Traditional Investment Structures

Traditional Exit Strategies for Social Enterprises

An “exit” is one of the methods an equity investor uses to get a return on investment.  Companies should consider exit strategies at an early stage of the company lifecycle, as it will shape the strategic decisions made along the way, including how and where to grow. 

This is especially true for social enterprises which must also consider elements such as mission and the impact of an exit on customers, not only profit and investors. Some social enterprises will find an alternative exit structure more appropriate, but many may be able to utilize an investment structure that relies on the traditional exit. The best strategy will depend on business type, company size, financial value, investor profile, and mission alignment. 

For investors, exits are important for a number of reasons including having the option to recycle funds to other investments. 

This article explains the types of traditional exits and corresponding considerations for social enterprises. 

Key Considerations for Deal Structuring

Mission

In addition to financial and operational considerations, social enterprises must also consider how an exit strategy affects their mission/impact. Some strategies may amplify the depth or breadth of the impact, whereas others may distract or detract. Founders/Managers should consider this early on, as miscommunication or confusion early in the enterprise life cycle could result in higher multiples and over-valuation, which could force the enterprise to be more aggressive in growth and sacrifice the mission. 

Customers

Different exit strategies will affect not only the company and investors, but also customers. In the case of social enterprises, the company may be the only provider of a basic good or service in the area of operation. When considering exit options, consider questions like “Will an intense focus on scaling or profitability shift the business away from poor or rural customers?” 

Common Exit Structures

Acquisition

Definition: Integration of entities or takeover of one entity by another entity.  The exit to the equity investor comes from the assets used to purchase the entity.  If the assets used to purchase the entity are illiquid, then the acquisition has not resulted in an exit.

Common Motives for Acquisition 

Strategic Acquisition

When the acquirer comes from a different business sector than the entity acquired

Benefits: Strategic acquirers can come from a wide range of sectors but share similar motivations. Strategic acquirers and investors often want to either increase their presence, or gain greater insight into the emerging markets where social enterprises operate. They may also be interested in exploring a complementary product or service to expand the reach or impact of the enterprise. 

Challenges: Social enterprise business models can be complex and differ from the core capabilities of potential strategic investors. Overcoming this requires time and resources from the strategic investors for them to understand the sector and theory of change.

Sector Merger & Acquisition 

Integration of entities or takeover of one entity by another in the same sector

Benefits: A sector merger or acquisition leverages existing synergies between companies, which could also mean amplified impact for a social enterprise. This would extend the reach of both companies to access new geographies, customer segments, products, distribution channels, etc

Challenges: Misalignment of mission is a risk in mergers or acquisitions of social enterprises. Even if they are aligned, other (even though larger) social enterprises may not have the capital to purchase other companies, particularly if investors are seeking a high valuation. Other companies may want to create their own tailored solutions in house instead of buying another company.

Secondary Sales 

The sale of existing equity shares to a secondary investor (such as VC funds, private individuals, private equity, investment banks, or dedicated secondary sales funds). This does not occur during full acquisition.

Benefits: Secondary sales, even those resulting only in partial exits, are a vital source of liquidity for investors. Existing investors may choose to buy the shares, which simplifies the capitalization table and gives them more control over the company. Secondary sales can also attract new investors. Strategic investors have shown a willingness to make secondary investments as a way of getting a foot in the door to better understand the sector without taking on the risk of early stage investment in an unfamiliar area.

Challenges: Secondary equity sales sometimes occur at sizable discounts to primary capital raises, resulting in cases where early investors may be unwilling to accept secondary purchase offers when they do materialize. Social enterprises must also be aware that perceived share price volatility can deter later-stage investors, such as PE firms. 

IPO, or initial public offering 

Process of offering company shares to the public through the issuance of new stock

Benefits: An IPO provides access to a large pool of capital for the company and gives earlier, private investors a chance to realize gains, particularly for social enterprises in industries that lack many potential acquirers. 

Challenges: IPOs are generally uncommon for social enterprises, especially in emerging markets. Depending on the enterprise and industry, there may not be a significant pool of potential buyers to make exchanges liquid. An IPO can also be taxing on a company due to the costs to execute and the stringent reporting and budgeting systems required to be publicly listed.

Share Buybacks 

The sale of existing investor shares to company management or founders.

Benefits: Share buybacks restore greater control over the company to its founders or management, allowing them more flexibility in decision making, especially when it comes to mission (in the case of social enterprises). 

