PARPAs ideal legal structure comprises both a nonprofit and a for profit

Note: Many of the decisions in this section are based on numerical assumptions. I’ve marked each of these assumptions with a 📊. I’ve put these quantitative factors into a model that can be referenced here, so you can play with it yourself

The ideal legal structure for ARPA would satisfy three conditions:

  1. The legal structure would enable people to make tax-deductible donations to the organization
  2. While enabling the organization and the people involved in it to participate in the upside of capturing value from technologies they’ve created.
  3. Enable the organization to become self sustaining. A self-sustaining organization either needs to sell a product or service, have an endowment, or regularly generate liquidatable equity.

On its face, these three conditions seem contradictory. In aggregate we can’t expect an ARPA-riff that is genuinely working on Things that are not paper-worthy enough for academia and not product-focused enough for a startupto be profitable. DARPA probably couldn’t have a positive return<Could DARPA have a positive return?> and Bell Labs was only profitable in conjunction with AT+T. This assertion is based on the fact that Current value capture mechanisms are crude, It is hard to capture value from research, and There is a significant class of innovations that would create drastically less value for the world if their value had been captured by their creators.

However, while an aggregate of all the activities of PARPA would not be profitable, it’s a reasonable (but still risky) hypothesis that a portfolio of companies that spun out of PARPA could end up doing well. Remember, companies can be an effective mechanism for technology dispersion regardless of profit, PARPA will eventually spin out companies. Furthermore, it’s an even safer bet that if PARPA is doing something useful profit-generating organizations will come into existence that can trace their DNA back to PARPA. Let’s ignore the latter for now.^6

I’m going to lay out a high level sketch of the simplest structure that (I believe) meets all three criteria - lets call it the platonic structure because implementing it will undoubtedly involve some changes for pragmatic reasons like not going to prison on a technicality. In a sentence, you have a big N-Nonprofit that owns a for-profit and also has an endowment.^1 <TODO:Picture of system>::THIS IS AN EXPERIMENT:: Let’s call them Alice, Bob, and Charlie because it will make the section much more interesting than saying “The Nonprofit” “The for-profit” and “The Endowment” over and over again. ::End experiment:: Alice runs all of PARPAs activities. Her operating capital comes from three places - tax-exempt donations from donors, cash from the c-corp, and dividends from the endowment. Bob owns parts of companies that spin out of Alice either as equity in the case of high-growth companies or as profit-share agreements in the case of low-growth companies.^2 People can invest in Bob in exchange for a claim on future profits.^3 Finally, the Charlie does what endowments do - he invests money broadly and attempts to generate a steady dividend that he gives to Alice. Charlie gets money either directly from donors or from the Alice when her revenues exceed her expenses.

At high level this structure satisfies criteria #1 by enabling people who prefer to make tax-deductible donations to donate either directly to the Alice’s operational budget or to Charlie. The structure satisfies criteria #2 by enabling people to invest in only the outcomes of programs that eventually become companies, which I do suspect could create real return (as opposed to the structure as a whole<Could DARPA have a positive return?>) . And finally the structure satisfied criteria #3 through the fact that the Alice is the “parent org”<Inverting the normal relationship between an R+D organization and is money factory may enable new classes of activities> combined with the Charlie and a reasonable hypothesis about how Charlie can get to a point where it can sustain operations.📊

There are a number of nuances, especially around the for-profit organization. The first nuance is about how the Bob’s stake in spin-out companies works. We’ve already established that PARPA will eventually spin out companies. However, it’s important to reiterate both that not every successful program will turn into a company📊 and that not every company that is the best vehicle to get a technology out into the world will be a high-growth venture-backable startup. Standard equity-ownership does not make sense for slow-growth companies because they may never be acquired or go public. Instead, the for-profit could own a share of their future profits. This profit sharing will end up being negligible on the for-profit’s balance sheet in a best-case-scenario📊 but it is a useful source of free cash flow. So in order to maximize technology getting out into the world, it’s important to offer companies a choice of profit- or equity-based ownership. The size of that ownership is another tricky matter.📊 The more ownership Bob maintains in the baby companies, the less profit or equity, they’ll have to fund their own operations and the less likely they are to succeed. At the same time, Bob needs to own enough to make a return for his investors. As a precedent, YC takes 7% and EF take 10%. We’ll go with 10% because it’s a nice round number and above it, it feels like the startup might really start hurting. Perhaps it should be lower.

