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.
- 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.
- Market value of property might fall.
- Economic and uninsurable events might cause the attractiveness of renting to fall, or harm the property value.
- Management incompetence
- Active management corruption of cash flow harming the long term viability of property to lenders
summary of Natural Finance competitive advantages for income properties
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.
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,
- Split each restaurant into their own operating companies with distinct loan queues, or
- Keep a single company and loan queue that operates both restaurants
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.
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.