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|
|2 Fundamental Risks||Failure||X||X|
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.
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.
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|
- 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:
- 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.
- 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|
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.
- Companies value themselves much higher when they sell stock to public investors than to private ones.
- 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.
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.
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
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.
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