Ep319: Karl Sjogren – The Fairshare Model: Raise Venture Capital via an IPO

Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community we know that to win in investing you must take risk but to win big you've got to reduce it. This episode is sponsored by a Stotz Academy's online course how to start building your wealth investing in the stock market. I wrote this course for those who want to go from feeling frustrated, intimidated or overwhelmed by the stock market to becoming confident and in control of their financial future go to my worst investment ever.com slash deals to claim your discount now fellow risk takers. This is your worst podcast host Andrew Stotz, and I'm here with featured guests car Shogun car, are you ready to rock?

Karl Sjogren 00:45
I am indeed

Andrew Stotz 00:47
from originally from the Motor City. And I want to tell the audience a bit about you. And so the first thing is that in 2019, Carr wrote the book, the fair share model, a performance based capital structure for venture stage initial public offerings, and in it, it presents an idea for how to raise venture capital via an IPO. The concept can be applied to a blockchain venture that raises equity capital via initial coin offering. Also, its name describes its purpose to balance and align the interests of investors and employees. A Detroit native call has a BA and MBA from Michigan State University and is a certified public accountant and credential in turnaround management car. Take a moment and fill in some further tidbits about your life.

Karl Sjogren 01:43
Well, hi, Andrew. Hi, everybody. Yeah, I'd like to tell you a little bit about how I came to write the book, the fair share model, and it from 1996 to 2001. I was co founder and CEO of a company called fair share. We had an online community of investors with interest in the IPOs of young companies. The idea was to build an audience by giving them education about deal structures and valuation, and the ability to share due diligence. Once we got to critical mass, our plan was to provide companies free access to their public off to pick their public offerings to our members, provided they had a legal offering a past due diligence, they used our deal structure, the fair share model, and allowed our members to invest as little as $100. It was crowdfunding before the term was coined.

Andrew Stotz 02:48
And I'm curious, I mean, we've got a lot of interesting stuff that we're going to talk about. And I I want to tell the listeners that we may take a slightly different format because of what Karl's experiences, but so I'm going to just go straight into the question, which is about my worst investment. And since no one ever goes into their investment, worst investment thinking it will be tell us a bit about the circumstances leading up to it. And in this case, I think you're going to tell us a little bit about not only what is the fair share model, but also the concepts that you've learned and the mistakes that you've seen along the way. So take it away, Carl.

Karl Sjogren 03:27
All right. So let me start off by just telling you what the fair share model is. It's for a venture stage company that is having an IPO, a raising venture capital via public offering. In it, there are two classes of stock. Both vote one trade one doesn't investors get the tradable stock. So that's the IPO investors and the pre IPO investors, employees get it as well for value generated as of the iPod. But for future performance for most of the enterprise value is the employees get a voting stock that doesn't trade. It converts into the tradable stock based on performance criteria they described in their prospectus or subsequently both classes of stock three, two. So the basic idea is instead of developing a valuation upfront, before the investors come in, the evaluation unfolds based on performance.

Andrew Stotz 04:37
And how does that differ from let's say, you know, a typical structure or the way things are what was going wrong, you know, in the other structures?

Karl Sjogren 04:47
Well, so I say this inside I developed from writing the book is that there's basically three equity structure three capital structures. Equity, conventional capital structure, a modified conventional capital structure and the fair share model. Conventional capital structure is used in most IPOs. And in private offerings where you don't have professional investors, friends and family type investors. The hallmark is there's a single class that stock. So an investor who owns say 10% of the company, if it's going to be acquired, they get 10% of the proceeds. Well, I see the noise here, Andrew.

Andrew Stotz 05:43
Yep, no problem. noises. Okay. It's a family podcast.

05:48
Yeah. Suzanne, are you done in there? Yeah. Okay.

Andrew Stotz 05:54
All right.

05:55
Okay, got

Karl Sjogren 06:00
a modified conventional capital structure? Well, so a conventional capital structure, the Hallmark is a single class of stock. So if you were to think of it in terms of literary models, it's sort of like The Three Musketeers, all 4111 for all and all for one. A modified conventional capital structure is used by professional investors, venture capital funds, private equity funds. The hallmark is a multiple class of stock multiclass capital structures are needed if you're going to treat shareholders differently. And what professional investors require our deal terms that give them specific rights and privileges. So from a literary standpoint, it's a bit like George Orwell's Animal Farm. All animals are equal, but some animals are more equal than others.

