A security that capped early investor returns would benefit employees
By: Ry Sullivan
Tags: Venture Capital, Equity, VC, Startup, Finance

The proposal for a employee-friendly TREE security

TL;DR — Join me for a thought experiment

Equity ownership is a zero sum game. Companies would prefer to retain equity value for shareholders (e.g. employees) who contribute creative capital rather than continuously pay an equity “tax” to already enriched early investors whose capital contributions no longer have meaningful impact on the business. The introduction of a new security type–the TREE –could cap early investor returns at pre-determined thresholds and free up cap table value for employees, providing a potential win-win solution. This instrument would likely not work for the structures of current early stage and venture capitalist investors, but could represent an alternative fundraising approach for companies and their future employees. This blog imagines how such a security could work in today’s market. It’s an exploration of an idea vs. a perfect solution.

Create more owners.

At Carta (my employer) we believe in the mission of “creating more owners.” Employees and workers should have equity participation in the value they create, rather than just receiving a wage while other owners reap the higher rewards for that effort.

There’s two ways to do this:

The total number of companies offering equity ownership to employees increases The amount of ownership offered at each company increases

The first is already showing promising change. The number and types of companies offering employees equity as part of their compensation grows each year. A normal occurrence in the technology industry, equity grants in the form of options, RSUs, and other awards are becoming more commonplace in the US and abroad. This has driven more ownership for more people.

A reexamination of the second point–changing the terms of ownership within companies–is where additional innovation can and should happen. Instead of divvying up the pie the way it always has–along with the natural questions of confusion and feelings of unfairness–employees and other value creators challenge the status quo.

Equity investments are a permanent company tax

Imagine this scenario: A group of people have an idea and form a company. They accelerate their idea with a capital raise. They can’t get a loan, nor do they feel comfortable having a debt burden yet. Instead they sell 25% of the company to an investor for $100,000. The group takes that $100,000 and builds a great product. Years later, the company is worth $10 million. The creative team who built the business are happy–they have created $7.5 million of value for themselves. The investor is happy. Their investment has returned 25x from $100K to $2.5M.

A few years later, the company is worth $20M. The investor is thrilled! The $100K investment has 50x’d to $5 million. The company team is also happy since they now own $15 million in value. But, they’re also perplexed. Getting their company from $10M to $20M was hard work that their sweat and creativity made possible. The investor’s $100K investment helped kick-start their business, but it hasn’t been relevant in years. Nor was the $100K particularly unique–it was capital that could have come from anywhere. Yet the investor just captured $2.5M of the additional value created. What’s going on?

It feels like the company has sold ownership over its labor to the investor indefinitely. They wonder: I’m proud we’ve been able repay the trust our investor placed in us, but haven’t we returned enough value? That $2.5M of value could have been distributed amongst the company’s employees rather than further enriching an already well-compensated investor. Long after returns on the investment have been realized, the company continues to pay out value to this early financier. The equity stake is a perpetual “tax” on the company.

The company and society begins to wonder why the people who are providing new ideas, finding creative solutions, and creating new value aren’t capturing more value. Employees–the company’s “creative capitalists”–are losing out to this tax placed on the company years earlier.

Even the investors might be surprised–albeit pleasantly. Wow, this investment was better than I expected! While still accounting for other investments that didn’t pan out, the investor’s total portfolio might come out ahead given the returns on the size of their investment. And they get to keep earning even more if the company continues to grow its value.

Financial capital is fungible; creative capital is not.

It’s easy to see why the founders took on capital via an equity round. They were looking to fast track growth, and outside financing gave them access to cash more quickly than building a profit-generating business on their own over many years. An equity investor had more risk tolerance than other risk-averse capital allocators like banks or lending institutions. The investor filled a gap on the investment capital spectrum. Their investment likely followed a venture or growth capital strategy of investing in many risky ideas. While many of the investor’s equity investments would fail, the returns of the successful ones more than cover these losses.

But what unique good did the financial capital provide? And how impactful is it over time? The investor provided an accelerated growth by providing cash without the burden of near-term cash repayment. Over time, however, its direct impact on value creation drops. At a certain point, it’s hard to see how the $100,000 check is responsible for any value creation. In our example, the company is perplexed that the investor continues to gain 25% of all value creation with no new inputs affecting that value. Even if early investors are diluted–which most real world investors are likely to be via stock plans increase, employee grants, etc.–they’re still capturing significant value.

