Friday, December 30, 2011

Solution to US Housing/Foreclosure crisis

The solution to foreclosure proceedings is a voluntary arrangement between borrower and lender that is a mix between a rental agreement, rent-to-own scheme, and Natural Finance's deposit option concept.

For borrowers, strategic squatting or strategic default can offer a direct financial benefit if their mortgage is worth more than the sales proceeds of their home.  The disadvantages include credit rating damage that could prevent purchasing another home, legal hassles, possible shame from neighbours and financial industry, and uncertainty as to length of foreclosure proceedings.  Some jurisdictions also force the home owner to declare bankruptcy and pay the mortgage with any other assets they may have.

For large financial institutional lenders, the greatest disadvantage to foreclosure is that it causes an inescapable accounting loss, and diminishes their capacity to deceive their shareholders and regulators as to their solvency and size of losses.  A related issue is that foreclosure is expensive for banks as it incurs legal and selling costs, a boarded up house is worth about $50k less than a comparable home, and there may be maintenance/renovating costs and paying of property taxes.  Every foreclosed home also decreases the value of every existing foreclosed home the bank may own.  A secondary reason not to foreclose is that it perpetuates an evil PR image, and there should be some shame to foreclosure considering the industry directly, and arguably intentionally (remind me to argue in comments), caused the housing crisis.

One proposed solution to keep people in homes has been voluntary mortgage writedowns by the banks.  This would be effective in keeping people in homes, because the borrowers would feel compelled to keep paying the new lower mortgage while hoping/waiting for their home to eventually appreciate in value from the current low levels.  The reason this is a non starter for banks, is that mortgage writedowns diminish their capacity to hide losses from their shareholders and regulators, even if it might mean keeping a paying customer, and be less unprofitable than foreclosure.

Somewhat similarly, a voluntary arrangement by lender and borrower for borrower to hand ownership to the lender, and then rent the home will incur accounting markdowns by the bank.  Other issues is that the renter can then demand major maintenance work be done, and take advantage of any other renter protection regulations.  The renter can also generally leave at any time, and so the bank still bears most of the costs of foreclosure, and all of the risks of future property depreciation.  Its a good deal for the home owner turned renter only if it allows him to avoid major repair costs and/or the rent is very competitive with comparable market rates.  These factors tend to make it less attractive to the bank.

Simplest solution
One simple solution that can be extremely productive for both sides is to renegotiate and write down the future interest cost of the mortgage.  If a home worth $150K has a $200K mortgage balance, then reducing the interest rate to 2% per year, can result in yearly payments of $9k or $10k (with $4k in interest costs) compared to a 7% subprime $200k mortgage which has $20k in yearly payments including $14k in interest costs.  For the home owner, halving their monthly payments can provide a cheaper alternative than renting while still owning their home, and if the housing market rebounds, profit from that ownership.  For the bank, this avoids forcing them to write down the value of the mortgage, and only costs them the ability to inflate future profits (by pretending th 7% interest on 200k will be paid), which in many cases would not be realized.

Productive government regulation here, would be to temporarily force foreclosure actions to be accompanied with an alternative bank offer to transfer the outstanding mortgage balance to a 10 year term 2% loan.  The reason banks would fight this legislation forcefully is that it would increase the number of strategic squatters and defaults.  Banks would also make new loans only with a required 25% down payment (which is the current norm as a result of mortgage crisis), so as to avoid strategic defaults on new and recent loans where property values have not come down significantly.

Reducing bank opposition to this regulatory proposal can be done by increasing the 2% interest rate.  Matching the current best bank rates is reasonable, but will cause banks to raise their best rates.  A (1 percentage point or so) premium to the US 10 year bond (current 2%+1% = 3%) would likely be an agreeable balance between bankers lobbying power, and being attractive enough for distressed borrowers to take advantage of, and close enough to existing mortgage rates not to affect recent mortgage home buyers.

Although we live in a world where bank's opposition to legislation is very effective in preventing that legislation, the proposal is a net benefit to banks, home owners, and construction industry, and it would surprise even the most cynical that the banks could successfully block it.

There is significant US economic benefits from adopting this plan.  First, reducing foreclosures is the first step in finding a bottom in housing prices.  Helping both stop the deflationary spiral harming the economy, and helping homeowners and banks with a healthy housing market.  For instance, homeowners with a low interest mortgage can get a premium selling price on their home if the buyer takes over the mortgage.  For instance, a property that was worth 150k (but with 0 in equity to homeowner), could be sold for $220k with an assumed 200k mortgage at 2 or 3%, and 20k in proceeds for the owner (less commissions and lawyer fees which probably leaves under 10k to owner).  Such sales prices though would allow homeowners to benefit a little, but help banks and the real estate industry quite a bit because such sales allow the industry to pretend there is a healthy rebound in housing prices, and so influence home buyers to be more interested, and shareholders to place a higher value on banks.

A government solution is not necessary, though helpful to force the solution.  A partial legislation or voluntary solution could apply to corporations formed to hold MBS securities.  In their case, since they are not involved in creating new mortgages, offering the optional alternative to foreclosure could transform subprime securities worth 10cents on the dollar with 7% nominal coupons into securities worth closer to 1 dollar with 2% nominal coupon.

More Complex Solution
The only significant problem with adjusting the interest rate of mortgages to help reduce the incentive or chance of strategic default is that it continues to give the home owner the option of defaulting if home prices don't come back up to the mortgage values.  Even if the home owner is provided with significantly lower financial carrying costs for staying in his home, he still has the option of reducing those carrying costs to 0 by defaulting and squatting in his home.  The bank is then left with traditional expensive foreclosure remedies, and so the only one who benefits from the arrangement might be the home owner who gets to delay strategic default (at a discount while waiting) until he is more sure it is his most favourable choice.  The unfavourable-to-bank home owner choice is less likely at a 2% adjusted mortgage rate, than it is at a 3% or higher interest rate.

The overwhelming attractiveness of the simple interest-adjustment solution above for the bankers is it allows them the opportunity to realize a 2% or 3% yearly return on their distressed housing loan portfolio, which is an option they would jump at today (facing 30% or so loss, currently).  The above paragraph outlined loopholes that might cause the banks to fail to meet such targets.  The proposition of allowing the banks to lock in a moderately profitable outcome is the key to an ideal solution for them.

The complex multipart solution that provides an improvement over simple interest rate adjustments is as follows.  Although the term "rent" is used initially, it actually refers principally to an option premium paid by the borrower:

First, calculate an attractive low market rental value for the property as a starting point, then reduce it by say $50/month further.  The purpose is to make renting the property attractive for a home owner as an alternative to foreclosing on him.

Next, reduce monthly "rental" further by an additional $100-$400 meant to cover expected maintenance and repair costs.  The reason for this additional decrease is that maintenance and repairs can be done at the home occupant's discretion either as DIY labour, or through an additional bank loan to cover the costs of approved third party craftsmen.

Next, comes adjusting the mortgage interest rate (I).  Yearly Interest Payments (YIP) = Annual rental payments (above) - Property taxes - Fire insurance premiums.  The latter 2 items are (ideally) paid by the bank.  The Interest rate I is thus = YIP / Mortgage balance.  The result is roughly equivalent to an interest only mortgage.  As an example, a $200k mortgage, with $2k in property taxes and $120 of fire insurance premiums, and $1010/month ($12,120/year) as the agreed "rental" payment, then YIP are $10k, and the adjusted mortgage interest rate is 5%.  For a 200k mortgage this adjusted interest rate may actually be higher than the original contracted mortgage interest rate (justification for home owner soon).  For a 300k mortgage, YIP are still $10k, and the adjusted  mortgage interest rate is 3.33%.  The term of the mortgage is reset to 30 years.

The rights of the home owner/occupier, are to continue occupying the property as long as he continuously pays the agreed "rental" fee.  The owner/occupier can transfer the right to occupy the property (for continued "rental"/support payments) to anyone he chooses, and may profit from that transfer.  The owner/occupier may sell the property at any time with the bank having first rights to proceeds (after 3rd party realtor/legal fees) up to the static mortgage balance.  The owner may abandon the property at anytime.  The owner/occupier has the right to pay down the mortgage balance at any time, which makes part of his future monthly payments pay down part of the mortgage principal instead of just the interest.

