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Preserving and Enhancing Impact

Hire an Esquire Legal Lifestyle Perspectives Blog

May 5, 2015

Presented By:

Susan Mac Cormac

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Susan Mac CormacPartner, Morrison & Foerster

•Partner at Morrison & Foerster and Co-chair of the Clean Technology + Alternative Energy Group and Private Equity and Venture Investment Practice•Extensive experience representing start-up to late stage private companies, social enterprise companies, and nonprofit companies, as well impact investors and venture funds•Company clients include EDF Renewable Energy, Monolith, Cornerstone, MADA Power, ICE Energy, OneSun, Posiba, Revolution Foods, Silicor, Change.org, The Nature Conservancy, Digital Divide Data, and Medicines360•Investor clients include Intel, SoftBank, Capricorn, Omidyar, Kleiner Perkins, New Island Capital, Calvert, Eagle Cliff, Brightpath Capital Partners, Buchanan, and Pacific Community Ventures•Deep experience in structuring for nonprofit/for-profit “hybrids” and new corporate forms, particularly the Social Purpose Corporation (CA) and the Public Benefit Corporation (DE)•Associate Professor at Berkeley Law School, Boalt Hall, on Social Enterprise (also offered at Haas)

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PRESERVING MISSION:

TRADITIONAL CORPORATE FORMS

This section will address the options, strategies and limitations of anchoring mission in socially-driven businesses within the existing framework of traditional

for-profit corporate forms. Such forms include the Delaware “C” corporation, limited liability companies and partnerships, and cooperatives and employee

stock ownership plans (“ESOPs”).

PRESERVING MISSION:

TRADITIONAL CORPORATE FORMS

This section will address the options, strategies and limitations of anchoring mission in socially-driven businesses within the existing framework of traditional

for-profit corporate forms. Such forms include the Delaware “C” corporation, limited liability companies and partnerships, and cooperatives and employee

stock ownership plans (“ESOPs”).

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Delaware “C” Corporation

• As the preferred business entity for entrepreneurs and investors, the Delaware “C” corporation offers several mechanisms to anchor mission, including:

• Business Judgment Rule

• The business judgment rule operates as a broad presumption that the decisions of directors, absent a breach of fiduciary duty, are in the best interests of the corporation.

• Fiduciary duties do not mandate that all management decisions be made for the purpose of maximizing immediate shareholder wealth.

• The business judgment rule provides significant freedom to pursue mission-aligned corporate activities that are made in the best interests of the shareholders and corporation, i.e. mission-driven decisions that simultaneously improve the corporate brand and long-term profitability.

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Delaware “C” Corporation

• Mission-Aligned Investors• The ability of mission-aligned investors to control mission drift can be

augmented by other protective measures including:o Voting/shareholder agreements.o Super-majority or class voting rights.o For other measures, please refer to “Preserving Mission –

Traditional Debt and Equity Instruments.”

• Constituency Statutes

• Businesses incorporated in one of thirty-one states with constituency statutes (not California or Delaware) permit or require a corporation to consider factors such as impact on employees, society, and the community in its decision-making.

• Constituency statutes have limited legal enforceability and do not override traditional corporate fiduciary duties.

• No reporting and very limited accountability.

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Delaware “C” Corporation

• Charter Provisions• Certain corporations have taken the step of embedding the promotion of

mission in their charter. o There is less legal risk in states with constituency statutes.

• As with constituency statutes, where embedded mission-protective provisions and fiduciary duties conflict, fiduciary duties are likely to prevail.

• IP Licensing• Valuable IP may be held by a mission-aligned founder or affiliated non-

profit entity and licensed to the corporation.

•  The licensing agreement may then contain provisions whereby if the licensee violates certain agreement terms or acts inconsistently with the prescribed mission of the corporation, the licensor can either increase royalty rates or terminate the license.

• But consider impact on M&A (i.e. the “spurn-out”).

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Delaware “C” Corporation

•  The aforementioned strategies to preserve mission assume operation of a corporation in the ordinary course of business.

• The effectiveness of these mechanisms may be compromised once the sale of a corporation appears imminent and inevitable.