The ideas and problem solving abilities of the company’s intellectual and human capital–creative capital–remains consistently impactful on the company’s value creation. That’s as true when the company just started out as it is when the company increased its value from $10M to $20M.

Here’s a (poorly draw) diagram of how different types of capital affect value creation over time:

Investors will disagree. Some would argue they provide unique insights built from years of experience and industry-specific expertise. Many are right. Investment professionals–like those at venture capital funds–are oftentimes successful founders and entrepreneurs who help companies navigate their way to success. Other investors provide ancillary services like marketing and recruiting help to relieve the burden of companies having to build these costly functions in-house. Their impact is felt even after cash has transferred between accounts.

Research on value-add perceptions between founders and VCs highlight this gap in thinking. A study done by Hackernoon, Newfund, and the University of Chicago “repeatedly point to VCs overvaluing how much time they spend with their portfolio companies as well as their contributions compared to the founders’ perspectives.” Additionally, “VCs generally overestimated how much startup founders valued the impact of their operational support.”

My point is not that impact doesn’t exist, just that it likely decreases the further one goes from a fundraise. It’s oftentimes true that early investors (angels, seed round) eventually get phased out by newer investors (venture, growth) who help companies through a period in which they have an expertise.

Another way of comparing the relative importance of impact from creative capital and financial capital is their fungibility. Funding generally provides cash, not the creativity and ingenuity that drives forward the success of a company and solves a customer need. Financing is dollars, and dollars are generally the same regardless of which financier provided them. Money in a bank account generally looks the same. The creative capital from founders and employees working directly on problems is a less fungible asset. While employees from the CEO down can be replaced, this group is most capable of solving company-specific problems over the long haul.

This again seems intriguing from a risk and reward perspective. As noted above, the business of capital allocators is to invest money into attractive ideas. Some will fail, but the ones who succeed create enough value to cover these losses and then some. Funds have the opportunity to vet hundreds or thousands of companies and can invest into dozens of them from a single fund. In addition to protecting against downside risk through each negotiated investment, risk is also mitigated by spreading funds across a diversified investment portfolio. To top things off, most funds charge a fee based on assets under management to make sure its own employees (partners, back office, etc.) are compensated regardless of returns.

Greater risk is assumed by creative capitalists. Each creative capitalist has a limited amount of time and opportunity to invest their skills into valuable problems. Imagine a 20 year-old who starts working today and wants to diversify their career in the same way a VC diversifies risk across investments. If they work a max of 4 years at any technology job that offers them equity (since most vesting schedules are 4 years in length, this allows them to fully vest their initial grants), they will work at only 10 companies over a 40 year career. While employees protect their downside via earning a wage from companies, there’s much less risk diversification in a career and therefore a reduced opportunity of outsized or transformational rewards compared to the investor model.

And yet, current financing negotiations treat the parties exactly the opposite. The less risky VCs protect their downside and maximize their value capture. Creative capitalists–particularly the employees who don’t even get to participate in negotiations–take what’s left, generally in the form of an equity pool that the board (mostly those same financiers and founders) allocate. While employees can and do benefit from receiving equity rights at a steep discount when a company’s value grows, they also have service minimums (vesting cliffs and vesting schedules) and other tax requirements (upon exercises and sales) that make their value capture less easy than it first appears.

Frustration with current options

Looking back, our fictional company feels frustrated. Over time the creative capitalists of the company–they and their employees–should capture more value, right? They’re the ones providing the greater impact on value creation relative to checks that were written years earlier and they’re the ones taking on risk in their careers by dedicating a portion of it to a company that might not be viable.

Thinking back on its negotiations, the company would have preferred a structure wherein financing was equity-like in the early days and debt-like when value had been created. Equity liabilities in the early days obviated the risks of debt default. As they created value, however, they’d prefer early liabilities to be debt-like and repayable by the value they’ve generated and repaid to investors. After they paid back the financier–and very generously–they could once again fully own the valuable fruits of their labor. And they could divide that value more fully amongst their employees–their creative capitalists.

