I come to capital markets via Main Street, not Wall Street. My 35-year financial career began at Fortune 500 manufacturing companies in the Midwest region of the United States. In 1983, I moved to California’s Silicon Valley, the hotbed of what was then called “high technology.” My first job there was with a personal computer company that had just had its initial public offering (IPO). It filed for bankruptcy nine months after I started. It was my initiation into a world more exciting and volatile than anything I had previously known. Nowadays, we call it the New Economy.
I then worked for a variety of companies before embarking on a career path as a consulting chief financial officer where I helped companies improve their performance and sometimes, raise money. In 1996, the insights I obtained led me to cofound a company that sought to make it easier for young companies to market IPOs without a broker-dealer. We built an online community of 16,000 valuation-savvy investors called Fairshare and it is the genesis of this book, The Fairshare Model.
My experience is detailed in Chapter 9, “Fairshare Model & the Future.” What’s important here, at the start of the book, is to know that we placed the interests of average investors—Main Street—first. That means the ideas presented herein are unlike those you can get elsewhere. Normally, views on capital markets are based on the perspective of entrepreneurs, investors in the private capital market, investment bankers or their best customers, the ones who manage to get shares in hot IPOs. Traditionally, the interests of average investors are relatively unimportant. I would like to change that.
That makes this a movement book. It seeks to rouse debate about a better way to structure ownership interests in companies that raise venture capital via an IPO. To set the stage for that, the book needs to help readers better understand capital structures. It must also promote awareness of the importance of valuation and expose a little secret—no one knows how to reliably value a startup. This knowledge will lead to a revolution in how public venture capital is raised because it will lead investors to demand better deals than they get now.
In Spring 2014, a few months after I began writing this book, I was awakened from a nap by a phone call. I thought I was in a dream state when I heard the caller’s opening words, “Whatever happened to Fairshare?” He told me he was from Wisconsin and had become a Fairshare member in 1998. I knew I wasn’t dreaming when he said that he looked at his member binder from time to time. As we began our membership drive, some people said that it was difficult to absorb all the information on our website—hyperlinks could confuse those new to the internet. Those who printed pages felt overwhelmed by the challenge of organizing them. There were enough requests for printouts that we experimented with binders for premium members. More than a dozen years later, this gentleman still had his.
I told him Fairshare was too early and met its demise in 2001. I also said that I had decided to write a book about its core concept because the time seemed right for it. He replied, “I always thought it was a good idea.”
The Purpose of this Book
The purpose of this book is to spark a movement to reimagine capitalism at the DNA level. 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 capital structures.
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. One trades, the other cannot; both vote on shareholder matters. Investors get the tradable stock, which I call “Investor Stock.” For past performance, employees get it too. For future performance, employees get the non-tradable stock, which I call “Performance Stock.” Based on milestones, Performance Stock converts into Investor Stock. The model’s structure is simple—its complexity flows from a question that is both philosophical and practical: “What is performance?” How that question is answered will vary—it can be whatever a company’s shareholders say it will be.
The idea behind the Fairshare Model is simultaneously radical and ordinary.
It is radical because the model 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. Recent changes in securities law will accelerate such activity. Another unique aspect of the Fairshare Model is that it presents a way for middle class 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 currently compete for public investors by offering lower valuations and better protections.
This reflects weak market forces. IPO issuers and Wall Street firms do not want to compete on deal terms, valuation, and investor protections. In addition, many public investors are unsure what 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 venture capital firm.
I hope you will discuss the Fairshare Model with others. To generate buzz among hives of people with interest in entrepreneurial companies is the job of this book. As the model’s philosophy gains traction, experts from a range of fields will evaluate how to implement it for different companies—but that will only happen if there is clear investor interest in the model.
The San Francisco Bay area, where I have lived for the past 35 years, is renowned for sourdough bread. Think of the process of popularizing the Fairshare Model as the process of baking. This book will serve as the “starter,” the yeast culture that gives the bread its unique flavor and texture.
Readers like you will contribute ingredients to make the dough, but instead of flour and water you will provide ideas and enthusiasm.
