Wednesday, May 30, 2012

Natural Finance's comparative advantage over equity financing

The key features of natural finance are the use of open (repayable at any time) loans without fixed repayment terms.  All loans have payment priority for interest and principle in queued order of when they are placed.  A 3rd party comptroller controls all cash in the organization and ensures that investors are repaid when the organization is able to, and directs better loan bid proceeds to repay existing loans.

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.
  • Control of the organization and incentives for profitability and success are retained by borrower/founders.
  • Open loans, and queued priorities, make it simple for a successful business to reduce its borrowing costs by inviting lower interest loans, ultimately achieving a perfect competition market from lenders by facilitating loans from the most willing bidders.
  • Permits continued expansion project financing without causing existing investor objections.
Advantage for lenders,
  • Being more attractive to borrowers means that buyers are more likely to accept higher loan rates.
  • Many risks and types of fraud or lapsed insurance can be eliminated.
  • Loan payment priority can never be supplanted or diluted.  It is impossible for traditional finance debt covenants to fully anticipate or satisfy objections to future dilution.
  • Risk profile of investment is much more clearly assessed at time of loan.  Much fewer things can go wrong.  For instance, generous management salaries, bonuses and perks cannot be implemented at greater risk to lenders.

The only disadvantage to borrowers of replacing equity financing with natural finance loans is that they lose opportunities for deception.  Even though common shareholders hold a theoretical right to receive dividends and to influence/control management through a board of directors, there is no obligation to pay dividends, or high enough dividends, and management regularly controls enough shares and board seats to control the firm's direction.  This can especially affect the powerlessness of minority shareholders.  Natural finance's key advantages over owning shares is that investors are repaid when the funds are available, and management and insiders can keep complete control, and benefits of long term profitability, over the enterprise.

Part 3 - Traditional Economy Corporations
I will show how natural finance can benefit a copper mine, and a large company that doesn't strictly need financing.

part 3a - A copper mine
A mining operation, at its early stages, cannot use traditional hard loans (bonds or bank loans) because project and production delays are common.   Mining projects simply lack the reliability to commit to fixed repayment terms, especially early on.

A copper mine will usually be financed with an offer similar to "$10M invested in common shares will result in $20M of profits attributable to those shares over 10 years, and a bit more profit over some more years until the hole empties out."  Even if the metal and profits estimates turn out to be accurate, the investor is extremely unlikely to be paid those future profits, because management is very likely to use those profits to drill more holes and scoop more rocks, and then with those profits, start even more mining projects.  Most public companies behave like mining companies, preferring to expand over repaying its shareholders.  Owning public shares is inherently a pyramid scheme unlikely to pay out on investment, which although carries the option to sell out, the information necessary to have the proper timing in selling out is only available to insiders.  Another issue worth emphasizing with the $20M expected value of a $10M common share offering is that it is very similar to a political campaign promise:  The goal is the physical transfer of your approval, and fulfilling the promise less important.  Natural finance solves this important issue by forcing management to believe in itself.

Natural Finance soft loans provide the mining company with the flexibility of not repaying investors until there is sufficient cashflow generated by operations, but obligates it to repay once funds are available.  While the copper mine management loses the complete control over profits, and power to obstruct investor repayments, they are still likely to be able to finance expansion projects if they properly steward the first project, because they are likely to be able to convince someone to trust them due to their past success.  Both existing and new investors should be willing to invest in those new projects.  The biggest advantage of natural finance for the copper mine management is that they can continue to own 100% of it, and they give up much less profit to investors.  Investors get the advantage of being repaid quickly and the power/choice of whether to reinvest.

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.  

To understand why each investor would bid very different interest rate demands, lets look at their actual returns.  The first 6 investors receive exactly what they bid, with the 6th investor having the highest total return of 16%/year.  Investors 7 to 10, due to the 100% total interest cap, receive less than their bid rates.  Their annual returns are 14%, 12.5%, 11% and 10% respectively.

A copper mine project has several risks that can affect actual performance/profitability.  Delays, the price of copper, the percentage of copper in rocks, and the cost of labour and fuel.  The first 3 investors (6-10%) are the most secure against adverse risks, while the last 4 investors (18%-24%) may be hopeful that profits will be better than expected.  But the motives for each investor choosing his position in the queue are deeper than this.

Loan queue investors have 2 important options when they are about to be repaid.  Their first, and most important, option is the right to not be repaid at that time, and instead keep their position in queue.  When this right is exercised, repayment is then offered to the next investor in queue, who has the same option.  The reason an investor would refuse to be repaid are: 1. He would like to continue earning interest, and 2. He would like to keep his priority position in queue because it is more secure, and 3. expects the opportunity to make a decision on receiving payment again soon.  In our copper mine example, in the first year of operations (year 3), it is likely that the first 6 investors (those with interest rates of 6%-16%) would all refuse the first repayment because they are content with the ROI they expect to receive, and content with the security of being at the head of the queue.  The 18% and 20% investor might choose either to be repaid or repaid partially, or also pass until their next opportunity.  Both these investors do not expect to make their full bid ROI (due to interest rate cap), but it will take a few years before they reach their cap, and they can expect to have the same decision opportunity at time of next payment.  They might also hope that operating profits could increase in coming years and thus pay them their full bid ROI. Receiving partial payment would reduce risk, and extend the time until they reach their interest cap.  The 9th investor (22%) would most likely take payment because of uncertainty in having the option to decide again.  The advantage of this mechanism for the borrowing copper mine is that the process allows it to pay off 20%+ interest debt instead of 6% debt, and so would typically save it interest expenses.

Under natural finance, investors know precisely their position in queue priority and know the amounts and interest rates of all other loans.  Together with straightforward information on past, current, and possibly expected future operational surpluses on the project, the investors can have a clear projection on an expected repayment date, and so able to make informed decisions as to how to act on repayment opportunities.  Unlike traditional investing shareholders, natural finance investors are not at the mercy of management's decision to finance new projects, give themselves bonuses or options, or fancy new offices.  Under natural finance all of those management decisions require new financing which will be placed at a priority payment position that is at the end of the existing investor queue.  In the case of our copper mine example, if annual operational surpluses were below $2M (or expected to be), then it would result in the 16% or 14% investor choosing to be repaid.

The 2nd option available to natural finance queued investors with an offer to be repaid, is to reinvest any part of their repayment back into the queue at an interest rate slightly lower than the copper mine's average/natural interest rate.  In the example, the average interest rate among all investors is 15%.  This is called the firm's natural rate, and represents its total interest costs on the full loan queue value.  In the first couple of years of production where the company is returning $2m per year to investors, the attractiveness of investing will have been established.  Reinvesting repayment proceeds at 14.9% would have a full ROI expected repayment date in 6 years if operations continue at experienced pace.  If the 5 investors at the head of the queue (6%-14%) prefer to obtain an expected return of 14.9% over 6 years (maybe shorter) instead of their more secure position at the head of the queue, then those 5 investors would move to the end of the queue in payment priority, and the 16% investor would now be at the head of the queue.  All investors would now expect to be paid their full bid ROI.  When the firm offers a $2M repayment to the investor at the head of the queue, if that investor refuses payment on a portion of his investment, and chooses to reinvest the remaining portion at the natural rate offer, then a $2M repayment offer remains available to the next investor in line.  If all 5 of the first investors (6-14%) choose reinvestment, it is likely that all other investors would prefer to refuse payment over cashing out or reinvesting.  Although, the 24% investor (originally last in queue) would likely also prefer to keep his interest earning investment, and normally has the option to do so, the copper mine has the right to choose which investor to repay when several choose refusal of payment.  As a result, the copper mine will choose to repay the highest interest 24% investor even if he would prefer not to be repaid.  It also has a bit left over to repay the 22% investor.

