Impact Investing Win-Win-Win for Entrepreneurs, Investors, Society – Part 2

Impact Investing Win-Win-Win for Entrepreneurs, Investors, Society – Part 2

This second blog post on impact investing will answer:

– How do you as an entrepreneur gain access to the large community of impact investors?

– How do you demonstrate that your impact is specific, intentional and measurable?

– How do you demonstrate that this impact is large and growing, making your venture compelling?

– How do you reduce perceive risk while maintaining market-rate returns?

See my first post for an introduction to impact investing – answering the questions why you should seek it as an impact entrepreneur (an impactreneur), and why you should invest in it as an investor.

The most abundant source of impact investment – wealthy individuals, family offices and family foundations

My personal experience begins with my own family’s preference for impact investing.  My father while alive specified that education and medical care be the emphasis in investing his assets.

Over several years of attending family office conferences as an investor, I had the startling experience of finding many other “allocators” (those managing family assets) requesting opportunities for impact investing.  Apparently the ultra-wealthy owners of family offices and foundations, and their heirs, are increasingly prioritizing impact along with capital preservation and growth in the allocation of funds.  This piqued my curiosity which led to Intelliversity’s approach to raising capital for mission-driven companies.

Here is a typical family foundation statement:  “A foundation can use its resources in many ways beyond grants. At The Russell Family Foundation, we’ve explored and implemented impact investing through our financial portfolio since 2005. Impact investing is any financial investment that generates both a social and a financial return.”

The Russell Family Foundation will invest in Program Related Investments (PRI) in the form of below-market-rate loans and mission-related investments, loan guarantees, and direct deposits in local community banks to bolster housing, economic, environmental and social benefits for particular communities.

As you’ll find below, there are tens of thousands of such foundations.

How many such private sources of capital are there?

According to the new edition of Key Facts on U.S. Foundations, the country’s 86,192 foundations held $715 billion in assets and distributed a record $52 billion in 2012. This annual research study estimates 2013 giving at $54.7 billion and the outlook for 2014 and 2015 (exact figures not yet available) show steady increases.

Quoting from the article “The Appeal Of Family Foundations” in Forbes Magazine, April 30, 2015:  “For the ultra-wealthy there are multiple benefits to establishing family foundations. As the number of ultra-wealthy increases, and as their fortunes become ever larger, the number of, and assets, in family foundations are likely to similarly grow.”

Continuing from Forbes, “The monies controlled by the ultra-wealthy as well as the number of people in this cohort are growing at a relatively astounding rate. There are also strong indications that the very rich are increasingly interested in establishing their own family foundation.”

Forbes concludes, “While there are certainly costs associated with creating and managing a private foundation, there are distinct benefits for doing so. There are many reasons the wealthy create a family foundation. Three of the most pronounced – often-interconnected – reasons include: … caring, legacy, and permanence.”

Don’t family foundations donate their money, not invest it?

It’s true that family foundations are required by the IRS (in order to maintain their tax-exempt status) to donate 5% of their assets each year to worthy causes consistent with their missions. In the past, this 5% was donated largely to non-profits.  Now there’s a movement to place some of the required 5% donations with for-profit companies and to receive a return on these investments.  There’s also a movement to place some of the remaining 95% with impact investments as well.  Let me explain.

IRS regulations allows a family foundation to invest in impact investments in at least two different ways:

  1. The 5% that must be donated by a foundation can be invested in for-profit companies. Such an investment is called a Program Related Investment or “PRI.”  The IRS clarified the freedom for foundations to invest in PRIs in 2012 and since then they have become increasingly popular.  The PRI rule allows any private foundation to invest money in a for-profit company, in lieu of donating to a non-profit, so long as a) the returns are riskier than normal or lower return than normal, and b) the purpose of the investment are aligned with the foundation’s mission.
  1. The remaining 95% of the foundation assets must be invested continuously to ensure that there are sufficient investment returns to replace donations and to cover for inflation. However, with public stock market and bond market investments yielding little in the current market environment, it’s essential that foundations round out their investing to include opportunities with higher returns, albeit with higher risks. The risks can be mitigated by investing in select private equity funds, venture capital funds, and other private investment vehicles. However, many allocators we have found are open to direct investments in early-stage companies so long as they have missions and impact that are aligned with the foundation’s.  In fact, foundations are permitted to make investments with higher risks or lower returns than they would normally make so long as the investment furthers the foundation’s mission. Such an investment is called an MRI (Mission Related Investment).

In conclusion, as an entrepreneur, you need to find a way to gain access to the right families and foundations. This is where your opportunity arises.

A thorough legal discussion of Program Related Investments and Mission-Related Investments is found in a paper you can download here: Mission Related Investments for Private Foundations

What is the difference between a family foundation and an angel investor?

A family foundation is a tax-exempt entity.  An angel investor is probably not tax-exempt, investing personal funds.  Both terms however, refer to investors who invest as individuals (or families) rather than as an institutional pool of capital (such as a private equity fund or venture capital fund.)  On the other hand, we normally think of “angels” as individuals who semi-professionally dedicate a portion of their assets and time to startups and early-stage ventures. Family Foundations are not specifically dedicated to such investing, but many are open to it … if the investment is aligned with their mission.

