This post is a followup to Part 1 and 2 which dealt with income property ventures and other typically debt financed ventures. I will focus here on larger traditional companies and new economy startups that are traditionally financed through public common shares.
First, let me repeat the major advantages of natural finance:
Advantages for borrowers,
- Cashflow from investment similar to equity investments in that repayments are only made when revenue/income permits.
An example copper mine that needs to raise a $10M investment. Under natural finance, 10 investors could each bid $1M (shown as 1000 in column 1 of chart below) at various interest rates from 6% to 24% (column 2), and they each receive their queue priority position based on lowest bid interest rate first (top row). After the 3rd year, the project will start contributing $2M (2000 in chart) per year in surpluses available to repay investors. For the example's simplicity, investors are only repaid at the end of a year (real companies would pay weekly or monthly). You may scroll the chart to the right to inspect accrued loan balances and repayments. Column 3 summarizes which year each investor is first repaid in, and column 4 show their total return on investment. The key result is that $6.9M in total interest is repaid to investors under this natural finance example compared to the $10M that would have been "promised" to new shareholders. Management also gets to keep all future profits for itself.
The net result of the initial $2M payment is that all loans that were from 6%-14% are now costing the company about 14.9% (actually slightly higher as the natural rate will edge higher when 6% investor reinvests at 14.9%), and it has removed one loan at 24%. The 24% loan was originally scheduled to "cap out" and cost the company only 10% interest per year over its lifetime. Thus, the reinvestment process would appear to be costing the company significantly higher interest costs, but the cascade of reinvestments isn't finished yet. The copper mine, once it is operating successfully, will appear to be an attractive investment at 8%-10%. The 24% investor that when we last left the example was paid out retains the option to reinvest, and since the natural interest rate being offered is well above 10%, the 24% investor should choose to reinvest. Natural finance queue positions are like a game of musical chairs where each player can shove others out of their chairs. If all the company's investors believe that investing in the copper mine as low as 10% is a good idea, then the natural rate will be driven down to 10%, and all of the investors will hold loans around a 10% interest rate.
Under natural finance, since there is a $12.5M loan balance after the end of the copper mine's 3rd year and first repayment, if there is $12.5M of investment capital in the world that thinks the copper mine is a good investment at 10% or 7% (or any rate below the company's current natural rate), then the company's interest costs will drop down to that level as a result of new investors buying out existing investors each at slightly below the company's natural rate. Using computer's and investors predetermining their responses to repayment offers between the time it is announced and paid, the musical chairs shuffling of investor queue positions can unfold in under 1 second, and the original steep interest curve (6%-24%) transformed into a relatively flat curve where each investor holds 10% interest rate loans almost instantly. For instance, the 6% investor could pre-decide his reactions to payment offers as: take 10% of the loan balance or just the interest profit portion as repayment, with the remainder reinvested to interest rates as low as 9% only if a payment offer of $5M or more is made, with 70% of the remainder to be refused payment, and the remainder reinvested as low as 8%. All of these predeterminations could be kept secret from the company and other investors. The logic of the 6% investor's example decision sequence is that he would like to leverage his optimal queue position to gain some regular income from the investment, is very willing to reinvest, swapping his queue position, if there is a large investment, because he won't be all the way at the more risky end of the queue, but is willing to reinvest a smaller portion of his investment anyway. Even if an investor secretly accepts a rate as low as 8% or 9%, he still gets to reinvest at the higher natural rate offer of the company, until other investors drive down the natural rate to his minimum acceptable rate.
Summary of the repayment opportunities for investors at head of queue:
- Company surpluses which must be offered as repayment
- New investor funds wishing to bid at an interest rate lower than the company's current average interest rate
- If higher queue priority investors refuse any repayment opportunity
- If higher queue priority investors reinvest some of their repayments into the queue.