Experts in various matters—law, tax, accounting, organizational development, and other areas—will knead it. Once the dough rises, early adopters will bake it.
The aroma of a fresh approach to capital formation will attract more people to the kitchen who will contribute more ideas on what to make.
I would rather have questions that can’t be answered than answers that can’t be questioned.
Often, after I’m exposed to a new idea, I see other things in a new light. I get pleasure when that happens—it’s a reward for being curious. I trust that you feel similarly. And so, I seek to engage you in new thinking about capital markets, stimulating the interplay of concept and possibility, analysis, and imagination.
And I hope you will inspire others to do the same.
At some level, I hope to fortify your sense that it is possible for people who are not wealthy or powerful to promote change in how established systems work—to make them work better for more people.
The Fairshare Model is an attempt to do that in capital markets. It harnesses two forces that many see as incompatible—market forces and cooperation.
I solicit your help to strengthen market forces. A way to do this is to encourage companies to compete for public capital. That can happen if they are required to disclose the valuation that they have given themselves when they sell stock. Chapter 16, “Valuation Disclosure,” explains this further and what you can do to help.
The other way to change capital markets is to enhance the rewards available to the providers of capital and labor when they cooperate and collaborate. That is what the Fairshare Model does. As support for it grows, so too will the opportunities to see companies explore the benefits of cooperation between investors and employees.
So, let’s begin to explore how to reimagine capital structures, the DNA of capitalism!
My vision for the Fairshare Model is that average investors will be able to make venture capital investments on terms that are comparable to those that venture capitalists get in a private offering.
My goal is to popularize a deal structure that can:
1. expand entrepreneur access to capital,
2. offer liquidity to investors who support private companies, and
3. create an attractive, yet prudent, option for average investors to be “mini-angel investors.”
Note the self-renewing cycle. Entrepreneurs are more likely to attract capital if investors feel fairly treated for the risks they assume. Angel investors are more likely to invest in a company when they believe it can attract investors to the next round of capital and there is the prospect of liquidity—the ability to sell shares. Public investors are more likely to provide that capital and liquidity if they, too, feel fairly treated.
Within a generation, I hope the Fairshare Model will present an attractive approach for companies that raise venture capital in a public offering. This will happen if it helps them raise capital and provides a competitive advantage in attracting employees and managing them.
Why not more quickly? It takes time for innovation to take root in a tradition-bound market.
While I proselytize about the Fairshare Model, I acknowledge there may be other ways to achieve the above three goals, and I welcome debate about the relative merits of alternative approaches.
In the simplest sense, my goal is to give average investors a more sophisticated understanding of venture capital. The more they know, the more they will want better deals when it is raised via a public offering. The effect will be to encourage entrepreneurs to offer them.
This is a book for thinkers. People who like Big Ideas but who are also practical; they like innovative ideas but also want a way to put them into practice.
My principal target audience is composed of investors who might want to invest in a public startup company someday. Some of them see a problem—such companies are notoriously difficult to value. For them, the Fairshare Model is a solution because it avoids the need to value future performance.
My secondary target audience is comprised of entrepreneurs willing to consider a public offering as an alternative to a private finance round from a venture capital fund—a VC.
There is another important audience made up of attorneys, accountants, investment bankers and others involved in the startup ecosystem. They are not my focus, but their involvement will be critical for companies that seek to implement the Fairshare Model. Their interest will naturally build as investor and entrepreneur interest in the concept builds.
Most readers will be new to capital structures or unsure how to define one, while a sizable proportion will be expert in them. In my mind’s eye, my reader is in their late teens to early forties and has invested in or worked for a venture-stage company or aspires to. More to the point, I sense three age-related clusters of readers. Those over 50 years of age will use their wisdom and experience to critically evaluate the Fairshare Model. The ones in their 30s and 40s will have the ambition to put it into practice—they will be the wellspring of entrepreneurs and investors who determine the adoption rate. Readers under 30 will provide the energy required to strengthen this movement.