• In such instance, management may be required to maximize shareholder value by selling to the highest bidder or face litigation for breaching their fiduciary duties pursuant to Revlon.

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Limited Liability Co.’s and Partnerships

• Limited liability companies (“LLCs”) and partnerships also present distinct advantages for mission preservation due to their contractual flexibility.

• However, state variations in LLC and partnership statutes may limit their suitability for anchoring mission (i.e. California LLCs are not an appropriate vehicle as discussed below). Delaware mission-protective options include:

• Expressly elevating preservation of mission over return to equity holders by contractual agreement and eliminating traditional fiduciary duties.

• Waterfall distributions structured to return money to related non-profits or mission-aligned investors first.

•  Stacking the boards of directors, membership, or partnership with mission-aligned individuals.

• LLC membership class voting and protective provisions related to mission.

•  Change of control, “tag-along” and “drag-along” provisions related to mission, specifically requiring approval from mission aligned investors.

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• However, LLCs and partnerships also implicate certain general disadvantages as compared to corporations that may make it harder for a social enterprise to raise outside funding and scale impact.

• These drawbacks include:•  Pass through tax treatment.

• Inability to offer highly-liquid equity grants as compensation.

•  Higher risk profile as a result of contractual flexibility.

• Not all states allow for similar flexibility to contract around fiduciary duties – recent changes to the California LLC statute in 2014 imposed traditional fiduciary duties on California LLCs.

Limited Liability Co.’s and Partnerships

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Cooperatives and ESOPS

• Cooperatives and ESOPs present unique ability to preserve mission based on their democratic corporate governance structures.

• For example, “one member, one vote” provisions with regards to key corporate governance issues and appointment of leadership ensures mission alignment with the entity’s membership or employees.

• However, the de-coupling of the amount of capital invested and influence over decision-making will be unattractive to large outside investors, making scaling of cooperatives and ESOPs more difficult.

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PRESERVING MISSION:

HYBRID CORPORATE STRUCTURES

This section will address the different variations of “hybrid” corporate structures and the unique challenges and opportunities they present to social

entrepreneurs and investors.

PRESERVING MISSION:

HYBRID CORPORATE STRUCTURES

This section will address the different variations of “hybrid” corporate structures and the unique challenges and opportunities they present to social

entrepreneurs and investors.

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Hybrid Corporate Structures• In general, a hybrid entity refers to a close relationship – via equity

ownership, funding or contract – between a non-profit and for-profit entity.

• General rules that apply to all hybrids:• Adhere to rule of “no competition” between non-profit and for-profit• All relationships between non-profit and for-profit must be documented• Do not spin out for-profit unless/until there is sufficient funding• Consider employment options and impact on the mission

• We will discuss five types of hybrid entities:

• a for-profit maintaining contractual relationships with a non-profit

• a non-profit as a minority investor in a for-profit

• a for-profit operating as a wholly-owned subsidiary of a non-profit

• a non-profit operating as a subsidiary of a for-profit; and (5) a non-profit investment in a for-profit impact fund

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Hybrid Corporate Structures

In each of these models, the non-profit, for-profit and investors must consider the following:•Both entities must track and document the flow of funds, the flow of services and resources and the flow of IP between the non-profit and the for-profit. •Documentation takes the form of intercompany agreements including an IP license agreement, services agreement and/or resource sharing agreement.•In terms of flow of funds, there are various options:

• The entities can make loans to the other; however, interest on loans will likely be Unrelated Business Income Tax (“UBIT”) to the non-profit.

• Better alternatives are dividends on equity held by the non-profit in a for-profit subsidiary and royalties on license agreements.

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Hybrid Corporate Structures

• The documentation must ensure that the for-profit always pays at least market rates to the non-profit in all three cases (for funding, services/resources and IP).

• Independent verification of “market” for the industry in which the entities are operating is recommended.

• There also must be good governance, specifically disinterested directors on the boards of both the non-profit and for-profit.

• Such disinterested directors typcially form a special committee of each board, which committee approves all intercompany agreements and monitors all relations between the non-profit and for-profit.

• Management is required to report on the flow of funds, services and IP to the special committee on a quarterly basis; amendments to the intercompany agreements are usually required as the hybrid evolves over time.

