A New Financial Instrument — Not Debt – Not Equity

A Different Form Of Investment Product

Aug 30, 2013 · 9 min read

I recently made a post suggesting the creation of a new form of business organization, a Consumer Controlled Company (https://medium.com/money-banking/c6a1257bac5a)

In that article I proposed a new type of financing instrument to raise capital for a CCC. I now realize that the PPI scheme I proposed was flawed and that the PPI mechanism I suggested needed to be revised. I also realize that this proposed new capital instrument, the PPI, might have material value as a financial product independent of its suggested use as a mechanism to fund a CCC.

This post is intended to outline how a PPI would work as an alternative to a traditional IPO or the sale of bonds.

Key Characteristics of a PPI Product

What if a company could sell a tradable instrument on a public exchange that would not dilute the existing shareholders’ equity and which would not entitle the holder to any voting rights? Moreover, the instrument would not be recognized as debt and would not appear as an obligation on the company’s balance sheet.

What if an investor could purchase a tradable instrument that would provide an annual cash flow, have the potential to generate 5X to 10X returns over the purchase price and whose cash flow would only be taxable after the total initial investment amount was returned?

That’s what I envision for what I’m calling a Profit Participation Instrument, a PPI.

Assuming that the applicable laws and regulations allowing its issuance and public trading were in place, here’s how it might work.

What Is A PPI?

Profit Participation Instruments (PPIs) are not voting instruments. A PPI entitles the holder to participation in a fixed percentage of a “profit equivalent” for a fixed period of time. PPI holders are neither equity holders nor creditors.

How Would It Work?

The corporation (e.g. Acme, Inc.) would offer to sell a fixed number of Profit Participation Instruments (PPIs) to investors at an initial offer price.

Each PPI would give the holder the right to share in a stated percentage (the Payment Percentage (PP)) of the company’s “Profit Equivalent” calculated on a standardized formula. More on this formula a little later.

The PPI would entitle the holder to receive annual payments based on the formula: Payment Percentage (PP) X Profit Equivalent (PE)/Number Of PPIs = Annual Cash Payment Per PPI.

As part of the offering the company would set the time frame (TF) over which payments would be made, e.g. five years, and the cap on payments, e.g. seven times purchase price (CAP). For example, Acme, Inc. might make an offering as follows

Issuer: Acme, Inc.
Number Of Instruments: 500,000 (+/- 2.5%)
Payment Percentage: 25%
Time Frame: 5 years
Payment CAP: 7 times PPI acquisition cost
Initial Offer Price: $10
Acme’s Historical PE Results:
Previous Year: $7M
Two Years Ago: $8M
Three Years Ago: $4M
Four Years Ago: $1M

Factors Determining The Final Sale Price

The price that the investors finally agree to pay will be based on each investor’s evaluation of the three terms – TF, CAP and PP, as well as the company’s anticipated PE based on past performance and anticipated sales, and the discount rate the investor uses in determining ROI on a discount-to-present-value basis.

If the TF is longer the price is higher. A shorter TF reduces the value of the PPI. A higher PP increases the value and a lower PP reduces the value. A higher CAP increases the value and a lower CAP reduces the value.

During the bidding process each potential investor would have access to a simple iPhone/Android app which would calculate ROI. The investor would enter the following data into the app: (1) price range per PPI: $10 — $20; (2) Number of PPIs To Be Issued: 500,000; (3) Time Frame: 5 years; (4) Profit Percentage: 25%; (5) Annual Average PE Range: $4M to $10M; (6) Discount-to-present-value interest rate range: 3% — 6%

The app would generate a set of graphs with ROI on the vertical axis and PPI price on the horizontal axis. As the price goes up the ROI goes down.

In each graph colored lines would show the ROI as a function of varying levels of average PE over the five year period. The higher the five-year average PE the higher the ROI.

Separate graphs would show the ROI at different discount rates, that is one set of ROI vs. PPI price lines would be based on a discount rate of 3%. A second graph would show ROI based on a discount rate of 4% and so forth.
The investor would select the discount rate graph he was comfortable with and the minimum average PE he expected the company to make over the five year TF and then pick the minimum ROI he would accept. The graph would show the maximum price he should pay per PPI based on his chosen level of ROI. If the price he could buy a PPI for was equal to or less than his minimum ROI he would accept then he would make an offer to buy PPIs at that price.

Different Offerings – Different Investor Demographics

Offerings from different companies would appeal to different investors depending on their ROI demands and the risk of loss versus the potential for gain. An established company with a low risk of loss would appeal to one class of investors. A newer, more volatile company with a higher chance of returning a multiple of the purchase price but with more risk would appeal to different investors.

The TF (payment period), PP (payment percentage of PE) and maximum payment (CAP) would all be variables set by the Corp at the time of the IPO. They would be taken into account by each investor in determining how much to bid for a PPI. The better the terms, the higher the price would be.

Since the PPIs would be tradable on the exchange, an investor who needed cash could sell his PPIs at any time just like any other security. On the other hand, if the investor wanted income he could hold the PPIs and receive annual cash payments.

Bidding Mechanics – Determining The Final Sale Price

Potential investors would use the Internet to post a non-binding offer for PPIs at the initial offer price of $10.

Suppose that the public collectively offered to purchase 750,000 of these PPIs at the initial offer price of $10. Since that volume exceeds the 500,000 instruments available the price would be automatically re-set to, say, $20, and re-offered at that price.

Demand at the $20 price now falls, for example, from 750,000 instruments to 400,000 units, less than the 500,000 instruments offered.

The price is again automatically re-set, this time to $17.50.

