Goldilocks and the three term sheets: finding just the right amount of investor power in mission-first businesses

By Aner Ben-Ami

This post was originally featured on Medium here.

From the CEO’s of Unilever and Blackrock to Elizabeth Warren, everyone seems to be taking a crack at fixing capitalism these days. Each has their preferred adjective to describe what capitalism should become in the 21st century: Conscious Capitalism, Stakeholder Capitalism, Accountable Capitalism, Sustainable Capitalism and more.

What all these voices have in common is the understanding that the incumbent Shareholder Capitalism model is untenable. Pursuing shareholder returns while ignoring long term impacts on people and planet has been a leading contributor to environmental degradation and climate change, as well as to extreme income and wealth inequality.

But beyond new labels and adjectives, what we sorely need are real case studies for how companies can be designed to distribute power and financial gains more equitably among their stakeholders. A 40-year old produce distributor in Eugene, OR, may not be where you’d expect to find this kind of pioneering innovation. But with Organically Grown Company, we believe that’s precisely what we found.

Organically Grown Company

Organically Grown Company (OGC) is an intensely mission-driven company. Since its inception in 1978, it has championed the highest organic farming standards and worked to support small mid-sized farmers in its region, all while operating thriving business with 40 years of positive growth and 35 years of profitability.

Along the way, OGC came to realize that in order to stay true to its mission, it had no choice but to look beyond its farms and trucks, and into the role that finance, ownership and governance play in determining its future. Ultimately, OGC saw in a very tangible way what the critics of shareholder capitalism are trying to tell us: that in order to be a force in support of sustainable, healthy food systems, it must be able to put purpose before profits, and to remain independent over the long term.

When it realized that it was impossible to ensure these things under the current paradigm, OGC became a somewhat unlikely pioneer in the movement to design new, more balanced models of capitalism. As OGC’s leadership expressed to us when we first met, they realized that they “can’t fix a broken food system with a broken financial system”.

OGC was looking for an ownership structure that would allow it to

(1) put purpose ahead of profits, (2) be accountable to multiple stakeholder groups (workers, growers and other allies) and (3) be perpetual in nature so as to remove any pressure to exit.

The structure OGC came up with was a Perpetual Purpose Driven Trust. Unlike a charitable trust, a purpose driven trust is very flexible in defining its mission. In this case, the mission was defined as ‘promoting a sustainable and healthy food system’. The trust would buy out all of the existing shareholders and thus become the single shareholder holding all of the company’s common (voting) shares. It would oversee OGC’s board of directors to ensure it is running the company in line with its mission.

About half of this transaction was being funded using debt, with RSF Social Finance as the lender. The remaining half had to be funded using ‘preferred equity’, which is where we at Candide Group stepped in on behalf of our client, The Libra Foundation, alongside our friends and co-lead investors at Purpose Ventures.

Our challenge as preferred equity investors was to design an equity investment in a context where an ‘exit’ is off the table, and where purpose is explicitly being placed ahead of investor returns. We tried to navigate between two existing paradigms. On one end of the spectrum is the standard preferred equity investor model, where the power given to investors is precisely the kind of power that gets in the way of OGC’s long-term mission orientation. On the other end of the spectrum is the employee ownership model, where equity investors essentially give up any kind of participation.

In between those two bookends, the structure we co-designed with OGC was intended to be a ‘goldilocks’ model where investors would have ‘just the right amount’ of power, and where both economic value and governance would be shared amongst the key stakeholders of the business.

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Shareholder primacy: the incumbent paradigm

Corporate governance in the US is organized around the notion of shareholder primacy. According to this paradigm, the corporation’s sole purpose is to maximize shareholder returns, and every decision the board makes must be judged by that yardstick¹. The not-so-subtle implication is that labor, suppliers and other stakeholders, are merely inputs that need to be controlled in pursuit of higher profits.

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The unsurprising outcome of this paradigm is that an outsized share of the corporate profits are going to investors in the form of dividends and share buybacks, while workers and other stakeholders get a smaller and smaller share of the pie.

  • Since 2009, real GDP has grown by about 14%, while real wages have inched up by less than 3% (see chart below from the Federal Reserve Bank of St. Louis).

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  • Of $976 billion in net income generated by the S&P 500 in 2014, $571 billion — nearly 60% — was spent on share buybacks. Layer in dividends, and total payout ratios topped 93%, leaving just 7% for re-investment (whether in the current workforce or to fuel future growth).²

With the shareholder primacy model we have a system that puts investors at the center, while marginalizing and extracting wealth from the people that are most directly involved with the business.

