perhaps instead of “Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month”

… it's simply holder of note holds option to be repaid… but may request to not be paid.

this would keep the value in the note.

A new financing event doesn't make the equity “valuable” (i.e. doesn't distribute cash), it merely sets a price.

I'm curious why you would convert outside of a liquidity event; setting valuation can be a contentious negotiation for business partners.

Suppose we have a business that is a lifestyle business. The upside will come from retained earnings (eg profit sharing) and not things like IPO, acquisition, etc. I mainly looking at this as social investment; I'd like to get my investment back and a limited upside is ok with me. I'd like to be actively involved in growing the biz but not looking for outright compensation.

As an investor, I put $10K into a biz with convertible debt at 10%.
We agree on terms to pay down the loan out of retained earnings.
At the end of a year, I have $11K in the biz.
The biz generates retained earnings of $25K.
We settle on 80% plowback and generate a dividend of $5K.
We settle on a 50% dividend split and I take $2.5K.
My net is $-8.5K.

At this rate, it will take about 4 years to break even the original investment, time value considerations largely excluded.

I proceed through the first couple years and have a loan balance of $5K. I decide to convert. It converts at a 25% discount to yield $6.6K in equity. We agree to value the company at 1x revenues. I own 6.6/250 = ~3% of the company.

At this point, the retained earnings repayment schedule doesn't apply. My equity is only valuable when the entrepreneur shares a profit or there is a new financing event.

Before I try to analyze it as a deal, is that basically how it would work in a simple company, single round example?

Great post. I love your articulation of the fundamental problem (which absolutely exists):

“. . . how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?”

Your third goal also jumps out at me:

“Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.”

And your proposed solutions have got me really thinking about what it would take to create a contract to support these goals.

You've hit on such an important issue. Starting-up a business is inherently uncertain, but the potential value is the natural counter-balance, so how do we share the risk and rewards of the germination phase given different types and amounts of investment?

If we had a new type of contract, as you're suggesting, to allow a consultant or freelancer to “invest” in the company with services as well as allow others to make small seed investments in such a way that they could be compensated as the business matured and revealed itself, that allowed them to ante up or cash out or trade that value horizontally (other investors at their “level”) or vertically (with angel or VC investments), then it would allow for a lot of tinkering and innovation that's not happening now.

I want it!

There must be some kind of cash/debt/equity structure, some of which I'm sure is contained in your post, that can make it a reality.

Look forward to your next post on this topic.

Great post. I love your articulation of the fundamental problem (which absolutely exists):

“. . . how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?”

Your third goal also jumps out at me:

“Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.”

And your proposed solutions have got me really thinking about what it would take to create a contract to support these goals.

You've hit on such an important issue. Starting-up a business is inherently uncertain, but the potential value is the natural counter-balance, so how do we share the risk and rewards of the germination phase given different types and amounts of investment?

If we had a new type of contract, as you're suggesting, to allow a consultant or freelancer to “invest” in the company with services as well as allow others to make small seed investments in such a way that they could be compensated as the business matured and revealed itself, that allowed them to ante up or cash out or trade that value horizontally (other investors at their “level”) or vertically (with angel or VC investments), then it would allow for a lot of tinkering and innovation that's not happening now.

I want it!

There must be some kind of cash/debt/equity structure, some of which I'm sure is contained in your post, that can make it a reality.

Look forward to your next post on this topic.

Great post. I love your articulation of the fundamental problem (which absolutely exists):

“. . . how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?”

Your third goal also jumps out at me:

“Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.”

And your proposed solutions have got me really thinking about what it would take to create a contract to support these goals.

You've hit on such an important issue. Starting-up a business is inherently uncertain, but the potential value is the natural counter-balance, so how do we share the risk and rewards of the germination phase given different types and amounts of investment?

If we had a new type of contract, as you're suggesting, to allow a consultant or freelancer to “invest” in the company with services as well as allow others to make small seed investments in such a way that they could be compensated as the business matured and revealed itself, that allowed them to ante up or cash out or trade that value horizontally (other investors at their “level”) or vertically (with angel or VC investments), then it would allow for a lot of tinkering and innovation that's not happening now.

I want it!

There must be some kind of cash/debt/equity structure, some of which I'm sure is contained in your post, that can make it a reality.

Look forward to your next post on this topic.