But the company was only presented with the opposite options from investors: equity investments and convertible note financings functioned like repayable debt in the early days and like non-repayable equity in valuable later years. When I say “repayable debt,” I don’t necessarily mean debt in the form of loan with interest and regular repayments. Rather I refer to how investors capture value early in the lives of companies. Convertible notes and preferred shares with liquidation preferences give first claims on the company’s assets when values are low. Early payouts are indistinguishable from those of debt as shown in the following examples looking at a $15M bank loan, $15M convertible note, and $10M preferred equity investment with 1 1.5x liquidation preference:

As the company’s value increases, investors capture valuable upside from their equity investments and ownership in the company. Preferred shares represent ownership directly. Convertible notes and SAFEs entitle holders to convert their debt and quasi-debt instruments into valuable equity and ownership. Both are efficiently structured to capture upside value. For example, preferred shares might have higher conversion ratios entitling them to convert their preferred shares into more common shares and capture outsized ownership. Convertible notes build on what is owed to them via interest and then convert into shares at a discount via a conversion discount of valuation cap.

When one looks at the payout diagram of a preferred equity investment with a valuation cap, you can see the debt-like and equity components. At first all of the value is extracted by investors: the slope of the line is 1. In the long-term, investors earn value based on their ownership percentage. If they own 40% of equity, then the slope is 0.4.

To companies this game design is unfortunate. Investors only invest when they can limit losses via first claims on value and assets while also participating in large upsides when value is high. Investors are in the business of maximizing returns for their funds by allocating capital to the most promising founders and their companies. When investors enter negotiations, they look to manage risk by protecting against downside outcomes while capturing upside whenever possible. This is built into fund construction models (loss ratios, etc.) and therefore the fund’s business model. Investors have structured securities over time (like preferred rounds and convertible notes) that accomplish these dual goals.

Capital raises and term sheet negotiations therefore often take place with investors having set the agenda of decisions to be made. Even when a company receives multiple and competitive term sheets, they’re still couched in the language of capital providers.

This makes sense when one considers that investors are highly incentivized and very knowledgeable on how to have their needs met in negotiations. VCs and other professional investors assess hundreds of deals each year. That’s a lot of negotiating reps for structuring capital investments on your “terms.” A founder on the other hand might only have this experience a dozen times in their entire career. Venture capital fundraises are set by venture capitalists. Preferred shares and convertible notes are their inventions. Companies transact in the currency investors provided.

Who decides who owns what

Ownership over assets is a zero-sum game. Increased ownership for one group must by definition come at the expense of another group. If creative capitalists are to own more, that means another group of current owners–mostly professional investors and founders–must own less. However, that doesn’t mean both can’t still be compensated well for the amount of capital (creative or financial) that they put in.

How ownership gets divided comes down to the moment when the terms of ownership are negotiated. Ownership discussions typically happen during capital raises. At this moment, companies and potential investors decide how they’ll split up the pie–both now and in the future. The most popular investment securities in startups today are preferred shares, convertible securities, and warrants.

It is my belief that to create more ownership for a company’s creative capitalists — or a payoff that feels more fair — one must understand the dynamics of negotiations and the menu of security types for investment. Riskier companies and ideas might see investors contract for more conservative terms with downside protections. Companies with exciting opportunities, proven results, and high demand will find more favorable terms from investors. More or less, securities can and do reflect the ultimate compromises between those accepting and providing capital.

Can’t there be an investment security that improves the risk and reward dynamics of creative capitalists while meeting the business needs of financial capitalists? I think there is and that the solution can be found at the initial fundraising negotiation table. By rethinking what we accept as truth about the types of investment securities today, we can create a new paradigm that truly does create more owners.

A new investment security — the TREE

Founders would love to keep control of their companies if they could or maintain more ownership for their creative capitalists, i.e. employees. However, companies struggle to find debt financing in early years because investors and lenders are afraid they won’t get paid back. Instead fundraisers turn to more risk tolerant investors who take equity investments in the company with the reward of unlimited potential upside. It solves the problem of cash, but the founders have been forced to give away potentially valuable equity for themselves and their employees forever as we’ve already seen.

