Venture Capital Via A Performance-Based IPO

Much has been written about how absurdly high valuations are for high-profile startups. It is common for startups with no or little revenue (let alone profit) to be valued in hundreds of millions. This can lead entrepreneurs to believe their baby is worth a lot more than anyone would pay to buy the whole company. It can also encourage investors, especially unsophisticated ones, to invest when a valuation is high.

The fundamental problem is that no one knows how to value a startup…reliably. It’s like ranking a class of elementary school kids based on who’s going to be happy in life, or a success (however you define it). You’ll have clues, right? But you’ll be wrong…a lot! That’s because it takes time for the outcomes to be determined. That’s certainly true of startups as well.

Nonetheless, the conventional approach to valuation places a value on future performance. Indeed, the lion’s share of a valuation is for future performance. There are two analytical ways to arrive at one:

Crystal Ball (or Income Approach) That is, apply a discounted cash flow calculation to projections. Performance rarely matches projections, thus the appeal of deal terms (discussed below).
Comparable Company (or Market Approach) For a startup, this means “Company X, which is 'worth' Y, so we should be worth Y too.” Such reasoning clones the crystal balls applied to Company X--a form of circular reasoning.

Both approaches are flawed. But their use is understandable as the value of a business should reflect expected earnings. Analytics, however flawed, help set a startup’s valuation.

What else does? This concept equation adds two additional variables:

Valuation = Analytics + Emotion + Deal Terms

Here, Emotion plays out in two ways.

Investors fall in love with companies they invest in. When they do, they believe others will fall in love with it too. Call this Breathing Your Own Exhaust (BYOE).
When a business space is hot (like AI is now), Fear of Missing Out (FOMO) will drive valuations high.

The effect of emotion on price is captured by what I call the Next Guy Theory. It holds that the price for an investment will not exceed what the investor believes the Next Guy will pay, less a discount. Here it is in a concept equation:

Expected Price a Future Buyer Will Pay $ XXX

Less: Discount Required (YYY)

Equals: Price Buyer Will Pay for an Investment $ ZZZ

The third variable in the concept equation for valuation, Deal Terms, is complicated but of vital importance to VCs. That’s because they provide price protection. That is, they reduce valuation risk—the risk of overpaying for a position. Examples are price ratchets, redemption rights, conversion rights, and liquidation preferences. Such terms condition the investor’s buy-in valuation on subsequent performance. If the company doesn’t grow in value as expected, the VC gets more ownership without additional capital.

Note: A company must have multiple stock classes to provide some investors with special terms. If there’s only one class, everyone must be treated the same. VCs demand special terms; you’ll never see one buy the same class of stock employees have.

The power of deal terms is apparent when you reflect on returns in the venture capital sector over the past four decades. They have delivered above-average returns in a space that has above-average failure risk. In part, it reflects the skill of VCs in picking companies to invest in. The more significant factor is that VCs use deal terms to mitigate valuation risk…to secure price protection.

My book is called The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.

{On Amazon, check out the Foreword and the Table of Contents.}

The Big Idea behind it is to adapt the VC model for private capital, where only wealthy investors can participate, to the IPO market, where anyone can invest.

How? By using a multi-class capital structure and deal terms to mitigate valuation risk for IPO investors.

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

IPO and pre-IPO investors get the tradable common stock, which I call Investor Stock.
Employees (which includes founders) get Investor Stock for actual performance as of the IPO.
For future performance, employees get the non-tradable stock. It’s a preferred stock that I call Performance Stock. It converts to the Investor Stock based on milestones that the issuing company defines and describes in its offering document.

This article is the introduction to a series of articles that discuss how the Fairshare Model can provide these benefits to entrepreneurs.

Enhanced appeal for IPO investors
Greater and faster return for pre-IPO investors
Competitive advantage in building and managing human capital
Potential to create powerful alignment within a supply-chain
Ability to create a low-cost marketing campaign that is durable and powerful.

Collectively, think of these articles as an online book that is updated with new content and responses to reader. I have three goals:

Address questions you have about the Fairshare Model.
Identify a few companies interested in raising venture capital using the Fairshare Model.
Identify accredited investors who may want to provide bridge financing to startups that want to prepare for a public offering using the Fairshare Model.

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