VC10X - VENTURE CAPITAL PODCAST
Venture Capitalists (VCs) & Angel Investors share their investing thesis, screening process, value-add, exits, and more. Hosted by Prashant Choubey (@ChoubeySahab)
William Stringer is a co-founder of Chisos. At Chisos they're re-imagining the traditional VC model by leveraging ISAs and SAFE notes.
We talk about:
Building a new funding ecosystem
So we are basically trying to build a new funding ecosystem. Today you've got your debt products, you've got your equity products. We're trying to build something different. We're literally trying to build a platform and an investment company that invests directly in people so people have a future earning potential as a big asset of theirs, especially if they're younger. And when they go out and try and build a company or pursue their athletic career or start their Twitch or YouTube stream, they need capital. That's where we're trying to come in, provide capital by investing directly in people. That's very interesting.
Who can get investment from Chisos?
We've really been focused on entrepreneurs so far as we've gotten started, and so we've seen a couple of different use cases of our capital. Sometimes it is day one. Our max check size right now out of our current fund is $50,000 on the smaller end, but it does help people get off the ground. It can be the capital needed to finish development of a minimum viable product. It can be capital to bridge to a seed round. But yeah, it's kind of across the board and it really just depends on if $50,000 or up to $50,000 makes sense for whatever project or company you're working. 15k is kind of our minimum right now. So 15k to 50K.
And when we're doing our underwriting, we're looking at both the individual on a couple of different levels, including their financial level, including their psychographic level, but then we're also looking at their business. So sometimes if your business is maybe super early or not even incorporated yet, then we're going to lean heavily on our underwriting of the person. If you do have a business, maybe you have some traction, then maybe your business carries a little more weight than the individual underwriting. So that's kind of the beauty of where we're at right now, investing in entrepreneurs, building businesses.
What does Chisos look for in founders while investing?
We've got about 15 different things that we're looking at, but the primary factor that we're trying to get to is what is this person's future earning potential? So a strong indicator of a future earning potential is what your previous earnings were. And so we are looking at your previous incomes. Sometimes that doesn't tell the whole story though. And so we are looking at what is your career path? Do you have a degree in a specific field? How long have you been working in a field?
We're looking at some different references. We're also looking at your credit and your financial picture. Make sure that you're not already underwater somewhere. So yeah, we're really just trying to get to what is that future earning potential. What do we think you are going to make going forward? In either a success case where your company raises a bunch of money or reaches profitability and grows, or in a failure case, if your company doesn't work out, what is it that you're going to do?
How does the CISA model work?
It stands for “Convertible Income Share Agreement”. Those are the terms that we're investing on in people right now. It basically takes two instruments. One, it takes an income share agreement, which has been used in the education space for a number of years now. And that agreement is directly between the Chisos fund and the individual. And that says when the individual earns a specific amount of income or over a specific amount of income, typically $40,000 a year or $3,333 in a month, then they share 10% of their income with us until they hit an amount cap or a time cap. So that's the income share agreement and that's with the individual. That's where we're literally investing in the individual.
Now, for entrepreneurs and with our current fund, we combine that with a safe or simple agreement for future equity. With that safe, we're essentially targeting a percentage. So we took a Y Combinator safe, modified it slightly so that we target a specific percentage, which is anywhere between half a percent and 4%, typically. And so that's the percentage of future equity that the company will issue to us. So when we make an investment, we have really two ways that we'll make money as the investor. One is through the income share agreement, one is potentially through equity. And that's really what allows us to come in, in the case of an entrepreneur at day one or even before day one at the earliest stage, by investing in that individual.
Investing at the friends and family stage
When we looked across the landscape of capital options at the early stage, let's say pre minimum viable product, you're probably not going to raise from angels or especially VCs. You don't have any traction. You kind of need that traction to raise from angels and VCs. Well, you need money often or if you're technical put in the time to build a product to get that traction. And so pre-traction you're usually looking at friends, family and personal savings money. Well, what if you tap that out? What if there's not a lot of friends, family, personal savings money available? Then what do you do?
All right, potential option, max out a credit card, go get a home equity loan, some kind of traditional credit product. Those aren't great because they have fixed costs and compounding interest. And so that's where we came in and created this flexible alternative to provide that capital upfront before any traction is available.
How does Chisos compare to the traditional bank loan?
So it's kind of have to think about what an interest rate is and the cost of capital and basically a lot of kind of deeper finance questions on how you finance your company or capitalize your company. So if you think about taking money from an angel or a VC, they're looking to return to their own LPs and investors somewhere around 25-30%, or if they're an angel, they're looking for that 25-30 even higher percent return. So essentially that's the cost of capital there. If you're taking that kind of money, you're giving up a piece of your company and you're trying to return 20-30-40% returns to those investors on the credit side of things, typically a personal loan.
Depending on your credit, you're going to get somewhere today. It's kind of fluctuating, but you call it 6% to 15%. That's the cost of capital for that credit type of product. And what happens with that product, typically, is you have a fixed payment every single month, no matter what. And as an entrepreneur, you're going to probably go into a period of time where your income is zero or low or unknown. And so when you have a fixed payment monthly and you have unknown income, it's a little bit of a mismatch. And so that puts a lot of stress on the entrepreneur. They have to make that payment no matter what.
