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July 30, 2011

Funding Social Businesses on Mainstream Markets

This article tries to show ways towards the co-existence of these two mindsets as shareholders of the same company and the opportunity this presents for all stakeholders of social enterprises.

Uli Grabenwarter, Researcher on Impact Investing and Visiting Professor at IESE University of Navarra, Barcelona; IESE/FOC Impact Investing Research 2011


The fall-out of the recent financial crisis has softened to some extent the debate on the merits of social enterprises as investment targets. Also, a clearer definition of the boundaries of impact investing has paved the ground for a new quality of arguments: Recent research suggests as a requirement that not only has an impact investment to be explicitly for profit but in addition there has to be a positive correlation between the social impact objectives and the financial return drivers of a target company’s business model1.  This additional feature clarifies the cut-off line of impact investing to philanthropic funding activities.

The requirement of positive correlation between impact objectives and financial return implies that the financial return drivers of funded business models cannot be dissociated from impact objectives. In other words, if the business model is the means of achieving the impact objective, by definition there has to be a positive correlation between the impact objectives and the business model’s financial return. Any business model in which every unit of social or environmental impact has a cost in terms of financial return is therefore inevitably a disguised form of philanthropy.
This insight may have far-reaching consequences for how impact businesses are perceived in the financial markets. In addition, it also opens totally new avenues in the funding of impact businesses. So far, the funding community of a business has been neatly divided into two constituencies, being the impact-first investors and the financial-return-first investors2. This division is based on the above-stated assumption that financial return and social impact are, if not mutually exclusive, at least mutually detrimental factors in the development of a company.
However, if one accepts that, for assessing the quality of impact, the investor’s motivation is meaningless as long as the achieved impact is intentional, then this trade-off debate becomes obsolete as well:
As a matter of fact, the attitude of an investor towards financial return generated by his investment is an investment decision dimension but does not necessarily have to do with the profit-orientation of the underlying business model. In other words, the fact that a business model’s core objective is to pursue a social impact does not necessarily mean that this company cannot generate a financial profit. And, in return, the fact that a social impact business is profitable does not impose any requirement on the profit-orientation of its investors.
To be considered an impact investment, the requirement of profit orientation does not relate to the company’s dividend policy but merely states that the company should be run with a for-profit mindset with a positive correlation between pursued impact and financial return drivers. The company’s dividend behaviour is not a feature that determines whether or not a business is an impact business. It is a feature of the investment product or instrument used to fund the business.
It is obvious that for-profit investors and non-for profit investors don’t share the same philosophy when it comes to profit generation of their investments. However, if social impact objectives are inextricably interwoven with the economic value drivers of a business model, then there must be ways that for-profit investors and non-for-profit investors fund the same business model even if they back the company they invest in for different reasons.
If financial markets manage to segregate the impact business model from the financial return preferences of investors, then a company that has a social objective at the core of its product or service offering should be able to be equally attractive for both for-profit and non-for profit investors. The preference of investors as to the use of financial return then would not be expressed in the business model of the company but in the features of the investor’s investment instrument.

Financial return expectations from impact investments reflected in different share classes
Different financial return preferences for instance could easily be captured in the characteristics of different share classes that a company issues.  Financial markets know already in many instances different characteristics of financial instruments used by various investors to fund one and the same business. The most obvious is the differentiation of debt and equity holders in a business. In the last decades, many shades of hybrid products between pure equity and pure debt have emerged. Within equity instruments various share classes have been created reflecting different risk/return preferences of investors. Hence there is no reason why such differentiating features of financial products could not also relate to impact businesses and the profit generated by them.
It is perfectly conceivable to have for-profit investors who judge a social business as a more attractive investment opportunity based on its selling proposition alongside purely impact-minded non-for-profit investors. Whilst the for-profit investors would subscribe traditional ordinary shares that pay dividends like any other share in the market, non-for-profit investors could buy into a different share class  which does not pay dividends but accrues profits in the company’s capital accounts. 
The weight of shares in the capital account would obviously change in the proportions of dividends distributed to “for-profit” shares and profits accrued for “non-for-profit” shares. As such for-profit investors would directly benefit from the financial profitability of their investment while non-for-profit investors can decide to scale the means for creating impact by maintaining their financial profit within the social impact business.

