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.

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