The Fairshare Model: Chapter Fourteen

Karl M. Sjogren

2015-07-02

Chapter 14: Valuation Disclosure

By Karl M. Sjogren *

Send comments to karl@fairsharemodel.com

Preview

  • Foreword
  • The Elephant in the Room
  • Key Conclusions You Should Have In Mind
  • The Case for a Valuation Disclosure Requirement
  • What Valuation Disclosure Might Look Like
  • What Disclosure of the Basis for the Valuation Might Look Like
  • Valuation Disclosure - Why Hasn't It Happened Already?
  • A Call for Action on Your Part
  • Onward

Foreword

This is an important chapter if you favor one or more of the following:

  • Market-based solutions
  • Transparent investor disclosure (a/k/a open, candid disclosure of significant information)
  • The Fairshare Model

This chapter asks you to petition policy makers require that issuers of stock plainly disclose and discuss the valuation they give themselves in their offering document.

The Elephant in the Room

Dara Albright is a New York based crowdfunding advocate who makes an intriguing comparison between the 1971 Intel Corporation IPO and the 2014 IPO of the much ballyhooed Alibaba Group.

Albright presents this table when arguing that equity markets are in need of repair. That big financial institutions help channel immense amounts of capital to a few deals instead of modest amounts to small, job-creating businesses. And, that banks allocate IPO shares in a manner that benefit privileged investors instead of average ones. She argues that this constitutes a misallocation of resources and that equity crowdfunding can help correct it.

Her table prompts me to contemplate these points as well:

  • Is it possible anymore to have a 38 page prospectus?
  • Do disclosure documents now emphasize risk disclosure to a brain-numbing degree?
  • Do disclosure requirements miss the proverbial elephant in the room, the valuation?

Not one of the 325 pages in the Alibaba prospectus states that it set its IPO valuation at $170 billion. The only references to valuation essentially said:

Prior to this offering, there has been no public market for our shares. The public offering price for has been determined by negotiation among us and the underwriters based upon several factors. [36]

Well, knock me over with a feather! That's illuminating!

Implicitly, Alibaba, just like all the other issuers that similarly describe how their IPO price is set (i.e., virtually all of them), ask investors to view the matter as if it were the birth of Athena, the goddess of wisdom in ancient Greek mythology. As you may know, Dear Reader, she was born fully formed, as an adult, springing out of the head of her father, Zeus, not from her mother's womb. Athena was also associated with purity, for she remained chaste.

Issuers who make pronouncements like Alibaba's about their IPO valuation indirectly assert both wisdom and purity in the setting of its valuation.

The wisdom is from the investment bankers.

Purity is evoked in a virginal sense. As a public company, its valuation is unsullied by prior transactions in the capital markets.

Now, of course, all IPO issuers have a valuation history as a private company. Why this is thought to be irrelevant to public investors is a curious matter, indeed. [37]

All of this is, of course, as much the basis of myth as Athena herself. Factors other than wisdom inform where the offering price is set, and, all companies have a valuation history leading up to their IPO.

But put the history to the side, what is the valuation? Investors need to pull it out of their head!

When it comes to valuation, the apparent, albeit unspoken, rule for offering documents is Don't Ask, Don't Tell. Investors should figure it out.

That seems, well, wrong-headed.

Key Conclusions You Should Have In Mind

Dear Reader, let's review some of the conclusions that I hope you've reached by now:

  • Valuation is an important determinant of investor risk and upside.
  • Investors who are valuation unaware are more likely to make poorer decisions than those who are valuation aware.
  • The issuer and its investment bankers decide what the valuation will be.
  • Comparable companies can choose significantly different valuations.
  • Valuation is "price" but it can easily be misconstrued as a representation of "worth"-investors can better evaluate the difference if the price is clearly stated.
  • Valuation is different from price per share; companies with the same share price can have wildly different valuations.
  • A simple calculation can determine a company's valuation-it is not rocket science.
  • Many investors may feel uncomfortable computing an issuer's valuation or neglect to do so.
  • Venture-stage companies are difficult to reliably value. (If he were an investor, the movie character Forrest Gump would compare them to a box of chocolates). [38]
  • Historically, emerging growth companies have been associated with economic growth, job creation and, arguably, the ancient Aristotelian concept of the Good Life. If follows that all could be enhanced by improving entrepreneurial access to capital.
  • Wall Street banks have been taking venture-stage companies public for decades; anyone how believes that average investors should not be allowed to invest in them should realize they already have the ability to invest in them.
  • VCs can protect themselves from investing at an excessive valuation but public investors cannot.
  • More venture-stage companies will be presented to public investors as a result of regulatory changes like the JOBS Act and evolving notions of how well-established a company needs to be before it is "ready to go public."