The bank has the right to increase annual "rental" payments according to local rent control board guidelines.  Any increases in rental/support payments reduce the mortgage balance as they are paid.  The bank should also have the rights to simplified eviction procedures, if the home owner fails to make payments.  The home owner should have the right to legal recourse, if the bank acts improperly in repossessing the home, but the recourse is for financial (including punitive) damages, rather than preventing eviction.  If any supplemental home improvement/maintenance loans are made by the home owner against the property, then if the owner transfers the payment obligations, the bank should have the right to either approve the transfer of supplemental loans or demand repayment of supplemental loans upon transfer.  Essentially the owner has the right to demand that essential repairs (roof, heating, plumbing, appliances if included in original mortgage) be paid for by the bank, but the costs of those repairs become a loan to the homeowner.  Non essential improvements/renovations have no obligation by the bank, but can have negotiated assistance, or can be freely undertaken by homeowner if he believes they will enhance the property's market value.

Taking a moment to explain this structure, a traditional mortgage is already very similar to a call option, and more specifically a deposit call option.  The owner feels like he is merely renting his home from the bank, though he has voting (director) control over the property.  The call option strike price is the current mortgage principal balance, and the characteristics that make it like a deposit option are that principal payments adjust the strike price down, and regular maintenance (mortgage) payments are required to keep the option in good standing.  The home owner, with a traditional mortgage, also owns a put option (giving him the right to limit his risk) with a strike price that is also the mortgage balance.  The put option is the choice of strategic default.  The major difference between a traditional mortgage and these call and put options are the legal hurdles that make exercising the put option right are slow or not completely free (for instance credit rating damage). to the homeowner, and makes cancelling the call option slow from the banks perspective through foreclosure proceedings.

The proposed solution to foreclosure has 3 major differences with a traditional mortgage.  First, all legal obstacles to exercising either the put option of abandoning the property, and the cancelling of the call option by the lender are reduced to the legal processes of month to month leases.  "Renter or landlord" can terminate with 2 months notice, but the "landlord" only has the right if the home owner refuses to pay "rent".  The home owner has the right to demand the privilege of essential repairs from the lender, even though he is responsible for their costs (through market rate loans).  Third, the option premium equivalents of traditional mortgages are significantly adjusted.  The home owner's put option is replaced with the renter's right to abandon a property. The traditional mortgage's deep-in-the-money call option (when substantial down payment is made, and/o there is homeowner equity) has its premium adjusted (as reflected in the interest rate) to reflect the fact that it is a long term out of the money option.  The above YIP formula  appropriately discounts the interest rate based on how far out of the money the option is.

The benefits to this structure are substantial.  First for the home owner, in the context of facing foreclosure proceedings or strategic default, the obvious likely eventuality is renting his next residence.  This provides the home owner with below market living accommodations if compared to rent.  The home owner receives an option that is valuable if the property value will approach market values that existed in 2007 (height of housing bubble) in the next 30 years.  If there is any reasonable hope for that outcome, then the home owner receives all of the profit resulting from a sale price exceeding the mortgage balance, despite only having the effective responsibilities of a renter.  Furthermore, because he can transfer his option (for cash) to anyone that does have the hope that the property value will exceed the mortgage principal within the next 30 years, or someone that appreciates the below-market rental obligations, there is additional significant opportunity for profit by the home owner.  If at any point the home owner feels confident that the market value will appreciate sufficiently, he can pay down the mortgage balance, and thus save on relatively high interest costs, or freely make home improvements that will either enhance his enjoyment or profit.

Benefits for the bank are also substantial.  They avoid recording losses on original loans.  In the above example of a property worth $150k with an original $200k mortgage, the resulting 5% interest rate is above current market rates.  So, not only do they avoid recording losses on bad original loans, they stand to make better than market returns on the original (higher than current market) loan value.  Even if the original mortgage was $300k, resulting in a mere market return of 3.3% on that original balance, the bank saves an additional $100k in writedowns.  In fact from a real cash flow perspective, both the above original mortgage (200k and 300k) interest results are identical to a 6.66% interest return on a new 150k interest mortgage without incurring the legal costs of foreclosure, or the transaction costs of finding a new home-owner borrower.  From the bank's perspective, even though the real market cashflows are identical between an original 200k and 300k mortgage, an original 300k mortgage as the call option strike price is much more valuable, because if the market price of the home goes up substantially over the next 30 years, the bank will be repaid 300k in principal rather than 200k or 150k.

The apparent free gift of profitability hope given to the "renter" is also of significant benefit to the bank.  Home owner's hope will remain marketable for the first 10 or 15 years no matter how poorly the housing sale or rental market performs in that time, because hope for the following 15-20 years should remain.  In fact, it will take 25 years before a clear opinion that the hope for a property reaching a specific value is deemed worthless.  Until then, in most likely valuation scenarios, someone will be willing to provide the bank with 6.66% annual return on the starting 150k market value because the hope for profit from the option is deemed not to be worthless yet.  After 25 years of continuous payments, the return to the bank would be 165% cumulative non-compounded, and if the property were still valued at 150k, it would be 165% cumulative profit.  After 30 years, if the property is still valued 150k, the bank returns are 200% ($300k in profit) from the property, if all payments are made.  If the property goes up in value, the bank profits up to the original mortgage balance.

Property management costs and benefits of the arrangement are a benefit to both sides.  Unlike a tenant, the home owner is incentivized to save on maintenance and repair costs because he is liable for their costs even if he is promised that the repairs will be made.  Unlike tenants, he has no incentive to ever break anything intentionally.  The vested interest in saving maintenance costs by the owner makes property management cheaper.  Both sides are relatively protected from a property in poor state of repair, even if the state of repair is misjudged.  The home owner's right to improve the property is a substantial benefit compared to a tenant, and such projects usually are a benefit to the lender.

Tax advantages to US home owners are substantial.  Almost the entire monthly payment by the home owner is treated like mortgage interest.  That is fully tax deductible in the US.  A 20%-50% government rebate on housing costs.  An equivalent rent payment would not be tax deductible.  A traditional mortgage would include at least $6000 in non-tax deductible principal repayments.  For the banks, there may also be a significant tax advantage.  I'm not a US tax law expert, but using Canadian tax principles for options, if the bank can argue that what is conceptually an interest only mortgage is in fact a call option, and its cash flow from the security is not interest revenue, but instead option premiums, then it can argue that it is not receiving taxable revenue.   Option premiums are considered part of the capital account, but rather than option premium cash inflows being considered capital gains when they are received, they are cost base adjustments, which have no immediate tax obligations.  This means that the taxes due on option premiums received by the banks would be payable 30 years from now when the option is exercised, and would be paid at the reduced capital gains rate, rather than the general income rate.

New Home Sales and non-bank home financing
The core aspect of the included distressed housing solution is to turn under-water mortgages into rental-like arrangements with an option to lock in a portion of far off future profits from the sale of the property.  The arrangement also involves a no-money-down/zero-equity-position home owner.  This section will show how the substantial benefits discussed above for home owners facing foreclosures from banks, can be applied to general home sellers and buyers.  Because there is no down payment necessary, banks or other external lenders aren't a necessary recourse.  The only complexity with private sales  involves ensuring that maintenance and repairs will be done.

First, let's name the 2 parties of this transaction.  The Occupant Director Owner is the person "buying" the home.  He has full ownership rights, and mostly rental obligations.  He is not necessarily on deed/title.  The Option-encumbered Owner is the person "selling" the home.  He is the one with ultimate capital at risk.  Has the obligation to take the property if abandoned, and power to evict only if due payments are not made.  Next, lets assume that a home with a current market value of $150k has a market value rent of $1200/month, and has an expected market value 30 years from now of $270k.  The exercise is to estimate the total value of the rights given to the Occupant director owner.

