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.

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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.

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