Sunday, January 30, 2011

Communal equity accounting re-introduced: restricted loans as equity.

(The version that follows here is no longer preferred.)

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.

I introduced communal equity accounting a few months ago, but before I link to that, it includes some items I no longer recommend.  First, I no longer consider non-refundable membership fees to be a generally useful component (replaced by a better mechanism here), and there is no need to attempt to set formulaic buy-in prices (though that idea could still have a place in purely social-purposed/charitable organizations).  That introduction also tends to have its key concepts presented at the end.  The original communal equity accounting draft is available, but what follows is a more thorough as well as slower presentation of proper egalitarian partnership or communal equity accounting transactions.  The term communal equity is used here as a label/brand name for a system of transactions that demonstrably enhances value over typical securities and ownership structure.

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.  Under natural finance that payment can be made to the company instead.  First, consider a company currently owned by partner1, where both partners agree is worth $2M in communal equity (no partnership is formed if they cannot agree on value of communal equity).    The second partner owes $1M.  If the company has 1M in  natural finance debt, then the 1M from 2nd partner will be used to pay off that debt, and 2nd partner will own 1M in restricted debt.  The 1st partner receives no cash other than payoff of any debt that he owned.  So we need to answer why would partner1 want to go from 100% ownership of a 2M worth company with 1M debt to 50% ownership of the company with same amount of debt, and without receiving cash.

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 as the result of communal equity transactions.  Restricted soft loans are NEVER repaid.  They become unrestricted (regular soft loans queued to be repaid) as the result of future communal equity transactions.  When a restricted loan is at the head of the repayment queue, it is automatically reinvested/rolled-over to the back of the queue, and the next loan is repaid instead (later recommendations make this statement not quite accurate, as it is recommended that restricted loans remain at the end of the queue until they become unrestricted if they have the recommended 0% interest rate.).

This still doesn't quite answer the question of why would partner1 accept an offer of no cash for half of his company.  Of course the obvious equity transfer of 1M cash from partner 2 directly to partner 1 is an option.  Consider the original example of a company worth 2M in communal equity.  But this time there is no debt.  If partner1 agrees to reinvest 1M of the transfer proceeds back into the company, then the communal equity is automagically worth 3M instead of 2M.   Partner2 would pay Partner1 1.5M, and when Partner1 invests it back into the company, it would have 1M in cash, which could immediately be paid as a dividend of 500k to each partner.  The result would be Partner1 having 1M in cash, and 1M in restricted loans.  Partner2 having paid 1M cash, and having 1.5M in restricted loans.  (reader excersice, if P1 agrees to reinvest 2M, communal equity is worth 4M.  Bonus excercise: what is formula for determining communal equity if 1/xth of P1's payment for half its value is reinvested into company).  If the company already has debt, then instead of the dividend to each partner, that debt would be paid off which is still to the equal benefit of all partners.  In the original 1M debt example, thus P2 pays 1.5M cash and has 1.5M in restricted loans, P1 gets 500k cash and has 1M in restricted loans, and all of the company's 1M in unrestricted debt owing is repaid and wiped out.  And it is natural for a company that was worth 2M with 1M in debt, to now be worth 3M with 0 debt.

Restricted soft loans can still earn interest.  Senior partners (those who have fully paid up for their share) have interest unrestricted (or just paid) when their loan comes to head of repayment queue.  The interest rate given should be the same for all partners.  rate should be low enough to not starve the company and investors of funds, and high enough to attract interest in the partnership.  I'll show later that a 0% interest rate should be high enough to attract partners, but a little more is conceivable.  Restricted loans become unrestricted when new partners buy into the partnership, or a partner abandons or sells his partnership.  Abandoning a partnership share may incur a small (agreed) % penalty to loans.  In the above examples, a debt free company leaves partner1 walking away with 1M in due loans, while partner2 can walk away with 1.5M in loans.  This is still equal because partner1 received 500k in cash in original transaction.  In the example where 1M debt was paid, if P2 walks away, what was a 2M company with P1 ownership is now a 1.5M company, but it has much cheaper debt than it had.  These are considerations to make when agreeing on value of communal equity, as the consequences of any partner abandoning might cause perceived innequalities.  Note that the equivalent 4M communal equity value if P1 agrees to reinvest all of the 2M received from P2, causes all inequities from abandonment to vanish in both the debt and debt free versions (and versions with much higher debt) of the enterprise, because both will have 2M in restricted loans.  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 potentially accruing interest, and the option of abandoning the share and converting it into debt securities.  For private corporations, this option is extremely valuable since it can be difficult to sell/liquidate partnership shares otherwise. For general debt holders, offering restricted loans to partners offers another substantial source of cash inflow into the organization (when communal equity is adjusted up to reflect reinvestment of partner proceeds) that can be used to pay off their debt, and so substantially advantages them as well.

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 first have 500k of their restricted debt become unrestricted, and if as a result either partner's restricted debt would go below zero, then the equivalent communal equity 50% increase with 66.6% partner reinvestment, or 100% communal value increase with 100% partner reinvestment should be pursued instead.  If the company has no debt, then a 6M communal equity value with  full 2M buy-in reinvested, has existing partners restricted loans increase by 1M each, and all 3 partners can receive an immediate 666k cash dividend, so net cost to 3rd partner is 1.33M.

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, and the paid portion becomes unrestricted.  Contributions from future partner buy-ins reduce the unpaid portion of junior partner shares.

