Monday, February 28, 2011

Natural finance comptrollership function - A Private regulation model

A Natural Finance Comptroller (NFC) controls cash, financial accounts, and the issuance of (loan) securities by the enterprise.  He may also restrict cash expenses and cash salaries for reasonableness, and thus manage deferred compensation .  May advise on future project loan structuring.  May manage share issuance and assist board or partnership issues.  The NFC is independent of the company, and his primary role is to ensure that investors, and suppliers/partners/employees are paid when supposed to, according to enterprise's voluntary contractual obligations, thereby enabling management to engage in flexible loans and supply agreements.

Comptrollership under natural finance principles provides different, stronger, and mostly cheaper financial controls over enterprise than does accounting audits.  Auditing still has value, but natural finance comptrollership (NFC) can replace almost all of that value.

Audited financial statements (by CPAs) are proactive regulation designed to protect investors.  The birth of the public accounting industry was the SEC acts of 1933-34 which made auditing mandatory for public corporations.  Against the act, corporations argued that not permitting them to say anything they wanted on financial statements would impede their ability to raise funds.  Today, investors, and even banks, prefer to invest in public companies over private companies largely because of the financial reporting integrity brought through audited financial statements.  The accounting industry would survive even if the legal requirement of audits was removed, because investors appreciate its value.

Potential Investor abuses (legal and illegal) in corporate governance
The following investor abuses are sorted from smaller companies to larger company issues.

Embezzlement, fraudulent liquidation, and fleeing to tropics.  This is one of the larger fears of bankers in giving general operating loans.  NFC prevents embezzlement by controlling bank accounts, pre-approving withdrawals.  Traditional auditing merely confirms what is said to be there is there, and cannot prevent the fraudulent liquidation of the company.

Ponzi/Madoff schemes and  unregistered investments.  NFC registers all investments.  Investors want their investments registered so that NFC can ensure their due payments.  Auditing can mostly prevent long term ponzi schemes (Madoff was never audited), but there are sophisticated arrangements that can fool audits. Investors only know about other investors if they are told about them.

Secret contracts, loan guarantees, and repurchase agreements.  A variation of the above.  First, a contract is a secret agreement (until it is enforced) between 2 parties.   Top US investment banks have been accused of shifting assets and liabilities to a 3rd party just before financial reporting timeframes, only to be reversed days later. Enron used most of these abuses.  Natural finance discourages loan guarantees and repurchase agreements are extremely difficult and also discouraged.  Secret contracts are impossible under NFC as long as one party wants his rights enforced.

Accounting conflicts of interest.  Best exemplified, again, by Enron and Arthur Andersen.  I am not aware of any bribing of individual auditors, but 25m in annual auditing fees and 27m in additional consulting fees influenced the firm's deference to management perspective.  More generally, financial reporting involves management exaggerating its results in the most reasonable manner possible, while the auditor certifies that it is reasonable.  An auditor competes for employment services with other accountants.  NFC retains its authority over the corporation until the corporation ceases to follow Natural Finance principles are repays all NF loans.  NFC focuses on cash flows, and ensuring they properly reflect revenue, expenses, and investments.  NFCs can offer consulting on future project securitization, accounting and mediation services, but cannot perform any other services for the organization.  Any financial reporting opinions (optional) made by NFCs are made from the NFC's perspective reflecting probable investor benefits, and not an endorsement of management opinion.

Friendly loans. accounts payable.  Friendly loans are informal loans made under the impression that borrower will repay when he is able to.  Accounts payable similarly are usually incurred providing the impression that they will be paid in prompt order.  More of an annoyance than an abuse, these types of obligations can often involve repeated requests for payment from the lender.  NF soft loans are very similar to friendly loans.  NFC formalizes friendly loans and ensures that such obligations are paid when due.  Traditional accounting principles enhance perceived cashflow through high accounts payable balances.  Natural Finance makes soft loans more attractive if accounts payable balance is low or zero, because accounts payable can impede the speed of repayment to investors.

