E Applying Complexity Theory To Valuation

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The last of three articles on corporate valuations and capital structures.

“What’s a simple definition of complexity theory?” I asked that of someone involved in the study of it. He replied, “It’s the study of how simple changes affect complex systems.”

People often feel powerless to affect complex systems. But such systems are dynamic; they change if sufficient pressure is applied to key points. Once you allow for the possibility of change, its intriguing to consider the possible effect of simple ones.

Capitalism is a complex system. A key part of it, capital formation, involves setting a price—a value— for a company when it sells new stock. Investors also do it when they trade existing shares.

Capital formation and valuation are subjects that I have studied for years. My 2019 book is The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.  

Its tagline is “Reimaging Capitalism at the DNA Level.” That's because 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 a capital structure.

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. Both vote but only one can trade. Investors get the tradable stock, which I call “Investor Stock”—common stock. For pre-IPO performance, employees get it too. For post-IPO performance, employees get the non-tradable stock, which I call “Performance Stock”—a preferred stock. Based on milestones, Performance Stock converts into Investor Stock.

The structure is simple—its complexity flows from a question that is both philosophical and practical: “What is performance?”

Shareholders can answer that anyway they wish, and there will be variation based on a company’s industry, stage of development, and the personalities involved. Likely measures include:

  • A rise in the company’s value, measured by the price of its Investor Stock.
  • Development goals, such as release of products.
  • Financial measures like revenue and/or profit.
  • The eventual acquisition price, if applicable.
  • Measures of social good, if relevant.

The idea behind the Fairshare Model is simultaneously radical and ordinary.

It is radical because it 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. Another unique aspect of the Fairshare Model is that it presents a way for average 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 compete for public investors by offering lower valuations and better protections.

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Karl Sjogren is author of The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.  Its name describes its purpose: to balance and align the ...

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