The right to occupy the property indefinitely ($1200/month = market value of rent), including the right to abandon all interests and rights in the property.
+ The right to all sales proceeds of the property above a specified strike price.
+ The right to sell the property if the Option-encumbered Owner is provided proceeds in the amount of the strike price.
+ The option to lower the strike price by paying down the "principal" (making supplementary payments) at any time.
+ The right to transfer his option and rights in the property to anyone.
+ The right to decide improvements to and use of the property including sublets.
+ The right to not be evicted just because the Option-encumbered Owner prefers to sell the property.
+ value of tax benefits
- The liability for the costs of repairs and maintenance if required from the Option-encumbered Owner.
- The liability and compliance duty of laws and regulations normally imposed on a property owner.

The most important variability in any premiums paid over the fair rental value is the strike price offered to the buyer.  The strike price offered is mostly based on the sellers optimism or concerns and his preference for either a more certain sale of the property or his willingness to operate a long term rental income property.  The best guess for what a property will be worth 30 years from today is the expected core inflation rate.  The 30 year future value of a 150k home is calculated as 270k by using a compound 2% growth rate, which results in 81% total growth.  Though, historical analysis of median home prices shows a 300% average price increase for median home sales over any 30 year period, these do not reflect the expected growth in value of an existing home, because homes have gotten larger and nicer over the years, and more homes are built and sold in growing and popular areas.

Using a 270k strike price option, that is giving the buyer the right to "fully purchase" the property any time within the next 30 years for $270k, we need to value this benefit to the buyer.  Although there are benefits to both buyer and seller of permitting the seller to increase required monthly payments each year by an inflation-based amount (justified later), the easiest way to value the option is to keep the monthly payments fixed for the entire 30 years.  Because the buyer can transfer his option and ownership rights freely, with locked in monthly payments, he gains at least the rental savings from the lack of a 2% annual increase in rent.  A simplified portrayal of a 2% annual "rent" increase would be a $300 annual increase in yearly payments.  So the 2nd year annual payments would be $300 higher, the 3rd year, $600 higher... and the 30th year, $8700 higher.  The average over 30 years is $4350.  That is a $130500 total benefit to the buyer over the 30 years. Since the buyer wants a fixed monthly payment, then a fair price to pay for the option to "fully buy" the property for $270k is an extra $4350/yr or $362.50/month.  Even though this front loads payments for the total benefits to the buyer in the first few years, its still fair to the buyer.  After 15 years, he may have overpaid the fair value rent by an average of $2175/yr, but the last 15 years are expected to be underpaid by $2175/yr, and that is a benefit that can be sold for that amount to a new Director-Occupant owner.  Importantly, the buyer can abandon all rights and responsibilities to the property if he is disappointed with the property's market value potential.  Finally, an option at the end of its life cannot be worth less than 0.  If the property 30 years from is worth less than $270k, then the terminal value of the option will be 0.  Even if the expected value is 270k, there is still a chance it will be worth more.  The option buyer gains all profit from the property's value in excess of 270k.  Option holders have a coin flip analogy of heads they win, tails they don't lose.

Just because the expected future value is 270k doesn't mean that is the only choice for an option strike price.  150k, the current market value, is also a natural choice.  Valuation issues aside, a seller may be more attracted to a 150k strike price because it makes it much more certain that the option holder or a transferee will end up buying the property in 30 years, and so much more likely that he will be committed to the property's upkeep and maintenance, and more likely to find a new buyer if he wishes to live somewhere else.  A low strike price eliminates most continued property management work the seller is likely to be responsible for.  More importantly, are the valuation issues.  A 150k strike price for a property expected to be worth 270k is a benefit valued about $120k higher than an option with 270k strike price (another $333/month in premiums).   Because this seems to transfer almost all of the risk onto the buyer, and likely with resistance from the buyer, a useful compromise is to halve the risk between buyer and seller.  A 210k strike price is worth $60k to the buyer, and so worth $166.66 in higher monthly payments to the seller.  A 210k strike price is low enough to keep the buyer, and his possible transferees, confident of realizing value from the property and committed to maintain it and continue sustaining the contract.

Lets look at the transaction  from the perspective of a seller and his alternative of selling the property for $150k.  Often, the decision to sell rather than rent out, is based on avoiding the hassles and risk of property management, which this arrangement is likely successful in achieving.  Instead of selling, he is able to generate $1200 + 362.50 + 166.66 in monthly revenue. $20750 per year or 13.83% annual return.  At the end of 30 years, he will either get $210k, or his property back if it is worth less than $210k.  So, up to an additional $60k in profit.  If he has good credit, he could likely qualify for a $120k 30 year mortgage at a 4% interest rate.  That results in $6840 annual payments of which $4800 is initial interest.  Net income (after interest) on the property is $15950, and net cashflow $13910 per year.  On the 30k invested/tied-up in the property, those are 53% annual yield, and 46.36% cashflow annual yield without including the potential 60k in profit at the end of 30 years.

The only complex part of the arrangement is how to handle maintenance and necessary repairs.  The core problem is that a private seller may not be able to adequately guarantee all necessary repairs.  Insurance companies could be more helpful here, but a solution that doesn't rely on them is necessary.  The basics of the maintenance/repair agreement is that any repairs/maintenance paid by the seller increase the option's strike price, and interest accrued by the cost of the repairs are added to the monthly premiums, while those costs paid by the buyer do not affect the strike price.  This is not balanced towards the buyer.  Compensation for the imbalance to the buyer can be in the form of  lower monthly payments (as mentioned in the above complex bank solution), but can also be in the form of a lower option strike price.  For instance, the 2% annual growth rate that was used to calculated the expected value of the property 30 years from now ($270k), may be considered conservative.  3% growth including expected maintenance and cosmetic improvements necessary to make it comparable to the "median future home sale" in quality is also reasonable. So using a conservative expected future value (2%) is fair partial compensation to the buyer for taking on the cost liability of maintenance and repairs.  All of the other intangible rights of ownership are also compensation for the buyer.  The biggest buyer compensation of all though, is the privilege to abandon the property, and the privilege to demand repairs.  The buyer gets the benefit of reacting to actual events.  If the home is a lemon, with many undisclosed defects by the seller, the buyer may choose to leave at the cost of a couple of months rent.  Its also easier to resolve a conflict with the seller (compared to traditional sales) because they have an ongoing relationship.

Dealing with the complexity of a seller being responsible for repairs, but preferring to avoid them, results in a 3rd negotiated amount (in addition to monthly payment and option strike price) between buyer and seller:  The interest rate to be charged for maintenance/repairs paid for by the seller.  A very high interest rate discourages the buyer from seeking repairs by the seller, but it may make the overall deal unappealing to the buyer, and if there are costly needed repairs early in the contract is likely to result in the buyer abandoning the property.  One solution is to have an interest range that increases over time.  For instance 4% in the first year growing to 34% in 30th year (or 8% first year, to 23% in 30th year).  Another point of negotiation between buyer and seller is the seller can admit that roof, heating system and appliances will require one replacement over the 30 year period, and so set aside special low interest funding provisions for those eventual events.

Transformation of home ownership society
This new home ownership model (lets call it Director Occupant Purchase Option) lessens the need for capital accumulation structures such as banks.  Though banks may not be inherently evil, they do make a "too-essential-to-fail" argument that allows them to extort benefits from society.  The Director Occupant Purchase Option is not a loan/credit transaction, so credit ratings don't matter any more than they do for rental contracts.  I see a potential for less litigation between home sellers and buyers (or long term lease renters) because the parties have more reason to compromise, and the buyer can simply abandon the property if disappointed.  It still allows people to upgrade to new homes.  Buyers can sell/transfer their ownership rights and option.  Sellers can transfer their income streams.