Andrew Stotz 07:06
And it's those those big investors that end up building in better terms for themselves,

Karl Sjogren 07:13
or do they? So So here's an important point is that I got was that investors in the venture stage, they face two fundamental risk, value, failure risk, evaluation risk, failure risk is the risk that a company is not going to achieve the operational targets that investors are expecting, you might think of it like I say, I'm gonna jump up to here to the top of my head, but I actually am somewhere between here and before, as failures. You can, you can use due diligence to avoid it. But once you're in, you can try to use influence with management, you may rely on corporate governance. But if it's an investment in a private company, you're pretty much strapped in for the ride. If you invest in a public company, and you send a rise and failures, you can always sell your shares. Yep. valuation risk is different. It's the risk of overpaying for position and you can overpay for position in a company that hits all of us marks. Now, what distinguishes you take a look at the most successful investors in the venture space under venture capital funds and private equity investment funds. They are better at assessing and controlling failure risk. Because they see more deals they've experienced and they tend to invest enough where they have more influence with management, they can affect things. They're way better at controlling valuation risk. The way they do that is with deal terms, deal terms such as price ratchet, which basically have the effect of saying if a subsequent investor gets a better price than they did, the company owes the investor more shares for free. It could be that the subsequent investor doesn't pay enough but premium, which triggers that liquidation preference is another one where it entitles the investor to receive their investment back or multiple of that before any remaining proceeds are shared with other classes of shareholders, and redemption rights. There's a bag of tools that can be used to mitigate valuation risk. And it's the Great idea.

10:01
And I love

Karl Sjogren 10:02
these industries to do very well in an area that has high failure rates.

Andrew Stotz 10:08
And I guess when you look at this, it's really a lopsided transaction in its sense that the people who built the business know all about the business. But truth is, the investors know all about investing. So they come at the founders, with all of these terms, all of this stuff. And I could imagine that many founders make mistakes in that transaction, under pressure, and all that, yeah. Let's go through some of the things that you've seen then, and maybe try to identify, you know, some of the things that you would like to share about that?

10:48
Well, I would say that

Karl Sjogren 10:51
oftentimes, it is mistakes that entrepreneurs make, they don't understand the deal terms, they may think that. Well, say there's, there's an old saying in the venture business, and investor will tell an entrepreneur or I'll give you your valuation, if you give me my terms. Because these deal terms have the effect of potentially giving a Pyrrhic victory. No, the entrepreneur may think that they got that high valuation, but they don't realize that these rubber bands are there. They it's sort of like going to sleep in a room with a Python and a corner. You know, if it's hungry,

11:44
you're not going to be very happy.

Karl Sjogren 11:47
But, you know, valuation is the problem for investors too. I drew the analogy in the book about the problem with setting valuations for venture stage, venture stage companies is as challenging as being put in front of a classroom of elementary school kids, and being charged with the challenge of ranking them based on who's going to be a success in life, or who's going to be the most happy, you can define those terms, however you want. The point is, you're going to be wrong. Because life is like that, it takes time to, to play out. When evaluation has to be set at the time of the equity investment. It is forcing an unnatural,

Andrew Stotz 12:38
that's a great way of describing it. It's a great way of describing it. Because as I'm listening to what you're saying, and let's just use that analogy and say, you know, we're going to go in, and we're going to put down money on one of these kids out of 50 or 100, or whatever. And, and and we're going to get a right to X percent of their income. Yeah, you know, over a long period of time. And and and what we have to do is we have to beat a random selection.