Crony-nepotism. overly generous salaries and perks.  Management paying itself and its friends anything it wants is a corporate governance issue.  Not an auditing issue.  Corporate governance makes no consideration for debt holder concerns.  One of the more controversial aspects of NFC (to business owners) is interference in cash salaries and cash expenses.  These restrictions vary based on profitability and debt levels of the organization, and whether the expense is unlikely to contribute positively to the health of the organization.  NFC can never demand cutting of expenses.  NFC is just able to negotiate acceptance of new expenses.  The business owner has several options in dealing with such NFC oversight.  First, all expenses funded through new soft loan issuances are always accepted.  Business owners have complete discretion in allocating deferred compensation prioritized after investor queues (3rd queue).  New ongoing fixed monthly increased expenses can be funded by new soft loans amounting to 6-20 months of such expenses, and whose proceeds are destined to repay existing investors.  And employees/suppliers can also have part of their compensation in the form of main investor queued soft loans.  The aggressiveness of NFC oversight in this area is determined at the time the company adopts natural finance principles.  Startups would tend to accept stricter expense oversight than converted successful public companies.  Strict oversight can be a selling point for investors as it necessarily improves expected repayment cashflows.  Strictness can always be raised with enterprise approval, and strictness can be loosened based on success benchmarks, and so pre-scheduled expense-standard loosenings can be determined and triggered upon success benchmarks.  The greatest limit on corporate debt today is the lack of expense controls protecting debt holders.

Debt and equity dilution. stock options.  These are legal abuses.  The core natural finance principle is that dilution should never occur.  A billion dollar company with no debt can borrow $1 at the lowest possible rate only if there is some guarantee that another billion dollars in debt won't be borrowed at the same credit priority.  Under natural finance the 1st dollar borrowed can be at much lower rate than the billionth dollar borrowed.  The first has top payment priority, and billionth last priority.  Under traditional finance, shareholders are abused through management coopting of board of directors, paying themselves generous stock options, issuing no or low dividends, and making poor acquisitions and investments.  Stock options specifically misalign management interests with long term shareholder interests by promoting bubbles which the options can be flipped.   NFC doesn't insist to involve itself in shareholder protections, but natural finance recommends communal equity principles which does eliminate possible shareholder dilution.  NFC can enforce communal equity principles.  Employee and management bonuses can be freely distributed as interest bearing deferred compensation.

NFC cost analysis

The most important benefit of natural finance is lower financing costs, and allowing management to borrow more, and retain greater or total control of the company's purpose and shares.  NFC provides stronger financial controls than mere auditing, but these can also be more minimalistic.

Cash account control and verification of investment and income flows.  This is the core NFC function.  It is the only essential information needed to control and verify the health of a company. It can be performed off-site, with one comptroller overseeing several enterprises.  Account control can be a banking service.  Investor repayments are straightforwardly automated.  A relatively low skill level is needed to approve what is authorized, or match contractual obligations between enterprise and its counterparties.

Accounts payable.  Enterprise may agree to have procedural accounts payable, and have automated NFC management of them.  Saving enterprise from devoting resources to accounts payable management.

Auditor functions.  While not absolutely necessary to the health monitoring of enterprise, management would like to be able to boast about future revenues and cashflow by highlighting accounts receivable, inventory, and order backlogs.  If management can prove the existence of those items to the NFC, then NFC can certify that they are accurate.  Essentially almost the same service as CPA audits, but incremental to core NFC purpose, and easier given existing relationship.  From managements perspective, these additional audit services may not be necessary.  The decision is based on whether they will bring down financing costs more than the fees.  Since, inventory, AR, orders will eventually turn into cash, apparent success will become eventual success, and lower financing costs eventually as well, all without these additional audting services.

