Fairshare Model FINTECH presentation 05.28.15

Fairshare Model: A performance-based capital structure for companies that raise venture capital via a public offering

Karl M Sjogren (book expected in Q4 2015)

OPEN MIC NIGHT --- MAY 28, 2015

THE VAULT, SAN FRANCISCO

Fairshare Model: a crowd-vetted book

Section I – Overview

Chap. 1 – Set-up

Chap. 2 – The Fairshare Model

Chap. 3 – The Problem With a Conventional Capital Structure

Chap. 4 – Crowdfunding

Chap. 5 – Target Companies

Chap. 6 – Fairshare Model History & Projection

Section II – Context

Chap. 7 – Economic Growth

Chap. 8 – Income Inequality

Chap. 9 – Cooperation as a Tool for Competition

Chap. 10 – Tao of the Fairshare Model

Section III – Valuation

Chap. 11 – Concepts

Chap. 12 – Calculation

Chap. 13 – Evaluation

Chap. 14 – Disclosure

Topics for Section IV (not written yet) –Fraud, Failure and some wrap-up topics

There are 14 draft chapters at www.fairsharemodel.com

The Fairshare Model Begins Here

ENTREPRENEUR: I have an idea but need money

INVESTOR:How much of your company do I

get if I give you the money?

Vision, Goals and Perspective

VisionMiddle Class investors can invest in the IPOs of venture-stage companies… on terms comparable to those that venture capitalists get in a private offering.

Goals1. Alternative to a VC round (for companies).2. Liquidity for pre-IPO investors (limited if offering is small).3. Attractive option for public investors to be “mini-angels.”

Perspective is that of average investors. Ranking of interests:1st Place --- Average IPO investors (i.e. what is best for them?)2nd Place --- [Tie] Entrepreneurs and pre-IPO investors3rd Place --- Secondary market investors

Fairshare Model is an idea. It has not been used before.

Look at IPOs from this angle and you’ll have an intuitive sense for the Fairshare Model.

What is a “Venture-Stage” Company?A company with these risk factors: • Market for its products/services is uncertain

• Unproven business model

• Uncertain timeline to profitable operations

• Negative cash flow from operations

• Meaning, it requires investor cash to operate

• Little or no sustainable competitive advantage

• Execution risk; team may not build value for investors

Many public companies list such risk factors in their disclosure documents. Crowdfunding will increase the number of public venture-stage public companies…but they are not new.

Fairshare Model (for a public offering)

• Two classes of stock, Investor Stock and Performance Stock.

• Both vote, only Investor Stock can trade.

• Performance Stock can never trade.

• Based on quarterly measures of performance, Performance Stock converts into Investor Stock.

Approval from each class required for:• Board member election • Change to conversion criteria.• Compensation plans involving Investor Stock.• Changes to capital structure.• Acquisition matters.

Fairshare Model premise: IDEAS ARE JUST A MULTIPLIER OF EXECUTION

Value of an Idea Value of Execution

Awful Idea = -1 No Execution = $1

Weak Idea = 1 Weak Execution = $1,000

So-So Idea = 5 So-So Execution = $10,000

Good Idea = 10 Good Execution = $100,000

Great Idea = 15 Great Execution = $1,000,000

Brilliant Idea = 20 Brilliant Execution = $10,000,000

To make a business, you need to multiply the two.

The most brilliant idea, with no execution, is worth $20.

The most brilliant idea takes great execution to be worth $20,000,000.Tip of the hat to:Derek Sivers www.sivers.org

That Premise Doesn’t Explain the Valuation of Venture-stage Companies

What drives the increase in valuation that often occurs as a company approaches its IPO?

Is it performance……. or is it something else?

Two Explanations1. The Next Guy Theory of Valuation

2. Market Forces

Discussed in chapter 3--The Problem With a Conventional Capital Structure

Next Guy Theory of PricingFor an investment, the price is no more than what the buyer believes the Next Guy will pay, less a discount.

Implication

Market ForcesNext Guy Theory applies to items without utility…like investments.

Retail

Wholesale

For items with utility (food, clothing, etc.), a wholesale/retail price bifurcation is common.

Might this concept explain the valuation climb? Let’s apply it to the IPO market:

•“Product” = equity in a venture-stage company•“Manufacturer” = issuer•“Wholesale customers” = pre-IPO investors•“Retail customers” = public investors

Comparable Product with a Retail Markup? No! The product is not comparable, there are important differences.

The product sold at wholesale to pre-IPO investors is better than the retail version. • The stock that VCs get have price protection and other features (i.e. liquidation preferences, anti-

dilution provisions, etc.)

The product sold to public investors lacks such features.

So, the retail buyer gets an inferior product and pays more for it!

I can’t think of another market—a competitive market—where that happens. Can you?