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
The repayment opportunities for lower priority investors are:

  • If higher queue priority investors refuse any repayment opportunity
  • If higher queue priority investors reinvest some of their repayments into the queue.
For the borrowing company, natural finance has a clear advantage over traditional debt in that repayments are made only when there is incoming cashflow.  And, clear advantages over shareholder financing, in that 100% control and ownership is maintained by insiders/management, and investors are repaid a capped amount calculated by an interest formula over the time of repayment.

Part 3b - A failing company
Let's consider what happens under natural finance when a company is failing.  Lets say our copper mine has an expected 3 years of life remaining (after which all the accessible copper is expected to be gone), and that each of these years it will generate $1M in surpluses available to repay investors, but there is $10M in outstanding natural finance queued loans.  For simplicity, let's say the queue is made up of 10 investors each owed $1M.

In this scenario, the owners will never be able to profit from the copper mine.  Their only interest in continuing to manage the company would be earning wages and salaries.  The sustainability provisions of the comptrollership function would ensure that before this point is reached, management salaries would be reduced to below market rates, and so in a failing company, the owner management is likely to just walk away, and they don't even have an incentive to lie about the health of the company.

The company still has full value for the first 3 investors ($3M combined due loans), and has no expected value for the remaining 7 investors.  The natural finance bankruptcy process is simply a formalization of owners walking away from the project.  Debt is never discharged, but some of the debt holders become naturally interested parties in keeping the company a going concern.  These investors can convince management to walk away through some kind of payment/incentive.

If the 3rd investor assumed 100% control of the company, there would be no inconvenience borne by the first 2 investors since they will need to be repaid before the 3rd investor can repay himself.  The only hard rule in deciding which investors split control over the company, in a natural finance bankruptcy, is that any investor that is fully repaid, drops all of his further control without additional compensation.

Part 3c - A failing company that can benefit from additional investment
In the last scenario, $3M in available surpluses will be repaid to investors over 3 years.  These projections are based on no new investments, but cover wages, energy costs, and rents.  If $500K in new investments (covering machine maintenance, digging out adjacent areas of the mine, reprocessing tailings/left over rubble) were to generate an expected $2M in additional surpluses, then that investment is economical and worth it for someone.

The issue is that the first investor is uninterested in spending even a penny in unnecessary expenses.  While the 4th and 5th investors would have their respective $1M loans be worthless if the investment is not made, and worth their full $1M if the investment is as successful as expected.  The obvious answer for where the $500k in new investment capital will come from is the 4th and 5th investors.  If these investors don't feel like putting up additional money, or don't believe in the new investment, they can sell their "worthless" $1M claims to anyone in a market-based transaction ($about $10k-$100k, likely), to someone that does believe in the investment.  Any additional investment, in a natural finance bankruptcy, is in the form of a loan with priority at the end of the queue, just as in a non bankruptcy situation.  The difference being that no one expects it to ever be repaid, and the motivation for the investment is the opportunity to repay higher priority loans owned by the same investor(s).

The next issue is how should the 4th and 5th investor split the investment.  The 4th investor would prefer paying the full $500k amount over the investment not being made at all (because he would make $500k instead of $0).  He'd also prefer that the 5th investor pay for some of it as well.  The 4th investor will receive a maximum of $1M, and any new investment he makes will almost certainly be lost.  Any amount that the 5th investor puts up as new investment will help the 4th investor's total return.

The recommended process, in natural finance bankruptcies, is that control of the company is entirely proportional to dollars of new investment made.  The investor putting up additional investment also decides what those funds will be used for.  If only the 4th and 5th investors put up investment capital then only they will have any decision input on the company.  The 5th investor will only be paid if the company makes an additional (to $3M) $1M to $2M in operating surpluses.  The 5th investor may prefer (to 4th investor's delight) to put up $251k ( 51%) of the new investment, in order to steward the company to make its full $5M.  Part of the negotiation can also involve the 4th and 5th investors offering to buy out or swap parts of each others loan holdings. After the 5th investor is fully repaid, control and ownership would pass to the 6th investor, and would be abandoned at his discretion if the company is worthless at that time.  

The other issue with allocating control of the company, is that the future may be predictable but it is never certain.  If copper prices were to fall, such that the original expected $3M turned into $2M, the 3rd investor would want the copany to stop producing temporarily, while the first 2 investors would prefer it keep going.  Such decisions would be given to whoever puts up additional investment.  Since the 2nd investor is only inconvenienced by a delay in being repaid if operations are suspended, he's unlikely to outbid the 3rd investor on new investment, since the 3rd investor risks losing everything if the copper is sold at too low prices.

Natural financed companies not only have an advantage of avoiding bankruptcy longer through owner "hope", once the bankruptcy process starts, there is a sensible process that keeps the company operating as normal through the bankruptcy, and even allows new investment to occur.  Under traditional finance' bankruptcies, new investment is impossible until all debt is "cleansed"/signed off, and even continued operations are likely to be terminated prematurely due to having to negotiate with creditors as a group.  Traditional finance bankruptcy is also expensive for all parties involved, and potential creditor dilutions are complex matters that can fool even sophisticated investors.

Wednesday, May 9, 2012

Linked in valuation part 2

This is a folowup to my recent valuation anaylsis for linkedin 

Chris Moreno from seekinalpha has since provided a much more detailed valuation for linkedin with the same overall conclusion.

The only thing I would add is that the assumed out year margins he used are higher than the company's reported internal targets of 30% (which would put downward pressure on his valuation if adjusted), while his discount rate may be a bit high (which would put upward pressure on his valuation if adjusted).

Tuesday, May 8, 2012

Natural Finance's comparative advantage - Part 1 and 2

This post is going to consolidate the competitive arguments for natural finance vs. traditional finance.  The key features of natural finance are the use of open (repayable at any time) loans without fixed repayment terms.  All loans have payment priority for interest and principle in queued order of when they are placed.  A 3rd party comptroller controls all cash in the organization and ensures that investors are repaid when the organization is able to, and directs better loan bid proceeds to repay existing loans.  The comptroller can in fact ensure all organizational obligations, and thus provide significantly enhanced trust in the organization's commitments, thus enabling the organization creative flexibility in financing and partnerships.

I feel that natural finance has competitive advantages for borrowers and investors in all business situations.  I will highlight a wide range of specific business situations, but in general:

Advantages for borrowers,

  • Cashflow from investment similar to equity investments in that repayments are only made when revenue/income permits.
  • Control of the organization and incentives for profitability and success are retained by borrower/founders.
  • Open loans, and queued priorities, make it simple for a successful business to reduce its borrowing costs by inviting lower interest loans, ultimately achieving a perfect competition market from lenders by facilitating loans from the most willing bidders.
  • Permits continued expansion project financing without causing existing investor objections.
Advantage for lenders,
  • Being more attractive to borrowers means that buyers are more likely to accept higher loan rates.
  • Many risks and types of fraud or lapsed insurance can be eliminated.
  • Loan payment priority can never be supplanted or diluted.  It is impossible for traditional finance debt covenants to fully anticipate or satisfy objections to future dilution.
  • Risk profile of investment is much more clearly assessed at time of loan.  Much fewer things can go wrong.  For instance, generous management salaries, bonuses and perks cannot be implemented at greater risk to lenders.
Scenario 1:  Income Properties. - High upfront costs. Stable revenues.
Income properties such as apartment buildings are the simplest kind of business.  There is a high upfront cost with typically stable revenue and expenses.  Similar businesses include farming and energy production.

