Making social startups more attractive to seed funders
Despite the increasing excitement around, and deployment of capital into, social impact investment over the last few years, there remains a relative scarcity of genuine seed investment, particularly where it’s most needed in early-stage mission driven consumer product ventures. In his April blog post, Nick Stanhope, our CEO at Shift, describes why this type of investment is so important in delivering meaningful and long lasting positive impact. In this blog, I would like to expand on the structure and process we’ve established here at Shift and why that has maximised our chances of securing seed impact investment for the new ventures we are putting into the world.
By way of background, I joined Shift at the beginning of the year, as Development Director, to lead the commercial and investment team. Whilst my wider role is focused on ensuring the products and ventures that Shift builds are commercially robust, with compelling business cases, able to scale to become self sustaining and high impact entities, my first priority has been the development of the Shift business model and in particular how to optimise our structure to give our ventures the best chance of raising investment. Previous to Shift, I managed a private equity direct investment portfolio where I worked closely with founding entrepreneurs helping them grow their businesses, and spent a lot time assessing new investment opportunities, which means I have a good idea as to what investors are looking for when they examine a Shift venture!
At Shift, we’re busy transforming our portfolio of innovative consumer products into a series of standalone, Shift-owned, ventures with their own business plans, dedicated management teams, and investors. One of these products is the biofeedback video game, which after 2 years of intensive research, product prototyping, and business model refinement has secured investment from a seed impact investor and taken its first steps as an independent venture, called BfB Labs Ltd. So how did we achieve it and what lessons have we learnt?
There are three questions that we needed to answer to be able to present a compelling investment proposition for BfB Labs:
- Is there a large market potential for our product and can we present a business plan which charts a credible path to delivering significant impact and financial value for investors?
- Can we establish a structure that allows us to present an investment opportunity that provides the maximum level of tax incentives for investors?
- Can we establish a process that allows for the transfer of assets from a charity to a for-profit legal entity, which is robust, complying with all aspects of charities law?
In previous blogs we have discussed how our approach helps us consistently answer the first question for our new ventures; in this blog I’m going to concentrate on how we answered the second two.
In the typical investment lifecycle for a standard for-profit new venture, taking it from inception to world domination, seed investment represents the first time entrepreneurs seek and take capital from the outside. It is a major milestone for the new venture, one which many entrepreneurs never pass, because it is the first impartial, cold-headed, assessment of the market and financial return potential of the business. Seed investors are accustomed to making high risk investments; they know that it might be as few as one in ten of their investments that will succeed, which means that the one that does has to deliver enough return to not only cover the losses from the other nine failures but also generate a risk appropriate profit to justify the original investment. This means they are typically looking for a 10-20 fold return on each opportunity.
It is in recognition of both the need for, and inherent high risk nature of, seed investment that the UK Government introduced the Seed Enterprise Investment Scheme (SEIS) in 2012, which provides tax breaks for individuals who invest in very early stage businesses. Under the scheme investors can claim back up to 54% of their invested capital immediately against tax paid, as well as take profits free from capital gains tax, or claim further tax relief if the investment goes bad such that they are 80% protected. Clearly this alters the risk/reward landscape considerably for seed investors, which means they can both increase their exposure to the asset class as well as reduce their expected returns from each individual investment, without negatively impacting the overall return from their portfolio.
The fact that the SEIS scheme allows for a reduction in investor’s return expectations is particularly important in the context of seed impact investing. It is generally accepted that social ventures are likely to take longer to germinate, and may well have lower profitability, which therefore means potentially lower investor returns than their non-mission-driven cousins in the mainstream venture start-up world. Seed impact investors are already comfortable with trading some financial profit in return for the impact generated from delivering on the social mission; the added benefit of an SEIS tax incentive cushion allows them to either further shift the balance towards impact and/or increase their overall portfolio exposure to the impact investment asset class.
Unfortunately the way a typical social enterprise is structured does not lend itself to attracting SEIS investment for two reasons. Firstly they often don’t have shareholders which means they can’t offer equity investment. Secondly even when they do have shareholders, and meet qualifying criteria for SEIS, the potential for equity returns is restricted when compared to standard corporations.
Some social enterprises are incorporated as Community Interest Companies (CICs) which are limited by shares, so qualify for SEIS, but they are still asset locked bodies, and have a legal cap on the proportion of profits which can be distributed to shareholders as dividends. Equity value is a function of the actual, or potential, cash flows to the holders of that equity. If these cash flows are restricted, as is the case for CICs because of the asset lock and dividend cap, then it must follow that equity returns, and therefore the value of that equity, are also lower than if the restriction wasn’t in place. The rationale behind CICs is sound, “a new type of limited company for people wishing to establish businesses which trade with a social purpose”. The asset lock and dividend cap is there to reassure partners, investors, customers, funders that the organisation is unwaveringly committed to the social mission at its heart, but is it not possible to achieve this without restricting equity return?
