Protecting and Monitoring Impact as an Investor: Part II

In the first part of this series, I wrote about how an impact investor can track traditional tools used by venture capital investors to protect and monitor an impact investment. In this part, I will discuss a new tool that needs to be created and the traditional concept that serves as its underlying foundation.

Information and inspection rights

As background, “Information Rights” and “Inspection Rights” tend to be noncontroversial. In fact, many term sheets simply refer to these rights as “customary” or “standard.” Information rights relate to an investor’s right (when not serving as a member or observer of the board of directors) to receive financial information, such as monthly, quarterly, or annual financial statements, while inspection rights permit an investor to visit the business and speak with management with some modest advance notice. There may be some negotiation regarding the specific financial information, such as whether an annual budget is provided, or regarding the time periods by which the financial information must be provided. However, the most frequently negotiated item is the threshold of ownership (either by percentage or dollars invested) that enables an investor to have these rights. This concept is embodied in legal documents in the defined term “Major Investor” and denotes an investor who gets these rights (along with several other rights) in a traditional venture capital transaction.

The context of a “Major Investor” is relevant to impact investors because it provides the framework for understanding how impact investors can approach the issue of getting information from their investments relating to social impact. Impact investors should consider explicitly calling themselves out in these transactions as an “Impact Investor” (as a defined term in the investment documents) and a subset of Major Investor. As a threshold consideration, impact investors should take the position that they are entitled to the rights of a Major Investor regardless of whether the “Impact Investor” meets the Major Investor hurdle. Particularly as it relates to the annual budget, an impact investor will need to understand how resources are being allocated to verify that the impact line of business is being nurtured (as I mentioned in the discussion of protective provisions in Part I). However, an impact investor needs more than the customary information and inspection rights.

Social impact metrics, benchmarking, and analysis

Before jumping into the rights that an “Impact Investor”  needs in regards to information, we first have to discuss the types of information an impact investor needs. In the third article of his series, “The Trouble with Impact Investing,” Kevin Starr comments: “What’s weird to me is that while all impact investors know that you could never maximize profit without measuring it, they often fail to recognize that the same is true of impact.” Despite Kevin’s observation, there are a number of efforts ongoing to solve exactly this issue, most prominently the Impact Reporting & Investment Standards (IRIS) project being undertaken by the Global Impact Investing Network, as well as the Global Impact Investing Ratings System (GIIRS) under development as a project of B Lab.

Whether IRIS or GIIRS (pronounced “gears”) will ever play the role for social impact metrics that the Generally Accepted Accounting Principles (GAAP) do for financial information is unclear. At Beyond Capital Fund, we have leveraged these resources and others to develop our own in-house set of social impact metrics that we use in evaluating prospective investment opportunities and monitoring the impact of our portfolio companies. Over time, as the industry matures and the participants collaborate, impact investors will gain sharper focus on the information needed to monitor their investments.

Collaboration

To that end, we have been fortunate to collaborate with other investors through the Toniic international impact investors network and have generated (thanks largely to our co-investors’ efforts) a short, concise model for monitoring our portfolio companies. A two-page analysis that breaks down a number of important social impact metrics using up-to-date data from the operations of a portfolio company’s business provides us with the ability to monitor social returns as an ongoing consideration. Examples of metrics we might report on are, for example, volumes of potable water produced by a company that provides clean drinking water or client visits made by a company that provides health care services to the rural poor. To the extent that we demonstrate our investments led to certain positive social outcomes, we are able evaluate the success of these investments—to ourselves and to our funders.

However, the most important channel for developing social impact metrics will come from collaboration between impact investors and social entrepreneurs. Each social enterprise is different, and the social mission underpinning the enterprise will necessitate a distinct set of social impact metrics. While we may achieve some uniformity in social impact metrics, each social enterprise will make use of a unique set of those metrics. Thus, collaboration between an “Impact Investor” and a social entrepreneur in each instance to design the right portfolio of social impact metrics on which to report is the only way that “Impact Investors”  will get the information they need.

This collaboration should occur during the time that impact investors are negotiating the terms of their investment. The impact report should be included with the legal documentation relating to the investment as an exhibit upon which an impact investor and a social entrepreneur agree. Over time, as the results of a social enterprise yield the need for updates and revisions to the impact report, the parties can agree to revise it, but a fundamental baseline document is an essential starting point at the time an “Impact Investor” commits to invest in the social enterprise.

Preparing the impact report

Finally, what about the time required of a social entrepreneur to prepare and discuss this impact report with an “Impact Investor”? Many impact investors are concerned about the time it takes a social entrepreneur to prepare this information. Nevertheless, impact investors are in the business of providing social returns to their own investors (or funders) just as traditional investors are in the business of providing financial returns to their investors.

Monitoring an investment requires, at minimum, receiving the type of information directly related to the returns an investor is seeking and therefore must demonstrate to their stakeholders. It is a given that entrepreneurs collect and analyze financial information, prepare financial statements, and disseminate that information to their investors. Social entrepreneurs and impact investors would be well advised to consider the collection and analysis of social impact information in the same light. For impact investors, the impact report is the logical extension and an obvious corollary to traditional financial statements.

Summary

The traditional venture capital model provides a helpful foundation for investors in or who wish to enter the impact investing space. The current tools available, such as protective provisions, need to be viewed in light of the special priorities and properties of impact investing and subsequently revisited with those in mind. Additionally, new tools need to be created, such as impact reports. These new tools will often find parallels within the traditional venture capital model from which to draw. Impact investing is not about reinventing the wheel, but simply calibrating the wheel with different ends in mind.

Read more stories by Brian Axelrad.