I'm about to make the argument for another conclusion that I'd like to share-offering documents should disclose the issuer's valuation. At present, they make prominent mention of the price per share but not the valuation.

The balance of this chapter is a call for regulatory change, for social and investor activism, designed to provoke a significant change in the market for equity capital. This chapter is an appeal for your help, Dear Reader.

The Case for a Valuation Disclosure Requirement

The Jumpstart Our Business Startups (JOBS) Act makes it easier for companies to sell stock to investors who are wealthy (i.e., they meet the Securities and Exchange Commission's "accredited investor" standard) and also, potentially, to small investors. The law called for the SEC to authorize rules for "equity crowdfunding" (Title III) by the end of 2013. More than two years after that deadline, it hasn't happened, purportedly, due to the difficulty reconciling the JOBS Act with the SEC's mission to protect investors.

No matter how the law is implemented, the SEC (and state regulators) could do much to help investors protect themselves by requiring that all companies disclose the valuation that they give themselves when they offer stock. Not only that, such a requirement would also encourage companies compete for capital by offering better terms. When investors are valuation aware, they are more likely to recognize when a company has valued itself attractively. This awareness encourages companies to compete for public investors based on deal terms, which is good for investors.

Valuation is occasionally cited in news reports, but many investors are unsure what valuation means. But you know, Dear Reader, that it is simply the price to buy the entire company, based on the latest price shares are sold at. When new shares are sold by an issuer, valuation refers to the "pre-money valuation". After the offering is complete (i.e., money is pledged for the new shares), it refers to "post-money valuation" or market capitalization.

Some investors know what valuation means but are unsure how to calculate it (chapter twelve shows how). Whether a company is privately held or publicly traded, the calculation assumes that stock is sold at market value and that the latest price is the value of each share outstanding. So, theoretically, it is what someone would pay to buy the entire company. Maybe it is. Maybe it's isn't.

Assume ABC Company has given itself a $50 million pre-money valuation. How might an investor evaluate making an investment in ABC's stock? If she knows the valuation (and its significance), it is easy for her to pose a fundamental question.

ABC Company has less than $1 million in revenue and no profit. Why should I invest when it is valued at $50 million?

If the investor does not know ABC's valuation, her price related question will likely be "Why should I invest when it is $5.00 per share?" But this is not meaningful! ABC could have the same valuation with a lower price and more shares outstanding; the valuation equals the number of shares multiplied by the price.

The important question is "Why is ABC worth $50 million?" Investors who don't know this are at greater risk of making a poor decision.

Valuation is important information and investors should not, as they do now, have the burden of calculating it. Some may not know how to. Others may be uncomfortable doing so or forget to. Some may calculate it incorrectly. Disclosure of the figure ensures that everyone has easy access to the right figure.

It also helps data aggregators compile valuation statistics. This enhances efficiency in capital markets the same way that Kelly Blue Book improves efficiency in the car market and home listing data improves efficiency in the real estate market. That is, a disclosure requirement facilitates the generation of comparable data sets or "comps"-about the market.

Investment professionals have better, albeit imperfect, access to this data via their network and fee-based research services, but many angel investors and virtually all public investors don't have it. That's not the hallmark of an open market.

An investor who knows the valuation of comparable companies is in much better position to ask questions such as these.

  • ABC is similar to XYZ Company, which was valued at $30 million recently. What makes ABC worth more?
  • Companies at ABC's stage of development have averaged valuations that are significantly different from others in this space -is there a reason?
  • ABC's valuation is half that of a comparable company that is backed by some major VCs. Given that ABC doesn't have similar support, shouldn't its valuation be even lower?

Questions such as these would be easier for angel investors in a private offering, easier for average investors to formulate for a public offering, if valuation comps were readily available.

