A 2:3 Paradigm for Investor Risk in Venture-Stage Companies

risk-paradigm-image How might one evaluate an investment in a venture-stage company? That is, one that presents high risk of failure and will require more money from investors in the future to survive.

It is a tough question, one that isn’t just the province of investors in private offerings—it affects average investors and anyone concerned they will be imprudent in their investment choice.

Venture capital can be raised in a private or public offering. Wall Street initial public offerings routinely raise venture capital; think most tech and virtually all biotech IPOs. “Venture capital” is defined by the issuing company’s risks, not how it is raised.

The JOBS Act of 2012 led to changes in securities regulations that make it less burdensome for companies to sell stock and for investors to invest in them. It will take time to assess their effect but this much is apparent—more young companies will sell their shares to the public in the years ahead.

The potential, not their performance, is their appeal. Thus, how to evaluate an investment in one?

Below, is a framework I developed while writing a book about a performance-based capital structure for companies that raise venture capital via an IPO.

It explains why I hold two opposing views about the JOBS Act reforms. I am enthusiastic about crowdfunding, online platforms and Reg. A+ offerings as they improve access to capital for entrepreneurs—people who contribute much to our economic vitality—but I fear that average investors will fare poorly when they invest in them.

The 2:3 Paradigm

I call this framework the 2:3 Paradigm.

The ”2” refers to the two fundamental risks for investors—failure and valuation. The first is that the venture will fail to meet expectations. The second is that the investor will overpay for a position, something that can happen even if the company meets expectations.

These risks underpin all others. Those related to market, technology, and management are a blend of these two. That is the case for fraud as well; it is failure and valuation risk garnished with false or inadequate disclosure.

Failure risk is omnipresent in a venture stage investment. Valuation risk lurks as well; an investor may invest in a successful company but lose money (or make less than expected) because the buy-in valuation was too high.

The “3” in the model’s title indicates that there are three paths to address them—analytics, cohorts and structure—and they can be combined for a variety of effects. Similarly, the primary colors—red, yellow and blue—can create an array of colors.

The following table shows that investors use two of these paths—analytics and cohorts—to mitigate failure risk and that there isn’t a structural solution for failure. In contrast, all three paths are potentially available to investors to mitigate valuation risk.

2:3 Paradigm for Risks in a Venture-Stage Investment 3 Pathways to Mitigate Risk
Analytics Cohorts Structure
2 Fundamental Risks Failure X X
Valuation X X X

Analytics Path

Analytics refer to data that one can independently assess. Established companies have a lot of it. Young companies don’t and what they do have has dubious predictive value, especially if they utilize novel technologies or business models.

In 1968, Edward Altman at New York University devised an algorithm to predict whether a public company would be bankrupt within two years. It weighed measures of profitability, working capital and market value for indications of weakness. Altman dubbed the result a Z-Score.

Could there be a forward-looking measure for early-stage companies? One that assesses the potential for success, not failure? It is a beguiling challenge, one that Nimish Gandhi at Invesights (www.invesights.com) has tackled. A former academic who has studied small companies, he has a methodology to predict the viability of early-stage and established companies. Invesights’ algorithm generates a score called Investment Outlook Score (IOS), akin to a FICO score that measures a person’s creditworthiness. Like a Z Score, an IOS seeks to portend the future. Unlike the Z Score, it measures business vitality.

Independent of such a system, analytics can screen for failure risk by identifying dubious assumptions, evaluating competitive advantage and the reliance of a company on future infusions of capital.

Analytics is central to valuation analysis and discounted cash flow (DCF) is its cornerstone. Theoretically, it is appealing; the present value of an enterprise is the sum of its future cash inflows, discounted for the time value of money (interest rate) and a risk factor. In practice, it is only as helpful as the earnings projections, which can be unreliable for established companies and are routinely so for start-ups. Computer scientists have an expression that fits—garbage in, garbage out.

DCF can suggest a valuation when an investor’s anticipated exit is via acquisition of the company. But there are problems here too. Namely, its very risky to set a valuation based on a discount to an outcome that may never happen. Then too, any purchase price may be a function of the company’s strategic value to the acquirer, not its cash flow, and that can vary greatly based on who the buyer is and the company’s future market position.

Multiples offer another analytic approach to valuation. Public stock analysts look at the multiple the market applies to a company’s earnings per share—its price/earnings ratio. Acquirers and private equity (PE) firms value companies using a multiple of sales, profits or indicators of value such as the number of customers. When a valuation exceeds a multiple’s norm, valuation risk climbs.

Multiples are not particularly useful to VCs for they invest in new technologies and disruptive business models and it is hard to identify relevant multiples for such opportunities.

Bottom line: in theory, analytic tools offer a compelling way to establish a valuation for a company but in practice, they have shortcomings, especially when dealing with venture stage companies.

Cohort Path

A cohort is a group whose members share a common characteristic, and here it refers to those who influence an investor’s assessment of a company. Since one need not have a personal relationship with someone to be influenced by them, the pool of potential cohorts is immense.

Virtually everyone heeds what others say or do. That makes the cohort path the most popular way to assess failure and valuation risks. As social creatures, investors want to know, what do others think of a company? Is it likely to go up in value?

