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Good morning and happy Tuesday.

Having first started this newsletter as a way to address the inequality present within the startup ecosystem, I couldn't be more excited to be writing about the Backstage Capital and Earnest Capital Reg CF offerings this week. Though most VCs have acknowledged the problem, few are doing as much as  Arlan Hamilton and Tyler Tringas to reshape the traditional venture mold. With both fund managers rethinking what founders and companies must look like in order to receive VC funding, it feels only right that two innovators like Hamilton and Tringas are the first to reimagine what you must also look like in order to invest in a VC firm.

Though the Backstage offering closed on April 1, Earnest Capital is raising up to another $840,000 on Wefunder. Because of how the two venture firms are legally permitted to raise capital from non-accredited investors, more than a few prospective investors have found themselves confused by complexities surrounding the offerings. So I dug into how venture firms traditionally raise capital, why non-accredited investors have historically been shunned, how Backstage Capital and Earnest Capital used Regulation Crowdfunding to circumvent this problem. and how investors can actually make sense of the terms in the two offerings.

Let's get to it.
Deep dive - The non-accredited way to invest in venture capital 
Backstage Capital and Earnest Capital look to the crowd
Not long after Backstage Capital became the fastest company on Republic to reach the $1.07 million offering limit, it became one of the first to meet the newly changed $5 million Reg CF limit. Grabbing notable attention for her first-of-its-kind raise, I wondered if Arlan Hamilton was shedding light on a viable alternative to raising capital that other fund managers would pursue.
  • It didn’t take long to find out. Less than one month since Backstage closed its offering, Tyler Tringas from Earnest Capital has followed in Hamilton’s footsteps.
If you’re unfamiliar, Backstage Capital is a venture capital firm that is led by outspoken fund manager, Arlan Hamilton. Focused on empowering underrepresented women, people of color, and LGBT founders, Backstage has received attention from VC peers as a leading voice advocating for entrepreneurs that are far too often overlooked.
  • Just as it has led the venture industry toward a more diverse future, Backstage Capital may again be at the forefront of changing how venture firms raise capital and who they raise from.
Raising $2 million in exchange for ownership in the Earnest Capital LLC management company, Earnest Capital has launched a very similar campaign to the one we saw from Backstage just a few weeks ago. 
Let's start with how venture firms traditionally raise money
Venture firms primarily raise capital from endowments, foundations, pension funds, insurance companies, and wealthy individuals. Also known as limited partners, these investors take a passive role in the fund’s operation and sit by on the sidelines as the VCs put their money to work. Commonly referred to as emerging funds, smaller and less established venture firms raise primarily from the latter of the five groups listed above – wealthy individuals.
  • Because these emerging fund managers are typically raising funds in the millions of dollars rather than the hundreds of millions, endowments, pension funds, and corporate entities generally are barred from investing in them due to their small size and lack of available results to lean on.
When just getting their start, emerging fund managers typically raise smaller funds from a wide array of wealthy individuals. As investments mature and funds produce handsome returns, managers (like Arlan Hamilton or Tyler Tringas) will raise progressively larger funds. At this point, the investor landscape in the fund will change with a larger percentage coming from institutional participants.
  • This only happens if the fund managers are able to progressively prove their successes with incrementally larger funds. Understanding this concept is an important part of conceptualizing how Backstage Capital and Earnest Capital intend to compensate their Reg CF investors with a return.
Why non-accredited investors can’t invest in venture capital funds
The correct answer is a somewhat complicated explanation pertaining to venture capital investor limitations. For the sake of understanding why non-accredited investors can’t invest in a venture fund, we don’t need to get too
in the weeds here. If you want a full understanding of the regulation, check out Chris Harvey’s detailed overview. What you do need to know is that each venture fund is limited to the number of individual investors that it can accept.

