Wanted: a Stock Exchange for Democratic Capitalism

Carl Milsted, Jr on Mar 4 11:42:49

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Table of Contents

1. Introduction
2. A Hole in Our Financial System
3. The Potential Power of Fan Capitalism
4. First, Stabilize the Market
5. What Must Be Reported
6. A Better Public Offering
7. The Insider Trading Problem
8. Democratic Capitalism
9. Blockchain or Physical Exchange?

There are social problems to be solved, markets to be filled, and a looming potential climate mess if somebody doesn't figure out economical energy alternatives. Few people have the combination of resources and good ideas to do something, and the rest of us stand by rooting for our favorite few. This is a recipe for despair — and socialism.

The federal government does have immense resources, and the government represents "us" — in theory. And so many turn to the government to solve too many problems. The current administration claims to have invested or directed investments to the tune of 649 billion dollars. If I don't get VC money or a job soon, I'm tempted to jump on the government gravy train myself. I've got a few nifty energy related ideas it would be fun to try...

But there are problems with the arrangement. Democracy is only slightly meaningful when there are a 150 million votes cast. Your vote counts only in the same sense that a single raindrop contributes to a flood. Furthermore, few elections have more than two viable candidates on the ballot. When there are hundreds of issues at stake, we don't have democracy with only two candidates, period.

For many problems and markets, we have the people who have good ideas, and those solutions are potentially profitable. Capitalism could do the trick, if the right people could get the capital...

A Hole in our Financial System

If you are repeating a well understood business model and just need capital to finance real estate, machinery, and inventory, bank financing is available.

If you have an enormous enterprise doing hundreds of millions of dollars in business, Wall St. has money for you.

If you have a bright idea that could lead to a Wall St. sized business, there are venture capital firms which might provide the early stages of financing. Ditto for firms which would likely be bought out by an existing enormous enterprise once revenues become significant.

But what of fresh ideas which are useful but not necessarily big? Or what of new businesses which must grow big slowly? Where is the exit for angel investors and venture capitalists? Private equity firms? The penny stock market? Employee buyout?

The Potential Power of Fan Capitalism

In between greed and charity there is capitalism for a cause. That is, some people are willing to take greater risks when investing if the potential upside is more than monetary profit. For environmentalists the cause could be energy efficiency or less toxicity. For right wingers it might be Christian compatible entertainment. For today's left wingers it might be workplaces where everyone needs to learn 57 varieties of pronouns.

Let people fund what they want, instead of pooling our funds into a gigantic treasury and fighting over how to spend it.

Why not?

Well, there are problems with the arrangement. Where there is money, there will be grifters, gamers, positive thinkers, and outright crooks. And once enough investors are wrongfully parted from their funds, the regulators will step in, with so many tedious regulations and requirements for expensive lawyers and accountants, that the resulting overhead will create economies of scale, and we are back to Only Big Players Need Apply.

Just look at what happened after Enron. We got Sarbanes-Oxley and big new corporations staying private as long as possible. Small investors are now protected from certain risks, but they are also protected from participating in the bulk of the growth phase. Not exactly a win-win solution.

To their credit, our congresscritters from both parties created a loophole for smaller startups: the Jumpstart Our Business Startups Act. This was a truly rare example of bipartisan legislation that was both liberating and sane.

But will the good times last? Or with the gamers and grifters ruin the loophole?

I submit that a small cap stock exchange needs regulation — and some pretty harsh regulation at that. But it should be the job of competing exchanges, not Congress, to come up with the optimal set of regulations. Experimentation is required.

We have conflicting goals:

• Investor trust and safety
• Entrepreneurial flexibility
• Low reporting overhead

In the sections to follow, I will propose a set of regulations for such an exchange. This will be an initial outline, of course, as I am not a lawyer or investment banker. I hope to inspire others to hash out the details.

First, Stabilize the Market

Long before Effective Altruism and B Corporations, libertarians and paleoconservatives were battling the evil Federal Reserve via their investment choices. Going way back to the 1970s I have received many a frantic advertisement for buying gold or small cap mining stocks as a hedge against the hyperinflation which was just around the corner. I even subscribed to one of these newsletters for a time. Interesting reading, but the actual recommendations were really bad on average. After I cancelled said newsletter, I started getting ads for it again, ads which touted the amazing returns on a few of the winners they picked. Disgusting!