Analysts who follow public stocks are on the analytic path when they consider the fundamentals of a business and its prospects for growth. They are on the cohort path when they compare their assessment to a company’s market value.

Technical analysis is a pure form of the cohort path. It’s practitioners study stock price charts to identify valuation risk. In wizard-like fashion, they attempt to discern meaning from patterns of trading that look like heads, shoulders, teacups, and so on. The same can be said for momentum investors, who buy when prices trend up and sell when they do the opposite. It sounds odd, but machine-based trading systems pay attention to cohorts too…they monitor the behavior of other robo-traders as well those who are human.

VC and PE firms use cohort networks to help them evaluate both failure and valuation risk in private companies. Angel investors do this too when they approach due diligence as a team sport, coordinating it with others.

In contrast, investors evaluating a public venture stage company have poor quality access to cohorts. Financial advisors sensibly discourage such investments because of their high failure and valuation risk, but that doesn’t prevent someone who wants to take a chance from doing so. Venturesome public investors are left with media reports, press releases, and online postings. These can help assess failure risk but they often offer notoriously poor information about valuation risk. Some of these cohorts put out misleading information for their own gain. They seek to spur demand for shares as part of a pump and dump scam or crash them to profit from short sale positions.

Access to the cohort path for investors in venture-stage companies is evolving. In 2013, the U.S. Securities and Exchange Commission began to let websites share information about private offerings with accredited investors. In 2016, the SEC allowed other types of websites to provide information on offerings to any investor. Such developments are recent and suggest dynamism for the cohort path in the years to come.

Structure Path

The structure path is about the terms of an investment. A capital structure facilitates deal terms, hence the name.

A corporation’s capital structure is defined in a document that goes by names such as the articles of incorporation or certificate of incorporation. It describes, among other things, the rights of its shareholders. The document must be amended before unique deal terms can be granted. For a country, the document is equivalent to its constitution, which sets forth, among other things, the rights of its citizens.

Deal terms don’t reduce failure risk. They can limit valuation risk, however, and significantly so. Put another way, the structure path does not help investors avoid a failure, but it can keep them from overpaying for a position.

The smartest, best networked investors in the venture space—VC and PE firms—are skilled at using the analytics and cohort paths to reduce failure risk. But since it’s hard for anyone to know the “right valuation” for a company, analytics are of limited value when assessing valuation risk. The cohort path is similarly handicapped because everyone has this problem. Therefore, while these investors use these two paths to evaluate valuation risk, they rely on the structure path to control it.

More precisely, VC and PE firms use the structure path to secure deal terms that can reduce the significance of their buy-in valuation…effectively, a valuation safety net.

A price ratchet clause is a basic way to do this. It retroactively reduces an investor’s effective price per share if later investors get a lower price (i.e., protected investor gets additional shares for free). Another is a liquidation preference clause, which entitles an investor to a preferential return, relative to other shareholders, and it is activated if the company is acquired or otherwise liquidated. A 3X liquidation preference, for example, entitles an investor to receive three times its investment from the proceeds before others get anything.

Thus, VC and PE investors tell entrepreneurs, “Give me my terms and I’ll give you your valuation.”

Apply the 2:3 Paradigm to Valuation Risk

Before considering how the three pathways address valuation risk, let’s touch on how a valuation is established.

Three are three approaches—asset, income, and market. The asset approach looks at the value of a company’s assets. The income approach estimates the present value of its future earnings and, possibly, its eventual value to an acquirer. The market approach uses the valuation of comparable companies as a marker. A valuation amount may reflect input from more than one approach.

This table shows how the approaches to establish a valuation intersect with the paths investors can take to mitigate the risk that it is too high.

Valuation: Ways to Set the Amount and Mitigate the Risk Mitigate the Risk
Analytics Path Cohort Path Structure Path
Establish the Amount Asset Approach X X
Income Approach X
Market Approach X

Explanation:

  • The asset approach is on the analytics and cohort paths because asset valuation can reflect independent assessment and/or the opinion of others.
  • The income approach is on the analytics path as it relies on independent assessment of DCF analysis, valuation multiples or similar metrics.
  • The market approach is on the cohort path because its goal is to evaluate what others think.

Note that no valuation approach utilizes the structure path. That’s because structure doesn’t set a valuation, it protects against a bad one. It can protect new investors from a valuation that proves to be too high (e.g., price protection, preferential rights to a return, claw back provisions). It can also protect current shareholders from a too low valuation from new investors (e.g., earn out provisions).

There are two key points here:

  1. Valuations based on the asset, income and market approach can be unreliable for established companies and are virtually always unreliable for a venture stage company. That’s not an indictment of the approaches as much as an acknowledgement of how challenging it is to get reliable data.
  2. Structure can make a valuation elastic, conditioned on subsequent events.

The final table shows that the structure path is available to private investors but not public ones.

Access to Paths Analytics Path Cohort Path Structure Path
Private (pre-IPO) investors X X X
Public investors X X

This one raises a question. If companies offer pre-IPO investors price protection, why don’t they offer it to IPO investors too?

Fundamentally, its because IPO investors don’t demand it, so issuers have little incentive to offer it.

