Over the past couple of decades we’ve heard a lot about “social enterprises,” a term usually applied to companies that are visibly making the world a better place. Those are the good guys, the heroes of our time. We would all like to be one of them, to do something positive for at least our corner of the world. Yet, not every company is curing cancer, feeding the hungry, or solving some environmental problem. What about the rest of us?
The good news is that regardless of your industry or the product or service you offer, your company can have a positive impact in the world – not just because of what your company is doing, but because of how you do it. But it requires that you challenge some of the conventional wisdom that you may have taken for granted. Here’s how:
Re-think your ownership. In the conventional wisdom, a corporation is owned by its shareholders and is solely responsible to its shareholders, with all other considerations being secondary. In fact, whether shareholders can truly be said to “own” a corporation is subject to some legal debate. Individual shareholders do not have the “bundle of rights” that is generally understood to comprise what we call “ownership.”
Some legal scholars argue that a corporation, as a person under the law, cannot be owned by anyone but simply has contractual relationships with shareholders, just as it has contractual relationships with employees, customers, suppliers, lenders, and other constituencies – all of whom in some sense invest in the corporation. In other words, what a stockholder owns is simply stock that confers certain rights, not the corporation itself.
Re-think your responsibilities. With an expanded view of a corporation’s owners and investors as including multiple constituencies, it follows that a corporation bears a responsibility to all of those constituencies. A corporation that prioritizes the interests of stockholders at the expense of all others is essentially a predatory corporation: It preys upon its community in order to extract wealth from the community and concentrate that wealth in the hands of its stockholders.
That is not what the law requires. A corporation’s board and management should recognize that the corporation owes a responsibility to all of its constituencies. Since the interests of its various constituencies are not always aligned, it is one of the core duties of a corporation’s board and management to balance all those interests in a way that is fair to all of them and does not unduly burden any of them.
Re-think your capital-raising strategy. In the conventional wisdom, a company that isn’t big enough for an IPO must raise capital from banks, angel investors, or venture capital firms. In each case, that involves putting your fate in the hands of a small number of people who already hold wealth and power. And if you succeed, your profits will further bolster their wealth and power.
Instead, you can raise capital from your own community, including the non-wealthy, using “community capital” strategies like crowdfunding, direct public offerings, and community investment funds. Members of your community invest because they want you to succeed, not merely because you offer the highest financial return on their investment. And when you succeed, the profits will continue circulating in your community and will build wealth right where you want it. As a bonus, when the investors of capital are part of the same community as the company’s employees, customers and suppliers, it is easier to balance their interests because at some level they all want the same thing: a peaceful, healthy and thriving local community.
Re-think the growth imperative. Our culture’s obsession with growth – at both the micro- and macro-economic levels – is unhealthy and destructive. At the level of the broader economy, it is increasingly clear that an economy cannot continue to grow indefinitely; it will eventually hit limits at which collapse is inevitable. At the level of individual companies, the problem with big companies is that they concentrate wealth, which leads to a concentration of political power that is fundamentally anti-democratic.
We are told that every company should aspire to go big and go global, untethered from community, and opportunistically locating wherever the most profits can be extracted. But if we think of a company as existing to serve its community – including all of the constituencies that make up its community – then it becomes clear that each company should aspire to grow only to the size that will allow it to most effectively serve those constituencies. Growth, then, becomes a means to an end, not the end in itself.
Re-think where your money goes. In the conventional wisdom, spending decisions are based on a simple calculus that balances cost against the quality of goods or services. Similarly, investment decisions are based on a balancing of risk and reward. It is often assumed, if rarely articulated, that these decisions are values-neutral.
And yet, none of those decisions are actually values-neutral. Every spending decision, every investment decision, and every choice of a supplier or professional provider is effectively a vote for someone’s set of values. Any company can greatly magnify its positive impact in the world by choosing to do business with others who share a similar commitment to a better world.
It requires that there be an inquiry into the values and social impact of any potential supplier, provider or investment target. That inquiry can become part of a company’s routine decision-making process. For example, before purchasing supplies from a big-box retailer, consider the impact of that retailer on the local economies in which it operates. Before sending legal work to a big law firm, find out whether that firm supports extractive industries at odds with your company’s values such as fossil fuels and weapons manufacturing.
You’ll notice that the changes described here start with changes in our underlying assumptions; and when those changes take root and become widespread, we will have a change in culture. It’s the broader culture that needs to change. But, of course, changes in assumptions and culture are not the end game. Rather, those changes will compel changes in behavior that will lead to a healthier and more equitable world.
When companies across the country recognize their responsibilities to all of their constituencies, when everyone has an opportunity to invest in their own communities, and when the economy is dominated by locally-rooted companies that deploy their resources in a values-conscious way, we will have an economy that is very different from the one we have today, one that is truly sustainable, and with opportunities for everyone to thrive. That is our vision at Cutting Edge Capital.
Sonoma West Publishers is a small newspaper group devoted to local community news coverage, a mission we have been following for 154 years. Each of our four newspapers is actually older than the incorporated cities they cover.
Why did you choose to do a direct public offering (DPO) to raise capital for the fund?
The DPO funding model allows for a broad base of local and smaller community investors. Readers and local businesses gain an extra connection and added sense of pride in the local newspaper. The DPO structure is superior to seeking a commercial bank loan or taking on larger minority partners. The structure also allows for continued independence for our editorial voice.
What were the long-term benefits of a doing a DPO?
New community investors will become better connected to our local journalism efforts via a series of live events, investor-only meetings and periodic reports from the publisher. Long term, we may seek another DPO campaign in the future, depending on the successful growth and sustainability the current investments produce or support.