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Contract-Based Relationship

• The most frequently used hybrid corporate structure involves a specific contractual relationship between a non-profit entity and a for-profit entity – the relationship only exists so far as dictated by specific contracts between both entities.

• Among other items, the two entities may contract for the provision of specific services or products, the sharing of resources (i.e. office space or equipment), or use of IP.  

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Contract-Based Relationship

• Key aspects defining the relationship between the two entities include:

• No ownership of equity in for-profit by the non-profit.

• No shared employees.

• Often no overlapping board members and no need for a special committee of disinterested directors (although if there are overlapping board members, such members must recuse themselves from voting/approving the agreements between the two entities).

• The for-profit must pay market rates for the services, products, or IP it receives from the non-profit.

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For-Profit Wholly-Owned Sub of a Non-Profit

• This form of hybrid structure occurs where a for-profit entity is held as a wholly-owned subsidiary by a non-profit entity (501(c)(3) public charity).

• This form contains several key advantages including the relative ease of structuring and improved corporate governance – mission alignment is created through oversight of the for-profit by the non-profit and there is reduced potential for conflict with investors.

• Note that the ownership structure can evolve over time if and to the extent that the for-profit elects to sell a minority stake in the for-profit to outside investors. However, the non-profit retains 51% control and usually a majority position in the board.

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Key structural, strategic and corporate governance best practices include:•The non-profit and for-profit must have separate and distinct functions – the entities cannot be in competition with one another.• Organizers must carefully consider whether all employees are employed by the non-profit entity, the for-profit entity or both.• All flow of funds, services/resources and IP is documented between the entities, with the non-profit paying no more than market and the for-profit paying at least market.• Typically the non-profit retains the right to nominate a majority of the directors on the for-profit board. Each entity should have a special committee comprised of at least two independent directors whose function includes evaluation of potential self-dealing between the entities.• Awareness of potential UBIT and compensation issues with shared employees.

For-Profit Wholly-Owned Sub of a Non-Profit

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Non-Profit as Minority Investor in a For-Profit

• Another structure involves a non-profit with a minority ownership stake (typically 20% or less) in a for-profit. Such an investment may be structured as a program-related investment (“PRI”) by foundations.

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Non-profit minority ownership in a for-profit implicates several challenges including :•Greater difficulty for the non-profit to ensure that the for-profit remains aligned with the non-profit’s mission unless it is established as a PBC or other new corporate form.

• However, the for-profit can create a different class of stock with protective provisions for the “founder” non-profit.

• Mission can also be linked through a license agreement.

•Potential conflicts between the non-profit and for-profit investors.•Redemption rights for non-profit “founder” and other non-profit can dampen enthusiasm for mainstream investors.•Impact on exit opportunities for the for-profit investors.•Need for intercompany agreements and increased importance of independence in governance and management of each entity.•Careful management of UBIT issues.

Non-Profit as Minority Investor in a For-Profit

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For-Profit Establishment of a Non-Profit

• A for-profit entity may also establish a non-profit entity (structured as a 501(c)(3) private foundation.

• Although the for-profit cannot formally own the non-profit, it can maintain control through funding and governance of the entity.

• Although this form is straightforward from a legal structuring perspective, it is typically favored by large corporations (i.e. Google.org) and not mission-driven social enterprises.

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• Key corporate governance best practices are similar to those raised by non-profit ownership of a for-profit and include:

• Maintenance of corporate governance independence – board member overlap should be kept to a minimum.

• Issues raised by resource and employee sharing.

• Awareness of potential UBIT issues.

For-Profit Establishment of a Non-Profit

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Non-Profit Investment in a For-Profit Impact Fund

• An additional opportunity available to non-profits involves investment in a for-profit impact investment fund.

• This raises difficult legal structuring challenges and is less commonly-used than other hybrid corporate structures.

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Additional key structuring best practices include :•Use of a corporation entity to protect non-profit investment from UBIT issues (“Corporate Blocker”).

• Non-profit invests through the Corporate Blocker (which is the General Partner of the impact fund).

• Non-profit’s share of the Corporate Blocker is considered dividend income (i.e. not UBIT).

