Magazine Extras (Summer 2014)
Supplements to the article “Creative Financing for Social Enterprise.”
Social enterprises, like all ventures, leverage ideas through the application of capital. To bring innovative products and services to market—to produce robust and scalable social change—businesses of this kind must have access to reliable funding. Without access to capital, even the most compelling social enterprise idea will go nowhere.
In discussing the challenge of capital access, social enterprise advocates often argue that traditional nonprofit and for-profit legal forms compel entrepreneurs to choose between protecting their social vision and raising capital.1 Nonprofit forms provide strong protection for the pursuit of a social mission. But nonprofit organizations cannot sell shares. Instead they must finance their growth through donations, borrowing, and retained earnings alone. For-profit forms allow companies broad access to financing through equity markets. But with equity investments come new owners who have the power to strip an organization of its core commitment to promote social good. Similarly, as Paul Brest and Kelly Born have pointed out in SSIR, investors in a for-profit social enterprise face the risk that “management and directors may discover opportunities to increase financial returns at the expense of social impact.”2
As these concerns have taken root, the need for solutions at the level of legal form has become a matter of conventional wisdom. In just the past few years, half of all US states have created special organizational forms to accommodate social enterprises.3 These forms include the low-profit limited liability company (L3C), the benefit corporation, and the flexible purpose corporation. Last year, Delaware joined the ranks of states that offer such options by creating an organizational form called the “public benefit corporation.”4 Noting Delaware’s status as the premier state for business incorporation, observers suggest that hybrid legal forms have reached a “tipping point” and have proclaimed victory on their behalf.5 Despite the spread of such legislation, though, there has been no rush by social enterprises to adopt these new forms. After 90 days, only 55 public benefit corporations had been formed in Delaware.6 In contrast, more than 145,000 legal entities were formed in that state in 2012.7
The tepid response to this legislation by social entrepreneurs is hardly surprising. Although these entrepreneurs do face a capital access problem, the problem is one of trust—and the newly developed hybrid forms do little or nothing to solve it. For capital to flow to social enterprise, entrepreneurs and investors must be able to rely on one another’s commitment to a double bottom line. The new organizational forms lack the safeguards that are necessary to provide such assurances, and there is no reason to expect other novel legal forms to fill that need.
The law, we believe, can and should play a role in easing the capital access problem that social enterprises face. What’s needed, however, is a renewed emphasis on innovation that revolves less around form than around financing. One potential solution, for instance, involves creating a specialized tax regime that would reward companies that demonstrate social commitment and punish those that engage in “greenwashing” behavior. That approach, and others like it, could fuel social enterprise by harnessing the potential of crowdfunding.8 In this article, though, we will present a solution that is aimed at sophisticated investors and designed to capitalize on the creativity of the legal and financial talent they can deploy. It involves a kind of flexible low-yield debt—or FLY Paper, as we call it—and it directly confronts the problem of trust.9
Hunting for Game—and Gaming the Hunt
Insight into the capital access problem faced by social enterprises can be found in an unlikely place—in game theory, and more specifically in what economists call an “assurance game” or a “stag hunt.” The stag hunt game traces its origins to a story by Jean-Jacques Rousseau. In the story, two hunters set out to hunt for either a stag or a hare.10 A stag is a big prize that will feed a hunter and his family for a considerable length of time, but a single hunter cannot bring down a stag alone. A hare, by contrast, is a smaller and less desirable prize, and each hunter can bring one home without the other’s help. In short, to capture a stag, the two hunters must work together. And they can work together only if each hunter trusts that the other will not defect in order to pursue a hare alone. Without assurances of reciprocal commitment, the hunters will be unable to get through the hunt and come home with the big prize.
In important ways, the capital access problem in social enterprise resembles a stag hunt. Social entrepreneurs and impact investors both seek to combine social good and financial gain; that combination constitutes the prize game that both parties desire. Social entrepreneurs aim (for example) to improve the environment, combat poverty, or empower women, but they also want to earn a profit. Impact investors want to earn a return on their investment, but they are willing to take that return partly in dollars and partly in cleaner air, better educational services for children in the developing world, more widely available job training for former prisoners, and the like. But if those groups cannot trust each other to stay in the hunt for that big prize, their quest to pursue a double bottom line will be for naught.
