The equity you sell pre-seed and seed-stage is the most costly. Frequently, founders find themselves holding only a small percentage of ownership as the business matures.  When you sell equity in a young business, the valuation is discounted for immaturity. The business has yet to prove product/market fit. It hasn’t demonstrated the ability to scale, and the team is untested. It also represents a long investment horizon. 

 

What if there was a way to regain some of the early equity? The good news is that is using structures like variable-based redeemable equity. 

 

This is a form of structured liquidity. It allows investors to purchase equity at the current fair market value and sell it back to the founder at a pre-agreed price over time. I will first explain the mechanics and then the benefits. I will end with how you determine if this structure is right for you as a founder. 

 

Mechanics

 

Redeemable equity is not a new concept. It has yet to be used frequently in our industry. We add a twist by having the redemption done through a variable-based payment. Here is how it works in simplified form:

 

The founder and investor agree on a pre-money valuation. For purposes of illustration, we will use $4MM. This pre-money valuation is used to calculate a price per share or unit. They also agree to the invested amount. We will use $1MM. The next step is to agree upon a redemption price. In this example, that is 2x the purchase price. The last two key negotiated points are the variable and percentage of the shares that can be redeemed. We will use a simple 1% of gross revenue for the variable. We will also assume the parties agree that 75% of the shares can be redeemed.

 

The business will pay the investor 1% of the gross revenue each quarter. This payment will be used to calculate the shares redeemed. This quarterly payment will continue until 75% of those shares are redeemed. We suggest modeling that redemption to be complete in roughly five years. 

 

In this case, the funder is investing $1MM at a 2x redemption. With 75% of their shares being redeemed by the founder, they would receive $1.5MM in payments over the five years and retain 25% of the shares purchased. This means the investor has seen a return of 1.5x their invested capital and still has all the upside potential in the remaining 25% of the shares. A good deal. 

 

Benefits

 

Variable-based redeemable equity offers investors who aren’t “power law” venture capitalists a reasonable blend of upside potential and downside mitigation. The upside is in the retained shares. That upside can come in the form of distributions or at an exit. It also provides them with a good return on invested capital. In our example, a 2x redemption at 75% equates to a 1.5x return. Unlike convertible notes, SAFEs, or non-redeemable equity, this structure provides quarterly cash flow, which takes risk off the table with each payment. Lastly, a good return is not reliant on an exit or raising another round of capital. 

 

This structure has many benefits for the founder. First, the costly early equity is clawed back, returning ownership to the entrepreneur. This structure does not require the founder to raise additional capital to convert or grow rapidly to attract investors or buyers. Rather, it requires them to build a good business with reasonable economics. 

 

Variable-based redeemable equity is not a panacea. It works for businesses with good margins and is run by disciplined founders. It fits more patient investors who aren’t looking for grand slams and will be satisfied with many singles and doubles. The alignment between founder and investor is key. 

 

There are ways to structure the capital needed to fund a business that will work better for founders and investors. You can get some of that early equity back while providing a good return to your investors. It just takes innovation and effort.

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