Monthly Archives: June 2020

Applying Complexity Theory to Valuation

The last of three articles on corporate valuations and capital structures.

“What’s a simple definition of complexity theory?” I asked that of someone involved in the study of it. He replied, “It’s the study of how simple changes affect complex systems.”

People often feel powerless to affect complex systems. But such systems are dynamic; they change if sufficient pressure is applied to key points. Once you allow for the possibility of change, its intriguing to consider the possible effect of simple ones.

Capitalism is a complex system. A key part of it, capital formation, involves setting a price—a value— for a company when it sells new stock. Investors also do it when they trade existing shares.

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Capital formation and valuation are subjects that I have studied for years. My 2019 book is The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.

Its tagline is “Reimagining Capitalism at the DNA Level.” That’s because a capital structure is a company’s DNA.

It defines ownership interests and voting rights—so everything that capitalism is (or can be) flows from the expression of qualities that originates in a capital structure.

The Fairshare Model is an idea for a performance-based capital structure for companies that raise venture capital via an initial public offering. Its mission is to balance and align the interests of investors and employees; to offer public investors a deal comparable to what venture capitalists get.

It has two classes of stock. Both vote but only one can trade. Investors get the tradable stock, which I call “Investor Stock”—common stock. For pre-IPO performance, employees get it too. For post-IPO performance, employees get the non-tradable stock, which I call “Performance Stock”—a preferred stock. Based on milestones, Performance Stock converts into Investor Stock.

The structure is simple—its complexity flows from a question that is both philosophical and practical: “What is performance?”

Shareholders can answer that anyway they wish, and there will be variation based on a company’s industry, stage of development, and the personalities involved. Likely measures include:

  • A rise in the company’s value, measured by the price of its Investor Stock.
  • Development goals, such as release of products.
  • Financial measures like revenue and/or profit.
  • The eventual acquisition price, if applicable.
  • Measures of social good, if relevant.

The idea behind the Fairshare Model is simultaneously radical and ordinary.

It is radical because it presents a different philosophy about how to structure ownership interests in public companies whose value chiefly comes from their uncertain promise of future performance. Such companies have raised venture capital for decades via Wall Street IPOs. Another unique aspect of the Fairshare Model is that it presents a way for average investors to participate in venture capital investing on terms comparable to what venture capitalists get.

The Fairshare Model is ordinary because it encourages the public capital markets to work the way most markets work, where sellers compete for buyers by offering a better deal (i.e., lower prices and better terms). Remarkably, this isn’t common with a conventional capital structure; companies don’t compete for public investors by offering lower valuations and better protections.

This reflects weak market forces. IPO issuers and Wall Street banks do not want to compete on deal terms, valuation, and investor protections. In addition, many public investors are unsure what a valuation is, let alone how to calculate or evaluate one.

Oftentimes, “market forces” is a phrase used to explain adverse developments for the middle class, but they can bring better deals to average investors. One way to reimagine capitalism is with stronger market forces that result in a better product and increased competition for public capital. The Fairshare Model promotes this in a win-win manner—with significant benefits for investors and employees.

So, how does one go about changing the DNA of capitalism? By popularizing a new philosophy about the relationship between companies and their IPO investors. The key idea? Treat public venture capital like private venture capital. That is, provide IPO investors price protection, comparable to what venture capital firms get in a private offering. Then reward well-performing entrepreneurial teams with more ownership than they would get if the financing were from a VC firm.

Below, I speculate on the impact the Fairshare Model will have on companies that adopt it. The first two are profound.

Incentive to Offer a Low IPO Valuation

A measure of performance is certain to be a rise in the market value of the company—measured by multiplying the shares of Investor Stock outstanding by the share price. Companies will have incentive to offer IPO investors a low pre-money valuation because doing so makes it likely that Performance Stock will convert to Investor Stock.

To illustrate, assume a company has raised $5 million in private capital and wants to raise $20 million more. Rather than raise it from a VC, it decides to it via an IPO. Comparable companies are valued at $100 million, so you’d expect it to be priced at a $100 million pre-money valuation and have a post-money valuation of $120 million immediately after the $20 million IPO.