Easily accessed valuation information sets set the stage for issuers to compete for investors, much as merchants do for customers. Some will view this is as undignified, but this is a characteristic of fair markets. And competition should result in better deal terms and lower valuations. It should also help investors make better decisions. And, it will benefit companies who offer a better deal because more investors will recognize when one is offered. All of this should good for the economy, good for investors and good for competitive companies.

The lack of a disclosure requirement has two negative consequences. First, investors are more likely invest unwisely. Second, issuers who offer better terms are less likely to create greater demand if investors who do not understand the importance of valuation.

I have met accredited investors who are uncomfortable calculating valuation. I am certain that many average investors would struggle if asked to do so. Some believe, mistakenly, that the SEC must assess an issuer's valuation before an IPO takes place. It doesn't. The commission assesses whether an issuer complies with the disclosure requirements-which does not include valuation.

Because the SEC does not evaluate an issuer's valuation, it tells investors, effectively, caveat emptor (buyer beware). [39] And this is understandable, for there is no reliable way to assess valuation and besides, in a market economy, prices are set in the market.

Even in a market economy, many believe government should move markets to be more transparent and competitive. But when it comes to valuation disclosure it hasn't, not in America anyway, the largest capital market in the world. That is something, Dear Reader, I hope to enlist your support to change, as you'll shortly see.

Skeptics of this idea might consider the likelihood that more money has been lost by more investors because they overpaid for a stock than has been lost due to fraud, which is a focus of regulatory attention. Investors who are not valuation aware are more susceptible to "irrational exuberance." Also, that entrepreneurs can be hurt by valuation-unaware investors for success at raising capital at excessive valuations encourages arrogance about OPM-Other People's Money-and/or naïveté about future raises of capital. Furthermore, companies that offer a low valuation will be met with blank looks from investors who are unsure what it means, which contributes to inefficiency.

It will take far longer for valuation disclosure to happen without government. Attorneys will advise issuers to not disclose their own because it is not required, and disgruntled investors may later argue the company represented itself as being "worth" the valuation. An undaunted CEO will find the task more complex than providing the figure because the prospectus will also need to explain what valuation is. The following concept formula summarizes why a government requirement is needed.

Without valuation transparency, the market for equity capital is far less efficient than many other markets. Grocery stores offer an analogy. Unit pricing helps shoppers evaluate and compare products. Where it's not present, shoppers must calculate price per pound, per ounce, etc. Some maybe too busy or uncomfortable to do so. Before it was adopted, food companies competed by promoting awareness of their brand and offering attractive packaging. In markets where unit pricing was adopted, competition shifted toward value as defined by price.

Nutritional Fact Panels take the food analogy further. The disclosure of fiber, salt, sugar, fat and calories in a serving encourages informed shopping, and, it encourages manufacturers to offer healthier products. It also helps small companies compete against large ones with established brands, better aisle placement and fancier packaging.

Similar dynamics are possible in equity securities. Issuers who are not marketed by Wall Street banks have a better prospect of competing for investors on valuation if all investors have ready access to an issuer's valuation and data about the comparable companies.

Two things seem true. Implementation of the JOBS Act will encourage more companies to offer stock to a larger pool of valuation-unaware investors, and, markets enhance the quality of products when relevant information is readily available to buyers.

Valuation disclosure may sound esoteric, but it's not. The SEC requires issuers to disclose risk factors in offering documents. Sometimes, the result is pages of eye-glazing prose.

A requirement for valuation disclosure could be accomplished on one page.

In and of itself, the figure would not necessarily mean much. As discussed in chapter fourteen, it is a challenge for anyone to evaluate a valuation. But one can't contemplate something unless they know what it is and engage in discussion with others attempting to evaluate it

At a micro level, valuation disclosure makes it easier to ensure that investors and companies consider an important data point that heretofore has been in the closet.

At a higher level, it encourages market forces to work in the capital markets the way they do in most markets-it promotes competition for buyers. A consequence of this would be better informed investors.

At an existential level, it promotes thinking about what constitutes value and how uncertainty is distributed.

