Wednesday, August 25, 2010

Public healthcare is good, but...

technological advances in healthcare seem realistically to only improve medical effectiveness while not reducing its costs.  A sad but inescapable truth about healthcare spending and longevity is that it guarantees further healthcare spending.  If medical treatment prolongs life, then additional different end of life treatment will be necessary in the future.   Deathcare expenses are innescapable. this link states the issue in a polite manner.  Public healthcare faces a difficult obstacle in not wanting to refuse care, not wanting to raise taxes (pay for it), and declining birth rates impose a substantial burden on those most likely to pay the taxes necessary to pay for deathcare.

There is a possible fair and socially distributed solution though:

First, we can predict the costs of deathcare per individual.  Not that I have an educated estimate, but say it is on average $20K per person regardless of cause of death.  If each person paid that much into a government invested savings account such that it grew to $20K by the time they hit age 85, then each person would cover their own deathcare.  Having high income people pay $25-30K, and low income people a smaller $15-10K is perhaps democratically preferable, but an insignificant detail.  $100/year (tax payment) from age 20 to 85 grows to over $30K at just 4% rate of return.  In socialized healthcare, the actual costs of deathcare would still be paid socially.  Individuals simply fund the expected costs.

If funding deathcare becomes politically palatable, then individuals could also choose to optionally insure for specific expensive and experimental treatments.  For example, you could choose to fund possible needed future cancer treatment, or choose to avoid cancer causing behaviours and not insure.   The cost of cancer treatment times the likelyhood of contracting cancer might be $8000 per person.  An alternative, that is unfortunately susceptible to horrifically evil medical corruption, would be to pay tax supplements for each month you survive cancer treatment in order to reflect the death avoiding healthcare you received and be proportional to the quality of benefits you received.

Without these direct, but still socially distributed, funding opportunities, managing healthcare costs will mean reduced healthcare (death panels) or higher general taxation.  The funding proposals would encourage life extending medical research.  Its a clear human benefit to enjoy life extending technology.  We just need to pay for it if we want it.  The high public debt in Ontario justifies these extra funding streams.

Monday, August 23, 2010

Intel purchase of McAfee - counterproductive control

Intel recently made a deal to purchase McAfee for $48/share.  A premium over $18 over McAfee's closing price, and resulted in a 70 cent, near 4%, loss for intel's share price on the day of announcement.  McAfee even at $29/share was very expensive when considering it was 24 times its earnings, with no obvious earnings growth prospects.  At $48, McAfee is valued at 45 times earnings.  Even Apple trades at 20 times earnings.

An obvious, but purely speculative, motive for Intel to make this purchase is that it is about to introduce a product that can benefit from McAfee's consumer security brand (and expertise).  We can value McAfee as two distinct entities.  Its future earning stream, and its security brand.  The future earning stream should not be worth more than 10x current earnings ($1.65B) which leaves its security brand's estimated value to intel at $6.05B. If instead of purchasing McAfee, it paid them  $363M forever each year  (license fees/ joint venture investment), then using a 6% pre-tax cost (estimated 4% after tax) alternative return on capital, the value to intel would be identical to purchasing McAfee's security brand.  It's hard to imagine McAfee refusing $363M/year for what is mostly just sitting and looking pretty for Intel, or that McAfee has key IP its competitors are unable to offer (and if so, the need to pay part of the $363M would disappear after legal protection for IP expires) .

Control of the security brand destroys its value.  A 3rd party security authority protects its brand through necessary integrity and dedication, and as we see from Intel's high offer, can reach exceptionally high intangible value.  Once cashed out, there is no reason for original organization to dedicate itself to continued excellence.  Whatever Intel "product with security enforced by McAfeee" is announced, quickly/eventually becomes diluted to "product with self-provided security."  The need for ownership control is a primal psychological delusion that transcends even society's most competent management teams, or at least compromises their duty of care for other people's (minority shareholder's) money.  Western democracies have the same authority as the monarchies and dictatorships they replaced or condemn, yet the illusion of autonomy, freedom and un-predetermined outcomes legitimizes government and reduces its security costs.

Intel shareholders, by reducing its market price by $0.70, democratically estimated that Intel overpaid for McAfee by about $4B.  If I were an Intel shareholder I would share their frustration, and agree with the approximate overpayment estimate.   Natural Finance  (QSLs prevents this abuse to shareholders by not burdening existing investors with future project decisions.

Getting back to the Intel McAfee relationship, the rational approach (for Intel) would be to identify the narrowest possible McAfee function it desires to control:  Likely some exclusive hardware license to one specific technology, and then negotiate to control that.  Both the security brand value to intel, and its investment value would be maximized.

Tuesday, August 17, 2010

Redefining Commune -- Communal enterprises

A Communal project is typically an equal partnership in  life/ventures/societies.  A commune is traditionally defined as a living project with equal partnership.  I will further redefine communal to drop equal partnership requirement, and mean a legal framework for sharing of liabilities regardless of any hierarchy or individual profit incentives, but with a substantial internal share of profits.   A cooperative is a communal enterprise.

This is considered a draft post for communal equity

A marriage is a commune in every sense of the word, while a family is not because there is no legal requirement for family members to mutually assist each other.  A bank is almost a commune:  A network of branches, investment banking, and capital trading all pool together to mutually back liabilities.  The extent of its communal nature is entirely dependent on the level of performance-based employment and profitability incentives of each unit.  Higher union wages and performance bonuses all increase the communal purity of a bank, even when it fails communal definition by returning the coomon surplus to shareholders.