As defined by the SEC, a qualified purchaser is an institution with at least $25 million in investable assets or an individual with at least $5 million in investable assets. Funds totaling $10 million or less in size are permitted to raise from 249 nonqualified purchasers. Funds totaling more than $10 million, however, are limited to 99 nonqualified purchasers.
  • Though nonqualified investors aren’t formally defined, they can simply be thought of as investors that do not meet the requirements of a qualified purchaser.
Because emerging fund managers are most often raising their initial funds entirely, or almost entirely, from a group of non-qualified purchasers, they have to be selective in choosing which investors they raise from. Inherently, they’re likely going to raise from those that can write the largest checks.
  • Herein lies the problem for non-accredited investors. Not to mention they’re generally better suited to handle risks associated with early-stage investing, accredited investors are simply in a better position to provide fund managers with larger investments. As such, it doesn’t make much sense for fund managers to seek out or accept capital from non-accredited investors.
What this isn’t
These offerings are not opportunities for Reg CF participants to invest directly into a fund of either venture firm. As great as it would be to invest in an upcoming fund of theirs, this is not that. As a non-accredited investor, you can buy a lottery ticket or bet on sports. Thanks to recent regulation, you can even invest in a startup. Yet you can’t invest in a diversified fund of startups, which inherently carries exponentially less risk than investing in just one startup. I trust one day we will live in a world where non-accredited investors can fractionally invest in a venture fund, but today is not that day.

