Author Archives: Karl Sjogren

The Stanford Social Innovation Review publishes excerpts from The Fairshare Model

The mission of The Stanford Social Innovation Review is “Informing and inspiring leaders of social change.” As part of that effort it publishes excerpts for the top books on social innovation https://ssir.org/book_reviews.

And I’m pleased to report it decided to include The Fairshare Model with the heading “Reimagine Capitalism at the DNA Level.”

The Fairshare Model Performance-Based Capital Structure

The Fairshare Model a performance-based capital structure for companies that seek to raise venture capital via an initial public offering. The concept can be applied to an initial coin offering to raise equity capital. I call it the Fairshare Model because it balances and aligns the interests of investors and employees—capital and labor.

When a conventional capital structure is used, the issuer and investors must agree on a value for future performance when an equity investment is made. The Fairshare Model is unconventional because it places no value on its future performance when it has an IPO. Thus, a company that adopts it effectively presents IPO investors with zero valuation risk.

The Fairshare Model has two classes of stock. Both vote but only one can trade. To make it easy to distinguish them, I call the tradable stock “Investor Stock,” and the non-tradable one “Performance Stock.” In practice, Investor Stock will be the issuing company’s common stock, and its Performance Stock will be preferred stock or a separate class of common stock.

No alt text provided for this image
  • The tradable Investor Stock is issued to pre-IPO and IPO investors—employees get it too, for performance delivered as of the IPO.
  • For future performance, employees get the non-tradable Performance Stock.
  • Performance Stock converts to Investor Stock based on rules established by the pre-IPO shareholders and described in the company’s offering documents.
  • The criteria for conversions can be changed if the two classes agree.

A challenge for Fairshare Model issuers will be how to define performance, how to measure it, and how to allocate the benefits of it among employees.

There will be variation in how companies do these things, reflecting their industry, stage of development, and the personalities of decision-makers. 

With that qualification, here are five categories of performance that issuers might adopt:

  • Market capitalization—defined as the price of Investor Stock multiplied by the number of shares of Investor Stock outstanding. 
  • Developmental milestones such as release of a product or securing intellectual property.
  • Operational measures like customer acquisition and retention, or measures of quality.  
  • Financial measures like revenue or profit.
  • Measures of social good
  • The eventual acquisition price of the company, if applicable.

 There are two profound consequences for issuers that adopt the Fairshare Model:

  1. A company’s management has incentive to offer IPO investors a really low valuation. After all, if a rise in the market cap of the company is a performance measure, it makes sense to set the pre-money valuation very low—like a Black Friday sale (the day after Thanksgiving). So, in addition to the allure of the company’s business, investors will be drawn to the financial deal.
  2. A Fairshare Model issuer will have a competitive advantage when competing for human capital. In addition to a salary and benefits, it’s stock options will have more upside than those issued by a company that used a conventional capital structure to go public. More significantly, it will be able to offer something such companies cannot–an interest in it’s Performance Stock. A Fairshare Model issuer will say, “If we—as a team—meet the performance milestones, we share in the wealth our labor creates.” Someone’s share in the Performance Stock pool will be determined by the Performance Stock shareholders—when an employee is hired, or how aggressive a negotiator they are need not be a key factor in how they participate.

What is Venture Capital, really?

Venture capital investing is popularly construed to be the exclusive province of institutions and wealthy individuals who invest in private offerings. Some define it more granularly, as an investment by a VC fund, and call investments before that “seed capital.” I’ve seen references to “pre-seed capital,” which refers to capital provided before that.

The apparent reason for such distinctions may be the idea that an investment by a VC firm “legitimizes” a startup. I think it has more to do with valuation—until a “Big Dog” establishes one, no one really knows where to set it. The fact is that no one knows how to reliably set a valuation for a startup, but that’s a different matter. The question I focus on here is “Is venture capital raised in initial public offerings?”

Recently, I spoke at the Global Capital Summit put on by F50 at Stanford University, which focused on the changing nature of venture capital.

Speakers reported that companies were raising larger amounts of money at a given stage than before.

Also, that VC funds were increasingly investing after a company was generating revenue—so angel investors are providing a larger proportion of funding for startups that are at a pre-revenue stage.

These developments inspired observations like “pre-seed is the new seed” and “series A is the new series B.” No one said that investments made by angels wasn’t “venture capital,” but I’ve heard it suggested elsewhere.

One thing that hasn’t changed is the view—in Silicon Valley, on Wall Street, and elsewhere—that an IPO does not constitute another raise of venture capital. Indeed, an IPO is commonly seen as an “exit”—a way for pre-IPO investors to liquidate their position by selling shares in the secondary market to public investors.

To me, this traditional point of view is narrow. I define venture capital broadly—as an investment in a venture-stage company. A venture-stage company has these risk factors:

  • Market for its products/services is new or uncertain.
  • Unproven business model.
  • Uncertain timeline to profitable operations.
  • Negative cash flow from operations; which means it requires new money from investors to sustain itself.
  • It expects to continue to have negative cash flow from operations; its future depends on its ability to raise more money later.
  • Little or no sustainable competitive advantage.
  • Execution risk; the team may not build value for investors.
No alt text provided for this image

These characteristics sound familiar, don’t they?

That’s because they routinely appear as risk factors in IPO prospectuses.

A foundational concept for the Fairshare Model is that capital provided to a venture-stage company is venture capital regardless of its source; it doesn’t matter if it is supplied by wealthy or average investors. Ergo, it doesn’t matter whether the money is raised in a private or public offering.

Put another way, whether or not an investment is venture capital ought to be a question of “What”, not “Who.” That is, the question should be decided based on whether a company presents venture-stage risks, not by who invests.

The difference between these two views of venture capital is depicted below. 

One could argue that this diagram should include investors who invest in a venture-stage company in the secondary market. It doesn’t because they buy stock from existing shareholders, not from the company itself. To me, a venture capital investor provides capital directly to a venture-stage company.

The Big Idea behind the Fairshare Model is to adapt the ideas behind a modified conventional capital structure—the VC Model—to an IPO. [The three types of capital structures for equity are described in articles listed below.]

Without price protection, the financial returns posted by VC and private equity funds over past decades would not have been as impressive as they have been. By adapting the price protection concept to venture-stage IPOs, the Fairshare Model reduces valuation risk for public investors. That makes it more likely that they will make money when they invest in a company with high failure risk.

Making it more attractive for public investors to invest in companies with high failure risk is not as crazy as it sounds. Since the 1980’s, venture-stage companies have contributed more to economic growth and job creation than those who were in the Fortune 500.

A New Way to Structure Ownership in a Venture-Stage IPO—The Fairshare Model

Several startups will raise venture capital via a public offering this year. My new book presents a idea for how to structure an IPO for a startup—be it a highly-valued “unicorn,” a less-anticipated “horse,” or a new “pony.” It is called The Fairshare Model: A Performance-Based Capital Structure for a Venture-Stage Initial Public Offerings.

No alt text provided for this image

In a Fairshare Model IPO, there are two classes of stock—both vote but only can trade. IPO and pre-IPO investors get the tradable stock. Employees get too, for performance-delivered as of the IPO. For future performance, employees get a non-tradable stock that converts to the tradable stock based on milestones described in the company’s offering document. It protects IPO investors from overpaying for a stock.

Traditionally, IPOs use a “conventional capital structure,” while private offerings with valuation-savvy investors use a “modified conventional capital structure.” Both are conventional in the sense that each sets a value for company’s future performance when the stock is sold. The modifications are deal terms like price-ratchets and liquidation preferences that protect investors from overpaying for a position. Thus, such terms provide investors in a company that uses a modified conventional capital structure with “price protection.”

Price protection is a terrific idea—without it, venture capital and private equity funds would not be nearly as profitable as they have. The problem is that price protection is not provided to IPO investors.

The Fairshare Model changes that with an unconventional approach—it places no value on future performance when an IPO occurs. Rather than pay upfront for potential, investors pay for actual performance via dilution of their percentage ownership of the outstanding tradable stock.

Valuation risk is the risk that new investors overpay for a company’s future performance. The following chart illustrates how valuation risk varies based on the capital structure used.

No alt text provided for this image
  • Valuation risk is highest for investors with a conventional capital structure, the type routinely used in IPOs and in some private offerings.
  • It is considerably less with a modified conventional capital structure—which is why VC and private equity firms require one when they invest in a private offering.
  • Remarkably, valuation risk is near zero for IPO investors when the Fairshare Model is used.

To be clear, the Fairshare Model is just an idea at this point—companies will not use it for their IPOs until a critical mass of investors express interest in it.

The next five charts drill-down on these assertions about valuation risk. The first one presents four basic characteristics about how companies raise capital.

Capital structure grid

It indicates that:

  1. Investors provide two kinds of capital—debt or equity.

2. There are two ways for a company to raise capital—a private offering or a public one.

  • Note: only accredited—that is, wealthy—investors may invest in a private offering, but anyone may invest in a public one.