Undoubtedly, this is because many public investors are valuation unaware. After all, if you are unsure what a valuation is, how to calculate it or how to evaluate one…why would you call for valuation protection?

Then too, the way-things-are works rather well for valuation savvy IPO investors who trade out of their position soon after they get shares. Rather than buy and hold, they buy and flip. For them, valuation protection comes from being a favored client of the underwriter, able to get an “IPO pop” of fifteen percent or more. If you doubt that, ask yourself, “If Wall Street banks allocated IPO shares in a lottery, how long would it take privileged investors to call for price protection?”

And, if public investors signaled interest in terms that reduce valuation risk, would issuers offer it? Surely, yes, for it is the nature of markets to respond to demand.

If they wanted to, how would companies offer it? While there would be variation in what was offered, all issuers would share a quality—they would have a multi-class capital structure when they have an IPO. It allows a corporation to treat IPO investors different from other shareholders. A single-class capital structure requires that all shareholders to be treated the same.

VC and PE backed companies always have a multi-class capital structure when they are private. Employees get a different stock than investors (i.e., employees get common stock and investors get preferred stock). When there are multiple rounds of financing, investors in each round have a unique class of preferred stock that specifies their deal terms.

Typically, when such a company has an IPO, its multi-class capital structure converts to a single class structure. The different classes of preferred stock convert to the common stock held by employees in accordance with their terms and new common stock are issued to IPO investors.

However, IPO issuers need not have a single class of stock. When Ford Motor Company went public in 1956, it sold Class A shares to the public while certain insiders held Class B shares with super-voting rights. Nearly fifty years later, the Class B shares represented about 2% of Ford’s total shares but controlled 40% of the vote. In 2004, Google took a similar approach with its IPO; the Class A it sold to the public had one vote per share and the Class B shares held by some pre-IPO shareholders had 10 per share. Since then, several companies have used a multi-class structure to similar effect in their IPO.

Note the irony of the way-things-are. Private companies adopt a multi-class capital structure to protect new investors while IPO issuers use one to protect insiders.

The Problem with Public Venture Capital

I opened this piece by saying I’m supportive of initiatives that make it less expensive for young companies to raise venture capital from public investors; such companies contribute mightily to economic growth and job creation. At the same time, I fear that average investors will fare poorly when they invest in them.

Not because of failure risk. Over time, I suspect many will be able to reasonably evaluate it themselves or through cohorts.

The problem is valuation risk. Average investors will be exposed to a full dose of it for two reasons.

  1. Companies value themselves much higher when they sell stock to public investors than to private ones.
  2. Public investors have poor access to good cohort data and virtually no access to the structure path.

Valuation Risk Reduction for Public Investors

Here are two ideas to help public investors reduce their exposure to valuation risk.

Valuation Disclosure

The first is a valuation disclosure requirement for offering documents. All investors, private and public, could reduce their valuation risk if the SEC makes it easier to use the cohort path.

It can do this by requiring all issuers of equity securities, whether private or public, to disclose the valuation implicit in their offering. That is, make issuers state in their prospectus that “based on the terms of our offering, our valuation is $X prior to selling our new shares” or words to that effect. Presently, investors must calculate the valuation and, I’ll bet, many don’t know how or neglect to.

This data point will enhance the competitiveness of capital markets by making it easy for data aggregation services to provide two key data points.

  • The valuation of comparable companies, be they private or public.
  • The valuation trend line for the issuer—from the earliest round to the present one.

The effect would be to make equity capital markets function more like real estate markets, where websites allow buyers and sellers to view the price of comparable properties and a home’s valuation history.

Fairshare Model

The second idea is to encourage companies to use a multi-class capital structure to reduce valuation risk for IPO investors; to treat public venture capital with the respect given to private venture capital.

The Fairshare Model, the book I’m writing, presents an idea for how to do this. It’s about a performance-based capital structure for companies that raise venture capital via an IPO.

The Fairshare Model has two classes of stock—one trades, the other doesn’t, but both vote on shareholder matters. Pre-IPO and IPO investors get the tradable stock, known as Investor Stock. For already delivered performance, employees get it too. For their future performance, employees get the non-tradable stock, called Performance Stock. Based on criteria described in the company’s prospectus, Performance Stock converts to Investor Stock. The criteria can change if both classes of stock agree.

The Fairshare Model minimizes investor valuation risk because the IPO valuation does not include the value of future performance. That means an idea alone is not worth $1 million. There are no unicorns. Rather, there is powerful incentive for employees to deliver performance.

Intriguingly, the Fairshare Model creates incentive for an issuer to offer a low IPO valuation. Since employees largely hold Performance Stock, they are focused on what it takes to convert it to Investor Stock. If a rise in the price of Investor Stock is a measure of performance, employees will want to see a low IPO valuation. This, in turn, allows them to say to IPO investors, “We don’t do well unless you do.”

The Fairshare Model can also reduce failure risk by helping issuers attract and manage human capital. In addition to pay, benefits, and stock options on its Investor Stock, a company can offer employees an interest in its Performance Stock. It pays off when they, as a team, meet the conversion criteria.

Companies will consider using the model if a critical mass of investors signal their interest in it because a well-performing team can end up with more wealth than they would had they raised their capital from a VC.