So what are you investing in?
Backstage Capital
The easiest way to think about this is that you’re investing in a Backstage Capital LLC, a management company that sits atop all of the Backstage Capital funds.
  • The management company is an investment advisor to several small funds that have already been raised and deployed (like Backstage Capital Fund I, and Accelerator Fund I), as well as those yet to be raised.
Offering Reg CF investors 10% of the Backstage Capital LLC management company for a total of $5 million, the offering is priced at a $50 million post-money valuation.
  • Over time, the group of Reg CF investors will be paid 10% of Backstage Capital’s management fees (if any) and 10% of its carried interest (if any). The carry shared with Republic investors includes proceeds received from all past and future funds, as well as special purpose vehicles (SPVs).
For those unfamiliar with carried interest, it can be thought of in its simplest form as one of two ways that VCs receive compensation. Carried interest, or carry, is the share of profits from a fund that is paid out to the VC firm.
  • At 20% carry, VCs can expect to receive $0.20 for every $1.00 that they return to investors.
  • Though carried interest percentages differ across the industry, 20% is the benchmark commonly agreed upon.
  • Acting as a performance fee, carry incentivizes fund managers to seek out the largest returns achievable.
Entitled to 10% of the carried interest received by Backstage Capital, Reg CF investors can otherwise think of this as collectively owning 2% of the firm’s total investment profits (10% of 20% is 2%). This 2% is then appropriately divied up to each Reg CF investor based on their investment size relative to the total amount received in the offering.
  • So, if I, for example, invested $1,000 into Backstage Capital via its Reg CF offering, I can expect to receive .02% of the carry that the firm distributes to its Reg CF investors ($1,000 is .02% of $5 million).
In addition to the carry that Reg CF investors are entitled to, they can also expect 10% of Backstage’s 2% management fee.
  • Management fees are the more straight-forward way of paying the salaries and administrative expenses associated with operating a venture firm.
  • Though fees vary depending on the fund, 2% is the typical rate charged across the industry.
  • Charging a 2% fee on a $10 million fund, for example, $200,000 should be allocated toward the management fee each year. Over the course of a typical 10-year lifespan, this 2% fee would amount to a $2 million total, which can otherwise be thought of as the equivalent of 20% of the original fund.
Having now made sense of all this, you may be asking yourself how Backstage is going to provide its Reg CF investors with a worthwhile return. According to Arlan Hamilton, Backstage will pay out distributions that can be compared to dividends. Payments will be made during years when the firm reaches a certain threshold. Though this threshold has not yet been decided and is at the discretion of Backstage Capital, Arlan suggested distributions would be paid “most likely any time there’s $5M or more in the pot from that year and/or rolled over years”.
  • As a reminder, the Reg CF “pot” is comprised of a combination of carry profits and management fees.
In the event that there’s $5 million in the pot and Backstage Capital decides to distribute payments to its Reg CF participants, the investors would share $500,000 (10% of $5 million is $500K) on a pro-rata basis.
  • So, if I had originally invested $1,000 into the Backstage Capital offering, I could expect a payment of $100 (.02% of $500,000 is $100) at the time of that particular distribution.
  • If in 2024, for example, Backstage receives $3 million in management fees and $7 million in carry, I could expect a payment of $200.
  • As a reminder, these are just examples. As put by Arlan, it could take years for investors to see dividend payments, or they could start by the end of this year.
Backstage Capital legally cannot make claims indicating what returns investors can expect. That said, Arlan stated that the firm is aiming to provide investors with 2x – 5x their initial investment. In order to achieve this, the firm will need to raise a series of large, very successful funds.
  • With approximately $13.5 million assets under management currently, Backstage Capital intends to raise more than $100 million “over the next few years” and “hundreds of millions over the next decade”.
Betting on women, people of color, and LGBTQ+ founders, Backstage expects its unique thesis to pay off big for investors. The firm has made over 160 investments in underestimated founders to date, and it intends to make hundreds more in the years to come. With such little diversity among those that have traditionally received VC attention, Arlan Hamilton and the Backstage team are anticipating outsized returns to come from a new generation of founders.
  • Though Backstage doesn’t yet have the results to back its unique approach, it should progressively begin to realize returns on its investments in the near future as its earliest companies mature and draw closer to liquidity events.
Earnest Capital
Raising $2 million in exchange for 10% of the Earnest Capital LLC management company, Earnest Capital has followed Backstage’s lead and offered investors with a similarly-structured offering. The Earnest Capital LLC management company sits atop all of Earnest’s current funds, as well as its future funds that have yet to be raised.
  • Those investing in the Reg CF offering can expect 10% of the firm’s 20% carried interest, which can otherwise be thought of as 2% of the firm’s total investment profits.
  • Contrary to the Backstage Capital offering, investors will not receive a percentage of the management fee that Earnest Capital charges on its funds.
According to Tyler Tringas, founder and general partner at Earnest Capital, distributions to Reg CF investors will begin as soon as one of the firm’s funds has provided investors (LPs) with at least 1x their initial investment.
  • The distribution timeline has not yet been scheduled, but Tringas has stated his expectation of making quarterly or annual payments.
Appreciating and/or paying out nearly double its initial value, investments made out of the firm’s first fund have provided promising returns in the 22 months since its initial investment. As of December 2020, the fund’s total value to paid-in capital (TVPI) was 1.88x.
  • A common metric by which VCs are measured, TVPI is essentially the total value of the fund’s holdings, both realized and unrealized, divided by the capital that has been outlaid by the LPs.
Of the 22 companies invested in out of Fund 1, 12 were made during 2020 and were less than 12 months old. As such, more than half of the fund’s investments were held at cost at the time that these calculations were made. With 3 companies paying shared earnings and one reaching an exit, the firm’s 2019 group of investments reflect a more impressive TVPI of 2.43x.

As put by Tringas, one way to think about the returns a Reg CF investor can anticipate is by using Earnest Capital’s performance thus far and scaling it across larger funds. Assuming the firm can continue to perform “at least as good as it has so far”, investors should expect to split a $2 million distribution for each cumulative $50 million that it is able to raise and invest.
  • At 3x returns (what has been achieved so far, according to Tringas) on a $50 million fund, Earnest Capital would be left with $150 million. Following the repayment of the first $50 million to LPs (repaying the initial investment), it would then be left with $20 million in carried interest on $100 million in profits. Paid 10% of the firm’s carry, Reg CF investors would receive $2 million. This exercise can otherwise be thought of as a roadmap for Reg CF investors to break even. In order to break even, investors will require Earnest Capital to produce $100 million in fund profits.
Though the biggest winners in a fund are capable of returning over $100 million in profits by themselves, these speculative investments that are traditionally made by VCs are not what Earnest Capital will be making. Described with great detail by Jan-Erik Asplund in his Earnest Capital deep dive, Earnest Capital’s strategy hinges less on picking a few big 100x companies and more on identifying profitable SaaS businesses with the potential for long-term returns.

