When it comes to bringing on an investor, many founders are accustomed to a simple sale of shares or the sale of a convertible note. The Shared Earnings Agreement is a less well-known kind of funding option. With this agreement, entrepreneurs and investors may align their incentives in an income-driven framework that prevents the dilution of equity of the startup.

In business, a “Shared Earning Agreement” (SEA) is an agreement between a company and an investor about an upfront investment in the company’s startup or small firm in exchange for the investor receiving a portion of the company’s future earnings. In the below sections, we’ll look into this form of funding in detail. 

Shared Earnings Agreement

A Shared Earnings Agreement (SEA) is often used as a replacement for equity-like arrangements such as a SAFE, convertible note, or a stock option agreement. Unlike debt, it is not subject to a set repayment schedule and does not need the provision of a personal guarantee. In order to match the interests of investors and founders in a broad range of outcomes, the purpose of a SEA is to provide founders with complete authority over their organization while leaving as much choice as possible for the business to choose from. Because a SEA is a long-term commitment that, in most situations, will remain for a significant period of time and directly trims down the company’s earnings, it is important to evaluate the terms as carefully as possible. 

In general, an investor of a well-established company earns through dividends, which is the portion remaining after deducting all salaries and other expenditures from the company’s revenues. However, if the estimates are done in this approach for startups, the investor won’t get any returns, since the revenues are very low in the early stages. This will also lead to a lot of discussion around how much salary is considered fair for founders of the startup. 

To avoid such unnecessary hassle, the SEA calculates ‘earnings’ for a startup by combining the founder’s salaries, dividends, and retained profits. However, in order to guarantee that the founder has enough money to support themselves, particularly in the early stages, the SEA sets a threshold on the founder’s wage. Till the startup’s earnings cross this threshold, all profits (i.e., salary) are sent to the founder in order for them to be able to meet their living costs without anxiety, and the portion of the investor’s earnings is only computed from that point forth.

Entrepreneurs may not prefer this deal if this initial investment leads to a lifetime sharing of their earnings with an investor. Many SEAs have implemented a “Shared Earnings Cap” in order to solve this problem. After the cap is achieved, i.e. when the founder has returned to the investor a certain portion of the profits, the shared earnings cease, and the founder is entitled to retain any future earnings that remain after the limit is reached. 

With SEA, an investor can get the benefits in the following ways :

• Shared Earnings, i.e. Investors Earn When the Founders Earn: Investors in equity are traditionally entitled to a percentage of dividends. But owners of most or all of their companies are entitled to draw arbitrary boundaries between salary, retained earnings, and dividends. There is nothing reasonable about this and it can lead to proxy battles over a “fair” salary and whether investors should have a seat on the board. Through SEA, investors get a predetermined proportion of the company’s earnings, known as Shared Earnings, which provides more transparency and better alignment. Once the Shared Earnings Cap has been repaid, Shared Earnings will cease, and the founders will be able to continue running the firm in its current form in perpetuity without having to pay another dime to shareholders. 

• Long-Term Alignment And Optionality: There are a group of persons who are both mentors and founders of the startup. It is essential to ensure a long-term alignment with the success of the startup because every investor backing companies at the very early stage also wants to have some chance of a huge uncapped return. As part of the SEA, investors are given a percentage of the business in the event that the founders decide to sell the company or raise a priced equity round from a typical venture capital firm, which is known as the Equity Basis (the numerator) and a Valuation Cap (the denominator). 

Why SEA is important

Shared Earnings Agreements aren’t a gamble; they’re investments. Additionally, it’s attractive to many angel investors, since they have a dual purpose for investing. A group of investors called Earnest Capital developed the SEA concept to help burgeoning companies grow as they grow while putting minimal pressure on them to grow too fast or in a certain direction. Once the business reaches a modest level of profitability, the SEA calls for the company to make payments to investors, but only until the investor receives payments up to a predetermined “earnings cap,” which is usually around 2-4 times the original investment. The investors don’t take ownership of the company, and once the payments are complete, the founders are free to continue on or do whatever they wish with their business. Earnest Capital and some early pioneers were so excited about their shared earnings model that they “open-sourced” their idea, making key legal documents available for others to use as a starting point.

Another thing to consider is the ability to exercise control. When investing via a SEA, the investor has no influence over the company. They are not entitled to equity, board seats, or voting rights in any way. In this case, the founder is left in total control of every choice that is made. It is for this reason that convergence on issues such as the aforementioned earnings criteria is critical.

Conclusion

All things considered, SEAs provide an excellent option for bootstrapped entrepreneurs who are looking to raise a little amount of capital to get their business off the ground and who are committed to building a successful company. In this article, SEA is clearly defined and the perspective of an investor as well as an Entrepreneur is enlightened. This article gives the importance of the SEA cap which is important for Entrepreneurs while also having an eye on the calculated benefits that are important for the investors. In general, investors get paid through appreciation of stock and dividends. This article introduces another way for investors to get paid, i.e.  a portion of salaries, which gives a better safety net to the startup. Startups can consider the merits and demerits of raising funds via SEA and choose for their own fundraising activities accordingly.