Consider a property that will cost $1M to acquire, and generate $100K in expected annual profits after deducting a $20K reserve for future maintenance, an allowance for empty units, and a market value of property management fees of $15k.

Through traditional finance, the buyer not having a downpayment might be able to obtain an interest only first mortgage of 500k@5%, and a 2nd mortgage (means 2nd priority) of 500k@15%.  Alternatively, the borrower might be able to obtain traditional 25 year amortized 1st and 2nd mortgages at 4% and 12% respectively.  Both options result in $100k annual payments.  We'll use the 5%/15% interest only figure.  The reason that the 2nd mortgage interest is so high, is that there is substantial risk in providing a 2nd mortgage to a borrower who has no risk in the  property.  Foreclosure or bankruptcy proceedings are expensive, and the 2nd mortgage holder essentially bears the entire costs of that process.  Because there is no risk for the borrower, he is likely willing to accept the high 15% loan offer, and an apparently no expected return from operating the income property (the $100k pre-interest profit is entirely paid to the lenders) .  The borrower gains if the property goes up in price.  The borrower has a 2nd opportunity to gain at considerable expense to the lenders.  He can pay himself the extra 20k per year earmarked for major maintenance reserves as extra annual salary.  He might also cut back on insurance or routine maintenance, maximizing his short term annual "management" proceeds while harming the long term viability of the property and its value to creditors.

So to itemize the risks to borrowers: 
  1.  Market value of property might fall.  
  2.  Economic and uninsurable events might cause the attractiveness of renting to fall, or harm the property value.  
  3. Management incompetence
  4. Active management corruption of cash flow harming the long term viability of property to lenders
The last 2 risks are reduced over time of the project.  If management doesn't show incompetence or corruption after the first year, its less likely that it will later compared to the undeterminable probability at the start of the project.  The Natural Finance comptrollership function further actively prevents foreseeable management corruption.  The first 2 risks (or the entire risk of foreclosure) can be aggregated into a single number by weighing the cost and probabilities of all negative foreseeable events.  If 5% is considered a risk free rate, then a 15% rate on a $500k second mortgage implies a "breakeven" (5%/yr return) if there is a foreclosure in 2 years (excluding compounding), and the foreclosure costs the lender $100k.  A longer time to foreclosure implies a net profit for the lender, or allows for higher possible foreclosure costs.  So a 15% mortgage rate implies either extreme pessimism on the part of the lender or usurious predatory lending on the foolish or desperate.

Scenario 1a - Under Natural Finance, the first mortgage can either remain, or be replaced by a secured queue of loan(s).  The 2nd mortgage is replaced with unsecured queued soft loans.  For simplicity, lets say that the entire 500k is lent at a uniform 15%.  The first advantage to the borrower is that natural finance uses simple interest instead of compound interest.  So after the first year, a little over 65k (75/1.15) of principal is repaid, and that means that 9.8k less interest accrues the following year (and increasingly less the following years), and so there is an eventual paydown of the total debt burden unlike the above traditional mortgage example.  The next advantage for the borrower is that paying down the debt burden, and demonstrating earnest management of the property, increases the attractiveness of lending to him, and so invites new lenders to replace existing ones at lower interest cost to the borrower.

Another advantage of natural finance is in dealing with the major maintenance project reserve.  Natural finance  provides a future project financing bidding and commitment process, and as major future project (roof, furnace, repaving) commitments are financed, then offsetting reserves for those projects can be released to repay lenders.  Even if the financing commitments for future projects are at an initially considerably higher rate than the company's natural (average) interest rate, the faster debt paydown will lead to a lower natural rate and lower total interest costs, and the better company attractiveness is likely to invite lower bids for the future project itself.

The major insurmountable negative of a traditional finance mortgage/bond that takes all of a businesses projected surplus in order to pay loan interest is that it virtually assures eventual insolvency.  The slightest extraordinary event (roof or furnace emergency repair, problem tenant, unusually high heat/cooling costs, etc...) will cause the company to be unable to make a loan payment.  Flexibility for one time events is a key natural finance advantage.  A borrower can be willing to accept "unreasonably" high initial interest rates rationally only if the eventual extraordinary costs that will occur are payable ahead of loan obligations.

A final advantage of natural finance is that the borrower may agree to a lower than market value for management salary in the first year, that increases by formula as the debt and interest burden is reduced, in order to get an even better financing rate.  It is always a red flag to lenders when the borrower has no capital tied up into the venture, and so the lower management fees ensure his vested interest and commitment level to the enterprise or ensures that he abandons it quickly to lenders to cut losses quickly for everyone involved.

Scenario 1b - Instead of an even 15% initial interest rate on the entire 500k natural finance loan queue (2nd mortgage equivalent),  Natural Finance allows for an unlimited sequence of loans.  This is roughly equivalent to having a 20th or 100th mortgage in traditional fiance with each previous numbered mortgage having payment priority of the next.  The major difference is that under Natural Finance there is no need for regulatory registration of each loan, as the loans are tracked by the comptroller.

Under natural finance, the value of being secured up to 500-525k of property value is substantially less risky than being secured from 975k-1M of the property's value.  Therefore being at the head of the 500k (after first mortgage) natural finance loan queue is worth earning very close to the first mortgage's 5% interest.  The risk in foreclosure is about the same.

However, those at the head of the natural finance queue are in an actually more secure position than the first mortgage holders.  Recall that an expected 75K is expected to be repaid in the first year towards the natural finance queue.  That means that the approximately first $71K in queue (@5%) are expected to be repaid in full during the first year, and so the lender's investment is expected to be short term, which normally expects a significantly lower rate, not including the significantly lower uncertainty as the result of low time exposure.

In addition, lenders at the head of the queue receive 2 options when they are about to be repaid.  They may 1. reinvest at a rate fractionally lower than the enterprise's (current average) natural rate, moving to the end of the queue, and using their funds to pay the next queue member; or more importantly, 2. elect to keep their position in queue (and interest rate), in which case the loan that will be repaid is either the first lender who does not make this election, or the highest interest loan from a preceding queue member who attempted the election.  Therefore, a lender at the head of the queue can essentially roll over a short term loan for an extended length of time.  This benefit and opportunity is cascaded down towards other loans relatively near the front of the queue, who will likely receive regular opportunities to cash out.

For the sake of this scenario, lets assume that the first 150k of the 500k in natural finance loans averages 5% interest (ranging 2%-6%), and the last 150k averages 25%.  Ignoring how high the last queue tranche interest is, note that the middle 200K must also average 15% in order to maintain an overall 15% interest rate.  Since, this middle interest profile is likely exponential-shaped rather than straight-lined between 6% and 24%, then it is more likely to average less than 15%.  This scenario, and paragraph, is hypothesizing that compared to a single-lender-flat-15% loan queue, that with multiple loans, the benefits of being near the head of the queue outweigh the costs of being towards the end.