Straying from the traditional venture model focusing attention on high-growth startups, Earnest Capital is instead interested in funding bootstrapped, profitable SaaS companies. It’s still positioned to profit on the exit of its portfolio companies, but it’s more narrowly focused on recouping its investment through shared earnings agreements.
  • A shared earnings agreement, also referred to by Earnest Capital as a SEAL, is a long-term commitment that pays back 2-5x the initial investment. SEALs do not have a fixed repayment schedule and often require a growth period after the investment is made before any shared earnings begin to be paid. Once the shared earnings cap is paid back, shared earnings payments from the company to Earnest Capital stop.
The SEAL does include an equity basis that defines a percentage of the company that investors are entitled to if the founders either sell the company or raise a priced round (Series A, for example) from a traditional VC.
  • This ownership claim ensures that Earnest Capital will get a piece of the pie in the event that one of its companies goes on to sell all, or a portion of, its equity.
Having invested roughly $8 million in over 30 companies since 2019, Tringas has ambitious plans for Earnest Capital and the scale it can achieve in the years to come. He hopes to soon be investing more than $50 million a year en route to becoming a major player in early-stage venture capital.
  • Capitalizing on what he believes to be a secular shift in the funding of software companies, Tringas believes his approach can yield top-tier venture performance in the years to come.
Betting on a new era of VCs
Evaluating these investments strictly from a returns viewpoint, investors should be asking themselves whether or not they believe that Backstage Capital and Earnest Capital can successfully scale their successes across larger funds. In order to produce a return better than what could have otherwise been achieved by simply investing in an S&P 500 index fund, Earnest Capital, Backstage Capital, and any other VCs that opt to raise from the crowd in the future must achieve a combination of the following:
  • Raise more funds that perpetually increase in size.
  • Earn higher multiples on their existing funds.
In Backstage Capital’s case, raising larger funds will result in heftier management fees that will ultimately trickle down to the firm’s Reg CF investors. There’s a tremendous difference between a 2% management fee on $13.5 million (assets currently under management) and a 2% management fee on hundreds of millions (where Backstage hopes to be in the not-so-distant future).

But at the end of the day, this opportunity for Reg CF investors ultimately hinges on the ability of the two firms to each produce strong returns and enticing carry profits. Each pioneering their own unique investment approach, investors participating in these offerings are placing long-term bets on Arlan Hamilton and Tyler Tringas.

In their own respects, Backstage Capital and Earnest Capital were both created to address particular shortcomings present within the VC ecosystem. For Arlan, it was the types of founders receiving investment. For Tringas, it was the types of companies. With both fund managers reshaping what companies and founders must look like in order to receive VC funding, it feels only right that two innovators like Arlan Hamilton and Tyler Tringas are the first to reimagine what you must also look like in order to invest in a VC firm.

Only in the early innings of their careers, the two managers have both garnered notable attention for their new and fresh approach to venture capital. Though they largely remain unproven, they‘ve each given an entirely new audience of non-accredited investors the ability to own a piece of what very well may be two flourishing venture firms ten years from now. Utilizing Reg CF, Tyler Tringas and Arlan Hamilton have introduced a brand-new way for VC fund managers to raise capital. And although this solution still does not allow for non-accredited investors to fully participate in the astronomical returns often earned by VCs, it is nonetheless a monumental step in the right direction.

Whether it be as investors in a fund or investors in a management company, I hope to be able to look back years from now and see that Tringas and Hamilton were the first of many VCs to usher in a new class of non-accredited investors into the world of venture capital.
Want me to take a deep dive look into a particular offering, ask any questions, or just reach out and introduce yourself? Shoot me an email at drew@thecrwd.com. Otherwise, I'll see you next week.
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