Natural Finance separates rewards for financial and labour contributions.  Assigns financial benefits to Investor's financial contributions, and purpose-holding benefits (by default, rights to distribute or direct ultimate profits) to labour.  A founder commune in the traditional equality sense is an obvious option.  Another option is allowing corporate/communal officers to democratically reward officer efforts with post-investor benefits.  Natural Finance facilitates several corporate currency instruments (deferred compensation, W, X and Z prizes are all addressed in manifesto).  Using democratic bonuses and deferred compensation, a communal enterprise can satisfy communal definition without equal participation by labour, and without any consideration for financial contribution.

Natural Finance treats sub-projects much like banks treat branches.  A sub-project is financed in the parent enterprise's name usually with a substantial portion as a secured QCSL tied to the project (which have interest and depreciation repaid each month/period).  Queued behind that secured QCSL are any benefits for the project leader(s).  Sub-projects typically have 10% of contributions go towards the queue.

Sub-projects can be very fine grained.  Any unit sales or production function, or any function that performs a measurable output can be made into a sub-project.  Sub-project managers have at least 3 compensation streams.  cash salary, enterprise deferred compensation, and project bonus (y prize).  The default relationship is an employee one.  As a default, the employee contract is re-negotiated (or discontinued0 after the y prize is paid.  Alternate options include giving sub-project managers "equity" stakes, and treating salary cash payments as (5%) advances on future distributions.

A co-operative can be viewed as a collection of sub-projects.  Co-operatives traditionally involve individual resellable ownership rights to definable portions of an asset, together with a democratic share of ownership and liabilities in the whole.  Achieving the same structure through Natural Finance, involves assigning a resellable perpetual right to the sub-project for its manager, rather than employment of the manager.   The communal tightness of each sub-project is flexible.  A joint-venture is a non-communal alternative, and sub-projects can be structured more like joint ventures than a mutual sharing of liabilities.  Ownership is not as key of a feature as joint vested interests in success.  Equality of members is also not critical to a communal definition, though democratic or equality of member opportunities scores many communal points.

Modern incentivised management techniques naturally benefit from shifting purpose-holding away from investors and towards labour and direct stakeholders.  While traditional financial thinking embraces individual rewards, and  has animosity to communal concepts stemming primarily from distant cold-war politics, communal responsibility and purpose has important motivational possibilities including peer-reinforced indoctrination, and when we drop mandated equality, can include traditional incentives for individual effort.

Communal equity principles

Sunday, August 15, 2010

Comptrolling function - verifying trust

Queued Soft Loans are repayable based on ability.  It is important to lenders that whim or choice not determine ability, and important that lenders need not request payment to obtain it.  Comptrollers ensure this in addition to preventing corruption of the enterprise.

Comptrollers are 3rd parties appointed when the enterprise becomes a Natural Finance Comptrolled Organization (NFCO).  The comptroller organization is appointed for "life".  The comptroller organization has control over all enterprise financial accounts.  It must sign off with enterprise officers on every major expense.

The comptroller's authority over future projects and expenses is based only on whether they compromise survivability of the enterprise.  He guards over high, potentially preferential, payments, and ensures that new project funding covers a portion of related ongoing expenses (6 months worth for example).  The strictness of the comptrolling function on management depends entirely on the health and success of the enterprise.  Companies in the startup phase, or with higher debts than assets have tight controls.  No revenue means management cash salaries are at their minimum levels, while they rise to their maximum when operational earnings reach 10% (or natural rate if lower) of outstanding soft loan principal.

NFCOs have 2 distinct stages in their lifetimes.  The transition occurs when secured and unsecured QCSL investors gain certainty of payment.  Defined as the point when all investor QCSL holders are projected to be paid in 5 years.  After the transition point, the focus or primary mandate of the comptroller becomes ensuring that purpose-holders (other than management) have their promises fulfilled.  It is possible for the enterprise to slip below the transition point, in which case the primary comptrolling mandate shifts back to investors.  Purpose holders care about total compensation, as compared to cash compensation that concerns investors.

The investor benefit of comptrolling is the superior certainty that enterprise revenue is diverted to repaying them, together with expense control.  Far superior to management employed auditors.  This is in addition to the certainty in priority of payment of natural finance QCSLs.

The management benefits of submitting to comptroller authority are in attracting investors, paying them less due to lower risks, and having a secure attractive currency with which to influence suppliers, project partners, and with which to influence social groups to become purpose-holders.  The manager gains the freedom to found companies without any out of pocket investment, earns comfortable to high salary when corporation is profitable, and gains ultimate freedom after company passes the transition point.

Maximum management cash salary ($100K) at 10% return to investors is justified in that an enterprise achieving such a return is naturally successful regardless of the market forces determining the natural rate for the enterprise.

Chartered public accountants in their audit role of a corporation differ substantially from Comptrollers.  First, the Agent-Principal problem exists with CPAs.  They are hired by management to project a perception of honesty and solvency to outsiders such as shareholders and tax authorities.  They can be fired if they are unwilling to confirm management's desired perceptions.  Bernie Madoff gave the impression he was audited, for example.  GAAP rules allow auditors leeway in interpreting corporate cashflow optimistically for investor perception, and pessimistically for tax authorities. Comptrollers have authority over the corporation that auditors don't.  There is no corporate right to fire them.  Cash-basis accounting determines all decisions.