Recall that to make a lowest-priority loan of 500k at 15%, in the event of a foreclosure costing $100k to the investor 2 years later, the investor still makes 5% total annual return (more with compounding.  about 10.25% total) on his investment, and this return is heightened the longer foreclosure can be delayed.  When making a last-priority $100k loan at 25%, if it takes 2 years before distress occurs, then close to 130K in principal would have been repaid by then, and so generate close to 30% total return for that investor in the 2 years, even after the foreclosure/liquidation.  A 150k loan at 25% would lose money (20k total), however, if distress occurred as early as 2 years away, but would make money if distress was postponed longer.

There are 2 strategies available to an investor who wants to compare carefully to a 2 year distress scenario.  First, he can invest very little.  In the above scenario, 15k invested at 50% interest rate would yield a full 100% total return after liquidation in 2 years.  Investing little makes sense if you require 25% or more as a lender since you are either predatory and usurious, or begging the borrower not to accept your offer.  The second strategy possible, is to simply request a lower rate so that you are closer to the middle of the queue than the end of it.  If foreclosure costs are indeed 100K, if it occurs, then you are likely to make your full returns if bidding 15% or 20% for your loan if you are not in the last 100k in loan priorities regardless of when distress/liquidation comes.  This is of significant benefit to the borrower since it pressures lenders to outbid each other to avoid being in an undesirable loan-priority position.

The point of this section has been to show that with a series of queued loans, as compared to original 1a scenario of a flat interest queue, the enterprise can afford an exceptionally steep yield-slope-difference between the head and tail of the queue.  Yet, there are reasons to expect that the back end of the queue will not result in super high yields, and therefore a series of queued loans creates value for the borrower by lowering total average interest costs.  The next scenario will show how to lower the yield slope even more.  This is important because a steep yield slope implies a large difference between the enterprise's natural rate that new investors can enter the queue at, and the perceived market value yield of being at the end of the queue (which is where new investors come in).  If the yield curve is too steep, then existing borrowers are deprived of the opportunity to be bought out by new investors.

One important point regarding exceptionally high yield requirements for lenders at the end of the queue, is that it underlines the importance of the borrower putting in some capital (these scenarios have assumed no financial risk from the borrower).  If the last queue priority loans require 25%+ interest rate, then from the borrower's perspective, he could consider even credit card loans (19%) in order to put in capital (even if that capital is in the form of an end of queue loan rather than traditional equity).  Doing so eliminates the most expensive part of the loan queue, and because the borrower is demonstrating a capital commitment to the project, reassures lenders, and is likely to significantly reduce overall interest costs as a result.

Scenario 1c - Flattening the natural finance (unsecured) soft loan queue yield further is accomplished by making the loan queue smaller.  To accomplish this, the project is financed with a $500k first mortgage (as before) @5%, a $250k secured queue loan (about equivalent to a 2nd mortgage) @ an average 7% interest, and the remaining 250k can be financed with an unsecured loan queue at up to 23% average interest to keep the project viable 15% total average interest cost (excluding 1st mortgage @ 5%).  The terms secured and unsecured have slightly different meanings in natural finance compared to traditional finance.  Both loan queues are secured against liquidation, and unsecured queue loans are guaranteed to never lose their priority position (be diluted).  The entire secured loan queue has priority over the unsecured queue loans in the event of liquidation of the asset (the property in our scenario) it is secured against, and the entire secured loan queue is paid interest (and depreciation costs if applicable) each month.  The unsecured queue is paid any surplus revenue after first mortgage, secured queue interest, and basic expenses, and so the unsecured queue's principal will be paid off first as a result of normal operations

In this scenario, instead of calculating risk to borrowers in terms of time to foreclosure, lets look at the project going bad in such terms that after the first year, proceeds available to repay lenders drops from 100k to 60k (or even less) per year.  The unfolding speculative tagline for this scenario is that the lender can accept the first year's projections, but in subsequent years, bad economy, bad tenants and/or chronic structural problems could arise.  Each year, the first mortgage holders are owed $25k (500k@5%), and the secured loan queue is owed $17.5k (250k@7%).  So 57.5k is available to pay down the unsecured queue the first year, and 17.5k is projected (in this bad project scenario) to be available to pay down the unsecured queue each subsequent year.

Natural finance uses Capped-total-interest loans instead of traditional unlimited interest loans.  Typically with a 100% total interest cap.  This means that regardless of a lender's promised nominal interest rate, the actual amount owned to him is the lower of his actual nominal accrued interest or 100% (+ his principal).  The core philosophy behind this is to prevent runaway ballooning debt, but also ( to some lender-oriented reluctance) the concept that a 100% total return on an investment (regardless of investment period) should be acceptable to every investor, but especially in the case of investments that do more poorly than expected.  The extremely significant advantage to lenders of capped total interest loans, is that every other lender (ahead of you in queue) also has a capped total interest loan.  This means that the investor is able to project a clear bad-case scenario at the time of his loan.  If a lender is to join the queue at the $200k position ($200k in loan dollars have higher queue priority than the last $ of his loan), then in the "worst case" scenario that lender will make a total 100% return (or the actual nominal promised yield) if the project generates at least $400k in total cashflow in its lifetime.

In our scenario, lets look at the investment profile for the first and last investors in the unsecured queue.  First year cashflow available to repay lenders is 57.5k.  Just as in the last scenario, those near the head of the queue have exceptionally attractive short term investments with an option to renew on a monthly basis at their locked in rate.  For those at the head of the queue, the only practical risk to their capital is an uninsurable calamity/war that prevents future rent income.  So if the first $55.3k of the loan queue average 4% interest rate, and they all chose to be repaid (57.5/1.04= 55.3) out of fear for future operations, then the remaining loan principal remaining to be repaid after the first year is 194.7k (250 - 55.3).  With the projected 17.5k available to repay investors in future years, then even if the remaining 194.7k in loan principal was made at more than 9% (17.5/194.7), then the very last priority loan is "guaranteed" to be repaid with 100% total interest in 22.37 years (389.4 / 17.5).  This would result in an actual (non-compounded) annual return to the last priority initial investor of 4.5%, which is not bad considering the project went sour.  Note that the investor could have made closer to 9%/yr (and would have been paid much sooner) if he had bid 9% to place himself towards the middle of the queue instead of being in last place with, say, a 30% bid.

From the borrower's perspective, in traditional finance, with a hard 100k/yr in repayment obligations, he would abandon the property once the annual income fell to 60k from 100k.  Even if the market value of the property drops from 1M to 600k as a result of the lower rental income, under natural finance, the borrower has no reason to abandon the property.  He put none of his money down, and in 22.37 years he will get to pocket 17.5k per year from the property if he chooses not to pay down the secured loan queue.  Any surplus amount available to pay back lenders is a basis to continue operating the business.  There can also be hope by the borrower that rental surplus returns to 100k/yr resulting in him pocketing 57.5k per year after the unsecured queue is paid off.  With traditional finance, a fall in market value of the property of 400k (1M - 600k) would cause 100% loss for 3rd mortgage holders, and greater than 50% loss for 2nd mortgage holders, while under natural finance, the same scenario causes the most disappointed lender to make 4.5% per year.