What our product is with the income share agreement is, it says only when you are making money and only when you're making money over a certain threshold are you making payments to us. So when you're making zero or below $40,000 a year building your company, you don't owe any payments. And in theory, you could make $39,000 a year for, you know, the first three, four, five years of building your company and make zero payments back to Chisos on the income share agreement.
Now, for us, as the investor, presumably you're making progress on your company, so your company is becoming more valuable, so our equity is becoming more valuable. So that's good for us. That's kind of the things that we thought through to make. It kind of a push and pull where if your company is doing good, maybe you don't have to make Isa payments.
On the flip side, if your company fails and you go back and get a job, then you start making ISA payments. But there is no required monthly payment. There is no compounding interest rate. It's just a fixed sharing percentage of your income until you hit an amount cap, which at the highest is 2X and can come all the way down to 1X or a time cap. Typically, we're looking to have individuals pay these off sometime within five or five years, can go up to 120 months of payments, is kind of the max time cap that we have on it.
Discussing an edge case
So let's say that there is an entrepreneur whose company isn't working out, and he has got a job and isn't making up to the threshold. And it's been some years, right? But you have given money to that person, right? So in that case, is the money coming back? Is there any way to get that money back for Chisos? How does that work?
So that's the risk that we're taking by investing in the person. If they are making below that threshold, if they make below that threshold for ten years, they don't make payments to us and the contract is complete. That is the risk that we're taking as the investor. So when we're doing our underwriting, we're kind of scaling our investments and looking to probability weight the future earning potential of that individual so that we get paid back.
But to that edge case, you fall on real hard times for a long period of time. There's no payments that are due, which is what makes this a pretty flexible instrument for people like entrepreneurs or other classes of people pursuing some type of creative endeavor.
How does Chisos track investments?
So we've got a few different ways that we're tracking and staying up to date. So one is we're just on a quarterly basis, reaching out to our founders and saying, what's the progress on your company? We always like to see, if not monthly, then quarterly updates from the entrepreneur helps us keep track.
But it's also just best practice, honestly, as an entrepreneur, to update people in your ecosystem of how things are going. On the income share agreement side, we do have a servicer that we use. So they monitor income, collect payments, ensure compliance, everything there. They're experts. There company called Meritos.
And so we use them for our income share agreements. And then on the equity side, just like any other traditional early stage investor, we're just tracking the portfolio and trying to stay up to date on how those companies are performing.
Flexibility in payback
So the language about the flexibility is more just about the income share agreement. So instead of rigid monthly payments with interest, no matter what, like traditional credit products, our income share agreement is flexible. If you make $10,000/month, then you make a payment on your income share agreement. If the next 15 months, you make $1,000 per month, then you don't make any payments.
And so as you go through your entrepreneurial journey or in the future, as you are an athlete or a YouTuber or Twitch streamer, or an artist, you're going to have ups and downs in your income. And so that flexibility comes in where the payments flex up and down with your income and even go to zero if your income falls below the threshold. So there are a few pieces of the terms that we negotiate upfront before we actually sign the contract with the individual. But that flexibility language that we're talking about is really just that up and down flexibility of payments based on income.
How does the equity clawback work?
So as I mentioned before, our convertible ISA is really made up of two instruments. One is the Income Share Agreement, the other is the SAFE. There's two ways that those agreements interact. One is this equity clawback. So every time you make an income share agreement payment, whether it's required because you're making them at the threshold, or it's discretionary because you're trying to hit the early repayment or just complete the contract, you're clawing back some of the equity owed to Chisos and you can claw back up to two thirds of that equity.
So this is kind of a founder friendly, again, push and pull. Business is doing well. Reduce ISA. Business isn't doing well, ISA comes into play. Example, we may call it a $50,000 investment. Our initial safe says as soon as the safe converts into shares, you owe us 3% shares. At any point. Until that safe actually converts into shares, you can make ISA payments and you can call back. In this case, 2% equity, meaning Chisos will only be owed 1% shares.
It's up to the founder decide what they want to do. Because in one specific case, we make that $50,000 3% investment, the founder is going to raise $5 million in a series a round, and all of their safes are going to convert at that point in time. They can decide, hey, I want to buy back as much equity as I can in a lump sum right now. And so they pay us back a lump sum, or they can decide, hey, I'm just going to continue paying my ISA as required by my income level, personal income level, and let Chisos equity convert into shares.
Typically, probably the math works out where they want to buy back as much equity as they can at that point in time. But yeah, it's up to the founder and how they want to play that. But that's how that equity clawback works.
And then how the other piece the way the safe and the income share agreement interact. If you are raising additional capital and you raise over $3 million in a priced round of equity, we're going to say that's de-risking the company to a late seed early series A stage. And we're going to bring down the ISA repayment cap, which starts at 2X. We're going to bring that down to 1X. So you'll just owe 1X back on the income share agreement, or the principal only. And then us as an investor will take our risk holding the equity in the company. So that's the two ways that those interact.
