Good financial innovation: small business equity investing

Felix Salmon has been on a tear lately. If you haven’t already, go read his fantastic post on the appalling double standard whereunder human creditors are morally bound to repay all loans while business debtors have a duty to default whenever they find advantage in doing so.

In another great post, Felix quotes commenter Dan, who argues that rather than “lend to a nearly bankrupt and profligate entity” (he means the US Treasury), investors might “learn basics of business and investing and carefully loan out [funds] to local small businesses.”

I love the idea of small business investing, in theory. But I don’t do it, because, in practice, it is time consuming and fraught with economic, legal, and interpersonal risks. One of the sad ironies of our pseudocapitalmarkets is that it is easy for small investors to supply funds to firms that are large and distant, about which we have little unusual insight. But it is difficult to build a diverse portfolio out of local firms we know intimately and have a personal stake in. This is an area where regulation is more a part of the problem than part of the solution: it is prohibitively expensive for the brilliantly run café down the way to meet all the requirements of selling public equity via pink sheets, let alone getting listed on Nasdaq SmallCap and doing an IPO.

In any case, common stock is a poor vehicle for small business investing, because it is nearly impossible to value even with the most elaborate financial reporting, and offers minority investors so weak a claim that thieves and charlatans flock to provide. There is no easier business than selling empty promises for good money. So, in the world-as-it-is, only investors willing to actively participate in a small business (or at least to actively supervise) take equity stakes, while more distant third parties prefer debt, with its promise to pay on time, or else.

But those choices are too stark. Small entrepreneurs would like outside investors to share the risk of building and running a firm in this dangerously uncertain world. They’d like outside investors to make their enterprise more robust. But debt financing magnifies the risks of a living firm. Entrepreneurs share burdens with debt investors only via bankruptcy, or via painful negotiations to forestall bankruptcy.

Outside investors who are enthusiastic about a small business might well be willing to provide the flexibility that entrepreneurs would want, in exchange for a bit of upside. But again, common equity is a nonstarter for passive investors in very small firms. Conventional preferred equity doesn’t work either: preferred investors tend to view nonpayment of dividends as default, and the lack of a legal ability to enforce doesn’t make them happier. Entrepreneurs therefore find preferred equity expensive to raise (especially given the tax disadvantage! see here and here and here and here and here). Since investor expectations of payment don’t correlate with business success, it doesn’t really diminish entrepreneurs’ cash flow risk. Psychologically, since there is unlikely to be liquid secondary markets for microbiz preferred equity, investors won’t perceive much upside in small business preferred: the base case is that dividends are paid on time and as promised, the downside is dividends are skipped and/or the business fails, leaving them screwed. One could try to sell convertible preferred to create upside, but that’s complicated to value, especially given the deficiencies of small business common stock.

If someone devised an equity instrument that would offer stronger, easier-to-value promises than common equity, that would effectively disperse entrepreneurs’ risks while offering investors an upside, that could be efficiently offered in modest chunks small investors could incorporate into diverse portfolios, I think that would be a fantastic financial innovation.

And it wouldn’t even be hard to do. For all the billions Wall Street poured into “financial innovation” over the last decade, investment bankers simply never bothered to try to solve this problem. Keep doing God’s work, Lloyd.

Here’s a sketch, one of many possible ways this circle might be squared. We’ll propose a kind of variable-maturity zero coupon bond. (Zero coupon preferred, really.) Imagine that every dollar of a small business’ operating cash inflow were indexed. That first dollar bill that gets framed and placed on the wall? That’s dollar number one. By the end of the first night of business at the new pub ‘n grub, maybe dollar number 2000 would have slid through the register.

Suppose businesses sold numbered dollars. Dollar number 420,167 has just been rung in. How much would you pay for dollar number 600,000? If you pay 91¢ for that dollar and it takes a year for the business to bring the next ~$180K, you’ve earned a 10% return. If business is great, and it only takes 6 months reach that sales level, then you earn a 20% annualized return. ROI is dependent only on the briskness of sales, something that is tangible and observable, something that customer/investors can understand and estimate. These claims would confer no control rights upon their holders (except potentially when they are in arrears), so entrepreneurs, the residual claimants, would price their goods and services to maximize profits, not revenue. Holders of fixed income / variable term claims would be along for the ride. Assuming a non-wimpy business owner, investors’ best strategy for maximizing the value of their claims is to drum up business, which is a win/win for the entrepreneur and the investor. Investor repayments would naturally correlate with business success: when business is slow, few payments to investors would come due. When business is brisk, lots of claims would mature.

This is the sort of instrument a financial technology start-up could invent and popularize. There’d be lots to think about: you’d want to provide a standardized and trustworthy accounting system to count operating cash flow, you’d want entrepreneurs to state and the system to enforce limits on the “density” of claims that entrepreneurs could sell (to keep incentives intact), you might want to provide (opt-in or opt-out) automatic reinvestment of maturing claims. A firm might permit claims to be redeemed in services rather than in cash on favorable terms, at investors’ option. Etc. At least initially, this kind of scheme would supplement, not replace traditional forms of financing. Businesses would want backup credit lines in case redemptions exceed reinvestment leaving the business starved of capital. But selling dollars of future revenue is simple enough for retail investors, for customers and clients, to understand. It could be implemented cheaply, in a standardized way, that would allow individuals to build diversified portfolios out of small exposures in the businesses they know and patronize. For entrepreneurs, it would offer a means both of raising risk-bearing capital and inspiring customer activism on behalf of the business.

Maybe this is a workable idea. Maybe not. But I am sure that the problem it tries to address is not intractible, or even that hard. If the brilliant minds behind the structured finance revolution would devote one or two percent of their synapses to inventing alternative forms of small business finance, we might find that the self-induced catastrophes of the legacy banking system needn’t translate into depressions for entrepreneurs and small businesses and all the people they employ.

Update History:

  • 01-December-2009, 6:05 a.m. EST: I’ve made a bunch of small edits over the night — nothing substantive, but every time I read through this I think it’s terribly written and want to rework an awkward phrase or sentence.
 
 

47 Responses to “Good financial innovation: small business equity investing”

  1. Harald Korneliussen writes:

    A practical way to give people a stake in local business would be very useful, if it could be made to work. Especially in small communities, on the border of what can support a baker, a bookstore, etc. I don’t think people always make well-informed decisions when deciding which businesses to patronize (otherwise, they should be happy when their local baker throws in the towel, and they rarely are!). Giving people an actual stake in the businesses important to them sounds like a very good idea.

  2. Nemo writes:

    Interesting idea, but the devil is in the details… It seems to me that this structure encourages not so much the maximization of profits as the minimization of operating earnings. (At most, they would be attempting to maximize profits per share.)

    For example, given the choice between investing in (say) productive equipment and repurchasing the company’s common stock, the owners would favor repurchasing stock, since these “zero-coupon preferreds” provide no claim on the per-share “return” of such a repurchase.

    Or instead of hiring new employees and expanding, the company would prefer to buy purely financial assets (like some other company’s stock), since such assets could appreciate in value while only realizing cash flow in the distant future. Again, their return would be unavailable to the ZCP holders.

    So I am not as convinced as you are that “it wouldn’t even be hard to do”. I do agree that the wizards on Wall Street could solve the problem if they wanted to. But then, why should they bother when the current system obviously works so well, from their point of view?

  3. Ronaldf Fink writes:

    Interesting post (and congrats on a successful migration). Dumb question: Why would the lack of control for holders of ZCPs encourage maximization of profits instead of revenue?

  4. Greg Taylor writes:

    I enjoy your fresh thinking on financing and your blog in general. The problems described here are certainly not contained to small businesses.

    Should we passively invest in equity? I’m not sure that it’s ever a good idea. Why are many of us willing to hold common stock in businesses we’ve not really analyzed and yet unwilling to invest in small local businesses with which we are familiar?

    The notion that “thieves and charlatans” might take advantage of minority investors with weak claims and no real ability to force management changes seems to apply equally to our largest publicly held companies. Owners must accept the responsibilities of ownership – hiring capable managers and firing failures are at the top of the list.

    Common stock has a “free rider” problem. Returns to stockholders who incur the costs of exercising their ownership responsibilities are the same as the returns to passive investors. With these incentives, most shareholders become passive, exercising limited, if any, controls on management. Managers soon find ways to reduce shareholder powers while unduly enriching themselves at the expense of the company with little risk of involuntary termination.

    I might invest in ZCP’s before traditional common or preferred equity in a well-established going concern. My hesitation would be in the nature of the density controls. The proposed instruments reduce or eliminate the risk of a management-controlled board of a profitable concern deciding not send returns my way. However, ZCP claims make firms less profitable and more likely to stop operations. ZCP risks are much like a covenant-free bond except that I don’t have a claim if the firm stops operations and the time to maturity is variable.

    Imagine a firm funded entirely by ZCPs. Owner/managers would have no outside shareholders or bond/loan covenants to act as a check on their activities. As the density of ZCPs increases, the harder it becomes for the owner/manager to earn a profit and the easier it is to walk away. Therefore, the value of the ZCP claim is highly dependent on the nature of the “density controls” envisioned. As a ZCP investor, I’d like to see better incentives to continue operations. Owners could “default” on ZCP claims by stopping operations, taking a vacation, reorganizing, and then restarting a similar business.

    We need to develop financing structures recognizing that the vast majority of investors are unwilling to accept ownership responsibilities. Attempts to pass these responsibilities to intermediaries (mutual funds, retirement funds, etc) haven’t worked out because the incentives aren’t there. These folks want to be free riders too. The ZCP proposal is at least a step towards limiting passive ownership. It might work better with larger more established concerns less likely to stop operations than with entrepreneurial ventures. Good work.

  5. Steve Randy Waldman writes:

    Nemo —

    So you’ll have to help me here. I’m not sure I get what you are saying.

    There are still common stockholders. They are the traditional entrepreneurs, and retain full day-to-day control of the enterprise.

    There is a new class of claimant, a preferred equity holder.

    Entrepreneurs can’t repurchase common stock. They already own all of it. They might be tempted, if they know business will be good soon, or if they have some means of manufacturing operating revenue at the expense of accruing a liability, to make use of their edge by purchasing back claims on future revenue they have already sold at a discount. But this problem obtains with any sort of passive investor in any sort of firm: if the insider knows that firm value will increase before other claimants do, she will be tempted to buy out other claims at a discount. For the big markets, we have rules like insiders must report purchases and firms must announce buybacks to persuade passive claimants that they won’t be too badly abused by this sort of gaming.

