The First Instrument

Volume I — Transition: From Here to the Living Economy Nine movements, one signature.

THE PLATE

A woman and a man seated together in a white gazebo, both writing in notebooks, daylight off the lake behind them. — Plate I.03Two Hands, One Page.An instrument is the moment a conviction acquires a second person. Until somebody else has signed it, it is still only an opinion with a spreadsheet.

THE LETTER

Two chapters ago you were asked to find the place where your organisation is already regenerative. Last chapter you made that finding legible — named, costed twice, given an owner and a line in the standing pack. You now have something true, written down, and belonging to somebody.

That is not yet an instrument, and the difference matters more than almost anything else in this volume.

An instrument is a structure that obliges somebody. It has a counterparty who can be telephoned. It has a term that ends. It has a number that moves money between two balance sheets on a date. The moment your finding acquires those three things it stops depending on your enthusiasm, your tenure, your persuasiveness or your remaining goodwill — which is precisely the set of things that evaporates in month seven of every transition programme ever attempted.

This chapter builds the smallest one. Not a fund, not a green bond, not a blended-finance vehicle with four classes of note and a placement agent. Those exist, they are treated in Volume III, and none of them is available to you on a Monday. The instrument here is a page and a half long, needs one signature on each side, and can be drafted by somebody who is not a lawyer and reviewed by somebody who is.

Its counterparty is the surprise, and it is the whole of the chapter, so it is best said immediately: the first counterparty is not a lender. It is a customer. The cheapest capital available to most organisations is already inside a trading relationship they have had for years, and it is cheap for a reason that can be computed rather than asserted.

What follows is the structure, the arithmetic that decides it, the two conditions under which it fails, and the ninety days that end with a signature.

— The Editors

DISCOVERY

The smallest instruments, already working

The prepaid offtake is not a proposal. It is one of the oldest financings in commerce and it is running, at scale, in four places worth naming.

Teikei, and the community-supported farm. In Japan in the 1970s, groups of households began contracting directly with farmers: money in the spring, food across the season, and the explicit understanding that both parties carried the weather. The practice arrived in North America in the mid-1980s — Indian Line Farm in Massachusetts and Temple-Wilton Community Farm in New Hampshire are the usually cited beginnings — and by the time the United States Department of Agriculture began counting it in the Census of Agriculture, it was being reported by farms in the thousands.

Look at the structure rather than the vegetables. A member pays in February for produce delivered between June and October. The farm receives working capital at the exact moment it has none, from a counterparty who has no credit committee, against security that is a box of food. No bank is involved in the most capital-constrained enterprise in the economy, and the cash still arrives.

Fairtrade pre-finance. The Fairtrade Trader Standard obliges buyers, on request from a small-producer organisation, to make pre-harvest finance available up to a substantial share of the contract value — the standard sets it at 60 percent. This is not charity and it is not labelled as such: it is a condition of holding the mark, written into a commercial standard, because the people who wrote it understood that a producer who must borrow at 30 percent to reach harvest will not be a supplier for very long.

The instrument here is a contract with a clause. The clause changed the cost of capital for an entire tier of the supply chain without any new money entering the system at all.

The solar power purchase agreement. In 2003 Jigar Shah founded SunEdison on a single observation: the obstacle to rooftop solar was not the price of a panel. It was that the buyer had to find capital for twenty years of electricity on day one. The PPA inverted it — the developer owns the array, the host signs for the electricity, and payment follows generation. Within a decade residential solar in the United States had been rebuilt around that contract, and the technology had not changed. The financing structure was the innovation.

Root Capital's purchase-order lending. Founded in 1999, Root Capital lends to agricultural enterprises in places where conventional credit is unavailable, and its central move is to underwrite against the buyer's order rather than the producer's balance sheet. The producer has no collateral worth the name. The buyer is a known firm with a known history of paying. Lend against that, and the credit question becomes answerable. Over two decades this has moved sums in the billion-dollar order of magnitude into hands no bank would look at.

One pattern, four continents. In each case somebody noticed that the creditworthiness needed to fund the work already existed — it was simply sitting on the other side of an existing trading relationship. The instrument's only job was to let it cross.

That is the discovery move for this chapter, and it is a different one from the previous two. Chapter I.01 looked for value being wasted. Chapter I.02 looked for value being uncounted. This chapter looks for creditworthiness being unused — and unlike the first two, it is not in your accounts at all. It is in somebody else's.

