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The Fairshare Model: A performance-based capital structure for companies that raise venture capital via a public offering
Karl M Sjogren (pronounced Shur-gren)
FINTECH CAREER VIRTUAL SUMMIT
MAY 2016
FINTECH & Capital Structures• FINTECH—innovations that make transactions work better for more people.
• The Fairshare Model inhabits a corner of that neighborhood.• Capital structures gets less attention than bitcoin or apps--shouldn’t be the case.
• A capital structure is to a corporation what DNA is to life.• It defines the relationship among investors and between investors and employees.
• It informs capitalism itself; how capital and labor relate to one another.
• The Fairshare Model is an innovation in capital structures, the kind used by venture-stage companies when they raise capital using an IPO. • It adapts features from a private offering, which is only open to wealthy investors,
to a public offering, one which anyone can invest in.
Fairshare Model Positioning
Debt
Equity
Kind of Capital How Raised Development Stage
Private Offering (accredited investors only)
Public Offering (open to anyone)
Established
Venture stage
Deal Structure
No price protection; high valuation risk
Price protection; valuation risk mitigated
The Fairshare ModelThe VC Model
New SEC rules on public offerings 1. Reg A+ offering—in effect July 2015 (anyone can invest & stock is tradable)
2. Equity crowdfunding rule--in effect May 2016
Tier 1 offering: Raise up to $20M per year
Tier 2 offering: raise up to $50M per year
Financial statement audit not required (a review is) Offering reviewed by SEC and state regulators (some have merit review standard)
Financial statement audit required Offering reviewed by SEC only (uses disclosure standard)—no separate review by states
Raise up to $1M per year; audit not required for first time users Anyone may invest—limits based on investor income Stock not tradable for one year New way to sell stock: Investment Portals
: crowdfunding pioneerFairshare, Inc operated 1997 to 2001: Karl Sjogren is co-founder and CEO
Fairshare’s Plan:• Build online community of investors interested in venture-stage companies
• Provide education on deal structure and valuation
• Allow companies to pitch their offering to members, commission-free. Requirements:1. Have a legal public offering (an S-1, SB-2, Reg A, etc.)2. Pass due diligence3. Adopt the Fairshare Model 4. Allow members to invest as little as USD $100
Big Idea: Facilitate start-up capital formations by organizing investors to get better deals on IPOs
Fairshare’s Positioning: Not a regulated Broker-Dealer; would not handle anyone’s stock or money
What Happened?
Fairshare concept was too early • We underestimated the time and expense of dealing with
concerns of securities regulators • Dot com and telecom busts undermined investor interest
in venture stage IPOs, 9/11 buried it.
Accomplishment--16,000 opt-in members• 2/3rds join as free member: • 1/3rd join as paid member (i.e., rewards-based crowdfunding)
2013--Resurrection of an IdeaGreat Recession begins 2007 dissatisfaction with convention; interest in entreprenuership
JOBS Act of 2012 securities law reforms ease restrictions on capital formation
• Widespread excitement about making it easier for young companies to sell stock
My 2013 conclusion:
• JOBS Act reforms would inevitably generate interest in better deals
• Other parties would emerge to help issuers sell their offering
• The unexplored country…better deal structures for public investors
• A book could spark broad discussion about how to re-imagine capitalism, something that could be of lasting significance.
• But, no one talking about how to improve deal structures!
2016: Crowdfunding to Publish The Fairshare Model
Draft is 90% complete.
Publisher selected: Inkshares uses rewards-based crowdfunding to decide what to back.
◦ It will commit resources to publish The Fairshare Model after it receives 750 pre-orders.
Preview chapter one: visit www.Inkshares.com and search for “Fairshare Model”
Direct link https://www.inkshares.com/projects/the-fairshare-model
Fairshare Model: a crowd-vetted book
Section I – Overview
Chap. 1 – The Fairshare Model
Chap. 2 – Orientation
Chap. 3 – Brief Q&A
Chap. 4 – The Problem With a Conventional Capital Structure
Chap. 5 – Crowdfunding
Chap. 6 – Target Companies
Chap. 7 – Fairshare Model History & Projection
Section II – Macro Context
Chap. 8 – Economic Growth
Chap. 9 – Income Inequality
Chap. 10 – Cooperation as a Tool for Competition
Chap. 11 – Tao of the Fairshare Model
Section IV – Fraud, Failure & Other Objections
Chap. 16 – Three Causes of Investor Loss: Fraud, Overvaluation & Failure
Chap. 17 – Failure
Chap. 18 – Other Objections to Public Venture Capital
TBD – Secondary Markets, Accounting Issues, Game Theory, Behavioral Finance and wrap-up
Full draft at www.fairsharemodel.com
Section III – Valuation
Chap. 12 – Concepts
Chap. 13 – Calculation
Chap. 14 – Evaluation
Chap. 15 – Disclosure
WEBINAR BONUS: Special version of chapter 13; it has tables to look-up a pre-money valuation based on % of company sold.