Home ownership is viewed as positive for a society, because it causes a vested interest in the society.  A healthy, growing, attractive society is good for property values, and both the buyer and seller in a Director Occupant Purchase Option (DOPO) benefit from a more attractive society (through the favourable impact on property values).  The model will increase "home ownership" rates because some people will find DOPOs more attractive than renting.  Its ironic that in cosmopolitan  urban centers such as Toronto,  most people in favour of community programs tend to be renters, and most opposed, property owners.  Its ironic because a sustainably attractive and livable city will drive up rents and property prices with more financial impact on home owners than its corresponding pressure on property taxes.

The link to Natural Finance
Natural Finance also separates the control (directorship and occupancy) of the organization from financial investment.  Investors are entitled to be repaid.  Not to interfere in the operations of the organization.  Investors only have the additional right that accounting controls exist to channel funds back to investors as promised, and ensure they aren't squandered or pilfered.

Monday, July 25, 2011

Natural Finance Sales function and queue repayment speed

Natural Finance can help both mature established companies and startups.  Natural finance offers separate advantages to each.  For mature companies that need relatively little borrowing it is better interest rates, and for startups it is higher borrowing/investment capacity without ceding control of the enterprise.

Natural Finance uses 3 seperate loan queues.  Each with successive priority:  General unsecured queue has top repayment priority, the Secured queue has next priority, but receives regular payments covering interest and depreciation.  Finally, the management discretionary queue is typically used for deferred employee compensation.

While all contributions above a few months expenses are destined to go to repaying the top priority loans in the top priority queue, there are a couple of mechanisms that can be used to bypass this order.  In the case of startups, natural finance comptrollership will insist on management sharing the risk of the venture by taking very small salaries, and deferring most of their compensation.  An automated, formula-based, increase in employee compensation is fair to employees and management, and ensures their motivation to bring in revenue available to repay loan investors.

As a rule of thumb, setting aside up to 20% of gross profit (actual percentage depends on company, prospects, salaries) to pay for sales incentives, deferred salary avoidance and past deferred salaries (split among those 3 at management's discretion) can ensure that a company capable of repaying its debt strives towards obtaining the revenue to do so, and can retain the talent to do so.  Not allowing some sales proceeds to go towards employee compensation can detract from employee commitment, especially if debt levels are very high, and expected payment of deferred compensation is 10 years or more.

The other mechanism to adjust payment flows is to accommodate loan investors' desire not to be paid too fast.  Depending on investor sentiment, at any time, management can set a target organic repayment rate for new loan projects.  These target repayment rates can range from 2 to 10 years.  Organic repayment means loans paid back from company income, as opposed to bought out by other investors.  Skipping over repayment of the first priority unsecured loan queue is only with the consent of those investors, and is typically the result of low company debt and high revenues and profits.  The profile of a mature company.

With these optional target repayment rates, an organization earning "too much" income can pay queues behind  the main unsecured queue.  Its optional and only occurs if there is investor demand for longer term loans.  Demand that typically is only present if future cashflows seem very certain.  The more important adjustment mechanism is management/employee rewards for revenue.  It ensures a balance between payroll austerity in startup/pre-revenue phase, and motivation and near term compensation for executing the organization's success plan.

Monday, July 11, 2011

Strategic Investment - an underutilized social progress tool

While strategic investment is an ambiguous term, I'd like to focus on its sense of investing principally for the products and outputs of an investment as differentiated from focus on the potential financial returns of an investment (called, say, greed investments).  While strategic investment includes ambitions of return of and return on capital, the investment is motivated by indirect benefits.

Government investment virtually always has pretexts of being strategic.  Infrastructure, welfare, job creation, industry and export subsidies are all done on pretexts of strategic social benefits, and not for the returns.  Private investment can be strategic as well if the indirect benefits are important.  Walmart could invest in Chinese transportation companies and shipbuilders for the purpose of enabling cheaper and faster imports.  Consumer electronics compani(es) could support materials or physics research without (theoretically) monopolizing the success of the research.  A specialty restaurant could support a local food producer for its ability to provide it quality or cost advantages. A remote town could assist a doctor or retailer to locate there.

Energy capacity is a common strategic and geopolitical issue.  Greed interests can easily convince national policies to ensure the control of resources, but while there is a strategic social benefit of increasing energy capacity and exploitation, giving control of foreign oil resources to say US-based Chevron, provides no assurance of US-favourable oil pricing or supply availability.  The social costs and attrocities of war make strategic resource acquisition and development (through war) net socially-destructive.  Beyond the moral argument against murder and destruction, the same strategic benefits can be obtained through cooperative strategic investment, and so a pro-social strategy always favours cooperative investment over war.

The politics of energy capacity, or more generally any industry's competitive landscape, are  usually corruptible.  While there is obvious net social benefit to increasing energy capacity such that the price per kilowatt could be driven down to $.05 or even $.01, it is to every energy producer's advantage if every other energy source is constrained.  So collectively, energy suppliers want to politically curtail energy supply expansions.  There is a collective energy supplier strategic political investment to oppose the social strategic benefits of expanded energy supply.

Direct government investment in the west tends to be constrained from ownership stake, based partly on the propaganda that if the government/society owns part of a project it is anti-capitalist.  That reluctance is also justified by potential favouritism for a partially-owned-by-government company versus competitors, by bureaucratic resources needed to monitor the company, and by politicizing blame for any company activity onto the current government.  Grants, loan guarantees, tax credits and other giveaways are often preferred even if they lack any government/social returns for the investments.  Government loans would increase the capacity for strategic investment compared to giveaways, because a loan program is likely to be self-sustainable, and if a business wants free money, but would refuse a loan, then it likely doesn't truly need the money.

Another constraint on strategic investment goals, is that often nationalist and xenophobic politics try to block partnerships or local ventures from sovereign strategic funds and even foreign private corporations.  While there is unknowable (but not disprovable) fear of foreign control, sovereign funds should have their own concerns in forming foreign ventures or partnerships since, in the event of diplomatic breakdown between nations, their assets and ownership stake can be unilaterally seized.

Debt financing in general, and Natural Finance Soft Loans specifically, are the most appropriate means to achieve strategic interests.  Debt achieves the strategic objective of funding and encouraging a project.  It does so without controlling the project direction.  Natural Finance Soft loans, as compared to traditional debt, provides more flexibility for projects by timing repayments around revenue and increasing borrowing capacity, and provides lower risk to borrowers by ensuring funds are used for their purpose and implementing management austerity measures when revenue is not coming in sufficiently.

The primary scenario for private company pure strategic investment is increasing competition to your suppliers or increasing your potential customers or improving their ability to buy.  The objective of cutting supplier costs or improving quality can be achieved by funding alternative suppliers without the requirement of controlling their activities or ensuring a large share of their profits.  Offering new suppliers affordable loans (as compared to expensive loans) makes them more likely to be successful and provide affordable products (successfully achieve strategic indirect benefits).

National and social strategic investment can be grouped into 2 broad categories that are also divisible between supply and demand sides.  Energy, food, materials and infrastructure are a common national strategic supply focus.  Employment, welfare, wealth redistribution and service subsidies are demand side strategic benefits.  While most demand side benefits are addressed with long term progressive taxation policies and entitlements, strategic intervention decisions tend to focus on the supply side or employment.  

Tax payer funded strategic initiatives/investment would gain better tax payer acceptance if the plan included at least return of capital.  Loans rather than giveaways serve that purpose.  The other issue is that the electorate generally needs to be more aware and vociferous about is anti-social investments such as war, and anti-competitive efforts that curtails energy production or other innovation.

Natural Finance as Strategic national benefit
The general social benefits of natural finance stems from funding more organizations, and so creating associated jobs.  The natural finance comptrollership function further employs highly skilled people from accounting, finance, relationship-banking and legal backgrounds.  Because natural finance focuses on repaying investors, and re-obtaining financing for new projects and expansions, money flows through the economy more rapidly (boosting it) rather than remain hoarded in corporate coffers or tied up in the stock market.  If natural finance is successful in replacing equity and bond markets as the primary investment mechanism, then there would be a more direct relationship between investors and borrowing enterprises, and so a more socially productive role for investors and financial professionals.