But what if investors and companies agreed that the benefits of equity ownership extended only up to a point? A pre-agreed returns cap could enable high returning equity to eventually convert into debt-like securities. Creative capitalists would own everything they’ve created once they’ve paid back sufficient returns to an investor. This seems counterintuitive on first-reading. For example, convertible securities convert debt into equity, not the other way round. Most financiers think of the debt to equity mechanism as a one-way door.

It is via this radical re-imagination that I’m proposing the creation of a new fundraising security: the Targeted Returns for Equity Exit (TREE) security. With this security, parties agree to allow investors to participate in the equity upside of a company up until a point. If a company performs extraordinarily well and returns a high, predetermined multiple to investors, then they can free themselves of a perpetual equity liability. The tax of financial capital for accelerating creative capital would be repaid. While this would probably not work for early stage and venture capital structures today, it could represent a new investment and fundraising approach for others.

Since the continued value-add of the original financial capital at this point is likely marginal, this makes sense. Thereafter the creative capitalists have the greatest impact on the future value and performance of the company and capture the additional value creation in the form of accelerating equity ownership (which corresponds to the leveling out of investor value capture).

The TREE security proposes the exact opposite of the current dynamic. Today, investors hold debt-like securities in their portfolio until it’s valuable to convert them to equity. TREE securities enable creative capitalists to hold obligations as equity on their balance sheet until it’s beneficial to convert them to something debt-like.

How it works today

Let’s see how this would play out in a real world situation. Imagine a company is looking to raise $10,000,000 of financial capital to grow its business.

In today’s world, the company and potential investors would hash out a term sheet. Let’s say they settle on the following: a venture fund will invest $10,000,000 in exchange for a 40% ownership stake, implying a post-money valuation of $25,000,000. Let’s also imagine that founders retain 45% of the ownership while 15% is set aside for employee ownership in an equity pool. Other considerations between the parties might center on the liquidation preferences of the preferred investment and whether the shares are participating or participating preferred depending on how much downside risk is to be negotiated. At a 1.5x liquidation preference, the payout diagrams will be familiar to venture capitalists and transactions advisors:

Payout Diagram for Preferred (Non-Participating) Equity Investment:

Payout Diagram for Participating Preferred Equity Investment:

In the early years the downside risk of the investors is protected via the liquidation preference–the first 1.5x of value (or $15,000,000) is theirs. Thereafter, value is divided between creative capitalists (founders and employees) depending on their ownership stakes and whether the investor’s preferred shares are participating or non-participating.

In the preferred (non-participating) scenario, the investor waits for the creative capitalists (founders and employees) to catch up in value capture at an EV of $15,0000,000. At $37,500,000 of EV (when the investors $15M represents 40% of value), all stakeholders continue to capture value at their respective ownership percentages.

In the participating preferred case, the investor captures the first $15M of value, then continues to capture 40% of additional value until a participation cap is reached. Let’s say the participation cap is 2.5x. This implies that the investor will stop and wait for creative capitalists to catch up at once they’ve captured $25M of value, which happens at $40M of EV. At $62,500,000 (when $25M represents 40% ownership), all parties earn according to their ownership percentage.

These models do a great job of allowing multiple options for investors to protect their downside risk. But what about when large amounts of value are created? At $100M of EV, investors capture $40M (40%) for a 4x return multiple, founders capture $45M (45%) and employees capture $15M (15%). At $200M, investors capture $80M (40%) for an 8.0x return multiple, founders capture $90M (45%) and employees capture $30M (15%).

These are the typical equity investments early stage investors use today. Their downside is relatively protected since they get all the value in extreme downside cases. And their returns continue to grow with the company indefinitely.

How the TREE could work

Let’s imagine now that creative capitalists decide to utilize a TREE security. Instead of the investor earning returns indefinitely, terms are written wherein once the investor achieves a 6x return, it no longer continues to participate in equity upside. How is this accomplished? The conversion ratio of its preferred shares dynamically readjusts such they must convert into a fewer number of preferred shares. In other words, investors own a piece of pie that grows proportional smaller relative to a growing pie, keeping the size of the slice exactly the same.