Karl Sjogren 13:13
And especially in for news, new companies was pivots that need to be made changes and strategies. And, you know, we're, we're in an era we've been in one for several decades now, where the half life of companies is dropping dramatically. I think I saw something where, in the 1930s, the, in looking at the companies that were on the Dow Jones Industrial, the average age was about 75 years. A couple years ago, the average age was about 15 years. So it is more and more challenging for companies to have a durable value proposition because their environment changes so, so rapidly, so unexpectedly. So both sides of the transaction, the entrepreneurial team and the investors are dealing with great anxiety. If I need a valuation, what will it be? And there's all sorts of efforts to avoid it to kick the can down the road. In early stage companies you see convertible notes, you see other type of instruments keep agreement to keep safe agreements they call SAP and kiss agreements. In m&a, mergers and acquisitions, you often find companies having to first off the price that they pay for a company isn't is good. by emotion or other issues other than valuation calculations. And for that reason, you can see companies having to write off goodwill, excess price paid over time, you see in various types of separation agreements or mergers, the idea of a clawback, you know, prices set and as a call back saying, All right, if it turns out that that's too much, we get to pull back some of that value, or it could be an urn out, or we say we will agree to a price, but it may not be the right price, maybe you can earn more if the performance of the unit is there. So, this is the battle between the imperative to set a price and the greater uncertainty as to what it should be.

Andrew Stotz 15:58
So, I think, you know, you've shared some great stuff. I mean, this analogy of the story of trying to pick the winner out of a class of kids, is a great way of thinking what they're doing from an investment perspective. So maybe now we can kind of just run through some of the main things that you've learned, that you can share, particularly thinking in that the audience is probably, you know, probably more startup folks than it is investors. So maybe you can just go through some of the things that you've learned from your experience?

16:29
Well, I think

Karl Sjogren 16:33
the biggest thing is to realize that Well, first off valuation is a complex topic, but no one knows how to do it, right. And I suggest to people that I can give them two questions that after they're in a gathering of people who are either raising money, or have invested money, two questions that they can ask and, and really show their influence, what is you ask? When we're talking about the company, what valuation and you might start to see a funny look on the person's face. You know, because you know, they may not know what it is. And let me know what it is, but not be sure how to calculate it. Or they may know how, what it was and how to calculate it, but they're not very certain that it's a good number. And the second question you're going to ask is, why does that make sense? So having some content yet the tools that one learns in courses, like the ones that you have, I think are fundamental in terms of working through the riggings. And it is come Plex, but it could step back, and and basically recognize that if you don't want to get into that full depth, there's a lesson here and that. Nobody, nobody knows how to do this particularly well. And if you think about capital markets,

18:20
I think that

Karl Sjogren 18:22
they're not necessarily rigged. I don't think people have that much influence. But the tilted against the interest of average investors.

Andrew Stotz 18:35
They're not tilted?

Karl Sjogren 18:37
Yeah. Yeah. And it's possible, I believe, to have innovation that benefits average investors that benefits entrepreneurs in sectors that have trouble attracting venture capital, or who want an alternative way to approach it.

Andrew Stotz 18:59
And can you give you a formula for valuation, you had talked to me about simplifying earlier before we started the podcast, and maybe you throw in your formula for happiness just for a little bonus?

Karl Sjogren 19:11
Well, so we were talking about devices that I was using in the book to make complex topics accessible. And so I use the idea of concept equation, then I lead off with an example of a concept equation for happiness. Happiness equals what's happening minus expectations. So you can improve happiness by improving what's happening or lowering your expectations. With respect to valuation, I had written an article recently where I identified the drivers of valuation. I said valuation equals analytics Plus emotion plus deal terms.

20:04
Analytics

Karl Sjogren 20:07
has it discounted cash flow for example. And, and, and it intellectually is a great idea very appealing. The problem is that the raw material that calls upon which projections of cash flows are notoriously difficult to make in a reliable way. And so that's sort of a fundamental approach. If you're looking at comparable companies, you know, the same issue there too. Nobody really knows what they're particularly worth, emotion. emotion is players plays a very key role and invest investment decisions, whether what an entrepreneur was going to sell shares for or what the industry is going to take. I, there's an anecdote I have in a book about a guy who's a venture capitalist, who became one after having several successes as an entrepreneur. And he says he, he called some friends, and he said, What's the secret regarding valuation. And he was told, there is no secret. We fall in love with we fall in love with a company's a market, its team and its technology, we think other people will do. But deal terms play a very critical role. And that's sort of the safety net, all that enthusiasm. If things go wrong, it allows the investor to recover. So that's some of the basic insights. This is the complex topic. But it's not it's only because it's unfamiliar.