    Viz the present proposal, I think these problems are likely to be less serious than they are with big firms. First, there’s no reason why there’d need to a be a secondary market at all for these claims. That is, a firm could sell say 10% what it estimates will be its next two years of operating revenues, and the buyer can be locked in until redemption. If the securities are expected short-term-ish, a requirement that investors hold until redemption is not too onerous. The entrepreneur, then, cannot buy back claims at all. If the entrepreneur wants to sell more distant future speculative claims (might make sense or not, depending on how deep a discount investors demand), then a secondary market would be helpful. Entrepreneurs (and the firm) can be forbidden from participating in the secondary market to avoid insider gaming. Such restraints are always porous, of course. (The no-secondary-market plan can be kept pretty solid though.) The insider can always collaborate with a friend. But that’s also true of every other passively held financial claim in the world. I don’t see why this kind of gaming issue would be less tractable here: claimants never have to sell, they can hold ’til redemption; they have much more information about small local businesses than they do in distant investments; if the insider fools them directly into selling good claims, that’d open up pretty clear reputational and legal risks in ways that anonymous purchases on large markets do not. You can argue that insiders of small firms make better conspirators, in terms of manipulating business perceptions, but then creating a “panic” in claims on a smallbiz s likely to impact the top and bottom line of a small biz more than spreading rumors on the stock market do. Overall, I think that suscpetibility to gamesmanship would be far less than for public common stock.

    It’s true that entrepreneurs under this proposal have a tactic not available to common stock manipulators, by virtue of the fact that they only pay out on operating cash flow. Entrepreneurs could try to defer cash flows by accepting revenue of ever expanding vendor finance. That would be tempting, as they might earn interest on accrued but uncollected revenue while deferring payouts to our putative claimholders. But for most small businesses, short of fraud, this would be a pretty visible in the accounts, if the hypothesized open accounting system is in place. The scope of allowable credit to customers could be contractually limited, or if not, this trick could be employed once, following which claimants would earn a zero (but not negative in nominal terms) return and no one would ever invest again.

    Similarly, firm invest of operating cash flows into financial assets can be limited. This proposal is intended for real economy firms, not hedge funds. A firm might try to become a hedge fund against finance it can make arbitrarily cheap by delaying operating cash flows, but it can only do that once, and financial investing would be visible in its accounts.

    If you take any form of claims-sharing in any kind of firm, you can frame the situation as different groups fighting over the same economic pie, or tranche warfare. But financial investing in real economic firms has historically often worked very well, because often entrepreneurs are able to take advantage of real opportunities they would otherwise have to skip thanks to the external finance. In this circumstance, it is perfectly rational for entrepreneurs not to try to stiff passive investors, but to use their funds to expand the business, expanding both their own wealth and payouts to other claimants. Undoubtedly with this or any other form of passive investment, their will be “entrepreneurs” who try to sell claims and welch on them, with or without building an actual business on the side. The question is not whether that will happen, but whether it is more or less likely with the proposed form of claim than with potential alternatives, and whether the gaming will be sufficiently minimal to render it overall a good deal for investors and real entrepreneurs. I think that the bad hypotheticals you could offer against widely dispersed common stock, if that hadn’t been tried, are much stronger than the hypotheticals I can think of w.r.t. direct claims on future operating cash flow. But maybe I’m wrong, or maybe I haven’t fully grokked the games that you’re proposing.

  6. Steve Randy Waldman writes:

    Ronald —

    There are no dumb questions, only crappy explanations on my part.

    We’ll call ‘em ZCPs: thanks Nemo & Greg for giving our claims a name! People holding the ZCPs have every incentive to want the form to maximize revenue rather than profit.

    BUT… under the proposal, they have no control rights over the firm. Control remains vested with the owners of common stock, who only get to retain profits after paying off the ZCP-holders and any other creditors. So, unless firm management is “wimpy”, as I put it in the piece, and allows ZCP-holders drive the business against their own interests, entrepreneurs have bot the ability and the incentive to maximize profit. In terms of interclaimant zero-sum games, as Nemo pointed out, entrepreneurs incentives are in fact to maximize profits while minimizing operating cash flow, if they have sold substantial ZCP claims and they can earn interest on accrued but unpaid revenue. But my view is that most small businesses don’t earn enough on deferred revenue to make these games worthwhile, and that for very many small businesses the coincidence of interests is likely to dominate the conflict of interest between ZCP-holders and common stockholders. The main conflict I see happening is that ZCP-holders would encourage owners to drop prices and maximize revenue by selling at slim or negative margins. But since all the power rests with owners, they are unlikely to do that, forcing ZCP-holders to the more beneficial game of trying to get all their friends to patronize the business.

  7. Steve Randy Waldman writes:

    Harald — You bring up an interesting point, in that people have every incentive to patronize unsustainable businesses if the entrepreneur is selling at below a sustainable margin, whether because prices are too low or the business is inefficiently run. If prices are too low, ZCP-holders have mixed incentives. On the one hand, if the product being sold is price-elastic, low prices might maximize revenues, so as described in my response to Ronald, ZCP-holders might encourage that, effectively profiting off a foolish business owner’s propensity or willingness to burn through his capital. On the other hand, ZCP holders are both patrons and investors. If the business fails prior to redemption of their claim they are screwed, and they are doubly screwed if they like and receive value from transacting with the firm. Further, although ZCPs as described are mostly one-off short-term claims, if claimholders have an option to reinvest (a potential variation briefly discussed), their may be a significant opportunity cost to hurrying payment of one round of claims while forgoing future rounds. (Obviously much would depend upon the terms of the option to reinvest, which would have to be carefully crafted.)

    I think I’m agreeing with you in suggesting that for some customers, becoming an investor would encourage more active participation in support of maintaining the business as a sustainable franchise. By definition, retail investors are people who have accumulated funds. They are disproportionately not abysmal in their understanding of simple accounting and business ideas. One benefit of this scheme is that people who would never have become ad hoc business lenders or minority shareholders would nevertheless become investors in the businesses they patronize, and might behave like investors in terms of helping entrepreneurs to understand how to run a business that can last.

    Again, the core idea is that outside investing can often be mutually beneficial for businesses and investors, especially if investors are in a position, whether via promotion or education, to impact the fortunes of a firm rather than merely to gamble. I think the specific proposal is not-to-bad, though I’m open to being corrected. But the deeper point is that neither common stock, conventional preferred, or debt exploit the possibilities for mutually beneficial smallbiz investing, and that we can and should invent means of creating and capturing those gains.

  8. Steve Randy Waldman writes:

    Greg —

    I agree with pretty much everything you say. Frankly, I find it extraordinary that passively held common stock has worked as well as it appears to have, that it has thrived rather than died out as an institution. Some of that can be chalked up, I think, to the attractions of a casino: Casinos are bad deals, everyone knows it, but they survive and thrive because in fact people enjoy the volatility and the bells ringing and the possibility of great gains even if on average they get taken. With common stock, there is no question that passive shareholders do get taken relative to some theoretical notion of the share of value they formally “deserve”, but in a growing economy, that “vig” can be overwhelmed just by virtue of their weak claim to general growth. I think that’s why stock has often seemed like a good deal, despite its obvious lack of safeguards for shareholders.

    The “ZCPs” proposed offer a novel (i think) mix of risks and safeguards. One can theorize about how they’d work (i vote for great!), but unless we find an obvious achilles heel, we’d really need to give them a try to know.

    The proposal as I conceived it was for small businesses, with the idea that investors could basically log onto a quickbooks-esque site, and review and understand the accounts in real time. For bigger firms, the complexity and opacity of the accounts leaves the instrument open to the sort of gaming that Nemo is concerned about. But then, common stock is very open to gaming as well, so these (much simpler and more-straightforward-to-value) instruments might serve as an interesting addition to the menu of financial claims on large firms too.

    The problem of “density” you point to is crucial, and brings up some important concerns. If the entrepreneur basically sells off claims against all of the next two years expected revenue net-of-expenses, then they have converted their own position to an option. They’d face a choice between maximizing the value of that option via investing the funds raised in the firm, or letting the option go and consuming the funds raised one way or another. Usually, investors would and should be uncomfortable with very high density sales, since even if the entrepreneur invests the proceeds to maximize the option value, she will seek volatility, which to the ZCP holders with capped upside is a cost. You could imagine hybrid arrangements where claims on near-term revenue are bundled with very cheap claims on lots of much more distant revenue, simulating a more traditional equity position. But that gets complicated, and starts looking more like speculative venture capital. This proposal was thunk primarily with “ordinary” small business in mind, rather than the VC business model of trading ten failures for one Google. Again, I’d be delighted if the proposed instrument were useful there too, but as I conceive of things now, entrepreneurs would generally commit to a density limit in order to keep their incentives reasonably aligned with ZCP holders, and entrepreneurs that want the right to sell away a greater share of near-term revenue would have to offer steeper discounts to investors aware of the risks that might create.

    Another point that’s worth mentioning is the possibility of offering ZCP holders control rights in arrears. That is, if entrepreneurs sell off too high a density of revenues, so that they cannot pay vested ZCP holders because of obligations to other creditors, remedies could be crafted that give ZCP-holders the some ability to control the business. Obviously, payments to the entrepreneur and related parties would be curtailed — maybe to zero, maybe to a minimal salary — when dividnends are in arrears. Further, there could be a gradual but steep transfer of control as greater dollar values ZCP fell into arrears. For example, the control rights associated with a dollar of ZCP in arrears might have control rights equivalent to three dollars of capital paid-in by the entrepreneur, and perhaps increasing with the length of nonpayment and permanently convertible to common stock. Thus the instrument would remain equity-like, in that there’d be no capacity for a few ZCP-holders stiffed for a limited period of time to force bankruptcy and liquidation, but entrepreneurs that fail to pay claimants en masse or indefinitely would lose control of the business (which might well then be liquidated to satisfy the outstanding claims). Hopefully these bad possibilities would serve as a disincentive to overselling density.

  9. chris g writes:

    I actively invest in small local businesses.

    The cost of capital for small business is tied mostly to mortgage rates and consumer finance. Search Craigslist under businesses and you’ll see creative offers by local restaurants and businesses that need capital (none of the offers are as creative as yours). Now that they can no longer “fog a mirror to refinance” or whatever the saying is, they’ve found craigslist?!

    I often ask myself if I would I rather buy my neighborhood grocery store, that has been there for 40 years, and earns predictable cashflows, for 10X cashflow; or would I rather buy Walmart which is now trading at 15X cashflow. Given that Walmart would be easier to get into and out of, given that Walmart has historically traded at 20x cashflow, given that Warren Buffett just bought more Walmart, etc. etc. I’m leaning towards Walmart.

    In the depth of the crisis I saw a primo coffee shop business fire sale for 3x cashflow. I almost was the lucky buyer. At the same time, I could’ve bought SBUX for 5.6x cashflow. Right now, I can buy a different, but somewhat similar premium independant coffee shop in my hood for around 5x cashflow. Sbux is trading up to 17x cashflow right now. So both coffee shop investments would’ve been a 3 bagger but it’d be a heckuva lot easier to exit sbux.