For this example, let’s imagine the same fundraising scenario as before, but with a TREE used in place of a traditional preferred fundraising round. All parties agree that once the investor achieves 6x returns, the company’s obligation to them is complete. At this point, the company decides any additional value is captured by employees to create strong recruiting incentives. All the preferred and participating preferred negotiations remain the same to protect the investor’s downside. Also, let’s imagine that the fundraising ends with the company having 10,000,000 fully diluted shares–4,000,000 for investors, 4,500,000 for founders, and 1,500,000 for employees–at a priced round of $1.00.

At lower enterprise values, our payout diagrams look exactly the same as before. However, when enterprise value reaches $150M, investors achieve their 6x return multiple (40% ownership of $150M = 6 x $10M = $60M). At this point they no longer continue capturing value, they’re agreed upon outsized returns have been achieved. The conversion ratio of their shares starts to decrease, while the conversion ratio of employee shares increases, allowing employees to achieve more ownership and value capture over their efforts.

Here’s what the new payout diagrams would look like:

Payout Diagram for Preferred (Non-Participating) TREE Investment:

Or viewed another way:

Payout Diagram for Participating Preferred TREE Investment:

Or viewed another way:

Let’s revisit our high EV scenarios from earlier. At $100M of EV, investors capture $40M (40%) for a 4x return multiple, founders capture $45M (45%) and employees capture $15M (15%). Investors continue to capture equity since their multiple target of 6x hasn’t yet been achieved. At $200M, investors capture $60M (30%) for a 6.0x return multiple, founders capture $90M (45%) and employees capture $50M (25%). Investors achieved their 6x multiple and no longer capture value. Instead employees creating new value capture more of this value.

This goal can be accomplished without having to issue or repurchase new shares or grants. Conversion ratios on TREE shares are dynamically adjusted based on the enterprise value.

At $100M of enterprise value, stakeholders earn:

Investors : 4,000,000 TREE shares10,000,000 fully diluted1 converted shares1 share$100M enterprise value = $40M value

: 4,000,000 TREE shares10,000,000 fully diluted1 converted shares1 share$100M enterprise value = $40M value Founders : 4,500,000 TREE shares10,000,000 fully diluted1 converted shares1 share$100M enterprise value = $45M value

: 4,500,000 TREE shares10,000,000 fully diluted1 converted shares1 share$100M enterprise value = $45M value Employees: 1,500,000 TREE shares10,000,000 fully diluted1 converted shares1 share$100M enterprise value = $15M value

At $200M of enterprise value, stakeholders earn:

Investors : 4,000,000 TREE shares10,000,000 fully diluted0.75 converted shares1 share$200M enterprise value = $60M value

: 4,000,000 TREE shares10,000,000 fully diluted0.75 converted shares1 share$200M enterprise value = $60M value Founders : 4,500,000 TREE shares10,000,000 fully diluted1 converted shares1 share$200M enterprise value = $90M value

: 4,500,000 TREE shares10,000,000 fully diluted1 converted shares1 share$200M enterprise value = $90M value Employees: 1,500,000 TREE shares10,000,000 fully diluted1.67 converted shares1 share$200M enterprise value = $50M value

One can model the conversion ratios of shares at different enterprise values:

The creative capitalists have paid the cost of acceleration and once again are owners of their labor and creativity. The “tax” of the early equity has been paid–an in multiples.

Iterating on the TREE

What does an investor do with their TREE security once it “maxes” out? There’s many options here that could be explored. If a company had enough cash, it could repurchase these securities and restructure their cap table. There’d be fewer hoops to jump through since the value of the stake would be known and easy to estimate. Or the TREE securities could continue to pay a cash or stock dividend, enabling the investor to sell their stake to an investor with more fixed-income needs. Or savvy financiers could create a structured Payment-in-Kind (PIK) product wherein the stake continued to earn interest or dividends in the form of some other asset that made it re-sellable.

One could also scrap the idea that investors stop earning altogether and instead just earns less at successive targets. In our example, an investor could agree that at 6x, their ownership accumulation rate halves. At 10x it halves again. At 15x, once more, and so on.

