Virtual shares – a win-win proposal for more inclusive economic model

RECAP OF THE PROBLEM

In our previous article, we painted a rather grim picture of capitalism as the economic model, acknowledging how capitalism excludes certain individuals or groups by limiting access to opportunities and resources. By doing so, capitalism hinders the growth and well-being of society as a whole.

We started by understanding the nature of the problem and examining how high income inequality reinforces the social immobility loop for poor people. We then turn towards analysing the different income streams and the access to financial instruments that enable income generation via capital gains. We concluded with a take-away on how access to such instruments is very limited. The main take-away was formed as a warning labelled “Pitchforks are coming”, from a decade-old publication from Nick Hauer:

If we don’t do something to fix the glaring inequities in this economy, the pitchforks are going to come for us. No society can sustain this kind of rising inequality. In fact, there is no example in human history where wealth accumulated like this and the pitchforks didn’t eventually come out. You show me a highly unequal society, and I will show you a police state. Or an uprising. There are no counterexamples. None. It’s not if, it’s when.

This article is taking a more constructive approach, describing one of the approaches to increase social mobility by introducing a more inclusive approach to equity management. Full disclosure - the company behind the post is offering products and services exactly in this solution space, so our opinions here might be biased. But however biased they might be - this is what we believe in and want to pull through.

Main thesis of the article is to demonstrate how unlocking access to equity as an asset class to a wider population is beneficial both at macro and micro level, unlocking the hidden potential for otherwise excluded people. At the same time, we analyse how economically benefiting both the company distributing the equity and people earning the equity in return for their help for the company.

STATUS QUO

Equity in traditional businesses is typically distributed between three groups of shareholders: founders, investors and employees. At different stages of the company, this distribution will change, as illustrated in the following example: The company is founded

• First investment is brought in, along with an option pool for employees is formed
• Two more investment rounds take place, diluting founders and employees.
• Finally, at the exit, the value created is distributed proportionally to all the shareholders

As the example illustrates - the value creation is captured by the handful of founders and investors, who in combination will end up reaping more than 90% of the value created during the journey.

To add insult to the injury, employees only rarely are offered shareholding through option programs. 50 years after employee stock option introduction is still offered only in some sectors and in larger companies, for example only 49% of S&P 500 members have active ESOP programs for their employees.

To understand the problem and the opportunity here, let's look at two examples, supporting our thesis on wider equity distribution.

Q/A platforms

Best examples of such platforms are Quora and StackOverflow, who monetize replies to questions asked on the platform, typically using ad-supported models. The platforms rely purely on the quality and depth of the replies, posted by the community.

Taking StackOverflow as an example, the Q/A site for engineering is estimated to have generated $171 million in revenue during FY2022. The company valuation is not public, but it was acquired in 2021 at 1.8 billion valuation.

What is stunning is that all this value created bypasses the authors and goes directly to the shareholders. The only reward authors get is personal brand promotion. The top contributors who must have spent thousands of hours of their time to craft high-quality responses for the thousands of questions they have answered can claim they are among the most respected community members. But there is not any revenue sharing model, or any other mechanism in place to reward the content creators.

Ridesharing

Operating in this market you will find well-known companies like Uber, Didi or Bolt. The business model for operators on this market is based on taking a percentage of every transaction taking place on the platform. For example if your ride on a ridesharing platform costs €20, anything between €15-19 is paid out to your driver and the remainder is recognized as revenue for the ridesharing operator.

The dollars from the take rate add up fast, for example Uber closed FY2022 with $8.5 billion in revenue. As a result the company currently trades at 90 billion valuation. And who reaps the benefits from the value generation? The investors, founders and (early) employees of the company, leaving the 5.4 million platform workers scraping to make the ends meet.

Among the platform workers are the very first drivers who took a leap of faith with the company in the early stage, helping the founders to validate the market, improve on the product and set the stage for growth.

Problem summary

The problem here is now understood enough to take a peek at the opportunity it offers. It should be clear that at least for certain businesses, involving people outside of the founders, investors and employees as shareholders would create a more fair distribution of the income, taking into account the contributions for everyone who helped to create the value.