With the Fairshare Model, the company might decide to raise the $20 million at a pre-money valuation of $10 million, giving it a $30 million post-money valuation when the IPO closes. The bet will be that secondary market investors will bid up the stock to a $130 million valuation. As that happens, Performance Stock will convert to Investor Stock. That will dilute the ownership of investors, but they will not care because the value of their stock is up!

VCs often say, “I’d rather own a small slice of a big pie than a large slice of a small pie.” It’s the same idea.

Attracting and Motivating Human Capital

Companies that use the Fairshare Model to structure their IPO will have a powerful tool to motivate employees. Like one with a conventional capital structure, they can offer salaries, benefits, and options on its tradable stock.

They can also offer something such a company cannot—an interest in its Performance Stock. It will have value if all the employees deliver the results that trigger conversions. This promotes esprit de corp—a sense of common purpose—among employees.


Some other implications of the Fairshare Model are below.


All companies can encourage customer loyalty by allowing them to buy their IPO shares, but they are more likely to profit—hence be more loyal—when the Fairshare Model is used.

Employee Compensation

Executives—indeed, all employees—will have incentive to limit demands for compensation if profitability is a performance measure. Doing so makes it more likely that Performance Stock will convert.

Employee Stock Options

Performance Stock provides a direct link between work and reward.

On the other hand, stock options create an indirect link. There are two reasons for this. One is that vesting—the right to exercise an option to buy the underlying stock—is typically tied to the passage of time, not the achievement of specific goals.

The other reason is that the reward is tied to stock price appreciation. That is, the reward is only a true reward if the stock is higher after the option vests than it was when the option was granted. If the stock price is at or below the exercise price (usually, the market price when the option was granted), there is no reward —the stock can be purchased on the market for the exercise price or less. 

When a company is private, this suffices because valuations tend to be higher in the public market than in the private one. Once a stock is pubic, however, the prospect for appreciation diminishes because valuations in the public are higher—sometimes excessively so.

Here’s the rub—the more enthusiastic public investors are, the less likely it is that employees will be motivated by new options. Indeed, they may feel it will take an act of God to keep the stock as high as it is, let alone increase it. It’s ironic that options are less of a motivator when a company is public because that’s when number of people invested in its success is highest.

That said, options should be a better motivator when a company uses the Fairshare Model because the value of future performance will not be fully baked into the price of its Investor Stock.

Short Selling

Valuing future performance leads to a peculiar game in the public market—short selling. It’s a way to profit when stock falls in price.

An investor who buys a stock takes a “long position,” and money is made if it rises in value. Such an investor takes a positive, long-term perspective, even when the stock is held briefly. The opposite of a long position is a short one; “selling short” is the opposite of “buying long.” So, an investor can profit from thinking positively (long) or negatively (short) about a stock’s prospects.

This sets up a contrast. With a conventional capital structure, the IPO price places a value on future performance and investors in the secondary market speculate on that value. With the Fairshare Model, the IPO price places no value on future performance. Investors in the secondary market can (and will) place one on it, however.

Short selling is fueled by negative energy. It’s a bane of existence for public companies but has a corrective market effect. Venture-stage companies are more vulnerable to it because their future performance is difficult to assess, and often unsteady. That’s why their price is so volatile. Negative energy has its place. But, isn’t it be better for the economy to have positive energy for companies as they struggle?

However you answer, companies that use the Fairshare Model may be less vulnerable to short selling. Why?

  • The value placed by secondary investors on future performance is unlikely to be enough to attract short sellers to begin with.
  • A short selling strategy will be more complex. If performance is delivered, Performance Stock conversions will be disclosed before they are effective. So the market will have time to assess whether the performance makes the company more valuable or just dilutes the Investor Stock. If it’s the former, the stock will rise. If it’s the latter, the price may drop too quickly for a profitable short sale.
  • The Fairshare Model will attract supportive investors who have a long-term perspective—they may buy Investor Stock if it slips in price.

In sum, the Fairshare Model can make it less likely that a short position will pay off, discouraging attention from “the Shorts.”

Stock Buybacks

A stock buyback is the repurchase by a company of its shares trading in the secondary market—it buys stock from shareholders willing to sell. Companies conduct them when they have more cash on hand than they can profitably deploy in their business and it feel that a reduction in the shares outstanding provides more value to shareholders. The idea? If the company has fewer shares, the remaining ones will rise in price—same demand, less supply.