Whatever their age, background or ambition, this book will appeal to people drawn to these topics:
· economic philosophy and behavioral finance,
· valuation (concepts, calculation, and evaluation),
· corporate governance and organizational behavior,
· how to align the interests of investors and employees,
· how to resolve the conflict between expanding access to venture investments for average investors and protecting their interests,
· the intersection of social/impact investing and capital markets,
· economic growth,
· a partial solution to income inequality that does not rely on taxes,
· game theory, and
· blockchain and initial coin offerings (ICOs)
All readers will want to better understand how economies work—some will want to change how they work. This book explores how venture capital formation works from the perspective of public investors; it also shows how it can be made friendlier to them.
Geographically, my focus is on the US capital market and my perspective is that of an American, however, the Fairshare Model is not US-centric. I anticipate that it will be adopted in other countries, possibly more quickly or with greater success.
Encouragement and a Compass
There may be times when my points are unclear to readers who are unfamiliar with capital structures. I offer two things to deal with those moments when you feel disoriented.
Every page or two, I hope to give you a “Ha!” or an “Aha!”
The first is encouragement. Stick with me and matters that seem obscure will come into focus. You will acquire a credible view of how capital formation works in a capitalistic economy. I make technical points in simple language. Philosophy, analogy, and humor are in my toolbox. Make this journey, and you’ll have a better understanding of a complex socio-economic process that affects many aspects of life. If you don’t already have one, you will acquire a coherent point of view about the IPO market for early stage companies. If you already have such a perspective, I may challenge it. Either way, if you like ideas, this book will be fun!
The second thing that I offer is a conceptual compass. With respect to how capital formation works, between where we are now and where I imagine we can be, is unexplored terrain. When you wonder where I am headed, where I will turn, how I think a matter should be settled, look to my compass.
On it, True North is the interests of public investors who buy stock from a venture-stage company in an IPO. The interests of entrepreneurs, private investors and investors in the secondary market are important, but not as central as those of the IPO investor; there is only one True North.
Public IPO investors occupy that position for the Fairshare Model because if they make money, there will be more money for entrepreneurs and better liquidity options for their private investors.
In the Fairshare Model’s hierarchy of interests, IPO investors are at the top. So the answer to any question about how to make the Fairshare Model work will be found by asking, “What is best for the IPO investors?” while considering the interests of the other key constituencies.
This ranking hierarchy is on display below.
The interests of IPO investors are at the top, in first place.
The interests of pre-IPO investors and the entrepreneurial team are in a tie for second place.
In third place are the interests of secondary market investors.
A reviewer of this book, Po Chi Wu, is a blockchain expert with a background in venture capital. He is also an educator—he is an Adjunct Professor in the School of Business at Hong Kong University of Science & Technology and a Visiting Professor in the College of Engineering at the University of California—Berkeley. He recommends that, at the outset, I encourage readers to approach this material with an open mind.
I know that some of you will sense conflict with what you already know. For example, if you believe that venture capital is only raised from venture capital firms, you will resist the idea that it can be raised in an IPO. You may be skeptical that average investors can cause innovation to take hold in capital markets. Then too, you may doubt capitalism can be changed for the better, or question whether is necessary to do so.
Major change to The-Way-Things-Are is rare, but it happens. For example, the competitive landscape for computer operating systems was upended in 1991 when Linus Torvald made the kernel logic for Linux available as open source code. The effect of a viable alternative to traditional proprietary operating systems was profound—Linux-based systems are now pervasive on all manner of computing devices. I hope that the Fairshare Model has a similar effect on the IPO market in the decades to come. It is open source idea for a capital structure—there will be variation in how it is implemented.
So, taking Dr. Wu’s advice, I ask you to nurture that part of you that is open to possibilities. We all have one. Some feed it by reading science fiction. Others do it by watching sports, movies, or magic acts. Political activism is a form of it—a spirited debate about ideas can be, at its best. The Fairshare Model relies on the imagination of those willing to explore new ideas about how to structure ownership interests in companies that raise capital via an IPO.