Seriously, buy or borrow a used copy of some of the old financial panic books from back in the day and compare their predictions with what happened.

Remember the hyperinflation followed by economic depression what happened in the 80s? The 90s? Remember the blood in the streets?

Neither do I. The gold bugs were just as bad about fomenting panic as the climate change activists today.

But they weren't completely wrong. The dollar has lost a lot of value since those books were written. And James Dale Davidson and William Reese-Mogg correctly predicted the demise of the prosperous U.S. factory worker and the geoarbitration later popularized by Tim Ferris. Keep that in mind when sneering at overblown climate predictions. Exaggeration of real trends...sells.

The other lesson I learned while following the gold bugs is that small cap stock prices are incredibly easy to manipulate. Bubbles and short squeezes are common. This creates a playground for speculators and a minefield for those who want to buy shares in a business based on its long term merits.

So my first goal for a new stock exchange would be to make the prices more stable. That means no margin trading. No borrowing money based on a stock's current value and no short selling either. (Short selling also involves borrowing: shares instead of money.) Margin buying creates a positive feedback loop. Those who buy on margin push up the price of the stock. A rising stock price increases the available margin. Short selling also has a positive feedback loop: short sellers push prices down, which gives the shorts more margin with which to short the market.

Both feedback loops can catastrophically reverse. A dip in price can cause margin buyers to have to sell even though they are bullish on the stock. This is what caused the great stock market crash of 1929. A rise in a stock price can force short sellers to buy back their borrowed shares — which pushes prices further up still. The resulting price spike is called a short squeeze.

Gamers, including writers of investment newsletters, can trigger such panics and short squeezes and profit thereby. A market free of margin players is harder to game.

This does not mean that the market need be boring for the adventurous, however. Call and put options would still be allowed as long as the options are covered.

A call option is a contract that allows one to buy a block of shares at a strike price, even if the market has gone up well beyond that price. Call options dampen price swings, as long as they originate as covered calls. A covered call is when the owner of a block of shares sells an option to buy said shares at strike price within a window of time. Selling covered calls can increase the rate of return for buy and hold investors who correctly expect the growth to be slow and steady.

A put option is a contract to allow one to sell a block of shares at a strike price, even if the market has gone down below that price. It's like a money back guarantee. A covered put option would be one which is backed by enough cash to make the purchase. A trader thinking about buying a block of stock might sell a put (at the cost of putting cash in escrow) instead. If the price dips, said trader may be forced to purchase, but he gets the block at the strike price (which is generally lower than the price when the option is created) and the money from selling the put option proper. One risk is being forced to buy even if the stock completely tanks. The other risk is missing a price jump which could have been enjoyed had he bought the stock instead of putting the money in escrow. When covered puts are exercised, price dips are dampened.

With the right rules risk loving speculators can stabilize a market.

This won't rule out all naughty price manipulation, but it would cut down on the practice considerably.

What Must Be Reported

Once upon a time I tried to figure out who was right in the perpetual flame war between the auto workers unions and management. Were the unions coddled and overpayed? Was management a bunch of overpayed psychopathic exploiters? I tried reading a major U.S. automaker's annual report — and learned nothing! I could not find out how much the CEO or top management made. I could not find numbers for what they were paying assembly line workers. I couldn't even tell how much production was done in house vs. by suppliers.

But boy howdy, did that report give great detail on how the spare change was managed and what the rate of return was on their money market accounts and other near cash funds. If I was thinking about banking with General Motors, then this is the report I would need.

I also found all sorts of tawk about market conditions and competition, followed by reams of legalistic CYA gibberish.

For a financial company such as Enron, the required reporting might make sense. But for a real company that makes things, most of what I read was worthless. The questions I would want answered as a [potential] investor would be:

• Is the company real, or is it simply slapping its name on other companies' products?
• Is management or labor milking the shareholders? Are they earning their pay?
• Is management underpaying labor? Can we expect a strike? (Sometimes a bit of social justice can be more profitable than near term greed.)
• Is the company overleveraged, both in terms of debt and fixed contracts? That is, could the company gracefully scale back in the even of an economic downturn?
• It the company spending R&D money on its future?
• Is the company over spending on growth due to a CEO with megalomania?
• Is the company supporting a cause or is it focused on making profits for shareholders? (Either should be legal, but investors need to know.)