    Sometimes I think local business owners are local business owners because they can’t deal with stocks & volatility. Lately I’ve noticed a new competitor in my search for local businesses: JOBLESS People! They’re tapping their IRAs to buy themselves a job. So they’re selling their Walmart stock at 15x cashflow to buy the local grocer at 10x cashflow.

  10. Steve Randy Waldman writes:

    chris —

    great points and insights.

    it is fun that among the sellers of used copy machines on craigslist are sellers of whole businesses. i’d never noticed that. i haven’t found businesses seeking capital, only outright sellers. i’d be interested to see what kinds of arrangements are offered, if you know any prime examples.

    when you say you actively invest in local business, do you manage to pull that off without managing/supervising becoming a full-time gig? i get solicitations to invest in CRE already under lease to small businesses, which i don’t touch, but at least i understand how that could be a passive gig. if you bought that bargain-priced cafe, wouldn’t you have had to run it? how many such businesses can you handle? it’s clear from your comments that you worry about illiquidity / the cost of exit. how do you generally manage this?

    i think it’s great that you do actively invest in small local business. i don’t know anyone who does so routinely, though i do know people who have partnered with one or two businesses that were either run by people they knew and trusted, or that they took on as active projects. what do you think the main barriers are to broader participation by investors other than banks? do you think the kind of thing i’ve proposed addresses real problems (of entrepreneurs as well as potential passive investors)?

    i love the jobless people buying themselves jobs thing. early in my career i was employed by a small business, which was purchased by a father who wanted his daughters to move with him to a retirement haven. he bought up a nice franchise, which gave his (very capable) daughters jobs and a project they could build and grow. i think it worked out great for all of them. a business, in a sense, is both a consumption and a production good, like a house. even if an investor might achieve similar financial returns on low maintenance paper, for many people there’s a benefit to having something more participatory, that occupies and engages, makes use of her talents. it is obvious that some “hobby” businesses, e.g. unprofitable boutiques run by wealthy wives, are consumption goods. but profitability needn’t make “labors of love” any less lovely.

  11. chris g writes:

    Over the years, I’ve seen quite a few ways people finance and acquire small businesses. None are as interesting as what you proposed. I think I will try to be more creative in my thinking/investing.

    “Jobless buying themselves jobs” with their IRA money just doesn’t seem right to me. Nowadays, a buyer can turn his IRA into a self-directed IRA and tap it without incurring early withdrawal penalties.

    Before the consumer finance craze really kicked in, maybe 5 years ago, I “almost” sold a business to an interesting fellow. He was a minority (not sure if that mattered but I think it fit into the equation somehow). He took a class on SBA loans and general “business”. Apparently, the paperwork is cumbersome to get the loan, but being educated on business was part of the process. He didn’t buy my business but about at that same time, a woman I knew took a similar class and started a fashion business from scratch with an SBA loan. I don’t hear about SBA loans so much anymore.

    The biggest problem I see among mom&pop businesses that are for sale now is that their fixed costs (mainly rent) are too high. I recently responded to an add by a restaurant on Craigslist looking to borrow $60k for 2 years at 15% secured by liquor license, inventory and the owners good credit. I didn’t like the idea and passed. His rent was too high and he was desperate.

    I have never liked franchise business opportunities. I’m suspicious when a big company, who has access to the capital markets, chooses not to use them and franchise grow instead.

    Anyway, I enjoy your writing. Keep up the good work.

  12. Brian writes:

    Randy,

    Passive investing in microbusinesses is not a recipe for success. You can’t assume that all entrepreneurs are competent or honest. At some point a distinction has to be made between management and ownership of a business if things are not going well. Most venture firms invest with an accruing, not cash paying preferred, that gives them the right to put it back to the investee after a certain period of time (5-7 years depending on the stage of the company). It is similar to a zero coupon, but allows participation in the growth of the value of the business (which is essential if the risks that are born in small business investing are to be offset with appropriate rewards). These preferred instruments usually come with a shareholder agreement that allows the investors to take control of the firm in certain circumstances. These financing agreements are the product of a lot of investing scar tissue – and passive equity approaches generally produce weak results.

  13. Steve Randy Waldman writes:

    Brian — I very much agree that indiscriminate passive investing in microbusiness would be a recipe for disaster. But I think you paint with far too broad a brush. There are plenty of very small businesses that are very well run, whose management is known and available to potential investors, and who might prefer alternatives to the debt finance upon which they currently rely, especially if those financial relationships strengthen their customer and community relationships.

    I want to draw a pretty strong distinction between what I am proposing and what VCs usually invest in. I’m very fond of venture capital, but this proposal is addressed to a different space. It’s primarily intended as a partial alternative to debt finance for functioning, cash-flow generating small businesses, where as VCs fund earlier stage firms on the hope that they become successful midsize or large firms. VCs must invest with less concrete information, and must forego cash for a long time. They must be very skilled and active both in the manner by which they evaluate potential growth firms and in supervising firms to ensure that capital not generating cash is not simply being burned.

    My claim is that there is a category of small businesses that are relatively easy to evaluate and understand, if investors have access to their usually straightforward accounts, and if investors patronize and are personally acquainted with the firms. As long as investment is not done in such a way as to undermine the incentives of existing “management (a hazard, thus the concern with “density” above), my claim is that largely passive investors have an easier search problem, can more easily discriminate between good and bad firms, when they are local and familiar than when they are distant and listed on a national exchange. Any investor who assumes anyone to be competent or honest will get the losses he deserves, but investors can observe, evaluate, and influence management of local small businesses in a way they cannot with bigger firm common equity. Passive investing is always fraught, for the reasons you allude to. But do you really think that passive investing is more dangerous with a well-defined instrument in a familiar firm than via common stock in firms you read about on Yahoo?

    Again, this is not at all intended as a substitute for speculative startup finance, where I think passive investing just can’t work. I’m sure the instruments you describe are much better tailored for that, and I respect your scar tissue. But I think customers should be investors in the good businesses that they patronize, that it would be advantageous both for the entrepreneurs, investors, and the community-at-large if they were. Do you really think it’s just impossible?

    (btw i go by steve…. i include my middle name just to distinguish myself from other, more famous “Steve Waldman”s.)

  14. chris g writes:

    This is an interesting business that I was thoroughly amazed by when I first saw it:
    http://www.prosper.com/

    It reminds me of your idea.

  15. Mike writes:

    Steve,

    I enjoyed your post, and completely agree with you in that a better way to direct capital into the real economy would be awesome–this is essentially what you are going after.

    But, you still failed to address the age old problem of such a thing:
    1) The extremely high cost of obtaining accurate information about small firms, in proportion to the amount of capital one is able to put to work.

    2) High information asymmetry between the entrepreneur and the investor. This is related to point (1) and raises cost of capital greatly–it really doesn’t matter what form the capital takes (debt, equity, preferred, hybrid).

    3) Agency problem between the entrepreneur and the investor.

    I really think the first two problems–the problem of information–is by far the most difficult ones to solve. Agency problems can be more easily solved by some clever financial instrument and other legal controls that aligns the owner’s incentives with investors to some extent. But how do you lower the cost of information and information asymmetry? Financial innovation can not do this.

    Especially with small businesses–these are both complicated and idiosyncratic entities, and will defy easy categorization and standardization. Of course, GAAP (or any sort of common accounting system) attempts to do this, but then we are back to square one.

    The cost of producing accurate and audited financial statements are what prevents these firms from accessing capital markets in the first place!

    I really do not see a way for financial innovation to conquer this problem. But that doesn’t mean technology won’t eventually triumph. For example, some highly sophisticated information technology may one day make accurate information cheap and plentiful. Who knows? We can only hope.

  16. Mike writes:

    This in response to Chris G’s last comment about Prosper.

    I know quite a bit about Prosper. Basically as a social experiment, I committed about $6,000 to it about 1.5 years ago and build a fairly diversified portfolio of about 100 loans. I can tell you right now: Prosper is a disaster and its failure illustrates the exact difficulty of implementing an idea like Steve’s.

    Prosper suffers from two weaknesses:
    1) Rational investors must devote a very large amount of time analyzing prospective loans, especially in proportion to the small amounts of capital they can put to work at any given time. My average loan size was well less than $100. If you “expense” your time spent, you will not make money.

    2) Because the individual loan sizes are extremely small (maybe just a few thousand each), Prosper cannot profitably verify vital information such as employment and income history; house ownership; credit history etc. And if the loan holder defaulted, it’s pretty much impossible to sue them profitably. Let me explain more:

    Prosper’s revenues = 1-2% fee on the loan size, and 1% of all the cash flows from loan over its life.

    So basically, on a $2,000 loan, the lifetime revenues are maybe $35. On this $35, they need to pay for baseline G&A, marketing, loan doc verification, investor/borrower service, legal fees, identify theft indemnities, etc. As you can imagine, this is not a good business model.

    Prosper’s solution was basically to create a “community self policing” system–similar to ranking EBAY sellers. This of course failed because there is no repeat business, unlike EBAY.

    At the same time, they did not do a lot of the vital work such as calling a borrower’s place of employment or even making sure they provided a real home address! And if a borrower defaulted, they basically sent a few emails and left an angry voicemail or two, and did not pursue further action. Predictably, there was a high degree of fraud and borrower self-selection (deadbeats with no other access to credit flocked to Prosper). Go to Ericscc.com and look at investor returns. They are horrible. I am lucky to eke out a 1-2% ROI (my account is marmot1)

    Prosper suffers many of the same fundamental issues of lending efficiently to small businesses.
    1) Self selection
    2) weak enforcement — costs are too high relative to capital employed
    3) extremely high cost of information
    4) agency problems
    5) information asymmetry

    Any business model or financial instrument designed to direct capital to small businesses must conquer these problems.

    Oh, and just to state the obvious… Your idea basically disintermediates a typical community bank. Of course, banking really only exists to do exactly what you are trying to do with this financial instrument. So the question is: How do you create a system that does a better job than a community bank?

  17. Mike:
    I agree with you. SW’s idea, if workable, would replace community banks. I don’t know how to make it work. The transactions costs would be high. I would not want to own a minority interest in a small business. The “principal-agent” problem is an impediment to getting a return on your money.
    I suppose “community banks” could offer “units” in “small business loans”. Wall Street would love this. It’s “financially engineered” venture capital for small businesses. The community bank makes an intrastate offering of say $10 million. It makes loans of say $50,000 to $250,000 to businesses within a 50-mile radius of the bank. It charges 2% a year to run the “fund”. The fund only loans to cash flow positive businesses valued at 3-6X cash flow at 8-20% a year with some equity “kickers”. But wait, didn’t Wall Street do this already? Weren’t there publicly-held SBICs that did this? When I can think of their names, I’ll post them here. Was one Annally?

  18. Mike:
    I was thinking of Allied Capital and Microfinancial which appear to be in businesses similar to what I suggested.