But capitalism is not designed around fairness. In order for a company to utilise its equity to be rewarded in return for their help, the issuing company must also benefit.

BENEFITS FOR THE ISSUER

There are numerous benefits materialising when a company turns its customer base into shareholders:

Alignment of Interests: When customers become shareholders, their interests become more closely aligned with the company's success. As shareholders, they have a financial stake in the company's performance and profitability, which can lead to increased loyalty and support for the company's products or services.

Brand Advocacy: Shareholder-customers are likely to become more engaged and vocal advocates for the company. They have a vested interest in the company's success and are more likely to promote its products or services within their networks.

Customer Feedback: Shareholder-customers may have a stronger incentive to provide constructive feedback, helping the company identify areas for improvement. This feedback loop can lead to more informed decision-making, as companies can rely on shareholders who are active users of their products and services.

Long-Term Relationships: The shareholder-customer relationship is likely to be more long-term and durable. These individuals are less likely to switch to competitors if they have a financial stake in the company.

Increased Trust: Shareholders have access to the company's performance, strategy, and future plans. This transparency can lead to a sense of trust and confidence in the company's operations.

Inclusivity: Allowing customers to become shareholders can create a sense of inclusivity and democratisation. It gives customers a chance to participate in the company's success and potentially benefit from its growth.

Community Building: Shareholder-customers can form a unique community that shares a common interest in the company's success. This community can foster a sense of belonging and engagement among customers.

To be fair there are also challenges when allowing customers to become shareholders:

Complexity: Managing a large base of shareholder-customers can be administratively complex, particularly if the company is not equipped to handle the intricacies of shareholder communication and engagement.

Regulatory Considerations: Depending on the jurisdiction and the number of shareholders, the company may be subject to additional regulatory requirements and reporting obligations.

Financial Literacy: Shareholder-customers need to understand the implications of ownership, such as financial risks and potential rewards. Ensuring that customers are well-informed investors is both a hard and important cornerstone for a successful outcome.

Limited Influence: Individual customer shareholders may have limited influence on the company's decisions compared to larger institutional investors. This might lead to limited engagement and involvement, if the psychology of the shareholder-customers does not support the belief that his impact is negligible.

Conflicts of Interest: Balancing the interests of shareholder-customers with those of other shareholders can be challenging, especially if the company needs to make decisions that affect long-term profitability and growth.

We will take a look at how to handle such issues in the Implementation chapter at the end.

UNDERSTANDING THE FINANCIAL SIDE

Flip side of the benefits is the financial side of the share issuance - it must be rewarding enough for the customers to feel the ownership and at the same time the founders-employees-investors cannot be diluted too much to keep their motivation intact.

To understand the potential value for the recipients of the shares as well as the dilutional aspect, let's take a look at two examples

Example #1: Growth company

In this example we will take a look at a growth company in its early stage of the journey. Let's take an example of a marketplace, generating 25 million EUR as gross revenue on a trailing-twelve-month basis. The marketplace has just raised an A round, valuing the company at 25 million EUR post-money. The company is growing well, tripling its gross revenue over the past twelve months and is expected to do so for the next two years, after which the growth is expected to decline to 100% a year for the next three years. Companies in such a quick growth trajectory typically do not generate profits nor distribute dividends. Instead, the value is captured by the shareholders through the growth in equity valuation. So let us proceed with projecting the company valuation in time. Using the same 1x ratio to GMV as valuation base, we can project the company valuation for the forthcoming years as follows:

Now if this marketplace is deciding to utilise 5% of its equity to support this growth, motivating its supply-side in the marketplace according to the gross revenue generated. This would manifest €90 million of the eventual €1.8 billion valuation to be allocated between the suppliers, paid out on acquisition or IPO.

If our hypothetical marketplace has 1 million suppliers throughout this period, the average payout on acquisition/IPO at 1.8 billion EUR valuation would be a measly 90 EUR per such shareholder. As this is clearly not motivating, the distribution of virtual shares must be based either on the quality, quantity or timing of the services provided in return of the shareholding:

• Time-based. Reward early supply more, in correlation to the value growth of the business. Becoming a supplier in 2023 should earn you more shares than becoming a supplier in 2028 when the brand is already established and there is less risk for the supplier
• Quantity-based. Reward only top suppliers by the gross revenue generated, for example requiring at least €100,000 gross revenue generated to be eligible for distribution of the proceeds from company sale/IPO
• Quality-based. Reward only suppliers whose goods or services get the best feedback from the demand side on the marketplace. This aspect can be combined with the previous two.