Below is what such a permutation could look like for the preferred (non-participating) TREE using our previous criteria along with the required conversion ratios. As you can see investors still earn upside at the target multiple, they just earn less relative to employees whose ownership is increasing more rapidly.

Or alternatively viewed:

The dynamic conversion ratio is tightened as a result.

It would require more terms structuring, but there are an infinite number of permutations for investors and companies to consider. One last example on this to show how it might work.

One could ask why current employees seem to benefit while the investor is capped. Doesn’t that just create the same situation of older employees piggybacking on the efforts of new employees while contributing less relative to the total value created? Also, don’t employees also get paid a salary, protecting their downside already?

If that’s a concern, instead the TREE could be modified so that value above the investor’s cap didn’t go to existing employee ownership, but rather went to a pool for new employees. This could help companies fulfill goals to be more employee-owned.

Why the TREE could work

Two hours later, the pros were meager and the cons were abundant, even if a few of the, in my estimation, were quite petty. “Well,” I said. “It was a nice idea. But I don’t see how we do this.” “A few solid pros are more powerful than dozens of cons,” Steve said. –Meeting between Bob Iger and Steve Jobs regarding a Disney-Pixar merger

There are obvious criticisms that people will raise with the TREE security’s payout structure. However, since the goal of this is to consider how a new security could work, I think it’s worthwhile to approach with an open rather than closed mind. Since we started with the premise that a TREE security is the exact opposite of security structures today and take the needs of companies as preeminent, this is to be expected. Let’s focus on what could work rather than focus on what couldn’t.

Why would investors ever go for this? It completely upends the way angel investors, venture capital firms, and growth equity firms are structured to invest. By limiting their upside, investments become less attractive, and investors are unlikely to invest at all.

This would require a rethink of the current fund structure model. That’s not crazy considering how quickly the venture investing structure has changed in the last 60 years. If TREEs became part of an investment portfolio, upside would be capped with each deal via a targeted return multiple. To compensate for reduced return, traditional VC and early investors would likely require increased risk reduction to make their fund model work.

One way to accomplish this would be for higher early ownership stakes via lower enterprise values during equity negotiations–i.e. investors initially pay less for more. If companies want the benefit of ownership in the long run, investors would want more guarantee of ownership up front to limit potential losses. This would change the way funds build their target loss ratios, but it could still be a sustainable model. Companies and creative capitalists wouldn’t lose their incentive to hit home runs either–in fact, this model encourages the creation of outsized returns.

There’s also the chance that this isn’t a security fit for the investors and investment models of today. However, aspiring and different-minded investors with a different model, thesis, or fund goals might find the TREE an attractive idea. There’s already a rise in new fund model types like those created by Indie.vc.

Could companies even propose something like a TREE?

All fundraises and investments are ultimately negotiations. That leaves ample latitude for parties to find agreement. Term sheets today include all sorts of non-standard things that parties felt important enough to include. Typically, if one side has asymmetric bargaining power or a deal non-negotiable, there’s room to explore new terms.

You can already see the way bargaining power has changed security structures today. Historically convertible notes were the favored debt-to-equity security of investors. As we saw before, it gave the benefits of debt when they needed first claim on value in downside cases and converted to valuable equity at a discount when the company’s value increased. Recently, new convertible types like SAFEs and KISSs have made an emergence. These securities aren’t debt and therefore don’t strap young companies with interest or the chance or the threat of repayment. Even while the economics of the investments remain the same — generally driven by the size of the principle — the change and new vernacular of clearer negotiation terms is significant.

SAFEs and KISSs were created by the startup accelerators Y Combinator and 500 Startups respectively, who represent young companies and their founders. Because these accelerators controlled access to a desirable pipeline of investments, they had increased bargaining power when it came to capital raises with investors on behalf of those companies. While SAFEs and KISSs once seemed new, they now represent the mainstream convertible investments in venture-seeking companies. AngeList noted that nearly 80% of early-stage financings on its platform were now done via SAFEs.

Companies have also shown an appetite for an expanded financing menu. This is clear with the growing deployment of venture debt, revenue-based venture capital, and profit-based venture capital solutions. All represent different models of fundraising for companies and their investors. In short, equity may not be the right (or sole) solution for all startups.

