Time to Rethink “Exits”
I spent the first 12 years of my career working predominately with technology companies that were either funded by venture capital or seeking to be funded by venture capital. From a technical standpoint, the transition to working with social enterprises and impact investors was easy because the financing documents, for the most part, were exactly the same. It didn’t take long, however, for me to wonder if the financing structures and documentation should be the same.
In “traditional” venture capital, investors presume that a small number of their investments will be wildly successful and the rest will fail completely. Success, of course, is measured financially, and comes in two forms: sale or IPO within 5-7 years. The legal documentation reflects this boom or bust mentality – in most deals, there is no mechanism for the investor to recoup investment without either a sale of the company or a public offering.
In the impact world, we purport to measure success differently. Presumably, we are not satisfied with financial return without positive social and/or environmental benefit. And there are many investors who lead with impact.
So, if the considerations driving investment selection are different than in traditional venture capital, is it reasonable to think that the “exit” scenarios may also be different? I know that Acumen thinks so, which is why they coined the phrase “patient capital.” But Acumen can afford to be patient because most of their investments are deployed through a non-profit vehicle that does not have to answer to limited partners.
And what if a venture has the potential to be profitable and make a substantial impact, but a sale or IPO is not feasible or perhaps not appropriate because it would jeopardize the venture’s social mission? Should such a venture be considered “uninvestable” because a traditional “exit” is not readily apparent?
In my opinion, both entrepreneurs and investors in the impact world need to start thinking beyond the sale and IPO as the only means to exit investments. I have been mulling some new approaches, but in the meantime, there is a tried and trued mechanism available: redemption, i.e. the company agrees to buy back the investors stock after a certain period of time at an agreed upon price.
Interestingly, redemption is a suggested provision in the National Venture Capital Association’s model financing documents. It is rarely used in traditional venture capital; perhaps because people view it as irrelevant given the shared expectation by founders and investors alike that the company will sell, IPO or fail. Or, even if a company is stuck in some middle ground, it is not likely to have the resources to pay the redemption price. In a recent survey by Fenwick & West (a leading Silicon Valley law firm), less than 20% of VC deals included a redemption clause. A start up lawyer who blogs frequently, in fact, counsels entrepreneurs to resist against redemption clauses because, among other reasons, they are non-standard.
I, on the other hand, think most deals in the impact space should include a redemption clause or other mechanism to allow for an investment return outside of a traditional exit. By thinking proactively about how to provide liquidity, entrepreneurs stand to make their investment opportunity more compelling to impact investors. Just this week, while reading the disclosure document for a new impact fund, I noticed that the investment manager actually highlighted the investments that included redemption or another exit mechanism.
There are, of course, different permutations for a redemption clause, and the approach should vary based on the amount of investment and other deal-specific characteristics. The NVCA model is worth a read. It provides that after an agreed upon number of years, the investors can request a buy back of their stock at a price equal to the greater of what they paid and the fair market value of the preferred stock at the time of the redemption request. The NVCA model also provides for a relatively generous payback period of three years. In a term sheet I worked on this week, we came up with a similar approach, except that we capped the investor return and required payback in a single installment (it is a small investment).
It’s not just about the money, but the money – and a return on invested capital – is essential. We need to be creative yet realistic both about the expected return, and how the return will be realized.