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. 

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