Early Stage Investment Challenges
In startup funding, one out of ten startups returns 10X+, three return 1X to 3X, one goes bankrupt, and the remaining five turn into lifestyle businesses.
Venture funding seeks to find the one out of ten startups that will return 10X+ the original investment. With so many other investors seeking the same investment opportunity, it can be challenging to access those deals.
Furthermore, venture capital, private equity, and other later-stage investors seek to maximize their position, reducing the return early-stage investors receive. Since later-stage funding is often critical for the startup to reach full potential, the startup will take the funding. This shift in control from early stage to later stage investors is one reason an early-stage investor should seek an early exit.
Early-stage investors have little to no control over the startups’ investment cycle. The more investors joining the deal, the more dilution startup investors suffer.
Enter: TEN Capital Early Exit Investment
The Early Exit Investment applies a redemption right on a startup investment giving the investor a 3X their initial investment in year three from the investment date. The investor may choose to take out the 3X or some portion of the investment or convert to equity at the Convertible Note cap rate.
The Early Exit Investment uses a Convertible Note that matures in 3 years and gives the investor a redemption right for 3X at year three at ‘Investor Sole Discretion.’ Each investor makes their own decision. A 3X return at year 3 is a 44% IRR.
TEN Capital proposes this investment tool for early-stage investors. They are at risk for investments into companies that go sideways and turn into a lifestyle business, leaving the investor without an exit.
It isn’t easy to negotiate redemption rights after the investment, so it’s imperative to set the terms before the investment is made.
Early Exit funding does not seek the one that achieves a 10X+ return but instead looks to avoid the one that goes bankrupt, meaning the investor can make gains on nine out of the ten startup investments.
The odds favor the investor with a consistent return on investment.
For the startups that track the 10X+ investment return, the investor can forego the redemption right and convert to equity.
The Early Exit model envisions returning at least the principal investment in year 3, with the remainder going to either debt or equity holdings.
Ideal Startups for the Early Exit Investment
Startups that fit this model are those who are not at risk for startup failure. The ideal candidate has some revenue typically above $500K annually and is on a growth trajectory of at least 30% year over year. At a minimum, the team needs to have the skills necessary to grow the business to $1M to $3M over the next three years.
Startups requiring FDA or have products that need additional Capital to achieve revenue are not good candidates either. Startups with recurring revenue, software-based businesses, and low-capital requirements are ideal.
If an acquisition or later stage funding occurs before year three, then the investor receives their redemption right at that time.
A recent investment into a camera company yielded a 2X return of the initial investment, with the remainder going into equity at the Series B stage. This occurred 18 months after the initial investment when later stage investors provided the next round of funding.
Challenges with the Early Exit Investment
One drawback to a convertible note is that valuation is not set at the time of investment but is contingent on the follow-on round of funding. If the startup is exceptionally well, then the valuation on the follow-on round will be set high, and the investor’s equity ownership will be small.
Choosing the equity path opens the investor up to the typical risks of not knowing when they will see a return, if at all.
Use Cases and Costs
For investors who want to build their startup community, this model provides a source of “evergreen” funds to invest in startups and use the proceeds to fund other startups.
Using funds from the investors’ IRAs makes this an attractive alternative for those seeking to build wealth for retirement.
The current structure for 3X3 investments through TEN Capital is a Syndicate. A fund is in the planning stage.
The startup pays the costs of setting up the initial investment, and then upon conversion of the redemption right, the startup will pay a monthly retainer to complete the payout.
For investors who want to build their startup community, this model provides an “evergreen” fund opportunity to invest in startups and use the proceeds to fund other startups.