Popular Equity

As an investor my account lists that I own D dollars of venture V with a total market value of TMV. D/TMV is my percentage of the venture.

If I want to buy more V, I can enter a buy order for D2 more dollars of venture V. Similarly I could enter a sell order for some fraction of D, D3 dollars of venture V. Buy and sell orders can be either made "at the market" or "price limited." Once an order is made, it's held until clearance. Orders that can't be satisfied don't execute. 

A price limited sale order might be sell D3 dollars worth of V but only at or above a 1% relative increase over the previous market valuation. In other words, if V is going up, I want to sell, but if it's staying flat, or going down, I want to hold. A price limited sale order could also be only at or above a 1% relative decrease to the previous market valuation. Then the sale only executes if the new valuation is higher than a 1% decrease from the previous market valuation. This differs from a simple market sell order that executes at whatever closing price the current market reaches.

A price limit buy order works the same way. An investor can buy D2 dollars of V at or below a 1% relative discount of the previous market valuation, or at or below a 5% relative premium. Again this differs from a market order because it doesn't execute if the criterion isn't met.

By default buy orders can become additional seed capital (diluting investors) when there's insufficient seller interest. But they can also be marked as "trade only" to require an explicit buyer, and not allow the investment to become additional seed capital.

From the previous example, we had an access market buy order of 8K, that would have executed, if we'd had sellers. By default (if the order wasn't placed as "trade only") the excess buy order that would have executed becomes additional seed capital, paid to the venture.

If VC or investment banks were involved we'd need a complicated negotiation that would set the dilution of existing investors to make room for the additional seed capital. With Popular Equity, this stage is simply streamlined with the following arrangement:

(1) The maximum seed capital investment is equal to the current investor holding (not including venture holdings of itself). Anything above that is held as a potential buy order for the next month (which can be cancelled).

(2) To compensate existing investors for the dilution of the seed capital, the seed capital is discounted by 20% (to 80% of its current value) to decide what fraction of the entire venture it represents. Similarly the total market valuation is adjusted so that investment is worth its face value.

In our example, let's assume the venture V has a total market value (TMV) of 100K with a 20% investor holding (80% venture holding). That means that the investor holding before dilution is 20K, so all 8K can be invested as seed capital.

If we don't discount the seed capital when determining ownership share, then there's no upside to existing investors for the seed capital. Discounting it by 20% (to 80% of its value) means that we now have 20 + 8 * 0.8 = 26.4K owning 20% of the the venture. That means that 8K just bought 6.4/26.4 * 0.2 = 0.04848.. of V. Since that's worth its face value of 8K, that means V now has a TMV of 8K * (1/0.0484848) = 165K.

The existing investors used to own 20% of V worth 20K. After dilution, they own 15.15% of V worth 25K. They own less of it, but what they own is worth more.

The tension here is that the venture itself held on to 80% ownership, and collected the seed capital. They went from owning 80K to owning 132K. That could be the right answer, or it could mean such a high evaluation that everyone now tries to sell.

A compromise is to dilute the venture somewhat, but at a lesser rate than investors. Diluting the venture itself discourages seed investment. So to start, for two years after starting the open market stage, the venture is not diluted at all. After 2 years, it can be diluted at 1/4 the rate of existing investors.

Interestingly, if we stick to the same discounting strategy relative to existing investors, then the impact on existing investors is the same whether we dilute only the investor class, or dilute all classes at the same time. The dollar value all investors own stays the same (old and new) in either case. So fractional dilution of the venture boils down to haggling over the final market valuation. Implementing a 20% dilution then means setting the final TMV 20% of the way in between the lower TMV with full dilution and the higher TMV that only dilutes existing investors. (Here's a detailed example.)

This might feel like we're playing games with prices, but that's exactly what happens when you negotiate seed capital funding, at any stage. Standardizing it with essentially one fudge-factor (80% of the seed capital invested) hopefully makes everything reasonably transparent, with everyone getting a reasonable deal. And after 2 years, we start diluting the venture a bit, too.