  19. […] Business Financing By Johnny Abacus A great post on Interfluidity about (the dearth of) financing options open to small businesses. There is also an […]

  20. Steve Randy Waldman writes:

    Wow. A bunch of great comments overnight. Thanks chris g, Mike, and IA.

    A few points.

    1) The connection to experiments like prosper.com (and lending club, etc) is very on point. This proposal is motivated by both my admiration for and dissatisfaction with those sites.

    2) Disintermediating traditional banks, including both small “community” banks as well as regional and national banks that engage in small business lending is very much intentional. I think that the banking model of business finance is deeply flawed, even when the banks aren’t too big to fail (although especially when they are). I think we should work to create alternatives and competitors to traditional banking.

    3) Questions of information are always very much on my mind. I claim that the proposal I’ve offered deals with informational problems better than a variety of very common, allegedly successful investing models, including bank lending and especially traditional stock market investing. I also think information is one of the reasons why this proposal is an improvement on experiments like prosper.com as a means of raising business capital. I’ll elaborate in a separate comment.

    4) As a “disintermediating” technique, the proposal helps to eliminate agency costs associated with a variety of traditional investment schemes. For example most equity investors no longer directly choose and monitor firms to invest in, but purchase shares in index or mutual funds. I claim (and I am hardly alone) that the imposition of an intermediary leads to less-than-optimal choices losses that a direct investor with the same information would avoid. The cost of these poor choices, of course, must be weighed against the benefits of economies of scale in information collecting and monitoring (along with diseconomies of scale in transaction costs and the menu of investable securities). My strong view is that, all costs and benefits weighed, the costs of delegated active investing outweigh the benefits on average, so on average there are gains to disintermediation. What applies to active mutual funds applies to even more emphatically to banks. Banks invest on behalf of funders who for the most part are very insensitive to bank investment performance. In all the centuries that banks have been played a predominant role in allocating capital, we have yet to solve the problem of incentivizing bankers to invest steadily and well, rather than counterproductively in procyclical trends. Investing well is an art that requires continual acquisition of information, careful strategy and technique, and qualitative human judgment. Neither bank human resources departments nor the stints of celebrity that give mutual and hedge fund managers access to funds have served us well in finding or creating good investors. I do not wish to say that delegating active investment is never wise — under some circumstances, for some investors, the problem of choosing a good agent may be an easier problem to solve than the problem of choosing a good investment. But on average there is little evidence that is true, so we needn’t be shy about creating alternatives to delegated investing and seeing if they don’t perform better.

  21. Mike writes:

    Steve,

    I disagree with your last statement.

    For one, I actually think banking in general has done a pretty good job of allocating our collective capital over the last few hundred years. Heck, look at our real GDP growth and GDP growth per capita for the last few hundred years! On the other hand, bank crises have been fairly rare–maybe one every few decades–and most of the time not causing permanent damage.

    To prove that banks have done a poor job, you would essentially have to do a social experiment where there is no financial intermediaries. Well, I actually could point you to one: Microfinance. Microfinance organizations (like Mohammad Yunus’s) basically introduces a financial intermediary to a system with one. Everyone lived day-to-day and savings were essentially stashed in tin cans buried in the dirt floor. It’s not a perfect analogy (because these organizations can be a giant fiscal/monetary stimulus, depending on who funds it), but I think it’s a favorable point for financial intermediaries.

    I personally think it would be a complete disaster if every individual had to actively choose to deploy their capital. I think my experience on Prosper illustrates this amply.

    Also, I would go as far as to claim MOST US citizens simply do not have the knowledge, judgment, or time to make even half-decent investment choices. I think that if you waved a wand and magically destroyed all the financial intermediaries and basically required everyone to fend for themselves, a class of “institutional investors” would quickly arise and fleece the crap out of the “small investors” out there. But that’s just my 2 cents.

    *** ***

    The trouble with financial innovation is that it doesn’t have a major impact on the size of the economic pie. (yes sometimes financial innovation might enable capital to be deployed slightly more efficiently, increasing pie size, but this effect is usually small and secondary)

    You have basically a pie, stemming from an asset or business enterprise, which I divide into three parts:
    1) Cash flows to the borrower
    2) Cash flows to the investor
    3) Frictional, transactional, tax, etc. Other Costs

    The first two cash flows can vary greatly based on the success of the enterprise and the structure of the investment.

    In lending to small business and individuals (e.g. prosper), (3) is too high. This squeezes (1) and (2) and makes the entire pie unappetizing to both investors and borrowers. Banks try to cut down on (3) by centralizing expertise and back office costs. You must do a better job if you want to disintermediate banks.

  22. Steve Randy Waldman writes:

    I want to compare and contrast what I am proposing with sites peer-to-peer lending sites like prosper.com and lendingclub. I am guardedly fond of p2p lending, because it tries to work around the banking system, and could in theory lead to a smart, decentralized approach to credit allocation. But I think that sites like prosper.com and lendingclub have very serious deficiencies that my proposal seeks to remedy. (It’s worth noting that those sites focus primarily on consumer lending, although business loans with personal guarantees can also be funded. My focus is business lending.)

    Our discussion will be dominated by the related and deeply intertwined issues of information and risk-sharing. p2p lending is built around traditional credit arrangements. Traditional credit arrangements try to compensate for poor information with strong promises. Conditional on lenders having very poor information, it is understandable that they would want strong promises. But that’s like saying conditional on your stabbing me, I would like some novocaine. The strong, inflexible promises layer unnecessary forms financial (and eventually systemic) risk on top of the necessary risks of operating a real business. It would be much better if information asymmetries could be reduced, so that financial arrangements with more risk-sharing — equity-like arrangements — could become practical.

    Sites like prosper and lendingclub both presume and to a certain degree enforce the notion that loans will be made between strangers. They permit a certain degree of communication via their websites, in the form of descriptions and proposals, profiles, messages, etc. prosper.com has a built in social network that allows users to register sometimes verifiable affiliations (e.g. alumni networks), develop histories, and vouch for one another. But that’s all. That might be the best they can do in consumer lending (which I consider a bit of an iffy business to begin with). Consumer finances are by their nature deeply personal and subject to privacy concerns. Loans between individuals who know one another directly can become emotional affairs, sometimes dangerously so. p2p lending sites are mindful of this and strive to restrict the communication of personally identifiable information. Absent an intrusive analysis, analyzing personal or household cashflows is difficult, both by virtue of ordinary privacy, because of a lack of formal accounting, and because there is no reliable information on the sustainability of past cashflows to the degree that they are observable. Most individuals’ only “client” is their employer, and most lenders have no means of learning the quality of value that individuals produce (which they might use to draw inferences on the sustainability of income). Lenders at prosper.com or lendingclub are really replicating bank finance — strong promises and no risk sharing to deal with information asymmetry — and do so with less information than traditional banks. Traditional bankers can interview clients, ask for personal references, and solicit intrusive documentation of finances. They also frequently have deposit relationships with clients, and can mine their own records for information on a potential borrower’s finances.

    Investors in a business often have an immediate advantage over consumer lenders: businesses offer services to the public, which potential investors can evaluate. Obviously, some businesses operate in specialized niches for restricted clienteles. But businesses that provide goods and services to the general public reveal a great deal of information just in doing so. Very many successful equity investors take into account personal experience with a business’ products and services prior to investing. My proposal is geared very specifically to this kind of business. It is not intended that investors should supply funds indiscriminately or based solely on accounting information to unknown firms. Rather it is my claim that, as a matter of course, individuals generate very valuable and important information about the businesses they patronize, and that this information could be used to inform investment decisions. Yes, a business’ owner still knows much more about her business than a satisfied or horrified customer. But over time, patrons can learn a great deal about small businesses. My contention is that the informational asymmetries facing a longstanding customer of a small business are often milder than the disadvantage faced by ordinary equity investors, despite all the detailed disclosures and accounting mandated for the latter. Investor/customers can evaluate the quality of service, can speak informally to the owners and a substantial fraction of the employees of a small business, etc. Despite SEC regulations, audited accounts, and mandated disclosures, it is very, very difficult to get a holistic sense of the value and condition of a large public firm.

    Yet I am more comfortable investing in large public firms. Why is that? It’s because I have other ways of mitigating risk. My investment in any large public firm is typcally a small fraction of my investable wealth, and represents a very small fraction of the capital used buy the target firm. I don’t feel unduly bound by the relationship: I can modulate my exposure to the firm consistent with ongoing evaluations via anonymous and unnoticed trades. I understand when I invest in public equities that some of them will be losers, but by diversifying and making good choices on average, I can potentially eke out superior returns, despite a profound lack of reliable information and almost no rights associated with my investment.

    Investing in smaller firms that I know and patronize would be more attractive if I could invest in anonymous small amounts adjustable over modest periods of time. I have a high degree of confidence that some small businesses will succeed, there are others I would sell short if I could, and a variety in between. I think I could build a very profitable portfolio of small firms, if success were a function of predicting business success. I believe that I and very many other investors would be much more capable of differentially evaluating small, local firms we directly patronize than large firms on distant exchanges.

    There’s a major problem, which is that no matter how good a business is at its core competence, poor accounting or operations can still doom a business to failure. Requiring small business to manage and disclose their accounts in the same way as Exxon/Mobile with armies of accountants squabbling over GAAP rules is an obvious nonstarter. But there are sensible intermediates. If there were fairly standardized “QuickBooks” accounts that could be made available on-line, small businesses might adopt a kind of “open source” accounting at very low cost. Sure, unscrupulous operators can always find away of looting a business and stiffing investors. But the accounts of many businesses needn’t and shouldn’t be very complicated.

    Further, in my proposal the choice of operating cash flows rather than profits as the measure determining timing of payouts and returns was a deliberate choice to address informational concerns. Profits and earnings are nebulous concepts, always dependent on uncertain estimation of costs. (Conceptually, profit is what is earned above and beyond what must be spent to sustain a business at its current level of operation. How much of revenues must be reinvested is a judgment call. Formal procedures of depreciation and expense allocation create conventional measures, but not necessary true or accurate estimates.) Operating cash flows are not without some smudge, but they can be pretty objectively measured.

    By basing investor payouts on operating cash flows, I aim to simplify the knowledge problem investors face. Investors can know with a pretty high degree of certainty the rate of historical operating cash flows. They can observe the customer-facing aspects of the business directly, and make estimates about whether they believe the rate of commerce will expand or contract in the near future. The primary place where information asymmetry bites is the question of will the business continue to survive and meet its obligations to investors over the relatively short term between purchase of a security at a discount and its redemption. In sum, investors must be able to make fine-grained judgements about changes in the visible level of sales as well as a course-grained judgement about whether a firm will continue as a going concern. Investors have plenty of information to evaluate the former, and the latter is a binary decision dependent in part on hidden variables, but still not intractably complex. How subtle operational choices affect the business’ level of profitability beyond subsistence is not the concern of external investors. Only entrepreneurs understand the operational details, and only entrepreneurs are impacted by how well or poorly they manage those details within the broad range consistent with survival.