So: who buys from you, has done for years, has a lower cost of capital than yours, and would notice if you stopped? That list is short, and it is your counterparty list. In most organisations it has never been written down, because nobody had a reason to sort customers by their balance sheet rather than by their volume.

THE ARITHMETIC

What the instrument is worth, and the two conditions it needs

An instrument is five answers, and a page that answers all five is a term sheet regardless of how informally it is typed.

  1  counterparty   who is on the other side, by name
  2  principal      how much moves, and when
  3  term           how long until it is finished
  4  price          the coupon, the discount, or the share
  5  trigger        the fact that turns the number on

Most failed proposals answer three. They name a sum, a purpose and a hope. The two they miss are the counterparty and the trigger, and those are the two that make a document enforceable.

The deal, worked.

A buyer prepays £200,000 on the first of January for a year's supply, delivered evenly. In exchange it takes a 3 percent discount on list value. The seller's weighted average cost of capital is 9 percent. The buyer earns 4 percent on cash it is not using.

Now the correction that almost everyone gets wrong. The money is not outstanding for a year. Deliveries run evenly across twelve months, so the buyer's capital is returned steadily as goods, and the average balance outstanding is half the prepayment.

  prepayment                       P   =  £200,000
  list value of the year's supply  P/(1−d)  =  £206,186
  goods received for nothing       £6,186
  average capital outstanding      P/2  =  £100,000

  annualised yield to the buyer  =  2d / (1 − d)  =  6.19%

A 3 percent discount is a 6.2 percent investment. Quote the discount as though it were the rate and you understate the buyer's return by half, which is why so many prepayment offers are refused by treasurers who never did the division. Say the yield, not the discount.

Where the money comes from — and this is the load-bearing paragraph.

The seller avoids borrowing £100,000 for a year at 9 percent, worth £9,000. It gives up £6,186 of goods. It is £2,814 a year better off. The buyer receives £6,186 of goods for capital that would otherwise have earned £4,000. It is £2,186 a year better off.

  surplus created  =  average capital  ×  (seller's WACC − buyer's cash return)
                   =  £100,000 × 5%
                   =  £5,000 a year

  seller keeps £2,814   ·   buyer keeps £2,186   ·   sum £5,000

Read that again with the question a sceptic would ask: where did the five thousand pounds come from? It came from nowhere. No new money entered the transaction, nobody produced anything additional, and both parties are better off by a total that is exactly the spread between their two costs of capital applied to the average balance.

That is the whole engine. Capital is not one price; it is a different price on every balance sheet in the economy, and wherever two firms with different prices already trade with each other, there is a surplus sitting between them that neither can reach alone. The discount does not create it. The discount only decides how it is split.

Which makes the negotiation computable. Both sides can work out both ends of the range before the meeting:

  d  must exceed   1.961%    below it, the buyer does better leaving cash on deposit
  d  must stay under 4.306%  above it, the seller does better borrowing from a bank

  d = 2.0%   yield 4.08%    seller +£4,918   buyer   +£82
  d = 3.0%   yield 6.19%    seller +£2,814   buyer +£2,186
  d = 4.0%   yield 8.33%    seller   +£667   buyer +£4,333
  d = 4.5%   yield 9.42%    seller   −£424   buyer +£5,424

The entire negotiation is 2.35 percentage points wide. A conversation with arithmetic in it and a known window is a twenty-minute conversation; the same conversation without one takes three meetings and usually ends in a deferral.

Now the honest part, and there are two.

First: below a certain size this instrument costs more to write than it returns. The surplus accrues at the spread on half the principal — 2.5 percent of the prepayment in the worked case. A first-time contract with proper legal review and a verification method runs to something like £9,000, which means the prepayment must exceed £360,000 before the deal has paid for its own paper. A great many sensible first instruments are smaller than that, and they are, on those numbers, not worth doing.

The exit is the reason this edition exists in the form it does. Reuse the paper and the cost falls to around £1,500, which moves the floor to £60,000 — a factor of six. A template is not administration. It is the thing that makes the small deal legal at all, and an organisation that has written one prepaid offtake can write its fourth in an afternoon. This is also why the seventy-seven Operationalize This movements in this edition are written as a catalogue and not as illustrations: the second instrument is where the economics actually live.

Second, and more serious: this instrument demands a delivery reliability that most new activities do not have. Work out the exposure honestly. If the seller fails to deliver, the loss is not financial — it is the customer relationship, and on eight years of tenure at £150,000 of annual gross margin that relationship is worth £1.2 million. Set that against a gain of £2,814 a year and the tolerable annual failure probability is 0.235 percent. The instrument requires 99.8 percent reliability, which almost nothing clears.