The essence of the Fairshare Model is that it balances and aligns the interests of employees and investors—labor and capital.

This has implications that go beyond this piece, such as economic growth, income inequality, and workforce competitiveness. These topics and more are discussed in the full draft of The Fairshare Model, which can be obtained at the “resources” tab at www.fairsharemodel.com

Conclusion

I hope I’ve given you a fresh, meaningful way to think about capital formation in the venture space.

There isn’t much that can be done to minimize failure risk—it is a defining aspect of this terrain. It’s a different story with respect to valuation risk.

All players, particularly average investors, will benefit from more robust market data, which is what a valuation disclosure requirement is about.

VC and PE investors have shown that the structure path can reduce valuation risk; the Fairshare Model takes a page from that playbook.

With articles like this and my forthcoming book, I hope to seed a movement to reimagine capitalism. Anything that ambitious takes time, of course, but begins with ideas. The more specific they are, the more actionable, the better. Should you challenge mine, I welcome it. Any effort to change the-way-things-are must survive the crucible of criticism.

If you like the ideas discussed here and in The Fairshare Model, share them and add your own.  Join me in calling for valuation disclosure. If you feel particularly supportive, please pre-order the book.

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Karl M. Sjogren is the author of a forthcoming book called “The Fairshare Model, a performance-based capital structure for companies that raise venture capital via a public offering.”

It will be published about five months after 250 people pre-order a copy from Inkshares, a publisher that relies on reader support to decide what to publish.

Preview the first chapter at https://www.inkshares.com/projects/the-fairshare-model

Applying a Formula for Happiness to Free Trade

formula-for-happinessExpressing happiness in a formula can prompt new thinking about the cause of unhappiness and how to be less unhappy.

Happiness = What’s Happening – Expectations

This formula states that happiness can be increased by improving what is happening or by lowering expectations.

The U.S. is nearly a decade into an economic cycle that has inflamed anxiety that the future is dimmer than the past. Concern about the effects of free trade unites polar opposites on the political spectrum. The happiness formula can help us untangle how we feel about trade by identifying which variables could change.

Turning down the heat on a matter is a good thing. Frustration led U.K. voters to exit the European Union, a decision most regret. In the U.S. anger over the 9/11 terrorist attacks caused a majority to support the invasion of Iraq which is now universally seen as a poor decision. Similar sentiments about the economic outlook has increased interest in protectionist policies.

Expectations

Let’s consider the second variable first.

Optimism is natural for Americans but some of us have not considered that, in many ways, we have had the wind at our back. We benefited from having abundant resources and separation by oceans from lands that suffered the ravages of war. A continuous infusion of immigrants, many of whom helped advance scientific and commercial innovation, also contributed. In other words, the rise of a prosperous U.S. Middle Class occurred when much of the world was in a weak competitive position.

Challenges to the post-war economy began in the 1970s as soaring oil prices saw foreign automakers take market share out of the domestic arena. Ensuing years saw increases in many imported goods, largely electronics, textiles and furniture. Some U.S. jobs were lost to imports, but there was as yet a feeling that trade was a rising tide that lifted all boats.

The North American Free Trade Act is a lightning rod now, possibly because Ross Perot memorably said in his 1992 presidential campaign that approval of NAFTA would be followed by a “giant sucking sound” as jobs moved from the U.S., but that treaty helped blunt imports from Asia.

Expectations began to waver as competitive factors other than free trade contributed to economic insecurity. Work migrated from the industrial centers to those that offered lower costs—from Rust Belt states to those in the Sun Belt. Companies outsourced activities they had performed in-house. Computers made it easier to move work to where it could be performed more cheaply. There has also been the effect of new business models; big-box and online retailers favor low-cost products and business practices that have devastated traditional retailers.

The cumulative effects are profound. In his book, Rebooting Work, Maynard Webb observes that:

The half-life of a company is diminishing quickly. The average life expectancy of a company in the S&P 500 has dropped from seventy-five years in 1937 to fifteen years today.

What’s Happening

Turn now to “what’s happening” and what can be done to improve it. Put aside tax policies or spending priorities that require unlikely political consensus. Should the U.S. abandon support for free trade?

There is support for this on the political right and left. If maximization of gross domestic product were the sole objective of trade policy, few countries would engage in free trade. They would instead do what promised to benefit their own economy, even if it damages other countries. Such a beggar-thy-neighbor approach was common after the first World War and it helped lead to the second one.

An argument for free trade is that countries that trade are unlikely to go to war; when goods don’t cross borders, armies will. Another is that global resources are better utilized and broader benefits are created when goods are produced by the most efficient producer. Greater choice and lower prices are other benefits.

A country’s challenge is to use social policies to ease the dislocation that occurs when workers in un-competitive industries lose jobs. When that doesn’t happen, the problem is with social policy, not trade policy. Anxiety over trade has intensified in the wake of the Great Recession but that crisis was rooted in capital markets (i.e., financial instruments based on unsound mortgage debt), not trade policy.

Some who cast a dim eye toward free trade view government negatively; they want it smaller and less involved in our everyday lives. For them, an embrace of protectionism is ironic because such policies require more government involvement in the economy. Government  decides which industries to protect and how to do it. It also decides how to spend the revenue generated by tariffs. Should it be used to improve the nation’s competitiveness? If so, how and where? The opportunity for influence-peddling leads lobbyists to anticipate protectionism as the media views an election—good for their bottom line.