We believe you can make the same commitment to social mission using a standard company, limited by shares, which has unrestricted equity returns to shareholders, and qualifies for SEIS investment tax relief; but how do we convince impact investors that this commitment won’t be compromised or eroded over time?
At Shift we wanted to find a way to bind the new ventures we put into the world to a specific social mission and convince impact seed investors that the commitment will endure. We embed a bespoke mission into the core constitutional documents (the articles of association or articles) of each of our new ventures, which the directors have a fiduciary responsibility to promote. We also commit that our charity will remain a shareholder of that business forever retaining a golden share over the relevant clauses of the articles, which means Shift is the guardian of that mission; it can’t be changed, nor can the Directors stop promoting it without our permission. Furthermore we will evaluate, and report publicly on the impact the business has made against that stated mission, using robust, transparent methodology and corroborate our findings with accredited academic partners.
Having decided to use a standard for-profit limited company legal entity, and found a way to embed the social mission, how do we ensure it qualifies for SEIS investment? Our early stage research and product development is done in the Shift Foundation, which is an incorporated charitable body. If we were to set up the new ventures as subsidiaries of the Foundation we would fall foul of one of the long list of SEIS restrictions which states investee companies cannot be controlled by another incorporated body. We have therefore established a mirror charitable trust, an unincorporated body with individuals as trustees, which has itself set up, and initially 100% owns, our new ventures. It is because the trust is unincorporated that it complies with SEIS regulation as the shares are held in the name of the trustees as individuals, rather than a corporate entity.
The final piece of the jigsaw was ensuring we could transfer early stage assets and IP (in the case of BfB Labs, game prototypes and methodology) from the Foundation, where the research was done, to the new charitable trust, as well as take investment into the new venture, without falling foul of charities law. By giving the new charitable trust the same charitable objects as the existing Foundation, and appointing a completely independent set of trustees, we have established a pathway whereby the early stage assets can be gifted to the new charitable trust, another asset locked body, so as to further the common charitable mission. The trustees of the new charitable trust can then place these assets into the newly incorporated venture (BfB Labs) being careful the investment can be justified on a mixed motive basis. Everything is then set for the new venture to take SEIS investment with the trustees making a final careful assessment that the potential for private benefit, in terms of equity returns for the SEIS investor, is appropriate given the potential to deliver against the charitable objects of the trust.
We believe we have developed an innovative, robust, mission-locking, structure and process, which now that it is established, enables us to simply and consistently raise seed impact investment for the new ventures we plan to put into the world. The proof is in the pudding - BfB Labs has raised money and is busy delivering on its business plan. Good structure will never be a substitute for the fundamentals of a robust investment opportunity - a compelling customer value proposition and credible business plan - but it can ensure that social enterprises which have great potential don’t operate with one arm tied behind their back when compared to standard for-profit seed investment opportunities.
So what can other start-up and existing social enterprises do to maximise their chances of raising seed impact investment?
Before you set up, think carefully about the type of capital you need and start with a legal structure that is suitable and maximises your chances of raising that capital
If you choose to be a unrestricted standard limited company, explicitly commit the business to the mission via its articles and ensure this commitment can’t be easily unwound. Look at ways this can be independently accredited (e.g. B-corp)
For social enterprises already up and running make sure you understand the full suite of tax efficient investment opportunities you are able to offer (e.g. Social Investment Tax Relief (SITR), which isn’t covered in this blog but is a strong incentive to make investments into social enterprises, particularly for those who are well structured for debt capital, i.e. those with stable and predictable income streams. It is not however well suited for very high risk seed capital that some organisations require because the qualifying debt instruments are not allowed to pay the break-out returns that seed impact investors would expect to compensate for the high failure rate of investing so early)
For social enterprises, like Shift, who have ambition to launch multiple mission driven ventures, think about setting up a mirror unincorporated trust to own them; that way you can retain charity control and an ultimate asset lock for equity proceeds without falling foul of the stringent SEIS regulations
In the long term it needs to be easier to establish a structure which maximises the potential for raising seed impact investment for social enterprises. As the impact investment asset class continues to grow, the legislative framework will need to keep pace, or else it will increasingly inhibit the most entrepreneurial, and potentially highest impact, frontiers of the movement. We’ll watch with interest as this evolution continues but in the meantime we have established a precedent at Shift which works well for a disparate set of stakeholders and think there are good lessons for other social enterprises to learn from what we’ve done.