22:10
Yep.

Karl Sjogren 22:12
It's sort of like talking about biology. Complex.

Andrew Stotz 22:17
Yeah, geology, just about anything. The interesting thing for the startup company is that they don't really need to deal with it until they have to. And maybe it's the same with biology, you know, you don't have to worry about how do you heal a hurt knee until you have it? And then all of a sudden, you have to deploy tendons, ligaments, muscles, you know, all that. I would go ahead.

22:45
There are things about

Karl Sjogren 22:48
the importance of deal terms, for entrepreneurs, just to understand i think is key, and then getting the idea. And let me tell you, I'd like to tell you two big things that I think will come out of the Fisher model. Yep. Let me give you an example. Let's say I have a company that I've raised $2 million for in private money, and now I want to raise $20 million. In an additional round, I can go private or public, I'm going private, as a venture round, because 20 million is a lot of money. If I go the private route, I'm going to wind up with a modified conventional capital structure, I'll have deal terms that should things not necessarily work the way I'm hoping the $2 million investors and the employees, including the founders get squeezed. If I go public, I have two choices I can do the conventional capital structure, or the fair share model. Let's assume for a moment that comparable companies are worth $100 million. You would expect I would find if I use a conventional capital structure that I would file for my IPO with a pre money valuation of 100 million. I would raise my 20 million in the IPO mediately. After the IPO closes, I would have a post money valuation of 120 million, right 100 plus 220. And then in the secondary market, it would float depending on what's going on. If I were to use the fair share model, I would file my $20 million IPO with a pre money valuation of something like 10 million, not 100 million. The reason I would do that is one of my deal. Performance Measures is the rise in the market cap of the company. If I'm if that's a performance measure, I want it as low To as possible to begin with 10 million gives a little kick for my $2 million investors would raise the 20 million. My post money valuation would be 30,000,010 plus 220. My bet would be the secondary market investors would be recognizing my company as an undervalued asset and bid the price up. as that happens, employees stock that voting stock that doesn't trade converts into the tradable stock. That diluting the position of the investors. But they don't care. Because the value of their position is going up. Right. So that's one profound thing. Normally, investors are going to be attracted to a company based on the market, the technology and the team. Now there's a fourth factor is the deal. Okay. But the bigger deal, I think, is when it comes to this alignment of investors and employees. So let's assume for a moment that I've raised my 20 million and I want to hire you, Andrew, somehow I'm able to do that. Yep. And you have an offer from Apple. And I say, Andrew, I can pay you a salary won't be as much as Apple, I can offer you benefits. won't be as nice as apples, I can offer you stock options on my tradable stock. And they have more upside than apples. But I can offer you something that Apple cannot. And that's an interest in my performance stock pool. That's non tradable voting stock. And it only has value if we as a team are delivering these results. There's an esprit de corps that comes from that is more intimate relationship between work and reward the stock options can provide, that's not influenced too much. When you join the company, there's ideas that come to an entrepreneur, if I wanted to raise that $20 million, I might say, Hey, you know, I could raise all of that from some private equity funds or some large investors. Let's say I have a consumer product. And I want to expand marketing efforts, I can say, I want my big investors to commit to 15 million be on standby for 5 million. And for a month, I want to allow investors to invest as much as $100. The idea is, so assuming I sell 5 million of it goes to in $100 allotment, I've got 50,000 new investors who, who have gotten the deal price on the IPO, they're going to make money and more assuredly than if I use a conventional capital structure. But I'm achieving a marketing objective without spending any marketing dollars is just simply how I'm allocating my, my my capital, the more investors I have, the more transactions are likely to occur on the secondary market. This is something that's helpful for me to qualify for a better exchange. So capital formation, valuation deal structures. It's sort of like the real system, the real complexity isn't so much how you calculate these things, but how they all sort of fit into an economy. How do you how do you in a world full of volatility, where the advantage of low cost is not necessarily Long, long lasting, and you want to have alliances. It just opens up a palette of ideas. You could take that performance stock, you could use it as a sweetener for your pre IPO investors, you might use it to enhance your supply chain. Where were key suppliers, you know, normally you would have a negotiation on price and terms and quality. But you could say, Hey, if you're well performing, we'll a lot some performance stock for you. And if we do well, you will do well.