Friday, August 13, 2010

The right of taxation vs the right of ownership

Governments hold the right to tax you.  Although most people would find the alternative distasteful, Government's holding a percentage ownership over you is actually a weaker right than the power to tax you.  A Government's passive right to a percentage of dividends you pay yourself is equivalent to the passive rights of a minority shareholder.  Under Modigliani–Miller theory, the government should be passive between the 2 choices.  A company that reinvests what it would otherwise pay in taxes, theoretically grows its accumulated profits more, and so has more funds available to pay investors and government when it pays.  The theoretical time adjusted return to government is identical for a 30% tax rate and a 30% ownership rate.

From the enterprise's point of view, it offers no real new tax avoidance opportunities.  It just greatly simplifies actions.  Instead of depreciating assets over their lives, enterprises simply use the natural cash based effects of their actions, and massively complex accounting rules designed to determine yearly tax obligations are no longer necessary to satisfy government obligations.

From an individual point of view, a government partial ownership would be almost equivalent to a progressive consumption tax:  Simply make all investment tax deductible, but raise progressive tax rates substantially.

The right of taxation vs the right of ownership is roughly comparable to the right of demanding specific regular dividends vs the passive right to claim a proportional amount of dividends when the tax payer decides to pay himself.

Under natural finance, the ideal tax regimes would be to tax salaries, benefits, bonuses, capital gains and dividends a flat 10%, while not taxing interest income.  There would be a progressive tax on total consumption, with a rebate of the 10% (salary/capital) tax for those consuming under, say, $20k/yr.  The reason for not taxing interest income under natural finance is that it is determined by perfect markets, and non discretionary:  If you are earning more interest than you deserve, someone will buy your loan away from you.  All other benefits and compensation are discretionary agreements.  Corporate taxes would be replaced with passive ownership benefits.

Tax rates have no impact on corporate investment

Take an investment opportunity that will either double the investment or lose it all.  We can compare it to a wager, and assume that no fun entertainment value exists in the wager.  We can compare a tax rate to a partner that funds a percentage of our bet, and so will take a percentage of the winnings.  Corporate taxes are such that when you lose, you carry the writeoff to other projects; present, past and future.  So the partner analogy holds approximately if you lose as well.

The only significant consideration in whether you place the wager or not, is your confidence in winning.  Whether your partner's share is 39% or 36% has absolutely no relevance.  It is dishonest for republicans to lie that a 36% tax rate on the "investment class" is going to create jobs and investment compared to a 39% tax rate.

The deficits vs growth debate places too much emphasis on growth.  First, in the short term, if you grow the deficit by $10T to spend on wars and cocaine, you will mathematically directly grow the GDP by at least $10T.   It is a sugar high, with no lasting economic impact.  When you reduce the deficit from year to year, you will cause a reduction in GDP by the amount of the cut.

So deficits directly cause growth.  But it does not cause investment and jobs, especially not when it is made by changes in the top marginal tax rate.  Deficits and a high total debt burden make the confidence of wagering on America very low.  It makes job creation and investment unattractive.  A path to the economic collapse of America is vivid to all.  Made even more vivid by the blatant corruption to ensure collapse by diverting economic sustainability to the greediest wealthy. A vivid path to collapse is directly related to the large debt burden, and there are 2 stark political choices.  Pillage all you can before the inevitable collapse, or prevent it.

A tax rate can be more attractive than a partnership agreement, because you retain control in how and when you pay your partner (assuming the partner doesn't want his cut immediately after each wager).  If you win the wager, you can pay yourself a higher management fee, or spend to make friends and influence people.

Thursday, August 12, 2010

Enforced Ability-based Soft Loans = Natural Finance Soft Loans

Enforced Ability-based Soft Loans is a more technically specific description of natural finance soft loans.

google and wikipedia tell us that Soft Loans have already been defined as:
"a loan with a below-market rate of interest. This is also known as soft financing. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provided by governments to projects they think are worthwhile. The World Bank and other development institutions provide soft loans to developing countries."
 Enforced Ability-based Soft Loans are loans without fixed date or amount repayment terms, based on the ability to repay, but mandatory repayment when the ability is present.  I could argue hijacking the word "natural loans", on the basis of the natural mathematical efficiency of enforced ability-based soft loans, but it would confuse.

Stock vs Cash Dividend - The 3rd choice

Variable Dividends (or Fixed Yield Dividends) are a cash dividend that is equivalent choice to a fixed fractional stock dividend.  A fixed fractional stock dividend of 1/10th or 1/40th of a share has a variable cash dividend equivalent of 1/11th or 1/41th of the stock's market value.  The cash value of the dividend is variable with the stock price, which makes the dividend yield fixed.  So even if corporations don't pay as high a dividend as shareholders deserve, they can pay more when stock price is doing well, and less when it is doing poorly.  So can afford a higher target payout ratio, and smooth out stock price fluctuations by providing investors with a mechanism to hold low and sell high.