    Finally, the form of the investment is designed to minimize going-concern risk, since the investments payout at a rate determined by briskness of business. That claims are paid only as operating cash flows are realized, and that the claims are equity (they can fall into arrears at some cost and threat of loss of control to the entrepreneur) diminish the likelihood that a business will simply fail compared to offering the same finance on traditional credit terms. Entrepreneurs can always quit, they might always choose to wind down the firm if business profitability is insufficient to keep them motivated, and in a liquidation there is the danger that investor claims won’t be made whole (although since these are preference shares, if the entrepreneur gets anything from the liquidation, all investors would be made whole first). But so long as an entrepreneur wishes to persevere, replacing debt in the capital structure with equity makes it likely that investors will face losses in the form of low returns via glacial redemption rather than outright loss of capital.

    That’s a lot more (and a lot less organized) than what I’d planned to write. I’ll summarize by repeating that I think that information asymmetry issues, while not solved, are mitigated and can be better managed under my proposal than in settings like prosper.com or major public equity markets. I came up with this idea to “scratch my own itch” as an investor. I find it terribly frustrating how much economically relevant local knowledge I have that ought to profitably enter into capital allocation decisions, but that for lack of appropriate contracting arrangements I can not apply.

  23. Steve Randy Waldman writes:

    Mike —

    I think we’re disagreeing less than you think. By “disintermediation”, confusingly I don’t mean eliminating all institutions of financial intermediation. That is I agree that if we had eliminated banks and not erected any institution in its place, economic development would have sucked over the last few hundred years. “Disintermediation” in this context is about decisionmaking. I think that given reasonable information, the ultimate bearers of economic risks and benefits make better allocation decisions than their agents and delegates do, that in fact the problems of agency in investment are very deep and very destructive. We need institutions to facilitate financial flows — indeed I’m proposing such an institution, a kind of electronic market on which hybrid debt/equity instruments are sold. But my view is that the best financial intermediaries are fairly transparent. That is, they minimize frictional costs as much as possible and idealy exploit economies of scale in information gathering, but leave actual allocation decisions in the hands of end-investors.

    It may be the case that, in the past, frictional aspects may have made such fragmented and decentralized decisionmaking with respect to millions of tiny firms impractical, and banks were the best that can be hoped for. But I think information technology changes that.

    I agree that very many people have neither the desire nor the ability to participate in capital allocation decisions, and that for modest amounts of wealth, we should accommodate those preferences with safe zero-information savings vehicles. Ultimately, however, carrying wealth into the future requires work and risk. Banks are only able to offer safe zero-information savings vehicles because they are insured by the state. The state can offer safe, zero-information savings vehicles only to the degree that it manages the economy well enough that via taxation and monetary policy it can maintain the real purchasing power of its claims (ie no major inflation that devalues dollars much faster than T-bill rates). My view is that the right policy is for the state to ration safe, zero-information claims on the future (because their production imposes costs and risks on others). But such claims have nothing to do with “financial intermediation”. It is much more accurate to adopt the chartalist view of banking whereunder “savers” effectively lend money to the state, and the state lends money to the public sector by delegating banks to allocate. People who “invest” in perfectly safe assets are not investing or meaningfully allocating economic capital at all. They are accepting free insurance provided by the state, receiving a subsidy. It’s a good subsidy, because the social and economic costs of forcing every baker to have to have a Bloomberg terminal would be high. But let’s not pretend that a baker is “investing” when she deposits modes sums in insured bank accounts.

  24. chris g writes:

    Buffett said: “I’m prosperous because of the society around me.
    Stick me down in some poor country and I’ll walk around and say I allocate
    capital, you know, and they’ll say, so what? What we need is a guy with a
    strong back. You know, and I don’t have a strong back.”

  25. Mike S writes:

    This idea is great, but there is almost no way people would do it. The concentration risk is too high for me – and probably for lots of other people too.

    It would be much more attractive to me to setup some sort of fund that invested in lots of businesses, with the same structure.

  26. babar writes:

    i am not sure why you see this as a problem needing a new “instrument”.

    as this whole shebang has revealed, making financial instruments work always falls back on making institutions (banking/regulatory) work. that’s because financial instruments are contracts and claims and are enforced by governments. so unsurprisingly, you need a new kind of intermediary.

    what’s wrong with community banks, or small venture capital outfits?

  27. najdorf writes:

    I think you’re looking for something in between listed stocks and partnership in small local business. That is, you want people to be more involved with their investment than they are in buying 100 shares of GE, but not so involved as a full partner in a small local business. My question is, why? Why do you think that someone who is not entrepreneurial enough to start their own business or partner with someone they know and put up capital for an ownership stake is going to be a useful capital allocator or semi-partner? Who is going to benefit from this model?

    I don’t think investors in local businesses, most of which struggle to pay their owner a living wage, are going to get better returns than they would get investing in public companies. I don’t think local entrepreneurs are going to be thrilled with answering to a bunch of new stakeholders with varying levels of interest and comprehension about accounting, when they get paid, whether expansion plans are a good idea, etc. On the other hand, if you force investors to a totally passive role, how exactly are you fixing the problems with public equity?

    The only kind of public ownership of small businesses I’ve observed is co-ops, which generally do a nice job making everyone feel good for about a year, then settle in to non-profitability and squabbling. The more successful ones are able to build the kind of core membership that enjoys the opportunity to fight about trivialities without being so incompetent as to drive away all possible new investors (i.e. sources of funds to continue operations). To imagine that the average American community could take this model and turn it into something profitable for all concerned seems optimistic.

    At best I think you could see the small investors get their cash back out with minimal returns and the owners eventually graduate to a more stable source of capital. Maybe this would give people a warm community feeling, but I don’t see it as a subsitute for banking/investing. If you want to make money in a small business you have to be an active participant or a serious investor with the influence in the community that entrepreneurs respect you, want your support, and fear defaulting on you (either the local bank or the kind of person who can make or break a business based on social networks). The inefficiences introduced by bringing in clueless and low-stakes small investors are going to outweigh any benefits gained by cutting the banks out, and Prosper is a great Exhibit #1 in the case for this argument.

    I think your best non-bank alternative is for those who are already successful and known in the community to individually support new businesspeople as partners. Every ethnic community that has come to America ran their businesses this way for at least a time, and some still do. I don’t think you can go more diversified/less controlled without losing the key element of responsibility for both the investor and the businessperson. This model also worked better when people knew their neighbors, didn’t have access to credit cards, and didn’t expect to up their consumption at the first minute that their business became cash-flow positive. But with the right people it still works today.

  28. winterspeak writes:

    Steve:

    The Treasury is NOT a “nearly bankrupt and profligate entity”. It is an entity which, uniquely, need never bounce a check and it has been extremely stingy in recent years, as can be seen from the 10% unemployment rate.

    That said, making loans to credit worthy small business, or heck, making loans to any credit worthy borrower, is an excellent idea. It’s why we created banks, actually, although it seems that that initial and core purpose has been lost in the mists of time.

  29. Just imagine I read it twice. While I am not as accomplished on this issue, I match with your determinations because they create sense. Thanks and goodluck to you.

  30. FreeSpirit writes:

    Isn’t this a job for “Angel Investors”, and couldn’t it be done by partnering with Community Banks and by structuring the Operating Agreement and the equity/debt capital so that the initial debt load (angel+CB) is light (and angel equity is high), and such that as debt is retired (say, to pre-agreed levels), angel equity is gradually converted to angel debt and becomes withdrawn from the business.

    I operate a veterinary hospital with a lot of initial debt, and it eats up the cash flow for 20 years. Cash is the lifeblood of business, so having less flow means higher risk of bankruptcy. By restructuring the debt into three parts (angel debt+CB debt)+(angel equity) and arranging an orderly exit plan (not necessarily IPO, as for larger companies), it is possible for the angel to earn ROI, the business to have a better chance to survive, and the founder to ultimately hold all of the business, and the CB to split the risk.

  31. Steve Randy Waldman writes:

    So, overall, there’s not a lot of love for this idea. Thanks to everyone for the comments. I think you guys are wrong, not to love this idea. It’s actually something I’m pretty excited about, something I might want to do when I grow up someday (at 39, I still have a long way to go). In my arrogance, none of the critiques offered so far have shaken my view that this is a pretty good idea that fills in some gaps and that could present an alternative to bank financing and the unnecessarily dependencies on a vast and broken system that come with bank financing. But you all have done a great job of persuading me that this is a case that doesn’t make itself, that the mere exposition of the idea doesn’t reveal its brilliance, and I’ll need to work a lot harder at making clear what’s so great about the kind of microscale public equity I’ve described.

    Anyway, a few responses to the last barrage of critical comments.

    chris g — nice quote!

    Mike S — So, I’m really suggesting this as an alternative to the set-up-a-fund/delegated-management arrangement, which I think succeeds magnificently in isolated cases but does a poor job of allocating capital in aggregate. I do think there should be more local/small-biz investment funds. But fundamentally, I think the investment-fund model introduces quirks and distortions into the investment process that more direct capital allocation could improve upon. Amd, there’s the matter of all the fees.

    You write, “The concentration risk is too high for me.” But one of the core goals of this proposal is to let you invest in small businesses without concentrating risk. What if you could literally buy a single dollar of future cash flow for 90 cents today? Suppose there are twenty local companies that you do business with, eight of which you think are well-managed and kind of great, that you think will keep doing well and perhaps expand. If you could conveniently invest a modest sum of money building a portfolio if the eight good firms, would that be too concentrated for you? Of course, investing in local small business does expose you to local-economy-systematic risk — great small businesses in Detroit no doubt have struggled despite being wonderfully managed, because Detroit’s economy is imploding. So it’d be unwise to invest only locally. But this is analogous to the traditional argument for international diversification. You’d want to invest locally, and more distantly, but since you have more information about local investments, your investing process might be different. You might go for low-information bonds and index funds nationally and internationally, but high-information direct investments locally.

    I want to qualify that when I use the word “local” I really mean whatever you have the most direct information about, given the habits of your life. That might usually mean physical proximity, but not always. Every individual who meaningfully interacts in the economy is “located” by virtue of the information that they naturally acquire without having to do costly information work or rely upon the representations and opinions of others.

    babar — first, instruments matter. say what you like about the 1990s equity bubble, but the general public didn’t bear much direct risk. when people invest in instruments that are clearly risky, that are supported by small institutions with only indirect connections to the state, investors, firms, and the state behave differently. it’s no good saying “only regulation and intermediaries matter”. Regulation, intermediaries, financial instruments, form of business organization, etc. are all interrelated. If bank credit were never state insured and returns on bank deposits were consistently volatile and frequently negative, then bank credit would be equity-like, and we’d decentralized investors would not have built the palace of glass that now threatens to shatter all around us. The nature of bank credit is set by its contractual form, by the nature of banks, by relationships with the state and central bank (deposit insurance, lender-of-last-resort, clearing and settlement systems, maintenance and organization of the interbank lending market). My view is that taking the banking system as given and playing with around with supervisory regulation is unlikely to lead to other than transient success.