Specific strategic benefits exist for sovereign funds and pension funds.  Sovereign and national funds can invest without governance control of the enterprise and so can avoid any xenophobic concerns, or accusations of cronyism or blame for borrower actions.  For pension funds, enabling a competing financial exchange (natural finance) provides another outlet for their investments.  In addition to lower risk and higher returns, natural finance loans focus on rapid repayments, and so enhance the cashflow back to investors/pension funds.

Charity vs Social benefits from strategic investment
Strategic investments that offer social benefits such as environmental quality, economic activity and job stimulation, and poverty assistance can offer similar pride, satisfaction, or public relations value to charitable giving.  While charitable giving is necessarily more selfless than a low return or break-even investment, the latter is likely more sustainable.  For example, building and selling affordable housing at break even, allows you to build and sell another house perpetually for the same investment, whereas gifting the house allows you to help just one person.

Lesson for society
Strategic investment for social benefit is a somewhat neglected tool for a community to help itself be prosperous and happy.  It is also relatively difficult to  recognize private investment groups or companies for making investments with social strategic benefits, usually because the greed of direct returns on the investment is not visible.  Companies or Government that make loans to projects with social benefits should do so to both help society and help their own image.  Its probably a more effective tool than government giveaways or certain forms of charity, and should be recognized as a viable tool.

Wednesday, July 6, 2011

Natural Finance summary for communes/partnerships

A commune does not imply a lack of profit maximization focus compared to a regular corporation.  It is simply an organization structured as an egalitarian partnership.  The overwhelming advantages of structuring an organization as a commune is overcoming the inherent abuse created by power imbalances of unequal ownership and hierarchical organizational structures, and controling corporate corruption by having more eyes with the authority to check employees and other partners.  This article is a summary and catalog of the ideas I've developed in promoting financial transactions in communes.

Natural Governance principles apply to any egalitarian partnership or society.  The one immutable principle is that the circle of partners has ultimate authority, and each partner has the right to an equal share of profits, and the right to be paid that share by default (subject to communal obligations decided by the circle).  As a solution to voter apathy, any partner can delegate his vote in any one or several functional areas to someone else, but delegate authority can be removed at any time.  As a solution to increasing decision speed, specific executive authority can be assigned  to individuals or groups for projects, duties, functional areas based on democratically approved proposals that include salary, budget, and specific narrow decision authority/mandates.  Approved proposals are rarely given any lengthy term or monopoly powers, are likely accompanied by supervisory/review proposals, but by default carry review powers by the full circle often though delegates for the single functional role.  Line item authority and project scope is reviewable by the circle and delegates.  Proposals to replace or eliminate the executor of duties or functional direction can be made by other individuals.  Natural Governance provides an entrepreneurial framework within an organization where any perceived need can be championed by any person that sees it, and who then tailors an exploration and implementation strategy that is acceptable to most partners.

Natural Finance and Natural Governance facilitate investment in communes without ever compromising the rights of creditors or other partners.  In natural financed communes, new partnership investment is a transaction exclusively among partners. For large partnerships, a democratically set (median) purchase amount is determined by the existing partners, and an nth partner willing to buy at that price, gets a new share, pays (1/n) the value of the partnership, and the proceeds are distributed evenly among the (n-1) existing partners.  So even in a partnership of millions, it is fairly straightforward process to admit new partners.  If the share price is too high for most people/workers to afford, they can share in the prosperity of the commune through communal equity options which can be tailored to any affordability level.

Because informed investors need to plan for eventual or possible exit from a private company or commune it is critical that processes to facilitate such exit exist.  Natural democratic governance processes allow the circle of partners to use their median bid for share repurchases as an amount a selling partner could accept, or allows the partnership to vote on accepting the best offer.  Both of these alternatives require that a natural finance project be funded with new loans (likely by existing partners in varying levels).  Another alternative that does not involve new partner funding is to give the partners and option holders the right to bid  against each other (at least 20% discount) in order to sell their share, at the time of a new buyer's transaction, and with proceeds coming from a new share buyer's transaction.

Natural Finance's main focus is debt financing guaranteed to never cause dilution to a creditor because all loans are ordered in sequential payment priority.  Natural Finance permits higher debt capacity and lower financing costs through lower risk loans primarily achieved by proactive monitoring.  The symbiosis with egalitarian partnerships is that equal authority of owners provides controls that limit waste and boondoggles to the benefit of both owners and creditors, and so limits the monitoring activity required from external natural finance controller.  Owners benefit from active control of financial accounts to prevent embezzlement from an owner.

Communes have traditionally been based in anti-capitalist ideology.  Natural finance recognizes the  oppression inherent in hierarchical management structures including towards minority and other shareholders.  The purpose of financial communal equity principles is to remove the restriction that all partners must provide equal labour and other contributions, and so enable the full range of contributions that can help the commune/enterprise be successful.

Tuesday, June 28, 2011

tax-back flipping options - Providing communal share liquidity

Communal Equity Options (deposit options) are a useful tool for attracting partners to a commune since they allow option recipients to participate in the future growth of the commune with minimal financial risk.  This article is most useful if you have read deposit options and communal equity descriptions.

Another option variation that is generally useful can be called a tax back flip option.  Either the option buyer or the seller(s) can have the right to flip the shares immediately at a fixed taxed percentage between 10% and 50% of the profit from the option trade.  For general speculative stock options,  the net result is that the option seller keeps his stock (for cheaper than it would cost to buy it in market), and pays cash to the option buyer in order to settle the trade.  The advantage to a buyer that intends to flip the underlying stock, if exercised, is that he doesn't need to have the cash to buy the stock, and is saved the price risk of trying to resell it right away.  If the option seller is the one with the flipping rights, then the cost of the option will necessarily be lower than a regular option without tax back flipping rights.  For general stock options, a tax-back flipping right is only moderately useful, because almost the same results from the sellers perspective can be achieved by selling only half the options if the tax-back right is 50%.

In the context of communal equity principles, a tax back flip option is much more useful.  First, there are restrictions on preventing any entity from owning more than 1 share so this allows existing owners or option holders to acquire other options, and second it solves the issue of employees not having the capital to exercise their option without a secondary trading market to flip it themselves.

Recall that whenever a new partner joins the commune new cash is available from the buyer for the partners.  Under communal equity principles, a tax back flip option is a right of the option holder to intercept part of those funds as his option exercise.  For example, if a new 20th partner is about to join the commune at a communal equity value of 10M, and someone else has a communal equity deposit option with 3M strike price and  20% tax-back flipping rights,  then if the option holder exercises his flipping rights, the new partner pays 500k (1/20th of 20M); the communal partners receive (1/20th of (3M + 20% of 7M)) 220k, and the option holder receives 280k (80% of 7M).  From the communal partners perspective, the commune is less diluted than it would be if the option holder also joined, and they receive additional cash inflows.  So the most important benefit of all for tax-back flip options/rights is providing liquidity in communal shares that is regularly lacking in partnerships.

Because the tax-back flipping right is held by the option buyer, it doesn't lower the premium he is willing to pay for the option because it is an additional right.  As a generic rule, communal partners should be willing to immediately repurchase a share for 80% of what they just sold it for, because if they are not willing to do so,  the implication is that they are selling it for too much.  A 20% tax-back rate is also a sufficient general incentive for owners to seek maximizing the communal equity price sought from new partners.   Because the option buyer's right to flip back has no tangible inconvenience to the partners that issue the option, there is no reason to want higher option premiums from the buyer.  Its almost like a retailer offering to buy a brand new still-in-package item for 80% whenever it sells such an item.

Since the tax-back flipping right can be offered to an option buyer without affecting the value desired or payable of the option, at a 20% tax-back rate, the right can simply be offered to all option holders as well as communal partners.  Whenever a new partner buys into the partnership, the commune can simply set a 20% tax-back rate as a minimum, and hold an auction for all option holders and partners to bid up the transaction's tax-back rate.  Option holders are advantaged in this auction because the tax-back rate applies only to the difference between their option strike price and the new partner purchase amount, while the tax-back rate would apply to the entire transaction amount for existing partners.  Technically, the commune could also find the opportunity to re-auction the proceeds from the first auction at a 10% minimum tax back rate in case there is substantial pent up demand to liquidate communal partnership positions.  