Challenges: Social enterprises may be overvalued and therefore lack the cash for share buybacks. 

Case Studies

Download four case studies of Traditional Exits in African off-grid energy companies by Acumen and Open Capital Advisors:

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Open Capital-Acumen Off-Grid Energy Exits Case Studies

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Additional Resources

This content has been developed from Lighting the Way: Roadmap to Exits in Off-Grid Energy. The full report can be accessed at https://acumen.org/energy-exits-report/

Contributors

  • Original report was published by Acumen and Open Capital Advisors, a regional ITP partner organization. 
  • The report was adapted for this site by Melody Jensen from the ITP team. 

Protective Provisions

Protective provisions are one of the special rights negotiated by investors participating in a company’s preferred stock financing. Protective provisions give preferred stockholders in a company consent rights with respect to key corporate actions the company seeks to take. The company will typically outline its protective provisions for investors in a series of clauses in its charter, which is the company’s central governing document. Examples of commonly negotiated protective provisions held by preferred stockholders include consent rights concerning the company’s ability to approve:

  • Amending its charter;
  • Creating a new class or series of capital stock, in particular when such new class or series ranks senior to or on parity with the existing preferred stock in liquidation preference, payment of dividends and redemption rights;
  • Incurring debt outside the ordinary course of business;
  • A merger or sale of substantially all of the assets of the company; or
  • Increasing or decreasing the size of the board of directors.

While this is a non-exhaustive list, it provides an idea of what types of actions are subject to approval by investors following a typical growth financing. This segment of an impact investing transaction can be critical in an entrepreneur’s efforts to commit and stay true to their mission-driven business.

Why are protective provisions important to entrepreneurs?

Protective provisions are one component of a system of checks and balances built into investment documents to allow investors to ensure that the company is meeting business expectations related to the capital being provided. However, the process of negotiating and finalizing investor consent rights enshrined in the protective provisions can also be helpful for entrepreneurs. Founders can gain important insight into the priorities and strategic direction that investors have in mind when deciding to provide capital to the business by understanding which business decisions such investors push to have greater authority over.

Striking a balance in the alignment of economic interests between founders and investors is not always easy. However, spending time carefully curating this balance between the rights of founders versus investors can make for a successful company that stays true to the founder’s foundational vision, while also benefiting from the identification of market need and other guidance and know-how investors can provide. By understanding an investors’ priorities vis-à-vis the approval rights that are central to their negotiation, founders can draw the knowledge needed to build leverage on their end of the table. Entrepreneurs should also keep this insight in mind in order to measure an investors’ priorities against their own, and to evaluate where to give and where to take in accepting outside capital.

As a company goes through multiple rounds of financing, founders and management should also be cognizant of the different consent rights granted from one financing to the next to ensure that no investor holds consent rights disproportionate to their position in the company. In the end, it is less controversial to build on the protective provisions granted to earlier investors than it is to attempt to revoke the rights granted to earlier investors in order to keep all investors on a level playing field.

In particular, a consent right which is granted to all preferred stockholders voting as a single class can turn into a veto right where one series of preferred stockholders hold a majority of all of the preferred stock outstanding. While there may be merit to this structure based on the size and pricing of different financing rounds within a single company, a company may calculate to instead negotiate different protective provisions for each series of preferred stockholders voting separately as a class to avoid a veto right down the line. In this way, a founder’s working knowledge of market protective provisions and awareness of existing rights within his or her own company is crucial to scaling and growing without swinging the pendulum too far in favor of any one investor group.

Ultimately, protective provisions can play a key role in promoting good governance and accountability as a company grows its business and builds upon its shareholder base. Our series on protective provisions will explore how different investor consent rights can be negotiated by impact entrepreneurs in order to communicate their commitment to a company’s mission and to find investors aligned with that commitment. An understanding of how protective provisions fit into the negotiation of a financing will allow entrepreneurs to maintain a balance among the decision-making authority of founders, investors and other stakeholders in an impact company.

Additional Resources

  • Daniel DeWolf, What is a Term Sheet?, MintzEDGE, http://www.mintzedge.com/blog/what-is-a-term-sheet
  • Daniel DeWolf et al., Corporate Formation: The Basics, MintzEDGE (March 11, 2016), http://mintzedge.com/blog/corporate-formation-the-basics