Understanding Shared Earnings Agreements

Many founders looking to onboard an investor are familiar with a straightforward sale of equity or a convertible note. A less well-known option is the Shared Earnings Agreement. This contract allows for incentive alignment in an easy to understand structure for the right type of founders and investors.

What is a Shared Earnings Agreement?

A “Shared Earnings Agreement” (SEA, sometimes also referred to as the Earnest Capital SEAL) is an arrangement between a business and an investor about an upfront investment in a startup or a small business that entitles the investor to a share of the future earnings (hence the name) of the business. 

The aforementioned earnings include the following: the founder’s salaries, dividends and retained earnings. The difference to a traditional equity investment is that the founder’s salary is included.

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In larger businesses, a simple participation of the dividend makes sense. However, in smaller ventures, salaries can be a significant part of the overall earnings and thus create misalignment regarding how much salary is reasonable for the founder to pay out to themself. 

The SEA solves for this misalignment as all earnings, including the founder’s salary, are counted together. However, to ensure the founder has enough to pay themselves, especially in the early days, the SEA most commonly constitutes a founder earning threshold (cap on founder's salary). All earnings (i.e. salary) up to this point go to the founder so they can cover their living expenses worry-free and the share of the investor’s earnings is only calculated from that point onwards.

Of course, founders may be concerned that the initial investment does not warrant a permanent share of their profits with an investor. To address this issue, many SEAs have a “Shared Earnings Cap”. When the cap is reached, i.e. the founder has paid the investor back a predefined amount of the earnings, the shared earnings stop and the founder gets to keep all residual future earnings.

When do Shared Earnings Agreements make sense?

The most important factor in deciding when a SEA makes sense is the company’s profile. The best-suited businesses are those that are likely to be profit-generating small and medium-sized businesses. 

This way, investors limit their downside risk as profitable SMBs have a higher success rate compared to growth companies attempting to become publicly listed corporations.

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Moreover, both the investor and the founder are aligned on the company’s goal: become a profit generating endeavour. Once the Shared Earnings Cap is reached, the founder will get to retain complete upside in the success of their venture and the investor will be happy with the return they have generated. 

SEAs do not make sense for startups on a “grow or die” path to reach unicorn status at all costs. Instead, for those company profiles, Venture Capital investments make a good fit as they are more risky (the failure rate is much higher for these businesses) and the upside for the investor is not capped. 

Another factor to consider is control. With a SEA, the investor has no control over the business. They do not get equity, board seats or voting rights. Here, the founder is left completely in charge of every decision. That is why alignment on subjects such as the aforementioned earnings definition is so important. 

On the other hand, investors in startups with 1,000x growth aspirations will want to get some control over the company to stipulate decisions around acquisitions, liquidity preferences, hiring and so on to ensure the company stays on course to become a unicorn.

All considered, SEAs are a great opportunity for bootstrapped founders who want to obtain a bit of funding to get their business off the ground and are determined to build a profitable firm. 

Founders who want to build a startup that eventually turns into a unicorn and defer potential profits far into the future are best suited for a growth capital fundraising round.

Further resources: Calm Fund, Crunchbase, A Review of Earnest Capital’s Shared Earnings Agreement