For instance, in the first example on this page, a 10M communal equity transaction and 3M strike price option at a 20% tax back rate, yielded 220k to the partnership.  If the tax rate had been bid up to 30%, the partnership would receive 290k.  That 290k (5.8M equivalent communal equity) can be re-auctioned off at a starting bid tax-back rate of 10%.  If a partner took the opportunity to sell his share at 10% tax back, he would receive 271k (5.42M communal equity), while partnership received 29k but reduced the number of partners by one.  So, if the commune is truly worth the 10M a new partner was willing to pay for it, reducing the number of partners from 20 to 19 (as a result of the re-auction) is worth 26,315 to each partner (as compared to not offering the re-auction and keeping 290k being only worth 14,500 to each partner).

Liquidity in the shares of private companies and communes is typically the largest concern for investing in such enterprises.  The right to a tax-back cashing out option for owners and option holders as well as the original partnership abandonment right (restricted loans ("put" options) from partner contributions into the commune) provides some ease in leaving the commune.  Although partners leaving rarely improves the health of the commune, the ease of exit makes entering more appealing.  Its the same principle as retailers offering money back guarantees.  Its done to increase sales despite its costs.  

Communal equity principles prevent the most desperate shareholder/partner to sell his share below the median democratically set price by all partners.  The tax-back flipping right though basically achieves the same result. There is a transfer of share from one seller to one buyer, the seller receives the amount he was willing to sell for, the buyer pays the median communal equity setting, and the commune pockets the difference.  In the case of re-auctions the commune uses sales proceeds to buy out one partner and retiring the share without having to raise more funds.

Another more straightforward means for natural governed and financed communes to provide liquidity (the opportunity for partners to sell their share) is to vote on a purchase price (determined by median amount - similar process as selling shares, or a vote on accepting the best offer from an existing partner), and have a transaction contingent upon regular natural finance project funding being met with a reasonable interest cap.  Those partners capable and motivated in increasing their share of the commune can individually add significantly to the funding pool available for repurchases.  Even if the funding for share repurchases is uneven among partners, it is still a rational choice for one partner to fund it all if he believes communal equity will increase, as he would profit from the interest on funding as well as share price appreciation.

Monday, June 27, 2011

Communal equity clarified - Restricted loans as equity

Communal equity accounting deals with how to split equity ownership of an institution with new equal partners, and how to facilitate attracting new communal partners who may lack the financial resources to buy an equal share.

This is another revision of communal equity concepts.  The last version was more complicated than it really needed.  It used restricted loans much more heavily than this now preferred version.  Here is the simpler and fair version.

The first 2 partners in an egalitarian/communal partnership set the partnership equity value by market transaction (mutual agreement).  All communal equity trades are transactions amongst partners.  So if there was originally one owner of an enterprise, the 2nd partner can make a direct payment to the first partner, for what amounts to 50% of the equity.  If both partners agree the company is worth $2M in communal equity (no partnership is formed if they cannot agree on value of communal equity).    The second partner owes $1M to first partner, and 50% of the ownership is transferred from 1st to 2nd partner.  

Mostly relevant for simplifying transactions among a large number of partners, we give the new partner the right to declare any amount up to the 1M he has paid (limit is because it ensures the first partner does not need more funds), as an additional contribution to the company to be made by each partner.  If the new partner decides that each should add 1M to the company, then a company that was worth an agreed 2M is now worth 4M with either an extra 2M in cash or 2M less in debt.  We can create slightly more flexibility through instead of a 4M company, we give each partner in exchange for their 1M, a restricted loan, and though the partners thus have 2M worth of total securities, the company itself is worth 2M (still 4M total).  The general reason for this mechanism is to provide additional rewards to compensate the risk to partners of investing capital behind the company's main natural finance loan queues.  

Natural finance investing at its core is debt made through queued soft loans which have no fixed payment terms, and are repaid either through organic company surpluses, or bought out by anyone willing to offer a lower interest rate loan than the company's average interest rate owing.  When a soft loan is repaid, the investor has the option to reinvest/rollover the loan at the new lower natural interest rate, and so many investors can be repaid in a fraction of a second as a result of a single new investor buying in.  Restricted soft loans are created when funds are invested into the commune.  Restricted soft loans are NEVER repaid.  They become unrestricted (become regular soft loans queued to be repaid) when a partner abandons his share.  Restricted loans stay at the back of the repayment queue until they become unrestricted.

The typical reason to have partners contribute additional capital is either to pay down debt or create some working capital (fund day to day operations).  If there was no debt (and no cash), then the partners could use the cash they just added to the company to pay themselves each a 1M dividend.  Technically, this would make the company worth 0, but it is actually worth something between 0 and 2M still.  It is worth close to 0 because what was worth 2M now has no cash and an additional 2M in restricted loans, but it is worth close to 2M because those loans are not repayable (yet), and what was worth 2M with no cash and no repayable debt should still be worth close to 2M.  A few seconds later, one of the partners may quit (perhaps in confusion) by abandoning his share.  This is the event that causes the quitting partner's restricted loan to become unrestricted, and be at the head of the repayment queue.  If the new partner quit, the history had him pay 2M into the company, receive 1M in cash dividend, and now has a 1M to be repaid as quickly as possible from revenue.  The original partner started with a company worth 2M, received 1M cash, and has a company worth 1M with a 1M@0% loan to pay.

Restricted soft loans could earn a small amount of interest (and more easily if interest begins at the time the loan becomes unrestricted).  But I'll show later that a 0% interest rate should be high enough to attract partners.  Restricted loans become unrestricted when a partner owning them abandons or sells his partnership share.  When a partner abandons his share, he gives up voting rights, and allows the organization to terminate any contracts it has with him.

Compared to regular common equity, restricted loans are extremely similar, but have the advantage for the shareholder of  the additional option of abandoning the share and converting it into debt securities.  For private corporations, this option can be extremely valuable since it can be difficult to sell/liquidate partnership shares otherwise, and its value increases whenever a commune obtains a large number of partners. For general debt holders, offering restricted loans to partners is an incentive for cash inflow into the organization (through reinvestment of partner proceeds in new partner transactions) that can be used to pay off their debt, and so substantially advantages them as well.  Furthermore, it is possible for someone willing to invest a lot in the company, and one of the main reasons in providing new partners with the right to demand reinvestment of share proceeds,  to first buy soft loans at a relatively high interest rate, then buy a share with a maximum partner reinvestment condition, so that the company's natural/fair interest rate goes down, and they enjoy an attractive, better than market, return until sufficient new investors come to buy them out.

The argument for 0% on restricted loans is that first in the case of a no-debt company, putting in 2M capital, and then withdrawing it immediately as a dividend gives each partner a 1M restricted loan for free.  So no reason to provide them any interest on top of that perk.  In the case of a company that has say 4M in debt at an average (natural) interest rate of 12%, then putting in 2M in capital not only reduces debt by 2M and save $240k in accrued annual interest, but reducing debt would likely reduce the company's natural interest rate to say 9%.  So there is an additional savings of 60k per year or 3% on the remaining 2M of debt.  Therefore, with a 0% restricted loan investment, the partners are actually earning 15% return on their 2M reinvested.  An extra 300k per year in annual (profits) expense savings can typically be worth over 3M in additional communal equity.  So a 2M company that has 4M debt and has 2M infused into it (without restricted loan) would grow in value by 2+3=5M to a total of 7M.  A very substantial return to each partner's 1M investment.

Keep in mind that there is little substantial difference in communal equity valuation between a company whose debt is reduced by 2M, and one with debt replaced by 2M of non-repayable 0% accruing debt.  To the partners, whether they own a 7M company or a 5M company with 2M total restricted loans is comparatively indifferent.  But considering that the 2M of debt is not currently repayable and accrues 0% interest, the 5M accounting value company should be worth close to 7M.  If IBM announced tomorrow that its executives have received indefinite put options entitling them to sell their shares for well below market value, there would likely be no noticeable market reaction to the stock because the stock trades higher and the likelihood of the options triggering is low.  Restricted loans could be implemented as off-balance sheet conditional promises, and so its probably fair to value them as such.