Pre-Order The Fairshare Model and I’ll send you the webinar bonus!
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?
The Fairshare Model• Two classes of stock:
• Investor Stock (common stock) issued for money or delivered performance
• Performance Stock (preferred stock) for future performance
• Both vote, only Investor Stock can trade.
• Performance Stock can never trade.
• Based on milestones, Performance Stock converts to Investor Stock.
Approval from each class required for:• Board member election • Change to conversion criteria.• Compensation plans involving Investor Stock.• Changes to capital structure.• Acquisition matters.
Vision, Goals and Perspective
VisionMiddle Class investors can invest in the IPOs of venture-stage companies… on terms comparable to those that venture capitalists get in a private offering.
Goals1. Alternative to a VC round for companies2. Liquidity for pre-IPO investors3. Attractive option for public investors
Perspective is that of average investors. Ranking of interests:1st Place --- IPO investors (i.e. what is best for them?)2nd Place --- Tie between Entrepreneurs and pre-IPO investors3rd Place --- Secondary market investors
Fairshare Model is an idea. It has not been used before.
Look at IPOs from this angle and you’ll have an intuitive sense for the Fairshare Model.
What is a “Venture-Stage” Company?A company with these risk factors: • Market for its products/services is uncertain
• Unproven business model
• Uncertain timeline to profitable operations
• Negative cash flow from operations
• 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. The JOBS Act reforms
will increase the number of public venture-stage public companies…but they are not new.
Fairshare Model 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
That Premise Doesn’t Explain the Valuation of Venture-stage Companies
What drives the increase in valuation that often occurs as a company approaches its IPO?
Is it performance?
Or, is it something else?
Two Explanations1. The Next Guy Theory of Valuation
2. Market Forces
Discussed in chapter 4--The Problem With a Conventional Capital Structure
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.
Next Guy Theory Implication
That is, a private company’s valuation climbs if investors expect an IPO or acquisition. • The driver—belief that The Next Guy (public investors or another company) will
accept a higher valuation. • A company’s positioning (hotness) can eclipse its performance as a factor.
Market ForcesNext Guy Theory applies to items without utility…like investments (securities, art, real estate).
Retail
Wholesale
For items with utility (food, clothing, cars), a wholesale/retail price discrepancy is common.
Apply this concept to the IPO market:
•“Product” = equity in a venture-stage company•“Manufacturer” = issuer•“Wholesale customers” = pre-IPO investors•“Retail customers” = public investors
A Comparable Product with a Retail Markup? No! The product is not comparable.
The product sold at wholesale to pre-IPO investors is better than the retail version. • The stock that VCs get have price protection (price ratchets) and other features (liquidation
preferences, etc.) that help ensure they don’t buy-in at an excessive valuation.
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 one—where that happens?
What Explains the Price Increase in “The Product” as it Approaches an IPO?
Four hypothetical drivers
1. It is considered “normal”- But, many things 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 better deals
4. VC value-add (knowledge, connections, ability to write a big check quickly)
- Challenge for public venture capital – “How to replicate VC value-add?”
- Just how much is the VC value-add worth to public investors?
Whatever the Explanation, What Risk does the IPO Valuation Present?
Why so much downside exposure?
Valuation Downside Risk Due to a Conventional Capital Structure
John Kenneth Galbraith coined the term “conventional wisdom.”
There is conventional wisdom about how to organize (and value) the ownership interests in a corporation. It is reflected in a “conventional capital structure.”
Defining characteristic of a conventional capital structure: A value for future performance must be set when a company raises equity capital
He uses it to describe a convenient and comfortable point of view that is often false.
Hard to do in a reliable manner!