While all investors should be disappointed with management's primacy of self agendas over their contractual mandates, I recognize that there are far greater evils in this world.  Living with the reality of corruption of mandates to shareholder value,  and deceptions to investors regarding shareholder rights, the continued health and capitalization of the corporation does benefit other direct stakeholders (management, employees, customers).  Yet a higher target dividend payout is possible through variable dividends without compromising the health of the company.

A 3rd choice is possible to boost target payout rates much higher.  Issuing a loan option instead of or in addition to the cash dividend option provides a way for the company to issue high dividends without reducing corporate assets at all.  Issuing a loan, retains the same earnings power for the company.  The interest benefit is a shareholder benefit if the loan is issued as a dividend.

A queued soft loan is a superior alternative in every way to a bond loan for both investors and the honest fair-minded corporation.  Soft loans have a certain priority to payment that can not be worsened for investors, and so corporations can benefit from lower financing costs associated with providing a better valued security.

To boost payout the highest, a cash dividend choice need not be offered.  If the company is debt free, then a QSL vs stock dividend choice results in a virtually immediate cash payment to some of the loan dividend choosers.  the company can pay its earnings towards the new QSLs immediately.

To price the QSL dividend choice benefit, the principal amount is equal the cash dividend equivalent to the fixed fractional stock dividend (1/11th stock price if fractional stock dividend is 1/10th of a share).  The interest rate could be bid on, but that requires logistical support.  In healthy public companies, because QSLs guarantee no dilution of payment priority to the loan holder, every loan has an estimated organic (from operations) payment date.  Organic expected payment date can be used to set the Dividend replacing QSL interest rate to match the government bond rates of similar duration, adding a premium of, say, 20 basis points per expected year of repayment.

A high dividend choice not only allows a naturally efficient mechanism to separate shareholders into those that want to determine purpose of the enterprise vs. those that simply want financial benefit from the enterprise, but it also helps expedite purpose-aspirational shareholders to takeover the company without paying market premiums for it, but in a fair way to all other shareholders.  By bidding on dividend increase projects through QSLs, purpose aspirational shareholders encourage the corporation to boost dividend payout even more, and provide the benefit aspirational dividend choosers with cash payments.

A typical target dividend payout ratio for mature healthy public corporations (that pay dividends) is typically 50% of earnings.  It is 75%+ for Canadian Income Trusts.  When Income Trusts have poor performance periods where there payout reaches 100% of income, their market capitalization tends to drop below their book value, and yields go higher than P/Es.  The market is scared of high payout ratios, mostly because of fear that fixed dividends will be reduced rather than the fear that bankruptcy becomes imminent.  A variable dividend can allow the income trust to pay according to target earnings, and can payout 90%-100% of those earnings targets, because when it falls behind, it will naturally drop in stock price, and pay out less.  Their dividends become self adjusting.

Because of the obvious appeal of high dividend corporations, and the announced intentions of industrial icons (Bell Canada) to convert to Income Trust structure, the Canadian Government has effectively banned income trusts starting in 2011.  Variable dividends will allow converted Income trusts and  those corporations that wanted to be income trusts to boost payouts within management agendas.

Wednesday, August 11, 2010

Converting Public Corporations to Natural Finance - Part 1

Part 1 of 2.   This is the basic plan for converting a healthy public corporation.  It is relatively straightforward, offers free choice, but can overpay by not taking full advantage of natural finance principles to bypass the market corruption caused by the price difference between buying 100 shares vs 10M shares.

copied from manifesto.
Converting a public corporation is voluntary by all affected stakeholders. It can be complete, partial, done in stages, and convert bonds, preferred and common shares. Once natural finance conversion has begun, no new bonds or preferred shares can be issued, and common share issues are not recommended..

Bondholders should be given first priority to convert. Secured QCSLs most closely fit the bonds the company considers too expensive for it. If all bondholders converted to unsecured QCSLs, they would all have enhanced security (demand lower yield) by the fact that they are first in line to be paid. Unsecured QCSL conversion for bondholders is essentially a cash redemption of bonds which is sometimes an enterprise right attached to some bonds. Secured QCSLs also offer better security to converting bondholders because in a distressed bankruptcy type scenario, they get theoretically 100% of principal, and they also receive high yields including a non taxable depreciation coupon. Those bondholders that do not convert, continue to have a fixed obligation paid before QCSLs, including principal at maturity, but they lose relative priority in the event of bankruptcy. A net positive to convert. Even when converting to natural financing in a distressed enterprise situation, if the conversion buys a few years survival, bondholders are substantially incentivized to convert. Better value to bondholders through natural finance, means lower borrowing costs to the enterprise.

Preferred shareholders are the only group that are economically-forced to convert in order to keep their relative security and payment regularity. Secured QCSLs match the payment regularity most closely. Non maturing Preferred shares are in fact a scam on its buyers, because the principal is never repaid. The odds that a non-liquor company will eventually (or within 200 years) go bankrupt are over 99.9%. Preferred shares tend not to have sufficient premium over bonds to understand that risk as properly considered. From the enterprise's perspective, paying a pre-profit coupon inflated by the inverse of its untaxed profit rate is equivalent to a preferred coupon. For example, at a 25% tax rate an 8% bond coupon is equivalent after tax to a 6% preferred share coupon (for same maturity date). From the investor perspective, forcing the exchange is forcing a net benefit of additional bond security, and forcing a net benefit is a gift. In most countries, on average, there is an equivalent after tax return to the securities as well. Offering the same optional conversion options to (converted) bondholders after the exchange, provides the same optional choice to preferred shareholders.

