Thursday, April 18, 2013

Salvation Through Redemption?

What follows below is an ill formed idea. It has been sitting in my brain for a while, and doesn't seem to be getting any better with age (some ideas do). So it is time to throw it out there and see what my bleeps think.

Something has been bothering me about impact investing: what if, in the end, it doesn't matter?

As a field, we are spending a lot of time now defining who is a worthy social entrepreneur, determining how to best measure impact and trying to attract funds to this emerging sector. Excitement is high. And yet... to continue a somewhat imperfect metaphor... what if we are covering the tuition and fees for a brilliant student doing a combined degree in social work, environmental science, and international development, only to see them take a job with a Wall St bank when they graduate? And, even worse, what if the way we are supporting them drives them to have to take such a job? Does the way we fund social enterprises doom them to mission drift as they grow up?

As I have pointed out in previous blogs, some of the things that drive financial investment may create a tension with impact. Like seeking liquidity (or "exit").  If  a company is financed by impact investors, who also desire to get their money back at some point,* it will likely be taken public or acquired. When that happens, its new owners are likely to care less about its mission than those impact investors. And this is likely to occur when the company really starts to reach scale and sustainability. So, Social Enterprise X (what an appealing acronym) experiments and pivots its way to a solid business model. Revenues grow, and profits arrive. They have reached the promised land of social enterprise. Except their investors want their money back. As a friend and mentor said to me last week, "perhaps liquidity is the original sin of impact investing."

My pessimism lifted this past fall as I worked on a transaction where, instead of an IPO or an acquisition, liquidity was obtained for New Belgium Brewing's founders and other owners through an ESOP buyout. Here, there was a stronger chance of mission perpetuation over the long term, as the mission rested with the employees who got the business to where it was, and who believed strongly in its mission and values. A chance for legacy,  as well as liquidity.

Yet New Belgium had financed its growth through bootstrapping and debt, not equity. In a conversation with Ross Baird a few weeks ago, he asked me about how we might design in, from the beginning, a structure that could allow entrepreneurs to use equity and still not "sell out" their mission as they grew. Ross cares deeply about this issue, as his firm, Village Capital, is supporting  young social enterprises around the world.  If the answer was "it doesn't work if you take outside equity", then it wasn't an acceptable answer for Ross. Over the course of a few golf holes and then a few beers, an idea emerged.

Staying at a fairly high level, and trying to keep the math easy, it goes like this:

1) Entrepreneurs could build in an option into all funding rounds that would allow them to redeem** their shares for specific types of transactions that would provide long term mission perpetuation (for instance, full ESOP buy out, or conversion to a cooperative).

2) Investors would agree to a price for that option equivalent to an enterprise value based on a multiple of EBITDA (or cash flow) that would allow for the company to borrow enough money to pay off the investors. This would not work for investors seeking solely financial returns, but could work for those interested in a blend of return and impact.

3) This would not prevent a company from deciding to go public, or be acquired by a larger firm. But it would allow a successful and profitable company to pursue a different path. All involved would take a lower price than might be available for a more traditional liquidity event; but they would also have the satisfaction of seeing the enterprise continue on the impact path which they originally supported.

What might these multiples need to be? Well known venture investor, Sir Ronald Cohen has written that he thinks that funds will flow into impact investments if the returns were "around 7%." And I have met with PE firms that are willing to structure equity deals with repurchase obligations based on EBITDA multiples. Earlier rounds might have to be at higher multiples (to deal with the longer time frames and greater patience of their capital). But in round numbers, if a company has strong cash flows and reasonable margins, it could redeem its investors at 6-10x EBITDA multiples, and cover the debt required to finance such a repurchase. For investors, this should represent a return on "winners" (though not the legendary 10x) sufficient to drive a 7% or more return across an impact investment portfolio.

Perhaps, through the broader use of such redemption clauses (and/or other innovations), salvation is possible for impact investing. If we can't solve the puzzle of liquidity and legacy, I fail to see how the sector will truly differentiate itself from traditional venture investing or how it will ever live up to its claims of addressing the world's biggest challenges.

So, bleeps, what do you think? If you are an investor, would you agree to such a redemption right? If you are an entrepreneur, would you find this interesting (remember, you would get less $$ too)? And for my academic friends, have I forgotten the second law of something or other? Fire away....
If you have read this far, you may want to keep reading my prior post Kickstarter and Long Shadows.
* is any capital infinitely patient? should it be?
**Bruce Campbell has advocated that redemption clauses offer an exit alternative, and should be more common in impact investments.

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