At the $17.50 price investors indicate a willingness to buy 510,000 PPIs for a total capital amount of $8,925,000. This is within the +/- 2.5% range so Acme notifies all of the responding investors that the price is firm at $17.50 and asks them to make a binding offer, providing that not less than a total of 487,500 units are sold and not more than 512,500 PPI units are sold.

When the sales close the company sells 500,000 PPIs at $17.50 each for a net amount of $8,750,000.

Example Payout Numbers

Assume that outside CPAs calculate Acme’s first year PE at $1M. That $1M PE would be multiplied by the Payment Percentage (25%) and $250,000 would be paid out to the investors at the rate of $0.50 per PPI ($250,000/500,000 PPIs).

At the end of the second fiscal year after the IPO the PE is determined to be $4M X a PP of 25% = $1M. $1M/500,000 = $2 per PPI.

At the end of the third fiscal year after the IPO the PE is $8M and the payout ($2M) is $4 per PPI.

At the end of the fourth fiscal year after the IPO the PE is $50M and the payout is $25/PPI.

At the end of four years total payouts would be $.50 + $2 + $4 + $25 = $31.50 paid for an investment of $17.50. The CAP is $122.50 ($17.50 X CAP of 7) so there is still room for more money to be paid.

The term is five years. The PE at the end of year five is $40M or a payment of an additional $20 per PPI. This brings the total payout to $51.50 on a $17.50 investment. This is the last payment.

No matter what the final payout is, the PPI expires on the date of fifth fiscal year payment. If the company did poorly and paid nothing then the investment would be a total loss. If over the five years the company made payments totaling $5 per PPI then the cash loss would be $12.50 per PPI. If the company did phenomenally well and it hit the CAP in year three, the total pay out would be the CAP amount of $122.50 per PPI and at that point the PPIs would disappear. The company could buy out the PPIs at any time by paying additional funds sufficient to equal the CAP amount.

To make a PPI more attractive the company could guarantee a minimum level of PPI payments, that is a payment of the Profit Percentage times the greater of the actual PE or $XXXXX per year. The $XXXX would probably be calculated to be equivalent to a return of 80% (or whatever percent) of the PPI issue price/TF so that would limit the downside to the PPI investor.

Tax Issues

If lobbying was successful, by statute PPI payments to an investor over and above purchase price (basis) would be taxed at a flat rate, maybe 20% or 25% (or some other percentage) irrespective of income tax bracket or time owned. No holding period, no variable tax rates.

Also, if lobbying was successful, by statute the company would be able to deduct all PPI payments in excess of the original capital amount raised as a tax-deductible expense for the purpose of computing corporate income taxes.

Essentially, the corporate profits’ tax would be shifted from the company to the individual investor and there would be no double taxation of profits. Since major corporations often only actually pay about 15% in taxes, by giving the corp a deduction in exchange for a 20% to 25% tax collected from the individual the government would actually see increased revenues.

Trading and Termination

PPIs would be tradable on the exchange just like stocks and other instruments. The farther the company was into the TF the lower the market would price the PPI subject to the market’s evaluation of future PE over the remaining years in the TF.

At the end of the Time Frame the company would have no other responsibilities to the holders of the PPIs. No equity participation or dilution. No debt on the balance sheet. And never any voting rights.

How Would The Profit Equivalent Be Calculated?

This PE calculation formula would need to be standardized for all PPI offerings.

At the end of the first fiscal year after the IPO the PE would be determined according to the standardized formula by an investor-designated independent outside accounting firm which firm would be prohibited from doing any business with the company for at least two years after the end of the TF.

This will never work if the PE calculation can be fiddled in a way that unreasonably reduces the PE amount. I would get three accounts who are very experienced in public corporation finance in a room and tell them: “Pretend that you want to find some way to allocate money in a public company so as to reduce reported profits as much as possible. Now, make up a formula for determining a Profit Equivalent that would avoid as many of those methods as possible.

The PE would be a financial calculation under which gross sales would be reduced by certain categories of expenses. Expenses that would be excluded from the calculation of the PE would be “excessive” compensation, payments to affiliated persons or companies in which any affiliated persons, directly or indirectly, had more than a XX% direct or indirect equity participation, amortization, capital expenditures in excess of a fixed percentage of gross sales, and other expenditures that might be used/abused to unreasonably reduce the PE and thus “unfairly” reduce payments to the PPI holders.

The formula would need to be modified as new ways to skew the result are introduced and new ways to unfairly reduce payments to investors were invented. Playing with the numbers so as to unreasonably reduce payments to investors will destroy market confidence and absolutely kill investment in PPIs.

Benefits To Issuer Over A Traditional IPO or Bonds

No dilution of original shareholders’ equity

No voting rights. Founders/insiders maintain full control

No fixed debt on the Corp’s balance sheet

The instrument disappears after a fixed life span

Unlike dividends, PPI payments to investors above basis could reduce corp income taxes

Benefits to Investors Over Stocks Or Bonds
Required annual payments if the company is profitable.

Basis recovered tax free. Payments above basis could be taxed at a fixed rate.

Potential for a multiple of investment amount of return

Liquid on the secondary market.

Value of the instrument is directly related to company performance not intangible factors such as market expectations or general social, political or economic events

Insider trading importance reduced because the value on the secondary market is primarily based on anticipated profits not intangible market factors.

Drawbacks To Corp

Required payments reduce capital available for expansion, research, and capital improvements

Emphasis is placed on short term net income over a long-term planning and strategy.

What Do You Think?

Does this make sense as a new investment product?

What do you think?

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Written by

Graduate of Stanford University & U.C. Berkeley Law School. Author of 17 novels and over 200 Medium columns on Economics, Politics, Law, Humor & Satire.

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