The 30-70 Rule

The 30-70 Rule (not found on Google) states that you can treat as investments any funds placed in otherwise private firms in which you hold more than 30% or less than 70% ownership. Less than 30% and you must expense all your funding of the firm. Over 70% and you must consolidate the financials of the firm into your corporate results. In-between these percentages, it’s just an investment like any other in NASDAQ.

Take any promising research program in any major corporation and spin it off as a separate legal entity. The corporation throws in the Intellectual Property to-date and funding for a couple of years, in exchange for 30% ownership. The research team throws in their experience and a commitment to pursue the research for a 70% ownership. The corporation retains right of first refusal for any product coming out of the small firm (an unnecessary, but comforting contract clause). Immediately, all expenses the corporation was previously booking for the research are converted into investments. The corporate Profit and Loss (P&L) statement takes an immediate positive hit. The corporate balance sheet (and the cash flow statement, since investments are often treated as near-cash) are essentially unchanged.

The 30-70 percent rule is most important as viewed from the perspective of the owners of the small firm. At the beginning, when the research is still unripe and highly risky, the owners of the small firm can still own 70% of the firm. They give up 30% of the firm in exchange for funding that carries them through a couple years of research and development. At the end of those years they must either have found other sources of funding or they must start to give up further ownership in their firm in exchange for further funding. They are in effect spending ownership shares with each dollar spent on research. They are no longer spending Other People's Money+.

Suppose the small firm immediately discovers a blockbuster+-potential product. Good for them. The corporation buys the product and the small firm is now worth a billion U.S. dollars. The corporation owns 30% of this firm and books a significant increase in value of its investment asset. Roughly, the corporation paid 70% of the value of the blockbuster product in acquiring it. “If we had just kept that research in-house…” Don’t think that way. The blockbuster would never have happened if you kept the research in-house. Additionally, the chances of a blockbuster happening during the period when the corporation is at less than 50% ownership are remote.

More realistically, the blockbuster is discovered by the small firm after the corporation owns more than 50% of the firm. The corporation has a majority vote at the small firm and therefore can direct the firm to spend its windfall+ on research for that next blockbuster. This is not a case of the small-firm management taking the money and running. Individual members of the small firm will be wealthy, but will not have full control over the U.S. $700 million windfall.

What about those failures, the small firms where the corporation decides to stop future funding? The corporation eventually needs to realize losses on investments, and this hits the corporation P&L statement! Yes, but the timing of these loses is completely up to the corporation. We time our losses to coincide with our wins, smoothing out the impact on the investment asset. A halt in corporate funding for a small firm is typically not precipitous. Funding continues at sustenance levels for a few years to allow the small firm the time to seek outside funding. The ‘end game’ is not a decision to realize investment losses, rather a decision to dilute corporate ownership in an investment over a stretch of several years.

This is the 30-70 rule: a way to immediately monetize all research in any industry. You get all the benefits of research and none of the expenses. You significantly increase the effectiveness of research through its effect on the motivations of all the personalities involved. You get much greater objectivity in your evaluation of research. Successfully implemented, this one rule can provide up to 20% of the benefits envisioned by World Class R&D. Importantly, this rule cannot succeed on its own. We need to make sure we’re not turning the suburbs pink. Bad management, bad science, and poor investment decisions do not get better through a financial sleight-of-hand.

Supplement:

Let’s assume you invest U.S. $10 million into a small firm for 49% ownership. You credit (reduce) cash on your balance sheet by that amount and debit (increase) the investment account. A simple movement from one asset account into another. Since you own 49% of the firm, the rate at which the small firm uses that $10 million is irrelevant to the value of your investment, which eventually will rise or fall depending on the underlying value of the small firm. Less than 30% and you would have had to debit (increase) expenses by $10 million. More than 70% and you would have had to debit (increase) expenses by however much the smaller firm spends of your money.

Suppose the small firm requires further funding from the corporation. That funding comes in exchange for further ownership by the corporation in the smaller firm. There’s a ceiling, 70%, to the ownership the corporation should be willing to assume. That is, once the corporation reaches 70% ownership, all further funding from the corporation stops. The smaller firm had better know where to secure further sources of funding before that ceiling is reached.

This article is not meant to offer financial or strategic advice. The approach has been vetted with senior individuals in the legal and financial fields, and is assumed to be directionally correct but its execution will be much more complicated than described. It is very easy to get this wrong. All percentages mentioned in the article are illustrative. You must consult financial and legal experts before attempting this approach (i.e., "Tell me how to do this!")
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