Thursday, October 06, 2011

Hacking The Financial System

There is a lot of attention now on #occupywallstreet - and I find it interesting to see a movement grow, and try to frame a meaningful goal from its "lets start something and see where it goes" genesis. To me, they have identified a "what sucks" but haven't articulated "what we are going to do about it." It is one thing to sit in, and another to stand up and take action. It is also interesting that some movements build, and some attack. The nature of movements is it is hard to define who is in and who is out. Yesterday, the infamous hackers at Anonymous targeted Wall Street for cyber attack- have they joined the movement? is their offer of "help" helpful? I offer this post as an alternative. I see entrepreneurs as society's hackers (in a good way, I hope).

This post is about some thoughts and conversations I have been having about the early steps of impact investing's journey. My concern? That the impact investing field is borrowing heavily from traditional start up finance- private equity (PE), venture capital (VC), angels, and yes, even Wall St. Will packing up these established concepts help impact investing speed towards its destination, or will they instead be a heavy load, or a false destination? Will they be useful, useless or harmful?

The basis of my concern is twofold: 1) this financial system got us to where we are, and has created some of the problems that entrepreneurs, activists and communities now must solve; and 2) the assumptions underlying the processes of this financial system may be antithetical to, or at least misaligned with, the goals of impact investing. Let me try to explain.

At the core of this concern is that financial capital relentlessly seeks returns. And we have built (or evolved) a finance system that satisfies financial capital's needs. The way private investors source deals, negotiate terms, conduct due diligence and monitor their investments is all premised on the idea that the entrepreneur will build a venture that creates (and captures) financial value. This is done through reducing risk, scaling the venture, and pursuing profits. Social and environmental impacts are largely external,  in either positive or negative ways.*

But impact investing turns that on its head. And, I believe, calls into question the entire system of financing start ups. At each step, impact investors need to ask "why?"  If maximizing social and environmental impact (rather than financial return) is what you want your capital to relentlessly pursue, then how does that happen? If instead it is financial return that is "largely external, in either positive or negative ways," then what needs to change?

At this point, I don't have answers, but I want to encourage founders and funders to think about it.

Let me provide two examples to illustrate my quandary:

1) Liquidity & Exit- early stage financing is premised on repayment. A funder provides money to a start up with an expectation of repayment of a greater amount in the future. This return on investment is, in the end, how success is measured. The longer the start up keeps the money, the greater the expected return. Investors have many opportunities, and an entire system has evolved to track and evaluate investment performance. But why does an impact investor seek liquidity? What if you find the perfect enterprise- one that is flawlessly executing a plan of scaling a solution to a global challenge? Then it seems to me that you wouldn't want to exit until the global challenge was solved. It would be inconsistent to take money from this enterprise to reinvest in a less effective (by definition) enterprise. So the reasons an impact investor would seek exit would be for investments in the less effective enterprises, where they felt they could redeploy their funds to achieve higher impact elsewhere. But it seems to me they should let investments in successful enterprises ride indefinitely, as liquidity would be counter productive for both the funder and the enterprise. Wouldn't this drive a different approach to portfolio design, evaluation and management? (Leslie Christensen and RSF have asked another set of provocative questions on portfolios, as well as provided a suggested approach.)

2) Crowdfunding- one challenge for the impact investing space is its emergent nature. As I wrote a few weeks ago, things that are emergent are "small, weak and hard to predict." There is a tension between many early stage enterprises seeking funding, and impact investors who are looking to help scale proven approaches to achieve impact. Our very own "valley of death". And no established bridges over that valley. The way traditional start up funding has dealt with this challenge has been through keeping investments local, working in syndicates to spread risk early, and tying funding to milestones. But the costs of doing financial deals for funders are often too high for small, dispersed, emergent companies, so these deals are left to universities, angel investors and government agencies (for instance, NIH and NSF research funding, or SBIR/STTR programs). This drives a "funnel-triage" approach. Investors screen hundreds of opportunities to fund a deal. Because they are looking for financial returns, they are looking for the best deals and want to concentrate on obtaining a significant percentage of ownership in order to capture these high returns. But I ask the same question as above- why would an impact investor seek a high percentage of ownership to capture high impact? The only answer I have come up with is ego. And that seems like a bad answer. Ego (and greed) are tolerated by the traditional financial system, because they are aligned with the systemic objectives of financial return. But if the goal is maximizing impact, it seems to me that the funders need to figure out how to efficiently source deals and do more smaller deals initially, until we get through the emergent phase and a more robust system evolves. This is where crowdfunding appears to offer some real benefit, and be more aligned with the goals of an impact investing system. Both founders and funders may become more comfortable with broad risk sharing and evaluation offered by crowdfunds, such as Kickstarter, Village Capital, Kiva, Inventure, Solar Mosaic and Hoop Fund.**

Well, I have written enough. But I'd encourage you to think about many of the "givens" of investment: relative founder/funder ownership percentages, board composition, preferences for equity (anti-dilution, liquidation), metrics. I see a lot of opportunity for change and redesign, but few people talking about it, much less doing it. In a recent deal by a leading impact investor, the Series A documents had one small change from a typical Series A deal. One small change.

