What is a Profit Share?
Profit sharing is a flexible capital product with no fixed interest rate. Profit sharing investors give a company growth capital in exchange for a percentage of the company’s ongoing profits.
Similar to traditional debt financing, investors collect monthly or quarterly payments. Rather than payments set at an interest rate, profit-based payments are flexible because they fluctuate with profits.
If profits slow down, then the payments will be lower; if the profits are higher, then the loan is repaid more quickly. Payments are made until the investor receives a predetermined multiple of the original investment or return cap. Typically, the company does not have to provide collateral or personal guarantees for profit sharing because its profits are essentially collateral.
Similar to revenue-based financing, profit sharing blends features of debt and venture capital, and founders should expect the cost of capital to fall within that range. Profit sharing represents non- or less-dilutive growth capital to bridge the path to sustainable profitability for growing businesses that do not fit the VC model.
The Income Share Agreement (ISA), like the Convertible Income Share Agreement (CISA) created by Chisos Capital, is much closer to profit sharing than revenue-based financing with the caveat that it more directly relies on founder income rather than business profitability. Another innovative capital product, the Shared Earnings Agreement (SEAL) created by Calm Company Fund, blends features of both profit and income sharing.
Profit sharing is not a novel idea and historically was used to invest in companies with predictable cash flow and high profit margins in the media, entertainment, food & beverage, and restaurant industries. Recently, profit sharing has been adopted by a small number of early-stage investors looking to provide optionality and allow founders to maintain control as they build sustainable and profitable companies over the long term.
What are the typical characteristics of profit sharing?
- Structured as a convertible note or debt
- Quarterly or biannual payments equal a set percentage of profits (typically 10-30%)
- Payments start following a grace period of 6-12 months
- Payments continue until a set dollar amount has been paid back, usually 2-10x the amount of the financing (this multiple is called the “cap”)
- At maturity, which is typically 7-10 years, any unpaid amount of the cap is due
- No collateral or restrictive covenants
Collab Capital Case Study
It is often cheaper than selling equity, but more expensive than bank loans. They typically cost 15% to 30% IRR compared to <10% for bank loans and 50%+ for VC. However, profit sharing can be as expensive as traditional equity if the founder chooses to raise follow-on VC funding, triggering the conversion of any outstanding debt to equity. If founders can get access to a cheaper fixed-rate bank loan and are willing to secure the loan with personal guarantees and collateral, then they should take it.
Profit sharing instruments like SPACE, SEAL, and CISA are structured as a convertible note with a mix of debt and equity-like features. Unlike traditional debt, they do not have a fixed repayment schedule, maturity date, or personal guarantees. These innovative capital products are structured as equity which means taxable LPs will likely have their investment returns taxed at the capital gains rate. However, royalty-like, profit sharing products without a convertible equity mechanism likely fall into the debt category where returns will be taxed at the ordinary income rate.
Profit sharing provides equity-like returns with better liquidity than traditional equity. Investors do not need to rely on an acquisition or public exit because of the self-liquidating returns for profit sharing. Founders pay back the investment from their company’s net income until reaching the return cap.
Capital Product Fit
When is profit sharing a good fit for businesses?
- Profitability: Businesses do not need to be profitable, but investors like to see a path to profitability within three years. Businesses need to be at least EBITDA positive.
- Recurring Revenue: Businesses need to average at least $10K in monthly recurring revenue (MRR). Investors like to see somewhat predictable revenues with repeatable or recurring customer contracts and customer diversity.
- Annual Revenue Growth: 25%+
- Net Margins: 40%+
- Exit Value: $50M+ business within 10 years
- Financials: 1+ years of financial statements
When is profit sharing not a fit for businesses?
- Too Young: If a business does not have at least one or two years of financial statements, then it is difficult for an investor to underwrite and make an investment.
- No Revenue: If a business does not have any revenue, then it is difficult for an investor to underwrite and make an investment. Most investors like to see $10k+ in MRR for several months.
- Heavy R&D: Businesses that are capital intensive and require a large amount of upfront funding to build large-scale projects or bring breakthrough technology to market.
- Blitzscalers: Businesses that require rapid growth to take over an entire market or create a new market and need large amounts of VC funding to scale. These “Blitzscalers” typically focus on speed and growth over cash flow and profits.
- Fundraisers: Founders always focused on raising the next round of funding for their businesses. Investors want to write checks to builders, not fundraisers, and do not want to have to spend a lot of time convincing founders not to take the traditional VC funding path.
- Misaligned Cap Table: If founders have raised $5M+ in traditional VC funding, then their existing investors most likely will be focused on raising another VC round at a larger valuation. Profit share investors do not want to compete with the different return and fundraising expectations of prior or potential co-investors. On the debt side, investors do not like to navigate a crowded and complex cap table with a bunch of lenders who are more senior to them and have expensive rates and warrants.
Why would founders want to choose profit sharing?