A very real risk in our current economy is that commercial real estate will crash much like the US residential housing crash of 2008.  A huge advantage of natural finance for the structural economy, as well as individual lenders, is the avoidance of massive mall closings and related job losses together with an other round of politically-connected big lender bailouts.  Natural finance includes a built in adjustment of interest cost for projects that dissapoint which greatly enhances the survivability of the project, and so protects the investors in that project, as well as anyone who depends on the project for income.

To get back to the interest yield slope of the queue, and the relative unattractiveness of being near last in the queue; if the new expected annual repayment surplus drops from 57.5k to 17.5k, and there is some confidence that it will not drop further, then a fair and attractive yield to an investor considering to buy the entire queue may be 8-9%.  If the enterprise's current natural rate is 15%, then it is attractive for one large investor to buy the entire queue at a fraction below 15%, and attractive for a 2nd large investor to buy it back a fraction below that until the natural rate falls to 9% or less.  For smaller investors, just as there is stock speculation that large investors will take over corporations, they can join the queue in anticipation that others will also eventually join the queue.  Essentially, though new investors join at the end of the queue, every investor's queue position can only ever improve, and so being end-of-queue is only temporary.  The advantage of being near the end of the queue, whenever a project is successful, is that with a relatively attractive interest rate, you will earn that interest for a longer period than those near the head of the queue.

So, even if the relative attractiveness of being at the end of the queue is lower than the enterprise's natural (average) interest rate, the decision to buy into the end of the queue can be based on the belief that the prospects for the project (while considering owning the entire queue) are more attractive than currently reflected in its natural rate (its fair natural rate should be lower), together with faith that other investors will come to your same conclusion and so move you ahead in the queue.

Scenario 1d - As a followup to the previous scenario, consider what if the available surplus to repay lenders drops to below 42.5k/year (from original 100K in first scenarios, and 60k in last scenario).  There is a promise to pay secured lending queue's interest in full each month, but the funds are not available.  The solution is that natural finance permits the enterprise to "print money".  If the enterprise is unable to arrange alternative financing, in lieu of its interest obligation, it will pay secured loan holders with an unsecured loan at 25% or 30% interest for any portion of the cash interest payment it is missing, by adding those obligations to the natural finance unsecured queue.

This situation skirts distress conditions for the enterprise.  If the poor circumstances don't appear to be temporary, and if the unsecured loan queue is very long (such that the new loans given to secured queue members seem relatively worthless), then the first step may be the comptroller's imposition of additional austerity measures in the enterprise, followed by, if the austerity measures are insufficient, demand by secured queue holders for liquidation.

summary of Natural Finance competitive advantages for income properties
Without getting too heavily involved in natural finance distress solutions, we'll note the significant advantage of natural finance in having significantly lower distress conditions (42.5k as the distressed income level compared to 100k under traditional finance) for the same project, and the flexibility to issue new securities/loans to avoid distress conditions or lower the distressed income level even further, all without compromising existing investor's claims to the enterprises income or assets.

The previous sections showed that a successful property venture will result in lower financing costs for a venture that is on-target or successful with natural finance compared to traditional loans.  Although any project is more viable if there is cash equity invested (a down payment), natural finance can make no-money-down projects viable because investors can choose their own queue position, and those at the head of the queue have the same financial protections as if all of the funds behind them in queue order were a cash down payment.  Those at the end of the queue in a no-money-down income property investment can ask for deservedly high interest rates to compensate them for the risk.

Income property ventures will have lower financing costs under natural finance.  Interest rates are lower for those investors scheduled to be repaid early, and interest rates go lower as the project goes on and it proves its income track record.

Scenario 2:  Restaurants and other companies with high monthly fixed obligations
This class of scenarios will look at restaurants, airlines and union/pension obligations.  The similarity between these businesses is that they all have relatively high fixed recurring expenses in addition to any upfront startup costs/loans.

Scenario 2a - Starting a new restaurant.
New restaurants have a high failure rate, and so are difficult to fund through traditional finance and external investors.  New restaurants have startup costs (design, kitchen supplies, renovations), and monthly fixed costs (rent, staff, loan interest for startup costs).  Survival of a new restaurant is critically dependent upon meeting those fixed cost obligations, and creatively attempting to defray cash outflows until there are sufficient revenue/inflows.  While it is the restaurant owners' interest to obtain as many creative cashflow enhancing investment terms as possible, it is a difficult proposition for potential stakeholders because collecting can meet with hassles and stonewalling, there is no accounting certainty in the business, and they won't know how many other promises are made or will be made that could have similar priority to them.

Natural Finance's core benefit is permitting the trust and verification system (through comptrollership) that allows an entrepreneur to offer and obtain creative financing terms through soft loans that are paid as cashflow allows.  Its possible to negotiate part of your rent to be a queued loan, part of kitchen supplies acquisition, part of design/architecture fees also.  The latter arrangement is possibly the easiest to negotiate as design fees are high margin, and offer an implied promise that they will enhance restaurant profitability.  A transferable liquor license holder might want $100k cash, but is likely willing to accept a $110k loan at 6% or 7%, if he retains the security of the natural finance comptrollership function that proceeds from liquidation or resale would flow to the liquor license seller if his loan is not bought out or repaid.  Financing startup costs through natural finance loans has double edged features:  On the one hand, initial loans are the less risky because they are the first to be repaid.  On the other, they are the most uncertain because there is no revenue data to provide an estimate of the restaurant's future success.  With that in mind, when negotiating a portion of rent to take the form of natural finance deferred loans, it is to the landlord's advantage to have a portion of the entire first year's lease to be deferred, rather than deferring a portion each month, because such an arrangement keeps his loan near the front of the queue.

Another tool available to the founder in enhancing the survivability of his restaurant venture is to defer wages and salaries including his own.  This likely means offering higher overall wages/salary benefits, but lower monthly fixed costs that need to be recovered before lenders are repaid.  Natural finance allows a management discretionary loan queue that is behind in priority to the investment queues, but management can freely use it as a currency most commonly for, but not limited to, deferred salaries and wages.  This deferred compensation queue must be repaid before the restaurant owners can take dividends.  Participation in the deferred salary queue aligns interests and motivation of the participants with the long term health of the enterprise, not only more so than employee stock options, but it is a compensation alternative available to private (non-publicly-traded) companies.

A feature of naturally financed enterprises is that the cause for "death" of a company is much more likely to be abandonment of the enterprise by the owners, and no prospective owners willing to take his role, rather than litigation initiated by creditors due to harsh loan terms not being met.  This is an obvious big advantage for anyone with vested interest in the long term survivability of the enterprise, but also a big advantage to creditors as it avoids the cost of litigation, and the longer management is willing to work towards generating some surplus for creditors, the more they will be repaid.  This also justifies management witholding a certain percentage of surpluses in order to pay the deferred loan queue so that a company with a high debt load but improving prospects has the means to keep management and employees motivated towards paying that debt, and a company with a low debt level can keep investors happy by not paying them back too quickly.  The percentage allowable to be withheld is based on the size of the surplus relative to the total debt level.