    What I’m proposing is both a new instrument and a new intermediary (although I should have made that clearer in the piece). The intermediary would be like localized miniature securities exchanges, that would manage and certify the integration of small business accounting systems to produce visible, near-real-time reports of operating cash flow, and would facilitate the sale of securities from participating business to the general public. (It would not necessarily offer a secondary market in the contracts. I’m of two minds about secondary markets.)

    Angel investors, venture capital firms, and community banks do exist. You might think that they are good enough. I don’t. From firms’ point of view, access to capital from those groups is touch and go, costly, and labor-intensive (pitches, business plans, lawyers, etc.). Many small firms have customers with investable cash who know they run a great business. It is inefficient that they should have to seek out a professional investor who’d never walk through their door, while informed customers put money into low yield bank accounts or gamble with no information via index funds.

    Putting the word “community” in front of a bank doesn’t make banks less poor a form of organized investing. Not all banks are poor investors, but most succumb to professional norms that are dressed up forms of irrational herding. Further, bank debt creates unnecessaqry financial risk for small enterprises. Venture funds are a bit better (mostly because they insist on long investor lock-up periods and invest more eccelctically), but they tend to seek growth businesses rather than supply capital to modest entrepreneurs. Angel investors are quirky. Whether one can find one depends a great deal on social connections, and they vary widely viz the quality and terms of their investment. I’m very glad that angel investors and venture capital exist as alternatives to bank finance. But they are insufficient, in my view.

    najdorf — I think there’s something I haven’t made clear enough (and, to be fair, I’ve muddied this in the comments). Investors in the instruments I propose would have absolutely no control rights in firms, so long as they are not in arrears in making redeeming claims as they come due. I agree re co-ops, and re public firms in general, that notions of shared, dispersed “ownership” are bullshit. The lived reality of firms is that managers run firms (sometimes owner/managers, sometimes not). Outside investors affect the operation of firms only indirectly via constraint: creditors impose covenants that limit manager behavior, and may impose control more directly when creditors are violated or in case of default via the threat of severe consequences to noncompliance. Management of publicly owned firms is constrained by equityholders primarily by exit, which is revealed as falling stockprices. (NB: I include the board of directors in management for this purpose.) When stock prices fall too much, fiduciary obligations of board members, shame and social ickiness, and the threat of external takeover kick-in. Managers must provide competitive returns so that shares don’t dramatically underperform peer firms. Beyond that and within their debt covenants, they have complete control and effectively own the firm.

    Viz the contacts I have proposed, claimsholders would exercise control only via exit (not reinvesting maturing contracts), or in arrears (in a manner to-be-determined, entrepreneurs would gradually cede control rights as contracts fell into arrears). I muddies things by saying I thought investor-customers would be helpful to firm management. I do think that, first and foremost by providing free promotion, and secondly by providing advice and assistance. But that would be informal and unremunerated. Investors would be clearly informed from the start that they are along for the ride in a dictatorship of the entrepreneur. The only assurance that their interests will be looked after at all is the confluence between their interests and the entrepreneur’s. Evaluation that confluence (given information about limits on the “density” of future operating cash flow sold off and the entrepreneurs’ history and stake in the firm) would be (as it always is) part of the informational work of investing.

    Re prosper.com, I reiterate my point that the big problem there is that the model is strong promises / low information investors, where what I propose is weak promise / high information investing. Investors under this model have direct, personal information about (but no control over) the firms in which they are investing.

    Re business that struggle to pay a living wage: all businesses are paying for their capital now, one way or another. Offering a reasonable return on capital isn’t an incremental new expense, but a replacement of existing expenses. I think that, especially in risk-adjusted terms, high quality firms would be able to raise capital more cheaply via direct equity-like claims from diversified retail investors than they do via banks or angels.

    A lot of my goal in this proposal is to try to institutionalize and de-ethnicize what ethnic communities have traditionally done. Ethnic-community-based investing involves high information (people invest in firms and people whom they know, and whose behavior is predicted to be constrained by known social relationships) as well as shared costs and risks. The legal formalities of ethnic-community investing vary widely from formal partnership/equity/credit arrangements to cash, a handshake, and expectations of reciprocity. On the down side, certain social skills and conformity to norms of the community are very important for potential entrepreneurs, and potentially good projects may go unfunded due to economically irrelevant slights and social clumsiness. Since much ethnic-community investing is informal and norms often discourage the involvement of external legal authorities, dispute resolution can be challenging.

    I think ethnic communities have been a very successful source of small business financing and risk-sharing. But I don’t think it’s reproducible, and the downsides are so serious (especially from the perspective of someone as socially inept as I am!) that I wouldn’t want small businesses to have to rely on such intimate and intrusive networks. I think we can invent institutions that serve the positive functions ethnic communities have served, without the exclusivity and intimacy of those communities. Again, that’s what I’m hoping to do.

    winterspeak — Re bankruptcy, profligacy, etc. I’m just reporting, not stating my opinion. That said, I’m more sympathetic to Dan’s view than you are, though of course I acknowledge that the government cannot be insolvent in US dollar terms except by choice. I’m a bit more concerned about the stability about the relationship between the real and financial economy than I think you are.

    you’re view of what banking should be (public/private investment funds whose private funders are incentivized to invest well via a position of first loss) is I think very elegant, but the degree of obfuscation in present institutional arrangements along with the lack of commitment by private funders (who constantly threaten to run) mean that banks fail to perform well the duties that in theory they’d be expected to perform. Plus, there is the Hayekian issue (that very much motivates my proposal) of making good use of decentralized information. Why should we expect bankers to be particularly well-informed, in a Hayekian sense, and wouldn’t we expect the quality of bank investment to devolve to that of crappy central planning with the concentration (via organizational dominance and professional convention) of the banking industry?

    if banks were explicitly constituted in the way that you describe and theorize them to be, they’d be better banks, and i might have less to complain about. i’d be in favor of moving towards Winterbanks. but i think there’d still be a place for direct equity-like investing, and that we should exploit the fact that information technology makes it practical to organized very fine-grained, high information equity investing.

    FreeSpirit — The description of your business experience is great, and goes towards what motivates this proposal. Initially you had a great deal of bank debt, and despite that you had a long-term positive enterprise value, you were always at risk because your operating cash flows and your debt service obligations could become mismatched. You resolved the situation by making creative and effective use of the menu of capital providers currently on offer: namely you found an angel and a bank by which you created a debt/equity mix such that the debt service burden was unlikely to create distress costs due to transient business fluctuations. To do so, you had to share some upside with your angel investor, the timing of whose cash flows from equty is not guaranteed.

    It’s great that you managed to do this. But what if you’d been unable to find an angel? Access to angel investors is always uncertain for small entrepreneurs. A lot depends upon a manager’s skill at beating bushes and making a formal case for the business, social connections, and luck, all of which may or may not be relevant to the success of the business’ core operations. I certainly don’t want to discourage angel investing, which I think is great. But I want to add to the menu of options a source of angel-like capital that would be more institutionalized, that would become available to firms known to be well-managed buy their customers/suppliers/etc, but not necessarily able to find angels. Also, I’d like to provide the opportunity for investors with only modest capital to become “mini-angels”, to create diversified portfolios of firms they know well and believe in, allocating only a fraction of even modest nest eggs to do so.

    Thanks to all for the very thoughtful, albeit not entirely positive, comments!

  32. I think that ZCP are a good idea for small well-established businesses looking to finance modest expansions with less default risk than a term loan. I’m not sure how well they’d function for day-to-day cash flow, like financing the monthly wage bill.

    I’m surprised that no-one’s considered taking a firm’s sales numbers from its tax receipts. Surely this is the best information source: the cost of collection has already been sunk and the penalties for gaming are severe.

  33. How about this for SMB financing idea?

    I have a credit card that works like any other. On it’s website I can see which businesses I regularly spend money on – and I can open a pre-pay account with that business. When I next use my card at that business, the bill is deducted from my pre-pay and I receive a discount (effectively a disguised interest payment from the business owner). Every payday I prepay for most of the local services I use by a (free) bank wire.

    My back balance would fall by 10-35%, the business owner’s could reduce their overdraft by the same amount; we then split the savings on the spread the bank would have earned, the tax on my interest income and the card company’s fees.

    The efficiency comes from me financing my own future consumption [which I know with great certainty], rather than a bank guessing what it might be.

  34. FreeSpirit writes:

    Sorry to return late to the comments.

    SRW, I didn’t mean to imply that I had been successful at getting an angel investor! I am, regrettably, up to my eyes in debt (but still able to handle it).

    I have been thinking for several months what to do when I have awesome cash flow thanks to economy of scale as we add doctors to our relatively fixed (and large) cost structure. My idea is to partner with my CB lending officers or with the SBA development companies to provide angel capital as part of the financing mix to prospective businesses. Your idea for a third way for business financing struck me as being similar in goal, though you are looking for something new.

    Being a small business owner, I like to push circular flow locally as best I can. I also think I can get more information from a local business in which I am invested. This is similar to the “de-ethnicized” capital networks you desire (and the ethnic financing networks concept was the perfect analogy, BTW). For small business financing, perhaps the mechanism can be formalized through the SBA development companies, merely by creating a roster of current and pending angel investors, just as they maintain a roster of banks (with local branches) that participate in the SBA program.

    I suspect that as angels get more diversified, they’ll create investment management companies, which would do well to offer value-added services for their invested businesses, such as management/leadership and finance training. (In the veterinary field, it is not uncommon to have non-owner management companies that operate veterinary hospitals on behalf of the owners. Veterinarians are notoriously bad business people, so the third-party expertise makes a big difference.)

    If a new way could be created, what you propose would work as an excellent substitute at the local, personal level. Long-term financing that is structured as equity but behaves (in the long-term) as a ladder of condition-based zero-coupon bonds would simplify the angel approach I outlined above.

  35. najdorf writes:

    Here’s my other challenge, this time to the investing angle on this: what would the cost of equity capital for small businesses be? Typically the entrepreneur puts in his own capital or takes on a partner who gets the opportunity to earn very high returns on equity capital. Additionally this partner is probably willing to take an operational role, help line up debt financing, or commit more equity as needed.