•Individual managers co-invest with corporation in the General Partner.•Clear inclusion of mission and mission-related terms in the Partnership Agreement including:

•  Mission as part of the purpose.

•  Agreement from Limited Partners (“LPs”) to focus on mission in investment selection, diligence and reporting.

•  Possible agreement from LPs to reduction in financial return for impact.

•  Required reporting.

• Limited ability to attract ERISA LPs.

Non-Profit Investment in a For-Profit Impact Fund

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PRESERVING MISSION:

NEW CORPORATE FORMS

This section will address new corporate forms created to help social entrepreneurs and investors navigate the gap between traditional for-profit and

non-profit entities. To address balancing social mission against pursuit of profitability, each corporate form contains different approaches to key issues

such as fiduciary duties, reporting and accountability mechanisms, and interaction with existing state corporation law.

PRESERVING MISSION:

NEW CORPORATE FORMS

This section will address new corporate forms created to help social entrepreneurs and investors navigate the gap between traditional for-profit and

non-profit entities. To address balancing social mission against pursuit of profitability, each corporate form contains different approaches to key issues

such as fiduciary duties, reporting and accountability mechanisms, and interaction with existing state corporation law.

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Low Profit Limited Liability Company

• Low profit limited liability companies (“L3Cs”) exist in nine states and their adoption has been considered in several others.

• By definition, an L3C must advance mission over profitability – it is principally designed to assist for-profit companies with a primarily charitable purpose and offers a lower rate of return to its members.

• Although L3Cs present a new vehicle through which social entrepreneurs may seek program-related investments (“PRI”), several important risk factors should be considered including:

• Foundations can already make PRIs in LLCs and corporations.

• L3Cs are not eligible for 501(c)(3) tax-exempt status.

For-ProfitNon-Profit

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Low Profit Limited Liability Company• No IRS ruling or attorney tax letter has been issued for either regular

for-profits or L3Cs.

• L3Cs do not address private benefit issues.

• Non-elective nature – due to its statutory definition, a mission-driven LLC with a charitable purpose created in a state with a L3C statute could unintentionally become subject to L3C requirements.

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Benefit Corporations

• Benefit Corporations are a new class of corporation created in 26 states.

• As with the SPC and PBC, Benefit Corporations are for-profit entities that attempt to anchor social mission by requiring directors and management to take mission into account with regards to corporate decision-making.

• It should be noted that many Benefit Corporation statutes have not been drafted to integrate with the pre-existing state corporation code.

For-ProfitNon-Profit

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Benefit Corporations• While each state statute is different, Benefit Corporation statutes

generally include the following provisions:• Defined Benefit

o A Benefit Corporation must pursue a “general public benefit” and other named specific public benefits matching certain pre-determined criteria.

• Corporate Governance and Protection from Liabilityo Directors are required to consider the effects of corporate action on

several enumerated constituencies including shareholders, employees, customers, community, and the environment.

o Directors and management may be subject to liability under a “benefit enforcement proceeding” (discussed below).

o A Benefit Corporation must name an independent “benefit director” charged with preparation of a Benefit Corporation’s annual benefit report.

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Benefit Corporations• Conversion of Other Corporate Forms

o The ability to convert into a Benefit Corporation varies across different states – in certain states (i.e. California) there is no established means of converting existing companies into a Benefit Corporation.

o Dissenters’ rights vary from state to state.

• Reportingo Benefit Corporations must produce a publicly-published, annual

benefit report.

o The report must describe how the Benefit Corporation pursued its general and specific benefit and an assessment of societal and environmental performance in accordance with a third-party standard..

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Benefit Corporations• Enforcement

o A benefit enforcement proceeding is a special cause of action for claims alleging a failure to pursue or create either a general public benefit or an enumerated specific public benefit.

o Benefit Corporations offer a broad enforcement right that may extend to third-parties – a benefit enforcement proceeding may be brought by the corporation, the shareholders in a derivative suit, directors, 5% owners of a parent entity of the Benefit Corporation, or other enumerated persons granted standing by the articles or bylaws of the Benefit Corporation.

