical seed fund that more directly targets these outcomes. Consider these hypothetical SEAL investor portfolios:

Long-tailed SEAL portfolio IRRs
SEAL portfolio composition 95% Zero, 5% Venture exit 46%
98% Zero, 2% Venture exit 32%
60% Zero, 38% Middle, 2% Venture exit 36%
Figure 19: Portfolio IRRs given different proportions of company outcomes. “Zero” means the company never earns any return for the SEAL. “Middle” assumes middle net income trajectory with no sale, financing, or residual value. “Venture exit” corresponds to the outcome modeled in Figure 18. All cases assume the base SEAL parameters.

These portfolios show that even a small number of venture-style exits could carry the SEAL fund. In these cases, some companies paying back their full return cap (the “Middle” net income scenario) would be a nice bonus, but hardly existential to the fund. Here the SEAL portfolio looks a lot like traditional VC seed fund!

Combined portfolios

Venture-scale exits are nice to think about, but realistically SEAL investors can’t count on them given the companies they invest in. Instead SEAL investors will expect a distribution of more moderate outcomes across their portfolio companies, including: repayment of return caps, income-based acquisitions, strategic acquisitions, and failures that return nothing. Let’s look at what returns might look like under hypothetical portfolios spanning these outcomes (and that don’t include a venture-scale jackpot):

SEAL portfolio outcome distributions and returns
Scenario Weights
Zero 30% 30% 80%
Low, return cap only 30% 30% 0%
Middle, return cap only 30% 15% 0%
Middle, income acquisition post-payback 0% 10% 10%
Middle, strategic acquisition post-payback 0% 5% 5%
High, return cap only 10% 5% 0%
High, income acquisition post-payback 0% 0% 0%
High, strategic acquisition post-payback 0% 5% 5%
Combined SEAL IRR 14% 27% 15%
Figure 20: Portfolio IRRs given different proportions of company outcomes. “Zero”, “Low”, “Middle”, and “High” are net income trajectories as described above. Acquisitions are also modeled as above.

Here each of the three columns under Weights represents a possible outcome of the portfolio, with the resulting IRR for the portfolio at the bottom.

These three outcomes illustrate core dynamics of our SEAL model:

So the SEAL investor needs a high proportion of companies to be profitable and a healthy portion of them to get acquired (or perhaps raise venture financing at high valuations). But they don’t necessarily require huge exits to make it work — those would be a bonus.

Conclusions

To summarize:

Overall I’m thrilled to see alternative financing options emerging for early-stage companies. I also appreciate how open investors like Indie.VC and Earnest Capital have been with their structures and thinking. I hope this analysis contributed usefully to the ongoing discussion around these offerings. If you have any thoughts it’d be great to hear from you!

Appendix: other questions

I haven’t been able to cover all aspects of how SEALs perform for investors. Below are some things I’d love to learn more about: