Last week, my friend Paul Hudnut posted a follow-up from a conversation we had around what Paul calls the “original sin” of impact investing: liquidity. In Paul’s words, “what if, in the end, (impact investing) doesn’t matter?” Investors put money into companies and enterprises grow; however, the only way investors get money back is if the company has a “liquidity event”—which is, most commonly, an initial public offering, an acquisition by a larger backer, or another event that gives cash back to the original investors—a requirement for the whole “investing” thing to work.
Yet liquidity is where most impact investing gets stuck—investors often won’t invest upfront because they don’t see liquidity options even in successful companies; at the same time, companies that do have “liquidity events” often worry impact investors because they lose mission. Conferences and articles are littered with examples such such as SKS Microfinance, who critics claimed lost sight of quality/impact control driving for ultimate growth, or Ben and Jerry’s, who got acquired by Unilever at an attractive financial return for investors, but might have sacrificed some of their social mission to do so.
We have to get this liquidity question right. The investor question of “how am I going to eventually get my cash back?” has killed more innovation from day one, in my experience, than any other investor concern. Many would-be impact investors just throw up their hands and don’t get involved—and I don’t blame them for having questions.
A few weeks ago, Paul and I were talking about an event that gives me hope. This fall, New Belgium Brewery (on whose board Paul serves) initiated a leveraged buy-out of initial investor shares that brought the company into employee ownership (formally known as ESOP). Initial investors were able to get a return on investment, and the employees who built the company are now in control of the mission of the company going forward. Amazing stuff, but not as easy as it sounds. Paul mentioned that employee ownership of the company was important to the founders and initial investors in the company from the start, and they designed the company’s financial and investment structure intentionally–and well in advance–to accomplish this.
So I asked Paul several weeks ago, “What would it take to design a company from day one for this?” Several hours later, we talked through a few options—one of which, a “redemption clause” option, Paul outlined in this blog post. For what it’s worth, here is my two cents on how to tackle the liquidity question for impact investors.
Impact Investment Structures: A Procrustean Bed
(As background, I studied the classics throughout school. This is important, though, so bear with me.) In ancient Greek and Roman culture, the xenia, or relationship between a guest and a host, was sacred. People’s character was measured by how well they could host—in fact, a guest-host relationship gone wrong between the Greeks and the Trojans is what started the Trojan War.
According to legend, Procrustes had built a reputation for being a miraculously good host. The reason: his guest’s beds, somehow, always fit them perfectly. What we learn in digging into the story, though, is that the way he made this work was barbaric: instead of custom-fitting beds to guests, he would measure his guests when they arrived at the house to one bed. If their legs were too long, he would chop them off; if their legs were too short, he would put them in a stretcher until they fit the bed.
Right now, impact investors are doing the same thing. This liquidity challenge is not one of substance, but one of structure. We’re using term sheets, investment structures, and corporate strategies designed in the “start-up world” for consumer technology in Silicon Valley, but they don’t apply with companies seeking impact and financial returns in Ahmedabad, Nairobi, São Paulo, or, for that matter, Louisville.
But if we break out of the Procrustean bed of Silicon Valley venture equity for liquidity, we can see a few solutions:
I. Redemption Rights/Revenue-Shares (the idea outlined in Paul’s blog post)
This was the original idea I discussed with Paul, and it has potential. Two iterations:
A) Redemption clauses in investments give investors the option to receive liquidity via the founding team buying back shares over time;
B) Revenue-share arrangements (a rough comparable: royalties in books/movies) enable investors to share in revenue from the company, rather than a repaid loan or an exit event that doesn’t yield liquidity. Seth Godin, an advisor to Acumen, describes the revenue-share arrangement elegantly here.
Yet for these to work, we need three preconditions:
a. Entrepreneur education on this is critical, and the conversations have to come early.
At the end of Village Capital programs, we offer investments to peer-selected entrepreneurs. We actually have redemption-rights and revenue-share term sheets in the Village Capital arsenal–we’ve made 16 investments in the past 12 months, and have offered these term sheets to all ventures–none have taken the revenue-share term sheet (though there were 3 ventures for which it would be a really good fit) and two took the redemption-right term sheet (and these were our two most experienced entrepreneurs–both had exited previous companies).
Both investors and entrepreneurs are ill-educated on this: yes, investors think that Silicon Valley consumer tech equity is the only way to invest, but to an entrepreneur, straight equity seems free when it’s offered (or equivalent to grants at least). More experienced ones know that equity is the most expensive cash you can take, but the majority of ventures out there don’t have this kind of experience.
b. Revenue/cash flow is king.
New Belgium has had the luxury of having terrific revenues (there’s no shortage of demand for beer, even in a recession). Yet don’t think this is a limit as much as an opportunity. To date, impact investors have overlooked high-revenue-generating ventures in favor of hockey-stick consumer tech-like models because of this liquidity issue. If we popularize alternative redemption structures for high-revenue businesses that might not have “exit events,” it might highlight investment opportunities in a completely different type of business. Agriculture and local economy businesses could be especially relevant for this structure, and at its heart, investing is an inherently local thing. So if we open up a new investment structure for a new kind of business, that’s not a bad thing.
c. What about the businesses without consistent short-term revenue potential?
Revenue-sharing and redemption rights wouldn’t “solve our problems.” Impact investment opportunities without strong short-term revenue prospects (to name one example: a lot of emerging market, affordable basic services for the poor; to name another: education technology) wouldn’t be the right fit for this structure—and for them, we’d just be constructing another Procrustean bed. John Kohler of the Global Social Benefit Incubator is developing a “demand dividend” structure that, in some ways, gets around this by tying investor returns to free cash flow instead of revenue—a great concept that I’m excited to see develop, and/but requires more monitoring than an early-stage investor might be comfortable doing. In the terms of Procrustes, choosing the right bed for the right guest is critical here.
But these aren’t the only options—what else are people working on?
II. Later-stage Buyout Fund (“The Godot Fund”)
Brian Trelstad of Bridges Ventures said that he had heard so many versions of this that it was like “Waiting for Godot.” The basic concept of what Brian terms “The Godot Fund”: a Berkshire Hathaway for the impact investing sector—that would buy secondary shares in companies that would provide liquidity to initial investors. Seems easy, right? Not so much:
A) The opportunity: a recognition that different investors play different roles in a spectrum. The seed stage, where a company typically has revenue but hasn’t “proven” the concept, is where some investors (like Village Capital) are comfortable investing, but most funds require more track record and growth from ventures before investing. We at Village Capital have seen deal-by-deal this happen in isolation—where later-stage investors buy out initial investors (primarily for more control over the company)—if the later-stage investors are mission-aligned, it’s great, and early-stage investors get their liquidity. Platforms such as Mission Markets are doing compelling work on a deal-by-deal basis—we know of one secondary sale, Better World Books, to a one-off investor, but there’s a way to go.
B) The challenge: adverse selection and fund economics. This “buyout fund” has an analog: traditional private equity funds. Yet without significant amounts of capital (the source of which has yet to be identified for impact investing)—it’ s very difficult to pay a team to manage the logistics of a buyout fund. We don’t know where the money is coming from for this fund. And even if we did—another problem Brian points out: if impact investing fulfills its promise to integrate into traditional business—the “best” companies (with the highest growth prospects and the best cash flows) are already being acquired by Fortune 500 companies (like Honest Tea being acquired by Coca-Cola) or are in revenue-share/redemption arrangement with these investors. So would the buy-out fund get the “worst” of the decent impact companies?
These are a couple of ideas that are, admittedly, more brainstorm than reality–but there’s a start. In my next post, I’ll write about a separate–but related–problem: the lack of liquidity for the founders of these successful, mission-driven companies, how it hurts early-stage impact investing, and how to fix it.