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.

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.

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Some other implications of the Fairshare Model are below.

Marketing

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:

• Valuations in the Pandemic (#1)
• The Drivers of a Valuation (#2)

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.

Analytics

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.”]

Emotion

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.

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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.

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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.

• A 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.
• A 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.

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

• Valuations in the Pandemic (#1)
• Applying Complexity Theory to Valuation (#3)

“If you had invested in WeWork at a $47 billion valuation, you’re getting fleeced!”

So exclaimed congresswoman Alexandria Ocasio-Cortez (Dem.-NY) during an informative hearing of the U.S. House of Representatives Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets on September 11, 2019. Her comment was part of one of several interesting exchanges between lawmakers and a panel of experts, comprised of three academics, one securities regulator, and an attorney in private practice. [Viewable here.]

Wall Street on Parade reports that “The thrust of the hearing was the negative impact that the ballooning private equity market is having on the dramatically shrinking pool of publicly traded stocks and the good of society in general.” Renee Jones of Boston College testified that there are half as many public companies in the U.S. today as there was a decade ago, and the number of public offerings was less than in the past. And that last year, there was twice as much equity capital raised in the private offerings as in the public ones.

Explanations for this trend are largely speculative because there is little data available on private equity transactions. That said, the panelists believed regulatory changes caused the private equity market to swell in recent years.

For example, the number of shareholders a company may have before it is subject to the disclosure requirements for a public company is now 2,000—it used to be 500. Another reason is that revisions to Rule 144 made it easier for stock in a private company to be resold—this provides a degree of liquidity to a company’s employees and private investors, easing the pressure they exert to go public.

Reasons for fewer IPOs were also discussed. An abundance of private money is a key factor. Another is that companies feel that the emphasis in public markets on quarterly results, and the cost to comply with reporting requirements, do not benefit their business. For small companies, the cost of a Rule CF (crowdfunding) offering—which is limited to about $1 million—represents a significant proportion of the sought-after proceeds, and it must be paid before a company knows if it can sell its offering.

Valuation came up several times. The topic is of particular interest to me, as it’s the focus of my new book, The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.

Here, I’ll touch on an exchange in the hearing that highlights unfairness in the IPO market—private investors routinely secure “price protection” when they invest, but IPO investors never get it. Price protection describes deal terms that can retroactively reduce an investor’s buy-in valuation to deliver a higher rate of return.

Since public investors buy-in at a far higher valuation than their private counterparts, they get a double dose of valuation risk—they buy in at a higher valuation, and they don’t get a safety net.

Representative Ocasio-Cortez brought up the parent company of WeWork which reportedly was valued at $47 billion in January 2019, when a private round of financing took place. At the time of the hearing, its potential IPO valuation was in freefall, due to concerns about its business model, the potential for the founder/CEO Adam Neumann and his spouse to control the company, and evidence that he had engaged in self-dealing transactions.

Ocasio-Cortez waved a news article about WeWork and said it “had raised money on a previous valuation of $47 billion. And now they just decided overnight—’just kidding, we’re worth $20 billion.’ They’ve cut it by over half. Correct?”

Subsequent events soon indicated that the congresswoman was even more right than she imagined!

Days after the hearing, WeWork reportedly eyed an even lower IPO valuation—$10 billion, a fifth of what it had been just months earlier! Shortly thereafter, the company announced that it would postpone it altogether. The following week, it announced that Neumann would no longer be its CEO.

Those evaluating its business model sensed higher-than-expected failure risk—reason to doubt the company would achieve the performance that it promised. Then too, investors were being asked to buy in at a very high valuation, so WeWork presented high valuation risk.

Other companies have gone public using the type of super-voting shares for founders that WeWork had, but other aspects of its governance provided another reason for investors to pass. As cracks in its “valuation dam” appeared, they grew and the apparent value poured out.

WeWork’s governance concerns will be addressed but it will be harder to re-engineer the business model before it refiles for an IPO. And it almost certainly will try again because:

1. WeWork is a venture-stage company—it requires fresh infusions of capital to survive.
2. The January financing was its eighth private round—it will be tough to attract many more.
3. The public market offers the best prospect for an attractive exit for private shareholders.