However one feels about government picking winners and losers, protectionism advocates face a key question. How will it increase long-term demand for American products?

If Not Protectionism, What?

The fundamental solution is for Americans to be more productive than their competition. If we can’t do that as the result of innovation, nimbleness or quality, it requires lower costs.

In their book, Better Capitalism, economists Robert E. Litan and Carl J. Schramm propose four strategic initiatives to change what is happening in the decades ahead:

  1. Encourage immigration by high-skilled foreigners
  2. Speed up commercialization of innovations at universities
  3. Improve access to capital for new firms
  4. Regulatory reform

The first initiative runs counter to anti-immigration sentiment, the running mate of protectionism, but it helps the U.S. compete on brainpower. The second and third enhance innovation and economic nimbleness.

Litan’s and Schramm’s fourth initiative is controversial. Industry upstarts and those on the political right often want less regulation. Those on the left want more, as may industry incumbents for whom regulations serve as barriers to competition. Nonetheless, policymakers can clear the regulatory underbrush. They can also reform social policies, such as those concerning education and training, to enhance competitiveness; those that promote equal opportunity will nurture hope in the future.

Another Idea: Cooperation Between Capital and Labor as a Competitive Tool.  

The Fairshare Model, a book I’m writing, presents a way to do this. It’s about a performance-based capital structure for companies that raise venture capital in an initial public offering. I call it the Fairshare Model because it balances and aligns the interests of investors and employees.

For decades, venture-stage companies have been responsible for more economic growth and job creation than Fortune 500 companies. They present investors with two risks—failure and overvaluation—and the model mitigates the valuation risk.

The Fairshare Model has two classes of stock. Both vote but only one can trade. Investors get the tradable stock, known as Investor Stock, and employees get the non-tradable stock, known as Performance Stock. Performance Stock converts to Investor Stock based on milestones.

The Fairshare Model improves access to capital (#3 above) with a deal that encourages investors to invest. If a rise in the Investor Stock price is a performance criteria, a company will set its IPO price low. It also helps companies attract and manage human capital. They will offer employees Performance Stock, which pays off when they deliver the performance investors expect.

If the Fairshare Model proves viable with start-ups, established companies may adopt it. To grasp the significance of this, consider the challenges that General Motors confronted as the era of rising fuel prices began. Uncompetitive products eventually led it to bankruptcy. If its capital structure had been based on the Fairshare Model, employees would have had owned Performance Stock that would have changed their response to developments. The quality of communications and the sense of urgency and responsibility throughout GM would have been higher. Product design would have been more competitive. Workers would have been more interested in better processes and training and less inclined to push for higher wages and benefits.

Now imagine that Sears and Roebuck, U.S. Steel, Eastman Kodak and other once iconic companies used the Fairshare Model. It has the potential to enhance competitiveness and ease income inequality by enabling those who rely on a declining return on labor to participate in the higher return on capital.

Over time, initiatives like these, which don’t rely on a lower labor rates, can improve “What’s Happening” by making the American economy more productive and its participants happier.

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The Fairshare Model will be published about five months after 250 people pre-order a copy from Inkshares, a publisher that decides what projects to back based on reader support (crowd funding).

You can preview the first chapter and place a pre-order here.

With the USD $5 credit that Inkshares issues to new customers, an e-book will set you back just $10. A combination of an e-book and signed print book, $20. If it isn’t published or you cancel your order before the book is shipped, Inkshares will refund your money. So, for a modest, risk-free amount, you can help launch a discussion about how to re-imagine capitalism.

Pre-Order Bonus

A special version of chapter 13, Calculating Valuation, with tables to look-up the pre-money valuation based on the size of the offering and the percentage of the company offered.  The tables are not in the full draft at www.fairsharemodel.com

If you are unsure what a company’s pre-money valuation is, why it is important or how to calculate it, this video is for you  https://youtu.be/cc2stjvgEbE The slide deck is here  http://www.slideshare.net/kmsjogren/premoney-valuation-how-to-calculate-it

Intelligence Squared style debate on equity crowdfunding

Link

In June 2013, I participated in a debate about equity crowdfunding that followed the format used in NPR’s Intelligence Squared program.
The two teams argued opposite sides of this question “Will equity crowdfunding and the JOBS Act benefit both entrepreneurs AND investors.”

The moderator was securities attorney Bruce Methven. Howard Leonhardt (Leonhardt Ventures) and Thad Leingang (VentureDocs) argued that the answer was “yes.” Ron Weissman (Band of Angels) and I were on the team that argued that the answer was “no”–that investors would not benefit.

This question hangs over the implementation of tha equity crowdfunding section (a//k/a Title III) of the JOBS Act. I just discovered that the debate is on YouTube.

The order of speakers is Howard (arguing yes), Ron (arguing no), Thad (arguing yes) and me (arguing no). My remarks start at the 16:40 mark.

Garden Variety Securities Fraud Hyped as “JOBS Act cited in Fraud!”