Common shares can be converted by either an internal “takeover” bid by management, a partial substantial issuer bid (bid for up to x shares). A company with net assets of 500K, making 100K per year, 10000 shares outstanding, and P/E of 10 has a $100 share price. If half the shares are sold in exchange for QCSLs loans at 10%, then after 8 years (QCSLs are repaid), without any operational improvement by the company, net assets are back to 500K, and the 5000 shares remaining at a P/E of 10 are worth $200. Every rational person who doesn't have direct oversight of management, and therefore cannot vouch for its confidence, would prefer to hold QCSLs (ignoring tax differences) because they are paid faster and more certainly even if the return is the same. From the enterprise perspective, if it can pay less than 10% interest rate (almost certain given profile), then it is net positive to the enterprise and remaining shareholders. Most successful public corporations should be able to achieve natural rates close to “riskless” government bonds (under 5%-6%).

Pensions are a scam/motivational technique on employees designed to keep them needing work. There are tax advantages for both parties, but administration fees and restrictions on cashability are net negatives compared to direct loans/deferred compensation. A pension system can continue under natural financing and invest its assets back into QCSL backed projects, but management may find employees willing to invest more if they provide them with higher returning and more flexible direct deferred compensation.

Tuesday, August 10, 2010

Queued CAPPED Soft Loans -- management protection

Queued Capped Soft Loans (QCSLs) are QSLs which are capped at a natural (arbitrary, but humanly digestible) 200% of original principal (for investor QSLs.  Employee cap is 300%).  A QCSL security can never receive total lifetime payments over 100% of its original purchase price.  A trade on the RE does not reset the cap, but a trade on the POE does create a new QCSL for the investor.

This is 3rd part in series of posts on Soft Loans part1, part2

The cap serves to protect both management from usury, but also all investors queued behind other loans (nearly all of them).  Usury is a genuine social harm.  Protecting people from accepting a loan for 50% interest does them a favour.  If you are in a position of a debt that will result in your murder if not paid, then you over promised in borrowing.  If death or harm could be caused by other means (lack of medical procedure), then the lender should be considering the benefits of charitable gift rather than usurious loan.

An equivalent security to a QCSL would be a QSL with an insurance policy (by company) that would pay investor all accumulated interest above the cap.  By having the investor self-insure the incredibly expensive and inefficient bureaucracy of a 3rd party insurance provider analyzing the investment, determining a premium, including an expected profit in its premium for adopting the risk, and aggravating the world with additional service offerings.  Self-insurance also protects against any incomplete insurance coverage such as non-payment conditions or lapse in premium payments.

An investor could purchase equivalent insurance product through 3rd party or as a derivative, that would pay him all gains lost due to cap, but doing so is absurd.  Expensive, but also being paid an eventual 100% return on an investment is unlikely to be considered harmful, and through the Soft Loan Exchange, the investor can cash out at any time.

The important investor benefit of QCSLs (capped) is that it allows investor decisions under certain worst case scenario.  If an investor is about to buy into the existing queue or future operations, then knowing that the company has $5B in existing QCSLs, then he knows with certainty that he will be repaid double or his annual bid rate if the company makes $10B (or more) of operational profit in its lifetime.

The main protection for purpose holders is that runaway debt becomes less likely.  Those behind investors in priority need the hope of one day being paid to continue striving for purpose.  Caps help maintain the possibility.

The main appeal to investors of QCSLs is the certainty of priority.  All unsecured QCSL holders can never have some other investor gain higher or equal payment priority than them.  All secured QCSL holders cannot be displaced by any future projects or asset acquisitions.  By contrast, in traditional finance, a 10 year bond holder is susceptible to any hair brained scheme by management to expand or to sell to a leveraged buyout scheme, and shareholders are susceptible to much worse dilution or management salary increases and risk taking.

Monday, August 9, 2010

QUEUED Soft Loans - enhancing predictability

Queued soft loans (QSLs) are soft loans that are setup in ordered payment priority.  All principal and interest of the first loan is repaid before any payment on the next priority loan is made.

This a followup to recent Soft Loans introduction.  Part 2 of 3.

The distinct advantage over traditional bond-loans are that there is certainty of leverage for the investor.  If you have no debt whatsoever, and high income, you could get a small loan at the lowest possible interest rate if you promised not to get any other loans.  That promise is never made or asked for, so lenders are forced to assume you may get a lot more debt later, and price their loan more expensively.  With QSLs the leverage rate at the time the loan is made is known precisely, and can never worsen for that investor, and improves every time another investor is paid.  The lender can furthermore estimate a date he will be repaid based on expected operational profits.

A Queued (capped) Soft Loan Regular Exchange (RE) is a market much like stock or bond markets where individual traders may buy and sell specific QSLs.  It is almost always a bad idea to buy a QSL for more than its accrued value, because it can always, and often, be paid off early.  The RE exists to help QSL holders to cash out at less than full promised returns, by offering up his QSL.  The company is unaffected financially by these trades and need not be involved in the exchange.  The RE collects a commission on these trades.