Andrew Stotz 29:56
So what's interesting you you mentioned about ICS and stuff like that. And one of the things about that type of I mean, in in, in my coffee business I've been looking at the idea of, could we do some sort of Ico that is related really, ultimately, let's just say a utility coin, that is a loyalty type of coin that encourages our farmers and growers to always sell to us rather than too competitive, and to encourage our customers at the other end, to always sell buy from us rather than from a competitor. And then if they earn coins from that, then that would be something that you know, would give them a loyalty program that would give them a lower price or a better deal or whatever. But then if those coins were tradable, then if the farmers that are going to put my child through high school, and therefore I need to get some cash, they could sell that coin. But also, if we tied that coin into a performance of the company, where we said 10% of the profits of the company would be allocated to that coin, then all of a sudden, we've got a performance aspect that we start to bring into it that says, anybody who participates in this coin is also really incentivized to make sure that this company as a whole, this whole ecosystem of a business is, you know, making more so that that's just something that made me think about,

31:20
yeah, it's a great point. The

Karl Sjogren 31:23
thing I would add to it is, you said profit sharing. With performance stock. The wealth isn't tied to profitability, it's tied to the performance goals, which could include profitability, it could include a rise in the market value, but it could include the ultimate acquisition price of a company, if there is one, or intriguingly, even measures of social good. So in the example that you provide, if the methodology of farming, and cultivation is an important part of your brand. And you've got some suppliers who are adhering to that more than the others in that that could become an element is just great alignment.

Andrew Stotz 32:23
So performance, so in other words, you set certain performance targets. And, you know, let's just say that we want to want more farmers to be organic, or to use a processing method that uses less water, as we continue to convert them to that. We're here performance targets.

32:41
Think think of,

Karl Sjogren 32:44
yeah, I say in the book that the Fisher model will be to capital markets, but Linux is to computer operating systems. Linux is a kernel, that open source kernel that basically displaced a lot of proprietary operating systems, features and there's a lot of variation in how it's implemented. There'll be different in the food business versus a software, business versus manufacturing versus service business. The stage of development will affect it, the personalities of the people involved will affect it. You mentioned blockchain or Icos. The last chapter in the book deals with blockchain and Icos and basically say, it doesn't matter if you're denominating ownership in stock or tokens, you still have a valuation issue. But I closed with an example of how a company might be able to use an IPO with the stock using the fair share model. And Icos if not mutually exclusive. So think of this example. Say as the movie studio or studio of some type that has multiple products, it could use a fair share model IPO to raise its parent level capital. And then use Icos security tokens to fund specific projects. And Icos have a functional current token to achieve a marketing goal, or loyalty program or on lines that you describe. So there's a rich palette here to play around.

Andrew Stotz 34:31
So for the listeners out there who are interested in it, that I'm going to put the links to the in the show notes to the book. I think I want to now start to wrap up and I want I would love for you to give one piece of advice for a company that is getting ready to raise capital, they don't know much about it. They're talking to some VCs and talking to family offices. They're talking to different people. What one piece of advice would you give them

35:01
Hmm. Well

Karl Sjogren 35:06
recognize that the dimensions to this. And I think my book can help open awareness to that. But recognize the importance of deal terms, under Pro, do dues, do some serious thinking, and discussions with people who other people who have raised money as entrepreneurs, or your investors, and understand what each of these terms has the potential to do to your other shareholders.

Andrew Stotz 35:53
Great point. And, you know, I think for the listeners out there, look at these deal terms. And also think about what could happen if what would happen in relation to this deal term, if things went really well, or went really poorly?

Karl Sjogren 36:07
I think that's if they go well, if they go well, with the conventional type of deal. Everybody's sort of happy. The one thing that I suggest in the Fisher model is to make it attractive is if it's going to be successful. Well, performing teams have to have the ability to wind up with more of the tradable wealth that they create with their labor than they could with a VC.