3. Companies that raise capital are either established, or venture-stage.

  • Established companies have an operational track-record and profitable.
  • Venture-stage companies are startups or companies in a turnaround situation—they are rarely profitable, and need infusions of fresh capital always hard to reliably value when an equity investment is made.

4. Deal structures either provide price protection or don’t.

The second chart shows how a conventional capital structure is positioned. On occasion, it is used to raise equity capital in a private offering—usually when the investors are unsophisticated. It is routinely used in public offerings, however. Also, it is used by both established and venture-stage companies and—significantly—it offers investors no price protection.

No alt text provided for this image

The third chart shows how a modified conventional capital structure is positioned. It is used to raise equity capital in a private offering for venture-stage companies using deal structures that provide price protection. I sometimes refer to it as the “VC Model” because VC funds use it when they invest in a company.

No alt text provided for this image

The fourth chart has the Fairshare Model—it is for raising equity capital in a public offering for venture-stage companies, using deal terms that provide price protection.

No alt text provided for this image

The fifth and final chart has the key point—the Fairshare Model applies the VC Model to an IPO.

No alt text provided for this image

Here are ways to defer valuation risk in an equity investment that do not deserve to be listed above:

  • Convertible note: When the investment is made, it is structured as debt, not equity. Should a promissory note convert to stock, it is structured in one of the forms above.
  • “Simple Agreement for Future Equity”: A SAFE is not listed because the investment is structured as debt or as a deposit—it is not equity.
  • “Keep It Simple Security”: A KISS is not listed above for the same reason a SAFE isn’t.
  • Digital token (ICO, STO, etc.): Tokens are not listed because they rarely convey an equity interest—they typically represent a contribution or a deposit. Also, they don’t provide a way to deal with valuation that isn’t addressed a conventional capital structure, a modified conventional capital structure, or the Fairshare Model.

The Fairshare Model Launches a Movement to Reimagine Capitalism

My new book launches a movement to reimagine capitalism at the DNA level, where ownership interests are defined. It’s called, The Fairshare Model: A Performance-Based Capital Structure for a Venture-Stage Initial Public Offerings.

The capital structure’s name reflects its goal: to balance and align the interests of investors and employees—capital and labor.

The Fairshare Model virtually eliminates valuation risk for IPO investors, making it more likely that they will profit when they invest in a company with high failure risk. It does that by taking a page from the playbook that venture capital and private equity investors use when they invest in a private offering.

They insist on deal terms that provide them with “price protection.” If a company’s performance is not as strong as expect, such terms effectively reduce their buy-in valuation, retroactively. Two ways this may happen are that the investor gets more shares for free, or receives a disproportionate share of proceeds when a liquidity event occurs.

It’s a sensible idea because no one knows how to reliably value a venture-stage company—often unprofitable, they have unproven business models, and rely on investors to survive. Such companies have high failure risk but deal terms can reduce their valuation risk.

Price protection makes it more likely that investors will profit when they invest in such a company and that, in turn, encourages them to invest in similar companies. Thus, price protection is critically important in an entrepreneurial economy.

There is a problem, however. While price protection is routinely provided in private offerings—the kind limited to wealthy or “accredited” investors—it virtually never happens in public offerings, the kind that anyone can invest in. That’s unfair because a dollar is worth a dollar, regardless of whether it comes from average or wealthy investors.

There is a derivative problem—public investors assume far more valuation risk than private ones, even when failure risk remains similar. That is, IPO investors don’t get a valuation safety net, and they buy-in at far higher valuations than pre-IPO investors do.

The Fairshare Model can change that because it places no value on future performance. It does that with a dual-class stock structure—both classes vote, but only one can trade. Investors—IPO and pre-IPO investors—get the tradable stock. Employees get it too, for performance delivered as of the IPO. But for future performance, which accounts for most the enterprise value, employees get the non-tradable stock—it converts into tradable stock based on performance milestones.

The journey that led me to author the book began in 1996, when I co-founded and led a company called Fairshare, Inc. Years before the term “crowdfunding” was coined, we sought make it easier for companies to market public offerings directly to investors, without a broker-dealer. To do that, we worked to build an online membership of people who had interest in learning about offerings from companies that:

  • Had a legal public offering
  • Passed a due diligence review
  • Adopted the Fairshare Model capital structure, and
  •  Allowed Fairshare members to invest as little as $100.

To attract members before we had offerings, we offered education on deal structures and valuation. We provided the ability to interact online and a vision for how to encourage companies to offer Fairshare members a better deal than they typically get. We underestimated the time and expense required to address regulatory concerns. Nonetheless, we attracted 16,000 members before calling it quits after the dotcom and telecom busts.