What Explains the Price Increase in “The Product” as it Approaches an IPO?

Four hypothetical drivers

1. It is considered “normal”- But, many things once considered normal are no longer

The Next Guy Theory provides insight into the dynamics, but what are the drivers?

2. A bigger neighborhood- More Potential Buyers = Higher Potential Demand = Higher Potential Price

3. Competitive market forces are weak- If strong, issuers would compete for investors by offering lower valuations

4. VC value-add (knowledge, connections, ability to write a big check quickly)

- Challenge for companies that crowdfund – “How to replicate VC value-add?”

- How much is the VC value-add worth to public investors?

Whatever the explanation, what risk does the IPO valuation present for public investors?

Why so much downside exposure?

Because of a Conventional Capital StructureJohn Kenneth Galbraith coined the term “conventional wisdom.”

There is conventional wisdom about how to organize (and value) the ownership interests in a corporation. It is reflected in a “conventional capital structure.”

Defining characteristic of a conventional capital structure: A value for future performance must be set when a company raises equity capital

He uses it to describe a convenient and comfortable point of view that is often false.

Hard to do in a reliable manner!

Nonetheless, a conventional capital structure requires…indeed, it demands a value for future performance at the time of an equity raise.

The Little Shop of Horrors that is a Conventional Capital Structure

FEED ME A VALUATION SEYMOUR!

A Conventional Capital Structure Poses Problems for Public Investors too

1. The basis for a valuation is shaky.

2. They assume most of the risk that it is too high.

Interlaced foundations of the problemPublic investors…

• Pay “retail” but don’t know it.

• Don’t get a better deal because issuers see little advantage in offering one. Investors may respond with “what’s valuation? Is it worth?”

• Don’t demand a better deal because they are not valuation savvy; terms were not an issue in the Occupy Wall Street protests.

• Are not valuation savvy, in large part, because the SEC doesn’t require valuation disclosure.

The Fairshare Model is UnconventionalIt’s complexity is designed to favor average investors—as well as well-performing teams.

Remarkably, it provides incentive to offer IPO investors a low valuation. Entrepreneurs do not care what the valuation is; it doesn’t affect their financial position or voting power.

What matters is “what does it take for Performance Stock to convert into Investor Stock?”

It is unconventional because there is no need to place a value on future performance!

BTW, that’s another difference—where there is complexity in a conventional capital structure, it is frequently to advantage insiders over average investors.

The incentive? A rise in the market cap can be defined as performance, triggering conversions.

Conventional Model Fairshare Model

Tao of the Fairshare Model

When should the ownership interests of insiders be defined, before or after performance is delivered?

Put another way…Who should bear the risk of uncertainty, should it be insiders (employees and existing investors)… or should it be new investors?

Taoism is a Chinese philosophy about truths. Finding one’s tao requires meditative and moral exploration.

Fairshare Model’s tao: harmony within the uncertainty inherent in a venture stage investment.

Contemplate this question:

Those who believe the risk of future performance should be borne by new investors will favor a conventional capital structure.

Those who believe it should be borne by insiders will favor the Fairshare Model.

Visualize the tao of the Fairshare Model

Imagine a long balloon. But instead of air, it is full of uncertainty.

Ownership side Performance side

And certainty is represented by a weight

One end represents ownership interests while the other represents future performance.

PrincipleIn a venture-stage company,

uncertainty can be moved but not eliminated.

Where the Uncertainty Is

The bet is on valuation. The bet is on human behavior; will shareholders agree on how to reward performance?

A different bet, not necessarily a better one!

How VCs Deal With Uncertainty

Takeaway The Fairshare Model simulates a

VC deal structure in a public offering!

Discussed in chapter 10

Entrepreneurs: Pick Your Challenge!

“What is the value of my future performance now?

“How do I define my deliverables?”

Meanwhile…

Conventional Capital Structure Fairshare Model

vs.

…VCs and Wall Street banks enjoy so much success with venture-stage IPOs…. that, eventually, public investors

may say…

Diner scene from 1989 movie, When Harry Met Sally

(portrayed here by Sally, simulating an orgasm)

As this happens, interest in the Fairshare Model will grow!

Chapters 3, 11 and 13 discuss the dynamics that affect the valuation of venture-stage companies.

The most controversial assertion is that valuations reflect weak market forces…an inefficient market…driven by public investors (Next Guys) who are:• unsure what valuation is, • why it is important, and • how to calculate it, let alone evaluate it.

Chapter 14 argues that regulators could strengthen market forces if they require issuers to disclose their valuation. Please join me in calling for it!

Let’s look at how the Fairshare Model might play out in some scenarios.

Skeptical? Why don’t companies compete for IPO investors by offering better deal terms ?

What Kind of Companies Might Adopt the Fairshare Model? Feeder Seeks capital to develop a product and be acquired.