    What would you be willing to pay a silent, small-stakes, low-commitment equity investor? If the answer is “less than you’d pay the bank for debt financing”, why would the small investor accept this return on a riskier investment (assuming the small equity investor is subordinated to some amount of debt, since you talk about risk-sharing/stock substitutes)? If the answer is “more than you’d pay the bank for debt financing”, why would you pay more just for the privilege of killing your local reputation rather than your credit rating if you have to default? I’m not trying to be difficult, I just don’t understand who the middle ground between real small business involvement and common stock investment is supposed to benefit. Small businesses are really risky – that’s why they’re funding by owner capital, equity partners, or secured bank loans. I can’t see a sweet spot where an owner would pay a local investor 10-20% for an odd, cumbersome form of equity capital and anyone would be happy.

    Also your proposal makes no allowance for debt-funding and long-term/short-term capex options. Investors in dollar #100,000 and dollar #1,000,000 might have some disagreements about the advisability of taking out a bank loan to open a speculative second location or existing location expansion of a currently cash-flow positive business. If they have no control, the person running the business has all sorts of opportunities to disadvantage one or the other. I don’t know how I would predict what sort of expansion plans the owner might engage in – do we want him or her forming a lot of semi-contracts that generate a lot of lawsuits by promising expansion/no expansion to investors?

    Furthermore, doesn’t loading small businesses with non-controlling equity capital with forced future payouts and weak claims on assets incentivize marginal owners to cease operations and create losses for equity holders? Doesn’t it make efficient changes-of-control hard to implement if the potential new owner doesn’t want to run the business with this sort of equity funding? It’s often easy to pay back a bank loan or buy out a minority share-holder, but if my desired capital structure is owner equity or heavy use of debt leverage, or if I want to transform the business in a way that violates the original agreement with equity-holders, how much of a discount am I going to demand for the hassle of buying out or running off a lot of small equity claims? Maybe enough of a discount that the deal doesn’t get done and the equity holders lose out as existing management simply walks away or runs the business into the ground.

  36. Steve Randy Waldman writes:

    Thomas — Tax forms certainly could be used as a means of tracking revenue (although taxable revenue and gross operating cash flow aren’t identical). I don’t think that measuring OCF would be too hard a logistical problem for remotely nonfraudulent businesses (I chose operating cash flow explicitly because it requires far fewer judgment calls to quantify than other measures of business success. Also because the existence of operating cash flows automatically increases the likelihood that the business can stand outflows to investors.)

    I like your idea about prepaying for consumption as a novel financial vehicle. I’ve though a bit about prepaying for consumption, and I suspect our thinking is fairly similar. As you point out, future consumers have information about their intended consumption that they fail to reveal if they store value in currency-yielding vehicles. We should be able to improve business planning, and therefore improve business efficiency, by giving consumers a reason to reveal that information in a way that businesses can act upon.

    Your proposal suggests that consumers might be persuade to store value in the form of preallocated future consumption by being given a cut of those efficiency gains. That could make sense. I’ve thought about it a bit differently, but my my thinking doesn’t contradict (and potentially complements) your view.

    The problem facing low-information savers isn’t how to maximize returns. In an reasonable system, low-information savers won’t on average or in expectation be able to earn anything more than “normal” returns, whatever those turn out to be, for whatever sorts of risks they choose to take. So why do savers who know they are clueless invest, say, in index funds? Some, of course, are speculators on history: they’ve heard the “stocks for the long run” story and run with it. Like all adult gamblers, they deserve what they get.

    But very many savers are just trying to hedge future consumption risk. That is, regardless whether some formal inflation basket skyrockets or not, savers face a challenge trying to ensure that they will be able to afford what they intend to purchase in the future, even if they could afford those purchases now, due to price changes.

    Coming back to your idea, if consumers could prepay for future consumption, at prices agreed in advance, they might not even require excess return as compensation for prepayment. They realize an increase in risk-adjusted return if they earn an ordinary interest rate against guaranteed future prices.

    This effect works in favor of your idea, as entrepreneurs might have to concede less than they otherwise might for the prepayments, if they are willing to accept future price risk. They should, though, because providers are often capable of hedging future price risk in ways that are implausible for individual consumers. Restaurant chains can buy ingredients forward, grocery stores can get price commitments from suppliers (who themselves hedge) etc.

    Very often, firms are willing to offer customers a near-immediate return on prepaying for consumption. You can often buy gift cards for less that 100¢ on the dollar, because providers value both the certainty of future business and earn extraordinary profits on the fraction of prepayments that go forever unredeemed. If they offered gift cards that were initially priced at a discount, offered a modest rate of interest if held unused (perhaps until a fixed redemption window, which would help the supplier plan future business), and could purchase goods at predetermined prices, that might be a very good deal to the consumer. Since the rate of interest firms would need to pay consumers to compete with bank accounts is much smaller than firms’ cost of bank financing (and since consumers might accept predetermined prices in lieu of interest payments entirely), firms might find these cards to be a convenient source of financing.

    I don’t think of done anything more here than rehash your excellent idea, with the wrinkle about hedging consumer price risk. (Retail derivatives in everything!) Actually, looking back I’ve left out something clever you suggested, the bit about substituting discounting for interest as a tax dodge. That would obviously sweeten the deal if it’s doable, but I don’t think it’s necessary to drive the idea. That is, I think the idea can succeed on its economic merits prior to tax considerations.

    I definitely think something like this could be worth pursuing.

    I’m not so excited about linking to existing credit cards, because of the muck and subterfuge associated with interchange fees. Wouldn’t a pair of banks still take 3% on transactions for which consumers have prepaid? (In your post you presume not, but I think prepaid cards currently do pay the fees.) Would we have to offer reward program kickbacks, and the inequities they create, in order to compete? Obviously, integrating with Visa has the advantage of putting the product automatically in everyone’s pocket and enjoying economies of scale by bundling prepayment accounting information with existing credit card statements and management infrastructure. Those are pretty huge positives. It’s quite possible that my visceral disgust with the banking system is distorting my view of the idea. But I’d much rather offer something fresh, with fees that are transparent and clearly accounted, than to join hands with existing products. Again, that could just be unreasonable on my part. (But hey, it’d be a selling point getting good discounts from vendors for prepayers, since they’d not have to pay such obnoxious interchange fees!)

    Anyway, if you can’t tell, overall I like the thrust of your proposal. I put it in a different, complementary, bucket from the idea in the headline post: “VTZCPs” (Variable! Term! Zero! Coupon! Preferreds!) would be a means of investors who view themselves as informed to seek maximal returns, while the prepayment idea would be a means for customers who perceive themselves as uninformed and at risk to hedge. From firms’ perspective, VTZCPs help hedge financial risk they would otherwise have to assume from cash-flow insensitive bank financing, while prepayments would offer cheap financing and an opportunity to reduce some risks associated with uncertain demand, in exchange for assuming (though potentially rehedging) risk regarding future pricing.

  37. Steve Randy Waldman writes:

    Free Spirit — I’m glad you are able to handle it! Managing the financial side of a small business, navigating the liquidity and capital constraints that all businesses face is really hard. Good small-entrepreneurship relies upon a “double coincidence” of skills — the ability to manage a business, with its financial and operational challenges, and talent in the business’ core competence. It’s no wonder that success is relatively rare.

    I like the point about local circle flow. Given that production and consumption are nonsimultaneous occur over time, all business relies upon mirror-image circular flows of real value and obligations. Capital flows from investors to entrepreneurs, and at the same time obligations flow from entrepreneurs to investors. Goods and services flow from entrepreneurs to customers, in exchange for customer obligations that in theory could flow back to investors in order to satisfy the entrepreneurs’ obligations. Customers and investors are in aggregate the same people, so the flow is circular. But since it’s messy to deal with the nonfungible, incommensuable promises of different and particular people, we don’t manage commerce as a circular flow. We let a centralized banking system denominate obligations in currency terms, and we satisfy obligations by delivering currency rather than goods and services. There are advantages and disadvantages to the system we have. But there’s nothing inevitable or natural about it, and it might be worth experimenting with variations that leave the hypothetical local circle flow less impacted by an external banking system that performs services, but also creates problems and costs.

    I guess the only additional comment I’d offer is that my proposal intends to add to the menu of existing options available to small entrepreneurs, not supplant the things you are already doing. Don’t get me wrong: there are some incumbent institutions I’d love to render obsolete. But, this sort of proposal is intended to offer an incremental path to change. Initially I’d imagine bank-financed small businesses would offer small amounts of VTZCPs to reduce some of the risk of continuing bank financing. But over time, they might come to occupy a larger fraction of the capital structure. A whole menu of alternative instruments and institutions (including e.g. what Thomas suggested above) might render traditional bank finance just one color in a whole palette of options by which small businesses match investing outflows with operating inflows to reduce risk while maintaining sufficient spread between operating flows and investor obligations to eke out some decent profit.

  38. Steve Randy Waldman writes:

    najdorf — First a general comment. Any financing arrangement beyond a sole proprietorship creates conflicts of interest between entrepreneurs or managers and investors, and between different clienteles and investors. (Yes, I’m aware of Irving Fisher and Modigliani and Miller style results suggesting that there needn’t be conflicts of interests between investors under certain maintained assumptions. Those assumptions never hold in the real world.)

    I don’t claim to have eliminated conflicts of interest. But I do claim that the characteristics of what I’m proposal are no worse than, and in many respects better than, now conventional flawed arrangements.

    Re your first question: Entrepreneurs would be willing to pay investors something more in expected value terms than bank debt, because the VTZCPs are a less risky form of finance, since financing outflows are matched to operating inflows. Entrepreneurs buy insurance all the time, paying a higher rate in expected value terms for capital they needn’t repay when business is bad is no different. Note that businesses don’t “kill their reputations” by falling into arrears if they pay slowly when business is slow, because the obligations don’t become due at a high rate when business is slow. That they have the option of falling into arrears at some reputational cost is an additional layer of emergency insurance — repairing ones reputation after a transient period of arrears is much more doable than recovering from a creditor-enforced liquidation. But the primary means of risk reduction would be through harmonizing the maturity of obligations with the capacity of the business to pay.

    Investors, on the other hand, might not demand any more, in expectation, than the cost of bank finance. There’s a disintermediation rent to be split between the business and the investor, since small investors prior to this vehicle had no capacity to build diversified portfolios of high-information local investments in the way banks do, and therefore had to pay a severe spread between bank deposit and lending rates.

    There’d be an economic surplus to be captured, both from firm risk reduction and bank disintermediation (diminished somewhat by increased risk to investors despite information and diversification). How much of that surplus would be captured investors and how much entrepreneurs would be a matter of each party’s alternatives and negotiating power. But both parties would capture some portion of the surplus, the change would be “Pareto improving” for investors and entrepreneurs.

    Buyers of dollar #1,000,000 in a small business whose sales run $100K per year would be speculative investors. All of these investors are passive. When they purchase their claims, they make predictions about how successful the firm will be and how it will be managed. But they don’t get to choose: the entrepreneur does. Because small businesses are so risky, I’d imagine that most investing would be for claims over a one to two year time horizon. Investors would probably demand to steep a discount over the very long term for entrepreneurs to raise much money, subject to density-of-sales limitations she has agreed to. But, if there is speculative enthusiasm for a firm, and if the entrepreneur views offers of long-term finance as attractive (because they enable her to exploit growth opportunities or because she thinks the offers are overpriced), she can certainly accept them.

