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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.

Impact Investing Blending Impact – Debt + Equity

<p>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.</p><p>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?</p><p>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.</p><h5>Consider Convertible Debt (It’s a  Hybrid)</h5><p>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.</p><h5><em>Convertible  Debt</em></h5><p>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.</p><p>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.</p><h5><em>Forming  an Agreement</em></h5><p>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:</p><ul><li>a new corporate form</li><li>charter</li><li>shareholders’ agreement</li><li>note purchase agreement </li></ul><p>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.</p><h5><em>Avoiding  Cross-Default</em></h5><p>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.</p><h5><em>Mission  Creep</em></h5><p>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.</p><h5><em>Financial  Transparency</em></h5><p>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.</p><h5><em>Take  on Traditional Equity </em></h5><p>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.</p><p>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:</p><ul><li>voting agreements</li><li>multiple stock classes</li><li>board representation </li><li>redemption rights</li><li>investor rights agreements</li><li>an option to change the conversion formula </li></ul><h5><em>Employing  Your Protective Provisions</em></h5><p>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.</p><h5><em>When  a Company Offers Multiple Classes of Stock</em></h5><p>If  the company offers multiple classes of stock to differentiate priority levels  amongst investors and founders, stockholder approval would be required for:</p><ul><li>a material change in the business plan </li><li>a sale of the company (including triggers for drag-along rights) </li><li>any action outside of the ordinary course of business that may have a material impact on the company’s mission </li></ul><h5><em>Designated Directors</em></h5><p>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.</p><h5><em>Dealing  With a Redemption Rights Clause</em></h5><p>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.</p><h5><em>Investor  Rights Agreements</em></h5><p>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.</p><h5><em>Conversion  Formula</em></h5><p>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.</p><h5><em>Determining  Deviation</em></h5><p>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.</p><p>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.</p><h5>Going Forward</h5><p>Morrison  & Foerster is one of the most knowledgeable firms in this space. The firm  represents:</p><ul><li>non-profit and for-profit social       enterprise companies</li><li>impact investors </li><li>venture funds </li></ul><p>Our  work spans all aspects of impact investing, including advising companies on  corporate forms and structuring transactions to help ensure impact.</p><p>For  more information, contact <a href="mailto:impactinvesting@mofo.com">impactinvesting@mofo.com</a>.</p>

<p>Blending Impact Into Traditional Debt and Equity Instruments: A Guide for Investors</p>

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