Aspirant Aspires to build for the long-term.

Pop-up Fund a project, product, movie, game, invention, oil well, etc.

Spin-Out Tired backers; a VC’s “living dead” or to-be-spun-out division of a company.

Rejuvinator Established company in financial distress (i.e., GM in 2009?).

These categories can overlap. Plus, a company may be a shape-shifter. • A Feeder may tell you it’s a Feeder….but it might may tell you that it’s really an Aspirant. • A Pop-Up may think that it’s a Feeder or Aspirant. • A Spin-Out can’t remain a Spin-Out—it must evolve into a Feeder or an Aspirant. • An Aspirant may wind up being a Feeder after all.

Discussed in chapter 5

Category of

Company

Strategic

for

Fairshare

Model? Goal

Likely

Offering

Size

Likely to be

a SEC

Reporting

Company?

Expectation of

Performance

Stock

Conversion

Secondary

Trading Market

Feeder Yes

Launch

product—get

acquired.

$3M to

$7MMaybe High

Pink Sheets; principal

investor exit via

acquisition

Aspirant Yes

Build a

company

that lasts

$5M to

$20M+Yes High

Pink Sheets, a

regional exchange, or

NASDAQ Micro for

larger ones

Pop-Up NoOffer equity

in a project

Less than

$5MUnlikely Low Same as Feeder

Spin-Out No

Alternative

for a new VC

round

$5M to

$20M+Yes High Same as Aspirant

Rejuvenator NoFund a

turnaround $20M+ Yes High

NASDAQ Micro or

better

Target Companies for Fairshare Model

We will look at scenarios for these two

Prelude to Feeder & Aspirant Charts

Five charts follow that illustrate possible scenarios for Feeders & Aspirants.

They show how conversion of Performance Stock may dilute Investor Stock.

Feeder charts1. Acquired 3 years after the IPO (with

presumed performance factor)

2. Acquired 1 year after the IPO (with presumed performance factor)

Aspirant charts3. No Performance at all

4. Presumed performance but no actual performance

5. Presumed performance, then actual performance

100% of Investor Stock = Investor Stock @ IPO + Performance Stock that converts

IPO + 1 yr + 2 yrs + 3 yrs

From Money 100% 92% 84% 50%

From Performance 8% 16% 50%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f In

vest

or

Sto

ck

Time Since Fairshare Model Offering

Shareholders agree that Performance Stock get 50% of the acquisition proceeds

Feeder Acquired 3 Years After IPO“Presumed performance” is a employee goodwill incentive.

No need to define or measure quarterly performance for a period (e.g., development phase).

Presumed performance assumption:• 8% year• 20% maximum

Acquisition offer in year 3.

Investor and Performance Stockholders agree to split the price evenly. So, 50% of the Investor Stock in year 3 is from Performance Stock.

No agreement, no acquisition.

Note 3 year time scale

Investor Stock issued via Performance Stock conversion for “presumed performance”

Feeder Acquired 1 Year After IPO

IPO + 1 Qtr + 2 Qtrs + 3 Qtrs + 4 Qtrs

From Money 100% 98% 96% 94% 40%

From Performance 2% 4% 6% 60%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Time Since Fairshare Model Offering

Shareholders agree that Performance Stock gets 60% of proceeds

% o

f In

vest

or

Sto

ck

Same presumed performance assumption as before (8% year or 2% per quarter).

Acquisition offer 1 year after IPO.

Shareholders agree that 60% of the proceeds should go to Performance Stockholders.

It is 10% higher…because the offer came faster.

Note 1 year time scale

Performance Stock conversions based on presumed performance

IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs

From Money 100% 100% 100% 100% 100% 100% 100% 100%

From Performance 0% 0% 0% 0% 0% 0% 0%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f In

vest

or

Sto

ck

Time Since Fairshare Model Offering

No Performance Stock conversion because there is no presumed nor actual performance (i.e. a dud).

Aspirant: No Performance Conversion

With neither presumed or actual performance, there are no conversions. Therefore, only Investor Stock issued for money or pre-IPO performance is tradable.

Company raises capital to build product and launch business. No presumed performance rule.

All Aspirant charts use 7 year time scale

Imagine it is… • A biotech and it’s product

fails FDA testing;

• A game developer that doesn’t release a product; or

• A software developer whose product flops.

Aspirant: Only Presumed PerformanceSame presumed performance assumption as for Feeder:• 8% year• 20% maximum

• Yr 1 - 8% conversion• Yr 2 – 8% conversion• Yr 3 – 4% conversion

Company fails to meet performance goals, so conversions cap at 20%.

IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs

From Money 100% 92% 84% 80% 80% 80% 80% 80%

From Performance 8% 16% 20% 20% 20% 20% 20%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f In

vest

or

Sto

ck

Time Since Fairshare Model Offering

Presumed performance conversion of 8% per year--capped at 20%

No conversion for actual performance

IPO + 1 Yr + 2 Yrs + 3 Yrs + 4 Yrs + 5 Yrs + 6 Yrs + 7 Yrs

From Money 100% 92% 84% 68% 54% 42% 32% 24%

From Performance 8% 16% 32% 46% 58% 68% 76%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f In

vest

or

Sto

ck

Time Since Fairshare Model Offering

Presumed performance conversion of 8% for year 1 & 2

Conversions in years 3 – 7 reflect actual performance

Aspirant: Presumed & Actual PerformanceSame presumed performance assumption • Year 1: 8% conversion• Year 2: 8% conversion• Year 3: 4% conversion

But performance is strong; conversions exceed the presumed performance.

Total = Presumed + ActualYear 3: 16% = 4% + 12%Year 4: 14% = n/a + 14%Year 5: 12% = n/a + 12%Year 6: 10% = n/a + 10%Year 7: 8% = n/a + 8%

This team performs so well, it winds up with 76% of the Investor Stock after 7 years—far more than would be possible with a VC.

Scratch pad to calculate annual conversions32 - 16 = 16 58 - 46 = 12

46 - 32 = 1416 - 8 = 8

Cumu-lative

8%16%

Below

Cumu-lative32%46%58%68%76%

68 - 58 = 1076 - 68 = 88 - 0 = 8

The Fairshare Model bargain for investorsIf the company performs, investors will be diluted on a percentage basis—their slice of the ownership pie will be reduced, possibly dramatically.

However, if the performance translates into a higher valuation, investors should not suffer economic dilution—their stake should grow in value.

VCs like to say “I’d rather own a small slice of a big pie than a large slice of a small pie.”

Same principle.

The Fairshare Model bargain for employees In addition to other compensation--salary, benefits, bonuses and stock options on its Investor Stock-- employees have an interest in its Performance Stock pool.

• Performance Stock is like cheap founder’s stock; its only value is its ability to vote and its potential to convert into Investor Stock.

As the team performs well enough to meet the conversion criteria, employees have another way to earn stock that they can sell (or hold).

Huge Potential: A company that adopts the Fairshare Model could have a competitive advantage with respect to attracting and managing human capital.

Wouldn’t you be pleased to get an offer that includes Performance Stock?

An employer’s “brand” reflects how it implements it’s philosophy about people.

Balance & Align Interests: Shared ValuesEntrepreneurs have an incentive to offer public investors a low valuation.

Equity incentives are tethered to collective operational performance vs. valuation at individual option grant date, which employees don’t control.

Investors have an interest in helping the company meet its goals

Bottom Line---The use of cooperation as a competitive tool

VS.

1st Challenge for the Fairshare ModelShow that a lot of investors like it! They signal interest in companies that use it.

We Are Here!

We Are Here!!

We Are Here!

We Are Here!!!

BEFORE companies think about how to make the Fairshare Model work for them…

….a LOT of you need to make noise.

Each of your voices must generate buzz.

Sounds that leads others to take note and join in.

People who like the Fairshare Model must combine their small voices and shout….

..just like the tiny residents of Whoville.

2nd Challenge for the Fairshare ModelDebug and tune it more tightly. This will be done with entrepreneurs, attorneys, accountants, angel investors, experts in capital markets, etc.

A conventional cap structure has Ponderables too!• Does it scale…downward? Its approach to

valuation works for established companies, but, does it work well for public venture-stage companies?

• Can the interests of investors and employees be better aligned as the valuation climbs?

The “Ponderables”:• How might performance be defined?

• Who should define performance?

• How might it be measured?

• Who should measure it?

• How should rewards of performance be allocated?

• Who should administer the rewards of performance?

• What are the tax and accounting implications of the Fairshare Model?

Variations based on industry, stage of development, geography, personality…

3rd challenge for the Fairshare ModelTime and experience. Sustaining goodwill between the providers of capital and labor is the central challenge.

Now

A Lot to Think About

So, join me to explore…

The new frontier… Better Capitalism

This is the construction of the Fairshare Model.

It’s mission: to explore new relationships between investors and employees,

to help entrepreneurs raise venture capital,

to boldly go where no capital structure has gone before!

Help Build the Fairshare Model!1) The Fairshare Model is in competition for inclusion in the world’s first crowdsourced

FINTECH book. *Recommend* the abstract…tomorrow or Saturday (before June)!◦ Google “The FINTECH book" to learn more about the project

◦ Google “The FINTECH book" + “Fairshare Model” to see the short abstract

2) Read the draft chapters at www.fairsharemodel.com

3) Help make it better. Send comments, challenges (love them!) and suggestions to me at [email protected]

4) Create buzz about the model!