There are 2 basic scenarios that increase the risk of a partner abandoning his share.  1.  If the company does poorly, and 2. If the commune grows in its number of partners faster than it grows in value.  A partnership worth 50M in communal equity with 50 partners is worth 1M per share.  Natural governance (democratic) principles don't take account any seniority among partners in deciding what positions or offices they hold, but partners who hold restricted loans have the power to threaten abandoning their share if they are unable to have a suitable duties.

When an opportunity to have a 3rd partner join the commune arises, mutual negotiated agreement is still possible, but for the 101st partner, a streamlined procedure is helpful.  Some partners would prefer that no additional partners be allowed to join, while others would welcome being paid, and welcome the additional creative energy that could help further increase the value of the partnership.  If every partner states their perceived value of communal equity, then the median of all partner stated values determines the buy-in price.  The median represents the democratically set (by definition of 50th percentile) value for the common offer price.  It would be the appropriate way to decide what to sell the entire company for, and so it is appropriate way to determine what to sell a fraction of it for.

If both partners agree that the communal equity is valued at 3M, then a 3rd partner is required (if he agrees to buy) to pay 1M to join.  Each of the first 2 partners would receive 500k cash.  The 3rd partner can  demand that all 3 partners invest up to 500k each in restricted loans into the company.  The general formula for Nth partner joining the commune is that he pays (1/n)th of the communal equity value, and those proceeds are split evenly among the (n-1) existing partners.

One difference between communal equity and common shares is that a transaction to sell common shares is made with the seller who is willing to accept the least.  While communal equity is transacted at the median offer of sellers.  There is actually a strong rationale to forbid the personal liberty of a communal partner directly selling his partnership share to a buyer privately.  First, there is a difficult integrity issue if a buyer approaches the commune to buy in, but is then approached by individual partners who try to outbid each other to sell their share for less.  Buyers buy in at a median offer price, and it would be a disservice to them if when selling they would need to out-offer all the other partners, or if new partners are never brought into the commune because one partner is always able to sell out at lower than median offer price.  Natural Financed private corporations enjoy software platforms that provides its continuous financial health to potential investors and partners, and that can make these private corporations have greater investment liquidity than public corporations.  So if the tools to attract partners are funded by the commune, and expected to be the main financial marketing mechanism, individual partners shouldn't be able to "pilfer" investors to the commune by underselling it, in the same way they shouldn't arbitrage employee product discounts to go resell to the enterprise's customers.  The right to abandon the share and receive compensation for it gives individual partners the ease of secession from the commune, without needing to resort to the right to sell their share individually. (Though this strength is much truer in the last version of communal equity which relied on creating more restricted loans with each new partner, and perhaps advantaged old partners somewhat.)  An individual partner can also secede from the commune by proposing that the commune buy back his share at below the median/market rate, and do so if a democratic majority of partners accepts the proposal.  

Natural Financed Egalitarian Partnerships can achieve higher market capitalization than standard corporations (median offer is always higher than lowest offer). They can raise funds continuously.  Issuing more shares never dilutes existing shareholders without directly compensating them for the dilution.  Insider information becomes a relatively irrelevant factor in the market because the communal entry price is the result of the median value of all sellers, who should all be insiders.  Capital contributing shareholders receive the advantage of an option to convert to debt holders, and the company/creditors gain investment resources through reinvestment of communal entry contributions by existing partners.  Egalitarian partnerships can also use natural governance principles which further enhances value over traditional corporations.


Senior Partners are those partners who have fully paid their partnerhsip share, as has been discussed so far. Junior partners are those who have not fully paid for their partnership share.  Many people able to contribute creative or productive energy to the enterprise would be unable to afford their share to join the commune.  The answer is simply a payment plan.  Junior partners would be accepted because of their creative/productive potential, and would be expected to make payments for their share through a portion of their employment benefits.  Junior partners are charged interest (5%) on the unpaid portion of their communal share, that interest is withdrawn from the paid portion of their share.  They have the right to abandon their share without penalty, in which case they no longer owe the unpaid portion of their share, but lose any paid portion.  Partner capital contributions made by senior partners, and which generally cannot be matched by Junior partners increase the unpaid portion of  the junior partner's share. Contributions from future partner buy-ins reduce the unpaid portion of junior partner shares.

In our example, if a 4th potential partner is a junior partner employee expected to contribute 30k per year to his share, then a 1M purchase price (4M communal equity value) with 50k per year in interest means that he would accumulate negative equity if no new partners came in or communal equity didn't increase.  Junior partners who abandon their share never owe anything if their paid up capital is negative.  After 100 partners, the junior partner would owe less than 40k for his complete share originally worth 1M. If communal equity were to increase to 10M, then the 101st potential partner would buy in at 100k with 1k going to each partner.  When junior partners join, any payments they make go evenly to all other partners.  Junior partners get accepted with negotiated payment rates as a percentage of employment benefits, and a lower flat rate should they no longer receive employment benefits from the organization.  Junior partners retain the right to their partnership share as long as they meet the payment requirements.  Junior partners have a full vote in setting communal equity of the organization, but may have fractional votes for other communal decisions.  In our example of 4 partners with 1 junior partner making 30k contributions per year, each senior partner would gain 7.5k (likely in interest bearing deferred compensation queued soft loans), while the junior partner would reduce his unpaid capital by 30k.

Junior partners get a similar benefit as no-money-down real-estate purchases in that they can abandon at little to no risk if their asset value does not increase in price.  In the above example 30k annual payments could be insufficient to meet the interest on the unpaid balance, and so they could accumulate negative equity quickly.  They also receive an effective-call option on the communal equity with strike price equal to the value at buy-in time that is valid as long as they meet agreed payment terms, and whose premiums is the 5% interest on unpaid capital.  This is substantial value for junior partners.  The senior partners do eventually receive the purchase price and collect the interest premiums, and if the junior partner abandons his share, the senior partners will have kept gains from the interest premiums, while the junior partner likely walks away with nothing, even though his interest payments were made with likely fake salary perks and so unlikely that he risked anything out of pocket.

A junior partnership for new employees is both too good of a deal for a brand new employee and too risky to get pushed out of a job that you were paid in large part with the promise of a future share.  If the commune has too few partners at the time the junior share is issued, it could take 10-30 years to pay off if new senior partners don't buy in.  If many partners do buy in, and the company grows moderately, the junior partner becomes extremely rich.  For example, if the communal equity doubles and the number of partners also doubles in a few years, then the junior partner could have paid for his share entirely through the contributions of new partners, and he would still own a percentage of the company that is worth what it was when he was awarded his junior share.  For these reasons, the recommended alternative for instilling a sense of ownership in employees are Deposit Options.  These can fit into a junior partnership being awarded a few years after an employee starts.

More partners allows lower buy-in value per partner which makes joining the commune available to more people, and so a higher likelihood that some people are willing to accept higher proposed communal equity value.  Its conceivable, as part of negotiation with junior partners that the commune provide another loan to the junior partner to serve as "down-payment" for his share in order to transfer more risk towards the junior partner, but this is only effective if the junior partner would have an ability/willingness to pay if he abandons his share.  Junior partnerships can also be offered to suppliers, customers, and lenders.  While 5% is a guideline interest rate to charge, it is somewhat negotiable.  Offering junior partnerships to speculators at higher rates should be discouraged, as requiring them to borrow funds elsewhere should be a suitable alternative.  And Deposit-options are almost always preferred to junior partnership offers made too early in the relationship.

Friday, June 24, 2011

Deposit Options - A security to facilitate communes

When you make an accepted offer to purchase a home, it is customary to include a deposit upon acceptance, and you pay the remaining balance on the closing date of the purchase.  Typically, if you walk away from the purchase there are no legal repercussions other than the seller keeping both your deposit and his home.