The experience of Atikus Insurance, a social enterprise that provides comprehensive credit insurance for microloans, offers a case in point. Despite having significant net revenue projections, the company met with skepticism from investors. Atikus has had “to justify the cost of its women’s empowerment and financial education programs, as well as its decision to charge low premiums to expand access to its product,” says cofounder Shane Fuhrman. “We need investors’ capital to scale up, but we want to ensure that Atikus will remain a tool for positive social impact beyond our tenure.”
The False Promise of Innovative Forms
The creators of specialized legal forms for social enterprise understand the capital access problem. In fact, the motivating force behind developing these new forms is the desire to attract equity investors to the social enterprise field while guarding against the risk that these investors will dilute or eradicate the social mission of an enterprise. But none of the new organizational forms solves the trust problem that entrepreneurs and investors face. At best, they provide one-sided protection.
The hybrid corporate forms available in various states clearly provide more protection against investor pressure to sell out than traditional corporate forms do. To transform a hybrid entity into a purely for-profit business, its board must recommend such a change to shareholders, and shareholders must approve it by a supermajority.11 Only if two-thirds of all shares embrace a preference for focusing single-mindedly on profit can the enterprise abandon its commitment to a double bottom line. Meeting that standard would require a great deal of persistence and, in some cases, a reshuffling of board personnel to seat a majority sympathetic to the views of profit-minded shareholders. Nonetheless, tenacious investors can still force a social enterprise that adopts a hybrid form to convert to a standard for-profit business—even over an entrepreneur’s objections.
L3Cs present exactly the opposite problem. Under the enabling legislation for that organizational form, if an L3C ceases to pursue a charitable and educational purpose, it becomes an ordinary LLC simply by operation of law.12 The firm retains its assets, its employees, and its liability protection. Thus an entrepreneur who leads an L3C can adopt a purely for-profit orientation merely by changing the entity’s activities. Investors do not have to approve the change; in fact, they may not even be aware of it. The signal that entrepreneurs send by offering investors a stake in an L3C is far from reassuring.
Some advocates may argue that fiduciary obligations will prevent unilateral defection from a double-bottom-line commitment. We have our doubts on that score.13 The enabling legislation for hybrid forms addresses fiduciary duty vaguely or not at all. Benefit corporation statutes require fiduciaries to consider a laundry list of factors in making decisions—from profit maximization to social, environmental, and employee benefits.14 As a result, fiduciaries have no guidance to follow, nor do they face a real threat of penalty. The Delaware public benefit statute instructs fiduciaries to “balance” their dual commitments to profit and social good, but that statute also includes no enforcement mechanism.15 L3C statutes make no mention of fiduciary obligations at all. Fiduciary duty, in short, is a slim reed on which to rest any hope of enforcing social mission commitments.
For the adoption of a specialized form to function as a credible signal of entrepreneurs’ and investors’ commitment to a dual mission, enabling legislation would need to be both more elaborate and more potent than it currently is. The legislation would need to place clear limits on either party’s ability to stray from the dual mission, and it would need to provide for enforcement of that standard. Enforcement, in turn, would entail regulatory costs that state governments today are reluctant to incur.
The Limits of Traditional Financing
Traditional legal forms are not the problem. The problem, rather, involves traditional financing instruments—standard equity and standard debt, in particular.
Ordinary equity won’t generate the trust that investors and entrepreneurs need. In fact, equity can fuel distrust between them. If entrepreneurs sell equity, they hand investors the ability to force their company to abandon its social purposes in pursuit of financial rewards. Shareholders can elect new directors with instructions to pursue profits alone. Shareholders can also literally “sell out” by tendering their shares to entirely profit-motivated investors. For impact investors, meanwhile, equity provides an exit strategy that they can adopt if their investing preferences change. Yet it does little to protect them from a similar change of heart by an entrepreneur. After all, entrepreneurs can also sell their shares, and impact investors are unlikely to provide cheap capital to an entrepreneur who can use that funding to leverage her own payout. They want a double-bottom-line investment, not a sucker bet.
Traditional debt, in light of the hands-off relationship that it creates with investors, is potentially appealing to social entrepreneurs who are eager to guard their company’s dual mission. Debt, however, must be repaid. Social enterprises typically earn below-market-rate returns, and social entrepreneurs will therefore resist debt financing unless investors agree to accept below-market-rate yields or other favorable terms in exchange for the promise of social returns. This is precisely the opposite of what market-rate lenders would demand. To compensate for the extra risk of lending to a non-profit-maximizing enterprise, these investors are apt to seek above-market-rate terms from borrowers of that kind.
One could posit a large community of impact investors who are willing to lend at a discounted rate in return for social value generation. These investors might even be willing to forgo the equity cushion that traditional lenders require. They will not, however, lend their money at great risk to entrepreneurs whose commitment to a double bottom line they cannot firmly trust. Standard debt offers lenders no such assurances and thus, like standard equity, offers no solution to the capital access problem.
In sum, standard common stock poses the same threat to social mission that hybrid forms have been designed (though ineffectively) to counteract. Standard market-rate debt fails to require investors to put “skin in the game” and leaves them vulnerable to entrepreneurial defection.
The FLY Paper Alternative
Luckily, traditional financing is not the only tool available to entrepreneurs and investors. Hybrid financial tools combine elements of standard debt and standard equity to fashion a product that provides substantially increased flexibility. These tools, which people in high finance have used for a long time, can be designed with reassurance in mind.
We envision a financial tool that we call FLY Paper. FLY stands for “flexible low-yield.” FLY Paper is a variant on the convertible bond—perhaps the best-known hybrid debt instrument. A convertible bond is, in the first instance, a debt obligation. It gives investors the right to a stream of interest payments but no role in enterprise governance. As a result, social entrepreneurs need not fear the power of investors to change the dual-mission orientation of their company. On the occurrence of a triggering event, however, a convertible bond transforms into equity. As holders of newly transformed equity shares, investors lose access to a steady payment stream but gain a role in governance and a right to share in the company’s residual earnings.
By selecting the right conversion event and by grafting on other essential features, FLY Paper provides the reassurances that social entrepreneurs and impact investors need. Unlike the array of new hybrid entities that are long on idealism and (so far at least) short on practical impact, FLY Paper provides a robust and transparent solution to the capital access problem. FLY Paper allows entrepreneurs and investors to signal their reciprocal commitment to a double bottom line, and it does so by combining three essential attributes.
Durability | Impact investors who purchase FLY Paper agree to take long-term interest payments that deliver a below-market-rate yield. The acceptance of a low yield signals the investors’ commitment to achieving both social good and profit. (After all, these investors could have purchased market-rate bonds instead.) The long-term structure of the debt locks investors into an enterprise for a significant period of time, albeit not forever.
Founders or capital contributors who seek perpetually asset-locked entities must understand that only charitable forms can offer that level of assurance. And social enterprises are not charities. Their assets are not irretrievably dedicated to the pursuit of social mission, and their founders and owners can receive distributions of profits. FLY Paper can ensure those parties that a social enterprise will remain committed to its social mission for many years. That arrangement should be sufficient to reassure investors and entrepreneurs who fear that their counterparts will pursue a quick payoff. It also marks a considerable improvement on the protections that specialized legal forms can afford to participants today.
Convertibility | If an entrepreneur agrees to transfer his or her shares in an enterprise, holders of FLY Paper can convert their asset into equity shares on favorable terms. Simply put, they have an opportunity to place their equity bets after the race ends, thereby appropriating for themselves any financial gains that pre-conversion shareholders had hoped to pocket. In that event, FLY Paper investors transform from creditors into equity shareholders with whom the entrepreneur must share any payoff that results from a decision to sell out. Convertibility signals entrepreneurs’ commitment to achieving both social good and profit, and it gives investors a cudgel to ensure that entrepreneurs remain faithful to their social goals.
Of course, this weapon is effective only for combating the ultimate defection: exit from a dual-mission orientation. FLY Paper does not address the incremental actions that entrepreneurs and managers may take to favor one side of their double bottom line over the other. Unless a triggering event occurs, FLY Paper owners have no recourse. Drafting bond covenants so that they include a broad array of triggering events—not only exit events but also maneuvers such as paying entrepreneurs excessive compensation—can ease but not entirely eliminate this problem. But in this respect, too, FLY Paper compares favorably with the use of specialized legal forms. In the newly designed hybrid entities, as we noted earlier, only the slender reed of fiduciary duty prevents entrepreneurs and managers from allowing an enterprise to drift incrementally away from its mission.
