Impact Business Group Case Study: Performance Aligned Stock

By Pam Rothenberg, Partner, Womble Bond Dickinson (US) LLP and Mark M. Newberg, President, Stockbridge Advisors, LLC.

The investment management world is experiencing a rapid shift in its operational assumptions.  Increasingly, investors are recognizing that environmental, social, and governance factors (ESG), principles of sustainability, responsible investment, and what many simply refer to as “Impact,” are indispensable components of the long-term investment strategies necessary to achieve consistent business growth, increased profit, and continuing value creation. 

In his open letter to the CEO’s of all publicly traded companies, Larry Fink, the CEO of BlackRock, emphasized that “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.” 

As a critical corollary to this growing focus on ESG and Impact, the investment community needs new and innovative investment structures that promote the founding, funding and growth of businesses designed and managed to integrate Impact principles into their core business operations.  The investment vehicles that have traditionally been available – conventional venture capital and debt – are often misaligned with the business plans, growth trajectories and mission objectives of these Impact-focused start-ups.  Among their shortcomings, customary venture capital and debt structures typically require short term investment periods and maturity dates. These terms directly conflict with the longer runways start-up companies (including the high growth ones) fundamentally need to generate revenue and create sustainable financial and societal value.  

To address this problem, members of our Impact Business Group worked with a group of impact investors and an impact entrepreneur to design, build and document a new, award-winning, investment structure that we call “Performance Aligned Stock” (PAS).  Our collective goal was to create a vehicle for early stage investments in Impact-focused companies that (1) affords the investors an exit from the company that does not result in a forced sale of the company; (2) allows the investors to achieve that exit at a predictable rate of return aligned with the company’s revenue growth; and (3) enables the company’s founders to retain control of the company.  The overriding objective of the PAS structure is to permit the company to continue to pursue its Impact mission following the exit of the investors.

PAS can be thought of as an equity investment that acts like debt, but with redemptions rather than repayments.  Similar to interest payments required for a loan, the investors receive a stated and predictable rate of return on their investments based upon a defined schedule and from a “dividend pool” that is funded through the company’s operating cash flow.  The timing of the funding of the dividend pool and the percentage of the company’s revenues allocated to the pool are designed to align with the company’s projected revenue growth. As a result, the growth of the dividend pool is tied to the actual revenue generated by the company and not an arbitrary repayment or recapitalization schedule that fails to correspond with the company’s performance. With each scheduled payment of “dividends” from the pool, the investors receive both a stated return on their investments and a return of a portion of their investment through mandatory partial redemptions of their equity.

PAS can be structured to afford the investors the right to participate in management of the company, through a board seat or other mechanism, but only for so long as they maintain a stated percentage of company ownership. That percentage will automatically burn down as the scheduled redemptions of their investments occur.  The investors can separately be given evergreen rights to participate in select material decisions that could adversely affect their investments. In practice, these rights might be triggered where the admission of additional investors of the same class would have a dilutive effect. .  However, with PAS, the investors have no rights to force a sale, recapitalization or refinance of their investments, or any other form of exit by the company, keeping the founders in control of the company and preserving the company’s impact mission.  

PAS can be used in any equity investment format (notwithstanding the use of the word “stock” in its name), including investments in limited liability companies, partnerships and S-corporations.  It can be customized to address the specific capital needs of the company, taking into consideration its growth plans and revenue projections, including the anticipated length of its runway until revenue commences.  The timing for the establishment of the dividend pool and the first dividend distributions, as well as the amount of each distribution, can be customized to meet the company’s specific needs and cash flow projections. Since it is structured as equity and not debt, PAS allows the company to have cleaner “debt-free” balance sheets, better positioning the company to close subsequent investment rounds. It also avoids adverse tax consequences for both the investors and the company that can be associated with debt, including phantom income issues typically associated with original issue discount and forgiveness of indebtedness.

The PAS investment structure helped Relevée, a socially responsible jewelry business in India, achieve an early stage equity investment.  Relevée uses ethically sourced gems and precious metals and employs women as artisans and goldsmiths, paying them a transformative middle-class wage. In addition, proceeds from the sale of this jewelry benefit the survivors of human trafficking, child marriage, child labor and other human rights abuses.

PAS makes it easier for investors to make investments in early stage companies because it provides a clear pathway to returns and repayment through redemption.  It also makes it easier for company founders to grow their businesses while maintaining control of their companies and their Impact missions, since the repayments and redemptions are specifically designed to be in sync with the companies’ growth.  PAS is replicable, scalable and customizable.

Since PAS is an adaptable investment structure, we envision the use of PAS or iterations of it, as we customize and improve it, in many different types of investment transactions for early and even later stage companies.  Currently we are designing structures to use PAS to fund a portion of the capital stack for affordable and workforce housing transactions, as well as to create working capital lines of credit for companies generating cash flow.  

There is mounting data supporting the proposition that established businesses enterprises can grow their competitive advantage with Impact. And, as demonstrated by Mr. Fink’s letter and BlackRock’s associated release of an initial set of specific Human Capital-focused questions, the integration of ESG and Impact into the core business operations of these legacy enterprises is becoming an imperative.  We believe that the PAS structure can be customized and used as a compelling tool in corporate venture capital transactions. Utilized properly, PAS can facilitate investments by legacy businesses into early stage companies that have both business and Impact objectives aligned with the legacy enterprise’s long term growth strategies.  

We are honored to be the inaugural winner of the Grunin Prize for social entrepreneurship presented by the Grunin Center for Law and Social Entrepreneurship at the NYU School of Law for development of the PAS structure.  For too long we have seen that conventional early stage investment structures are at odds with the needs of early stage companies – especially those that do not have a “natural” point for an investor exit.  It is critical for the growth and scale of entrepreneurial ventures, particularly those that are Impact-focused, to have investment structures that align the interests of entrepreneurs and investors in the pursuit of long term profitability, growth, and Impact.  We are privileged to be a member of the collaborative team that contributed to the development of an innovative investment structure that we believe can help power commerce in the Impact Economy.