What percentage of the income is owed to Chisos?
So it's usually 10%. In rare cases, we can move that around, but typically it's 10% income share and it's usually for a period of three years and can be reduced. So max of 120 months of payments or a 2X repayment cap is how that starts. If an entrepreneur pay or an individual pays 1.5X within five years, then the agreement is complete. So kind of incentive to pay quickly or the 120 months of payments. So that's the standard terms.
Investment process at Chisos
So step by step, we send everyone to our online application. It's open online application. There's a big orange button on our website. You fill out an initial form. Basically what we're looking for there is send us your pitch deck. Tell us generally where your credit stands, where your income level stand. Give us your LinkedIn. Trying to just get a general sense of what the opportunity is. There are some thresholds where there'll be some automatic, hey, you're not quite a fit for us.
And so those get automatically weeded out at that point. Most, I think 80% of individuals especially. So we're only investing in US citizens and permanent residents today. So that's another question we ask. Typically after that form, you'll get a follow up email that says, hey, please log in and fill out your profile. In your profile in our app, you'll fill out a little bit more information about your business, about your career, about yourself. That will give us enough information to dig in and say, okay, this deal seems like it's interesting enough, seems like it fits our criteria. At that point, we'll typically have a call with the individual, kind of an interview call, hey, tell us about yourself. We'll ask some questions about your business past that we'll finalize our underwriting, maybe ask one or two more clarifying questions but finalize our underwriting and get to a spot where we issue a term sheet. That term sheet, a little bit of negotiation on a couple of terms there.
Once that's signed we can move to final docs pretty quick. Final docs, signed, wire the money, all of that can occur in theory within one or two weeks. We're moving a little bit slow right now. We've been doing deals in two to four weeks but that's the process on how we're underwriting.
Striking a delicate balance between founder interest and investor interest
So it's the middle ground that we've struck between founder interest and investor interest. So when we're coming in and making investment in the person super risky, typically it's really early. There's some other edge cases where we're bridge but typically it's super risky. And so most people are not going to be investing directly in the company only company equity only. That's why we have the income share agreement. That is our downside protection, that provides us some cash flow and if we look at the stats, not insignificant number of very early stage companies don't end up panning out.
So for us to be able to provide that capital at that stage we need the income share agreement with us. Now we also realize that as an investor or as a founder continues building their company and has some success that we don't want to have be on the cap table for let's say 3% or 4% when we only put in $50,000. And so that's why we put in the clawback mechanism so that the founder can reduce that equity o de Chisos, reduce their own dilution but they still got that money in the beginning. So that's why we still have that residual piece so that if they create a billion dollar company we'll still have some equity ownership. So it was a process of kind of give and take where we wanted it to have some founder friendly features so that our capital would be attractive. But as an investor we also need to have some type of risk adjusted return that makes sense for us to raise money and to deploy that capital.
So that was kind of the thinking on why we had that equity clawback mechanism in place. The other piece is in order for an equity clawback to occur we're getting paid on the income share agreement. So it's not like we're just kind of giving that up for free. We're getting paid back on the income share agreement. So we are returning money to our investors.
Helping portfolio companies succeed
So far we have 32 investments, relatively small portfolio that we can have some hands on experience with. So a couple different examples. We bring everybody into a slack channel where we have resources and perks building out a mentor advisor database, people in our networks and people that we've met that are willing to help founders trying to make those connections. Investors is another one.
We have investors in our network that we try and intro the founders to so everything around money and mentorship and advisorship. We are also having office hours and we're having webinars. So we'll find somebody who is really good at marketing or who's really good at determining how to go about building your minimum viable product or developing, and we'll hold those webinars and then the founders can attend, learn best practices, and then ask those questions of those individuals. Lastly, kind of the most hands on thing we're doing is our team has some expertise in just fundraising processes, structuring a deck, thinking through business strategy at the early stages. And so we'll have one on ones where we'll just meet for 30 minutes to an hour with the founder and brainstorm with them and provide them feedback that is less scalable.
But I think there will always be an element of that where you get that kind of hands on, one on one conversation with part of the Chisos' team. And I think that's a valuable piece for founders because information is everywhere online. You can go Google search, anything. A lot of YC startup school has some great resources, but talking with a person and really trying to flesh out your idea and your strategy is on a totally different level of helpfulness than just kind of watching a video, at least in my experience.
Rapid fire round
Sectors and regions you invest in?
Sector agnostic. Regions is United States based, capital efficient and scalable type businesses. So no brick and mortar bakery, but capital efficient and scalable.
What stage you typically invest in?
Typically pre seed all the way to potentially a seed bridge.
What's the typical check size?
Anywhere from $15k to $50k.
Where can founders and potential founders with you?
Online. At Chisos.io we have an open online application that you can start.
Where can our listeners follow you?
Twitter is a good one at @wdstringer or @ChisosCapital LinkedIn I think the same. And then I'll throw an email firstname.lastname@example.org. You can send us an email and we'll get back to you. We're pretty easy to find just through the socials on our website.