Finding investors for a social enterprise that combines business with impact, like an employment program or an environmental benefit, is harder than you might expect.
It’s not about the cash flow. Cash flow in a successful social enterprise with a dual mission can equal that of a business that prioritizes profits. Increasingly, consumers like social enterprises and patronize them. Evidence also is building that the practices of social enterprises, like prioritizing the well-being of employees, contributes to the health of businesses.
Cash flow delivers returns for investors, but usually slowly – perhaps less than 10% a year.
After cash flow, the second way to deliver returns, often faster, is through an exit, meaning the sale of a company to a larger organization or selling shares to the public through an IPO. Most investors, even the socially minded ones, want at least the possibility of a big return that lands pretty fast, say within 10 or 15 years. Some investors also some have financial obligations to limited partners if they are part of an investment firms.
Exits, however, pose a problem for social enterprises. It is still harder for a social enterprise to exit, according to Steve Zuckerman, formerly the managing director of Self-Help, a large North Carolina-based community development finance institution (CDFI). Because when social enterprises exit, they often shed their social missions over time.
One example of this challenge is what happened to Ben & Jerry’s. The famous ice cream brand sold itself to publicly held Unilever in 2000. Even though the ice cream company remained an independent subsidiary, it still found itself in a conflict in 2022 as its independent board took a stand against Unilever’s decision to sell the brand in the occupied Palestinian territories. The Ben & Jerry’s board said selling ice cream to people living in illegal Israeli settlements in the Palestinian West Bank went against the company’s brand. (The litigation filed by the independent board against Unilever was reportedly settled last month).
One Potential Solution
I came across an innovative capital structure that helped First Light Hospitality, a B Corp based in Yosemite Village, in central California. The capital structure allowed First Light Hospitality to take investment and grow without having to build an exit into its financial scenarios.
Founded by Brian Anderluh and Lee Zimmerman, First Light Hospitality runs two environmentally minded,
high-end lodges, Evergreen Lodge and Rush Creek Lodge and Spa, near Yosemite National Park. The lodges also sustain an employment program for youth transitioning out of the social service system.
A hidden key to the 21-year-old company’s success is its capital structure that I heard about when reporting a story in the past nine months for the Stanford Social Innovation Review, set to appear next spring.
“Capital structure is where a lot of very well-intentioned social enterprises struggle,” Steve Zuckerman said during an interview. Zuckerman is a finance executive who invested in First Light, which launched in 2002. In addition to advising Self-Help, he’s now working on a nonprofit called Stroke Onward, which helps people navigate the emotional journey after a stroke.
In a series of conversations with Zuckerman and Zimmerman, they outlined the specifics, which could be the blueprint for other social enterprises. The structure makes sense in a business that generates cash flow and eventually has access to inexpensive debt financing, which usually comes from banks (who make their decisions based on cash flow).
The top line: The structure provided investors with a preferred return of 8% per year on their invested capital. First Light’s founders also committed to share excess cash flow beyond the preferred return, with investors getting the majority share.
The Specifics of the Structure
In the early years of the business, the investment structure deferred payments of preferred returns, until cash flow from operations was available to pay investors. When cash flow became available, the accumulated deferred returns had repayment priority until repaid in full.
When First Light grew large and sufficiently healthy, the founders refinanced the company. The debt proceeds were used to fully pay back all investors their initial investment. They retained their same ownership interest in the lodge.
With their investment capital out, the investors no longer received a preferred return, but they continued to receive the same share of free cash flows as always. And the founders, rather than paying 8% to investors on that money, are now paying a lower interest rate to the bank, which serves the organization well.
In the few cases where an investor wanted to cash out completely, the founders offered to sell that stream of returns to other investors.
This structure meant investors could redeploy their investment capital while retaining their ownership in the lodge, and it has allowed the lodge to operate with the same stable ownership and continue its social mission for 20+ years now.
Over the past 20 years, most of the investors have earned between two and three times their initial investment, according to Zimmerman. In essence, Zuckerman said, the capital structure replaced the upside potential investors might usually seek with a fast exit with the return of capital, plus slow and steady returns in the long-term. The continued ownership in the lodge means there is still an upside potential, but there’s no time pressure to deliver it.
“It hasn’t been an Amazon. It’s been a good solid return over a long period of time,” Zuckerman said.