Buybacks provide three potential benefits for executives:

  1.  Insiders can get a better price for their stock by selling into the buyback.
  2. The value of their stock will rise because fewer shares outstanding will increase earnings per share, a metric that drives stock prices.
  3. The resultant higher EPS can trigger bonuses and incentive pay.

A Fairshare Model issuer will be less likely to engage in stock buybacks because:

  • Few will think that it has too many tradable shares—it will have fewer than with a conventional capital structure. (There will be enough shares of non-tradable Performance Stock to reward several years of performance.)
  • Secondary market investors are unlikely to bid up the Investor Stock if it will cause Performance Stock conversions.
  • The Investor Stock class is unlikely to support a buyback that results in Performance Stock conversions.
  • If a buyback will not encourage Performance Stock conversions, management is unlikely to pursue one—they will view it as a stupid use of cash. A dividend will make more sense, especially if it triggers conversion of Performance Stock.

The Fairshare Model proposes a simple change to how capitalism operates. Its implications go beyond those mentioned above, and the book explores a number of them. It also encourages readers to help launch this movement to reimagine capitalism.

This is the last of three related articles on valuation and capital structures. The prior two in the series are:

The Drivers of Valuation

The second of three articles on corporate valuations and capital structures.

Stock analysts say that expectations for future performance define a company’s valuation, and if the market seems disconnected from the state of the economy, it’s because investors are looking ahead. This suggests broadly shared clairvoyance among investors, something that eludes business and public policy leaders.

This concept equation offers another way to understand what drives a valuation. [Note: a valuation is the price to buy a company, based on the price for a fraction or share of it.]

Valuation = Analytics + Emotion + Deal Terms

It states that a valuation reflects analytics, emotion, and deal terms. These variables manifest themselves differently in the public and private capital markets.


Investors vary in the quantity and quality of insight that informs their perspective on a stock. There are smart and not-so-smart investors in both markets but, on balance, they tend to be smarter in the private one.

A stock’s price is thought to reflect expectations for the income—dividends or capital gains— it will produce, discounted for the time value of money. Thus, the stock of a company facing difficulties might hold up if it is expected to rebound. A bad quarter will be excused if the next few should meet prior expectations. If that next quarter disappoints too, but those that follow are expected to be on track, the stock should be stable. Put another way, investors focus on what’s in the headlights, not in the rear-view mirror.

Some companies will thrive in this latest incarnation of the New Economy while others will be unaffected by the changes. For the rest, I question whether the optimism implied in the stock market makes sense, for three reasons.

1.      If a company is adversely affected by the pandemic, it will take time to recover. Minimally, that means diminished projections for several quarters (i.e., lower earnings in the headlights).

2.      Business models that were already in doubt are being painted with a fresh coat of it.

3.      Expectations that were reasonable months ago are less so now. Assumptions about customer behavior and supply chains are less certain, for instance.

All three reasons suggest public company valuations should be lower than they are. So perhaps another one is at play—analytic thinking that anticipates investors fueled by relief and optimism as economies are reopened. A Wall Street saying captures this approach—“Buy on the rumor, sell on the news.” [A NYT article published after this one is called “Trading Sportsbooks for Brokerages, Bored Bettors Wager on Stocks.”]


Lava lamps evoke the effect of emotion on markets. The opaque fluid—the lava—represents emotion, which rises as it is heated and falls as it cools; it’s life-like energy is beguiling. Imagine two such lamps, one with more lava than the other. The one with more is the public market, and the other is the private one. That is, while emotion affects both markets, its more evident in the public one because private investors are more valuation-aware, and they get deal terms that provide “price protection.”

Deal Terms

Deal terms are rights granted by a company to its investors. Some address governance matters—voting rights—but the ones relevant here limit valuation risk. That is, they can protect an investor from overpaying for a position.

Private investors routinely secure such deal terms. It’s hugely important for them—they would be far less successful if they had to rely on getting a valuation right when they invest. Tellingly, VCs tell entrepreneurs—“I’ll give you the valuation you want, if you give me the terms I want.” 

[Guess what? NO ONE can reliably value a venture-stage company.]

A popular deal term is known as a price ratchet. It entitles an investor to additional shares at no cost if a subsequent investor gets the stock for a price that is insufficiently higher. The free shares lower the average price and increases the ownership of the protected investor.

Another deal term is a liquidation preference. It orders how the proceeds from a liquidation event—like the company being acquired—are divvied up. Think of how animals decide who eats a kill first, second, and so on—it’s the same idea. An investor with a 1X liquidation preference receives its investment back before sharing what remains with other shareholders. One with a 5X preference receives five times it’s investment before sharing.

Many deal terms are used in the private market can effectively modify a valuation.

Public investors, however, don’t get price protection. It’s ironic, given that they invest in venture-stage companies at far higher valuations. That said, an ephemeral form of price protection exists for those who get shares in a hot IPO. It’s based on investment banking practices, not deal terms. Bankers decide the price and who gets the new shares. For them, a successful IPO raises the sought-after capital at a discount of 15 to 20 percent to what the shares sell at in the secondary market. That price pop attracts investors, many of whom flip their shares. It also promotes interest in other offerings the broker-dealer has.


In sum, valuations work differently in the private and public markets.

In the private one, they are set infrequently by valuation-savvy investors who use analytics and emotion to assess worth but rely on deal terms to protect themselves from buying in at a price that is too high. Such an investor may wind up with a larger stake, which comes out of the position of employees and investors in a weaker position.

Public market valuations are set daily, and investors who are not valuation savvy help set them. That suggests weaker analytical ability and more emotion than found in the private market. Strikingly, public investors don’t get deal terms that mitigate valuation risk.

Why don’t public investors get deal terms that reduce valuation risk? They don’t demand them! Also, because the capital structure used for IPOs doesn’t enable special deal terms. It’s possible with a different one, however.


A capital structure defines ownership interests in a corporation. There are three types—a conventional one, a modified conventional structure, and the Fairshare Model. The first two are common. The third is an idea described in my 2019 book, The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.

  • conventional capital structure has a single class of stock. In one, all shareholders are treated alike, which means no special terms. Like in Alexander Dumas’ novel The Three Musketeers, its “All for one and one for all”—all shareholders get the same deal. This type is used by public companies and private ones with non-professional investors. It’s “conventional” with respect to when a valuation for future performance is set—it happens when an equity investment is made. To illustrate, if you buy half of my new company for $1, we agree that my future performance is worth $1. Thus, the company’s pre-money valuation is $1. After you put in your money, its post-money valuation is $2. These terms are explained in this video I created years before the publication of The Fairshare Model, so the information about the book is out of date.
  • modified conventional capital structure has multiple classes of stock. Its “conventional” because a value for future performance is set when an equity investment is made. It’s “modified” because it allows a company to treat some shareholders different from others, by providing deal terms that can reset the upfront valuation. It evokes George Orwell’s Animal Farm, in which “All animals are equal, but some animals are more equal than others.” Again, VC and private equity investors require a modified conventional capital structure because one is necessary to secure deal terms they demand. Public companies occasionally have multiple classes of stock for governance reasons (i.e., super-voting shares for some shareholders), but not to reduce valuation risk.
  • The Fairshare Model is unconventional. It places no value on future performance when equity capital is raised—instead it defines how to reward actual performance. It’s also novel—no company has used it yet. The Fairshare Model uses multiple classes of stock to accomplish two goals. It limits valuation risk for IPO investors. It also balances and align the interests of investors and employees—capital and labor. There are two classes of stock—both vote but only one is tradable. IPO and pre-IPO investors get the tradable stock—employees get it too, for pre-IPO performance. It’s common stock, but for simplicity, I refer to it as “Investor Stock.” Employees get the non-tradable stock for future performance—a preferred stock I call “Performance Stock.” The Performance Stock converts to Investor Stock based on milestones described in the company’s offering document, or that both classes subsequently agree on. With this structure, public investors are more likely to profit when they invest in a company with high failure risk, because they have less valuation risk. And a well-performing team can end up with more of the wealth they create than VCs would allow.

To consider the significance that reduced valuation risk can have on capital markets, perform these two thought experiments.

  1. Ask yourself “How might the private capital market change if VC and private equity funds could only use a conventional capital structure?” [Without deal terms to reduce valuation risk, their success would depend on having superior analytics, and not being overly swayed by emotion. I believe this would cause investing activity to dramatically shrink because private investors would be exposed to a full dose of valuation risk.]
  2. Now ask, “How might the public capital market change if companies used the Fairshare Model when they go public?” [Public investors would be more likely to profit when they invest in a venture-stage company, and there would be better alignment between investors and employees. As a result, venture investing would grow, and the economy be more vibrant. That’s because these types of companies are the engine of economic growth and job creation, not the Fortune 500.]

In closing, the Fairshare Model provides a framework to structure IPOs so that more average people benefit—public investors get price protection, and employees have the opportunity to earn more of the wealth they create. Thus, it can help address the epic economic challenge of the 21st Century—to distribute the benefits of capitalism more fairly and broadly.

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 This is the second of three related articles. The other two in the series are:

Making Sense of Valuations in the Pandemic

With the pandemic induced havoc, how is that the stock market is not down more? And what effect will the economic downturn have on the valuation of startups?

In mid-April, when the Dow Industrials index was around 24,000, a friend with a predictive model for public stocks told me the market had priced-in the forthcoming bad economic news. He did not expect to see the Dow back at the 18,600 level it had hit a few weeks earlier. I had a hard time believing that, but the market hasn’t validated my sense. It has remained stable as other economic indicators have worsened.

I’m not good at predicting the market—highs are higher than I think they should be, and lows are not as low as I believe they ought to be. Many people share my puzzlement.

This is the first in a trio of articles about expectations, and how uncertainty affects valuations in differently the public and private capital markets.

Classic thinking is that stock prices for established companies reflect actual performance, and that history suggests future performance. Of course, expectations that have no historic basis influence valuations too. Companies go public before they have revenue, let alone profit.

Expectations that affect valuations are being upended. Business models that were stressed before Covid-19 face potential collapse, while new ones are being viewed more soberly. For private companies with venture capital investors, an eventual exit—via IPO or acquisition—may appear more distant, and less valuable. This will cloud valuations for VC-backed private companies in the forthcoming quarters when they need to raise additional capital.

Dichotomies in valuations have always existed between the public and private markets, but current conditions may lead more people to wonder about them. Here are some thoughts that may reconcile Wall Street measures of health with reports of economic blood on Main Street.

  • With interest rates so low (even negative), investors lack an appealing alternative to stocks. Absent new fear-provoking developments, investors have weak incentive to move money out of the market.
  • The companies in the Dow lead their industries—they are likely to remain strong.
  • Public companies have better access to capital than private ones, which enables them to be prepared when the economy opens up. Closely held small businesses lack such access, and many are suffering greatly.
  • Public investors are less valuation-aware than those in the private market. Tesla, for example, has had a higher valuation than General Motors and Ford, even though both dwarf Tesla in terms of vehicles produced, assets, revenue, and income. Another example is that the stock of companies often climbs after they file for bankruptcy, even though shareholders may be wiped out.
  • Emotion has more impact on valuation in the public companies than private ones. Thus, rumors of a possible Covid-19 treatment or vaccine can ignite enthusiasm for public stocks. Emotion affects private capital too, but those investors demand deal terms that protect them from overpaying (more on this in the next article).
  • A public company’s valuation is set daily. For a private one, it is set infrequently—when they raise equity capital. Many startups will need money in the next few quarters and a number of them have laid off employees and taken other measures to preserve cash. For those with weak performance or questionable business models, there is the prospect of a down round—a lower valuation—which will squeeze the ownership position of other shareholders and employees.

This table highlights some of the valuation dynamics.

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The high-level point I leave you with is that valuation is a tale of two cities—two markets, in this case.

One is set frequently in the public one, with participation of investors who think in terms of share price. But a valuation is more than that, it is the product of the share price and shares outstanding.

In the private capital market, a valuation is set infrequently by valuation-aware investors who insist deal terms that provide price protection.

This is the first of three articles that discuss corporate valuations and capital structures. The other two articles in the series are: