Saturday, March 30, 2013

Natural Finance competitive advantage for startups

This is part 5 in the series of comparative advantages of natural finance over traditional finance tools.  Part 1 and 2 focused on traditional small businesses that frequently finance through loans.  Parts 3 and 4 focused on capital intensive companies that frequently finance through equity/shares.  Although startups also typically rely on equity financing, they differ from traditional capital intensive companies in that they need relatively little funds, and offer a much more speculative business proposition.

Natural Finance Soft Loans are business loans without fixed repayment terms.  Instead, they are repaid when business cashflow materializes.

 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.

Startups as one of the few paths to great wealth
Technology startups have created significant wealth for some founders and initial investors.   Some have even created that wealth without creating a profitable company.  The primary reason for the wealth success stories of startup founders is their relative strong bargaining power in both needing very little funding, and having good business stories suitable for IPOs (Initial public stock offering).  The bargaining power permits founders to retain control of the company, and the IPO prospects allows them to conspire with initial investors and IPO sales partners to prevent takeovers and dividend payments.

The issues with traditional financing of startups
Many startup businesses will never generate profits to pay anyone but its founders, and many more startups do not even achieve that level of success.  Since there is a high failure rate, investors typically require a story that allows them to hope for a 10x or 100x return on investment, and so traditional loans is not a possible option since startups could not possibly afford an interest rate that provides those returns.

The key comparative advantage of natural finance for startups
Compared to the traditional finance goals of turning a startup into an IPO, the founders of a company using natural finance must have confidence in making eventual profits, because they will need to repay investors in order to collect those profits.  The IPO game just needs a story to be successful, and establish an empire for the founders.  The reason for founders to prefer natural finance is that investors are idiots or corrupt to prefer an IPO.  Public markets exist to trade minority stakes in companies which are always worth less than the company itself, and the empire of majority control of the company.

Natural finance tools for startups
The main natural finance tool is soft loans.  It is recommended that a total cap on interest of 100% be in place, and that the interest rate never exceed 30% per year.  The reason for the total cap is to permit predictability of repayment for all lenders, and prevent runnaway indebtedness that prevents future investment.  When a loan reaches its cap, the cap acts as distress-limiting function that would help the company survive and repay its investors.

Another key feature of natural finance is its encouragement of communal partnerships.  The ideal organizational structure a business should aim to eventually accomplish is that of ownership by equal partners.  The advantages are the prevention of abuse by majority owner(s), and the power of shared supervision to prevent any other abuse.

The tool most handy for startups is deposit options which allows one (or communal partnership of) owner(s) to promise a future equal share at a locked in buy-in price in exchange for monthly payments.  The buyer of the option has the right to abandon it at anytime, by not making the next monthly payment.  The "strike price" (buy in price) of the option is based on a specific total value of the company divided by however many partners happen to exist at the time it is exercised.  The strike price is adjusted down based on the monthly payments made and/or dividends paid.

Very early stage financing
Deposit option premiums of $1500 or $10k per month  paid to the startup founder act as a salary that the business need not pay to the founder.  The lack of expenses by the business means greater financing flexibility (capacity for new loans) for it.  Whether the strike price is in the millions or billions, for very little investment, the founder is "sponsored" for further research/development, and the investor can hold a future claim on the business which he can materialize in value by further assisting the company.

Deposit call option premiums of $4000/month buy a much lower partnership share strike price than does an $2000/month premium.  These premiums are paid directly to the founder and not to the company.  The founder might accept both offers if the lower immediate "salary" justifies a much higher future partnership share sales price, and he is confident in achieving that future value.

Another option that necessarily suits the founder, and likely is more attractive to the potential partner is a call option premium of $4000 with the added condition that $2000 of that premium received by the founder be reinvested as "low interest" loans to the business to cover sales, travel, and other investment acquisition expenses.  The re-investment condition ensures that the founder is focused on generating revenue so that he may have those loans repaid.  Compared to a $2000 option premium and a $2000 additional monthly loan investment into the company, the investor is much more likely to prefer a lower future purchase price of a partnership share over the potential small returns on small monthly loans.

Recent post on communal equity options is most focused description of communal equity options.  Deposit options are most likely to help design-type startups, and does so without hampering the company's borrowing capacity. 

Organizing a company with external sales and investment agents
While traditional companies favour keeping sales, marketing and investment acquisition functions in house, there is no obvious requirement that they be so, since the performance and compensation of such departments is relatively independent of the actual operations.  Natural finance facilitates that separation mainly through its comptrollership function which ensures that payments owed, are made when able to.

