Limited return – what is the “right” design
Independent of which method is used for determining investment returns in steward-ownership-aligned financing, there will be a certain total upside for investors regarding their initial investment which will make up the capital costs for the company. The discussion around the adequate height of where or the process of how the investment should be limited is where it gets complex, personal and individual.
What is “adequate” and “fair”? This is extremely subjective and depends a lot on the individual company and its investors. It involves questions like: what is feasible and “appropriate” for the company and its future financial potential, what is appropriate in relation to the capital and risks the investors took or in relation to other (non-financial) investments in the company (e.g. founder compensation).
The conversation around fair returns and where and how the investment should be limited is one of the most important aspects of conversations with investors in the future. Please note: this is an extremely important and socially interesting but also challenging discourse. Particularly investors usually investing with conventional equity investments are not used to the questions of “how much is enough, what works for you, what feels adequate for the risk you took?”. However, fixing a limit or a process to a limit doesn’t even mean that investment returns need to automatically be lower than in conventional investments but it challenges the need to maximize limitlessly.
It could also be possible that you don’t want to dive into the "What is it worth?" discussion too early, especially when key future information is still unknown or having such conversations feels overwhelming. In such cases, relying on market valuation methods (accompanied by a limitation through e.g. termination rights, or limitation in investor influence) can be helpful. However, if a valuation method is used, make sure that you use (and fix) one that does not inflate the valuation. Not only to avoid unnecessary pressure for rapid growth but also to not make it practically impossible to buy back the investors’ shares (without forcing the company into a growth trajectory that is not healthy). But of course: if someone takes on a lot of risk, this risk can be compensated adequately – as long as the height and way of compensation don’t jeopardize the purpose and health of the company.
Finding the right limitation with investors also heavily depends on the pressures and expectations that the investors or funders themselves face. For example, a fund that aims to maximize returns, promises extremely high profits and wants to outperform the market and other players will likely struggle to accept a more modest but reasonable return that aligns with what the company can sustainably deliver.
So, for determining the “right” cap for your scenario, you will need to take a realistic look at the financial potential of your company and the risk – and eventually go into discussion with your investors as to what feels (risk-)adequate for all sides. The further journey will support you on both of these accounts.
Want to dive into some examples? We recommend exploring these case studies.