However, the big story here shouldn’t be WeWorks per se for it merely illustrates a bigger problem with capital markets—market forces are not strong enough to benefit average investors.

For instance, unlike many areas of commerce, companies don’t compete for investors by offering lower valuations and/or better deal terms. I explain that in a 2017 article called The Case for a Valuation Disclosure Requirement. In this article, my message is that public investors routinely get a lousy deal when they invest in a public startup.

To wit, all venture-stage investors—private and public—assume two basic risks; failure risk, and valuation risk. (Fraud is not a unique form of risk, it is simply failure risk and valuation risk, garnished with false and/or misleading disclosure.)

Failure risk is that a company will not achieve the operational goals that investors anticipate. Due diligence can help investors assess it and the valuation, but failure risk is omnipresent. Private investors in the failed unicorn, Theranos, conducted notably poor due diligence. They did not discover that the company’s technology was grossly unable to perform as the founder/CEO claimed, thus they also badly misjudged its valuation.

Valuation risk is the risk of overpaying for a position, and one can overpay for a company that has no failure risk. The fundamental problem is that it is difficult to perform due diligence on the valuation of a venture-stage company. In part, it’s because it is hard to get valuation data on comparable private companies. But the most significant reason is that no one—no one—knows how to reliably value a venture-stage company. That’s because such an endeavor relies on projections that are often wrong.

For that reason, sophisticated private investors rely more on getting the right deal terms, than on getting the right valuation. Such deal terms provide price protection, often is ways that are unclear to entrepreneurs who are happy about the apparent valuation they got.

CNBC reports that investors in WeWork’s January financing will benefit from a deal term known as a price ratchet, which “could give them $400 million worth of additional shares (for free) in the event of a weak IPO performance. This is expected to be the biggest of that type of protection in history if and when the start-up goes public.”  

Put another way, WeWorks’ January investors were satisfied with its business model, untroubled by corporate governance issues, and willing to accept a unicorn valuation of $47 billion because they believed that public investors would soon accept an even higher valuation so long as they received price protection.

Price protection is a great idea. It can ensure that investors make money even when they fail to accurately assess failure risk.

Sophisticated private investors routinely get price protection and it ought to be provided to IPO investors too. The Fairshare Model shows how it could happen. It adapts the VC investment model—which limits valuation risk—to the IPO market.

The Fairshare Model has two classes of stock—both vote but only one is tradable.

• IPO and pre-IPO investors get the tradable stock. Employees get the tradable stock too, for actual performance as of the IPO.
• For future performance, employees get the non-tradable stock; it converts to the tradable stock based on milestones. The milestones can be whatever the two classes agree to, even measures of social good.

The Fairshare Model encourages investors to invest in startups, a category of enterprise that has proven to be an engine of economic growth and job creation. It also provides a path to ameliorate income inequality that does not depend on taxes because the beneficiaries of any rise in the issuer’s market value includes average people—non-accredited investors and employees.

Wall Street on Parade closed its reporting by saying “U.S. markets once commanded the respect and trust of the world. Today, U.S. markets are simply a well-orchestrated wealth transfer mechanism for the one percent.”                               

Arguably, that will continue to be the case until venture-stage IPOs come with price protection.

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

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

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

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

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

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

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

The 2:3 Paradigm

I call this framework the 2:3 Paradigm.

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

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

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

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

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

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

Analytics Path

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

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

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

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

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

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

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

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

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

Cohort Path

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

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

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

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

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

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

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

Structure Path

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

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

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

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

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

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

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

Apply the 2:3 Paradigm to Valuation Risk

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

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

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

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

Explanation:

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

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

There are two key points here:

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

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

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

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

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

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

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

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

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

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

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

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

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

The Problem with Public Venture Capital

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

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

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

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

Valuation Risk Reduction for Public Investors

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

Valuation Disclosure

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

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

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

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

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

Fairshare Model

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

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

Happiness = What’s Happening – Expectations

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

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

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

Expectations

Let’s consider the second variable first.

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

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

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

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

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

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

What’s Happening

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

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

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

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

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

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

If Not Protectionism, What?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Pre-Order Bonus

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

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