While sales and investment functions can be separated from a company, it is not completely clean to do so.  Both sales and investment have a tendency to over-promise on what can be delivered, and the concern is amplified if sales and investment teams are external to the company.  There is also often the need to get the operations department involved in a sale to both negotiate on what is possible how fast, and help close the sales or investment.  The only other major issue in using external sales agencies is you likely need that they are not involved in any competitive companies.

To control the investment sales over-promising tendency, its compensation can be based on investor repayments.  Natural finance can completely align the interests of investors and their solicitors by ensuring they are paid by the same transaction.  It should provide the investor with confidence knowing that a soft loan he "buys" only results in a payment to the salesman when the investor himself is repaid the loan with interest.

To form a closer partnership with marketing sales agents, you likely want them to intend to become partners in the business through deposit call options, and/or reinvestment of sales fees into soft loans for the business.  The benefit to the sales agency for such arrangements can include territorial exclusivity or other favours.  To handle the involvement of the operations department in closing and negotiating sales, the sales agent can "hire" the operations department (with fees conditional upon closing sale).

The benefit of external agents is lower fixed costs, which tends to be important for a startup.  The benefit of having the function in house is tighter control over people's lives and behaviour.

How a 30% interest initial loan for almost any venture is profitable
30%/year interest loans are very expensive and usually unsustainable.  Natural finance makes such loans possibly sustainable in 2 important ways.  First, there is a 100% total interest cap, so the amount owing on a 30%/year loan will stop growing after a little more than 3 years. Second, all natural finance loans are open, meaning that anyone who offers a lower interest rate can replace the loan.

For someone that invests in a natural financed startup at a 30% interest rate, he has an immediate interest in becoming an investment agent for the company, and needs no formal agreement with the company to do so.  This is fundamentally the same conflict of interest that exists within the traditional financial industry: creating hype for what they own.  But, the behaviour benefits the startup, and the financial promoter's help is likely much needed.

The advantage of accepting exploitative and onerous loans from investment or sales agencies is that you get their services for free.  They become instantly motivated to promote your startup so that they may be repaid their high interest loans.

If the company takes a few years before earning revenue, then whether a loan is at 30% or 10% won't matter too much because of the total cap of 100% interest.  The importance of the cap is detailed here

Hiring a first employee
The example near the bottom of the paper on communal equity put options shows how using natural finance securities can lower the cash compensation costs of employees by over 70%.  Providing employees with deferred compensation (soft loans), deposit call options to become a partner, shares, and put options on those shares, replaces the cash costs.  Lower cash costs in a startup business enhances its sustainability and investability.

Closer partnerships with suppliers
If your startup is ever likely to pay one company $1M or more for products or services, then that supplier is a good candidate to invest in your business, by becoming a full partner or participating in soft loans.  For soft loans, it may be possible to tie lower interest rates to continued purchases from the supplier.

Part of ongoing operations of a natural finance company is to fund large projects with new financing rounds that are placed in last payment priority.  Getting the people and companies that will receive what the funding will be spent on to help fund the project provides benefit to both the buyer and sellers.

Partnerships with customers
Kickstarter is a popular crowdfunding site that lets people fund art and gadget startups by letting them buy advanced copies of merchandising, promotional meetings, or the gadgets themselves.  The problem with the service is that customers have no guarantee of ever receiving what they supported.

While getting a product among the first is likely the most compelling reason for a customer to fund a startup, natural finance loans can provide the same features as kickstarter pledges by allowing lenders the option of redeeming their loans for products, collectable gimmicks and promotions.  While that practice can slightly violate the natural finance rule of always repaying investors at the head of the queue before repaying those behind them, it is excusable if the profit margin on redeemable loans for products is high, and it is fully justifiable if the intent of the loan was for a specific product redemption at the time the loan was made, and if not, also fully justifiable if replacement financing is obtained to produce what is necessary to honor the loan redemption.

Natural finance loans, in addition to providing any kickstarter ability, also allows business customers that may be able to profit from your product to help support and improve it.  It further provides customers compensation for delays in developing the product, and the opportunity to withhold product redemption until the next generation product is released, or otherwise change their product redemption intentions based on new collectibles or promotions offered.

(see the grocery cooperative example near end of paper)

Partnerships with society
If your startup wants to develop an AIDS medication that doesn't cure patients but requires a daily dose to keep them alive, and you gain monopoly power to charge whatever people will pay to stay alive, then even if you are improving society by giving it an option it did not previously have, its a stretch to think you deserve social approval, support or funding.  Pure financial interests can support you.  If on the other hand, you want to research the effectiveness of a natural or unpatentable AIDS remedy that cures patients, with say a mixture of grasses, aspirin and red wine, then there is great social interest in the success of the research or any future effort based on the research.  Health insurers, patients, wine marketing associations, people at risk of being patients and humanity, all have reason to support such research without any serious concern for a financial return of their investment.  In fact the social interest is usually best served if the support keeps prices down, and the returns on investment are in kind, but for supporters higher prices and/or moderate prices means that the net cost is kept low due to the refund of profits on top of a reasonable priced cure..

I define strategic investment as investment for the benefit of seeing something accomplished rather than out of concern for the direct profits possible, or their distribution, from that accomplishment.  Helping a company get oil or copper out of the ground has the strategic benefits of lowering the price of oil and copper.  Helping society build roads gives me the strategic benefit of customers and myself getting to my place of work easily.

We often think of proposals with social strategic benefits as worthy of petitioning government to assist with.  In the case of developing an affordable cure for AIDS, government can be corrupted against such a social interest, by the financial interests of an expensive life prolonging established solution.  

Social sponsorship of projects whether they are high profit, low profit, or non profit is made easier through natural finance.  "Donors" can treat their contribution as a donation, but if the project is successful they will receive a direct benefit from that donation whether it is through cheap social distribution of the innovation, or their share of the financial benefits from a not so cheap distribution of the innovation.

Another way to invite social commitment for your project is to grant a permanent right for any social institution to purchase your company at a fixed price.  It may or may not be generous to allow society the right to purchase your company for $100M or $20M, but it is still an explicit gift, than can be judged simply on its merits, and is unlikely to discourage the efforts required of you that might make society consider this opportunity.

The great benefits of many partners
Having 20 or 20 million partners in your company provides energy for product, process and investment ideas, and creates an army of people with a vested interest in the company to help promote it.

As more partners join, the affordability of a partnership share improves.  For 1000 partners, every 1M in company valuation costs $1k for a new partner.  If it is affordable for more people interested in the viability of the company, then there is more demand for a partnership share, and part of the investment may become justifiable through intangible benefits of influence and status.

For the original owner(s), 20 or more partners means selling 95%+ of the shares in the company.  No matter how many partners or how long ago the founder gave up authoritarian control over the company, odds are that the founder's ideas and direction are still likely to be valued in some role, even if perhaps the huge salaries and perks he might be able to bestow on himself if absolute control were denied to him.

One advantage of large partnerships is decentralized governance where partners bid for the right to lead projects or perform functions rather than have them bestowed through a hierarchy.  Its similar to my natural governance principles for wider society, and creates competition within the enterprise that benefits all partners.

The control freak's guide to starting a commune
Even if you are sure of the best decisions needed for "your" company, and sure that having to listen to other input will be tiring and unproductive, partners can still benefit you greatly.  The best way to ease your concerns over having to deal with partners, is to make a condition of initial partnership, the protection of any key roles that you want to keep, for up to 5 years.

The benefits to future partners is that relief from your tyrannical ways is eventually assured, and so the attractiveness of a partnership share greatly enhanced, and so the rewards (monetary partnership share value) of selling future partnership shares greatly enhanced for you.  You gain the protection to make the right decisions for the company for the next 5 years so as to further enhance partnership value, and will continue to have significant advantages in having your ideas heard after your 5 year reign.

A company, and partnership share in that company, is always more valuable without a monopoly over ideas, including a monopoly on deciding the leadership's salaries.

The Power of the comptrollership function
The 3rd party comptrollership function permits much of the creative cooperative arrangements discussed in this paper by creating trust.  Investors and stakeholders are assured of being paid when revenue and cashflow materializes, without requiring audits, inquiries for payment, or management's discretion on whether to follow up on its promises.  Financial statements and repayment predictability  assessments can be produced daily or weekly.  The contracts between parties in a natural finance are much simpler from a legal perspective, because the elements of dilution risk is eliminated, as is the element of discretion in repayment, and so it is conceivable for very creative agreements to be agreed without legal representation from both sides.  The comptroller can act as a legal arbiter for both sides.

As shown in the next example, an even stronger benefit of natural finance is the preference for higher interest rate loans by the borrower, that is created by trust and flexibility.

Example wholesale venture
I want to buy 24000 drinks in 1000 cases for resale.  It will cost $24000 to get the drinks delivered.  I expect it will take 2 to 6 months to resell all of them, and total revenue will be $34000.  The financing options are I can borrow the $24k against my house from a bank (or from you) @ 6% (0.5%/month), with $3k/month minimum repayment.  Borrow a soft loan from you @9% (0.75%/month), or give you 20% of the shares in a corporation in exchange for the money.

Regarding the shares vs soft loan decision, if I plan on reinvesting the money, or sitting on it, instead of repaying you the money, then I prefer you take shares, and you should prefer the loan, because odds are you will never be repaid.  If I plan on repaying you quickly, then I much prefer the soft loan approach.  Since you want to be repaid, and I will say that I wish to repay you to sell you on the investment, then according to what we say, we both prefer the soft loan investment to shares.

The risks of the venture are:
  • Product may be lost, stolen or break:  The most serious risk.  If I borrow against my house, I lose $24k if product is lost.  If it is a soft loan, I still lose the profit opportunity.  This risk can be mitigated with insurance.  For the lender, a soft loan can be seen as equivalent to a loan + insurance product.  The extra interest may compensate for risk, but insurance for the investor's benefit is an option that may be both less risky and still more profitable.
  • There may be delays in shipment, personal or medical emergencies that delay my ability to sell the product:  Such delays could cause me to incur expensive credit card debt to meet fixed loan obligations.  Under a soft loan, if these are merely delays, then it is not a burden on the borrower, and results in higher returns for the lender.
  • I may lose interest in selling drinks, or it is not as profitable as hoped due to competition: Solution options include selling the drinks in larger lots at less profit, or hiring/delegating the sales efforts to others.  Although I feel much more pressured to enact one of these options quickly under a fixed loan than a soft loan, there is still moderate profit opportunity sufficient to repay the investor under the soft loan option.
For me, a soft loan is well worth the higher interest cost to save the risk of bankruptcy, credit score, and credit card fees.  Its likely also worth the insurance premiums on top of the higher interest cost.  For you, as the investor, if there is insurance to cover the main risk, then higher expected and likely returns are also worth any slight delays to repayment.  The most important point is higher interest return for you that happens to also be preferred by the borrower.

Virtual corporations and open source
Open source software is usually offered free of charge to users.  It frees users from oppressive reliance on a monopolist for future features, fixes, and systems compatibility.  Open source software still has a business model in paid consulting, features, fixes from the original artisans that likely have the best knowledge of the product.

One reason not to collect product sales revenue, is that it would be expensive/complicated for partners in the software to audit sales, and decide how to distribute rewards based on contributions.  A 3rd party natural finance comptrollership, or 3rd party mediator, or internal committee can assist with that function.

A virtual corporation is one where there are no physical offices.  All the employees work from their homes or at client offices.  Software and web companies are suited to this model, as is any startup with either no revenue, or no strict requirement for customers to come to their office.  Any corporation  could technically benefit from the cost savings of virtualization, but ornamental office space can enhance trust by giving the impression of financial stability.

A far more useful trust and confidence enhancement tool than office space is 3rd party natural finance comptrollership of the company's bank accounts.  If employees and investors cannot see the customers, they need accurate information to base whether and when they can be paid, and assurances without requiring nagging and repeated requests that they will be repaid when they are supposed to.  Natural finance comptrollership is likely much less expensive than office space, and may have some of its costs deferred.  NFCs provide especially significant trust enhancement to international stakeholders.

Solar cell industry
Commercial solar installations are already more affordable in terms of cost per MW capacity than moderately clean/efficient coal plants.  That is before considering operating and fuel costs.  Solar power delivery contracts are being signed well below new coal projects and even below existing coal delivery costs (5.8 vs 6.7).  Despite this, there has been many high profile solar cell manufacturer bankruptcies due to overproduction and rapid innovation.

Natural finance soft loans can help somewhat stop overproduction by not having fixed repayment obligations, and so enable the strategic option of not overproducing, but more importantly because natural finance companies have lower fixed costs, the option of overproducing to drive competitors out of business is also an option.

Because investing in solar power, even in residential installations, is one of the lowest risk possible investments, where power savings is a tax free return for residences, and so should be competitive at 3% ROI over 25-30 years.  Natural finance's power to form cooperative agreements with customers, and delay cash outflows to meet inflows, and even get company investors to finance customer purchases.  If the problems with the solar cell industry can be described as under purchasing instead of over supply, then facilitating customer purchases/financing would cure the industry.

A Grocery store cooperative
Customer cooperative grocery stores have been done before.  I haven't seen them done right, and basically what you can do with a grocery store, you can do with any business.  There are 3 key stakeholders in a traditional coop model, and they are rarely all addressed quickly.  Customers, management/employees, and financiers.

The principal appeal of being an owner of a grocery store coop is likely to be the customer benefits.  Providing every owner with a discount such that there sales target (very slightly above) 0 profit, is attractive to heavy customers and does not disadvantage any other owner.  If that discount is 10%, then it would be a benefit to grocery store customers of $200 to $600 per year (tax free), and so no matter how many owners join the coop,  a floor price for a share should be around $3000.  

Natural finance soft loans can also be used for a coop.  Small customer loans can be taken at very low interest rates if part of the repayment options includes using the same discount available to owners.  Loan balances are lowered by the actual value of the discount.  Loans are still repaid in queue with profits, but the repayment can be with store credits.  Interest should just need to be better than bank deposits, or equal to after tax mid-term government bond rates, to be attractive.

Employees and management can have part of their compensation be variable, and based on sales and profitability.  This "management performance bonus" should be included in the calculation for the owner price discount.  Employee and management performance for quality, service, selection and price is unaffected by whether sales are made to owners or non-owners, and so management/employees deserves compensation for making the store an attractive shopping option.

As mentioned earlier, the customer discount benefit of ownership alone may be worth $3000 per owner, and so $3M communal equity with 1000 owners with no profitability.  Every time an owner joins, all of the other owners are paid directly with the proceeds.  This means that there is significant incentive for a non-customer investor to get in early.  If initial capital and inventory costs are $500k, even if initial 50 partners are brought in at under 1M communal equity, and next 200 owners buy in at $2M, there is significant financial profit opportunity just from growing the network of partners.

The difference between what allows a 1000 owner (customer) coop and 10,000 member coop is not only price and quality performance that draws people from further away, but also store capacity.  A supermarket can serve more people than a smaller store.  Wider product selection means greater value in the customer-owner discount.  Expansion into a larger store or more locations increases customer-owner capacity (going from 1000 owners to 2000 owners at $3k/share, raises an additional $3M for ownership pool, and so 1000th partner would get most (about $2250) of his purchase price back).  Expansion into other retail categories (pharmacy, brewing supplies) increases selection and so the value of the discount.  Expansion into warehousing and wholesale services, or buying store location instead of renting would increase either profit or the discount percentage.  All of the above either increase the value per share or increase the capacity of owners and customers that can be served.

To expand from a 1000 member small store coop to a potential 10000 member supermarket coop, and raise the initial investment to do so, 1000 additional shares could be sold at $6000 each, with most of the proceeds set aside for development, or individual existing shareholders or outside investors can lend to the coop for any part of the development costs.  Growth from 1000 to 10000 owners still provides substantial profit opportunities for the 1000th and 2000th partners.  A 10000 member coop with $3000 owner discount benefit is worth $30M even if it makes 0 profit.

One issue with the grocery store owner discount benefit is that is worth much less to a single person, than to a family of 12.  Its not necessarily a major issue as it would simply make large families more eager to be shareholders, but there is an actual solution that is an overall improvement. If a 10% discount to owners results in 0 profit, then an 7% discount results in a 3% surplus that can be distributed to owner partners.  The small shopper that is an owner (or lenders) profits from the large and average shopper owners, while the average shopper owner is unaffected.  This is an overall improvement because it makes the value of a share more attractive to more people, while still providing a great deal for large and average shoppers.

A bigger issue, is that for simple customers the thought of investing over $10k or even just $3k is not a typical conscionable occurrence regardless of the potential benefits.  The natural finance solution is deposit call options.  One solution might be to offer customers a (version 1) call option with strike price of $3.5M where premiums are based on 7% of purchases.  This would mean that any customer that spends $50k in the store would automatically become an owner after 1000 other owners exist.  They automatically gain ownership after spending $25k if 2000 other owners exist.  From the existing partnership perspective, they prefer the first scenario to the second, and they don't like the lack of a fixed commitment to the option.  Because the owner discount provides a unique value to a share that is independent of the number of owners, the partnership may feel cheated if it receives less than $3k for one share.  A solution that keeps the customer simplicity of the first option is that if a customer either spends $50k, or pays the difference between 7% of what he spent and $3500, then he will receive the 7% discount in the future, and when there are at least 1000 partners, he will become a full partner.  Another alternative is to allow the customer the option of purchasing a share at $500 more than whatever the partnership wants to sell it for but allowing the customer to deduct 7% of all past store spending.  All of the above alternatives have no cost to the customer, and no benefit until a share is acquired.  Its like a long term rewards program, but may be too long to seem attractive.

A more balanced deposit call option terms is to offer a $4M communal equity strike price for premiums of $400/year ($34/month).  This is using the version 2 deposit call option formula.  Assuming an initial (arbitrary) 360000 non-voting shares, the call buyer gets in return for his $400/year in premiums in addition to the call right, 36 shares per year, and an 8% discount (1% higher than owners) while he maintains the option.  Because, in this scenario, the owners and company are paid each month/year for the benefit of the discount, they benefit if the customer doesn't spend very much, and they benefit if they spend a lot.  Whether there becomes 1000 or 2000 partners before the option is exercised, there is no loss to the owners from granting the option.  Note that although the option is for a $4M total equity value, the option buyer is accumulating non voting shares at the cost of $400/36 ($11.33).  With 1000 owners, once he owns 360 non-voting shares he gains full owner status, and so after 8 years of the option he has accumulated 288 shares, if the communal equity market for a full share is at $3M, he can abandon his option and pay $600 for 72 remaining shares that he needs instead of $800 over 2 years for those shares.  There are significant advantages to the partnership of granting such options.  For one, if a happy target value of the company is $3M in the future, then selling shares today at a $4M value is good for the partnership.  Also, non-voting shareholders do not receive any proceeds from communal equity transactions when new buyers join the partnership, and so early partners are not diluted by option holders when it comes to sharing new share buy ins or option income.

Yet another option for financing share purchases that is useful both when there are very few partners and very many is to create a natural finance soft loan queue to finance the share purchase.  Since buying a share involves paying cash directly to the partnership group, the partnership giving a loan to the purchaser instead is always an alternative.  The partnership would be advised to take at least a small deposit, but it can then finance the rest of the share purchase at say 12%/year.  Under natural finance principles, anyone and any individual partner can underbid the collective partnership by offering part of the loan at a lower interest rate and thereby receive higher payment priority.  The terms of the loan are likely to include a payment schedule, and the new buyer/borrower may abandon his share at any time by stopping the payments.  Let's say the founder who spent $500k on creating the business will sell you the next day half the business for a total equity value of $1M, and so your required payment would be $500k.   If the founder allows you to leverage that investment by only putting down $1k, and having a $499k loan at 12% with $50k/year in payment obligations.  One way to meet the payment obligations is by having new partners buy in.  If a 3rd partner paid cash ($200k) for a $600k equity value, although you appear to be losing money because the company value is going down, $100k of that $200k would go towards paying down your loan, and you have no payment obligation for 2 years as a result.  If instead the 3rd partner bought in at $1.2M equity but used a $400k loan instead of cash, you may be ahead on paper, but you have not received any liquidity help in making your required annual payment.  Incidentally, you becoming the 2nd 50% partner at say $600k equity value with very little of your own money would be a sensible proposal if you were going to manage the operations.  It can be great for you because you have so much leverage, and can walk away without losing much.  It can be good for the financial partner because of the high interest returns or getting back their share while keeping any payments if it doesn't work out.

For a smaller partnership buy-in fee of $3000 (1000+ partners), some people might still prefer a loan.  A $300 annual payment and 5% interest.  Doing so purely for the benefit of the owner discount may make sense, and if you don't want to shop at the store often after some years, you wouldn't really lose anything if you abandoned your share, and neither would the partnership or company.

Cooperatives Advocacy
Communes and cooperatives are always worth more than the same company under traditional corporate structure because first, communal equity values shares at the median owner value rather than the most pessimistic owner's opinion, and second and more importantly, equality of ownership prevents the systemic bias towards a majority owner.  That systemic bias necessarily pushes actions towards corruption and oppression even if those actions don't cross a thin binary moral/legal line that defines corruption and oppression.

IMO, it is a mistake to advocate for cooperatives on the basis that they are a near charity to the employees.  This places employees above and in opposition to investors and customers.  Instead, the proper way to reward the contribution of labour in a broader more open commune is through a performance bonus "tax".

Monday, March 11, 2013

Communal equity put option

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, March 5, 2013

Basic Income - Real definition, and leftist justification

Basic income is a cash amount given to every citizen from social funds (government).  There is neither any condition for receiving the cash, nor does the the amount given (pre-tax) get reduced or increased based on the recipient's other income or wealth.

This article will be longer than the above statement because that definition is not agreed upon, and the most prominent advocacy groups, conflate the term basic income with a larger set of policy alternatives (mainly Guaranteed income) which though they may have similar appeals and motivation, are economically incoherent and thus objectionable, and destined to fail any legislative attempt.

Groups that correctly describe basic income
The Basic Income Earth Network defines basic income perfectly, and the link provides organized responses to many questions.

Citizen's Income is another word for basic income.  I am unsure who coined it.  It is a great word because it reflects the core philosophy of basic income.  A benefit entitlement to citizens rewarding them for their participation in society whether or not that participation is limited to consumption.  The commitment of society to its citizens can hopefully motivate additional contributions to society from its citizens.

Unfortunately, some groups include programs with other philosophies (guaranteed income) under a citizen's income "brand".  If I were allowed to name the umbrella of policies that include basic and guaranteed income, I would call it "populist income"

I define programs that follow citizen's income natural philosophy to be basic income, and (my definition of) social dividends.  Social dividends is the surplus of tax revenue over social expenses that is, as it should be, distributed equally to all citizens.  Basic income is the fixed component of citizen's income, while social dividends is a variable entitlement based on the success of the economy, and any government efficiencies or program cuts.  Social dividends ensure that government administration is diligent and purposeful, because every citizen pays equally for any program (because the alternative to any program is distributing its cost equally to citizens).

Groups that corrupt the definition of basic income
USBIG (Basic Income Guarantee)'s definition "a government ensured guarantee that no one's income will fall below the level necessary to meet their most basic needs for any reason." is unfortunately Guaranteed income, and not basic income.  They see themselves as an umbrella group for all populist income proposals.

Guaranteed income of $15000 vs Basic Income of $10000
Guaranteed or minimum income of $15000 means that every eligible recipient receives a socially funded cheque equal to ONLY the difference between their other income sources and $15000.  So, they receive nothing if their income is $15k or more, receive $1k if their other income is $14k, and receive $15k if they have no other income.

To understand why basic income and guaranteed income are drastically different, in the context of work:

  • Basic income (of $10k) is identical to giving every full time (40 hour/week) worker a $5/hour raise, and every half-time worker a $10/hour raise.
  • Guaranteed income (of $15k) reduces every full time worker wages by at least $7.50/hour, and every half-time worker wages by at least $15/hour.  In exchange for a $15k payment.
The obvious shortfall of guaranteed income is the work disincentive it provides.

The naive and misguided appeal of Guaranteed Income
Would you rather receive $15k for not working or $10k for not working?  A citizen's income should not provide a rational incentive for people to refuse work, and especially not even part time work.  The only rationale for preferring Guaranteed income over basic income is if you intend to refuse all work.

Guaranteed income, if we assume no one refuses work, can appear to be more affordable because fewer people are eligible, and most people might not receive the full amount (because their other income reduces their stipend).  The problem here is more complex (dealt with shortly), but the presupposition that no one refuses work is false, as it directly makes many work propositions unacceptable and irrational.  The forecasted costs of guaranteed income are impossible to be accurate without certainty of the rate at which people might refuse work.

Guaranteed income is a stupid idea designed to sabotage populist income policies
Refusing work is rational if the work will pay $20k or $25k per year (regardless if that income is earned with part time hours).  $15k for doing nothing, means no commuting and lunch expenses, and more free time, autonomy, and less stress.  If we are not born qualified for a full time $25k+/year job, then it discourages training and working for the experience required to be qualified for a $25k+/year job.

If you can make $10k tax free by stealing or traficking, then that may be more appealing than a $25k/year official-economy job.  You make as much when adding the $15k government stipend.

With a $15k guaranteed income, employers will prefer to pay you a small amount of cash instead of a salary.  That could even apply to well paying jobs, as you would gain more total benefits at a lower cost to the employer.  This would harm the tax base used to fund the guaranteed income.

People with incorporated businesses would instead of paying themselves, pay their children, or pay themselves $45k+ every 3 years, and get the guaranteed income the other 2 years.

People with investments can have negative income.  Even if Guaranteed income were limited to a maximum of $15k, then there are already extremely risky investment alternatives equivalent to betting on a roulette spin in a casino.  If I had earned $15k already that year, I would bet red on a roulette wheel.  Red I win another $15000, black I get whatever I lost back from the Government.  Other investments within the tax code include losing $15k this year, in hopes of earning more in following years.

For seasonal workers such as teachers, fishermen, and farmers, earning $5k/month for 4 months would provide them with no economic benefit whatsoever, unless they are confident in finding work outside of those 4 months.  Similarly, people starting a job search in the middle of the year would be very unlikely to make money from employment.

There would be an attractiveness to develop schemes where people with high incomes appear to lose and transfer all of it in order to get an extra $15k.