I'm introducing the definition of a Deposit Option as a call option where the premium paid for the option is deducted from the strike price on exercise.  A regular call option is the right for the buyer to buy a security or property at a specified price before a specified date.  The price paid for a regular call option does not affect the amount due.  A deposit option is extremely similar to the good faith deposit when purchasing a home, except that it caries no obligation whatsoever to follow through and purchase the property.

A deposit option can have applications as long term publicly traded stock options as well.  If Company X's current share market price is $100, a deposit option to buy X for $150 in 2 years could be traded for say $20.  This gives the buyer the right to pay an additional $130 for the stock within 2 years.  The buyer of this option can resell it anytime as a regular call option with $130 strike price, since $130 is the break even point determining the buyer's choice to exercise the option.  There is a bi-directional convertibility between regular call options and deposit options, which I will only briefly mention that this means we can use standard option valuation models, and deposit options can offer the seller higher initial premiums for options "in or near the money".

My rationale for introducing the concept of a deposit option is in its use for making deposits on securities generally, but also allowing for renewable options and modifications to strike price.  Communal Equity Principles determine financial processes for equal partners to earn their equal share.  There is a distinction in rights between Senior Partners (those who have fully paid/earned their share) and Junior partners (those who have a contractual path to obtain senior partner status).  The concept of fostering junior partners is desirable primarily to encourage workers (without the capital to buy share outright) to work in the best interest of the commune and thus the best interest of their eventual equal share.

While the original "payment plan" described for junior partners was focused on potentially interest bearing loans on the unpaid balance of a fixed initial buying price, but there are several issues with that approach.  It can be too good of a deal to give junior partners today's buy-in price while giving them 10 years to pay it off. When new senior partners buy into the commune, they have the option of asking all partners to put some portion of the proceeds the new partner pays them back into the company.  Doing so, substantially benefits the junior partner's share because it increases the value of the company by the amount of proceeds invested in it.  There is also an issue of the junior partner potentially losing his share by losing his employment and potentially forced out for the purpose.

A better payment plan for Junior partners is deposit options.  Ones where the strike price adjusts based on capital (equity) inflows and dividends, and options that can be transferred/sold if desired or needed.  As options, they can be offered to any investor.  Not just workers.  But workers get the advantage of being paid enough to cover the option premium(s).

A Communal Equity Option is a deposit option to buy one equal share of a commune at a specified communal equity value by a specific time.  The striking difference between communal options and regular equity options is that the total number of shareholders and therefore price per share at the time of exercise is unknown.  The option strike price is based on the total value of the commune and divided by actual number of partners to determine share price.  They are implemented as deposit options.  The communal equity strike price is adjusted up for partner capital contributions and down for dividends paid out. The other striking novelty of a communal equity option is that the sellers are the communal partnership of owners in equal portion.  The option premium paid goes directly to owners in equal share.

Long term Communal Equity Options can be priced in installments.  This makes each installment an option to renew the option.  The obvious application of an option installment plan is for workers who lack capital but can be given a salary bonus that covers the option premiums.  Pricing for employee options must be model-based and based on the democratically set communal equity value, and with approval of preferably a natural finance comptroller or an elected options policy governor.

Another very useful application of Communal equity options is that of an angel investor role.  Having the option to buy a share of the company in the future, while paying a relatively small monthly option premium to the founders allows for founders to draw an equivalent to a salary in collected option premiums, and does so off-balance-sheet to the company, and thus doesn't saddle the startup with as much debt compared to an investment in the company followed by drawing salaries from the company.  For the angel investor, many smaller option premiums gives the opportunity to walk away if sufficient progress is not achieved.  Since angel investor options involve cash payments between parties (worker arrangements can involve accounting entries that create loans from premiums) there is no need to place any model or comptrollership limits on the amount of the premiums.

As an example angel investor scenario, A very early stage startup might have communal equity value of $50k.  An angel investor might be offered a 3M strike option with 5 year term for 2k per month in premium or 4M strike with 10 year term for 3k per month in premiums.  Conceptually, even both options can be offered on an either/or basis (only one can be exercised) for a premium of 3.1k per month.  The first option would give the angel investor the right to buy a share, with circumstances of say 5 years later there are 4 partners in the commune, for 600K less the options premiums paid (60 * 2k) of 120k = 480K.  So, buying a share is attractive to the Angel investor if he believes the commune is worth 2.4M or more.  The more partners there are at the time of the exercise, the more valuable the option is to the buyer because the cost of one share is smaller, but the deduction for paid premiums is the same regardless of the size of the partnership.  Attracting more partners to the commune is generally in the interest of existing partners as it both allows them to partially cash out, and brings additional resources to help make the commune grow.  Option premium installments have the advantage to the buyer of reducing the effective strike price with each installment, and the advantage to partners of providing steady cashflow.

Communal options are supplementary alternatives to the Junior partnership share that was intended for workers.  The Junior Partnership arrangement of buying a share with secured loan is still possible, but the encouraged arrangement is to offer communal options to employees, and let the employees exercise those options when appropriate with the commune lending them the additional purchase funds they need.  Thus turning a communal option into a junior partnership share.  The advantage to the employee is that his option is sellable/transferable, and the advantage to the commune is that the sales price can be estimated to be the value in 2 or 5 or 10 years rather than current equity value, and the paid in option premiums serve the function of a down payment (vested interest) on the junior partnership when exercised, and so a reasonable share of both risk and reward compared to senior partners.

The most important difference between a Junior partnership (part) share and a communal purchase option is that no voting authority occurs until the option is exercised.  Holding the option still provides an incentive for enhancing communal value, and unlike traditional stock options, the option holder is insulated from a high dividend payout policy.

An option does carry the risk to the buyer that it will expire worthless.  There might be an appearance of a slight bias in motivation by the partners to not be too successful.  Because a communal equity option is essentially renewable on every installment, there is a clear incentive for the partners to continue progress on the enterprise in order to continue enjoying receiving option premiums.  Even if there is a 3M option on the commune, attracting partners at a 10M valuation before the option is exercised, both lowers the cost of exercising the option to the buyer and reduces the share of the company given up by the existing partners.  So, if the true value of the commune is 10M and there are 19 partners, the optionholder can acquire a share for 150k (less premiums already paid) instead of 500k.  The 350k "lost" by doing too well is much less than the share value remaining and cashed out by the first few partners as a result of obtaining additional partners near 10M in communal equity buy-ins.

On a related note, before your startup grows to be worth $10M, it will at one point along the way be worth $3M, and $3.5M.  At that time, an option holder may very well want to exercise his option before it expires because 1.  It removes his obligation to keep paying option renewal premium installments, and 2.  He obtains voting rights, and 3. If he is hopeful about the prospects of the company, he can gain a much larger share of the company if he would be, say, the 5th  partner today instead of the 20th or 100th partner years from now when the option expires.  So 1/20th of 10M is 500k, and a 350k profit on the option, but buying 1/5th for 600k, would make that 5th worth 2M when company is worth 10M, and so 1.4M profit.

A note about employee/management options in traditional corporate structures is that they have a corrupting influence as a result of no adjustments for dividends and share capital infusion.  AAPL for instance has over $65B in cash, and no real use for it.  But if it paid that cash as dividends, it would hurt those employees who have stock options even if the dividend would be in shareholder interests.  Though most share capital infusions tend to be made at a fair price, excessive management options can dilute shareholders and fellow option holders.  The significant harm of unadjusted options though is the dividend reluctance it causes management.  In the case of even successful companies such as AAPL, it makes it more likely that it will go bankrupt before paying back owners its current valuation.

There are also significant tax advantages to options in Canada and manywhere else.  Options have an electable treatment as to whether they are capital gains or income.  Thus partners can treat option premiums received them as capital reduction to their share value (only taxed when share is sold).  Angel investors can treat option premiums as an income expense, and though likely an un-recommendable stretch, employees could treat their paid option premiums as an offsetting employment expense.