Andrew Stotz 36:40
Got it? That's a great summary of what you're getting at with the fisherman. Yeah. All right. So just one last thing for me is, whenever I go in and teach valuation, the first thing I do is I go up to the board, and I write down, why a W. And I asked the students to try to figure out why a w? And the answer is, you are always wrong. In fact, it is. So I call it y'all. But I say it aligns exactly with what you said, which is there is no right answer. And that's that the framework that we talked about evaluation is just that it is a framework. But it is there is no right answer. There is a range, as you said, which is another thing that I like so and what it means sometimes when people hear that there's no right answer that thing. Well, what's the point of all this? Well, there's a lot of benefit of learning how that structure works, and understanding what are the drivers, and you talked about the drivers of valuation being the analytics, the emotion and the deal terms. When it comes to the analytics, I always tell my clients in particular, that there's four drivers of value of a company when we look at it from the analytic side. And I usually stand up in front of them and turn around and show them the back of my body. And I keep my clothes on, of course, but I asked I point out my butt, and I asked them, What is this, and they they shout out things like ass. But in fact, what I teach them is it's my rear. And then I teach them that there's four drivers in the traditional model DCF, its revenue, which is the arm and rear, keep it up, get the revenue up, expenses, which is the Ian rear, bring them down or random down relative to revenue. And then the A in rear is the amount of assets that you deploy in the company, you want to either reduce the assets or get more from the existing assets. And then R is the risk. And that is a bigger one where we try to we try to capture risk in the model through the discount rate and all that. But there's many, many different types of risks, not just, you know, the risks that we're used to, in looking at a model, there's risk of geographic, you know, dispersion of your revenue and all that. So there's a lot of different things that I appreciate the discussion about, is there anything you would add to those things I just said,

39:17
you know,

Karl Sjogren 39:20
there's a lot of similarities to what we're talking about to philosophy, even religion, you know, social show social discussions, that they're important for the well functioning of a system. But it's difficult to take out an AI concept, like justice, for example, and say, Yeah, exactly, exactly. What does that how does it look like but everybody in a system has to feel that there's enough of it to make it work. valuations a little bit like that. It's a social science in a sense, and, and so I think you're doing to say, you would be advised to understand your technique that's like chemistry or something. There's just technical rules or techniques that you use to figure out something. But you want to step back, I say in a book, think of valuation as art. And describe how I experienced Art Museum. Now came back, okay, close look at the side, look at the placard. They're all expression, human expression of an emotion or an image of something. And the more I see,

40:35
the more I recognize, in new pieces of work,

Karl Sjogren 40:40
valuation like that, because it's an expression of human hopes and fears and ambitions and all sorts of things. And the more you pay attention to it, you're clued into If nothing else, what the other party across this table view is a human's human society.

Andrew Stotz 41:04
Yep. So for those listeners out there that want to dig deeper into it, just go and get the fair share model, a performance based capital structure for venture stage, initial public offerings, also, my mind book about nine valuation mistakes and how to avoid them. It's a good one because I try to highlight the mistakes that I see people making in real life. And I talk a lot about what Carl has said, which is that finance is both art and science. Science is the structure. But now, what call teaches us is that art, the art aspect is the emotion. And I guess the other art part is the art of the deal, the deal terms. So now, let me let me ask you the last question, which is what's your number one goal for yourself for your business in the next 12 months

Karl Sjogren 41:59
to launch a social movement to reimagine capitalism, to see enough investor interest in the Fisher model like companies consider adopting it to raise venture capital via an IPO.

Andrew Stotz 42:12
Exciting and for those listeners that are interested in learning more, I'll also have all the contact details for Carl on the on the show notes so feel free to reach out there alright listeners, there you have it another story of loss to keep you winning Remember to go to my worst investment ever.com slash deals, to claim your discount on how my course how to start building your wealth, investing in the stock market. As we conclude call, I want to thank you again for coming on the show and on behalf. Yes, have a Stotz Academy, I hereby award you alumni status, returning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Karl Sjogren 42:55
It's possible to innovate in this space in a way that benefits investors, companies and companies.

Andrew Stotz 43:02
Beautiful, and that's a wrap on another great story to help us create, grow and protect our well fellow risk takers. This is your worst podcast host Andrew Stotz saying. I'll see you on the upside.