Cash handling security.  If the business involves cash transactions and employees, there's already likely to be cash management security processes.  Having NFC involved in cash comptrolling, either through certifying processes and/or point of sale systems adds additional helpful security.  It becomes essential security if there are no employees, and/or management is doing the cash transaction handling.  Though this is an additional expense, for a business that does substantial cash transactions, cash controls can make the difference between being investable or not, since otherwise, investors cannot be assured that financial reporting  is accurate (that cash is not disappearing).

Investment packaging consulting.  Natural finance encourages funding new projects with new loans.  A secured tranche/queue exists for funding hard assets.  A minor goal for enterprises using natural finance principles is to keep all of its secured loan queues at equal risk and interest rates so that investors need not be overly concerned over which assets to accept as security, or risk one asset being unfunded while other assets are too popular.  NFC can assist in setting the percentage of loan to value that both minimizes the expected interest costs and vouches for the appropriate comparable (to other secured assets of enterprise) risk level of the asset.  For the unsecured queue, repayment policies may be modified without violating the no-dilution principle of natural finance:  Many investors have an aversion to being repaid too quickly.  So an enterprise with fairly low outstanding loans can adopt a policy that targets organic (from profits) loan repayments to 3 years or 5 years effective for future loans.  NFC can help maximize investor participation and minimize enterprise interest costs by recommending loan conditions (enforceable by NFC) to the enterprise.  Conditions are voluntary, but acceptance carries stronger recommendation by NFC to investors.  Both the entire enterprise and individual future projects are an investment packaging under natural finance principles.  The NFC recommends controls, and enforces those accepted controls.  The basis for management acceptance of controls is ample financing and cheaper financing costs.

Natural finance comptrollership provides simpler controls than auditing.  These controls are more effective though, since they prevent embezzlement and fraud instead of uncovering past crime.  It enforces the impossibility of investor dilution compared to auditing's after-the fact (and weak in the case of employee stock options) reporting of dilution.  NFC has independent authority compared to auditor's employment services contract and so is less likely to have integrity compromised.  Through NFC, natural finance can enable funding of private, even small, business, and significantly reduce the cost of capital of large public companies.

Private regulation model
NFC is an example and model for private voluntary regulation.  Natural finance can benefit from a granted government monopoly that would make it mandatory, but it can also prosper under the voluntary model through its natural obviousness.  Verified trust in an enterprise's promises makes the promises meaningful, and thus enhance their value, enhancing the price/benefits that can be charged for them.

Environmental and social responsibility claims by enterprise could also benefit from a verified trust regulator, which can be private rather than public-legislative-based.  Government regulators always have plausible deniability when they express shock at disasters and abuse.  Regulatory legislation tends to be too vague, and lags behind industry development, not to mention being industry wide rather than company or project specific.  When BP proposes a deep-water drilling plan seeking social funding or permits, verified trust in its drilling and safety procedures should carry significantly more weight for approval than would advertisements featuring puppies.  If BP were unwilling to adopt comptrolling of its practices (as it ideally should be allowed), then any competitors willing to submit to verified safety practices would have a significant competitive advantage in obtaining permits/social funding.

An odd example of government regulation "weirdness":  In the beef industry, at times of mad cow scares, individual beef producers were prevented by regulator from certifying their meat as mad-cow-disease-free under the reasoning that it might force the rest of the industry to adopt costly safety measures.  Certified corporate responsibility should be an obvious right of enterprise, and many consumers would pay the price premium caused by certification.

Wednesday, February 9, 2011

Case study on shareholder dilution: OpenTable

OpenTable is an online restaurant reservation service.  From latest financial report, in North America it has  13795 restaurants signed up to its service out of a primary addressable market (universe of target clients), according to company, of 30k-35k restaurants (39.4%-46% penetration), and a secondary addressable market of up to 20k restaurants.  From its average restaurant client, excluding installation fees, it is earning between 6k-8k in revenue per year (closer to 8k if latest quarter is extrapolated).  Its spends over $7000 in sales and marketing costs per new restaurant acquisition.