A rule of thumb for our restaurant-type enterprise is that $50k per year in investor repayable surpluses would allow for a 500k loan balance to yield as little as 10%.  That is, there should exist some investor willing to bid down the restaurant's natural interest rate to 10% if the outstanding unsecured loan queue balance was $500k or less.  While the percentage withholdable for management and employees is primarily based on the surplus to debt ratio, it still varies for each natural finance business.  Other important factors include how important and difficult the sales function is and how much sacrifice of riskless/fixed salaries management and employees are making.  Some guideline amounts for a restaurant at a 10% surplus to debt ratio, is 18%-20% of surplus. At a 20% surplus/debt ratio, 40% withholding is appropriate.  At 5% surplus/debt, 10% withholding is appropriate.  A general formula of 1.8x-2x (times) the rate of annualized surplus to debt ratio can be withheld for purposes of management/employee short term motivational bonuses, and it makes sense for a portion (half) of that to be used to avoid the current period's deferred compensation while the other portion (half) pays off past deferred compensation.  The purpose of this management privilege and formula is to balance short term incentives of bonuses with the long term incentives of deferred salaries, and balance employee and management retention when an enterprise is struggling with paying back investors too quickly when the enterprise is booming.

A 3rd tool available to control fixed obligation costs is to replace a portion of owner's salary with (deposit) options which are speculative bets made between existing owner(s) and prospective owners.  It is hoped that the restaurant eventually achieves either inherent resale value or a consistent profit stream to owners, and so has an estimated future value of ownership.  The reason these options can replace salary, rather than supplement it, is that they can be atttractive for key investors or key employees (cook, maitre D), and so can increase owner's "salary" (income from the restaurant) while the restaurant is "on track", but because these options involve continuous payments, the options are likely cancelled if the restaurant struggles more than expected.  In the case of a key employee such as a cook, it gives the cook the option to adjust his net income from the restaurant (by keeping or abandoning the option) based either on short term or long term considerations.

Traditional finance possibilities might allow an entrepreneur to start a restaurant with 500k in startup costs if there is a reasonable likelihood of generating $100k/year in surpluses without hiring a restaurant manager or $50k/yr with a restaurant manager.  Realistically, the entrepreneur would be very lucky to find $250k of external financing with loans as low as 10% under traditional finance, and more than likely would need to put up almost the entire 500k in capital.  Natural finance not only allows for additional financing of startup costs, but the reduction in fixed costs directly results in an increase in available surpluses available to repay lenders.  So if the owner is willing to manage the restaurant for 20k instead of 50k, and able to cut fixed staff salaries from 250k to 200k, then the annual projected surplus grows from 50k to 130k, and either substantially increasing lending capacity (to 1.3M) or substantially decreasing interest costs if external loans stay around 500k, or reduces the breakeven cashflow contribution required for the restaurant by $80K.  Furthermore, if the restaurant owner is successful in negotiating a fixed-rent reduction of $5K/yr in exchange for say $7K/yr in soft loans, it's a substantial enhancement to the sustainability of the business since 5K additional surplus increases borrowing capacity by 50K, while only 7K of that is used.

If natural finance becomes sufficiently publicized and understood especially among investors, and natural finance opportunities are easily discoverable, then its not critically important to the business what the initial loan rates are, because if the restaurant is successful, market competition among investors will bring the loan rates down, and if it is not successful then it would likely fail at any interest rate.  The next paragraph will detail situations where there is "almost success", but I also want to mention here, that wider public knowledge of natural finance not only allows traditional partners/suppliers and employees to participate in lending/investing in the business but also new opportunites in restaurant services such as groupon-like promotions, or internet reservation systems which tend to include proud promises of profitability, and even direct diner partnerships by including discounts for lenders and/or the opportunity to cancel (repay) loans through a portion of their guest bill.

Expected Return On Assets (ROA) or Return on Investment (ROI) determines whether an asset or investment is acquired, and 10% is often a good enough cutoff rate.  Under traditional finance, if you finance all of an asset (have loan amount equal to asset cost) at 10%, then you are giving the lender the first 10% in returns on the asset, while also giving the lender the right to take away the asset if at any point it fails to generate 10% returns.  Under traditional finance, you are only willing to acquire that asset if you are fairly sure that it will return more than 10%/year, because otherwise it would be a waste of your time.  After a project proves that it can earn 8-10%/year, under natural finance, it should cost under 8% in investor interest costs because it becomes a safe investment after it proves itself.

Scenario 2b - Opening a 2nd restaurant.
In both traditional and natural finance, opening a 2nd restaurant location after establishing the success of the first is much easier to finance than the original project.  Menu and operations have been fine tuned, and more importantly, there are 2 income streams available to repay new financing costs.  There are 2 basic natural finance structure options for opening a 2nd store,

  1. Split each restaurant into their own operating companies with distinct loan queues, or 
  2. Keep a single company and loan queue that operates both restaurants
Neither structure creates any hardship for existing/past investors because any startup costs will be raised through a new funding round, which has no effect on previous investors payment priority.  In fact, if the new restaurant creates positive cashflow, it will benefit past investors by repaying them quicker.  Overall, from the company's owners and total sustainability perspective, the best financing terms are available if they borrow from a monolithic company with a single queue, since there are 2 income/cashflow streams available to contribute to repaying the loans, even if the new financing round has its initial repayments delayed.

The primary reason for choosing separate restaurants with separate loan queues and income streams is to reward employees and partners of each restaurant based on that restaurant's performance.  There's also an issue of deferred employee compensation in the first restaurant being involuntarily put at risk by expansion if the new restaurant turns out to be a financial disaster.

But, the separate restaurant funding route provides more investor flexibility, and can achieve the same or lower total interest costs as the monolithic option, mainly because the first restaurant can borrow a new financing round for the purpose of lending to the second restaurant.  Lets say the monolithic company could borrow the $300K in startup funds at an average of 7% interest.  The first restaurant could instead offer to borrow $200K at 6% and lend it to the second at 8%.  The second restaurant could raise another $50k at 4% (likely to be repaid in first couple of years.  Lower interest result of the process described in 1b, above) and another $50K at 9% (to be repaid after $200K at 8%).  While the total interest costs from the perspective of the 2nd restaurant is 7.5% ((8*2 + 2 +4.5) /3) as a result, from the perspective of the owners of both restaurants, it is 6.13% ((6*2 + 2 +4.5) /3), and so actually better for them than the monolithic 7% interest cost.  From investors perspective, they now have 3 main options instead of the 7% monolithic company loan proposal.  They can take 4% if they are mostly focused on being repaid quickly, or always maintaining the safest queue position.  They can take 6% with the protection that they will be repaid even if the second restaurant fails, and $100K of that failure will be borne by someone else.  Or they can take the 9% option if they are very comfortable with the prospects for the 2nd restaurant.  Employees (deferred compensation queue) and owners of the first restaurant also benefit through the 2% profit spread between what they borrow and lend at.  That profit is justified by the brand awareness and service quality the first restaurant contributed to pave the way for the 2nd restaurant's creation and success.

Scenario 2c - Operating an Airline.
Airlines are a very similar business to restaurants but on an extremely large scale.  Very high fixed costs (planes, airport access), with large salaried skilled and unskilled work force.  Airlines also face much more competition than restaurants in that there is very little diversification among competitors, and no real lasting incumbent location advantage.  They are also even more vulnerable than restaurants to business cycles mostly because of high fixed costs, but also because flying customers fluctuate even more than restaurant diners in boom vs bust times.

Though large airplane manufacturers can offer traditional financing, as shown in sections above, natural finance provides cheaper and more flexible financing alternative.  Boeing or Airbus could provide almost all of the initial startup costs for an airline, and in addition to doing so primarily in order to sell their own airplanes, the open nature of natural finance loans means that they are likely to be bought out, and therefore repaid with interest, quickly, and so able to focus on building more planes.  Natural finance would be a decisive competitive advantage in an industry where competitive advantages are very limited.

The boom and bust economic cycle is also a significant advantage for natural finance borrowers.  In economic booms, and good times for the company, its natural interest rate will be bid down, or additional expansion opportunities will be financed, from exuberant investors.  These actions effectively lock in low interest costs to the company for future struggling economic periods.  Just as sub-prime housing loans are effectively self-defeating, where 8%-15% interest costs lead to defaults when the same lenders would continue to pay if rates stayed at 3 or 4%, a natural fianced airline not only doesn't face risk in poor economic times due to not having to repay loans if there is no surplus, but would maintain good operational performance and motivation in a low interest cost environment compared to a high accumulating interest cost.

Scenario 2d - Airline unions and bankruptcy reorganization.
AMR (parent of American Airlines) had 80k employees in 2011, was worth $2B prior to its 2011 strategic bankruptcy (designed primarily to renegotiate union and pension contracts), and is worth under 160M today.  It was worth $10B in 2007 with essentially the same problems it had in 2011/2012.  It made $1B in gross profits in 2011.  The strategic bankruptcy point is a term that is used by AMR's CEO.  It is taking advantage of court petitions to force changes in its pension and union obligations without targeting other stakeholders. Its operations have not been affected since declaring bankruptcy.  Its creditors did not initiate the proceedings, and the fact that its stock is still worth $160M shows that its shareholders expect it to go back to normal once its employees have been strongarmed.  It speaks to the byzantine nature of traditional finance laws, and is a counter-intuitive application of bankruptcy provisions.

80K employees could, through a one time cost of $2000 each, buy AMR for $160M.  Equal ownership satisfies the only required principle for communal partnerships.  Communal partnerships have a mathematical basis for fundamental fairness.  The main benefit of an employee owned AMR would be that any labour cost restructuring benefits to the company would be simply lost from employees left pocket and gained in their right pocket.  If AMR went back to a value of $10B after reforms, then each $2000 share would be worth $125000.

AMR has a pension obligation of $16B (on 23B in total assets).  Reported as underfunded by $5B. It probably is as unsustainable as management claims.  Defined benefit pensions (where the company promises the beneficiary a fixed return on their contributions) are difficult to be sustainable because the promised returns common 20-50 years ago are difficult to achieve today.  The general problem with all pension plans is that they are susceptible to accounting tricks where even if the pension obligations are funded, they are tied into assets related to the survival of the company, and may require continued (pyramid-like) growth of the company and the number of employees in order to maintain pension solvency.

The natural finance alternative to pensions is the deferred compensation queue.  It is unfunded (in that no funds are claimed to be set aside in advance to repay) and allows management to use an unlimited currency in rewarding who it wants.  No matter how large the deferred compensation queue grows, though, it cannot affect the sustainability of the organization because the main financing queue always has higher payment priority, even if new loans are made in the main financing queue after deferred compensation obligations are added.  The deferred compensation queue can be paid down even when there remains some debt in the main finance queue, either as sales/performance incentives or when the main finance queue is sustainably small.  A recommended cap of 3x the original obligation amount on deferred compensation helps sustainability by limiting runaway exponential growth in the deferred compensation queue.  Natural financed corporations encourage an upper limit on cash compensation for executives and top talent, and so deferred compensation obligations are designed to replace compensation above that cap.

The deferred compensation queue may become unsustainable.  Management/shareholders may hand out deferred compensation obligations like candy, much like they do in traditionally structured corporations with bonuses, stock options and pension obligations.  There is no comptrollership (or main investor) restrictions on the amount of deferred compensation management can promise, because there is no cost to the sustainability of the enterprise to investors as a result of deferred compensation.  The costs of an unsustainably high deferred compensation queue is entirely borne by the company's owners and its top employees likely to receive future deferred compensation.  When the deferred compensation queue balance is unsustainably high, future offers of deferred compensation appear relatively worthless.  So there is strong motivation by owner-management to keep deferred compensation balance sustainably low.   The deferred compensation queue still has a certain paydown date (even if main natural finance queue loans can be added with higher priority) as a result of the sales/performance incentive percentages that are allocated towards paying the deferred compensation queue.  So, if a company is able to set aside $1M annually towards paying the deferred compensation queue, then $20M will be repaid including full interest over 20 years.

An option available to management and deferred queue holders to lower the balance of deferred compensation queue is to allow deferred compensation queue holders to trade those loans in exchange, for example, for discounts on products and services to holder or their family and friends (with the interest-accumulated balance value), or for shares or deposit options in the company (with the original balance or principal only value).  If the organization has a small/sustainable main natural finance queue, it could offer monthly cash redemptions of the deferred queue at a significant discount.  The redemptions can be financed like any new project, with likely motivated contributions from employees, and can also be financed by those wishing to trade-in deferred queue obligations for more secure main queue obligations.

Getting back to AMR's pension problem.  A partial traditional finance solution would be to cancel up to $16B of pension obligations and provide up to $16B worth of shares to the pension holders.  Because this transaction results in (up to) $11B extra cash and value to the company (pension is $5B underfunded), a fair price per share would be based on a company value of  $11.16B, and pension holders would own upward of 98% of the company.  While that fails to provide the full $16B in value to pension holders, the missing $5B can be provided as  natural finance deferred compensation holdings.  The $11B in generated cash can be used to pay down debt and enhance AMR's competitiveness and sustainability.  Existing shareholders would strongly disapprove of this plan (almost complete dilution), but the idea of bankruptcy should have been against their interests to begin with.

The key point about AMR is that a profitable and sustainable business should not be in bankruptcy.  Traditional finance's hard promises of loan and pension obligations create extra risk.  A poor legal framework for those obligations creates a threat to a business that can be valuable and sustainable under natural finance.  Ownership by employees or pension holders can be an alternative to AMR's bankruptcy, and a proper alternative to an enemy relationship between union employees and management.

Summary of Part  2
Natural finance permits creative partnerships among stakeholders in an enterprise, and that permits owners/management to use the future earnings and cashflow of the enterprise as a currency instead of cash.  The new stakeholder partners are assured that they will be paid (through comptrollership) if those earnings and cashflows materialize.

By reducing cash expenditures, a natural finance venture increases its borrowing capacity or decreases its interest costs.  Success in good years and paying down its debt allows it to lock in low interest rates, and obligations/promises that are based on ability to pay prevents common causes of failure such as that of AMR.

Part 3 and 4
Parts 1 and 2 focused on businesses that fund themselves mainly through loans.  Parts 3 and 4 will show how natural finance is a better alternative to equity financing for businesses, and include looking at mining operations, startups and IPOs. 

Saturday, May 5, 2012

the economic distinction between Savings and Investment

The importance of this topic is relevant to the economic multiplier effect and the waste of money's time (discussed recently).

Investment, to deviate slightly from Wikipedia, is total business spending excluding financing cashflows.  It is Expenses plus plant and equipment purchases.  It is not financial holdings.

