Fairshare ModelA performance-based capital structure for companies that raise venture capital via a public offering

Karl M Sjogren (book expected in early 2015)

NATIONAL ASSOCIATION FOR BUSINESS ECONOMICS

SILICON VALLEY CHAPTER

OCTOBER 14, 2014

Hofstadter's Law

It always takes longer than you expect, even when

you take into account Hofstadter's Law.

Target audience for the book• Thinkers. People who:

• Have expertise in capital structures

• With potential interest in investing in, or working for, an emerging growth company (start-up).

• Want practical insight into how to spur economic growth and job creation.

• Are open to new perspective on how to reduce income inequality.

• Are open to a fresh sense of how capitalism could work, if only market forces are brought to bear in capital markets.

• The horns of my dilemma--write for experts (small #) or novices (big #)? How to do both?

• I want to enhance your ability to contribute thought-provoking ideas with those who consider themselves informed about micro & macro economics. • Squirm questions: “What was the valuation of the company?” and “Why does that make sense?”

Think of a Capital Structure as ArtLook at it from different angles.

• How is it constructed?

• Are voting rights concentrated by class?

• Stock-based compensation: concentrated or broad participation?

• Who benefits from unusual features?

• Do deal attributes fit the company’s stage of development?

• Valuation; what does it say about how the company views investors?

• Is it earned based on performance or the passage of time?

Vision, Goals and PerspectiveVision

Middle Class investors will be able to make venture capital investments…

…. on terms comparable to those that professional investors get

Goals1. Expand entrepreneur access to capital.2. Offer liquidity to wealthy angel investors who support private companies.3. Create an attractive option for middle class investors to be “mini angel” investors

Perspective Public investor-centric (vs entrepreneur-centric or private investor-centric)Robust appreciation for everyone who participates in the entrepreneurial processGame-theory: Pareto-optimality vs Zero-Sum

The Fairshare Model Begins Here

ENTREPRENEUR: I have an idea but need money

INVESTOR:How much of your company do I

get if I give you the money?

Target Companies for Fairshare ModelCompanies that have raised a round or two of funding from angel investors

Need $5M+ in venture capital.

The Fairshare Model is an alternative to a round from a venture capital fund.

◦ There is no limit on the amount that can be raised.

It is designed to raise public capital for a venture-stage company.

What is a “Venture-Stage” Company?A company with these risk factors:

• Market for its products/services is new/uncertain

• Unproven business model

• Uncertain timeline to profitable operations

• Negative cash flow from operations

• In other words, it requires investor cash to operate

• Little or no sustainable competitive advantage

• Execution risk; team may not build value for investors

Many public companies list such risk factors in their disclosure documents

Fairshare Model

• Two classes of stock, Investor Stock and Performance Stock.

• Both vote, only Investor Stock can trade (registered with SEC).

• Performance Stock can never trade.

• Based on performance, Performance Stock converts to Investor Stock.

Approval from each class of stock for:• Board member election • Change to conversion criteria.• Compensation plans involving Investor Stk.• Changes to capital structure.• Acquisition matters.

Premise: IDEAS ARE JUST A MULTIPLIER OF EXECUTION

Value of an Idea Value of Execution

Awful Idea = -1 No Execution = $1

Weak Idea = 1 Weak Execution = $1,000

So-So Idea = 5 So-So Execution = $10,000

Good Idea = 10 Good Execution = $100,000

Great Idea = 15 Great Execution = $1,000,000

Brilliant Idea = 20 Brilliant Execution = $10,000,000

To make a business, you need to multiply the two.

The most brilliant idea, with no execution, is worth $20.

The most brilliant idea takes great execution to be worth $20,000,000.

Tip of the hat to:Derek Sivers www.sivers.org

But, that doesn’t seem to explain the valuation of venture-stage companies

When a conventional capital structure is used, what drives the increase in valuation that often occurs as a company approaches its IPO?

Is it performance……. or is it something else?

For public investors, what risks does the IPO valuation present?

What is a “conventional cap structure?”John Kenneth Galbraith coined “conventional wisdom.”

It is often promulgated by experts and media pundits.

There is conventional wisdom about how to organize (and value) the ownership interests in a corporation.

I refer to it as a “conventional capital structure” or “conventional model.” And, the terms of the sale of stock using such a structure as a “conventional deal.”

Two characteristics of a conventional cap structure: 1. A value for future performance must be set when a company issues new stock, and2. If there is complexity, its purpose is to favor pre-IPO shareholders (over public shareholders).

He uses it to describe a convenient and comfortable point of view that is often false.

Conventional Model Fairshare Model

What are the Problems of a Conventional Capital Structure?

Fundamental problem--valuationAchilles’ heel: At the time of an equity financing, it requires the issuer and investors to set a value for future performance.

For venture stage companies, this is hard to do in a rational manner.

The need to value undelivered performance is the fundamental problem of a conventional capital structure.

Key difference between a conventional model and the Fairshare Model; How they deal with uncertainty

In equity finance, uncertainty can’t be eliminated, it can be moved

VCs Side-Step the Valuation ProblemVCs sidestep the valuation problem by securing “anti-dilution provisions”

Price protection (a valuation cushion)

If later investors buy in at a higher valuation, all is well.

If the valuation doesn’t rise enough, investors with price protection get additional shares for the money they initially put in (i.e. their buy-in valuation is retroactively reduced).

Risk of overpaying for future performance

You may ask yourself… “What explains this valuation discrepancy?”

Is it performance? Lower risk?

More buyers competing for shares?

Less savvy buyers?

An IPO is not a controlled experiment on value; it does not compare what wealthy pre-IPO investors feel the company is worth to what wealthy public investors feel it is worth.