The JOBS Act is prominently cited in stories about Daniel F. Peterson, and his company, Real Estate Fund 1, Inc.  On April 24,2013, the Securities and Exchange Commission charged him with securities fraud as he raised more than $400,000 in an offering of common stock from 21 investors.

But the JOBS Act is not the story, fraud is.  The kind of fraud that has existed since the SEC was created.

If the SEC’s action should provoke a public policy question, it should be “How can investors know if a securities offering is legitimate?”  Unfortunately, the question that media coverage encourages is “Is the JOBS Act a bad idea?”  Its sensational, not substantive.

According to the SEC[1], Peterson raised the money between November 2010 and June 2012.  The JOBS Act was signed into law in April 2012, two months before the last money came in!

The complaint says Peterson made false JOBS Act claims, but the material ones don’t make good headlines.  Peterson raised money years before the JOBS Act was passed–$300,000 was raised in 2008 using promissory notes that he had defaulted on.  To escape liability, he persuaded the noteholders to convert the judgments they had against Peterson into common stock in his company.  Other investors apparently bought about $100,000 in the company’s stock as well.

Allegedly, Peterson told investors he was about to raise billions of dollars in a secondary offering with reputable financial firms who had performed enough due diligence on his firm and business plans that they were “structuring..sales agreements and pricing as we speak.”  The complaint says these claims were false; there was no credible secondary offering underway, and he had no affiliation with the financial firms he claimed would underwrite it.

The complaint details false or misleading claims that Peterson made, but guess which one is picked up in the media?  His claim that the future secondary offering “would be made possible by” the JOBS Act.

Headlines and excerpts from three media sources are:

SEC Fraud Case Cites Spokane Man’s JOBS Act Pitch to Investors [2] –Bloomberg News

  • “A Spokane, Washington man sued for defrauding investors used the 2012 Jumpstart Our Businesses Act to tout his plan to raise billions of dollars in capital, according to the U.S. Securities and Exchange Commission”.

SEC aims to protect investors from fraud under new law [3] – Washington Post

  • “The rules aren’t even in place yet, but allegations of fraud are already flying.  The Securities and Exchange Commission is crafting rules to implement a new law that makes it easier for private firms to raise money. But it has been struggling over how to do so in a way that protects investors from fraud.  In a civil complaint, the SEC accused Peterson of telling investors that the law — known as the JOBS Act — would enable him to raise billions of dollars from the general public and generate 10-year returns of up to 1,300 percent for early investors.”

SEC says man used JOBS Act to lure investors into fraud scheme [4] – Thomson Reuters

  • “The Securities and Exchange Commission on Thursday filed charges against a man accused of luring investors into a fraudulent investment scheme by promising big returns under a provision of the 2012 Jumpstart Our Business Startups Act.  Daniel Peterson and his company, USA Real Estate Fund 1 of Spokane Valley, Washington, allegedly told investors that the JOBS Act would let him raise billions of dollars because of a measure that lifts restrictions on general advertising, the SEC said.  But Peterson, 63, did not really have a guaranteed investment product or any affiliation with a financial firm, the SEC said. He allegedly took investors’ money and then used it to pay for rent, food, entertainment, vacations, a rented Mercedes Benz SUV and expenses at a Las Vegas casino, among other things.”

Reporters should try to find out why the investors converted their $300,000 judgment into stock.  What due diligence did the new investors do?

The real story is “What should investors do to determine whether a securities offering is fraudulent?” That is a large and complex question.

Some products offer ways for the consumer to help determine whether they are authentic (i.e. drugs, software, clothing, liquor and cigarettes).  There is no “seal” or authentication code for a securities offering.

Investor education is an obvious way to combat fraud.  What other avenues–proactive ones–should be looked at?  Can securities regulators make a registry of “legitimate” offerings available to investors before they invest?

 

 

Until the 1990s, companies didn’t have “business models”

Interesting article about the expanding usage in the 1990s of the term “business model”.  http://qz.com/71489/until-the-nineties-business-models-werent-a-thing/

My theory is that the phrase became popular as the availability of venture capital grew, and, those responsible for investing it sought to filter deal flow.

Through the 1980’s, “strategy” was used to describe business activity and the deployment  of assets.  However, the blossoming of all-things-electronic—computer and consumer electronics—demonstrated that conditions were ripe for brand new businesses.  “Model” is a lighter word; it can be articulated before committing to activity and assets.

As the supply of potential deals expanded, and, the fleeting nature of success in the nascent technology sector was repeatedly demonstrated, VCs needed two things.  Theories about the kinds of businesses that were likely to find success, and, a quick way to test theories as they shift through deals.

Hence, there were “elevator pitches” about how to find success in rapidly changing markets.  Untested business strategies were better described as models.

In Hollywood, studios are pitched “high concept” and, when one bites, “it’s a movie”.

In Silicon Valley, business model became the equivalent of the high concept; appealing models produced funded companies.

A Call to the SEC to Require Valuation Disclosure

The Jumpstart Our Business Startups (JOBS) Act is a year old and we’re still waiting to see how the U.S. Securities and Exchange Commission will implement it. In particular, it’s “crowdfunding” provisions.