Flexibility | By default, FLY Paper is pay-in-kind debt. That feature allows a social enterprise to defer making interest payments to investors by paying these obligations in the form of more FLY Paper. For enterprises that need time to grow, this provision functions as a built-in “patient capital” feature, and by purchasing FLY Paper on such terms, investors provide additional evidence of their commitment to an entity’s double bottom line.
The pay-in-kind feature has much to recommend it, but we see it as an optional feature. Each entrepreneur will need to decide whether its benefits outweigh its costs with regard to limiting the market for debt of this type. When debt has a pay-in-kind feature, it generates an unpredictable income stream. Indeed, if an enterprise makes all of its interest payments in the form of additional debt and then goes bankrupt, this instrument might yield no income at all. If retaining this feature will make FLY Paper insufficiently attractive to investors, entrepreneurs should strongly consider opting out of it.
Like all convertible bonds, FLY Paper also has the potential to crowd out equity investment: In the event of liquidation, as we noted, it functions as an equity equivalent with priority over common stock. Entrepreneurs may want or need to issue equity as well, particularly in order to attract and retain key personnel. Indeed, we anticipate that entrepreneurs themselves will retain an equity interest and will offer FLY Paper alongside common stock. Fortunately, because an issuer need not pay cash interest to pay-in-kind investors and because the conversion feature remains dormant unless equity investors sell their shares, crowding out will be a less consequential problem with FLY Paper than it can be with other convertible bonds. Although the effectiveness of FLY Paper depends in part on its value relative to that of equity holders’ stakes, FLY Paper need not be the exclusive security issued by a social enterprise.
Hanging FLY Paper
The actions of impact investors and social entrepreneurs will provide the best evidence of whether FLY Paper and other hybrid financial instruments are as potentially effective as we suggest. There is reason to be optimistic, however. Angel investors who fund early-stage for-profit startups, for example, already make extensive use of convertible bonds, and social enterprises—many of which are small entities that engage in disruptive innovation—have a lot in common with startups of that kind. As a favorite of angel investors, moreover, convertible debt is familiar to the high-net-worth individuals who make up a large part of the impact investor community.
Some early adopters are already using convertible bonds in a social enterprise context. Issuing convertible bonds “was a really important mechanism for getting us across the divide between a point where we could price the equity and when we could raise it,” says Tony Abrahams, cofounder and CEO of Ai-Media, a company that develops technology to serve people with disabilities.16 The RSF Social Finance Mezzanine Fund, meanwhile, offers convertible notes to its investees with the express goal of solving the trust problem. The purpose of the fund, according to the RSF website, is “to provide growth capital without the need for a company to sell equity, resulting in little to no dilution of ownership or loss of control—a key consideration for companies with deep social missions that might be compromised through traditional financing.”17
FLY Paper is but one of many specialized financial tools that entrepreneurs and investors might craft to solve the assurance problem at the heart of social enterprise. They might design a class of preferred stock, for instance, or they might fashion a shareholder-rights plan to enforce their commitment to a social mission. Only their level of skill and imagination limits the variety of instruments that they might develop.
From Form to Finance
Social entrepreneurs and impact investors share a belief in the power of social enterprise. Unfortunately, they lack faith in one another. Specialized legal forms fail to provide the credible signals of commitment that would-be social entrepreneurs and investors need. That’s true even of the new law in Delaware that allows for public benefit corporations. Fortunately, social enterprises don’t have to wait for state legislatures (or, for that matter, Congress) to enact a perfect solution. Unlike the empty promise of specialized forms, FLY Paper offers a real solution to the capital access problem. FLY Paper gives both investors and entrepreneurs credible signals about the intentions of their counterparts. Each party can then gauge the other party’s long-term commitment to pursuing a social mission as well as personal financial gain. And that process, in turn, will enable capital to flow.
The field of organizational form provides too small a canvas for the legal innovation needed to solve the capital access problem. Worse, attempting to remake that field is, in large part, a wasted effort. Sophisticated investors, with help from talented legal and financial advisors, can develop customized financial instruments that make for-profit organizational structures safe for social enterprise. True to the spirit of social enterprise, in other words, FLY Paper and other creative financial solutions offer a second chance to those traditional (and unfairly maligned) legal forms.