A new, active ingredient is in the mix; investors who have been unable to invest earlier.

They effervesce the valuation because:1. They are generally valuation unaware2. They are enthusiastic

Price inelasticity

Two Explanations for Valuation Discrepancy1. The Next Guy Theory of Valuation

2. Market Forces

Next Guy Theory of PricingFor an investment, the price is no more than what the buyer believes the Next Guy will pay, less a discount.

Implication

What you pay to play…

Depends on….

who you are

Market ForcesNext Guy Theory applies to items that have utility (food, clothing, etc.) and to those without utility (investments).

For items with utility, a wholesale/retail price difference exists.

Apply the concept it to capital formation• “Product” = equity in a venture-stage company

• “Manufacturer” = issuer

• “Wholesale customers” = pre-IPO investors

• “Retail customers” = public investors

Comparable product, different pricing? No, the products are not comparable, they have important differences.

The product that is sold at wholesale to pre-IPO investors, the institutional ones at least, is much better than the retail version. • The stock that VCs get have price protection and other features.

The product sold to public investors lacks such features.

So, the retail buyer gets an inferior product and pays more for it!

Can you think of another market—a competitive market—where that happens?

“What explains the valuation increase in the product as company approaches an IPO?”

Four hypothetical drivers

1. It is considered “normal”- But, many things that were once considered normal are no longer

The Next Guy Theory provides insight into the dynamics, but what are the drivers?

2. A bigger neighborhood- More Potential Buyers = Higher Potential Demand = Higher Potential Price

3. Competitive market forces are weak- If strong, issuers would compete for investors by offering lower valuations

4. VC value-add (knowledge, connections, ability to write a big check quickly)

- Challenge for companies that crowdfund – “How to replicate VC value-add?”

- How much is the VC value-add worth to public investors?

When sellers compete for buyersBuyers get better deals

• Food and over the counter drugs: generic or private label vs. branded

• Books: Amazon vs. book stores

• Real Estate: web-listings vs. the Multi-Listing System limited to broker-dealers

• Clothing: designer knock-offs vs. designer labels

• Stores: Factory outlet vs. department stores, or, warehouse (Costco) vs. traditional retail

Can a similar dynamic be applied to stock in venture-stage companies? Lower valuations, better investor protections?

Yes, if the SEC requires all issuers of equity securities to disclose their valuation and how they rationalize it. This information would strengthen market forces lead to Better Capitalism.

Problem of a conventional cap structure for Public Investors

1. The basis for a high valuation is shaky.

2. They assume most of the risk that it is too high.

Interlaced foundations of the problem

• Public investors pay “retail” but don’t know it.

• They are not offered a better deal because sellers see no advantage to offering one (buyer: “what’s valuation?”).

• Don’t demand a better deal because they are not valuation savvy.

• Not valuation savvy because the SEC doesn’t require valuation disclosure.

The Fairshare Model bargain for investorsIf the company performs, investors will be diluted on a percentage basis—their slice of the ownership pie will be reduced.

On an economic basis, however, if the performance translates into a higher valuation, investors should not suffer dilution.

VCs like to say “I’d rather own a small slice of a big pie than a large slice of a small pie”.

Same principle.

The Fairshare Model bargain for employees In addition to the typical forms of compensation--salary, benefits, bonuses and stock options on its Investor Stock-- employees have an interest in its Performance Stock pool.

• Performance Stock is priced like founder’s stock; its only value is its ability to vote and its potential to convert into Investor Stock.

As the team performs well enough to meet the conversion criteria, employees have another way to earn stock that they can sell (or hold).

Huge Potential: A company that adopts the Fairshare Model could have a competitive advantage with respect to recruiting and managing human capital

Balance & Align InterestsEntrepreneurs have an incentive to offer public investors a low valuation.

Equity incentives tethered to collective operational performance

Investors have an interest in helping the company meet goals

Cooperation as a competitive model

VS.

1st challenge for the Fairshare ModelEstablish that there is a critical mass of investors with interest in the Fairshare Model

We Are Here!

We Are Here!!

We Are Here!

We Are Here!!!

BEFORE companies think about how to make the Fairshare Model work for them…

….A LOT of you need to make a little bit of noise like the tiny residents of Whoville.

With each of your small voices you need to create buzz.

You can cause others to take note and join in.

People who like the Fairshare Model must combine their small voices and shout….

2nd challenge for the Fairshare ModelDebug and shake it down. This will largely be done by experienced entrepreneurs, attorneys, accountants, angel investors and others.

Conventional cap structure Ponderables• Does it scale…downward? Its

approach to valuation works for established companies, but, does it work well for public venture-stage companies?

• Can the interests of investors and employees be better aligned as the valuation climbs?

The “Ponderables”:• How might performance be defined?

• Who should define performance?

• How might it be measured?

• Who should measure it?

• How should rewards of performance be allocated?

• Who should administer the rewards of performance?

• What are the tax and accounting implications of the Fairshare Model?

3rd challenge for the Fairshare ModelTime and experience. Sustaining goodwill between the providers of capital and labor is the central challenge.

Better Capitalism…the new frontier This is the construction of the Fairshare Model.

It’s mission: to explore new relationships between labor and capital,

to help entrepreneurs finance companies with public venture capital,

to boldly go where no capital structure has gone before!

Let me know what you think!www.fairsharemodel.com

Under Resources tab, first chapter available.

Each month, I’ll add another, up to about five.

Target is about 300 pages & 20 chapters.

Plan A: e-book in Q1 ‘15, then crowdfund a print version.

Email me: karl@fairsharemodel.com

Meanwhile, Talk About the Fairshare Model!