All of this would help market forces improve how capitalism works regardless of whether the Fairshare Model is

What Valuation Disclosure Might Look Like

What might a SEC valuation disclosure requirement look like? Before issuing new rules, the commission calls for public comments-respondents on this subject would have an array of views. Like many things, the more one seeks to define rules to apply a concept, the more complicated it can appear. But it is possible to craft an approach for most situations and ways to deal with those less straight-forward.

What kind of offerings should be covered? To generate useful data, it should be required for all equity offerings. That is, for both private (e.g., Reg D offerings) and public offerings of stock (e.g., Reg A, S-1 offerings, etc.). There is another reason to include private offerings-some angel investors are uncomfortable calculating it-just because they are rich enough to invest doesn't mean they know how to calculate it. So, it makes sense to require it for all stock offerings, even private offerings. The costs are miniscule and the potential benefits are large. [40] There is an argument to be made that the valuation private investors place a private company should not be public, but private companies have long been required to inform securities regulators when they sell stock.

Where should the disclosure appear in a prospectus? On the front page, where the price per share is displayed and in the section that summarizes key aspects of the offering. In both these areas the pre-money valuation should be stated.

What would the disclosure say? Something like the following:

Based on the terms of the offering, we (the issuer) have given our company a valuation of $XXX. This is calculated by multiplying the shares outstanding at the time of the offering by the offering price per share.

This would cover most equity offerings, but not all. Some issuers may want to define their valuation differently. For example, there may be restricted shares outstanding that the issuer believes should be excluded from a valuation calculation. That is certainly the case for an issuer that uses the Fairshare Model. It will want to calculate it based on the shares of Investor Stock outstanding and exclude the Performance Stock (explanation in chapter twelve).

Any issuer ought to have an opportunity to offer a valuation that is calculated differently, provided explanation makes sense to the securities examiner. If there is disagreement on this point, an issuer ought to be able to provide an alternative figure in addition to the one the regulator requires. The standard for deciding such matters would emerge from the SEC's rule making process.

A far reaching idea for public offerings is to disclose the valuation trend in recent years, focusing on significant financing events. Private companies often provide this to VC and PE investors that are considering an investment. One could argue it makes sense to disclose an IPO prospectus, if the goal is to provide public venture capitalists (i.e., public investors who buy new stock from a venture-stage company) with data that private venture capitalists have.

What Disclosure of the Basis for the Valuation Might Look Like

A strong case can be made for valuation disclosure. Should there be a requirement for an issuer to discuss how it arrived at the figure? I think it should be encouraged to discuss the basis for a valuation but not necessarily required to do so. Why? If a company's management doesn't want to talk about its valuation, they will say something like this:

The initial public offering price of our common stock was determined through negotiations between us and our underwriters.

If valuation must be disclosed, many issuers want to say something about it, if only to make the figure seem reasonable. The following is an example of a more informative explanation:

We estimate the fair value of our common stock using a discounted cash flow model and in consideration of the following factors:

• the market value of comparable companies;

• our historical results and forecasted profitability;

• our market and liquidation value of our assets; and

• market and economic conditions that are expected to affect our industry

Those who say something about how they chose their valuation may struggle because just as it's a challenge for an investor to evaluate, it is a challenge for companies to set. Here are the Top Ten more candid explanations (i.e., not written by a lawyer) that one might see:

For fun, here are some explanations an issuer may have for a valuation that you'll never see in an offering document, especially one reviewed by an issuer's attorney.

Valuation Disclosure - Why Hasn't It Happened Already?

Why doesn't a prospectus say "our valuation is X% lower than comparable companies"? Because it would be confusing to readers who have little idea about what the number means or how to evaluate it. Legal counsel will advise issuers to not disclose valuation in offering documents because it is not required. Plus, if it is disclosed voluntarily, disgruntled investors may argue that the company represented itself as being "worth" the valuation.

So, issuers don't compete for public investors by offering better terms. Is this market-driven capitalism? Or, is it something else, a self-serving arrangement among those in positions of influence?

When you think about it, this stands in extraordinary contrast to most markets; sellers normally offer deals to attract buyers. Why is price-based competition prevalent in virtually every market but not in public equity? Is this a demonstration of free market economics? Or, is it example of a rigged market? Or, something in between a free and rigged market?