Opportunities for policy makers and legislators
Such differentiation in share classes allows social impact businesses to access capital from both the for-profit investor space and the non-for-profit investor community, provided that the business model offers an appealing social impact that can be scaled in a way to deliver also attractive financial returns. Such funding structure appears vital to provide social businesses with an access to mainstream markets, helping them to overcome capital constraints that they typically face when purely relying on the non-for-profit investors community.
However, such funding models are not only attractive for the flexibility they offer for enterprises. They also provide scope for targeted action by policy makers who seek to foster social businesses as a substitute to public services. Just like the social impact bonds  created in the UK3 combines public sector incentives with private sector investment products, companies with different share classes with different return features for their investors could be used to tailor tax treatments to the policy objective on one hand and the combination of impact affinity and profit orientation of investors on the other hand.
It is for instance conceivable that corporate taxes on a business’ profits available for distribution to for-profit investors (A-shares) are taxed differently than profits allocated to capital accounts of non-for-profit investors (B-shares) accruing their profits within the company in order to scale impact.
Such differentiated tax treatment of A- and B-shares could take the form of a permanent tax benefit in case the proportion of A-shares and B-shares is fixed. It could however also be merely a deferred tax advantage in the case B-shares can be converted into A-shares at given times. In such case the earnings allocated to the capital account of B-shares could benefit from preferential tax treatment until conversion. From the point of conversion, the portion of retained earnings in the capital accounts of B-shareholders becomes taxable at company level (catch-up for tax brake on corporate tax) and the balance becomes distributable to investors.
The impact-related tax treatment of profit attributable to shares is undeniably the most complex one. Hence, such impact-related treatment is fairly easily adaptable to all types of financial instruments including bonds, convertible bonds and any form of mezzanine finance.

Qualification as eligible impact business
Obviously, in order to put such funding models for for-profit impact businesses in place, criteria for eligible business models need to be defined. Such criteria are not only relevant for the bilateral relationship between for-profit and non-for profit investors in one and the same company but also for its eligibility under special tax regimes and its legal forms of incorporation as a social business.
It appears advisable to create a corporate structure for social businesses which requires them to define impact objectives and their metrics for monitoring. Such metrics need to be tailored to the business model of the enterprise.
Also, ratios of A- and B- shares should be set in a legal framework as requirement for qualifying as an impact business.

Benefit for for-profit and non-for profit investors
The co-existence of financial return objectives and impact objectives within the same business model does not necessarily lead to contradiction. As matter of fact, if they are positively correlated, they serve as mutual catalysts and amplifiers.
Hence, for for-profit investors the social impact is at the source of financial return. For impact investors, financial return becomes the means for scaling impact.
Besides this intrinsic joint interest of for-profit and non-for-profit investors in the development of impact objectives within the business model any tax benefit and/or tax-brake granted to the impact business provides additional incentives for for-profit investors in impact businesses. Any corporate tax brake operated at the company level increases the financial resources available for developing the business and hence improves the capital efficiency for investors.
The size of such tax benefits can be tailored to the policy objectives of the legislator and also to the achieved savings in the public budget if parts of the public services currently paid through taxpayers’ money can be shifted to private sector business models (crf. the social impact bonds in the UK).

Challenges in the governance of social impact enterprises
Obviously, the co-existence of for-profit and non-for-profit investors within the group of shareholders of a company can lead to anything between lively debate on strategic orientation of the company to mutual blockage through the exercise of their respective voting rights.
This risk is the reason why a very diligent definition of the legal bases of a social impact enterprise is vital. Such legal base needs to define minimum impact requirements, requirements on metrics and reporting and protection rights comparable to minority protection rights for for-profit and non-for profit investors. However, whilst such legal framework can provide downside protection for each of the investor constituencies, the most effective protection of their interest rests in the alignment of interest through the success factors of the business model they invest in.
A great facilitator for an effective balance between for-profit interest and social impact interest lies certainly in the tradability of shares. Hence, the creation of a liquid stock exchange for social impact businesses appears to be a potentially powerful amplifier for this market segment.

The above article tries to identify areas of action suitable to improve the access to finance for social impact businesses and to bring them onto the radar screen of mainstream financial markets. Undeniably, such evolution of financial markets would require a sizeable effort from policy makers to set a suitable legal base for social impact businesses. Defining the right balance between rights and obligations for for-profit investors and non-for-profit investors appears vital and is far from trivial. However, integrating social impact into the financial markets’ reasoning, although requiring out-of-the-box thinking in its conception, will create tremendous opportunities for businesses, investors, managers, service providers and not least for governments as it allows to entirely rethink the dividing line between tax-funded public services and private sector funded social business activity. Given the potential spill-over of business activity to all service providers connected to the financial markets, the trend of financial markets towards impact conscious investing will reward governments, policy makers and their economies for their creativity and innovation in defining the regulatory framework for the social finance sector.


1 Detailed elaboration in: In search of gamma - An unconventional perspective on impact investing; U. Grabenwarter/H. Liechenstein 2011

2 Monitior Institut, 2009: Investing for Social & Environmental Impact- A design for catalyzing an emerging industry

3 Social Impact Bonds typically have a fixed maturity and often do not have a pre-set coupon rate or interest. Repayment to investors is often contingent upon specified impact indicators being achieved. Hence, in terms of investment risk Impact Bonds are often comparable to equity investments.

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