Monday, June 27, 2011
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.
Posted by Pascal J. at 4:23 PM