OpenTable is a very exuberant stock story.  Shareholders have reason to be satisfied with management on the simple basis that shares have risen substantially, at the time of this writing (morning after earnings release), opening over $87/share.  Over $2B in total value.  This is 150x diluted earnings per share of 0.58.  If the company doubled its restaurants and doubled its revenue per restaurant tommorow, quadrupling its earnings, and then grew at 5% per year afterwards, it would justify a 15x earnings multiple, and a stock price that should be (2.32x15) $34.80.  Doubling that to account for international opportunities, which are significantly less developed than north america, $69.

According to OpenTable management, their reservation platform does not increase the total number of restaurant diners.  It just increases the number of diners who use opentable to make a reservation.  This means that if Opentable is as successful as the market hopes it becomes, that the service could simply be more of a tax on restaurants than a restaurant profit generator.  OpenTable claims that some of its restaurants in San Francisco have up to 50% or their reservations made through the software platform, and possibly explains why a SF restauranteur made this rant against the service in October 2010.  Considering that the cost of developing a competing platform would be 1-5M, and the sales and marketing costs of "stealing" 10000 of OpenTable's customers probably less than $70M, then there is a present and future competitive threat to the hoped success of its business model.  Competition on price becoming more of a threat the higher OpenTable's revenue per restaurant grows.

The above illustrates that although shareholders have reason to be happy with past and current performance, there is a wide range of possible future stock prices, and it would seem that the market is already at the very high end of that range.  External shareholders simply have no control over the outcome, and face unproductive risk and anxiety as a result.

2 core natural finance principles are that management and insiders should own the equity/shares of the company because they are the only ones able to foresee, and be responsible for outcomes; and that outside investors should never be diluted (new shares offered/given away) because involuntary dilution is figurative theft.  OpenTable has an aggressive employee/executive options program that illustrates several points in favour of natural finance and severe failings of traditional stock market investing model.

OpenTable's shares outstanding grew by at least 32.4% from the average 2009 level to the end of 2010 to just shy of 23M shares.  It has at least 1.3M optioned shares outstanding at the end of 2010 (company reports average diluted shares, so if options are awarded on last day of quarter, they only count as 1/90th of a diluted share).  Compared to previous quarter, options are growing at 184k shares (change in diluted shares) per quarter.  The compensation value it records for these options is $2.69M or $15.59/share.  From recent filings, Between January and Feb 7, 2011, several insiders exercised options that expire in 2017 at a strike price of $4.87 (this is the amount the company receives) and sold the stock for over $80 immediately thereafter.

The above indicates that the company has a generous options compensation package, offering employees very long term options.  If options  were being exercised at $87 proceeds to the company, then they would be dilution neutral to other shareholders.  At $4, they are management candy that take away shareholder value.  Whatever superb growth the market expects from the company in coming years, I'd be surprised if shareholders are factoring in 9% increase per year in shares outstanding.

As said before, shareholders have reason to be happy with performance of stock.  Therefore, there is coziness between shareholders, board of directors and management.  That shareholders are happy when a bubble is growing, creates a confluence of interests by all parties to help grow that bubble.  The potential for exaggerated financial reporting is quite real.  Financial analysts can also be provided with benefits aligned with stock price increase.  Regulators tend to only get involved if the company turns into an Enron disaster, which is quite unlikely for OpenTable.  All of these factors, allow management to reward itself within barely reasonable limits, and if they were to fudge on the proper valuation of employee option compensation (there is considerable leeway to do so), they would be unlikely caught if no one is likely to complain.  The 15.59/share per average option seems surprisingly low considering that the market values an 11 month $87-strike option (when stock is at $87) on OPEN at $23, and especially if the company continues to offer 10 year options.  OpenTable options are considerably more expensive (on public market) than average companies because it has such a wide range of opinions on possible outcomes.

