An increasing number of startup founders are operating their companies as lifestyle businesses, prioritizing revenue and sustainable growth over scaling for sale or public offering. In the wake of this phenomenon, funders who have invested in such companies with traditional early-stage investment vehicles like SAFEs (Simple Agreement for Future Equity) or convertible promissory notes are left waiting for a liquidity event, such as further qualified financing or liquidation, in order to convert their investment into equity or secure a return on investment. With no clear conversion timeline, investors are left wringing their hands, waiting for the emerging company to grow quickly or applying pressure to the startup in order to trigger a conversion event.

In this place of limbo, alternative investment vehicles have slowly entered the scene, seeking to meet the priorities of both funders and slow-growth founders. Take, for instance, shared earnings arrangements.

What Is a Shared Earnings Arrangement?

A shared earnings arrangement is an alternative to traditional equity financing that allows investors to receive a percentage, often capped, of the company’s total earnings. The scope of earnings subject to sharing is typically negotiated and can include dividends and/or retained earnings, as well as adjustments for founder-specific expenses, such as founder salaries.

Investors make an upfront capital investment and then realize the return on investment upon receiving their agreed percentage of earnings. Shared earnings models that adjust for a negotiated threshold for founder salaries exclude the earnings needed to fund those salaries from the earnings investors participate in, allowing the founders to pay themselves a living wage first. Shared earnings are usually capped at two to five times the initial investment, after which payments cease and an equity stake may be retained, depending on the arrangement.

Why Use a Shared Earnings Agreement?

• Alignment: Establishes alignment between founders and investors to build profitable, sustainable businesses without the pressures inherent in traditional early-stage investment vehicles, which often lead to the need for additional funding or company sale.
• Control: It gives founders greater control over business growth while balancing investors’ need for returns with founders’ need to keep options open, whether building a lifestyle company or a billion-dollar venture.
• Sustainable: Unlike traditional early-stage investment structures, this arrangement doesn’t force founders into growth-at-all-cost scenarios and allows them to focus on building healthy, profitable companies that can thrive in the long term.
• Quicker Return: Investors can start realizing a return much sooner than if they needed to wait for a conversion event.
• Flexible: The arrangement can be nimble enough to allow investors to retain a small equity stake after the earnings cap is reached. That stake may be converted if the company is sold or raises further funds in a traditional, qualified financing event.

What Are the Potential Drawbacks?

For founders

• Limit on Profit: Shared earnings arrangements require founders to share a portion of what would otherwise be retained earnings or founder income until the investors’ cap is met. This can feel inhibiting during profitable years, particularly if the cap is on the higher end.

For funders

• Limited Upside: Shared earnings arrangements cap shared earnings returns, reducing pressure on founders for an exit event. This may deter traditional funders who rely on fast-scaling investment models with significant buyout events for a substantial return.
• Unfamiliarity: These are new investment arrangements. Funders may be wary of entering into such an arrangement when the space is still in its early stages of development and there are few examples of success.

Ultimately, this growing investment vehicle is worth considering for both entrepreneurs seeking to prioritize revenue and a balanced lifestyle, as well as investors looking for a steady return on sustainable-growth startups.

Tony Mayotte contributed to this article