Reimagine Capitalism at the DNA Level

The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings

Karl Sjogren

438 pages, Fairshare Model Press, 2019

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The monumental contest of the 20th Century was over whether the world economies would be controlled by an idealized state or by imperfect markets. It was a battle over whether communism or capitalism would most benefit mankind.

What will define the epic struggle of our 21st century? It seems it will be defined by competition for resources and spheres of influence, stoked by conflict regarding values, beliefs, and attitudes—traditional versus modern. The damage that humans wreak on the planet seems certain to be the epic struggle, and it may involve nuclear devastation, be it by accident, war, or terrorism.

However, if the question focuses on economics, the answer may be that the defining challenge will be “How can the benefits of capitalism best be shared?”

The Fairshare Model provides fresh perspective on how to answer that with a revolutionary idea about ownership interests in companies that raise venture capital via an initial public offering. It describes a capital structure—a corporation’s DNA—that balances and aligns the interests of investors and employees—capital and labor.

The Fairshare Model does that with a dual-class stock structure—both vote but only one is tradable. Pre-IPO and IPO investors get the tradable stock. For value created as of the IPO, employees get it too. For future performance, employees get the non-tradable stock. It converts to the tradable stock based on milestones, which can be anything, including measures of social good. So, investors pay for performance after it is delivered, via dilution of ownership, rather than upfront, when stock is purchased.

The first excerpt presents the premise of the Fairshare Model—that valuation risk can be virtually eliminated for IPO investors. The second one considers a paradox: since startups have high failure risk, how do investments in them benefit society? —Karl Sjogren

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The Big Idea

In the minds of many, venture capital is associated with venture capitalists—investment professionals who manage funds that invest in private companies.

But venture capital is not the exclusive province of VCs, or their cousins, private equity firms. It can be raised in either a private or a public offering. In fact, Wall Street IPOs are routinely used to raise it. Many technology IPOs are for companies that are unprofitable and rely on new capital to survive. Ditto for biotech IPOs—some are for companies that lack significant revenue.

A central premise of this book is that venture capital is properly defined by the risks presented by the company, not by how it raises capital—in a private or public offering—or by who invests—accredited or average investors.

Venture capital investors face two fundamental risks. The first is that a company will fail to meet its operational expectations—failure risk. That is, management says it will do “X” but achieves less than that. It may achieve 90 percent of X, 50 percent of it, or a complete dud. Anything less than X is a measure of failure.

The second risk is that the investor will overpay for a position—valuation risk. It can happen even if the company meets all operational expectations. Put another way, one can invest in a completely successful company but lose money (or make less than expected) because the buy-in valuation is too high.

These twin risks underpin all others. Those related to market, technology, and management are but a blend of the two. It is also true of fraud, which is a serving of failure and valuation risk, garnished with false or inadequate disclosure.

Failure risk is omnipresent in a venture-stage investment—it can’t be eliminated. Investors can mitigate it through due diligence. Once they invest, they might be able to limit it by using oversight—if they have influence. If the company is private, they are stuck with the failure risk. However, if it is public, they can sell their stock.

Valuation risk is different. VCs mitigate it using deal terms that provide price protection by retroactively reducing their buy-in valuation if it turns out to be too high. Price protection—lower valuation risk—is a terrific idea. It increases the likelihood that investors will profit from an investment in a company with high failure risk.

The problem is that companies only offer it to private VCs, not to public VCs (a.k.a. the general public). Since public VCs buy in at far higher valuations than their private counterparts, they get a bigger dose of valuation risk—a higher buy-in and no price protection.

The big idea behind the Fairshare Model is to reduce valuation risk for IPO investors, to make it more likely that they will make money when they invest in a company with high failure risk. And if that happens, more public investors may take a chance and invest in a startup. Since they are the engine of economic growth and job creation, the Fairshare Model can therefore be good for the economy too.

Failure

Next, I’d like you to contemplate the relationship between innovation and failure at a macroeconomic level. It is uncontroversial to suggest that societies that tolerate failure are more likely to create innovative products and services than those that look down on those who try and fail.

In Chapter 7, I cite evidence of this provided by Edmund Phelps in his book Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change. His research led him to conclude that societies thrive when they are economically dynamic because such dynamism spawns’ growth and opportunity. It can also result in bad luck—that is, failure. For me, an important takeaway from his book is the idea that participants in a dynamic economy find a sense of purpose as they attempt to innovative. That is, its participants find greater meaning in their lives when they endeavor to create value for themselves and society—even when the result is failure.

Value is routinely measured by the income it generates, or the utility it provides. Ascribing it to an unsuccessful effort is a remarkable concept in economics, but a familiar one to philosophers and poets. Ralph Waldo Emerson said, “Life is a journey, not a destination” and Lord Alfred Tennyson penned, “Tis better to have loved and lost than never to have loved at all.”

Phelps writes that modern beliefs, attitudes, and values are the foundation for a modern or dynamic economy, and that such an economy facilitates what Aristotle called the “good life.” Phelps argues that innovation is a byproduct of a dynamic economy and that the pursuit of innovation brings individuals and society meaning and vitality. Why? Because the pursuit encourages intellectual and moral growth, the sine qua non of human experience. You may recall the two equations I used to express Phelps’s concept. They help us appreciate the upside of failure.

One can, therefore, say that at a macroeconomic level, the pursuit of innovation can contribute positive things to people and society, even when it results in failure.

Now, descend to the microeconomic level. How might one assess the effects of failure there? Let’s consider the question from the view of entrepreneurial teams, suppliers, customers, and investors.

• Founders: Failure can be a badge of honor of sorts as it indicates a willingness to try to do something that demands sacrifice, talent, discipline, optimism, and pluck. A failure may exhaust them, but it can season them for other opportunities. Plus, they have the satisfaction that comes from having pursued something they were passionate about.
• Other employees: Employees of a failed enterprise will lose their jobs, but they can find that their experience helps them get new work and accelerate their career.
• Suppliers: The consequences for a supplier of a customer that fails can range from a learning experience to dire. Much depends on whether they were properly paid.
• Customers: The cost of a company’s failure is inconsequential unless the customer was reliant on it for future services.
• Investors: The consolation prize for investing in a failure is a tax deduction, and a reminder to invest prudently and practice diversification.

This breakdown presents a paradox. The macroeconomic benefits of failure are sensed, but it is hard to see them at a microeconomic level. How can there be societal level benefits to failure when it is hard to identify who the beneficiaries are?

One explanation is that the benefits of businesses that succeed more than offset the cost of those that fail. But that is unsatisfying. I’ve met many people who experienced failure, sometimes multiple ones, without an offsetting win. As a rule, they were happy, or at least content, to have taken the risks they did. Their pursuit of the good life enriched their lives in a way that a cautious path did not. In other words, there are people who do not have enough success to offset their failures, yet they derive satisfaction from the attempt.

Another explanation is that an entrepreneurial culture encourages people to develop skills and attitudes that increase the skill and mobility of the economy’s participants. Its failures plow and prepare the ground for new efforts. The lessons learned, directly and vicariously, enable entrepreneurial teams and the investors who back them to be more skillful the next time they try to succeed.

Then, too, failure is the shadow of a powerful emotion—hope. Where there is hope, the possibility of failure follows. That’s because building a company is hard and deciding whether to invest in one is a challenge. All participants in a venture-stage ecosystem are imbued with hope. They seek to gain advantage, to make a mark, a difference, and profit. The collective hope of all these parties is the fuel of a dynamic, innovative economy.

Failure is the shadow of hope, and it is a major cause of investor loss.