Our financial systems should discourage outside investors from speculating without control and inside information through minority stock ownership.  The tax code should encourage loans instead.  Natural finance soft loans are less risky than traditional loans for investors, and allow them to make investment decisions based on simpler to forecast revenue and operating cashflows, and guarantees them never to be diluted by other investors or management compensation decisions.  From management's perspective, natural finance queued soft loans provide flexible financing repaid only when cashflow allows, at the lowest interest rate the market can bear, and a continuous source of financing.  Management and insiders can keep the entire ownership of the company.  Even in OpenTable's case, a spectacular stock promotion success story, if the company were worth only $1B (half), under natural finance, the 1B would belong entirely to insiders, and it would be better able to finance its expansion plans.

Sunday, February 6, 2011

The most profound lie in finance and economics

A profound lie is one that affects observable reality.  One that shapes social policy at both individual and collective decision-making levels.

Dividends do not matter is the most profound lie in finance.  From a shareholder perspective, higher dividend payouts are always preferable to lower dividend payouts with the caveat that the solvency of the enterprise is not threatened.  The obvious and simple reason this is true is that one of the choices the shareholder receiving that dividend can make is to reinvest it back into the company.  DRIP programs accomplish this reinvestment with minimal transaction costs.

The bedrock finance principle is that there is shareholder ambivalence between owning a company valued at $100 and owning say a $20 cash dividend and the remaining $80 company value.  The reason that this is false, is the ambivalence only holds if reinvesting the $20 back into the company is in the shareholder's opinion the absolute best use of those funds among the billions of alternatives.  A more detailed criticism previously posted.

The reason that this is a profound and pernicious lie is that the ambivalence of dividends together with small transactions costs and tax implications is used as an argument to not pay dividends by both academics and financial professionals.  Government through tax and other policies is a co-conspirator in creating the lie, which I will explain shortly.  Transaction costs are minimal and have come down significantly since the 1970s when the theory was "proven".  The tax costs of dividends, in Canada anyway, are only an  accelerated timing of tax payments.

For the financial professionals that sell stock offerings to the public, corporate executives are their clients and the confidence/gullibility of shareholders (and their money) are the product.  From an executive's perspective, having spent considerable effort obtaining shareholder money, there is natural acceptance of justifying alternatives to give any of it back, just as there is natural acceptance of receiving Ayn Rand's praise and glorification.  "Dividends don't matter" is the lie executives want to hear and repeat because it it is an excuse to never have to pay shareholders.  The docile, deluded, shareholder class will invoke cult heroes such as Buffett and Jobs as an excuse for the other 15000 US public companies not repaying shareholders.

To some, this might all seem like a very small issue or an irrelevant dispute between capitalists and corporatists.   There are profound social costs too, though.  First, if shareholding is a ponzi scheme that will never see adequate repayments to holding shares then there is an expectation of eventual collapse of financial markets.  Second, capital allocation to the most worthy investments is harmed by corporate hoarding of cash. Innovation and new project funding is less available.  Third, as of June 2010, US non-financial companies have in aggregate cash and liquid assets totalling $1.84 trillion.  Recirculating that cash in the economy would provide needed economic stimulus without indebting us all through government debt.  These are the simpler social value arguments.

A corporation does not have to pay dividends in cash.  A novel way would be to pay them with loans.  Natural finance queued soft loans provide ultimate cashflow flexibility for the corporation.  Beyond cash on hand, corporations could provide soft loans with say 2% accruing interest to shareholders in lieu of cash dividends while through their DRIP programs allow shareholders to trade the loans for more shares if that is what they prefer.  This satisfies the Modigliani–Miller ambivalence of dividends and shareholder fairness principles.  The main reason for using loans instead of or in addition to cash as dividends is the social value of reducing market capitalization of the corporation.  Reducing market capitalization of companies by issuing quickly repaid loans distributes more cash into the economy that can be used to fund the most productive ventures, and it shelters that capitalization from disappearing in the next crash.  This is a similar argument to the 3rd point in the last paragraph.  US market capitalization is approximately $50T.  But the additional argument is that transferring market capitalization to shareholders significantly reduces the risk to shareholders.  All companies eventually go bankrupt, and if a company always double downs instead of distributing profits and accumulated market value to shareholders, then the only hope to profit from shareholding is to find someone else to buy shares from you.  Shares that will eventually be worth 0, and without dividend payments will have returned 0 to the shareholder.