The JOBS Act makes it easier for companies to sell stock to investors who are wealthy (i.e., they meet the SEC’s “accredited investor” standard) and also, potentially, to small investors.  Purportedly, the delay is due to difficulty reconciling the JOBS Act with the SEC’s mission to protect investors.

No matter how the law is implemented, I have a suggestion for how to protect investors that could also help companies compete for capital;  require that all companies disclose the valuation that they give themselves when they offer stock.

Valuation is occasionally cited in news reports, such as this one comparing the anticipated valuation range for an initial public offering by Alibaba Group Holdings, a Chinese Internet company, to Facebook’s.

Facebook’s IPO valued the company at $104 billion (its market capitalization has since slipped back to $63 billion). Estimates of the likely valuation of Alibaba range from $55 billion to more than $120 billion.

Many investors are unsure what valuation means. It is simply the price to buy the entire company, based on the latest price shares are sold at.  When new shares are sold by an issuer, valuation refers to the “pre-money valuation”.  After the offering is complete (i.e., the money is collected and shares issued), it refers to “post-money valuation” or market capitalization.

Some investors know what pre-money valuation means but are unsure how to calculate it.  Here’s one way.

    Pre-Money Valuation = Shares Outstanding Before Offering  X  Price of a New Share

For example, suppose ABC Company has 10 million shares outstanding and plans to issue 1 million new shares at $5.00 per share to raise $5 million.  With these terms, the ABC gives itself a $50 million valuation (e.g., 10 million X $5.00).

Here is the relationship between ABC’s pre-money and post-money valuation.

   $50 million  is ABC’s “Pre-money” valuation (10 million shares X $5.00 per share)

+     5 million  is the “Money” raised in the offering (1 million shares X $5.00 per share)

= $55 million  is ABC’s “Post-money” valuation (11 million shares X $5.00 per share)

After the offering, if someone sells a share of ABC stock for $6.00, the company’s valuation—its market capitalization—will rise from $55 million to $66 million (11 million shares X $6.00).  Conversely, if the most recent share price is $4.00, ABC’s valuation fall to $44 million (11 million shares X $4.00).  Whether ABC is privately held or publicly traded, the calculation assumes that stock is sold at market value and that the latest price is the value of each share outstanding. Theoretically, it is what someone would pay to buy the entire company.

So, in setting its terms, ABC suggests that it is worth $50 million.

Maybe it is.  Maybe it’s isn’t.

How might investors evaluate the price?

When investors know ABC’s valuation, it is easy for them pose a fundamental question.  “ABC has less than $1 million in revenue and no profit. Why should I invest when it is valued at $50 million?”

When investors do not know ABC’s valuation, the pricing question will likely be “Why should I invest when it is $5.00 per share?”  However, this is not meaningful; ABC could have the same valuation with a lower price and more shares.

The important price question is “Why is ABC worth $50 million?” This question is especially critical when an issuer is private—the kind of company the JOBS Act is designed for—because its stock does not trade in a market.

Valuation is important information and investors should not, as they do now, have the burden of calculating it.  Some may not know how to. Others may be uncomfortable doing so or forget to. Some will calculate it incorrectly.

For venture capitalists, valuation is the most important consideration when evaluating an investment. Yes, they must feel that management is capable, that the company’s market is attractive and that it has a compelling competitive advantage.  However, if the valuation is too high, they don’t buy.

Valuation disclosure will help data aggregators assemble valuation statistics for investors and companies that improve the efficiency in capital markets the same way that Kelly Blue Book improves efficiency in the car market and home listing data improves efficiency in the real estate market.

I also suggest that the SEC requires issuers to discuss factors they considered as they set their valuation and, perhaps, encourage them to suggest why the figure is appropriate.  This would set the stage for issuers to compete for investors like merchants do for customers.  Some may view this is as undignified, but this is what happens when markets are efficient.

Two negative consequences result from the present lack of a disclosure requirement:  unsophisticated investors are more likely invest unwisely, and, issuers are less likely to compete for investors by offering better terms.

I know accredited investors who are uncomfortable calculating valuation and I am certain that most small investors would struggle if asked to.  Some believe, mistakenly, that securities agencies “approve” an issuer’s valuation.

Fact is, valuation is caveat emptor—buyer beware.  Undoubtedly, more investors have lost more money because they overpaid for a stock than has been lost due to fraud.  Valuation-unaware investors fuel valuation bubbles—they are more susceptible to “irrational exuberance”.

Interestingly, entrepreneurs can be hurt by valuation-unaware investors too.  Success at raising capital at a too-high valuation encourages them to be arrogant about OPM—Other People’s Money—and/or naïve about future raises of capital.

The second negative consequence of the absence of a valuation disclosure requirement is weak competition for investors.  Issuers are disinclined to compete on the basis of valuation because many investors don’t know what it is.  Plus, their legal counsel will advise them to not disclose valuation in offering documents because; a) it is not required, and b) disgruntled investors who sue may argue the company represented itself as being “worth” the valuation.

The result is that the market for equity capital is far less efficient than many other markets.

Grocery stores offer another analogy. Unit pricing helps shoppers evaluate and compare products. Where it’s not present, shoppers must calculate price per pound, per ounce, etc.  Some maybe too busy or uncomfortable to do so.

