Investors - Equity is Dead! It's Time to Embrace the Profit-Sharing Model

In Part 1 - Founders - You Should be Building Your Next Company with $50,000 or Less, I explored how startup founders can leverage $50,000 to build successful AI-driven companies. Key strategies included utilizing decreasing costs of AI technology, no-code platforms, globalization, and affordable marketing. We discussed case studies of companies like Buffer and Zapier that have effectively used these methods to grow without significant upfront investment. With these insights, founders are better equipped to navigate the startup landscape.

The Death of Equity? Why Profit-Sharing is the New Angel Investment Game

In today's evolving investment landscape, traditional equity-based investments are becoming less effective, particularly for angel investors who typically invest smaller amounts. The changing market conditions have made it increasingly difficult to see substantial returns from equity stakes. This article explores how profit-sharing models offer a compelling alternative, providing faster and more predictable returns for angel investors.

The Exit Strategy is Broken: Angel Investors Need a New Plan

The investment environment has shifted dramatically over the past few decades. Historically, equity-based investments were the standard, with investors banking on substantial returns through company exits or IPOs. However, the number of publicly traded companies has decreased significantly, dropping from around 8,000 in the mid-1990s to approximately 4,000 by 2020 Sources: FRED, The Atlantic

"Private equity has made one-fifth of the market effectively invisible to investors, the media, and regulators... In 2000, private-equity firms managed about 4 percent of total U.S. corporate equity. By 2021, that number was closer to 20 percent. In other words, private equity has been growing nearly five times faster than the U.S. economy as a whole." - The Atlantic

This decline in public companies means fewer opportunities for lucrative exits.

Moreover, the increasing rate of mergers and acquisitions, often scrutinized and blocked by regulatory bodies like the FTC and the Department of Justice, (sources: NY Times, McDermott Will & Emery) adds to the complexity and uncertainty of traditional exit strategies. For angel investors, this environment poses a significant risk of dilution, as startups typically go through multiple funding rounds, each potentially diluting earlier investors' equity stakes. However, let's say you hit the jackpot with a unicorn, like Figma, will you even see a return with recent regulatory changes?

Here are some examples of mergers and acquisitions that have been blocked by regulatory bodies:

• The Department of Justice successfully blocked Penguin Random House's $2.18 billion buyout of publishing rival Simon & Schuster, citing concerns over reduced competition and lower advances paid to authors.
• The Department of Justice unwound a partnership between American Airlines and JetBlue, citing concerns over reduced competition.
• The Federal Trade Commission recently moved to block Kroger's $25 billion acquisition of Albertsons, citing concerns that it would limit competition in the supermarket industry and negatively impact customers.
• The UK Competition and Markets Authority (CMA) blocked Microsoft's $69 billion acquisition of Activision Blizzard over concerns it could lessen competition in cloud gaming.
• The proposed merger between Adobe and Figma for $20 billion was abandoned after facing antitrust scrutiny from regulators over concerns it could hurt competition in the design software market.

The Profit-Sharing Model

Profit-sharing models present a viable alternative for angel investors, offering a more immediate and predictable return on investment. Instead of relying on uncertain exit events, investors receive a percentage of the company's profits over a set period.

Benefits for Angel Investors

1. Faster Returns: Unlike equity, which may take years to yield returns, profit-sharing provides immediate income based on the company's performance.

2. Aligned Interests: Both investors and founders are incentivized to ensure the company becomes profitable quickly.

3. Reduced Risk of Dilution: Profit-sharing agreements focus on profit distribution, thereby avoiding the dilution that comes with additional funding rounds.

Benefits for Startups

1. Flexibility: Startups can attract investment without diluting ownership.

2. Focused Growth: Profit-sharing aligns with sustainable growth and profitability rather than speculative growth.

3. Attractive to Investors: Easier to attract investment as it offers quicker returns and lower risks.

Implementing Profit-Sharing Models

Structuring Agreements

Creating a clear and mutually beneficial profit-sharing agreement is crucial. Key elements to include are:

- Percentage of Profits: Clearly define the share of profits investors will receive.

- Time Frame: Specify the duration for which the profit-sharing will be in effect.

- Payment Terms: Outline how and when payments will be made to investors.

Legal and Financial Considerations

Consulting with legal and financial experts to draft profit-sharing agreements ensures compliance and clarity. Key considerations include:

- Tax Implications: Understanding how profit-sharing payments are taxed.

- Regulatory Compliance: Ensuring the agreement complies with relevant financial regulations.

- Transparency: Maintaining clear and transparent financial reporting to build investor trust.

Case Studies

Gumroad

Gumroad, a platform for creators to sell their products directly to consumers, adopted a profit-sharing model to attract investment. This approach allowed them to raise funds without diluting ownership and align investor interests with company profitability.

ConvertKit

ConvertKit, an email marketing company, used profit-sharing to bootstrap their growth. By offering investors a share of their monthly recurring revenue, they were able to secure funding while focusing on sustainable growth and profitability.

Indie.vc

Indie.vc offers an example of an investment firm that uses revenue-based financing, a form of profit-sharing. They provide funding to startups in exchange for a percentage of future revenue, ensuring investors receive returns without diluting founders’ equity.

Challenges and Considerations

Potential Drawbacks

While profit-sharing models offer many benefits, there are potential challenges to consider:

- Cash Flow Management: Ensuring the company can manage regular profit-sharing payments without straining cash flow.

- Performance Pressure: The need to maintain profitability can add pressure on the company’s operations. However, as an Investor, this is what we should be expecting from our investments - profitability, not just an exit.

- Agreement Complexity: Drafting and managing profit-sharing agreements can be more complex than traditional equity deals.

Mitigating Risks

To mitigate these risks, startups can:

- Maintain a Healthy Cash Reserve: Ensure sufficient cash flow to meet profit-sharing obligations.

- Set Realistic Profit Targets: Agree on achievable profit-sharing targets to avoid undue pressure.

- Regularly Review Agreements: Periodically review and, if necessary, renegotiate terms to adapt to changing circumstances.

The Profit-Sharing Playbook: How Angel Investors Can Secure Their Spot in the Next Big Thing

The shift from equity to profit-sharing models reflects the evolving needs and realities of the current market. For angel investors, this approach offers faster and more predictable returns, while for startups, it provides flexibility and aligns with sustainable growth strategies. As an investor, you have a lot of options on how you want to structure the deal and you don't have to forego the traditional methods. However, if you have a startup founder who thinks they can get to revenue quickly on a shoestring budget, try proposing a Profit Share model for the next 12-18 months with Pro-Rata Rights to Invest at a discount after the original time period. This ensures ROI and also guarantees you the opportunity after the company has proven Product-Market fit and may need an exit or additional funding to scale exponentially, which is exactly where you want to be as an Investor. By embracing profit-sharing models, both investors and startups can ensure mutual success in the AI-driven future.

Stay tuned for Part 3, where we will explore how Marketers and Content Creators can leverage profit-sharing models to generate recurring revenue and sustain growth.

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