While management's view of market conditions is somewhat useful data, it's the job of investors to act on their own options on such fluffy info. And annual report should report what the company in question is doing. It's the job of investors to either sell the shares or vote out management if they don't like what management is doing.

My degree is in physics, not finance. Maybe I looked in the wrong places. Maybe I got baffled by accounting conventions. Please correct me where wrong in the comments!

In summary, I'd ditch any requirement for detailed reporting of market conditions and the legal magic words needed to avoid investor lawsuits. I want the basic accounting stuff that is included plus:

1. Some kind of reporting on top management pay.
2. Maybe a histogram of pay in general.
3. Some kind of numbers to indicate whether the company has gutted itself in the name of outsourcing and to what degree is the company real. Break out employee pay, building and equipment maintenance, etc. from the cost of sales.

Now, let's turn to an example of under reporting for a small startup. A few years back a video ad appeared on my Facebook feed featuring Bill Nye, the Scientism Guy pitching a company called Rayton Solar, which had an apparently cool idea for making cheaper crystalline solar cells by slicing silicon wafers using a particle accelerator. My feelings were seriously mixed. On the upside:

1. This looked like a really cool idea. For solar to be practical it needs to be affordable and efficient. Crystalline silicon is more efficient than amorphous.
2. This was exactly the sort of thing that fan capitalism should be funding. Let solar enthusiasts fund breakthrough technology.

On the downside:

1. I loathe Bill Nye for assorted reasons. This set off my alarm bells.
2. The amount of money requested was well within the personal budget of a single national celebrity. If they could get Bill Nye's attention, couldn't they get a single virtue signalling Hollywood celebrity to fund the whole thing?
3. On the other hand, the amount of money requested seemed low. My intuition said that some significant R&D was still needed. They didn't even have any pictures of finished solar cells made by their prototype.

The points above should not have been deal killers. After all, there are enough solar enthusiasts out there to finance the cost overruns, so if the public offering succeeded beyond the goal, it would all work out. Right?

WRONG!

I dug deep into the fine print. Once the target fundraising goal was met, additional funds would have gone into allowing the original investors to cash out. That stank! This was information which should have been placed front and center. Indeed, one rule I would enforce in my proposed exchange would be clear separation of public offerings from cash outs by early investors.

A Better Public Offering

The value of a corporation is a function of how much capital it receives. Consider a do-nothing corporation which simply puts its equity into T-Bills. If the company raises a million dollars, it becomes worth roughly a million dollars. If it raises 100 million dollars, it becomes worth roughly a hundred million dollars. (I write "roughly" as there is overhead in setting up a corporation, tracking stockholders, etc.)

OK, that was a stupidly simplistic example. Consider the web site that this article is sitting on. The value of the software developed for Conntects depends wildly on investor interest. Without angel or venture funding, the software is just a toy and I wasted a year and a half of my time writing it. With a half million dollar investment, there is a half decent chance of this becoming a real competitor to Facebook and other social platforms. The resulting business might become worth a billion dollars or more. With a million dollars of seed money, that half decent chance becomes more than a decent chance. With a quarter million, there might be enough to get to the paid platform stage and demonstrate the ability to lure paying customers and thus raise a second round. With 50K, it might be possible to patent some of the tech, but that's it. The value of Conntects is a nonlinear function of seed money raised.

One common approach to this nonlinearity problem is to have an investment bank guarantee the IPO in return for a windfall should early investors pile on. This is expensive and requires setting a fixed target instead of being open to a fuzzy range and letting the market set the target.

For my proposed exchange, an initial public offering would consist of the company putting up a fixed share of the company for sale. New investors commit money towards a piece of the action. If new investor interest is high, the investors get fewer shares of a stronger company. If investor interest is low, those who do participate get more shares of a weaker company. We have offsetting values which is kind of stabilizing.