As a result, the top 1% of the suppliers on the platform will be earning out a shareholding valued in tens of thousands of euros, being a significant enough income difference to make the program lucrative for the audience.

Example #2: Value company

In the second example let us take a look at a more traditional business, generating €10,000,000 of revenue and €1,000,000 of profits each year, paying 100% of the profit as dividends. For simplicity's sake, let's assume that the company growth is magically exactly adjusted for inflation, so in terms of 2023 Euros, the company’s future trajectory is flat.

Now if the example dividend company would decide to allocate 5% of its annual dividends to be distributed between its customers, the resulting payout would be 50,000EUR/year. If the company has 5,000 customers, the average payout per such a customer-shareholder would again be measly - just 10EUR in this case.

Now again the allocation of shares should be tweaked to motivate the people helping you the most. For example, as a customer, you will be eligible for dividends in a given year if you have either

• Subscribed to goods and services for at least 5,000EUR during the period
• Referred three new customers during the last year
• Published a brand awareness campaign, with the reach of at least 10,000 people
• Participated in a focus group, assisting product development

Again, designing the shares earn-out models around what benefits your business the most, the dividend payments can be targeting only a fraction of your customer base, netting such customer-shareholders at least 2,500EUR/year as dividends.

IMPLEMENTATION

Having understood the benefits of wider equity distribution to both companies and society as a whole, it is time to take a look at the practical solution itself, highlighting how implementation issues around such a share program can and have been tackled.

Rights on the financial instrument

First - making your customers actual shareholders, bringing them into the cap table of the company is too heavily regulated to make the solution viable. To tackle the problem, we have created a financial instrument carrying most of the rights of company’s common stock, allowing the holders of the instrument to earn like shareholders and be heard like shareholders.

Such an instrument is called virtual shares, typically granting its holder the following rights:

• Company sale rights
• Liquidation rights
• Dividend rights
• Information rights

Additional rights, typically held by shareholders such as governance rights, anti-dilution rights, transfer rights or pre-emptive rights are most often not included due to implementation complexities around such aspects.

But the key take-away for you to understand is that virtual shares can be designed to represent rights close to actual shareholding, allowing to treat the holders of such an instrument as a specific shareholder class.

Issuance

Key element of issuance is the means the virtual shareholder will become the holder of the shares issued. Such shares need to be earned and cannot be bought from the issuer. This is beneficial both from a regulatory perspective - the issuing company is not subject to emission prospect nor further public transparency. It also serves the purpose of engaging the virtual shareholders in activities benefiting the company - you can earn shares through means made available by the issuer such as:

• Using the company’s product or services.
• Referring a new customer to the company.
• Building brand or product awareness in social media.

Issuance should also be easy. The paperwork involved in becoming an actual shareholder is way too complex, but in order to turn your customer into a virtual shareholder, all you need for issuance is the email or phone number of the new shareholder. The technical and legal infrastructure provided by koos.io takes care of the rest.

Legislation support

Issuing shares is regulated according to the local jurisdiction. Issuing virtual shares is possible across borders, the legal framework built and verified by koos.io and its partners is making it possible to issue virtual shares across the entire European Union and United Kingdom. Adding more countries to the supported jurisdictions is work in progress.

Other aspects

There are multiple other implementation details that need to be taken into account when implementing a virtual share program, such as taxation or representation in cap tables. Such nuances are covered in the reference manual of koos.io.

TAKE-AWAY

We are firm believers that the adoption of virtual shares by companies will be a win-win for everyone involved:

• More loyal and engaged customer base for the company
• New income streams for the customers
• More inclusive society with less income disparities and lower barriers in social mobility

Our belief has gone beyond writing. The company behind the article is offering the products and services to make the virtual share programs a reality for our customers. If you are among the people who do believe that the future of capitalism should be more inclusive, book a call with us to see whether and how our offering can help to achieve this.