    If there are very long-term claimants and short-term claimants, then we have precisely the situation that obtains with every passively invested public firm. There are always conflicts of interest between short-horizon investors and long horizon investors, unless you believe there is only one rational infinite-horizon valuation of a firm and markets are perfectly efficient at finding it. (Then you van believe in Fisher’s separation theorem, and we won’t have much to agree about.) Firms can make choices that maximize short-term earnings or cashflow at the expensive of long-term deterioration of unmeasurable organizational capital. Firms can pursue strategies that will burn through cash and yield little revenue for a period of time, but enhances the likelihood of fantastic success down the line. Investors planning to sell soon would make different choices for the business than investors planning to hold forever. In public firms, in theory, all these investors vie for control and fight it out, though in practice I think shorter-term investors tend to be better able to affect firm behavior. (See e.g. http://www.interfluidity.com/posts/1224982646.shtml)

    With VTZCPs, all investors want the entrepreneur to maximize the operational cash flow rate, but shorter and longer term investors would probably have different risk preferences. A short-horizon investor would be comfortable with a high growth strategy that creates significant risk of failure sometime after she is made whole. A longer-maturity investor would want to be sure that growth concerns are tempered by respect for long-term sustainability. But, in this case, their preferences simply don’t matter, as they have no means of enforcing them. (That’s overstated a bit, as they can try to persuade.) Investors would have to make judgments about how the entrepreneur runs her business prior to investing, and price their claims, of whatever maturity, accordingly.

    I think we’d want to formally disallow side-contracts, to keep these claims standardized. If entrepreneurs want to raise capital, and can do so more cheaply by committing to some strategy, they can do so via custom contracts, on terms and with remedies specified in those contracts. But we want to offer a standardized claim with no control rights, and would specify in our formal definition that both parties agree that purchases cannot be made contingent on side-contracts, rendering any of those unenforceable. Broadly, our claims would specify very weak formal protections: this is equity, investors need to rely upon their judgment and accept the risk of the business, and we wouldn’t want to substitute firm legal risk for firm financial risk. If you think this implausible, again consider common stock of public firms. Yes, shareholder suits do happen. But they are relatively rare, and not frequently successful. Ex post they matter a great deal to investors who feel bilked by bad managers, but I would claim (do you disagree?) that, ex ante, the possibility of such suits contributes very little (and not necessarily positively) to investor valuations. Our claims would be designed to discourage claimholder suits other than for not sticking to a few clear rules: Firm cash flow must be accounted for, not pocketed, and priority of claims must be respected once claims are due or in arrears. Violations of those rules might well amount to criminal fraud under existing law anyway.

    With respect to transfers of control, entrepreneurs who might wish to sell a business need always to keep that in mind when designing their capital structure. Firms can have nonprepayable bank loans a potential new owner finds disagreeable (perhaps the new owner has better credit and could have borrowed much more cheaply). A firm may have issued long-term or perpetual preferred shares that it has no right to call.

    The obligations I’ve proposed are very straightforward. They offer no control rights, so do not represent the sort of minority interest that would create legal hassles for a new controlling shareholder. They eventually remove themselves from the capital structure as they expire. I’d expect them to be predominantly short-to-medium term, so a new owner could look forward to being rid of them over a modest horizon if she saw fit. Again, if control rights or strong legal protections attached to these claims, I could see your point. But since they don’t, I don’t think the claims proposed would offer much disincentive to a potential buyer, as long as the logistics of tracking and redeeming them are easy. (That’s our job, as the start-up designing, promoting, and managing the claims!)

    I’ll stop here. I appreciate the critiques — they’re smart, and they force me to think things out. But, for better or for worse, I remain stubbornly enthusiastic.

  39. vlade writes:

    Steve,
    I’m glad you’re getting to this. It is something I have been thinking on and off for about a year now, but haven’t figured it out yet.
    The main problem I have with your solution is that the instruments you propose are non-trivial. Would your grandma who wants to invest 5k into a local corner shop understand what it is about?

    I think the strenght of something like that would come not from a few super-investors, but number of small contributons from local community. That is where the trust would come from as well – if the shop is established for a few years there, and you chat to the owner every other day, your kids go to a school with his kids etc., you probably know more about him than his banker.

    The problems you face then
    – control (which you don’t really want as a small “investor” or don’t want to give up as an owner)
    – ease of use/costs (for investors and investees)

    The shops or businesses that provide services you regularly consume are probably easiest in this – for an investment, you could receive a permanent discount (effectively a perpetual bond paid in commodities). You could set up “discount” cards, which would entitle you to a total sum of a discount per month (your choice whether you use it all for single purchase or $5 off each purchase) based on the notional value of the card, and you could even trade them (so that when you move out of the location, you can pass it on to someone)!

    It gets much harder for businesses which provides something you have no interest in consuming (say small manufacturing business). My current thinking there is to set up a trust (either open ended, or fixed-life) which would lend the money to the business on some conditions – be it equity etc. – with the local people purchasing a share of the trust as a way of investing. Of course, setting a vehicle like this makes sense only if there’s a reasonable number of investors.

    I admit that the second part is still pretty dodgy, but I keep going over it again and again. I think what one really needs is a pilot.

  40. reason writes:

    Steve,
    I’m surprised that nobody has picked up on this, but it seems to me there is a technical problem on this form of financing from the issuer side (everybody has concentrated on the investor side). How do you avoid being forced to accept a high cost of capital? Can you stipulate a minimum price?

  41. Steve Randy Waldman writes:

    vlade —

    again, there are no perfect solutions to problems of asymmetric information, control given divergences of interest between entrepreneurs and different classes of investors, etc. but these are issues i did think pretty hard about in giving form the the proposal.

    although i think direct claims on future operating cash flow could be a useful addition to the overall menu of financing tools, i’ve mainly addressed this proposal to the case that you (very rightly) point out would be easiest: businesses that customer/investors know well via frequent direct interaction. that, plus the fact that the securities are based on observable operating cash flow rather than nebulous and manipulable profitability, should help mitigate (though not eliminate) problems due to information asymmetry.

    plus, the vehicle is intended to be purchasable in arbitrarily small quantities, so investors can manage risk in part by diversifying. i have mixed feelings about diversification — i think blind diversification is a terrible and destructive way of managing risk. (By “blind diversification”, i mean eschewing information work entirely and just capturing little pieces of the whole market on the theory that other people will ensure the whole world doesn’t fall apart.) but not all diversification is blind, and a wise investor will (i think) take a diversified portfolio of carefully chosen securities.

    although i am certainly not opposed to people forming trusts or funds for small business investment, i think that most delegated money is subject to structural problems that render funds unlikely as a class to allocate capital very well. there are certainly exceptions, but competitive forces favor poor funds over smart ones, as the low information customers of management use short-term performance to evaluate and allocate their funds among managers. i’m almost always trying to come up with alternatives to both dumb passive management and delegates active management.

    i like the kind of ideas that you and Thomas Barker (in the comments above) are presenting, in terms of letting some of the returns on investment be deferred in-kind consumption of the products and services of the firms in which they invest. (i suggested very simple redemptions-in-kind in the headline post, but you and Thomas offer cleverer and more interesting suggestions.)

    i agree very much that what one really needs is a pilot. we can, and should, discuss all we want, and hopefully our discussions will rule out very obviously bad ideas. but as an abstract matter it would have been much harder, i think, to make the case for widely dispersed common equity than for the instruments that i propose. for whatever reason, though, public shares were tried, and turned out to work well enough to evolve (for better and for worse) into the massive markets we have today. conversation can hone an idea, but in the end only reality can test it.

  42. Steve Randy Waldman writes:

    reason — entrepreneurs initially own all claims on future operating cash flow. they are not compelled to sell, and would only do so if they consider the price fair relative to the costs of other financing options. if someone offer 91¢ for a dollar estimated payable a year from now (est’d 10%), but they can borrow for 5%, the entrepreneur should probably borrow. if the estimated cost of this new form of equity capital is only 6%, though, and bank finance costs 5%, entrepreneurs might well opt for the equity, because it reduces their risk by helping to match cash outflows to investors with operating inflows and, as a form of equity, reduces the risk that a transient cash flow problem will lead to liquidation.

    in any case, transactions are always mutual and voluntary, the entrepreneur may always refuse to sell for whatever price is on offer. i think we’d want to set up vending of blocks of future dollars via second-price auctions in which entrepreneurs set a reserve price schedule of minimal acceptable bids for more or less distant claims.

  43. schraebner writes:

    I love this idea. I currently invest in microfinance, via Kiva, giving small loans to small business around the world, from which i see no interest, but the loan originators do. What would the differences be?

  44. vlade writes:

    Steve,
    My thinking about trusts was to simplify the process, and make it less costly to the business.
    Don’t know about US, but in the UK if you as a small business try to set up even debentures (not to mention tradeable ones!) it’s a royal PITA, with a lot of admin costs. On the other hand, getting a single commercial loan from a trust is relatively easy.

    The trust would not be typical managed trust – it would be really a single purpose vehicle to raise money for one single syndicated loan/investment. At least in the UK it would be realtively cheap to set up, run and be fairly transparent.

    I have to admit, I stole part of this idea from how Lloyd’s Insurance trusts work (when there were still things like Names, and when a group of people would say create a trust to underwrite a specific ship’s voyage), and from the fact that that idea worked well for a few hundred centuries :)

    Some legislation helping with this (while regulating it as say for size etc.) would be again relatively easy to pass I think (I think trust like I describe above would be likely extempted from FSA regulations, but I’m not 100% sure).

  45. reason writes:

    Steve,
    thanks for the clarification.

  46. […] nugget from Steve Randy Waldman in a post about financial innovation and small business equity investing: I want to qualify that when I use the word “local” I really mean whatever you have the most […]

  47. Steve Randy Waldman writes:

    schraebner — some differences: 1) this is an investment to the funders, not a charity. people who invest expect to make money. 2) this is more of an equity than a debt arrangement: neither repayment schedule nor yield are fixed in advance.

    vlade — oh, you are a step ahead of me then! i’ve been putting regulatory issues aside, although they are of course a gigantic elephant in the room. in practical terms, how to set up what i’d like to set up without having absurdly costly reporting and registration of every dollar invested in the local laundromat will be a serious challenge… either clever use of existing structures (as you suggest) or lobbying for a different regulatory regime suitable for microbiz would be required. i’m hoping for the latter, but then hoping that regulatory bureaucracies can be persuaded to do the right thing in a way that creates blowback risks if something goes wrong may not be a very realistic plan.