(All of this presumes that the new company needs money as part of its IPO. If the company is already profitable and cash flow positive, you could have a simpler IPO consisting of the original angel and/or venture capitalists putting up some of their shares for sale. This would be flagged as such! New investors should know readily whether they are buying shares from earlier investors or if they are adding funds to the young company!)

Let's do a scenario. The Yeltrag Industrial Strength body care company board decides that the company would be comfortably worth $50 million if the company receives a fresh $10 million cash infusion in order to expand their manufacturing facility. So they put out an IPO of 1 million shares while the founders and original investors hold 4 million shares in total. If the IPO meets the target, the new investors get their shares at a price of $10/share and all is cool. If new investors only pledge $1 million in total, those daring investors get shares for a dollar each, but of a company that needs to downscale its expansion plans. If there is wild enthusiasm and $50 million gets raised, the new investors pay $50/share for a company that is more cash rich than expected.

Maybe these extremes should be avoided. Perhaps an IPO could include a range, where if not enough money is pledged, the deal is off and/or if too much money is pledged the bidding closes. (And yes, there is a thing such as too much money. In the example above, if the board cannot think of a good plan to spend the extra money in order to justify a $50 share price, then there are going to be some pretty angry new investors when founders and/or venture investors cash out driving the share price down. Better to shut out the excess investors from the IPO and let them use their money to let early investors cash out somewhere close to the original target price.)

This procedure also works for Secondary Public Offerings. Suppose Yeltrag has been in business for a while and the original VCs have cashed out. The cashout has driven the price down to $5/share. The company is profitable, but it could use a cash infusion to expand their product line to include industrial strength body lotions. The board thinks that a $25 million cash infusion would more than double the value of the company long term, so they accept a 50% dilution in order to attempt to get said infusion. So they issue 5 million new shares.

For simplicity's sake let's run through some scenarios with no guardrails in place.

If interest in the SPO is extremely low, those new shares are still very valuable! If the company remains worth $25 million, then if investors pledge only $1 million in fresh capital, they get $12.5 million in stock value for a mere $1 million. This is bound to be interesting to sophisticated investors. Indeed, suppose the market immediately discounts the old shares down to $2.50/shares due to the dilution. Those freshly issued shares are still momentarily worth $2.50/share in this market. Arbitrage will happen, even by players who disbelieve in the company.

And the company will get some cash infusion. Unless the market thinks the company will completely waste the new cash, the company becomes worth its original value plus additional value based on the new cash -- which will pull the price of those new shares up which boosts the value of the company in a delightful virtuous cycle.

The cycle stops when investors believe that an additional dollar of cash infusion will produce less than an additional dollar of value. And fans of the company can completely drive the process; no need for permission from Blackrock, Goldman Sachs, etc.

Back in the 1990s I was such a fan of a couple of companies: Atari and later Be Inc. Atari was making computers with MacIntosh like capabilities for half the price, but they seriously needed cash to get the next generation out and promoted. Later, Be Incorporate had developed a truly new computer operating system, one which had a true C++ interface to the graphical interface, and some serious use of multi-threading. The OS needed work but it was way ahead of its time.

I put a bunch of money into Be and had I cashed out a few months later I would have easily quadrupled my money. But I believed that Be was more valuable than Red Hat, which merely packaged an OS vs. actually owning one, so I held on as the company dwindled due to lack of funds. Had my SPO system been in place back then, existing shareholders could have infused the company with enough cash to work out the remaining bugs in the OS and the company could have become worth billions once Moore's Law hit a roadblock for clock speeds and multi-headed CPUs became the only way to add power.

(Steve Job's NextStep was pathetically slow compared to BeOS. The Spinning Wheel of Doom you see while the computer is thinking originated with NextStep.)

The Insider Trading Problem

If a business is to have any trade secrets, insiders are going to know things that small investors don't know. This is unavoidable. No amount of paperwork requirements can fix this. Either public corporations need to be completely public, or there is going to be some insider trading.

Trade secrets are useful, so let's look at a rule that can allow a bit of insider trading without screwing outsiders.

And here it is: require that all insiders post their bids and asks a couple months in advance. Now, the insider trades become useful information for outsiders without completely giving away company secrets.

And the founder who wants to dump some shares in order to enjoy some of the earned riches before getting too old to enjoy them can do so — but not at a premium.