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California Social Purpose Corporation

• The California Social Purpose Corporation (“SPC”), formerly known as the Flexible Purpose Corporation (“FPC”), is a new corporate form integrated into the existing California Corporations Code effective as of January 1, 2012.

• Overall, the new entity seeks to provide an extra “safe harbor” in addition to the business judgment rule – SPC management may consider environmental and social factors, in addition to shareholder value, in both ordinary course of business and change of control situations without incurring liability for breaching their fiduciary duties.

For-ProfitNon-Profit

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California Social Purpose Corporation

The SPC differs from a traditional Delaware “C” corporation in five areas:

•Defined Social Purpose• A SPC must name one or more social or environmental purposes in its

charter as agreed upon by management and its shareholders.

• Social purpose must be contained within categories enumerated by the non-profit code including promotion of the positive, or minimization of the negative, impacts of the corporation’s actions on employees, customers, community, and the environment.

• The management or board of a SPC must consider the social purpose in addition to maximization of shareholder value in the course of its decision-making.

• The social purpose cannot be changed without a two-thirds vote of each class of the corporation’s shareholders.

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California Social Purpose Corporation

• Corporate Governance and Protection from Liability• Broad discretion to boards and management in terms of weighting

mission and profitability in decision-making.

• Directors and management are shielded from liability when making decisions involving trade-offs between maximization of shareholder value and promotion of the social purpose in both ordinary course of business and change of control situations.

• Conversion of Other Corporate Forms• An existing public or private corporation under any jurisdiction (LLC,

partnership, or other entity) may convert into a SPC with a two-thirds vote of each class of voting shares.

• Dissenters’ rights are granted in the event of a material change in the SPC’s social purpose or conversion without consent.

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California Social Purpose Corporation

• Reporting• A SPC is required to publicly publish regular reports with the objectives,

goals, measurement and impact or return on its stated social purpose.

• “8-K-type reporting is also required if there is a company action that would have a material impact on mission or financials.

• No requirement of measurement by third-party standards but must employ “best practices” in terms of reporting.

• Required public disclosure on web-site or other medium.

• Enforcement• Shareholders retain traditional enforcement rights with respect to

enforcing the social purpose, i.e. removal of directors.

• Third parties do not have enforcement rights.

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Delaware Public Benefit Corporation

• On August 1, 2013, the Delaware legislature added a new subchapter to the Delaware General Corporation Law creating a new entity – the Public Benefit Corporation (“PBC”).

• In general, the PBC closely tracks the provisions of the California SPC, including the following similarities:

• A PBC must name a specific “public benefit” in its charter.

• “Public benefit” is defined as the positive effect (or reduction of negative effects) on “persons, entities, communities or interests (other than stockholders in their capacities as stockholders) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”

For-ProfitNon-Profit

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• Directors and management of a PBC are required to balance the public benefit alongside maximization of shareholder value in their decision-making and are shielded from liability for breaching their fiduciary duties for such balancing decisions.

• A two-thirds shareholder vote is required to amend the enumerated public benefit in a PBC’s charter.

•  There are no mandated third-party standards for measurement of social impact.

•  There is no third-party enforcement right.

Delaware Public Benefit Corporation

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•  The PBC does differ from the SPC in two important ways:• Higher Shareholder Approval Requirement for Conversion

o  In order for an existing entity to become a PBC, 90% of the existing entity’s shareholders must approve the conversion. This is in contrast to the lower two-thirds shareholder vote required by the SPC.

• Less Stringent Reporting Requirementso  As opposed to the SPC’s annual reporting requirement, a PBC is

only required to issue its reports biennially.

o PBC reports are not required to be made publicly available; reports must only be made available to a PBC’s shareholders.

o  PBC legislation does allow for more frequent issuance of reports, public-reporting mandates, and use of third-party certification standards if included in a PBC’s certificate of incorporation.

Delaware Public Benefit Corporation

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PRESERVING MISSION:

TRADITIONAL DEBT AND EQUITY INSTRUMENTS

This section will address the strategies and opportunities available through use of traditional debt and equity instruments to anchor mission in social

businesses. We focus on key investment terms familiar to entrepreneurs and investors to stimulate co-investment through (1) convertible debt and (2)

preferred equity financings.

