Webinar Recap: Alternatives to Venture Capital with Tyler Tringas of Earnest Capital
We recently hosted a webinar with Tyler Tringas, General Partner at Earnest Capital, covering alternative financing options available to startups. During the webinar Mike, our CEO, and Tyler covered the current state of venture and SaaS markets, all things Earnest Capital, and SEALs. In case you missed it, check out the recording and our favorite takeaways below.
Financial –> Production Capital
One of the driving forces behind the Earnest Capital Investment Memo is the notion that software is entering the deployment age (read more about the deployment age in the investment memo here). In short, Tyler explains the deployment age as a time when products, software in this instance, can and should be distributed to every corner of the economy. This creates a new software category where niche and sustainable business can succeed as opposed to the winner take all software companies we’ve seen in the past.
Generally speaking, venture capital has been the default funding option for software companies but as we enter the deployment age there will be a need for a new form of funding. As a result, the type of capital companies need is shifting from financial capital to production capital (Enter: Earnest Capital).
The Peace Dividend of SaaS Wars
Another key driver to Earnest Capital Investment Memo is the idea of “The Peace Dividend of SaaS Wars.” The idea is that when countries are at war they will throw money to escalate and create new technologies. An example Tyler gives is the development of synthetic rubber during WWII. After the war, synthetic rubber could be applied to consumer goods.
So how does this relate to SaaS? Investors and early leaders are throwing money to create new technologies in the winner take all SaaS markets. As a result, it is less capital intensive than ever before to start a new business. Tyler mentions that software companies can be started on a free Heroku plan where in the past you’d need to buy your own servers and space. In turn, this helps companies attack markets with a smaller total addressable market and may not be a fit for venture capital.
The New American Dream
Entrepreneurship is in decline in the US. Tyler believes that one major component of the decline is because, “the major area for new entrepreneurship, software and software-enabled businesses, has no default form of aligned funding.” In the past (think 1970s or 80s), an entrepreneur may have had experience or been highly qualified in a field, went to the bank for funding, and likely built physical locations. But with no physical collateral for a software company, who is supplying the funding to grow these companies? Another sign of a need for a new form of financing.
Tyler argues that, “building, owning (and possibly someday selling) a profitable remote software business is the new American Dream.” Entrepreneurs can employ 15-20 people, distribute their profits amongst employees, and still create huge economic impacts for themselves and those involved with the business.
Shared Earnings Agreement
Tyler discovered that the traditional financing options for early stage investors (SAFEs, convertible notes) are not aligned with “Earnest” founders so they create a new financial product: Shared Earnings Agreement. Tyler discusses why they created the SEAL in the webinar and dives into a few of the key components. If interested in learning more about SEALs, we suggest checking out this post.
Send Updates to Potential Investors
Tyler briefly touches on the importance of sending investor updates. Tyler mentioned that he has seen investor updates as the best tactic they have seen in use to help companies fundraise. If Earnest speaks with a company they are interested in but are not quite ready to invest, they’ll ask to be sent updates about the business. From here, Earnest can be in the loop and ready to make an investment as soon as possible.
Check out the Founder Summit
Earnest Capital is hosting a summit for founders and startup leaders in Mexico City in March. The summit is intended to allow founders to meet and network as oppose to another conference full of presentations. If you’re a founder and interested in learning more about the summit, check it out here.
Mike and Tyler tried their best to answer all of the questions at the end of the webinar. For the questions they did not get to, you can check out Tyler’s answers inline below:
Q: I assume that at least some incumbents/market leaders will try to meet growth expectations by appealing and selling to niche audiences. How much weight does this threat carry in your investment decisions? If it’s not a threat, why not?
A: Competition from large incumbents is definitely not something we outright ignore, it’s just that we try to dramatically lessen the risk by backing founders tackling markets that just wouldn’t move the needle for a $10B or 100B+ firm even they came in and took 100% of the market. That said it certainly can still happen. I don’t think we have a special sauce for that scenario other than to encourage founders to lean in to their startup competitive advantages. One thing we do is encourage founders to not try to make themselves seem bigger than they are (don’t use the “Royal We” if it’s actually just You). It’s surprising how much some customers really want to support an independent small brand. The Basecamp folks are putting on a masterclass on how to counterpunch on BigCos like Google with this
Q: How does Earnest protect itself from a business defaulting on quarterly shared earnings payments?
A: Pretty much the only “investor right” we ask for in our investment docs are the right to inspect the books. Many founders just go ahead and give us access to their Quickbooks. Which is how we would address some kind of fraud or misrepresentation of Founder Earnings. At another level it’s quite hard to accidentally “default” in the sense of being unable to make a payment, since the Shared Earnings are always a % of Founder Earnings, the business should have generated the cash to make the payment (in contrast to debt where a payment is due whether you have the profits to pay for it or not). Lastly if a company has the Founder Earnings but just refuses to pay, we are somewhat protected by the fact that a) the company is obviously doing well and therefore is valuable and b) not making Shared Earnings payments keeps our implied % of a sale higher, so the founder is kinda shooting themselves in the foot if they ever intend to sell the business, we’ll likely get more money from the higher % of the sale than they would have paid out in Shared Earnings along the way. All about aligning incentives!
Q: The required “hit rate” for a SEAL portfolio to work is really high (given the capped return + long time horizon): How do you think about this question? Do you have a target % of startups that must “survive” to get a return?
A: It is higher than you would see in a traditional seed VC portfolio, but our theory is that the failure rate is not a law of startup physics but rather the whole venture strategy ratchets up both a) the chance of being a unicorn and b) the chance of failure. We don’t know what the typical failure rate is for a basket of highly filtered and selected, post-revenue bootstrapped businesses, but our basic bet is it’s much much higher than is typical in venture. I go into this in some detail here.
Q: For your portfolio companies, to what extent do they also have other investors beyond the founding bootstrappers? What is your range of size of investment and also the range of time horizon to large-scale recurring revenue?
A: We have done a mix of being the first/only investor in a company, leading a round where several angel investors co-invest with us, and a few deals where we co-invested with other investors (least likely for us, but does happen). We’re open to anything but have a slight preference to be the first/only just because it’s so much easier to close (can be as fast as 2 weeks). As of this moment, we invest $50k-$250k which may increase over time. As a fund, ideally we would love to see business mature and get to real profitability in 7-10 years but we are early-stage, long-term investors and understand that timeline is out of our control.
Q: Tyler mentioned a mix of outside capital and sweat equity, however Earnest and other micro-VCs only seem to want to invest in products that are built and have traction. How do I get help building an MVP? I’m a technical founder so I can write code, but trying to do everything myself is taking forever.
A: Yea, I have to concede that one of the main advantages the venture model has over ours (similar funding for bootstrappers ideas) is that pre-seed VCs have a model where they can invest at the “idea stage”… because we are not unicorn hunting, we also can’t take the very high risk of investing pre-product pre-launch. One of the main effects of the Peace Dividend that I talk about is that it’s now pretty reasonable to bootstrap, as a side project, a real product to real revenue from real customers. So as an investor, I (and many others) now really have to wait until that stage because so many entrepreneurs are getting there without funding. Some good resources would be some of my Micro-SaaS blog posts (microsaas.co), Indiehackers.com, and Makerpad (makerpad.co) for tips on building an MVP for business ideas without writing a ton of code.