Scenario: Suppose it's February and the researchers at Yeltrag Industrial Strength Body Care notice that their their secret experimental okra and stinkbug body lotion makes a great mosquito repellent. They decide to buy up shares before the news gets out. According to the rules, such insider bids need to be posted two months in advance. Some ordinary investors notice a bunch of insider bids with a stop loss of $10/share for April. The price creeps up to $9/share by the time the bids become active. Come May, the product is released, and as consumers notice the bug repelling quality of the new body lotion, the shares creep up to $12/share — but not much more, because many people would rather be bitten by mosquitoes than use the lotion.

The naughty researchers get a premium for their discoveries, but only $3/share instead of $7/share. Outsiders get hints of the new product without the company giving away a trade secret.

An imperfect solution. But better than throwing lots of parasitic lawyers at the problem.

Democratic Capitalism

Is it the duty of management to maximize shareholder value? Or should management consider stakeholders or some cause?

And what constitutes shareholder value? Near term profits? Long term viability? Risky growth? Opinions differ!

Consider my potential arch nemesis Facebook. Facebook is in serious aggressive monetization mode now. I see more ads and Suggested for You posts in my feed than I see posts from friends. In the near term this very likely adds profits. But it is also causing many users to post less or even leave the platform. In the long term, a Facebook that completely gives up on profit growth and settles for being a cash cow that keeps customers happy would maximize profits.

Which is uncertain. What is certain is that shareholders have no business suing the company based on law for either decision. This is a decision which should be made by voting — either voting by selling shares or voting by changing the board of directors.

But changing the board of directors in a modern corporation is terribly difficult. Shareholder democracy is an utter joke. Campaigning for proxies or getting a large number of small shareholders to actually show up at stockholder's meetings is terribly expensive. We are back to Go Big or Go Away. Public corporate democracy becomes nearly as bad as government democracy.

So the final element of my proposed stock exchange would be to provide an online forum for the stockholders of every stock — something like the old forums on Yahoo Finance, but without the delays and ads. And there would be two very important twists:

1. You have to own shares to participate.
2. Your forum profile will show how many shares you own.

Such forums could be a source of information (they would be visible to outsiders) and a cheap campaign ground for gathering proxies for shareholder's meetings. Indeed, one should be able to grant or retract proxies through the same forum interface. No sending out expensive proxy ballots by mail! No campaigning for proxies by expensive snail mail!

If you can afford to get to the shareholder's meeting and can afford to spend time on the company forum, you can cheaply gather proxies of those who agree with you.

And management and board members could safely communicate with disgruntled shareholders without violating insider trading rules, since the transcript of the forum is public.

Blockchain or Physical Exchange?

When I first contemplated these ideas years ago, I hoped to pitch them to local bigwigs as a framework for a stock market outside New York. I lived not far from Charlotte, NC, a major banking center, at the time. Why not have a stock market there as well?

Or maybe this could be a killer application for a blockchain. A shared ledger would be a nifty way of determining who owns which company. And maybe it would be possible to do trading without any market makers. Maybe have a system of round based trading: either purchase or sell based on outstanding asks/bids or add a bid/ask during the current round. Having "fat" rounds -- on the order of multiple minutes or even hours -- would be a feature. A bit of time friction keeps the system from being gamed. Let the computerized gamers play in bigger spaces. Here, we want the players focused on the fundamentals.

However, there are some properties we need which don't fit certain blockchains:

1. Real IDs are needed to determine who owns what company.
2. And yes, tax compliance is needed, unless you stick to gray market companies.
3. Need a stable currency to fund companies: dollars or maybe gold. Using a cryptocurrency that oscillates wildly compared to the expenses of running a real world business adds too much noise to the system.
4. On the other hand, we don't have to completely solve the Byzantine Consensus problem. The chain needs to be a consensus of meat space brokers and traded corporations -- and no one else.

Then again, perhaps some combination of location and blockchain is the way to go. Need some governmental entity to finalize dispute resolution. The Catawba Digital Economic Zone looks like an interesting possibility.

As for hosting the shareholder forums, I have the technology...

Tags: antitrust people's capitalism blockchain