Nutritional Fact Panels take the analogy further.  The disclosure of fiber, salt, sugar and fat in a serving encourages informed shopping, and, it encourages manufacturers to offer healthier products.  It helps small companies compete against large ones with better known brands or aisle placement.

Similar dynamics are possible in equity securities.

Two things seem true.  Implementation of the JOBS Act will encourage more companies to offer stock to a larger pool of valuation-unaware investors, and, markets enhance the quality of products when relevant information is readily available to buyers.

Valuation disclosure may sound esoteric, but it’s not.  The SEC requires issuers to disclose risk factors in offering documents.  Sometimes, the result is pages of eye-glazing prose.

A requirement for valuation disclosure could be accomplished on one page and it would do more, I suspect, to protect investors.  It would also enhance competition in the equity capital market—whether crowdfunded or not.

Karl M Sjogren is a consulting CFO to start-ups and turnarounds, based in Oakland, CA.  At www.fairsharemodel.com, he blogs about the Fairshare Model, a performance-based capital structure for companies that seek venture capital via a public offering.   

Post Script

Why doesn’t the SEC require valuation disclosure?  It’s puzzled me, given the merits described above.

My speculation is that no constituency with a significant voice has called for it.

1)      The general investing public doesn’t know what it doesn’t know (i.e., the importance of being valuation-aware), so they don’t call for it.

2)      Issuers are not anxious to see it.  Neither are investment banks or broker-dealers.

3)      Sophisticated investors and those favorably positioned to get allocations of IPO shares know how calculate it.  Plus, they see no benefit if a wider pool of investors are similarly valuation-aware.  After all, such investors are the ones most likely to bid up the price of shares that they hold.

4)      Legislators are generally valuation-unaware, especially those inclined to be consumer advocates.  Those who are valuation-aware are likely to be in group #3 above, and/or, see no benefit to advocating for something:

a)      for which there is little constituent demand, and

b)      that will inhibit the flow of campaign contributions (see #2 and 3).

On March 23, 2012, former SEC chairman Arthur Levitt interviewed then-current chairman of the SEC, Mary Schapiro, on his radio show, A Closer Look With Arthur Levitt[1].  Concluding a discussion about the failure of the Congress to approve “self-funding” for the SEC, Mr. Levitt said the following.

“I guess I can afford to be more cynical now, Mary.  I think that the reason you didn’t get self-funding was because Congress didn’t want to give up the appropriation power over the agency.  Because historically, it’s ‘self-funding’ for them in terms of campaign contributions.  I can say it now.  You probably can’t.  Sit back and listen (chuckle).”

5)      The SEC is has been underfunded as well as overworked for years; they are more likely to focus on immediate demands than to create new requirements.[2]

6)      No SEC Chairman has championed valuation disclosure. (More on this at the bottom.)

7)      Regulators tend to be attorneys, not financial experts that are attuned to making markets more efficient.

The last point came into focus as I read Professor James J. Angel testimony before House committees. At a March 30, 2011 hearing on the costs of implementing the Dodd-Frank Act, he said[3]:

The SEC is just getting around to measuring how many of its staffers have industry designations such as the Certified Fraud Examiner, Chartered Financial Analyst (CFA), or FINRA Series 7.

Alas, in their FY 2010 annual report they were unable to report the number and reported it as N/A, and listed the goal for FY 2011 as “TBD”.

I searched the CFA Institute’s directory and found that only about 60 CFA charter holders are listed as working for the SEC. How can the SEC really review the filings from over 35,000 registrants(public companies, mutual funds, RIAs, broker-dealers, transfer agents, securities exchanges, and rating agencies) with only 60 Chartered Financial Analysts?

The SEC seems to be able to hire lots of lawyers, but not enough people with financial expertise.”

Professor Angel iterated this perspective on April 11, 2013 when he testified on the implementation of the JOBS Act.[4]

“…the SEC has a long history of misallocating the resources that it has received. Rather than hiring experienced people with the financial and technical experience it needs to regulate today’s complex high-tech markets, it has hired lots of attorneys who engage in hairsplitting minutia while missing the big picture.

Don’t get me wrong. My father and grandfather were attorneys. I actually like lawyers.  They are interesting people and it is fun to get into intellectual debates with them.

However, if you have a leaky pipe, you need a plumber, not a lawyer. The SEC needs to hire more market plumbers and fewer lawyers.”

Regarding the absence of a champion (point 6).  New SEC Chairman Mary Jo White seems likely to champion stronger enforcement, however, she will also oversee full implementation of the JOBS Act.  Therefore, I openly make the following (cheeky) suggestion.

Dear Chairman White,

Valuation awareness seems like sex education.  Many acknowledge its benefits…but few want to provide it.  As a result, people are left to their own devices, more at risk of unwise decisions.

As Surgeon-General in the ’80’s, C. Everett Koop cut against convention and championed anti-smoking and safe sex awareness.  The Associated Press says “Koop was the only surgeon general to become a household name”.

As you oversee implementation of the JOBS Act, I hope you adopt a page from Dr. Koop’s playbook and champion education and disclosure about valuation, for the reasons described above.   It would be a good way, I think, for an SEC Chairman to become a household name.

Respectfully,

Karl M Sjogren