Monday, March 11, 2013

Communal equity put option

Communal equity deposit call options are an innovation that allows small investments by angel or potential investors and employees and trade partners in a business to be put towards a partnership share in that business.

Communal equity is corporate finance principles as applied to communes and equal partnerships.    Communal partnerships are an ideal corporate structure for purposes of motivation of and fairness to owners, and control of corruption in the corporation.  Communal equity also permits trading of ownership in a fair, market determined, manner without the use or necessity of public markets.  The innovation of communal equity is using a median price asked among existing partners as the purchase price paid by a new partner.

This paper describes an additional tool (among several) for facilitating new partner memberships that wish to contribute by means other than cash, or through more affordable periodic payments.  This paper introduces a new kind of communal equity option, Communal put options, that are primarily designed to reward employees and external partners that make one time, or short term, contributions.

Communal equity purity
A pure commune is one where all the partners have equal shares.  It protects shareholders from each other: Mostly abuse from majority owners over minority owners.  With that said, offering someone a partial, less-than-full, share is worth more than offering them nothing.  While communal equity has been previously modeled as 1 share per equal partner, the size of an equal partner share can arbitrarily be set to any number such as 10000 or 100000 shares.  I like to model the total shares as non voting shares, and 1 voting share is awarded based on

Lets say the initial number of shares in a single owner company is 60k owned by that owner.  Normal communal equity trades are transactions exclusively among owner partners.  So 60k initial 1 owner shares, becomes 30k shares each after 2nd partner joins, 20k each after 3rd partner, and so on.  If there is ever a fractional number of shares created by such a transaction, the shares can simply be "split"  by awarding all shareholders an equal number of additional shares to avoid the existence of fractional shares.

Issuing a partial communal share (non-voting shares) to someone like an employee, means issuing a number of non-voting shares taken equally from each of the partners.  To turn a partial partnership share into a full partnership share simply means obtaining the difference in shares between the number of shares the partial owner currently owns, and the full partnership level of shares that would exist with an additional partner.  With 3 existing partners, and 5000 shares already accumulated by the employee option holder, the employee would acquire an additional 10000 shares from (split among) the 3 partners (adjusted to prevent fractional non-voting shares).  All equal partners always hold the same number of non-voting shares.

Communal equity financing events
When a new partner joins the commune either through purchase or exercising a deposit call option, although that is a transaction among the partnership, rather than the company, there is or can be involvement with the company.  There is a lot of new cash available to partners and so it creates an event for some of the partners to sell out.

One such mechanism to sell out is the tax back flipping right that can be offered to all partners and call option  holders, essentially as a free right without cost to the partnership.  The tax-back flipping right gives any partner the right to sell his share at a 20% discount to the cash inflow created by a current communal equity financing event.  If more than one partner wishes to sell out, they must outbid each other for the right to sell during the current communal financing event.  The reason that the right can be offered free to all partners from the communal partnership is that anything you are willing to sell for $100, you should be willing to instantly rebuy for $80.

The minority shareholder put right
The new put option of this paper is a right that can be provided to minority (less than full partnership) shareholders.  The minority shareholder put right can be given to employees as a right accompanying any shares they are issued.  The minority shareholder put right is the right to sell shares that you own, during a communal equity financing event at a 25% discount to that communal buy-in transaction.  Minority shareholders should have a higher priority in selling their shares than full partners, because they lack a vote in the organization.  While the right is worth something to the right holder, it does not necessarily cost the right granter anything.  A put with a lower discount rate (say 0% or 10%), but which can only be exercised during a limited number of future communal buy-in events would be worth more, and makes sense as a severance benefit.

The usefulness for employee compensation
Providing employees with shares as an intermediate step towards granting them a full partnership share can be an effective motivator, and is cheaper for the company than paying them cash.  Granting the employee a deposit call option in lieu of a portion of salary (paid in premiums to the communal partnership) is also motivating and cash saving, but the issue with the call option is that it is only valuable if the company meets likely high success targets, and even if there are mechanisms for the employee to keep paying deposit call premiums after leaving the company by using some of the other deferred compensation he likely earned, the employee is unlikely to want to keep paying for the call option because the other deferred compensation is more certain to be paid back.

A small number of shares paid monthly or quarterly is a more permanent benefit which can have significant value if the company grows as successfully as hoped in a call-option-based compensation offer, but still has moderate value if the company's performance is more moderately successful.  Offering both shares and call options to turn those shares into a full partnership share is a better compensation package.