Savings is money that is not spent or invested.  While these definitions are simple and clear.  It describes Savings as completely different and separate from Investment.  "Investing" in the shares of a company by buying them form some other shareholder is Savings.  Even trading your savings to a company (for,say, some of its shares) such that it holds them in their bank account is still savings.

Classical Economists viewed savings and investment as equivalent, under the presumption that Savings is available funds for Investment, and so Savings will eventually be invested or spent.  The predominant view was that to increase Investment, you simply had to increase Savings, and this would allow bankers to lend to businesses at lower rates and thus increase investment.

A good critique by James Kroger led to his following formula for investment: Investment = (some % of Savings not used for Consumption) + (the corporate earnings that finance 85% of Corporate Investment) + (newly created money by the Fed deposited in banks)

There are a couple of problems with this model.  First, not all money created by the Fed is invested.  Most of it, in the 21st century, is placed in financial instruments by the Fed's member/client banks.  Second, while Investment does depend on the availability of consumer and corporate savings, there is no rational investment decision process that allocates a percentage of Savings to be invested.  Rather,

Investment = Those good ideas that cost less than available savings (and available money creation capacity), which in a wealthy economy is usually simplified as all good ideas.  A good economic idea has a simplified definition as one that will likely be profitable relative to holding financial instruments.  Investment has pull (good ideas) and push (available money) components, but the availability of money/savings is not currently a relevant constraint.  

A structural shift that is and will continue to plague the economy is the reduced need for labour.  The growth companies/industries require much less labour than companies of 20-100 years ago did.  Google's self driving car and other innovations will also reduce the need for labour.  These structural shifts mean that good ideas of today and tomorrow do not employ as many people as good ideas of yesterday.  The combination of this structural shift with the 2008 realization that building/owning a home is no longer considered a good idea by banks causes a very large surplus of uninvested savings.  Low employment, and accompanying lower demand, means that there are fewer opportunities for good ideas

Before I list ideas to stimulate investment, let me make you read through multiplier theory.

The Economic multiplier is the amount by which any spending or investment is respent/reinvested.  Though difficult to quantify precisely,  A multiplier number represents the amount of times a dollar is spent and respent in one year.  It is usually discussed in the context of Government spending as a justification for some spending programs over others, but its effect applies to all spending.  If you can double an economy's aggregate multiplier effect, then you will double its total economic spending and activity (GDP).

An economic multiplier of infinity is theoretically possible if there is no savings, and no constraints on labour, production and resources.  While no savings, means impossible instantaneous spending, if all funds are spent after being held one day, it would create a multiplier of 365.  These 3 constraints represent the 3 wastes discussed in the economic justification of taxes.

The simplest rule that follows understanding of the multiplier is that paying money to people who will save it a very short time prior to spending/investing it (generalizeable as the poor) always creates more economic activity/social benefit than paying that money to a saver (i.e. rich), because saving halts the multiplication effect of that spending.  The second rule is that all money eventually trickles (back) up to a saver 

Promoting Investment and good ideas
Since wealth naturally trickles up, the key to promoting investment is to make it trickle back down.  We can imagine a world a few decades away, where machines make everything, and a very select few own all the machines.  The machines are only useful if there are people available to consume their product, and so it is only a good idea to invest in the machines if those customers will exist.  Recommended programs and policies:
  • Wealth redistribution though taxation, basic income, and social dividends.
  • Unfiltered, unpoliticised, wealth redistribution (basic income) is a far preferable system to ensure social harmony, than military/police/prison spending purposefully inflicting unhappiness on citizens.  It also frees up people's time to pursue something productive.
  • Unpoliticized wealth redistribution so that taxation cannot be claimed as theft used to fund winning political special interests.
  • Relatively high corporate tax rates, combined with a tax code that simplifies receiving tax rebates for losses, such that investing in (good) ideas is less risky.
  • Tax deductibility of corporate dividends so that corporate savings in excess of their future good ideas are redistributed to those who will spend or fund good ideas.
  • High marginal personal tax rates, but with top marginal tax deductibility for investing and income splitting through personal services.
  • Tax code incentives that encourage flow of funds into the economy through exports and imports.
  • Reduce the need for savings and improve labour's health, productivity and competitiveness through universal healthcare.
  • Natural finance structured organizations that foster investment and ventures with less required cash.
  • Renewable energy production sufficient to drive down energy prices such that indoor agriculture, and other good ideas become economically viable.  This would furthermore occupy people's time productively, and support higher populations.

The tax code proposals are the heart of Natural Taxation policy.  The necessity of an egalitarian-based wealth redistribution mechanism is only partly based on a future that lacks employment opportunities based on technological productivity and on stabilizing population.  The other justification is preventing social unrest that results from directed politicized assistance.  The power of older demographic groups manifests the 2 wolves and a sheep democratically deciding what is for dinner problem, and in fact Canadian politicians without any financial crisis are already dismantling benefits for younger generations.

Friday, May 4, 2012

LinkedIn valuation

LNKD reported Q1 2012 results last night, and looks to trade around $120/share as a result.  There are a few abuses of reporting which may be fooling investors:

Non-GAAP EPS as a headline, and undiluted GAAP EPS as secondary headline.
This is enabled by stock promoting media, but the big exclusion in non-GAPP earnings is its stock (option) based compensation.  Diluted (GAAP) EPS was $0.04 compared to the headline of $0.15.

Sales go up every quarter, but earnings don't
LNKD net income has not gone up since 2010.  They are adding $20M in sales each quarter, but also adding $12M in sales and marketing expense.  Other expenses keep making up the difference.  Job sites can behave unethically by advertising fake openings in order to entice more members.  If investors only care about a company's sales growth, then there is potential abuse possible by booking fake revenue.

Forecasting a slight loss to break-even for 2012
Forecasting 172.5m in adjusted EBITDA for 2012, which excludes its stock based compensation, they're also forecasting up to $175m in stock compensation and amortization expenses, and mentioned in their conference call that income taxes would equal net income for the year.  So the trend of "buying sales" is expected to continue for 3 quarters.  Its upward revision of sales forcasts includes its announced acquisition of slideshare.

Comparisons to OPEN table
In my analysis of Opentable last year (trading at the time near $120, and around $36 today), I criticized it for its valuation relative to its total potential market, the (ease) threat of competition, and the rapid shareholder dilution that was likely to continue.  A problem that Opentable did not have compared to LNKD is that at least its income was growing with sales.

  • LNKD expects its diluted shares will grow another 3M to 115M by the end of 2012.  About 6-7% for the year.  Diluted share growth almost entirely consists of management/employee compensation, and is one of the abuses of shareholders that natural finance addresses (let management/insiders own a company and outside investors own queued undilutable soft loans).
  • The total potential market for online job sales has been estimated externally at $3B
  • Facebook, and facebook add-on applications, are a likely future threat

If LNKD's top potential sales are $2B-$3B per year, and it will eventually gain 20%-30% margin on those sales, then that warrants a $6B top valuation.  (about $60/share)

If achieving that sales and margin target is 3-5 years away, and shares will be diluted by 30% in 5 years (thus worth 30% less), and it faces competitive uncertainty over that time and in the future, LNKD should be trading closer to $42/share than $120/share.  To value LNKD at $12B ($120/share) implies future $3B in sales at high margin and market dominance with continued growth expectations.  There's just too much that can go wrong in those expectations.

An update is here