A QSL Perpetual Offer Exchange (POE) is typically offered by the same organization running the RE.  It allows any entity the opportunity to buy into the queue of soft loans (at the end) by accepting the natural bid rate which is a small increment below the queue's natural rate (which is the average interest rate in the queue).  The proceeds from the new buyer go directly to whichever investor is at the head of the queue.  The POE does not collect regular fees on these trades, though is part of Comptroller entity fee based duties.

A QSL Future Operations Market (FOM) is a market where investors and the company agree on funding the company's future weekly operations and special and new projects.  For weekly operations the company is forced to accept bids at the natural rate, and use any excess revenues (over reserve of usually 1 month) to repay QSL queues.  For projects, the company may arbitrarily set a maximum interest rate that it will accept initiating the project for.  Potential investors may make a standing bid for the next weekly operations slot at the natural rate at time of bidding, and if so their bid may be accepted even if the natural rate falls below that bid (and there are not enough better bids).  It is yet to be determined if investment banking fees will be incurred in this market.  There are comptroller fees for reviewing and packaging projects for offer, but weekly operations are included in standard comptroller duties.

QSL holders have some options to faciliate reinvestment in the company, whenever they are about to be paid for their loan:  1. They may guarantee an accepted bid in the company's next Future Operations Market auction at the natural rate.  2.  They may repurchase into POE at a slightly advantaged average of the natural bid rate and the natural rate, and 3.  If (and only if) their QSL rate is below the natural rate, they may pass on being repaid.  Choosing instead to continue maintaining their safe position at the head of the queue, while accruing interest.

The natural rate is the average interest cost to the company.  By allowing automatic bids below the natural rate to be accepted, the interest cost to the company tends down, and individual investors are repaid much more quickly than they would if only organic (internal to company: revenue surpluses) payments were made.
By allowing for programmed orders from QSL investors, the natural rate can rapidly cascade down as a result of improved outlook in the company.  For example if 100 investors are each willing to lend $1000 to the company at 9%, but the company only needs a total of $100K in financing, then the negotiated rate could be closer to as much as the company may bear (15% for sake of example).  But if 1 extra investor is willing to invest $1000 at 9%, then the natural rate will quickly cascade down to 9% because every investor who is offered repayment will choose to reinvest.

The unlimited supply of loans created by the POE satisfies the perfect competition ideals of Adam Smith, for enterprise financing.  Open loans, means that whoever provided the first acceptable finance terms doesn't forever encumber the enterprise with high rates.  (Investors who prefer not offering open loans have free reinvestment options).  Expensive loans can be easily replaced.  Its an advantage to investors as well because in a $100M project, putting in the first $10M is much more risky than putting in the last $10M.  Namely, the risk that the other $90M won't be raised, or incur delays.

Part 3: Capped QSLs

Introducing Soft Loans - A new corporate security

Natural Finance uses Queued Capped Soft Loans.  This is first of 3 part post series.  This is meant as a concept introducing post, but the official statring point is here .

Purpose Holders of a traditional corporation are its shareholders.  Management has a duty to maximize shareholder value.  The Founder of a corporation typically conceptualizes and executes its function through management of it, but if he needs more money than he is able/willing to risk, he must, most commonly, negotiate away much if not most of the purpose-holding to stock investors.  If it is most of the purpose-holding, then he completely loses control of his concept and mission for it.  If it is less than most, then stockholders are helpless captives to nearly every management whim.

Soft loans are loans with no fixed date/amount repayment terms, but rather based on ability to pay.  They are similar to royalty streams with the major exception that they expire as soon as all of the principal and interest is repaid.  They are much more similar to interest accruing accounts payable, or a promise to suppliers to pay them when some sales are made.  Soft loans are transferable the same way any lender could assign your borrowing obligations to be paid to someone else.

From an investor perspective, a soft loan must have tight accounting controls that prevent the borrower from interpreting or managing his "ability to repay" obligation.  The lender never wants to have to call and request for payment time frames.  These trust issues explain why soft loans have traditionally been unpopular for lenders. When trust is verified, soft loans are much less risky than owning minority stock.

The capitalists role is to get a return of and on his capital.  The most direct way is through loan interest.  His role is not to interfere in how to provide that return, or demand and delude himself into promises of unlimited returns on his capital

Queued Soft Loans have significant advantages to both minority stock or bonds/traditional debt to investors (details comming).  soft loans share bond-loans predictability of repayment.  While bond predictability is affected by likelihood of default projections, soft loans are not only necessarily less likely to default (details comming), but have an expected date of repayment, which usually, even when it misses expectations does not affect the return to investors.  Stock returns have no tangible predictability.

From management's/purpose-holder perspective, soft loans have the same benefit as share capital in that you never have to consider paying them back unless you are able to, and the advantage over bond-loans that you are never forced to pay unless you are able to.  When trust is verified for stakeholders, and controls on management spending and salaries in place, soft loans become an enterprise currency, where suppliers, customers, and employees can be provided with assets with much more tangible value than stocks or options.  Tangible value that is much less affected by unknowable management possessed information and competencies.

Part 2 Queued Soft Loans

Sunday, August 8, 2010

The Modigliani–Miller theorem is false

The Modigliani-Miller_theorem states that dividend policy doesn't matter.  The basis for that is that a $50/share company that pays a $1 dividend, might become worth $49, but the investor got $1, so the investor still has $50 total worth of economic value.