While I won’t delve into the full spectrum of new financing instruments, it’s worth noting that there is appetite for a changed ownership and funding options. While the bargaining power continues to rest with investors–you still see more companies fail from lack of funding than investment funds from lack of capital deployment–the dynamic could be changing. If more money continues to flow into the early stage investment arena, it could reach a point where capital is so abundant that companies gain more power for negotiating which funds they choose rather than which choose them.

Lastly, there actually aren’t that many businesses that become billion dollar, generational companies. Indie.vc’s research shows that only 10–20 companies a year make the jump. That means most companies could benefit from a funding structure that helps them build a great business without needing to achieve unicorn status to justify the investor returns. Great ideas and businesses that would benefit from a lower risk-reward structure than is currently offered by many venture capitalists and seed investors.

Investment funds, like those in venture capital, ultimately are beholden to the return needs of their limited partners. Wouldn’t you have to change the minds of LPs to accept potentially lower returns?

There’s two ways to approach potentially flipping this narrative. First, LPs could invest in funds that have switched their models to better support TREE securities. Those funds would have lower outsized returns, but also lower risk as well. It’s a different type of investment, but not necessarily one for which there’d be no appetite.

Second, now and in the future, not all limited partners are strictly motivated by maximizing returns. Many investors elevate other considerations to guide their investments–creating net positives for society, funding non-profits, etc. Many branches of the federal government take such an approach, as do some pension funds, retirement funds, endowments (like the Bill & Melinda Gates Foundations), university tech incubators, sovereign wealth funds, and other high net worth individuals. There are many parties who might want to see more ownership given back to employees and creative capitalists compared to padding the returns of investors. This is particularly true in the current environment where investors and societies are looking to create more owners among historically underrepresented ownership and minority groups–women, African Americans, Hispanic Americans, and others.

It’s also worth noting that there are already LPs willing to invest in funds using alternative financing structures like revenue-based capital. TREEs could offer fund managers a differentiation in attracting LP dollars in a crowded field where the biggest funds already tend to reap the lion’s share of the rewards.

Would companies go for it?

“I’ve built something I never thought would be such a success, but I cannot think of Chobani being built without all these people… Now they’ll be working to build the company even more and building their future at the same time.” –Chobani Founder and CEO Hamdi Ulukaya on granting all 2,000 employees equity stakes in the company in 2016

Using a TREE financing, companies might expect to give up ownership earlier on in exchange for more ownership in the long term. That might scare some founders away, whereas others are willing to take the trade. In fact, some companies might think that their ability to offer greater returns to creative capitalists via a TREE financing round could act as strategic recruiting. The message of “we’re aiming to becomer more employee owned” and “the better we do, the better you’ll do at an accelerated pace” might be a noticeable differentiator in a crowded talent market.

A TREE-backed company could attract employees who aspire to maximize their personal earning potential or feel like they want to work for a company with an employee-centric cause. If a company can attract the best employees, this in turn could make them a more attractive and less risky investment. A TREE could be a talent and value-creation accelerant.

Companies have goals beyond just growth and value maximization as well. Many founders and companies aspire to create more ownership for employees and underrepresented segments of societies. TREEs could provide a long-term path to returning ownership to employees. This isn’t a new idea. Employee-owned enterprises have existed for over a century. Even larger corporations are recognizing employee ownership as both a differentiator and societal good.

Would companies lose brand capital by eschewing the old model?

Companies point to their investor base as a positive signal to potential executives, employees, and follow-on investors. Brand name investors create a strong perception of viability to the market. Would a TREE hurt this signal? More often than not, the company’s growth will be driven in the long-term by its fundamentals rather than the source of the dollars in its bank account. Brand name VCs may not utilize this type of security, but they represent just a sliver of the market that very few companies actually get funding from.

Why not just raise venture debt instead of creating a new security?

TREE securities would be better than venture debt. For companies that perform poorly or fail, investors would still receive the same preference in value payout via either the terms of the debt or the liquidation preferences of the TREE securities. In cases where the company does well, investors can make multiples of their initial investment, rather than just a higher interest repayment. Companies would opt for the TREE over debt given it doesn’t come with the restrictive covenants or personal liability of debt.