Curiously, it may actually be easier to access a family foundation than an angel investor. Angel investors frequently operate under the cover of angel investing groups.  Family foundations are listed in public directories and can be reached with little difficulty.

Your task with family foundations is to:

Target the proper foundations based on mission and put them into your funding pipeline
Move the receptive foundations through a sequence of conversations and meetings that magnify their interest (while eliminating the ones who are not interested)
Capture their interest in the form of an appropriate investment agreement

How can entrepreneurs help investors understand the impact of their products and services?

To assist investors in determining whether a given project or company is an impact investment, I recommend that companies do the following:

  1. Determine the long-term consequential positive impacts of your products and services beyond filling the specific near-term needs of your customers. These can be in any areas that may interest investors, such as social, environmental, health-related or economic development impacts.
  2. Determine the metrics (measurable results) that would indicate success in achieving these impacts.
  3. Project the impact metrics over a 10 to 20 year period forward, assuming your company fully achieves its desired growth.

We call such a document an “Impact Statement.”  In order to make quantifiable and rational projections, several companies have emerged that perform exactly this kind of analysis for non-profits and impact businesses, and their investors.

I recommend that companies prepare such an Impact Statement before seeking investors.  I also recommend that impact investors insist on such an Impact Statement before seriously considering investment in a company or project, to avoid being swept away by emotional appeals.

More information about measuring impact can be found in a paper on the Intelliversity site:  “Measuring Impact Workgroup Paper

How does an Impact Statement differ from the “problem-solution” sections of a business plan?

These parts of a business plan are concerned with the immediate, short-term and direct problem to be solved by a product or service.  Suppose for example the product is a prevention for Type 2 Diabetes.  The problem might be the intractable nature of Type 2 Diabetes. Suppose the solution provided is a medical device that effectively reduces blood glucose far beyond any previous treatment.  The solution section of a business plan might enumerate demand for such a device and how many cases of Type 2 Diabetes might be prevented.

In contrast, an Impact Statement would list various consequential impacts of this treatment and then project these results forward.  Consequential impacts might include:

  1. Delay of general aging and senility
  2. Reduction of related chronic diseases such as heart conditions
  3. Lengthened period of time on average before aging individuals require assisted living
  4. Increasing and lengthening the period of economic productivity of aging population
  5. Increasing the productivity of younger populations
  6. Reduced medical insurance rates
  7. Reduced government entitlement expenditures

How can impactreneurs reduce the most significant perceived risks?

To reduce perceived execution and management risk, recruit an executive team with proven execution talent in your market.  Put a high priority on marketing and sales talent, not only product development or production talent.  If you don’t have the funds to pay senior sales and marketing execution talent, then recruit them and put them in a standby mode.  Ideally, take the high road that Mark Zuckerberg did early in the life of Facebook and recruit an individual with the execution talent of a Sheryl Sandberg, and make sure she or he is trusted and given the necessary level of responsibility and incentives.  Execution is all about the senior team members.

To reduce perceived liquidity and exit risk, if your company is generating revenue or is nearly ready to do so, avoid dilutive financing (selling equity).  This is key because, with respect to early-stage investing, perceived liquidity and exit risk among investors is not only large but seems to be growing.  You are best advised to minimize this perceived risk as you move forward meeting with investors.

The best way to reduce liquidity and exit risk is to request a non-dilutive form of financing.  If you have some operating history, you may be able to obtain some or all of the financing you require as some form of debt.  (Convertible debt, if it relies upon the hoped-for conversion to be attractive, does not solve the problem.)  For the remaining financing you require, I recommend revenue royalties.

Why are revenue royalties preferred?

As conceived by wall street veteran Arthur Lipper (Chairman of Intelliversity’s Board of Advisors), revenue royalties are better for both the investor and investee.

For the investor, revenue royalties as a mode of investing eliminates the liquidity and exit risk.  Liquidity begins almost immediately and the investor is made whole (principle is paid back) within a period of a few years (typically about five years, though the payback period can be shorter or longer.) No exit is required. This is clearly attractive to many if not most investors today.

For the investee, the advantages of revenue royalties are equally compelling.  If and when a liquidity event does occur, founders hold onto a much larger portion of their equity.  In the long run, say over a ten-year period, founders pay less to their investors because the investors perceive less risk.  You as a founder hold onto a much greater part of your earned wealth.

There is more for founders.  As founders, revenue royalties do not involve any sale of ownership, hence result in much less interference in management. You’ll experience a higher level of privacy and freedom to operate.  You’ll also experience a reduced possibility that you as founder may be removed if your exit strategy and timing don’t match investor expectations.  Instead, we believe, you’ll experience an investor who takes an interest mainly in assisting you in boosting revenues.  This becomes a win-win relationship with you and your investors.

Win-win becomes pervasive with Revenue Royalties.  Most important for both parties, the management of your impact-driven company is not skewed toward generating an exit event (usually an acquisition and sometimes a public offering.)  Both founders and investors can focus on creating a meaningful sustainable company and maximizing desired impact.  In the long run, the results are optimal for all parties and society as well.

A further discussion by Michael North of Pacific Royalties on the relevance of Revenue Royalties for impact investing can be downloaded from this site: Impact-Investing-Royalties-Convergence.

Feel free to contact me with questions on this topic at [email protected]

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