To prime your imagination, here are thoughts that Professor Wu shared with me as he reflected on what he had read.
The words that come to my mind when I [Po Chi Wu] think of [the Fairshare Model] is “decoupling/uncoupling” because I think those words help us understand why understanding does not come easily.
Of course, the subject matter is complex, but the conventional mindset is rigid in how the basic concepts of “power,” “ownership,” and “value/valuation” are linked together inseparably because of all the assumptions and expectations we have about how the world works. We cannot think of one without being reminded of its connection with the other two.
You are asking—What if we could deal with these three aspects separately? Let value/valuation be directed by market forces. Power should be held primarily by those who are doing the hard work of building the business. Governance considerations will add some nuance to this idea. Ownership can reflect contributions of money and/or labor.
To break up this “unholy trinity,” you suggest decentralized mechanisms for each feature. In a way, I think that blockchain implementation could actually make your ideas easier to understand because of the fundamentally distributed framework.
To change someone’s mindset, we have to bring them into a fresh context, one that doesn’t have the usual baggage.
That is my goal—to present a fresh context that opens up your thinking about how companies can raise capital from public investors.
How This Book Is Organized
As Professor Wu notes, capital structures and markets are complex matters. To enhance your understanding of them, I avoid overwhelming detail. Instead, I present core ideas in a manner that helps you associate them with things that you already know—I emphasize breadth over depth. Strategically, I trust this approach will encourage you to consider the implications of these ideas further, in your way.
To aid navigation, each chapter opens with a list of its subtopics.
Stylistically, I favor a light manner. I also provoke; being inspired by Diogenes, the ancient Greek philosopher to whom the following is attributed:
“Of what use is a philosopher who never offends anybody?”
I serve up ideas using a literary adaptation of “pointillism,” a technique of painting in which dots define and fill an image. Here, ideas from a range of sources serve as dots, and I share images that I see. You will surely see dots too as you consider the images they form. Ask yourself “What is really going on here?” Then, ask yourself “Is there a better way?”
To simplify ideas, I sometimes use a conceptual equation. This approach is inspired by Chip Conley’s 2012 book Emotional Equations. Chip founded the Joie de Vivre chain of boutique hotels in the US before going onto head strategy at Airbnb, a startup in the vanguard of the “sharing economy.” He came to his book in an effort to analyze emotions he struggled with. A friend suggested that he find a way to express a feeling as a formula, to focus his attention on the variables that cause the emotion. For example:
Anxiety = Uncertainty X Powerlessness
This emotional equation states that anxiety is a multiple of uncertainty and powerlessness. It suggests that one can reduce anxiety by reducing uncertainty, the sense of powerlessness, or both. My favorite equation was suggested by a caller when Chip was interviewed on a radio program.
Happiness = What is Happening - Expectations
This states that happiness can be increased by improving what’s happening, by reducing your expectations, or both.
Substantively, these emotional equations are insightful. Stylistically, they de-tangle a complex subject. So, occasionally, I repurpose the concept as a conceptual equation like this:
Performance = Results - Expectations
This formula states that performance has a positive value when results exceed expectations, which helps shed light on a slippery question, “What is performance?”
Organizationally, a river of thought meanders through the five sections. That is, you can proceed straight through or jump around to topics that interest you because key concepts presented early on repeatedly touched on later in the book. Before you do that, however, read Chapter 1, “The Fairshare Model,” Chapter 2, “The Big Idea and Thesis” and Chapter 4, “Fairshare Model Q&A.”
The first section, Fairshare Model Overview, covers microeconomic points. It is written for those knowledgeable about capital structures but in a way that a novice can follow.
The second section considers the macroeconomic context for the Fairshare Model—its chapters cover economic growth, job creation, income inequality and the potential for cooperation to be a tool for competition. If the first section seems too technical for you, skim it, move to the second section, and then return to the first one.
The third section has four chapters on valuation—concepts, calculation, evaluation, and a call for a valuation disclosure requirement. Valuation disclosure can strengthen market forces in a way that benefits all investors.