PRESERVING MISSION:

TRADITIONAL DEBT AND EQUITY INSTRUMENTS

This section will address the strategies and opportunities available through use of traditional debt and equity instruments to anchor mission in social

businesses. We focus on key investment terms familiar to entrepreneurs and investors to stimulate co-investment through (1) convertible debt and (2)

preferred equity financings.

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Convertible Debt• Use of convertible debt is a typical financing mechanism for early-stage

entrepreneurs and investors.

• To preserve mission, key strategies include:

• Portfolio company and lenders agree on the scope of mission at the time of the investment.

o Mutually confirm how the company will memorialize the mission – in a new corporate form, charter, shareholders’ agreement and/or purely in a note purchase agreement and note.

• Affirmative and negative covenants regarding mission.o Affirmative covenants – e.g., Borrower shall use the proceeds of

investment only in a mission-aligned fashion.

o Negative covenants – e.g., Borrower shall not change its business plan, which plan shall be mission aligned; Borrower shall not incur any material capital expenditures for activities that conflict with mission.

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Convertible Debt

• Include violation of mission in the definition of “event of default.”

o To avoid issues of cross-default with other debt instruments, this can be altered to trigger prepayment as opposed to default.

o If borrower fails to pre-pay, mission-preserving contractual remedies for the debtholder can be included, such as a board takeover.

• Interest rate increases or prepayment in the event of “mission creep.”

o If the borrower takes certain action deviating from the mission, higher interest rates or prepayment automatically applies.

• Removal of automatic conversion mechanisms. o Conversion will not be automatic in the next round of financing if mission

creep exceeds a certain threshold.

• Reporting Requirementso Include detailed requirements regarding reporting on mission and impact

with financial reporting required to note-holders.

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Convertible Debt

• These strategies implicate a key question – who determines the permissible level of mission creep before penalties are triggered? The alternatives for making such determination include:

• The holder of the debt can make a determination that there has been a material deviation from the mission agreed at time of investment, to which the company can object and then forward to a designated third party.

• The company may appoint a special committee of the board tasked with oversight of mission, which committee reports to the board (and investors) if there has been material deviation.

• The company and investors can agree to establish mission based on a third-party standard (e.g., certain scope on a B Labs audit).

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Preferred Equity

• Traditional equity investments in the form of Common or Preferred Stock are also frequently used by entrepreneurs and investors, including social entrepreneurs.

• Strategies to anchor mission can be established by the social enterprise’s founders at the time of the company’s formation or required by investors in later stages of investment.

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Preferred Equity

• Key protective provisions include:

• Voting Agreements.

o Requiring by contract approval from certain investors for actions which are mission (or not mission) aligned.

• Separate classes of stock for mission-aligned investors and founders.o Class approval for material change in business plan (including

mission).o Class approval for sale of the company and triggers for drag-along

rights.o Class approval for any action out of the ordinary course that could

have a material impact on mission.

• Provide board representation (and designated director approvals) for mission-aligned investors.

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Preferred Equity

• Redemption rights in the event of material deviation from mission

o If Company deviates from mission, Company must repurchase investors’ shares or face certain penalties if unable to do so.

o If mission creep or change of mission occurs and company is unable to honor redemption rights, contractual remedies may include board control until redemption price is paid.

o Option of “secondary sale” or sale to a co-investor who serves as a guarantor in the event of mission deviation.

o Use of the aforementioned redemption rights provisions may have a chilling effect on co-investment options, particularly outside of “impact” space.

• Investor rights agreements including information rights regarding mission and impact together with reporting of financial information.

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Preferred Equity

• Change of conversion formula (preferred to common) in the event of material deviation from mission.

o Can have formula which allows for conversion ratio to increase (i.e. more common shares upon conversion of preferred shares) in the event of “mission creep.”

• Dividends to become cumulative in the event of material deviation from mission.

• Preferential waterfall provisions rights for mission-aligned investors.

o Waterfall provisions can provide priority to mission-aligned investors.

o May face IRS issue issues if foundation/non-profit investors have lower priority in waterfall.

o Additional option is to change the waterfall and or the return (e.g, change 1X to 2X or change from non-participating to participating preferred) in the event of deviation from mission.