Worker ownership: a ‘Copernican revolution’ in corporate governance

One powerful alternative to the shareholder primacy model comes from the worker ownership movement. With co-ops and ESOPs, ownership is placed in the hands of workers. This shift is akin to a “Copernican Revolution” in corporate design — rather than shareholders being at the center (while other stakeholders are on the outside), we now have workers at the center, with investors (and others) on the outside.

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These worker-owned companies still need investors, of course. But investors only earn a fixed returns on their capital — they do not participate in any upside alongside owners, nor do they call the shots for the company.

One challenge for worker-owned companies is that they are generally only able to take on debt financing, rather than equity (The Working World and Shared Capital, two companies that Candide clients are invested in , are among the leading co-op lenders in the country). This is an issue because at some point companies do need more flexible capital to support their growth, and lenders generally will only lend to companies that have enough equity to de-risk their loans.

There are a few notable examples of co-ops who have come up with a work-around to this challenge. These companies (like Organic Valley, Equal Exchange or Namaste Solar, another company supported by Candide clients) have issued ‘non voting preferred equity’ shares. These shares earn a fixed dividend rate and, as the name implies, have no voting or control rights.

These ‘non voting preferred’ structures reverse the traditional power structure between investors and the company. But in doing so they place investors in what amounts to equity-level risk with debt-level returns. Unlike a lender, these investors have no guarantee that their dividend payments will be made (and no recourse if they’re not made). And unlike traditional equity investors, these investors do not participate in any upside no matter how well the business does. They also have no voice in the governance of the company.

A ‘third way’ : multi-stakeholder governance and economics:

To design this structure for OGC, we worked closely with our friends at Purpose Ventures. The team at Purpose is 100% dedicated to supporting ownership structures that enable long term independence and mission alignment for their investees. They are championing the concept of steward-owned business, which place purpose ahead of profits and move away from the concept of the company as a tradable commodity.³

Our combined efforts with OGC and Purpose ultimately resulted in what we view as a ‘third way’, representing a more balanced allocation of power and economic benefit. The trust that owns OGC is accountable to five stakeholder groups: investors, workers, growers, customers and community allies. Unlike both the shareholder primacy model and the employee ownership model, in this model no one is on the outside — we are all equal stakeholders, and we all benefit together when the company does well.

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In practice this means a model where both financial upside and governance are shared amongst the stakeholder groups:

  • Shared upside: Preferred equity investors are entitled to a 5% ‘base’ preferred dividend, similar to the non-voting preferred offerings from companies like Namaste Solar or Equal Exchange. This dividend is cumulative (ie, if it’s not paid one year, it is still due the following year) and it gets paid out before any of of the other stakeholder groups participates in profit distributions. (We believe this investor preference is fair because workers/growers already get their ‘base’ pay as part of the ordinary course of business, and so investors should get their preferred/base return before others get their upside). In addition to this, OGC will distribute any excess profits to its 5 stakeholder groups based on a pre-defined split. We designed this split to ensure that investors have significant upside participation (as would be expected in an equity investment), while also making sure that we’re not capturing an outsized share of that upside at the expense of other stakeholders (at most 40% of upside goes to investors).

  • Shared governance: The five stakeholder groups will jointly elect a committee that will oversee the board on behalf of the trust. This committee will ensure that the company is prioritizing its mission of supporting a healthy food ecosystem. But it will also keep the board accountable for operating the company “for the benefit of its stakeholders”. In other words, if one of the stakeholder groups feels that the board is making decisions that are unfairly biased against it, it can file grievance with the committee to intervene on its behalf.

This structure will undoubtedly be tweaked and refined as new companies and investors roll up their sleeves to design their own versions of stakeholder participation and mission-preservation.

There is a wave of businesses in the organic food sector and beyond that are thinking about succession and seeking a way to remain true to their mission. Already, several of these companies have turned to OGC to explore whether a similar solution could apply to them. OGC has moved the conversation forward, and we couldn’t be more excited to see and support others along the path.

Notes:

  1. University of Florida Levin School of Law: A Legal Theory on Shareholder Primacy

2. Transform Finance, Excessive Share Buybacks

3. see case studies of the steward ownership model here: http://purpose-economy.org/wp-content/uploads/2017/07/Purpose_Steward_Ownership_Rethinking_Ownership-in-the-21st-Century.pdf

Disclosures