There is an unwritten argument in favour of shareholder acceptance of foregoing corporate repayments to them (while still clinging to delusion of future corporate repayments).  Monopolies and companies with government lobbying or other corporate power can make a case that reinvesting with them is more profitable than what most shareholders could do.  Monopolies or corporate legislative handouts may harm society, but it does not harm shareholders.  Repaying shareholders could also be used to fund competition to the monopoly.  Market and social corruption can thus be to the benefit of shareholders.  Reduction of market capitalization through large dividend distributions can mean less power to abuse the rest of society.  The strong government-corporate alliance which at least used to be considered dangerous and worth resisting, but which we now seem to have moved to dejected resigned acceptance, would be weakened by emptying corporate coffers and increasing corporate accountability to shareholders.  This is an unwritten argument because it is an "evil is good for some of you/us" argument.

While shareholder oppression may not be the greatest social injustice in this world, it is a key to unraveling other oppression.  There are laws protecting shareholder rights which are much stronger than those protecting the people.  If citizens can view themselves as equal shareholders of society's surplus (its tax revenue) then they can demand the same protections.

Government takes on the role of economic stewards with the encouragement and support of many.  A related broad mistaken belief is that companies that pay back investors harm the economy by taking away capital that could increase production (and create jobs).  Tax policies that favour common share investments over loans reinforce the outcome.  The truth is that all restrictions on financial flows harm the economy.  Too much capital tied up in corporations with few attractive projects would be better directed to consumption which can then improve the outlook of future projects.  The investor class receiving the financial flows likely has a propensity for further investments, improving capital allocation to needed projects, but even if they choose to set aside returns from investments for consumption, they can invest it back if offered higher incentives.  Increasing financial flows increases the velocity of money which directly increases the economy. Economic theories (schools) that focus on the primality of capital and investment for economic function are wrong due to false presumption that society operates at maximum investment capacity, and thus that further production depends on further capital, and that money cannot be quickly allocated (or even fabricated) to production.  Faster financial flows not only permits the proper capital levels, it distributes capital where it is needed most.

Tax policies that would encourage distributions to shareholders and promote loan investments include to put a maximum cash salary (or service contract compensation, including transfers to multinational affiliates) of 100k per year but allow compensation in securities above that.  Instead of taxing people's investment gains/losses on sale of securities, they should tax withdrawals from investment accounts.  Increasing corporate and personal tax rates, but making dividends tax deductible to the corporation would ensure that corporations often effectively pay 0 tax, but keep neutral tax revenue by getting more from individuals.  A small tax on market capitalization (or equity) would further encourage distributions to shareholders, as would heavy investment in shares by management.  Taxing dividends and capital gains the same as ordinary income would further balance lower risk loans as investment vehicles.

Public company executives abuse shareholders principally by being able to appoint their own (oversight) loyal board members.  Even if laws and procedures exist for shareholders to receive the payments they deserve (and those that benefit greater society), its simply often easier for shareholders to secede from the corporation (by selling shares) and find a more benevolent dictatorship.  Its easy because there are no other easy choices.

Natural finance provides investors with better, less risky, investment choices.  From corporate perspective, less risky investments means a lower cost of capital, and natural finance soft loans are also more flexible and less risky.  The only corporate downside being the loss in power to corrupt society and delude shareholders with a false hope of repayment.  Arguably, there is upside in affirming social responsibility.  For the social and economic steward role (of government), natural finance should be a national strategic initiative.  An easy alternative to choosing among lesser oppressors is needed for investors.  Natural finance only needs modest funding.