For senior partner buyins, 0% interest restricted loan securities are equivalent to buying both common shares and put option protection on those shares.  McDonalds (MCD) shares today are worth about $73.50, and a 3 yr put option at 75 is worth 10.50.  So buying both together is worth $84.  If nothing changes, reselling both tied together is still worth $84.  Communal equity as restricted loans is not quite equivalent to stock and put option combined, because the put option is not an option to get immediate cash for the share, but rather an exchange for debt security.  If the company comes into solvency issues, that debt is worth less than cash, and the put option strike price can effectively decline.  A good argument can thus be made for restricted loans to accumulate 0% interest.  Because it's simplest.  The original 2M company with no debt inflated to 4M communal equity with 100% reinvestement, gives both partners 2M restricted loans (put value) in addition to 1M cash back each.  There is substantial value in the restricted loan even at 0% interest.  The first partner, not only receives the fair $1M for 50% of the communal equity he is giving up, he receives a future 2M (providing continued solvency) when he decides to withdraw from the partnership.

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, senior partners restricted loans only become unrestricted at the rate the junior partner makes payments.  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 in loans becomming unrestricted, while the junior partner would get a kickback of 7.5k reduction in unpaid capital.

Junior partners get the similar benefit of a put option on paid up capital that senior partners receive.  They 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.  That is, they also receive a 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 if the junior partner fulfills his obligations to keep the call option for the years it will likely take to pay off, 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 fairly little paid up unrestricted loan value.  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.

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.  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.

The reason why even zero interest restricted debt is mixed together into the queues of debt investors rather than held as some form of deposit, is that it integrates with natural finance soft loans once the deposit becomes unrestricted, and even if unrestricted and offering 0% interest, when up for renewal the investor retains the option of reinvesting at the new natural interest rate, whether or not he is still a partner.  A strong rationale exists to make restricted loans (if they have 0% interest) stay at the end of the unsecured soft loan queue, and effectively join the unsecured queue when they become unrestricted.  That rationale is that debt investors continue to be provided the complete certainty of no dilution and fixed payment priority that is the main advantage of natural finance.  This is thus another argument for 0% being the earned interest rate on restricted loans.  If restricted loans are mixed into the queue order of regular unrestricted investor soft loans, then loan investors are forced to guess at the probability of communal partners abandoning their shares, and potentially delaying their expected repayment.  The cost of natural finance loans is lower than traditional loans because investors are guaranteed better certainty through simpler forecasting of company activity (they are guaranteed to be repaid if lifetime company revenue or surplus is above x, independent of any company future financing activities).

Natural Financed Egalitarian Partnerships can thus achieve higher market capitalization than standard corporations.  They can raise funds continuously.  Issuing more shares does not dilute 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.  Shareholders receive the advantage of an option to convert to debt holders, and the company/creditors gain investment through reinvestment of communal entry contributions by existing partners.  Egalitarian partnerships can also use natural governance principles which further enhances value over traditional corporations.

Thursday, January 27, 2011

Natural Governance for enterprise

Natural Governance is a sister site that focuses on national level organization, or more specifically, governance among social associations of communities.  Its essential philosophy is that citizens are equal partners in a society, and as such deserve an equal portion of social (tax collection) surpluses.  Cash distributions to citizens in the form of Basic Income continue the wealth redistribution mandate we insist upon our societies, and achieve the mandate more efficiently, and with ancillary benefits.

The key innovation in natural governance is the decentralization and removal of hierarchy from government.  This is achieved by electing each independent governance function and making it accountable to promised mandate and budgets.  New projects, splits of government functions, and elimination of government functions are proposed and voted upon, and have no interdependence or direction from other governance silos.

Natural Governance scales down to the enterprise level quite well.  Especially for egalitarian partnerships.  In fact the ability to apply natural governance principles to an enterprise is another substantial reason to prefer egalitarian partnerships over other corporate structures.  Natural governance citizens are obviously equal partners in their societies, and both citizens and shareholders have a natural share of proceeds in the organization.

Natural Governance principles can be applied to allocating work in a decentralized manner.  Partners (or the public and employees) can bid on roles and project expansions, while other partners vote on which proposals to accept.  Voting is not anonymous and not necessarily final.  A software platform similar to can aggregate and organize proposals, compromises, counter-proposals, and track voting status.  Delegates (someone you vote for, who then votes all the votes delegated to him for all issues, or specific categories of issues) can accumulate voting blocks from those who don't care enough how their money is spent to research or monitor proposed functions.

Consider a hotel resort or co-housing large egalitarian partnership.  Simple tasks such as gathering firewood, cleaning and cooking can have streamlined requisitions process.  Banquets, renovations, medical facilities operator, brewmaster are all functions that require specific budgets, plans, and qualifications, and so require proposals and requests for proposals.

Natural Financed Egalitarian Partnerships advantage bids by partners for work and positions because natural finance facilitates deferred compensation, and the voting partners will prefer to award employment benefits to other partners due to reinvestment of proceeds or part of the benefits given as queued soft loans.  The Natural Finance appointed comptroller can also be available to mediate disputes.

In closing, I will touch on the philosophical acrimonies between centrally planned, socialist, and market ideas.  All existing enterprises are centrally planned, with command and control over their resources.  Central planning is pervasively condemned as inefficient and demotivational.  Market benefits are the encouragement and guidance of chaos through invisible hands that motivate effort to provide value to other market participants.  Natural governance similarly enhances motivational energy by providing opportunities for responsibility and decentralizing management and oversight to all of its members.  "Socialist" or group funding of projects can be more efficient by avoiding metering, cash handling/transaction time/security, and profit markup of services.  Natural governance provides the means to organize voluntary group funding by participants with equal to gain or lose from projects.  Natural governance within an organization or society can bring forth the best of both market and progressive social philosophies.