Protecting and Monitoring Impact as an Investor: Part I

Previously, I wrote about how to construct the case for impact investment and how to think about investing beyond exit as two key strategic questions social entrepreneurs should ask themselves when pitching to impact investors. As entrepreneurs get better at responding to these questions, impact investors are finding more investible opportunities in the marketplace. They also, however, will be challenged to distinguish their investment practices from traditional venture capital investors to protect and monitor their impact investments. With that in mind, this two-part series looks at some tactics that will enable impact investors to do just that.

Background: traditional venture capital framework

When negotiating investment terms, the venture capital industry has well-established and widely used market practices embodied in the National Venture Capital Association model legal documents. Within the framework of these documents, entrepreneurs and investors agree on the various rights, responsibilities, and obligations that will govern their relationship and the rules by which a company will live.

Protective Provisions. A frequently (and at times contentiously) negotiated set of investor rights is the “protective provisions.” Protective provisions address control over a company, and an investor uses this section to establish certain veto rights. Put another way, a company needs an investor’s permission before it takes an action covered by the protective provisions. As you can see, protective provisions are a rare instance where the legal jargon is somewhat self-explanatory; that is to say, the focus is protecting the investor.

Information and Inspection Rights. A second set of investor rights, also negotiated in a venture capital transaction, deals with “information and inspection rights.” Information rights address an investor’s ability to obtain information about a company, typically financial information, such as monthly, quarterly, and annual financial statements, along with the annual budget. Inspection rights address an investor’s ability to visit and have access to a company and its personnel. At their core, information and inspection rights are about the investor’s ability to monitor an investment.

Let’s dig into each of these topics a little deeper with the recognition that impact investing has special priorities and properties that traditional investments do not have and therefore requires special attention in negotiating impact investment terms.

Protecting an impact investment

A quick Google search on protective provisions yields a number of articles and blog posts in which various individuals have offered their thoughts on these protections, which typically break down the “standard” versus “controversial” (or “negotiated”) protections. Again, these rights allow an investor to veto certain actions, and range from selling or financing the company to hiring and firing executives—and quite a few in between. Generally speaking, the traditional universe of protective provisions still applies to impact investors. However, an impact investor needs to reconsider these veto rights with respect to company actions in light of the specific case of an impact investment.

Example: The Case of Blocking Impact “Shut Down.” Naturally, an impact investor is going to be most concerned about a company pivoting away from the line of business in which it is creating or expects to create an impact. As I wrote about previously, there is a considerable amount of anxiety about impact “shut down” both before and after an impact investor exits an investment. At Beyond Capital Fund, we are constantly viewing investments with this consideration top of mind. Nevertheless, this issue has many subtleties.

While it might seem simple to negotiate a veto right over a company “exiting the impact line of business” or inserting purpose restrictions into a company’s charter, it is far from that simple. As a principal matter, “impact” means different things to different people, so defining “impact” in the context of the specific company is a critical first step. Yet, even a well-defined notion of “impact” might still cause problems. For example, will it scare off future investors and impair a company’s ability to raise future investment capital as it grows and scales if earlier impact investors have that much control? Asked another way, should impact investors be expected to give up these controls as a company scales?

Additionally, “exiting” or pivoting away from the impact line of business does not address the case of a company scaling back or failing to devote sufficient resources to the impact line of business and inhibiting its growth. These scenarios could certainly arise if a nonimpact focused expansion of the business takes a company down a more profitable path. Do impact investors need to revisit the usual list of protective provisions in this light? Do they need to consider whether approval over the annual budget makes more sense in this context in order to ensure that resources are allocated to achieving impact? Or perhaps approval over hiring and firing management to ensure that management is aligned with achieving impact?

Entrepreneurs will typically look upon a request for approval over the budget and hiring/firing management with the suspicion that an investor is trying to wrest away control of the business. However, in the impact context, an investor with these rights who is aligned with management’s mission and vision for impact can stand as an important ally in the future as a company grows, as control diffuses throughout the organization, and as more financially motivated stakeholders gain an increasing say over the company’s business.

Bottom line

There is no simple solution for an impact investor to protect an investment, but these considerations need to be the topic of conversations during the negotiation process in a way that is more pronounced from traditional investment negotiations. For an impact investor, it can help pressure-test management’s commitment to impact, potentially give the investor a seat at the table in the future to protect a company’s mission, and offer important controls in guiding the company toward achieving impact.

Read more stories by Brian Axelrad.