Nonetheless, a conventional capital structure requires…indeed, it demands a value for future performance at the time of an equity raise.
The Little Shop of Horrors that is a Conventional Capital Structure
FEED ME A VALUATION SEYMOUR!
The Problem of a Conventional Capital Structure for Public Investors
1. The basis for a valuation is shaky.
2. They assume most of the risk that it is too high.
Interlaced foundations of the problem
• Don’t get a better deal because issuers see little advantage in offering one. Investors may respond with “what’s valuation? Is it the same as worth?”
• Don’t demand a better deal because they are not valuation savvy; terms were not an issue in the Occupy Wall Street protests.
• Are not valuation savvy, in large part, because the SEC doesn’t require valuation disclosure in offering documents.
Public investors…
• Pay “retail” but don’t know it.
The Fairshare Model is UnconventionalIt’s complexity favors public investors—as well as well-performing teams.
Remarkably, it provides incentive to offer IPO investors a low valuation. Entrepreneurs do not care what the pre-money valuation is; it doesn’t affect their financial position or voting power.
What matters is “what does it take for Performance Stock to convert into Investor Stock?”
It is unconventional because there is no need to place a value on future performance!
BTW, that’s another difference—where there is complexity in a conventional capital structure, it usually benefits wealthy investors, not average ones.
The incentive? If an increase in the price of Investor Stock is a measure of performance, the company will set the IPO price low. Secondary trading should cause it to climb to market value.
Conventional Model Fairshare Model
Tao of the Fairshare Model
Should the ownership interests of insiders be set before or after performance is delivered?
Put another way…should the uncertainty of future performance be borne by insiders (employees and existing investors)…or by new investors?
Taoism is a Chinese philosophy about truths. Finding one’s tao requires meditative and moral exploration.
Fairshare Model’s tao: harmony of interests within the uncertainty of a venture stage investment.
Contemplate this question:
Those who believe the risk of future performance should be borne by new investors will favor a conventional capital structure.
Those who believe it should be borne by insiders will favor the Fairshare Model.
“Tao” is pronounced “Dao”
Visualize the Tao of The Fairshare Model
Imagine a long balloon.
Ownership side Performance side
And certainty is represented by a weight
One end represents ownership interests while the other represents future performance.
PrincipleIn a venture-stage company,
uncertainty can be moved but not eliminated.
But instead of air, it is full of uncertainty.
Where the Uncertainty Is
The bet is on the valuation when new stock is sold. The bet is on human behavior; will shareholders agree on how to reward performance?
A different bet, not necessarily a better one!
How VCs Deal With Uncertainty
Takeaway The Fairshare Model simulates a
VC deal structure in a public offering!
Discussed in chapter 11
What Constitutes Performance?• A company’s insiders and investors decide; no one-size-fits-all answer.
• It will vary based on a company’s industry, stage of development, geography and the personalities involved.
• Possible components• The market price of Investor Stock
• Financial performance (sales, profits)
• Operational achievements (release of product, market share)
• Value of company when acquired
• Measures of social good
Entrepreneurs: Pick Your Challenge!
“What is the value of my future performance now?
“How do I define my deliverables?”
Meanwhile…
Conventional Capital Structure Fairshare Model
vs.
…the success VCs enjoy enough with venture-stage IPOs is …. encouraging public investors to say…
Diner scene from 1989 movie, When Harry Met Sally
(portrayed here by Sally, simulating an orgasm) And as that happens, interest in the Fairshare Model will grow!
Capital Market Forces are Weak The most controversial assertion in The Fairshare Model is that venture stage valuations reflect weak market forces…an inefficient market…driven by public investors (Next Guys) who are:• unsure what valuation is, • why it is important, and • how to calculate it, let alone evaluate it.
Skeptical? Why don’t companies compete for IPO investors by offering better deal terms ?
Chapter 15 argues that regulators could strengthen market forces if they require issuers to disclose their valuation.
Let’s look at how the Fairshare Model might play out in some scenarios….
Please join me in calling for it!
What Kind of Companies Might Adopt the Fairshare Model?
Feeder Seeks public capital to develop a product and be acquired.
Aspirant Aspires to build for the long-term.
Pop-up Fund a project, product, movie, game, invention, oil well, etc.
Spin-Out Tired backers; a VC’s “living dead” or to-be-spun-out division of a company.