All of the above are perverse incentives that would ruin the tax base that Guaranteed income relies on to be feasibly fundable, and especially ruin economic participation and activity.  The gross stupidity of guaranteed income is the same obvious abuse that too-big-to-fail banks can make through bets where heads they win big, tails we (society) reimburse any losses they "sufferred".

Basic income is the freedom to do anything
Basic income provides freedom from slavery by equalizing the bargaining power of parties in the labour market, and prevents generational theft of providing retirement benefits to the current generation of seniors but not funding future generations' retirement.

Basic income contains no disincentive for work, and through the spending it adds to the economy, creates significant work opportunities.

What is likely the greatest benefit of all of social dividends is its power to make sure everyone pays an equal amount for any social service.  It is too easy for citizens to resign themselves to the government taking as much money as it can from society in order to pay for whatever it wants.  A viable alternative to any program/cost must be an equivalent cash payment to citizens.

Basic income as a great benefit to labour
While guaranteed income would provide organized labour with the huge benefit of forcing extremely high wages in order to make people want to work, and so fewer people in the labour force, and much better bargaining position for wages, guaranteed income would destroy the economy by reducing work too much, and having an unsustainable funding requirement.  It will never be adopted because of this, and is merely a ploy to get political campaign funding.

Basic income may be a smaller beneft to labour, but it is still the same benefit.  Some people will work less, and thus improve labour's bargaining position.  Increased spending means there will be more work available to do, further benefitting sellers of that work.  If more people have the freedom to pursue education or business startups, then that further enhances the competitive position of those who want to work now.  Basic income is sustainable, with predictable funding requirements, and is not a power grab for any constituency.

Balancing life quality away from the 1%, while still benefiting them along with everyone else, is a win for labour too.

Basic Income should be a taxable benefit
The only controversial point among real basic income proponents is whether the benefit should be taxable.  It should be because it suits both of the 2 core philosophies of basic income.

The first philosophy of basic income is that it is an anti-poverty program.  If it is a taxable benefit, then at whatever taxation policies, a higher amount of pretax basic income can be afforded than if it is non-taxed (say $10k/year taxed vs $8k/year non taxed), and the poor will keep a larger portion of the benefit compared to the very rich.

The 2nd philosophy of basic income and social dividends is that it is a rightful benefit of participating in society.  Your existence, through consumption, benefits society fueling its work and purpose.  Your duty to pay back a portion of your benefits from society should not be affected by the source of those benefits.

The mathematical distinction between taxable and non-taxable is not very large.  An equivalent balance of benefits to poor vs. rich can be made by increase top marginal tax rates at the same time that basic income is first implemented.  To me, the philosophical purity of the 2nd point is more important than the feel good appearance made by calling it non-taxable.

Criticism of basic income levels
Set too low to meet comfort levels: The core justification of basic income is to permit survival so as to eliminate oppressive slavery-like forces as a reason to work.  For someone who doesn't want to work, they may be unable to afford certain lifestyle choices such as living alone in an urban apartment.  Solutions include getting a job or room mates, electing municipal politicians that will implement a local basic income supplement, or moving away if all work seems oppressive or unsuitable.

Set too high such that it discourages work:  The only criteria for determining if basic income level is too high is that it is socially unaffordable.  If robots do all work, then $50k or $100k in basic income/social dividends is not necessarily too high, if the robot owners pay high taxes.  When determining social affordability, basic income can be too high to motivate some people to bother with working, but unlike minimum/guaranteed income, there is still an incentive of always earning more by working than by not working, and so people who value life style and status will always be willing to work.  Still the balance between people doing real work to pay real taxes, and those pursuing science, education, art, and entrepreneurship to potentially pay future taxes must exist.  Too high a tax rate on those earning work income such that it prevents needed work from being done can occur, but usually high taxes on very high incomes just provides more opportunity for work sharing and work delegation.  A sustainable level of basic income is simply the tax revenue raised less the cost of other wanted government services.

Unemployment and inflation concerns: Unemployment occurs because work is unwanted or un-needed.  Price (of labour) is a perfect market mechanism for determining employment levels, but slavery or coerced work should not be an appropriate tool to reduce unemployment.  If wage rates go up, it may cause some inflation, but coerced work is not an appropriate tool to reduce wages and inflation.  Variable social dividend levels is another market feedback tool that allows society to adjust to economic or natural conditions in a moral reaction to how work is needed or wanted.

Recommended implementation guidelines
Starting a basic income program at the lowest possible level that provides survivability, so that its sustainability and affordability is certain is the best approach.  From that certain initial implementation, it will become obvious what sustainable increases to the fixed basic income level, and variable social dividend are possible.