My thoughts about Fairshare laid dormant for about a decade, until I noticed how attitudes about innovation were changing and that entrepreneurship was becoming cool. Heck, colleges increasingly offered degrees in it! Plus, valuation was becoming a more frequent topic of discussion. Then too, the JOBS Act of 2012 authorized reforms to securities law such as:

  • Investment portals for accredited investors.
  • Funding platforms for average investors.
  •  A dramatic increase in the amount that could be raised in a public offering using an exemption from registration called Regulation A—it rose from $5 million to $50 million.
  • A new public offering exemption—Rule CF, for crowdfunding—to raise up to about $1 million.

Another factor fueled interest in financial service innovation—a movement now known as “fintech.” It was a loss of confidence in financial institutions and the regulators that oversee them. Whether that dissatisfaction was expressed as support for stricter regulation, or for new ways of doing business, the common denominator was dissatisfaction with The-Way-Things-Are.

In particular, with respect to capital markets, I saw ideas on how to innovate the distribution or sale of new stock (i.e., crowdfunding), but few on how to innovate how equity interests are structured for public investors. I concluded that:

  • The time was ripening for a Fairshare-like innovation,
  • I had a unique perspective on IPO deal structures, and
  • Others would emerge to help popularize and implement the core idea behind Fairshare—a deal structure that minimized valuation risk for IPO investors, the Fairshare Model.

I decided that a book was a good vehicle to popularize the concept of price protection for IPO investors because it could focus attention on the idea and avoid burdens associated with creating a platform to deliver it. That is, there would be others who would be interested in helping companies prepare for a Fairshare Model offering and facilitate the sale of their stock. What was needed was someone to popularize the idea itself with investors, entrepreneurs and others in the ecosystem of capital markets. 

An inspiration was Linus Torvald, who released the LINUX operating system kernel as public domain software in 1991. It led to an explosion of computer applications that could run on any hardware platform, including smart phones and cloud computing. By making the Fairshare Model an open-source idea, I could ensure that it took root.

Even though I can describe the Fairshare Model in a few paragraphs, the book is about 400 pages, and took five years to produce. In part, it’s because the subject matter—capital structures and valuation—is unfamiliar to most of my target readers, so there are many facets to cover and it has to presented in an accessible manner. [At the same time, many in my target audience have expertise in capital formation. It was a challenge to find a way to engage both kind of readers.]

The other reason it took so long to produce is that the implications of the Fairshare Model ripple into other areas. I felt the book would be more interesting if it explored valuation and ways investors lose money in venture-stage investments, as well as macroeconomic matters such as economic growth, income inequality and shared stakeholding. Throw in chapters on game theory and blockchain, and you have a long book. One that amounts to an easy-to-grasp graduate level course on finance, economics, and philosophy.

How might the Fairshare Model become more than an idea? Geoffrey A. Moore’s 1991 book, Crossing The Chasm, provides a framework that can visualize the answer. He uses a “technology adoption life cycle,” shown below, to explain how customer acceptance of a technology product evolves. The time scale begins at the left, when a product is introduced. The market expands in the growth phases until it reaches maturity, when the adoption rate declines.

No alt text provided for this image

The early market is comprised of “Innovators” who are enthusiasts for the technology and a larger group of “Early Adopters” who can imagine how they might benefit from it. The mainstream market has three different groups of customers. There is an “Early Majority” whose pragmatic concern—”What’s in it for me?”—must be addressed before they buy. Then, the “Late Majority” who is conservative when it comes to purchasing a new technology—they want evidence that it meets their needs. And, final group of customers will be the “Laggards,” who are generally skeptical about new solutions.

Moore says that there is a gap in the adoption cycle between the early market and the mainstream market. He called it “The Chasm,” and says that products that successfully cross it can go on to expand their market. Those that fail to do so are likened to a train that falls off a trestle bridge that spans the gap. The technology Adoption Life Cycle explains why some products grow from niche to mainstream markets, while others that do well with early customers fail to catch on with larger numbers of them.

The Fairshare Model has a chasm to cross before it is put into practice by companies. I call it a “Concept Gap.” To cross it, investors must signal that they like the Fairshare Model, and professionals in the capital formation and organizational matters must be prepared to advise companies on how to make it work. The Concept Gap is shown here—the time scale is subject to Hofstadter’s Law (i.e., cognitive scientist, Douglas Hofstadter).

No alt text provided for this image

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.

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

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.

………………………………………………………………………………………….…….

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