If that same $50/share company gives an absurdly high non-cash dividend of 1 share to every shareholder, then the share value drops to $25/share, but shareholders have twice the shares, so still have $50 of value.  The offer is a complete waste of time to all involved because the outcome is identical to offering no dividend at all.

The same offer as the last, but this time the shareholder is offered the choice between a $25 cash dividend or 1 bonus share.  If 80% of investors choose the cash option, then the company will have paid $20 per share in dividends.  Its new capitalization per share is still (300/12) $25, and both those who chose to accept cash or shares have $50 of value.  However, the choice itself is of extremely high value to shareholders, and at least of obvious greater value than no choice at all.

So dividend policy obviously does matter.  Modigliani–Miller theory is management serving.  It is used to preserve their right to run the company into the ground instead of ever paying the investor back.  Their mandate to serve shareholders is a minimum satisficing one, instead of a passionate one.  A foundation of natural finance is that the only ones who should want ultimate purpose-holding (right to unlimited profits) authority is executive management, because their agenda subjugates any mandates they pretend to have.

The specific real world flaw of Modigliani–Miller theory is that all investors necessarily want to continue investing, and if given cash and a decision would reinvest in the same company at current market prices.

Note that any firm (worth $50) that offered shareholders the more reasonable (from management's greedy perspective) regular option of a dividend of 1 share per 10 shares owned, or $4.55 per share, roughly a 9% (1 - 10/11)  yield, would even if maintaining theoretical shareholder value,  actually significantly improve shareholder value by making share holding more attractive (only real source of share price increases) to buyers.  The share price increase would be even more beneficial for those that take share dividend over cash dividend.

Proof that Dividends matter
The choice of a stock or cash dividend, under Canadian tax law, offers in the stock option, 0 tax, liquidity and transaction cost issues.  If everyone chooses the stock dividend, there is no impact on the market value which management cares about, but is irrelevant to investors.  Even though there are tax cost from accepting cash dividend, there is also a corresponding future tax bonus from the reduction in market cap.  The first proof that Dividends matter is that most rational people would choose the cash dividend despite the theoretical inferiority of receiving it.  Public companies sometimes approximate this choice with DRIPS which are inferior to the choice because they may (do everywhere I know of) incur non-deferred tax costs for those that choose the option closest to a stock dividend.  50%-85% (believe higher end) of investors choose not to reinvest.  This proves a market appetite for dividends.

In the case of banks, future earnings expectations are based principally on book value, as it makes money from its money.  When it issues dividends, it reduces both its book and market value by the dividend amount, and so affects its future earnings projections.  Since most healthy banks trade above book value, the second proof that Dividends matter, apparently in favour of not paying them, is that market price as a function of book value and earnings optimism, drops by more than the cash dividend payment amount.  Yet this again proves a market appetite for dividends.

If the dividend choice (cash or stock) is significantly above earnings, for example both of the above ($50) examples, then book value and market value will both converge to each other, and converge to 0 if the dividend is continuous. For a $50 stock, and a 1 share for share dividend choice, the capitalization per share in each successive period halves [25, 12.5, 6.25, 3.125...], excluding  continued earnings contributions.  When companies trade below book value, then counter-intuitively, paying a high dividend increases shareholder value even if it decreases corporate survivability.  Trading below book value, is the market telling the corporation it is incompetent in managing its assets, and telling it, it should return investor capital.  The third proof that dividends matter is that since corporate capitalization goes to zero as a result of high dividend choice, Those who choose the dividend realize full theoretical capitalization payments in cash, while those who choose shares risk losing the full capitalization if bankruptcy results.  Whenever management chooses not to pay dividends it asserts its privilege to bankrupt the company without ever returning capital to shareholders.  Proof that traditional corporate structures are corrupt is that management asserts its privilege to power, salaries and longevity of the company over its mandate to maximize shareholder value.  Minority shareholders do not hold the democratic power to direct purpose of the corporation, and so are merely passive beneficiaries who are deceived by illusions of possible future dividends.

Note that the above offer of 1 share or equivalent cash dividend per share does not necessarily lead to a decrease in capitalization, much less bankruptcy!  A $50/share company with $5 in earnings (10%) maintains its capitalization if only 20% of investors choose the cash dividend.  The shareholder that chooses dividends each period will have collected (1023/1024) $49.95 over 10 periods, while his percentage of ownership will have decreased by 1/1024th.  Excluding the timing of tax payments, can be a net 0 tax benefit as well: capital losses offset dividend gains.

Very high dividend choices provide a natural, mathematical achievement of ideal perfect competition models for capital transfers, which imperfect markets corrupted by limited demand, supply, and information, and further corrupted by power, privilege and policy cannot achieve.

An easy and novel way to value stocks

Stock valuation is typically based on book value, earnings, and expected earnings.  It's the best we can do.  An intriguing variation of the efficient market hypothesis would be that every stock is expected by the market to be worth double todays value in 10 years (dividend adjusted).  If buy and hold is a legitimate investment strategy (and it happens to be the foundation of financial advice industry **cough**) , then picking stocks based on confidence of value in 10 years would seem like the best approach.

