Blending Impact Into Traditional Debt and Equity Instruments: A Guide for Investors

Many impact-focused companies are founded with a strong commitment to social or environmental goals — but history has shown that this commitment can erode over time. Mergers, high-yield equity and debt financings, new investors, and going public can all shift the focus from mission-driven objectives to profits and revenue growth.

If the success of the enterprise (and your investment) relies on the strength of the company’s commitment to a cause or to successful integration of ESG (environmental, social, and governance) principals, how can you ensure that the company stays on track?

A carefully structured investment can increase the commitment to and discourage a deviation away from the company’s mission. Done properly, this can also help stimulate co-investment into the company and ensure its future success.

Consider Convertible Debt (It’s a Hybrid)

A popular and often inexpensive option, convertible debt financing is attractive to many early-stage entrepreneurs and investors. It is particularly appealing to new companies because it allows them to defer establishing a valuation, which can be arbitrary during the company’s infancy.

Convertible Debt

Part debt and part equity, a convertible note either automatically converts to equity based upon pre-set terms, or must be repaid in cash at a later time. Interest accumulates during the life of the loan and equity is offered at a predetermined discount upon conversion. A valuation cap adds a layer of protection to the conversion. The cap sets the highest price at which debt can convert to equity once company valuation is determined; although in practice the cap can set a de facto valuation earlier than the company might prefer.

Because the success of convertible debt financing relies on continued growth, several types of incentives can be built into the loan to help keep the company mission-focused.

Forming an Agreement

Discussing the scope of the mission with the company at the time of initial investment is a great way to mutually confirm how these objectives will be memorialized via:

  • a new corporate form
  • charter
  • shareholders’ agreement
  • note purchase agreement

By including both affirmative and negative covenants in the agreement, you can clearly state how the borrower may use investment proceeds. At the same time, you can prevent the borrower from changing its mission-aligned business plan or incurring material capital expenditures for activities that conflict with the mission.

Avoiding Cross-Default

To circumvent issues of a cross-default, a prepayment system can be set up to trigger automatically if the mission is violated. If the borrower fails to pre-pay, contractual remedies, such as a board takeover, can be included. Most social enterprises will go to great lengths to maintain board control and avoid giving up decision-making power to investors.

Mission Creep

In the event of a “mission creep,” or a deviation beyond the company’s original goals, the inclusion of a clause that allows for an automatic increase in interest rate or a demand for immediate repayment can further protect your investment. Automatic conversion mechanisms can also be removed if the mission creep exceeds a certain predetermined threshold.

Financial Transparency

Financial reporting transparency is critical to the value of your investment. Establishing high-quality reporting requirements will provide you with detailed updates on the status of the mission, impact, and overall financial health of the company.

Take on Traditional Equity

SAFEs, common and preferred stock, are traditional equity instruments frequently used by entrepreneurs and investors. Both SAFEs and equity often appeal to companies because they do not require cash repayment. SAFEs are structured as the promise of future equity and do not grant ownership rights until they “mature.” In contrast, equity is beneficial to investors because it grants ownership of a piece of the company and may give investors a voice in the decision-making process.

The social enterprise’s founders can minimize the risk of mission drift associated with traditional equity investments by employing strategies to anchor the mission. If these are not agreed upon at the time of the company’s formation, it’s a good idea to require them prior to, or in connection with an, initial investment. These strategies use key protective provisions that include:

  • voting agreements
  • multiple stock classes
  • board representation
  • redemption rights
  • investor rights agreements
  • an option to change the conversion formula
Employing Your Protective Provisions

As an equity shareholder, the creation of a voting agreement allows you to combine your voting shares with other shareholders who wish to participate in decision-making for issues that are mission or non-mission aligned.

When a Company Offers Multiple Classes of Stock

If the company offers multiple classes of stock to differentiate priority levels amongst investors and founders, stockholder approval would be required for:

  • a material change in the business plan
  • a sale of the company (including triggers for drag-along rights)
  • any action outside of the ordinary course of business that may have a material impact on the company’s mission
Designated Directors

You should consider negotiating the right to name a director to the board. The designated director serves as a consultant to mission-aligned investors during the board’s decision-making process.

Dealing With a Redemption Rights Clause

If the equity instrument includes a redemption rights clause, it could be triggered by a deviation from the mission. Redemption rights require the company to repurchase your shares or face other penalties if they are unable to do so. If the company is unable to honor the redemption rights, contractual remedies (such as taking over board control) may be used until the redemption price is paid. Inclusion of an option for secondary sale or sale to a co-investor can provide additional benefits. The co-investor would serve as a guarantor in the event of a deviation from the mission; however, the use of redemption rights may have a less than favorable effect on co-investment options, particularly outside the impact space.

Investor Rights Agreements

Investor rights agreements are used to attract investors by offering them rights to detailed information regarding the mission and impact. These agreements often include inspection rights and access to financial records and reporting.

Conversion Formula

A conversion formula change provision can be set up to trigger if a material deviation from the mission occurs. The formula allows for an increase in the conversion ratio, resulting in the delivery of more common shares upon conversion of preferred shares. Dividends would also become cumulative in this scenario. The addition of preferential distribution or “waterfall” provisions provides priority to top investors; however foundation or non-profit investors with lower priority should consult a tax professional regarding potential IRS issues.

Determining Deviation

If you suspect a deviation from the mission has occurred, the social enterprise can object and choose to consult a designated third party for further review. The company may appoint a committee to specialize in the oversight of the mission. The committee would report to the board and investors should a material deviation occur. In the alternative, the company and investors can agree to a third-party “expert” to whom they would refer any disagreement on whether there has been sufficient mission drift to trigger rights.

Structuring these investments to ensure alignment with social and environmental goals generally costs no more than it would to create traditional debt and equity instruments and may be designed in such a way that appeals to both traditional and mission-aligned investors. Impact investments can provide a unique opportunity for lenders. Interested parties should seek out a law firm that not only has experience with traditional debt and equity instruments but also understands the additional considerations and concerns of socially conscious investors.

Going Forward

Morrison Foerster is one of the most knowledgeable firms in this space. The firm represents:

  • non-profit and for-profit social enterprise companies
  • impact investors
  • venture funds

Our work spans all aspects of impact investing, including advising companies on corporate forms and structuring transactions to help ensure impact.

For more information, contact impactinvesting@mofo.com.