Why the Building Society funding model is the best kind of corporate structure.

1. I have mused on this topic before, see e.g. Inefficient Markets Hypothesis, The multi-billion Chinese investment in Thames Water was no such thing and Beyond The Corporation, part 1, part 2.

2. Please note, I am not talking about the respective merits of banks or building societies, this is about having a system which has the benefits of public limited companies without the drawbacks and applies to all types of businesses (not just banks/building societies).

3. It is claimed that the big benefit of being able to switch your investments between different types of business, by selling shares in one and buying shares in another is that this leads to an efficient allocation of capital. If you do it properly and you are lucky, then yes, this leads to an efficient allocation of your own money, but there is a complete disconnect between what you are investing in (the shares) and the real underlying investment in productive capital (which is carried out by the companies whose shares are bought and sold). So whatever signals the secondary market in shares is sending, there is little or no link between that and what businesses are actually doing.

4. People are unfamiliar with Limited Liability Partnerships (which are a far better corporate structure than a limited company for small and medium sized businesses), so let's talk about how things would work on the scale of large plc's if their share capital/reserves side were structured in the same way as building societies. In other words, instead of a company having assets of (say) £1 million and share/capital reserves with a balance sheet value of £1 million, but whose shares might be worth a multiple of that, the company would just have 'members' deposits' with a balance sheet value of £1 million.

5. The gimmick being, that you cannot 'sell your shares' in a building society to a third party on the secondary market, if you want your money, you just withdraw it and somebody else invests in your place. Unlike with companies limited by shares, there is no distinction between the 'primary market', i.e. shares being issued (where an investor gives the company cash for shares) and the 'secondary market' where the first investor sells those shares to a third party, who can sell them on to a fourth etc.

6. If quoted plc's were like building societies, then at the end of every profit period (a year, a month, a quarter, it does not matter), the company would draw up a new balance sheet and allocate the increase in value (the profit) pro rata to all members' deposits, instead of paying out part of the profits as dividends on shares.

7. At any time, some members will want to withdraw some of their profits or their deposits and others will want to invest in that business, so the company will end up running simplified deposit accounts for all members (which is perfectly do-able - banks and building societies manage). The company might have to limit the amount which members can withdraw or limit the amount of new deposits which it can accept, so there might have to be some sort of waiting list approach or a cap on withdrawals/new investments. Withdrawals and new investments are to a large extent equal and opposite, so if a company accepts cash deposits it doesn't really need it will have spare cash to repay those who want to cash in immediately - which is how it works with banks and building societies.

8. So this would save investors the bother of doing two quite separate analyses: the first being an analysis of the health of the underlying business and the second being an analysis of how the share price is doing and what future dividend payouts are likely to be. Instead, you would just look at the list of public traded companies in the financial pages, and for each one it would say:
- what the profit share in the last profit period was as a percentage of deposits (the higher the better as far as investors are concerned;
- how long the waiting list is to invest in that company (if there is one), and
- whether there is a restriction on withdrawals, i.e. because the company is making losses, because it plans to expand in future and/or because not enough new investors want to put their money in.

9. To make a comparison between the two:

- Let's say that a quoted plc started the year with total assets £1 million, made profits of £200,000 (so now has £1.2 million total assets) and intends to pay out £120,000 as dividends (keeping £80,000 for future expansion). Dividend yields are currently 4%, so all things being equal, the shares in that company are worth £3 million. £1.2 million of that £3 million is real wealth (the real net assets of the business) and £1.8 million is pure speculative value; it's a nice capital gain for the original investors but a potential capital loss for future investors.

- Using the building society funding model, the total assets are also £1.2 million, and 20% is added to members deposits b/f of £1 million, and the directors announce that members may withdraw up to a tenth of the face value of their deposits (i.e. up to £120,000). If the directors know that there is a long waiting list of potential new investors, then the one-tenth figure will be increased of course, that's just details.

10. The two big advantages of the building society funding model are:

- There is no speculative capital gain to be made - either you are happy leaving your money with this business and earning 20% a year in profit share (or interest) or you want to withdraw your money, either to spend it or because you want to invest it in a different company which pays 25%, or which pays less than that but which has a safer business. Now, some people will bemoan this, but one man's capital gain is just another man's capital loss. If you are lucky to get into a successful company right from the word go, then you can sit back and be paid your 20% return each year, withdrawing or reinvesting it as you please, which is a better way of doing things that sitting there waiting for the right moment to sell your shares (i.e. just before the share price collapses).

- Instead of focusing on things not directly related to the actual business (like the share price or the dividend yield), investors will just look at how profitable businesses actually are, i.e. how much interest they pay on deposits. So profitable businesses will find it easy to attract new investment and the directors of not-so-profitable businesses will have to up their game to prevent members wanting to withdraw everything (like a 'bank run', only this would be a 'company run'). In extremis of course, the members would sack the management and either install a new one or just sell off all the assets, shut the company down and take their cash elsewhere. For the investors, this will be a lot less risky than with a plc, because they won't have paid £3 million for their shares, they will not have paid more than £1.2 million (using the same figures as above).