The fourth section discusses the causes of investor loss—fraud, failure, and investing in an overvalued company. It also considers the objections some have to participation in venture capital by average investors.
The fifth section, Advanced Topics, begins with a deeper dive into the investor risk concepts that are touched on in Chapter 2, “The Big Idea and Thesis.” It goes on to cover game theory, then blockchain and initial coin offerings. The Fairshare Model was conceived for IPOs, but the idea of a performance-based capital structure makes sense for ICOs too.
The epilogue revisits what needs to happen to make this movement to reimagine capitalism move forward. Before you put the book down for good, please read it.
Finally, there is an appendix with tables that show the valuation of a company based on how much ownership new investors get for their money.
Throughout the book, footnotes provide context to text on the same page. Some chapters conclude with endnotes that list source material referenced in the chapter. Footnotes are numbered uniquely. Endnotes are identified with a letter that is unique to the chapter, but not to endnotes. That is, the first endnote in each chapter that has one is an “A,” the second is a “B,” and so on.
Website links can go bad. If you encounter one, visit fairsharemodel.com. Under the Resources tab, you’ll find a list of current ones.
Terms with Conventional Meaning
Capital: Money raised from external sources in the form of debt or equity financing. Capital can also be in the form of intellectual property, rights, or services.
Issuer: A company that issues or sells a security to investors.
Security: Generally, a security is either a debt or equity instrument. Debt is a loan, and it conveys no ownership interest—the issuer is obligated to repay what is owed. Equity represents an ownership interest in the issuer, who is not obliged to repay it, unless it was sold illegally. Securities include exotic financial instruments that are neither debt or equity—derivatives like warrants, options, forward contracts, investment contracts and digital tokens. The definition of a security is broad and can vary by securities regulator.
Securities regulator: All developed economies regulate securities. In the US, the Securities and Exchange Commission—the SEC—is the federal securities regulator; states and US territories have regulators too. There are also non-governmental regulators, not-for-profit organizations like FINRA and stock exchanges that are a self-regulated organization—an SRO.
Capital market: The market for financial instruments. Generally, to buy a security in the private capital market, one must be an accredited investor. In a public capital market, anyone can invest.
Initial public offering (IPO): When a company first sells equity or stock in a way that any investor can buy.
Secondary offering: A public offering by a company whose shares are already publicly traded.
Original issue market: Where investors buy new shares from the issuer, as opposed to other shareholders.
Secondary market: Where investors buy issued shares from other shareholders, not the issuer.
Shareholder: Someone who has an ownership interest in a company.
Creditor: Someone who provides capital in exchange for an issuer’s promise to repay it, or goods or services in exchange for a promise to be paid
Accredited Investor: The designation for investors who meet a wealth and income standard defined by the SEC that fewer than 10 percent of US households meet.
Non-accredited investors: Anyone who is not an accredited investor (90 percent of US households). They are often referred to as average investors.
Deal terms: The terms of an investment agreed to by an issuer and investor or creditor.
Debt capital: Capital provided in exchange for the issuer’s promise to repay it, along with interest and fees. A convertible note is a debt instrument with terms that allow it to convert into equity. Debt holders don’t have voting rights. If a company is liquidated—sold or dissolved—creditors are entitled to be paid before money is distributed to shareholders.
Debt seniority: Creditors rank in seniority, based on deal terms. The more senior the debt, the better positioned the creditor is, legally, to be repaid.
Equity capital: Capital provided for stock, which provides an ownership interest and, usually, voting rights.
Stock class: An issuer can have a single class of stock, where all shares have the same rights, or multiple classes of stock, where some classes have rights that others don’t. Private companies tend to have complex capital structures: common stock and multiple classes of preferred stock. Public companies tend to have a simple capital structure: a single class of stock, common.
Common stock: The basic form of stock issued by a corporation.
Preferred stock: A class of stock senior to common stock in designated rights. Multiple classes of preferred stock are frequently present in private companies with professional investors.
