Tag Archives: Valuation

Making Sense of Valuations in the Pandemic

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

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

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

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

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

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

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

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

This table highlights some of the valuation dynamics.

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

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

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

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

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.

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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.

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  • 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.

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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.

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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.

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

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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.

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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).

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A Call to the SEC to Require Valuation Disclosure

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Maybe it is.  Maybe it’s isn’t.

How might investors evaluate the price?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Similar dynamics are possible in equity securities.

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

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

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

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

Post Script

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

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

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

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

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

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

a)      for which there is little constituent demand, and

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dear Chairman White,

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

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

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


Karl M Sjogren