Because communal partnerships aren't designed to become IPOs, minority shareholders need the protection of put options/rights attached to those shares.  Put options provide the liquidity for communal shares that is generallly unavailable in private corporations, and so can trap private minority shareholders into something worthless.  Put options avoid that.  The only reason for management (communal partnership) to refuse to provide a share repurchase at a 25% discount to incomming partner contributions is if they intend on keeping minority share positions worthless.  So the right can be permanently attached to shares at no cost, as part of a good faith implied value of those shares.

Special put options of a limited time, and/or covering limited number of future communal financing events, but at a more favourable discount to the option holder can be offered to employees/contractors that provide short term or immediate benefits to the company such as sales or investment inflows, where the long term prospects of the company, and future desire to become a full partner, are not related to the contributions being made.

Example of a software developer
A software developer with $100k/year alternative employment prospects, might be hired for a key role in a startup with the mutual hope and intent that he eventually become a full partner.  The startup has 60k shares among a communal partnership of 2 owners.  His compensation package includes $30k cash salary, $12k in prime queue soft loans @ 8%, $36k in deferred compensation queue soft loans @12%, a monthly renewable deposit call option for a partnership share at strike price of communal equity value of $60M, and paid for by a $20k/year ($1667/month) in deferred compensation loans to the communal partnership. (Employee can choose to abandon call option and receive instead $20k/year in additional deferred compensation), and he receives 20 shares per month with the basic put right.  The total annual compensation value to the employee is $98k + value of 240 shares.

For existing queued soft loan investors, the cost is $30k/year.  For future soft loan investors, it is $42k (30+12).  For the owners, it is $78k (42+36+shares).  That cost to the owners is with reduced risk, because they receive a $20k benefit in exchange for promising a future partnership share at an attractive price today (If 60M call is exercised, and there are only 2 partners at the time, a ~$20M payment would be made, and split $10M each).

For the employee, although only $30K is the sure salary.  $42K + interest should be predictable, and an extra $36K+ higher interest will be paid if the company has moderate success, or more simply eventual sustainability.  The value of the call options is entirely dependent on the future, but the employee has the right to abandon the option in exchange for higher deferred compensation, and so a proper estimate is $20k +12% interest, that he can choose instead.  If the interest rates given for the deferred compensation is a fair reflection of the risk of repayment, then the deferred compensation can be counted as equivalent to a cash benefit.  The employee receives 98k in tangible benefits.  If the stock shares are worth $10 each, then with 240 shares, he receives more compensation than his $100k alternative cash employment.  The taxable income could be as little as $30k/year as well (depending on jurisdiction and many other factors outside of scope here).

If the partnership grows to 10 partners, then the employee will automatically become an equal partner after 25 years, without exercising his call option, since he will have accumulated 6000 shares; the same amount as the other 10 partners.  With 20 partners, an equal partnership share is 3000 shares, and after 10 years, the employee has paid in $200k in deposit option premiums, and has accumulated 2400 shares.  To exercise the call for an equal share means accumulating another 600 shares.  A 60M strike price communal equity call option with 60k shares in the communal partnership pool, can be viewed as a $1000/share strike price call option.  With 20 partners, the call option is for a maximum 600 shares, and so $600K is the total buy-in price.  Since he has paid 200k over the 10 years in call premiums, and deposit options allow premiums paid to be deducted from the strike price, the employee only owes $400k to become a full partner.  Every month, the amount owed is reduced by 20 shares ($20K), and $1667 in premiums paid.  So, 19 months later or so, the employee will become a full partner.  Sooner if another partner joins.

If the startup is moderately successful, and it is reasonable one day for the company to be worth $60M or more, then the 20 shares received each month become worth close to $20k ($1000 each), and so its likely not needed to increase the employee's base pay even as he becomes senior and better.  Moderate success also results in deferred compensation being cashed out.

If the startup struggles, then it might be necessary to offer more salary, priority and future benefits in order to retain the employee, or the employee might be blamed for the struggles, and considered for termination.  In the negotiation over which course of action to take, the employee's past shares awarded are his to keep.   They may have little current value (if company is struggling), but retain potential future value.  The put right allows the employee to cash them out in the future, even if it is decided that his employment should be terminated, and that he is unlikely to want to maintain the call option.  The 240 shares the employee has accumulated after 1 year would become a full partnership share if ever 250 (60k /240) partners join the commune.  They would be worth $24000 if the company is ever worth $6M, and could be cashed out for $18k (25% discount of put option) if there is ever a partnership transaction at 6M communal equity value.  The employee also retains the right to be eventually repaid any past deferred compensation that was awarded him.  If the employee does abandon his call option, then any premiums paid to the communal partnership are theirs to keep without further obligation.