So it would be unwritable — except for one term.

  shortfall clause:  any undelivered balance is refunded in cash at LIST price,
                     plus a stated make-good of 15% of the prepayment,
                     payable within 30 days

The clause caps the loss at £30,000 instead of the relationship, and the tolerable failure rate rises to 9.4 percent — which ordinary supply reliability clears comfortably. The clause is not a courtesy and it is not boilerplate. It is the term that makes the instrument writable, and a prepayment written without one is a bet against your own supply chain at odds nobody would take if they had run the numbers.

It also tells you what to prepay for. Not the new thing. The proven thing — the line you have shipped every month for six years, financing the regenerative change behind it. Which is exactly where chapters I.01 and I.02 sent you.

DREAM

An economy where relationships carry capital

Describe the version that has already happened, in the present tense, because a dream in the future tense is a wish.

Procurement functions have a prepayment line. It is not exotic and it is not an exception process — it sits beside payment terms in every supplier negotiation, and the question "would you take a discount for cash in advance, and what would it be?" is asked as routinely as the question about volume breaks. Buyers know their own cash return to two decimal places, because that is the number that tells them what they can afford to offer.

Sellers publish the window. A supplier's terms page states the prepayment discount and the delivery guarantee together, because the second is what makes the first credible. Nobody is surprised by either.

The finance director of a mid-sized firm no longer treats the bank as the only counterparty in the building. There is a page in the board pack headed Capital from trading relationships, and it shows five customers, the average balance each is funding, the blended cost, and the comparison with the revolving credit facility. In a good year that page carries more capital than the facility does, at two-thirds of the price, and the treasurer regards it as ordinary treasury management, which it is.

Small producers hold contracts rather than pleading for overdrafts. The creditworthiness that funds the season belongs to the buyer and travels down the chain by agreement, so the cost of capital a farmer pays looks more like the cost of capital a supermarket pays. The difference between those two numbers used to be the largest single tax on regenerative agriculture anywhere in the world, and paying it was never a decision anyone made — it was simply what happened in the absence of an instrument.

And the covenant is normal. Contracts carry a line saying that the second tranche releases only if the stock the contract draws on is not deteriorating, with the metric and the verifier named. Nobody finds this intrusive. It is the same instinct that put a condition survey into a building lease, arriving at last in the place where it does the most good.

None of this needs a change in law, a subsidy, or a new market. It needs a page that both sides can read in one sitting, and somebody willing to ask a customer a question that has not previously been asked.

DESIGN

The page, built

Seven parts, in the order you write them.

One: choose the counterparty by tenure, not by volume. Sort your customers by years of relationship and by consistency of order, not by size. You want the one who has bought steadily for years, whose finance function is more conservative than yours, and whose buyer answers the telephone. The largest customer is usually the wrong first counterparty: the negotiation will be run by a procurement professional whose compensation depends on extracting the whole surplus, and you will end up outside your own window.

Two: compute both ends of the window before you ask. Your WACC is in your own accounts. Their cash return you can estimate from their filings and their sector within a point. Take the range to the meeting — it changes the conversation from a haggle into a joint calculation, and a joint calculation is a different social event entirely.

Three: size it against the paper. Principal must exceed the documentation cost divided by half the spread. If it does not, either combine it with another year, or write the template first and take the smaller deal second.

Four: write the trigger. What fact turns the money on, who observes it, and by when. A trigger that depends on a judgement is a dispute with a delay fuse. Use the trend test from the previous chapter: the second tranche releases if the named stock metric is flat or improving against a signed baseline.

  soil organic carbon  %       2.10 -> 2.24    improving — release
  press tolerance  microns    42.00 -> 39.00   improving — release
  team capability  index      68.00 -> 68.00   flat      — release
  fishery biomass  t        1,180   -> 1,105   deteriorating — HOLD

Notice that flat releases. A covenant that demands improvement every period turns into a ratchet, and a ratchet ends the relationship in year three. You are gating against depletion, not demanding a performance.

Five: write the shortfall clause before you write the discount. Refund at list, make-good stated as a percentage, thirty days. Doing it in this order matters: the clause is what lets your counterparty's risk committee say yes, and a discount negotiated before the protection is agreed is a discount you will have to give twice.

Six: get it reviewed, not drafted, by a lawyer. A page and a half of plain English that answers the five questions can be reviewed in an hour. A brief asking a firm to design an instrument produces fifteen pages and a bill, and the fifteen pages will not be read by the person who has to sign them.

Seven: sign it, and file the template. The template is the durable asset. Name it, store it where the next person will find it, and write one page recording what you would change. That page is worth more than the first deal.

On the order of the seven. Steps four and five look like drafting detail and are in fact the structural work. Everything else is arithmetic that anyone can redo. The trigger and the clause are where judgement lives, and they are the two parts a template cannot supply for you.

DESTINY

How a signature holds

An instrument has an advantage over every other transition artifact: it renews itself, because renewal is a date rather than a decision. But three things end it, and each has a countermeasure.

The discount becomes the price. After three years of prepayment at 3 percent, the buyer's system has learned that your list price is 3 percent higher than it needs to be, and the discount migrates into the standard terms where it funds nothing. Countermeasure: the discount is stated on the invoice as a financing line, separately from price, every time. What is never shown as a price does not become one.

The prepayment becomes a habit with no discipline. Year four's contract is last year's contract with the dates changed, the trigger is not tested, and the covenant quietly stops meaning anything. Countermeasure: the verifier is named annually and is somebody who did not verify last year. A test nobody can fail is not a test.

Concentration. Two prepaying customers become a third of your working capital, and now your funding and your revenue fail together. Countermeasure: a stated cap — no single counterparty funds more than a set share of average working capital, written into the treasury policy before it is convenient to ignore.

And the honest limit, which is a boundary rather than a fault: this instrument does not raise capital, it relocates it. The total funding available through prepayment is bounded by your counterparties' idle cash and their willingness to part with it, and that ceiling is reached faster than people expect. It is excellent for the first £200,000 and useless for the first £20 million. What it does is buy you a completed transaction, a template, a track record and a verified result — which is what the larger instruments in Volume III will ask to see before they will speak to you.

Sequence is not a compromise here. It is the mechanism.

DELIGHT

The pleasure of a short document

There is something particular about a contract you can read in one sitting.

Most instruments arrive as a bundle — schedules, definitions, a side letter, a deed of priority — and the experience of signing one is the experience of trusting a summary of a summary. A page and a half is different. You read it, you understand all of it, you notice the sentence you want changed, and the change takes four minutes.

Then there is the meeting itself, which is the better pleasure. You bring a window rather than a proposal. You say: here is your return, here is ours, here is the range within which we both do better than our alternatives, and I have brought the workings. The other side's treasurer, who has spent a career being handed cases engineered to obscure exactly this, checks your arithmetic and finds that it holds.

What arrives in the room at that moment is not agreement. It is relief. Somebody has come with the whole picture, including the part that favours the other side, and the negotiation can therefore be about the thing rather than about the framing.

And afterwards there is the pen. A signature is a small physical act that converts an argument into an obligation, and the ninety days end with one. You will find that you remember it.

OPERATIONALIZE THIS

At the level of finance

The instrument: a covenanted prepaid offtake — the regeneration forward.

A customer prepays for a defined quantity of a proven product, takes a stated discount, and the seller applies the cash to a named regenerative change whose stock trend is tested before the second tranche releases.

The terms.

Term	Setting
Counterparty	One existing customer: longest tenure, steadiest order pattern, lower cost of capital than yours
Principal	Prepayment exceeding documentation cost ÷ (spread ÷ 2) — see the arithmetic
Term	Twelve months of delivery, in two tranches of six
Price	A discount `d` inside the window, quoted to the counterparty as the annualised yield `2d/(1−d)`
Trigger	Tranche two releases on a signed stock-trend test: flat or improving
Protection	Shortfall refunded at list, plus a make-good of 15% of the prepayment, within 30 days
Security	The delivery obligation, and the shortfall clause behind it
Concentration cap	No counterparty above a stated share of average working capital

The balance-sheet treatment. A prepayment for goods is a contract liability — deferred revenue — not borrowing. Under IFRS 15 and ASC 606 it sits as an obligation to deliver, recognised as revenue as performance occurs. Three consequences follow and each is worth naming to your CFO in this order: it does not consume covenant headroom calculated on financial indebtedness; it carries no interest line, because the discount reduces revenue rather than appearing as finance cost; and it does affect your working-capital ratios, so anyone reading the cash-flow statement will see it and should be told beforehand. Where the prepayment is large or the term is long, a financing component may need to be separated and accounted for accordingly — a narrow question, asked early, of the auditor who already signs your revenue policy.

