Venture capitalists get price protection when they invest but investors in the public offering of a venture stage company don’t. Here is how I define my terms:

• “Price” is valuation. Specifically, the pre-money valuation—or price to buy the entire company given the terms of an offering.
• “Protection” refers to deal terms (e.g., ratchets, liquidation preferences, etc.) that retroactively lower a VC’s effective buy-in valuation if it turns out it was too high.
• A “venture-stage company” is unprofitable and has uncertain prospects. To exist, they require cash from investors because they don’t generate enough from operations.

The core challenge facing investors in a venture stage company is how to value them. Their operating history is null or glum, their asset value is slim or dubious and their future is steeped in uncertainty. When such a company sells stock, whether in the private or public market, it raises venture capital.

Venture capital markets have a provocative quality. Private investors—arguably “the smartest guys in the room” with respect to valuation—typically get price protection. Public investors don’t.

It makes sense if you expect the “best and brightest” to get the “good stuff.” It’s odd if you think that protections ought to go to those who need them the most. This situation deserves thought by anyone who wants to see both cheaper entrepreneurial access to capital and greater opportunity for average investors.

Why? The greatest sources of investor loss are business failure and overvaluation.

Now, all venture investors all face exposure to failure—and it is higher for VCs. However, there is a great divergence in valuation risk. VCs are valuation savvy, negotiate their best deal and secure terms that mitigate the risk that they they were wrong. Public investors face much greater risk of loss due to overvaluation because they are generally not valuation savvy so they don’t demand it and issuers lack incentive to offer it. These two conceptual equations convey the difference between a private and public venture round.

Here is another point to consider. Reducing IPO valuation risk will encourage pubic investors to invest in entrepreneurial ventures, the kind responsible for much economic growth and most job creation.

The price protection discrepancy came to mind as I read an article called Where Will All the Unicorns Go? (In 3 Charts) which describes conditions that will activate VC price protections. Written by Max Motschwiller, a VC with Meritech Capital Partners, it provides an informed perspective on the valuation of so-called unicorns—startups with private market valuations that approach or exceed $1 billion. You can read it here. — The image that heads up the piece is sure to make you laugh!

Motschwiller says that the dynamics that spawned these valuations are cooling. He points out that nearly…

…one new $1B private company [has been] created per week over the last 108 weeks! There is only so much unicorn-worthy oxygen in the world, and this growth is definitely pushing its limits.

The unicorn pipeline is so full that he estimates it could take four years for the present ones to raise the IPO money they expect. Should market receptivity to highly valued startups deteriorate, as it seems increasing likely, it will take longer. Motschwiller says that

I suspect that the [public] demand to pay the prices of previous private rounds will not always be there. I believe we will continue to set new records for the number of public tech offerings, but fear the IPO will not be the ultimate moment of validation and celebration for a company as it once was. The IPO, as it has been for many already, is becoming a bitter-sweet occurrence.

Left unsaid in the article is that VCs will see their buy-in valuation adjusted down when this happens.

As a result of the Jumpstart Our Business Startups Act (JOBS Act) reforms, many more venture-stage companies will raise capital in the public market. The amount that can be raised using a Regulation A form of public offering has been increased from $5 million to $50 million—Reg. A is now known as Reg. A+. Then there is the equity crowdfunding rule that goes into effect May 2016; it makes it less expensive to raise $1 million in a public offering.

So, the range of venture-stage companies available to public investors will be wide—from unicorns raised by VCs on a cash-rich diet to free-range startups seeking their first round of capital. Wouldn’t it be a good idea if public investors could get price protection too?

My forthcoming book, The Fairshare Model, presents a deal structure that encourages issuers to provide IPO investors with price protection. How does the Fairshare Model do this? There are two classes of stock—one trades, one doesn’t—and both vote.

Investors get the tradable stock, which I call Investor Stock. For value already delivered, employees get it as well.

For their future performance, employees get the non-tradable stock, Performance Stock. Based on milestones, Performance Stock converts to Investor Stock.

Initially, the conversion criteria are defined by the issuer and described in its offering document. They change when both classes of stock agree on new rules.
Intriguingly, a conversion rule based on the market price of Investor Stock provides incentive for an issuer to offer IPO investors a low valuation. For instance, if comparable companies are valued at $50 million, an issuer has incentive to give itself an IPO valuation of $10 million because a rise in the price of Investor Stock will trigger conversions.

Price protection is the goal of both a VC deal structure and the Fairshare Model, but it is implemented differently. A VC will tell an entrepreneurial team, “I’ll give you a valuation you’ll accept but reduce it if you don’t deliver the results I expect.” The Fairshare Model says “You’ll get the capital you need but you will not get wealthy until you deliver on agreed upon targets.”

The Fairshare Model is just an idea at this point—no company has used it. Before any consider doing so, a critical mass of investors must express interest in it. As it becomes apparent that an audience exists, an array of experts need to consider how to implement the model in different situations. Entrepreneurial teams and their backers need to figure out how to make it work for them.

Once these two steps take place, issuers will try it.

To sum up, VCs routinely have price protection when they invest but IPO investors don’t, even though they are at higher risk of overpaying. The Fairshare Model addresses that by creating incentive for an issuer to provide a low valuation. Thus, it offers a promising approach for how to marry public venture capital with the needs of entrepreneurs.