So, what do you think? A journey of a thousand miles first starts with a single... question- "where are we going?" I think we need to hack the financial system to do impact investing well and build an alternative... an impact system. What do you think? Who are the pioneers, scouts and guides?
* This is key. I am not saying there aren't enterprises that don't create financial value through creating social and environmental value. I am saying that the primary objective of their investors is financial value, and social and environmental values are secondary. I am also saying that in the financial system, as long as one stays within societal rules/norms, negative impacts are allowed. The second hand smoke of our financial system, so to speak.
** I recommend Alex Goldmark's recent GOOD article on crowdfunding and Bruce Campbell's good post as well.


Unknown said...

You are not crazy.

On your first point, however, your thinking is a bit muddy about the perpetuity of the investment. An impact investor would exit a mature social change vehicle if the MARGINAL opportunity for deploying that investment in the next new idea were higher than the opportunity in the current investment. So imagine an investment in say, clean cookstoves. We invest $1m and the company grows at 100%+ per year for a few years and soon it is serving 5m people and then growth flattens and it adds another 500,000 new customers per year for a respectable 10% growth rate. Fantastic. Problem of the world’s open fire cooking not solved, but a real success.

And over the next 10 years should basically double (the math is funny, so let’s say they add a flat 500,000 per year, which means the rate of growth actually tapers from 10% in year 1 to 6% in year 9).

Now imagine that a clean water filter, which has EXACTLY the same health benefits as clean cookstoves, is just emerging. They sell to 50,000 people, but a company needs a $1m investment to get it to scale. There is risk, but they think that they can get to 5m over the next 10 years. If I could exit my cookstoves investment WITHOUT destroying the business, how great would it be to try again. The world would then possibly get two companies, one selling cookstoves with 10m customers and one selling water filters with 5m customers.

In this case, you are choosing between two equal increments of 5m new benefitted customers. One could imagine that the growth of the cookstoves might be lower, the growth of the water company might be larger (or the certainty of the two might be different), but you will have the same opportunity cost thinking in social investing that you will in traditional investing.

People should look to maximize the yield on the investment and many mature companies by definition yield less as a percentage of their investment because they are so large.

Anyway, I do think that you are onto something. You are right that people are using conventional tools for investing and that early stage investing is still broken. I also think there is an opportunity for players like Bohemian to help invent new tools.

But as long as you have traditional “capital” in the mix with ERISSA compliance and fiduciary duty, things will potentially always stay stuck in the old rut.

But here’s an idea. Much like I many people are not "qualified investors" (by not being rich enough), what if we came up with a category of “qualified” investor that meant committed to or savvy about environmental or social outcomes first.

What if you changed the definition of qualified to not just mean wealthy enough, but it meant wise enough to do know how to change social and environmental systems?

What if there were pools of capital that had to be screened on mission before they were allowed to play in the game?

If enough people with enough capital agreed to play by those rules, you could start to see a real shift. Then very interesting investments would only be open to those who were aligned, willing to use new tools. And the rest of the capital would be stuck with their traditional finance first investments and a very boring life…

Just some food for thought. But happy to come to Ft. Collins to chew on that over some New Belgium.

Bopreneur said...

Thanks, Brian. Appreciate the comments!

Bopreneur said...

Brian- I think you are saying that securities regs would need to be modified (or could be to benefit this emerging sector)... there is little regulation of donations to non-profits... if an impact investor is more interested in impact than return, then the types of protections and disclosures would need to be different too. A fraud might look a bit different if it was accurate on financial reporting, but didn't disclose its ecological footprint, or overstated its C02 reductions.
Interesting expansion of the "turned on its head." idea.

Bopreneur said...

And while I am here, think about how companies with impact could issue impact certificates to their investors. How might we come up with a way to do that?
Yes, Cassandra, your donation really did help 10 children attend primary school... or distribute 10 bed nets. That seems to be the promise of carbon offsets... a validation scheme. Trust... but verify. I know, it's too expensive...
But if equity traditionally represents control and a share of economic profits, what if equity instead received a dividend in the form of a certificate for pro rata share of an organization's verified impact. Or perhaps these certificates could be used in lieu of cash to repay a portion of loans, for any impact performance delta over BACO?