The counterparty. Outward, not upward. The first two chapters routed you to your treasury; this one routes you across the table, and the reason is permissions. An internal facility needs a treasurer's approval and a policy that contemplates it. A prepaid offtake needs a customer, a page, and two signatures. Each instrument in this catalogue requires fewer permissions than the last, and that direction is deliberate.

The number that decides it. One line, on the front page, and it has two ends:

                          2d
   buyer's cash return  <  ────  <  seller's cost of capital
                         1 − d

If the yield sits inside that window, both finance functions improve on their own alternatives and no one is being asked for a favour. If it does not, there is no deal to be had at this price and the arithmetic says so in a sentence — which is itself worth having, because a fast no costs a meeting and a slow no costs a quarter.

The first ninety days on a page.

Day	Action	Artifact
1–10	Sort customers by tenure and order consistency; pick three	The counterparty shortlist
11–20	Compute your WACC and each candidate's cash return; draw the window	The window, on one page
21–35	Agree the stock metric and sign the baseline with the sponsor	The signed baseline
36–50	Draft the page and a half: five answers, trigger, shortfall clause	The draft term sheet
51–60	One hour of legal review; one hour with your auditor on IFRS 15	Reviewed draft
61–75	The meeting. Bring the window and the workings	The agreed discount
76–85	Sign. Bank the prepayment. Deploy against the named change	The signature
86–90	File the template and the one page of what you would change	The template

APPRECIATIVE QUESTIONS

Twelve, for a room

Discovery — what is already working

Which customer has bought from us steadily for the longest, and what have we never asked them for?
When has a supplier or a customer of ours solved a cash problem for us without a bank being involved — and what made that possible?
Where in our contracts is there already a clause that obliges somebody to do something good, and who negotiated it?

Dream — what becomes possible

If capital moved freely between the firms that already trade with each other, what would our smallest suppliers be able to do next year?
Imagine our board pack had a page headed Capital from trading relationships. What would we want it to say in three years' time?
What could we finance out of relationships we already have, if the only thing stopping us was that nobody had written the page?

Design — what we build

What is the one product we deliver so reliably that we would happily be paid for it a year in advance?
What stock does that product draw on, and what metric would honestly show whether it is improving?
Who would sign this on our side, who would sign on theirs, and what does each of them need to see first?

Destiny — how it holds

How would we know if our prepayment discount had quietly turned into our price?
Who verifies the trigger next year, and how do we make sure it is not the same person as this year?
What share of our working capital would we be comfortable having a single customer fund — and who decides that before the answer is forced on us?

WORKS CITED

Fairtrade International. Trader Standard, current version. Fairtrade International, Bonn. (Pre-finance on request, to 60 percent of contract value.)

Groh, T. and McFadden, S. (1997). Farms of Tomorrow Revisited: Community Supported Farms, Farm Supported Communities. Biodynamic Farming and Gardening Association.

United States Department of Agriculture, National Agricultural Statistics Service. Census of Agriculture, 2007 and 2012 editions. (CSA marketing first enumerated 2007.)

Shah, J. (2013). Creating Climate Wealth: Unlocking the Impact Economy. ICOSA Publishing.

Root Capital. Annual Impact Reports, 1999–present. Cambridge, Massachusetts.

Macneil, I. R. (1980). The New Social Contract: An Inquiry into Modern Contractual Relations. Yale University Press.

Williamson, O. E. (1985). The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting. Free Press.

Hirschman, A. O. (1970). Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States. Harvard University Press.

International Accounting Standards Board (2014). IFRS 15: Revenue from Contracts with Customers. IFRS Foundation. See also FASB ASC 606.

Blue Forest Conservation and World Resources Institute (2017). Fighting Fire with Finance: A Roadmap for Collective Action. (The Forest Resilience Bond, piloted on the North Yuba.)

Ostrom, E. (1990). Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge University Press.

Cooperrider, D. L., Whitney, D. and Stavros, J. M. (2008). Appreciative Inquiry Handbook, 2nd edn. Crown Custom Publishing.

Efficiency Valuation Organization. International Performance Measurement and Verification Protocol (IPMVP), Core Concepts. Successive editions.

Note on figures. The prepayment deal, the average-outstanding correction 2d/(1−d), the surplus and its split, the window, the documentation break-even and the two failure thresholds are all computed in lib/verify/I_03.py and reproduce with python3 lib/verify.py I.03. The worked deal is illustrative and labelled as such: the figures are internally consistent and are not drawn from any single firm's accounts. Accounting treatment is stated at the level of the standard and is not advice; the narrow question for your auditor is named in the text.