Rejuvinator Established company in financial distress (i.e., GM in 2009).
These categories can overlap. Plus, a company may be a shape-shifter. • A Feeder may tell you it’s a Feeder….but it might may tell you that it’s really an Aspirant. • A Pop-Up may think that it’s a Feeder or Aspirant. • A Spin-Out can’t remain a Spin-Out—it must evolve into a Feeder or an Aspirant. • An Aspirant may wind up being a Feeder after all.
Discussed in chapter 6
Category of
Company
Strategic
for
Fairshare
Model? Goal
Likely
Offering
Size
Likely to be
a SEC
Reporting
Company?
Expectation of
Performance
Stock
Conversion
Secondary
Trading Market
Feeder Yes
Launch
product—get
acquired.
$3M to
$7MMaybe High
Pink Sheets; principal
investor exit via
acquisition
Aspirant Yes
Build a
company
that lasts
$5M to
$20M+Yes High
Pink Sheets, a
regional exchange, or
NASDAQ Micro for
larger ones
Pop-Up NoOffer equity
in a project
Less than
$5MUnlikely Low Same as Feeder
Spin-Out No
Alternative
for a new VC
round
$5M to
$20M+Yes High Same as Aspirant
Rejuvenator NoFund a
turnaround $20M+ Yes High
NASDAQ Micro or
better
Target Companies for Fairshare Model
We will look at scenarios for these two
Prelude to Some ChartsFive charts follow that illustrate possible scenarios for Feeders & Aspirants.
They show how conversion of Performance Stock may dilute Investor Stock.
Next—two charts that illustrate Performance Stock conversion scenarios for a Feeder.
1. Acquired 3 years after the IPO (with presumed performance factor)
2. Acquired 1 year after the IPO (with presumed performance factor)
100% of Investor Stock = Investor Stock @ IPO + Performance Stock that converts
IPO + 1 yr + 2 yrs + 3 yrs
From Money 100% 92% 84% 50%
From Performance 8% 16% 50%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% o
f In
vest
or
Sto
ck
Time Since Fairshare Model Offering
Shareholders agree that Performance Stock get 50% of the acquisition proceeds
Feeder Acquired 3 Years After IPOPresumed performance assumption:• 8% year• 20% maximum
Acquisition offer in year 3.
Investor and Performance Stockholders agree to split the price evenly. So, 50% of the Investor Stock in year 3 is from Performance Stock.
No agreement, no acquisition.
Note 3 year time scale
Investor Stock issued via Performance Stock conversion for “presumed performance”
“Presumed performance” is a employee goodwill incentive.
No need to define or measure quarterly performance for a period (e.g., development phase).
Feeder Acquired 1 Year After IPO
IPO + 1 Qtr + 2 Qtrs + 3 Qtrs + 4 Qtrs
From Money 100% 98% 96% 94% 40%
From Performance 2% 4% 6% 60%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Time Since Fairshare Model Offering
Shareholders agree that Performance Stock gets 60% of proceeds
% o
f In
vest
or
Sto
ck
Same presumed performance assumption as before (8% year or 2% per quarter).
Acquisition offer 1 year after IPO.
Shareholders agree that 60% of the proceeds should go to Performance Stockholders.
It is 10% higher…because the offer came faster.
Note 1 year time scale
Performance Stock conversions based on presumed performance
Now—three charts that illustrate scenarios for Performance Stock conversion for an Aspirant3. No performance at all
4. Presumed performance but no actual performance
5. Presumed performance, then strong actual performance
IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs
From Money 100% 100% 100% 100% 100% 100% 100% 100%
From Performance 0% 0% 0% 0% 0% 0% 0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% o
f In
vest
or
Sto
ck
Time Since Fairshare Model Offering
No Performance Stock conversion because there is no presumed nor actual performance (i.e. a dud).
Aspirant: No Performance Conversion
With neither presumed or actual performance, there are no conversions. Therefore, only Investor Stock issued for money or pre-IPO performance is tradable.
Company raises capital to build product and launch business. No presumed performance rule.
All Aspirant charts use 7 year time scale
Imagine it is… • A biotech and it’s product
fails FDA testing;
• A game developer that doesn’t release a product; or
• A software developer whose product flops.