For competition to happen, buyers (investors) must know what the price is, the valuation in this case. When you break it down from the perspective of the players involved, it makes sense that market forces don't result in valuation disclosure. Issuers with Wall Street IPOs don't need to compete on this basis. Their agents, the investment bankers and broker-dealers that they engage, see no advantage in making the valuation clear to the public. In fact, they reap a benefit when it isn't disclosed. An IPO is considered a success when there is a "pop" from the offering price to where the stock trades in secondary market. A jump in share price translates into happy clients-the investors who agreed to buy shares at the offering price. Such investors often "flip" or quickly sell their shares to those who lack the wealth or influence needed to get an allocation of shares at the IPO price.

Fundamentally, I think issuers don't compete for public investors because these investors are not a market force. They are not in a position to shape outcomes. Rather, they are the target of market forces; at the bottom of the financial market food chain. They are the buyers who are eager to invest in venture-stage companies but haven't been allowed to do it at earlier stages-so, they compete amongst themselves to get the shares, bidding the price up in the secondary market.

When market forces don't promote competition, government has an opportunity to encourage competition via regulation. Why hasn't government stepped in to require the disclosure that the market hasn't? I have theories that involve the congress and the SEC.

At the congressional level, many politicians raise campaign money from the financial services lobby. The CBS news magazine 60 Minutes reported that a number of them have become "very, very wealthy" in office as a result of their ability to astutely trade stocks or to gain access to desirable IPO allocations. [41] Legislators who are otherwise inclined to be consumer oriented may not have much interest in the capital markets; they may be more likely to oppose small investor involvement than to find ways to make it more competitive.

At the regulatory agency level, I suspect the SEC hasn't required valuation disclosure because the financial services industry is certain to discourage it and there is no political outcry for it. Since the agency is wholly dependent on the Congress for its annual appropriations, this is a recipe for inaction on valuation disclosure. In March 2012, former SEC chairman Arthur Levitt interviewed the then-current chairman of the SEC, Mary Schapiro, on his radio show. Concluding a discussion about the failure of the Congress to approve "self-funding" for the SEC, Mr. Levitt said the following.

I guess I can afford to be more cynical now, Mary. I think that the reason you didn't get self-funding was because Congress didn't want to give up the appropriation power over the agency. Because historically, it's 'self-funding' for them in terms of campaign contributions. I can say it now. You probably can't. [42]

If the SEC were self-funded it would be able to use money that it collects in fees, fines and legal settlements to cover its budget. Self-funded financial regulatory agencies include the Federal Reserve, The Federal Deposit Insurance Corp. and the Office of the Comptroller of Currency. The only two that are not are the SEC and the Commodities Futures Trading Commission (CFTC). Among the influential groups in favor of self-funding for them is the Systemic Risk Council, whose members include former SEC Chairman William Donaldson and former CFTC Chair Brooksley Born. They argue that the difference between self-funding and the Congressional appropriations process is "enormous."

Self-funding helps agencies hire and retain good staff and insulates them from political pressure exerted by the deep-pocketed institutions they regulate. It also allows them to make and implement strategic decisions to adapt to changing markets and build needed information technology to become more effective and efficient, all which require multiyear budget certainty. The SEC and CFTC have none of these advantages. [43] [Bold added for emphasis]

Of course, it may also be that the SEC staff just doesn't see this as an issue, even though the agency's motto is "The investor's advocate." After all, all that an investor needs to do is to pull two numbers out of the document and multiply them, something that would be obvious to those who work at the commission. But, this logic is inconsistent with the lessons learned from unit pricing in grocery stores, which also requires a simple calculation that many shoppers are too uncomfortable or busy to make; it empowers buyers to make wiser choices and encourages competition that benefits consumers.

A Call for Action on Your Part

I close out this section on valuation with a call for action by you, Dear Reader. If you want to see market forces work for public investors, you and other like-minded people have to do some things. In chapter one, I wrote the following:

Changes to the The-Way-Things-Are-Now always have challenges. It has been observed that change occurs when the pain associated with doing things differently is less than the pain of continuing to do it the way it's been done. That suggests that public investors should channel Howard Beale-they should make their discontent known.

Recall that Howard Beale is a character in the movie Network. The news anchor who exhorts his viewers to go to their windows and yell out I'm as mad as hell, and I'm not going to take this anymore!