- Less-Dilutive & More Control: Founders maintain more ownership and control over their business than traditional VC. Once the investment is paid back by founders, the investor is not on your cap table permanently. Investors typically do not take a board seat.
- Flexible Payment Schedule: Profit sharing provides more flexible payment terms based on a percentage of net income, rather than term loans with fixed payments that do not fluctuate with net income. Payments scale up and down along with net income growth.
- No Restrictive Covenants: Unlike traditional bank loans, profit sharing investments typically do not require the borrower to agree to any restrictive covenants where the borrower must manage their business in a specific way, such as maintaining minimum liquidity levels. Factoring or merchant cash advances also come with more restrictions and need to be paid daily or weekly compared to monthly or quarterly for profit sharing.
- Cheaper than VC: Profit sharing is often cheaper for founders than selling preferred equity to VCs. Founders may believe that traditional equity costs less with no expected payments until an exit, but profit sharing is most likely cheaper over the long-run on both total dollar amount and IRR basis. Profit share investors cap their investment at a 2-5x return instead of aiming for 10x+ returns like VCs. Also, profit sharing enables startups to leverage more of the investment capital to scale during the early years than RBI. Depending on the grace period, revenue-based products typically require faster and larger repayments upfront than profit sharing since they are linked to top-line revenue and do not factor profitability into the deal terms.
- Fundraising Optionality: Founders do not need to follow the VC funding path of raising larger follow-on rounds of dilutive equity capital. Profit sharing offers cheaper, non-dilutive growth capital that can enable businesses to scale and eventually raise VC funding or access cheaper bank debt. It provides founders the optionality to pursue the funding journey that makes the most sense for their business.
- Access to Capital: Profit sharing is more accessible for underrepresented founders because the underwriting process is based on the company’s revenue, margins, and other financials, not the owner’s credit score, income, or personal real estate assets. Traditional debt financing continues to use outdated and discriminatory lending practices that limit access to capital and increase the cost of capital for underrepresented founders. Profit sharing has improved the investment process with a more inclusive underwriting approach.
What should businesses look out for with profit sharing?
- Less Predictable Payment Schedule: Profit-based payments fluctuate with net income which can provide flexibility for founders but also be harder to predict for financial projections than traditional loans with fixed monthly payments. They have a variable interest rate instead of a fixed interest rate.
- More Expensive than Bank Loans: Most founders seek profit sharing investments because they cannot access bank loans or VC. Profit sharing usually costs between 15% and 30% IRR compared to bank loans at <10% IRR and VC at 50%+ IRR. If net income grows quickly, then payments will also do so. This leads to a shorter payback period, but also a higher cost of capital. Founders need to be comfortable with the fixed return cap or total payment, regardless of their net income growth rate.
- Net Margins > % of Profits: Founders need to be comfortable giving up the percentage of net income to pay back the investment. Net margins need to be sufficiently high enough to support the financing costs or else the investment will start to reduce the growth potential of the business.
- Equity Warrants: It depends on the investor, but founders may need to agree to equity warrants in addition to the profit sharing. The equity warrants provide upside participation for investors and are typically tied to hitting revenue and/or net income milestones and exit scenarios. Profit sharing with equity warrants will drive up the cost of capital for founders, but it will likely remain cheaper than traditional equity and tends to have more founder-friendly terms than bank loans or venture debt.
- Further Down the income statement than RBI: Profit sharing can lead to more potential conflicts of interest between investors and founders than RBI. Net income is further down the Income Statement than revenue which means more line items that impact the repayment amount to investors. Gross revenue is an easier, top-line metric to measure and track than bottom-line net income. There needs to be an ever greater level of transparency and trust between investors and founders.
Example Terms: What do investors typically charge businesses for profit sharing?
- Investment Size: up to 1/3 of ARR rate (typically $25K to $3M check sizes)
- Initial Ownership (Equity): 0%
- Percentage of Net Income (Payment): 10-30%
- Return Cap (Total Payment): 2-10x
- Payment Schedule: Quarterly or bi-annually
- Grace Period: 6 to 12 months
- This is the date founders will begin making profit-based payments. These start dates can range widely given the intent of the founders and investors. Some investors might choose to set the start date to begin immediately while others may set it at 12+ months post-investment.
- Equity Warrants: Up to 15% ownership based on predetermined milestones
- Personal Guarantee: None
- Financial Reporting: The investor has financial data access to the company’s financial statements, including monthly balance sheet (plus YTD), monthly cash flow statements (plus YTD), monthly bank reconciliation report, monthly bank statements, and monthly compliance certification — certifying the information delivered.
- Board Seats: None
Convertible Income Share Agreement (CISA) Open Source Term Sheet: Chisos Capital
The CISA was developed by Chisos Capital. The CISA is a debt-equity hybrid approach that lets us invest at the earliest stages of a person’s entrepreneurial journey.