Aspirant: Only Presumed PerformanceSame presumed performance assumption as for Feeder:• 8% year• 20% maximum
• Yr 1 - 8% conversion• Yr 2 – 8% conversion• Yr 3 – 4% conversion
Company fails to meet performance goals, so conversions cap at 20%.
IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs
From Money 100% 92% 84% 80% 80% 80% 80% 80%
From Performance 8% 16% 20% 20% 20% 20% 20%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% o
f In
vest
or
Sto
ck
Time Since Fairshare Model Offering
Presumed performance conversion of 8% per year--capped at 20%
No conversion for actual performance
IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs
From Money 100% 92% 84% 68% 54% 42% 32% 24%
From Performance 8% 16% 32% 46% 58% 68% 76%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
% o
f In
vest
or
Sto
ck
Time Since Fairshare Model Offering
Presumed performance conversion of 8% for year 1 & 2
Conversions in years 3 – 7 reflect actual performance
Aspirant: Presumed & Actual PerformanceSame presumed performance assumption • Year 1: 8% conversion• Year 2: 8% conversion• Year 3: 4% conversion
But performance is strong; conversions exceed the presumed performance.
Total = Presumed + ActualYear 3: 16% = 4% + 12%Year 4: 14% = n/a + 14%Year 5: 12% = n/a + 12%Year 6: 10% = n/a + 10%Year 7: 8% = n/a + 8%
This team performs so well, it winds up with 76% of the Investor Stock after 7 years—far more than would be possible with a VC.
Scratch pad to calculate conversions32 - 16 = 16 58 - 46 = 12
46 - 32 = 1416 - 8 = 8
Cumu-lative
8%16%
Below
Cumu-lative32%46%58%68%76%
68 - 58 = 10
76 - 68 = 88 - 0 = 8
+ current period cumulative conversion – prior per. cumulative conversion = current period conversion
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, possibly dramatically.
However, if the performance translates into a higher valuation, investors should not suffer economic dilution—their stake should grow in value.
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 other compensation--salary, benefits, bonuses and stock options on its Investor Stock-- employees have an interest in its Performance Stock pool.
• Performance Stock is like cheap 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.
Huge Potential: When it comes to attracting and managing human capital, a company that adopts the Fairshare Model could have a competitive advantage over companies with outsized valuations.
Wouldn’t you be pleased to get an offer that includes Performance Stock?
An employer’s “brand” reflects how it implements it’s philosophy about people.
Balance & Align Interests: Shared ValuesEntrepreneurs have an incentive to offer public investors a low valuation.
Equity incentives are tethered to collective operational performance vs. valuation at an individual option grant date, which employees don’t control.
Investors have an interest in helping the company meet its goals
Bottom Line---The use of cooperation as a competitive tool
VS.
1st Challenge for The Fairshare ModelShow that a lot of investors like the idea!
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 noise.
Each of your voices must generate buzz.
Sounds that leads others to take note and join in.
People who like the Fairshare Model must combine their small voices and shout….
..just like the tiny residents of Whoville.
2nd Challenge for The Fairshare ModelDebug and fine tune it. This will be done with entrepreneurs, attorneys, accountants, investors, experts in capital markets, etc.
A conventional cap structure has Ponderables too!• Does it scale…downward? Its approach to
valuation works for established companies, but, does it work well for public venture-stage companies (i.e., hard to value issuers)?
• Can investors and employees be better aligned as the valuation climbs? A stock option is a poor motivator if employees feel it will take an Act of God to keep the stock at the current price.
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?
Variations based on industry, stage of development, geography, personality…
3rd Challenge for The Fairshare ModelTime and experience. Sustaining goodwill between the providers of capital and labor is the central challenge.
Now
A Lot to Think About
So, join me to explore…
The new frontier… Better Capitalism
This is the construction of the Fairshare Model.
It’s mission: to explore new relationships between investors and employees,
to help entrepreneurs raise venture capital,
to boldly go where no capital structure has gone before!
Help Build The Fairshare Model!1) Pre-order The Fairshare Model from Inkshares!
https://www.inkshares.com/projects/the-fairshare-model
2) Read the draft chapters at www.fairsharemodel.com
3) Make it better. Send comments, challenges (love them!)and suggestions to me at [email protected]
4) Create buzz about how to re-imagine capitalism!
Thank you for taking time to learn about
The Fairshare Model!