Registered offering of securities: An offering that is legal to sell in the jurisdiction of a regulator. Large IPOs, those sold by Wall Street broker-dealers, are frequently registered with the SEC using a Form S-1.
Offering exempt from registration: A legal offering exempt or excused from full registration requirements. Exemptions are created by legislatures to reduce the regulatory burden for issuers. They affect all private offerings, which are largely limited to accredited investors, and certain public offerings. The most amount that can raised in an exempt offering—a Reg. A+ offering—is $50 million.
Other offerings: An offering that is not registered or exempt from registration may be illegal.
Digital token: A financing device that has emerged from blockchain technology. Just how digital tokens (or coins) fit into the regulatory scheme is evolving. Often, they convey no ownership interest or voting rights. They appeal to investors who are neither shareholders nor creditors but who are willing to bet that token will rise in value. Chapter 22, “Blockchain and Initial Coin Offerings,” defines other terms that are unique to initial coin offerings.
Capital structure: Refers to how a company is financed; the composition of debt and equity, taking note of the rights attached to each financial instrument.
Exit: An event that allows an investor to convert an investment back to money.
Venture capitalist: A general partner of a venture capital fund. VC firms invest in early-stage private companies in the hope that they can sell their position at a profit if the company is acquired or becomes publicly traded. Limited partners are a fund’s investors; they usually provide 99 percent of the capital while general partners provide one percent. General partners run the fund in exchange for management fees and about 20 percent of any profit earned.
Private equity firms: Private equity firms are VCs that invest in more established companies. Sometimes, they buy all the stock of a public company and take it private. To finance their deals, PE firms rely heavily on debt, secured by the assets of the companies they invest in. To repay it, they sell off assets and improve the performance of what remains. Their goal is to sell the company or take it public at a higher valuation.
Broker-dealer: A regulated seller of securities that can charge a commission.
Terms with Unconventional Meanings
Failure risk: The risk that a company will fail to fully deliver the operational performance that investors expect. A company can fall short of these expectations and have investors view an investment a success.
Valuation risk: The risk that an investor overpays for an ownership position.
Venture capital: Capital provided to a venture-stage company, whether in a private or public offering. It is unconventional to say that venture capital is raised in an IPO; many feel it is limited to capital provided by a VC or PE firm. I find that definition unnecessarily restrictive and inaccurate. Venture capital should be defined by what the investment is, not by who makes it.
Venture-stage company: A company that has significant risk with respect to performance. Examples include startups and other companies that require future infusions of capital to survive.
Price protection: Deal terms that limit valuation risk. They are provided to sophisticated investors in the private capital market, but rarely to public investors. Price protection comes in a variety of forms. For example, a price ratchet, which is a form of an anti-dilution clause. It requires that a company issue more shares for free to an investor with this protection if a later investor gets stock at a lower price than allowed. A liquidation preference is another form of price protection. In a liquidity event, it entitles an investor to a recover its investment, or a multiple of it, before other investors share in what remains.
Conventional capital structure: This term is explained at length in Chapter 5, “The Problem with a Conventional Capital Structure,” but mentioned before that. A conventional capital structure places a value on future performance at the time of an equity investment. It is used in some private offerings and in virtually all public offerings. The Fairshare Model is the opposite of a conventional capital structure—it places no value on future performance at the time of an equity investment.
Modified conventional capital structure: A modified conventional capital structure is also called the VC Model because it is used by venture capital and private equity funds. It also places a value on future performance at the time of an equity investment, but it has deal terms that provide the investor with price protection. Thus, the VC Model limits valuation risk.
Investor Stock: This is a Fairshare Model term. It refers to common stock issued to investors for capital and to employees for actual—not projected—performance.
Performance Stock: This is also a Fairshare Model term. It is preferred stock (or non-tradable common stock) issued to employees and others for future performance. It converts to Investor Stock as performance milestones are achieved.
Ownership interest: The percentage of share ownership an investor has in a company.
Ownership payoff: The proportion of total proceeds that a shareholder receives when there is a liquidity event. A shareholder’s ownership payoff can differ from their ownership interest due to price protections they or other shareholders have.