I now ask that you channel your inner Howard Beale, then, in polite language, send the SEC chairman [44] a message that conveys your support for a valuation disclosure requirement. If enough people do this, the matter will capture the attention of the SEC staff. A simple message like this will suffice:

The commission provides this email address chairmanoffice@sec.gov for communications to the Office of the Chairman. The postal mail address is:

Office of the Chairman

Securities and Exchange Commission

100 F Street, NE

Washington, D.C. 20549

Then, send your congressional representative and senators a similar message. Since 2016 is a presidential election year, those running for office are likely to pay attention. If you can speak to a candidate for federal office, ask them to support a valuation disclosure requirement.

Use social media to create awareness of the valuation disclosure movement. There is strength in numbers!

If you live outside the U.S., take similar action in your country. Equity crowdfunding is further along in the Canada and Europe, so other countries may adopt valuation disclosure rules before it happens in America.

Over time, valuation disclosure will encourage market forces to benefit non-professional investors. It will also create conditions that shorten the time it takes for the Fairshare Model to emerge as popular alternative for companies that raise venture-stage via a public offering (see the end of chapter six for perspective on how long it might take for this to happen).

Onward

This closes out section III. The next section, the final one, addresses fraud, failure and a mélange of topics

[36] Alibaba Group 2014 prospectus, page 62 and 267. Technically, the foreign-based Alibaba sold American Depository Shares that represented ordinary shares.

[37] It makes about as much sense as excluding the private sector background of a candidate for public office from disclosure or consideration.

[38] Famous line from the 1994 movie, Forrest Gump's-Momma always said, 'Life is like a box of chocolates, you never know what you're going to get."

[39] Some states use their Blue Sky laws to evaluate an issuer's valuation, but, they lack authority over offerings that are registered with the SEC.

[40] Beginning in 2009, the SEC has been rolling out a requirement that companies use a technology called XBRL in their regulatory filings that makes it easier for readers to find, extract and analyze data. Valuation disclosure follows that spirit as well as that of the so-called FINTECH movement, a term that come to be applied to innovation in financial services (e.g. PayPal, Bitcoin, mobile payment systems, Big Data and predictive modeling).

[41] "Insiders: The Road to the Stock Act" report, CBS News program 60 Minutes, aired Jan. 17, 2012, http://www.cbsnews.com/news/insiders-the-road-to-the-stock-act/

[42] "A Closer Look With Arthur Levitt: SEC's Mary Schapiro (Audio)", Mar. 23, 2012, Bloomberg, http://media.bloomberg.com/bb/avfile/vlbmyA3v.W0A.mp3 Check out Levitt's interviews with other business and political leaders here https://www.bloomberg.com/feed/podcast/closer-look.xml

[43] "SEC: Self-Funding vs. Congressional Appropriations, by Dunstan Prial, Fox Business, May 17, 2013 http://www.foxbusiness.com/economy/2013/05/16/sec-self-funding-vs-congressional-appropriations/

[44] The current chair of the agency is a woman, Mary Jo White, as was her predecessor. Nonetheless, it's an acceptable practice to address her as "chairman" or her position as the "office of the chairman".

Karl M. Sjogren *

Contact Karl Sjogren is based in Oakland, CA and can be contacted via email or telephone:

Karl@FairshareModel.com
Phone: (510) 682-8093

The Fairshare Model Website

A native of the Midwest, Karl Sjogren spent most of his adult life in the San Francisco Bay area as a consulting CFO for companies in transition—often in a start-up or turnaround phase. Between 1997 and 2001, Karl was CEO and co-founder of Fairshare, Inc, a frontrunner for the concept of equity crowdfunding. Before it went under in the wake of the dotcom and telecom busts, Fairshare had 16,000 opt-in members. Given the rising interest in equity crowdfunding and changes in securities regulation ushered in by the JOBS Act, Karl decided to write a book about the capital structure that Fairshare sought to promote….”The Fairshare Model”. He hopes to have his book out in Spring 2015. Meanwhile, he is posting chapters on his website www.fairsharemodel.com to crowdvet the material.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Karl M. Sjogren. This work reflects the law at the time of writing.

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