The expected value of a stock in 10 years though,  isn't based on book value, earnings, and expected earnings.  Instead it is based on what the book value, earnings and expected earnings outlook will be in 10 years.  It's relatively easy to predict if a stock's book value will be double in 10 years.  But if earnings are gone, and earnings outlook weak, then a market to book value of 2 today, could turn into a market value below book in 10 years, and so price might have gone down after 10 years.  Earnings and earnings outlook 10 years from now are extremely difficult to predict, but still better a better basis for expected market value in 10 years than cashflow analysis using today's more tangible numbers, because you're unlikely to be paid any of the cashflow growth.  The valuation assumption that you will eventually is simplifying but wrong.

 Apple at 21 PE 6x book and $260  today has great earnings and earnings outlook.  10 years from now (or 20), will it have hit products, and will Jobs still be with the company?  Probably not.  The high P/E implies near term growth, which the market may be correct in anticipating, but a $520 stock price probably would need 4x current earnings (10 P/E).  Its hard to have confidence in that outcome.

Microsoft at PE of 12 and $25 (and 2% yield) has decent earnings outlook.  It has product franchises on PC and console, and could get growth from web strategies, and its not impossible that it comes up with a successful phone/tablet.  Microsoft doing about the same or better seems more probable than Apple.

 A different  but relevant question than which company is most likely to be worth double is which company is more likely to be still alive in 20-30 years.

While both these companies could convert to natural finance, Apple especially would never consider buying out its shareholders at current prices, because it would be too expensive to.  Converting shares into loans is only attractive when those shares feel undervalued to the company.  On the other hand, even if Apple is one of the least well suited companies for natural finance share conversion, it could still benefit from converting the relatively little debt it has to natural finance soft loans:  There is more certainty that Apple will make $10B more in profit before it collapses than the US government will be solvent in 10 years.  So investors should be willing to buy up to $10B in Apple soft loans at rates lower than US bonds (currently under 3%).

One of the main advantages of natural finance to investors over common share ownership,  is that it is much easier to estimate the likelihood that a company will make $10B or $50B before dying, than it is guesstimating whether it will have a positive earnings environment in 10 or 20 years.  The advantage of natural finance over bonds for investors is that there are no substantial obstacles to prevent the company from issuing substantial debt at the same credit priority as your bond.  A natural finance investor can never have his secured priority subjugated by corporate dilution or new debt.

Saturday, August 7, 2010

Hello World! -- the concept

Natural Finance solves the contradiction of the following 2 axioms:
  • It is stupid for any investor, not closely affiliated with management and/or with quality access to inside information, to invest in the common shares of an enterprise.   Because a distant shareholder can only guess at company valuation, and has no power to stop management from overpaying itself or bankrupting the company before paying him.
  • It is stupid for founders/management of an enterprise to finance exclusively with debt, because they risk losing the enterprise too easily due to solvency covenants. 
The main conceptual natural finance instrument is soft loans with no fixed term, or fixed payment. They are repaid based on ability/profit, and repaid in the queued order they are made.  Typically all revenue above 1 month's worth of operational expenses is paid back to soft loan investors.

New project and operations are financed through new soft loan issues, at buyer's bid rates.  The average resulting interest rate is the natural rate for the enterprise.  Existing loans, in addition to being paid through operational surpluses, can be repaid (in queue order) by anyone willing to invest at slightly below the natural rate (through a market replacing mechanism that is essentially perpetual offer to sell at ever decreasing interest rates), or can be transferred (sold) in a private transaction to any other entity.

Unsecured soft loans have the highest organic payment priority.  Traditional bond/debt investors benefit from investing in queued soft loans by not risking dilution from future debt.

Secured queued soft loans have next payment priority.  They aren't quite as soft, as they do have fixed payments for interest and depreciation designed to keep the loan principal value equal to the secured value of an asset, but are soft in that pay downs below the secured value are paid from contributions (profits) related to the asset, in addition to general contributions once unsecured soft loans have been fully repaid.

The last queued soft loan tranche is deferred management and labour compensation.

Because natural financed corporations require no equity investment, the ultimate purpose holders of the corporation are completely flexible.  From greed-purposed (such as traditional public corporations, but 100% of stock ownership defaulting to founders/management.) to any percentage of social purpose (labour, customers, community, charity, innovation/R&D, society(tax), and humanity).  When a founder chooses to have a fully social purposed corporation, he may typically assign himself a success prize for successfully delivering the enterprise to its purpose-holders: by paying off all of the soft loans it incurred to be in a position to reward those purpose-holders.

A key component for fostering trust and integrity of natural financed corporations is 3rd party control of all bank accounts and payments (and a 4th party bank that ensures 3rd party integrity).  This 3rd party comptroller, trained in natural finance standards, can enforce all contractual promises made by the enterprise, and regulate salaries and rights the enterprise entitles itself and its employees.  Management/employees never touch customer or investor money (except for cash sales).   In the case of investor to investor loan buy outs, not even the enterprise bank accounts touch investor money.

Liquidity for an enterprise is generally guaranteed by backstop bidder(s) who guarantee bidding on future operational needs for x years, up to $y in placed investments, and at a predetermined rate.  Some consideration for doing so is generally expected, but high returns from backstop bids are partially self-justifying.

Natural financed corporations allow a confident entrepreneur to finance projects of all risk profiles (including those with too little risk and return for traditional equity investment) as long as he is willing to draw low salaries until the success path for the project has evolved.  As the company's success becomes established it is natural/normal for new investors to come in, bidding down the company's financing costs, and enhancing its success chances even more.

the manifesto is the more detailed and comprehensive description

first of 3 part series introducing soft loans