Applying John Rawls’ Theory of Justice to IPO Valuation

John Rawls, an American philosopher, considered the broad question of what constitutes a fair system and his answer has implications for the capital markets.

His 1971 book, A Theory of Justice identified two principles that would produce a just, moral society.

1. Each person’s right to liberty is extensive, so long as it is compatible with the liberty of others.
2. Social and economic positions are designed to be to everyone’s advantage and open to all.

Rawls explored the challenges societies would face when adopting these principals. One consideration was whether it was easier to construct fair systems in a wealthy society than in a poor one. He felt wealth was not a requirement — that poor societies can create just systems. In fact, he felt that rich ones could be hindered in their ability to create them because great wealth can create “meaningless distraction at best, if not a temptation to indulgence and emptiness.”

To create a just society, Rawls believed it is necessary to understand that all people want “meaningful work in free association with others” and for these associations to be regulated “within a framework of just, basic institutions.” The mark of a just system isn’t equality of outcomes. Rather, it is the ability of anyone to self-actualize, as Abraham Maslow famously described in his hierarchy of needs.

The School of Life has a video about Rawls on YouTube that is well worth six minutes of your time. https://www.youtube.com/watch?v=5-JQ17X6VNg

It opens up by saying “Many of us feel that our societies are a little –or even plain totally — unfair. But we have a hard time explaining our sense of injustice to the powers that be in a manner that sounds rational and without personal pique or bitterness.”

As the video indicates, Rawls had a practical approach to create a just society: 
• Provide a safety net, one that meets the basic needs for a culture to function (i.e., access to food, shelter, education, meaningful work).
• Put yourself behind a “veil of ignorance.” 
• Ask yourself whether a method for distributing benefits and burdens is acceptable to you.
• If it is, the method is fair. If it is not, it is unjust.

Rawls’ veil of ignorance is a device to ensure objectivity when evaluating a system for fairness.

As the School of Life video explains, it is a thought experiment in which Rawls asks us to imagine ourselves “in a conscious, intelligent state before our own birth, but without any knowledge of what circumstances we were going to be born into; our futures shrouded by a veil of ignorance.”

“We wouldn’t know what sort of parents we’d have, what our neighborhoods would be like, how the schools would perform, what the local hospital could do for us, how the police and judicial systems might treat us and so on.

The question Rawls asks us to contemplate is: if we knew nothing about where we’d be end up, what sort of society would we feel safe to enter?”

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Which turns me to fairness in the capital markets.

Many people sense that something is wrong with how capitalism is practiced but they have trouble persuading others what needs to change. Is it the tax code? More or less regulation? Reducing the cost of capital for small companies or protecting investors?

The-Way-Things-Are reflects a lot of things. Some will cite market forces as the reason bad things happen as in “market forces caused the jobs to go away.” Sometimes, however, bad things happen as a result of weak market forces. For example, a high price for a product can reflect weak competition for the company that makes it.

Weak market forces play a significant role in IPO valuations. Companies don’t compete for public investors by offering better deals, something that would happen if market forces were strong. CEO’s don’t say “Hey, buy our stock, it’s a better deal than XYZ company’s!”

One reason is that many public investors are valuation unsavvy and would wouldn’t know what constitutes a better deal. Another reason, is that the capital structures used in private offerings are investor friendly…and those used in public offerings are not.

I’m writing a book called The Fairshare Model. It is about a performance-based capital structure for companies that raise venture capital via an initial public offering. A company that adopts the model will have incentive to offer IPO investors a deal comparable to what a venture capitalist would get.

The book describes the fundamental problem with a conventional capital structure; the need to place a value on future performance when new stock is sold.

For example, if I sell you half of my newly formed company for $1, we implicitly agree that my future performance is worth $1. Put another way: my idea ($1) + your money ($1) = the value of the company ($2) after your investment. The problem is that neither you or I know if my future performance will be worth $1.

Add zeros to the amounts to make it more realistic but the principle remains. A conventional capital structure demands that the parties set a value for future performance, something that is hard to do in a reliable manner.

VCs have a work-around to this problem. When they invest in a private offering, VCs require a capital structure that is modified in ways that protect them from buying in at too high of a valuation. The details are not as important as the fact that IPO investors don’t get comparable protections when they invest. This unfairness is amplified because they invest at higher valuations, often when there is still significant risk of failure.

The valuation amount isn’t the injustice here because no one knows what it “should be” when investors invest. Rather, it is the unequal opportunity to reduce valuation risk. This veil of ignorance thought experiment reveals the unfairness.

Imagine that, starting tomorrow, shares in Wall Street IPOs are no longer allocated based on wealth, privilege and connections but in a lottery that is open to all.

Will investors who have routinely been able to get shares at the IPO price be content with a conventional capital structure?

If they have to buy shares from the lottery winners in the secondary market, might these well-connected investors clamor for a different approach to IPO valuation?

The School of Life video says “Rawls understood that debates about unfairness and what to do about it often get bogged down in arcane details and petty squabbling which means that year after year, nothing quite gets done.”

The Fairshare Model provokes fresh, practical thinking about capital formation in a manner that engages experts and those who have difficulty explaining what a capital structure is. Your support for it will spawn innovation in the capital markets that is designed to enhance opportunity for entrepreneurial teams and the investors who back them.

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Other articles I’ve put up on Medium:
Class Action Investor Lawsuit Raises Facebook IPO Valuation Issues
Valuation Uncertainty Illustrated…With Balloons!
Shouldn’t Public Venture Capital Investors Get Price Protection Too?

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The Fairshare Model will be published about five months after 750 people pre-order a copy from Inkshares, a new style publisher that decides what projects to back based on reader support.

You can preview the first chapter and place a pre-order here https://www.inkshares.com/projects/the-fairshare-model

With the credit that Inkshares issues to new customers, an e-book will set you back just $10 USD. A combo package of an e-book and signed print book, $20 USD.

If it isn’t published or you cancel your order before the book is shipped, Inkshares will refund your money.

So, for a modest, risk-free amount, you can help launch a discussion about how to re-imagine capitalism!