Chisos Investment Terms Explained (Part 1)
At Chisos, we're creating a new investment product for companies and ideas that have a difficult time accessing capital. We are calling it a Convertible Income Share Agreement (“CISA”).
We look for companies that do not fit the “grow at all costs” venture capital funding model, or do not fit the “5-year predictable growth with hard asset collateral” model that is usually required for a traditional bank business loan. We're happy to fund any type of business. Given the extremely early nature of a Chisos investment, underwriting the entrepreneur as an individual is just as important (if not more) as underwriting the business opportunity. As you read through the explanation of a Chisos investment, keep in mind that we are trying to design a funding mechanism for businesses and ideas that do not have other good options. We think Chisos investment terms balance founder-friendly and investor-friendly terms, but others are sure to disagree. If 4%, non-recourse bank debt is an option for your business or idea, then Chisos is likely not the right funding option for you. On the flip side, if $50,000 in 25% APR credit card debt is your only option, we might be a better solution. Every entrepreneur has a different situation, and we are one tool that is available.
Chisos is looking to fund entrepreneurs and their businesses with $25,000 — $50,000 checks. This capital can be invested in one lump sum, or can be tranched out based on milestones of the business. This is a new investment product, so we are open to discussion as we figure out what terms work best for both entrepreneurs and investors.
The core innovation of the Chisos investment product is the use of an Income Share Agreement (“ISA”) (you can learn more about the basics of an ISA here). There is also plenty of information out there on the internet. ISAs have traditionally been used in the context of education. The income share agreement funds education expenses for a student and allows them to pay back the education provider in a flexible manner with no compounding interest that can get out of hand. Personally, I think the idea is great and it aligns incentives for students, education providers and investors when structured correctly. As with any financial instrument, each individual must consider all their options to choose the best tool for their situation. In some cases, student loans from government programs end up costing much less than an income share agreement. Everyone must do their homework.
Chisos is using income share agreements in a way that allows investors to get comfortable funding a company or an entrepreneur at such an early stage. Think of the Chisos Convertible Income Share Agreement as a feature combination of revenue-based financing, a bank loan with a personal guarantee, and a convertible note. This sounds confusing, but let’s break it down.
There are two parts to the Chisos CISA — 1) The terms of the ISA with the entrepreneur, and 2) the equity ownership and convertibility features tied to the entrepreneur’s business.
The Income Share Agreement
Given the fact that most businesses, especially at the earliest stage, do not end up working out, the income share agreement acts as a backstop for the equity investment. While different than collateral or a personal guarantee, the ISA serves a similar purpose of de-risking the investment.
For simplicity sake, let’s look at an example scenario where the business fails immediately — If Chisos invests $50,000 and the business quickly fails, that entrepreneur will now be responsible for paying back 10% of their personal income (not business revenue or profit) for 120 months or until 2.0x ($100,000) is repaid. There are multiple caveats to this scenario.
· There is an early repayment benefit — If the ISA is paid back within 5 years, the repayment cap is 1.5x ($75,000).
· There is a salary floor, where the entrepreneur pays back $0 during periods of time where they are not earning above $40,000.
· There is a 60 month deferment period that could extend the ISA contract past 120 months.
These terms must be compared against alternative options to appreciate the flexibility and cost of capital. If you compare the ISA to a business bank loan with a personal guarantee (the bank can seize assets), or a personal loan with interest (fixed payments are required no matter what your income level + compounding interest can increase your balance due faster than you can pay it down), the ISA is much more flexible. If you can find cheaper capital and are not worried about flexible repayment, then the Chisos CISA may not be the right investment product for you. However, we think the flexibility is important to entrepreneurs who may not be earning much income for many years while they build their business.
Equity Ownership and Convertibility
When designing the Chisos CISA, we realized the need for equity ownership in order to align the incentives of the entrepreneur, the business and investors. However, we did not want to overburden the equity ownership of the company at such an early stage, so we designed a mechanism that allows entrepreneurs to “buy back” their equity ownership. We think this is a unique feature that allows entrepreneurs to conserve their equity ownership in their business. It is worth mentioning here that the Chisos investment will never include a board seat or voting rights. We are here to help, but do not want to interfere with how you choose to run the business.
On day 1, when the money is invested, Chisos will be entitled to a certain equity percentage of the business. This often takes the form of a SAFE. Over time, as the ISA is paid down, the equity percentage owed to Chisos is reduced. Fully paying off the ISA allows the entrepreneur to reduce the equity percentage owed to Chisos by 2/3rds. Example:
· Chisos invests $50,000 and is entitled to 5% equity ownership. The ISA liability is 2.0x the investment amount ($100,000)
· Once $50,000 (50% of the repayment cap) has been paid down on the ISA, the equity ownership claim is reduced to 2.5% (50% of the original equity).
· Once $100,000 has been paid down on the ISA, the equity ownership claim is reduced to 1.67%.
· *If the entire ISA is paid down within 5 years (1.5x cap with early repayment benefit), only $75,000 will be due, and all 2/3rds of the equity will be reduced.
The Chisos CISA has unique convertibility features should you sell your business or raise a larger round of investment. The terms of the agreement will specify what a Qualified Financing looks like, but in general it will designate a situation where the entrepreneur raises a larger (>$3,000,000) amount of equity capital from investors at a specific valuation.
In the event of a Qualified Financing, the equity ownership claim will convert to shares at the outstanding equity ownership claim level (somewhere between 1.67% — 5% if using the previous example), and the amount due under the ISA will drop to a total of 1.0x. In the example above, if, upon conversion, $50,000 has already been paid down on the ISA, then the ISA liability is satisfied, and no other ISA payments are due after conversion.
As a rule of thumb, entrepreneurs will be required to repay at least 1.0x what they borrow in a flexible manner using the income share agreement. This downside protection allows Chisos to invest at the earliest (and riskiest) stages of business creation. The CISA gives plenty of flexibility to the entrepreneur, while providing an acceptable return to Chisos investors….a win-win.
As I mentioned before, we are open to discussion and excited to talk with entrepreneurs. If you have a question or are interested in receiving an investment from Chisos, reach out and let’s talk.