The next nuance is about Bob’s legal status. The two main choices are whether he should be an LLC or a C-corp. The most pertinent differences between the two revolve around taxes and the ability to issue shares. LLCs are ‘pass-through’ legal structures so only investors would be taxed on income they make from Bob. As a C-corp both Bob and his investors would be taxed. C-corps have much more legal precedence and people are more comfortable with them, so unless the double-taxation is a significant burden it’s generally a good idea to default to a C-corp. The way to navigate this tradeoff is to look at where Bob’s (hypothetical) value is going to come from and which structure would maximize technological dispersion (do not forget our goal!) The majority of Bob’s value will be in holding equity in companies that are high value. The classic trap here is to set up Bob’s incentives so that he is incentivized to lean on those companies to have a liquidity event as soon as possible. Bob would be incentivized to push for liquidity events if his value were in the cash he would be returning to investors. Instead it would be better if Bob’s value was instead based on the long-term value of the equity he held. Aligning those incentives seems to suggest that Bob should be a C-corp. While this might be an obvious conclusion to you, it was not actually my conclusion coming into this. The one other consideration that might tip the balance is that there are more constraints on how ownership works in an LLC than a C corp.

The next nuance is how ownership of Bob will work. The ways that you can legally divide up ownership in an organization are heavily regulated so I am going to first describe a platonic system that is probably illegal and then explain how it could be crudely implemented within the constraints of the law. Obviously investors and Alice herself are going to own a good chunk of Bob, but it’s also important to figure out how to enable Alice’s PMs to participate as well. Enabling PMs to own a meaningful part of Bob is actually important to incentives, when you consider that there will be some programs that will naturally lead to valuable companies but many others that will be hugely impactful, but won’t make good companies<There is a significant class of innovations that would create drastically less value for the world if their value had been captured by their creators>. If the implicit choice for PMs is “if your program becomes a company, you’ll get financial upside but if it doesn’t you get nothing” you will incentivize PMs to either push programs that shouldn’t become companies towards becoming companies or to never start uncommercializable programs in the first place. If instead, you give everybody an equal share of the value produced by work done at PARPA, it will hopefully alleviate that pressure. Of course, this won’t stop PMs who are strongly driven by economic incentives from skewing all their work towards companies. Nor will it create totally equal outcomes - PMs who go on to create successful companies will obviously own far more of those companies; arguably the majority of a technology company’s “excess value” is not actually due to its technology.^4

Ownership based on an accumulating ledger of points would enable everybody involved in the organization - both those who put in money and those who put in time - to participate in upside on roughly equal ground. You could assign different number of points for different activities that help the the enterprise as a whole - “you get N points for the first year of service, 1.2*N for the next year, etc.” “You get M points/$100k.” At the end of the day, you end up with a list of people and how many points each of them has - ownership is just your points divided by the total number of points. The ledger system ultimately has the same outcome as selling and awarding people shares that get progressively diluted as a company increases in value (more points will be created over time so a fixed number of points will represent a decreasing fraction of Bob); however, it has several positive features that standard shares do not and avoids some of their downsides. One upside to this system is that it gives everybody the same type of ownership - avoiding preferred shares, etc. The ledger can roughly stand as an accounting of who contributed to the organization’s success.^5 Combined with ‘pseudopoints’ for donations to the nonprofit (which can’t be financially rewarded) the ledger could be a public source of pride instead of a secret and source of jealousy like company ownership normally is. The points system would also enable people to participate in multiple ways — there would be no accounting hassle for an employee who also wanted to invest — instead of different types of shares shunting people into different buckets according to their roles. There’s also a psychological component to the difference between adding a grain to a growing pile of sand instead of getting a slice of a fixed pie. I realize this all comes with a whiff of utopian faeries and rainbows - regulatory constraints will undoubtably make this full system infeasible. It’s important to lay it out however, so that we can get as close to the ledger system without going to jail.

Bob’s existence won’t free Alice from depending on donations to fund operations for many years. However, Bob can possibly free Alice from depending on donations in the long run by filling Charlie’s coffers. This scheme relies on two big assumptions — that Bob will eventually become very valuable and/or that Alice will be able to get enough donations to cover operations that, through some combination of those donations and money from Bob, there will be enough to slowly build up Charlie’s principal to the point where its dividends can fund Alice indefinitely.📊 <TODO:Picture of system with world>

^1: “…That’s it?” You ask yourself? “You built up to and agonized about that??”
^2: This may be the first part that makes you stop nodding your head and scratch it - I’ll dig in later I promise.
^3: (Second head-scratch — not equity??
^4 :<sidenote> See Jerry Neumann’s Productive Uncertainty
^5: As with any metric, it will be very imperfect. It’s not actually possible to convert between four years of service and $200k. Both are essential and uninterchangable.
^6:<sidenote>If every company whose core business depends on technology that can be traced back to DARPA gave some tiny percent of their revenue to DARPA, it would clearly fund DARPA (and in a way they do, via taxes in the US - You need a certain scale for technology development to be worthwhile.)