So, natural finance, communal equity and its options and rights allows a company to pay less and with more flexibly, while providing an employee with more if he shares in the risk of the venture.  The owners pay $78k to provide a $100k+ benefit to the employee.  The financial investors pay even less ($30k) for the effort that the employee will contribute to their eventual repayment.  This tends to work out to all parties' advantage as long as the company's prospects are not hopeless.  The nature of natural finances queued repayment priorities is that hopeless ventures are automatically abandoned by management.

Without the put right attached to shares, an employee might value them near $0 because there is no likely way of ever selling them without an IPO.

Deposit Call Options version 2.0
A Deposit call option contract as previously defined, allows the call buyer to pay say $2000/month for the right to buy an equal share of the company at total value of say $10M (strike price) within an unlimited period, but the right is only maintained if the monthly premiums are sustained.  The right disappears if the option buyer stops paying the monthly premiums.  If there is only 1 partner at the time the option is to be exercised, the call owner would pay $5M for an equal share adjusted down for all past premiums paid, and any compensation above $100k/year to any partner, and all divididends paid.  If there are 9 other partners, he would pay $1M for that equal share, less adjustments.

The core assumption behind this original option structure is that if the buyer abandons the option (by stopping monthly payments) he also wants nothing further to do with the company.  This is not necessarily an invalid presumption, and compared to version 2 (described shortly) has the advantage of lower monthly payments.  The one nagging risk in this form of the deposit call option, is that there may be circumstances where the founder wants to harm the performance of the company in the short term order for you the buyer to give up his option.  If the founder is able to sell partnership shares at well above $10M communal equity value, then he keeps more money if he is able to get "rid of" option holders.

Version 2 of the deposit call option for the same communal equity value strike price of $10M, would have the buyer pay say $3000/month.  If there are 100k non-voting shares in the partnership, then the $10M total  equity strike price is equivalent to a $100/share strike price.  Under version 2 of the deposit call option, the option buyer receives 30 shares each month for his $3000 payment.  He may (likely) also receive communal put option rights on those shares.  He can view the call option as a prepurchase of non-voting shares at the strike price, with the right to buy more up to an equal partnership (voting) share at the same locked in price.

Version 2 of the deposit call option with $3000 monthly premium is identical to the version 1's $2000 monthly premium with an extra purchase of 30 shares for $1000 (about $33/share).  The adjustments at time of exercise no longer need to include premiums paid  because the option holder simply has a smaller number of non-voting shares to buy out in order to qualify for a voting share.  The dividend adjustment is slightly more complicated:  The strike price continues to be adjusted down by total dividends paid out during period of the option, but they are adjusted up by the dividends received by the option holder.  The strike price continues to be adjusted down by deferred compensation queue benefits awarded to partners.

The advantage of the version 2 tie in of shares are primarily that the option buyer is left with something if he chooses to abandon the option.  Shares and the put right to sell those shares during next communal equity transaction(s).  Although the buyer is paying an extra $33/share monthly, he has the right to pay that $33/share in perpetuity, and so that extra premium may be worth it even if the current estimated value of shares is less than $33.  If the value of shares ever reaches $33/share or higher, then even if the option buyer abandons the option without exercising it, the total cost under version 2 will be lower than the version 1 option due to proceeds from selling the shares.  A larger benefit is that the option buyer gets towards a full voting share 50% quicker by paying $3k instead of $2k per month.  He will automatically receive a voting share after 10 years ($360k spent), and 28 or so other partners, while it would take 15 years with the same number of partners to automatically earn the share at $2k/month.

The advantages, of version 2 deposit options, for the founder/partnership/seller of the option is that more immediate cash is paid to the partnership.  A more subtle advantage, is that future inflows and outflows to the partnership is more predictable, and so more predictable for potential immediate partners.  Every month the partnership essentially sells a fixed number of shares (30) to all the call option holders at their respective strike prices (of $100).  The partnership and potential partners can continue to expect that the remaining shares will eventually be purchased by the call holders, and if some option holders stop paying and give up their option, no huge windfall accrues to the existing partners.  The partnership sold some shares for as much as they were ever going to get from that option holder.  They only gain the benefit of not being obligated to sell more shares at that price, and can freely market partnership shares at the median price determined by partner bidding.

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