Did any of the outcomes surprise you?
We weren’t too sure what to expect, since we were the first newspaper in the country to launch a DPO. We experienced some slow periods of acquiring investors, but lately as we reach our expire date, we are gaining investors almost daily.
How much are you raising and how long will it take to raise that amount?
Our goal was $400,000 with the 12-month stock offer that expires Jan. 30, 2019. We are currently at 70% of that goal with almost 100 investors.
What were some of the challenges you faced and how did you overcome them?
We are a small corporation, owned by a husband and wife. We did not hire or do any outreach for marketing or other support. We relied on our own website and newspaper announcements and some word-of-mouth from early investors. We never encountered any opposition or criticisms. Quite the opposite, we met with lots of enthusiasm and encouragement, but not everyone who said they would invest has ended up writing a check.
What were your favorite aspects of the DPO process?
We received very personal testimonials in support of our journalism and our journalists. Many investors said we are invaluable in defending democracy. Journalism is hard work, with low pay. The DPO campaign allowed us to explain our roles in the local community and a free society.
Could you share 3 pieces of advice for other groups considering a DPO?
1) Be ready with your marketing plan early. Don’t wait for state approval because the 12 months can go very fast. 2) Enlist marketing and campaign help form your best friends or local associates. Test your messages early and often. 3) Don’t be afraid to ask for money and don’t be afraid to ask multiple times of the same people.
How do you hope to see Sonoma West grow in the next few years?
The DPO community investment has shored up our basic business foundation and will provide for a stable staff. Newspapers must be very innovative right now in this disruptive Digital Age. We seek to grow stronger at our core of publishing local news, and we seek to expand into new journalism ventures like our “reader-powered” newsroom, series of live community events and more enterprise and investigative journalism.
How can people get involved and support you?
Our DPO campaign and new newspaper business model was featured in a New York Times article in August, 2018. We received lots of national and newspaper industry attention. We aim to be a successful trendsetter for our industry and hope we can help other small newspapers stay in business and better serve their own communities through the many new innovations we are putting together. It would be great to attract some foundation or grant support, added to a Lenfest Foundation grant we already have received.
In 2018, CERO was a winner at the Massachusetts Sustainable Business Awards. A few years prior, Cutting Edge Capital helped them complete a successful DPO. Listen to CERO general manager, Lor Holmes reflect on their experience and give advice to other organizations interested in direct public offerings.
At Cutting Edge Capital, we think a lot about the possible legal strategies that can advance community capital. There are the often-used (if not well-known) strategies like crowdfunding, direct public offerings, and charitable loan funds. But then there are strategies that have been on the books for decades but have seldom, if ever, been used as a vehicle for community capital. Sometimes innovation isn’t about doing something new, but rather doing something old in an innovative way.
Years ago, I helped a charitable organization set up a pooled income fund (a “PIF”). The idea of a PIF is that a contributor puts money or assets into a trust, where it is pooled with the contributions of other contributors and jointly invested. Income from the investments is distributed to the contributors (and often their spouses or other beneficiaries) for their lifetimes. Upon the death of each life beneficiary, the pro rata value of the fund at that time is removed from the trust and given over to the charity that sponsors the trust. A portion of the amount contributed is tax deductible to the contributor in the year of the original contribution, based on a formula that measures the actuarial value of the remainder interest that will eventually go to the charity.
Many foundations, universities, and other (usually large) charities have established PIFs as a planned giving device. From the point of view of these sponsoring charities, the purpose is to eventually receive the remainder interest upon the death of each contributor, though the charity may have to wait years, and sometimes decades. But with enough contributors in a PIF, it is inevitable that one by one they will pass on over the years, and those assets will come into the charity, as planned.
Meanwhile, the assets of the PIF are typically invested as most charitable assets are – in Treasuries, bond funds, perhaps some socially screened equity funds, but nothing that looks too risky. Big charities are a pretty conservative bunch. From the sponsoring charity’s point of view, the goal is to preserve and grow principal, while generating just enough income to fulfill the promises made to contributors.
So we went to work at this charitable organization, thoroughly researching the topic, developing a plan for how we wanted the PIF to work, and carefully crafting all the necessary legal documents, including a declaration of trust, a contribution agreement, and a disclosure document that explained everything. There was no discussion of using the PIF to make place-based investments – by which I mean investments in small ventures rooted in a local community that could contribute to a healthier and more resilient local economy. But I’ll come back to that in a moment. This PIF, like others, was to invest its assets fairly conservatively. And the charity would take a fee off the top for managing the fund.
When it was all finalized, we put it out there. And it flopped. The feedback was that anticipated annual returns, after deducting the charity’s management fee, just weren’t enough to make it attractive. Ultimately, the PIF attracted only a small handful of contributors before the organization pulled the plug and went through another hassle to unwind the PIF. It seemed like a lot of wasted effort.
Fast-forward to the present. Recently we at Cutting Edge Capital have focused on community investment funds as a critical tool for moving the needle forward significantly toward a more inclusive and equitable society. (We wrote about that here.)
But there are gaps in the legal landscape for community investment funds – a landscape dominated by the Investment Company Act of 1940. That law imposes a heavy regulatory burden on any investment fund that doesn’t qualify for an exemption, a burden so heavy that it is not financially feasible for a community-scale fund.
But, the 1940 Act includes a number of exemptions. It’s fairly simple to set up a charitable loan fund or a community-owned real estate fund, because each of those is exempt from the 1940 Act. However, there is no simple exemption strategy for a fund that makes equity investments in small businesses and is open for investment by the non-wealthy. There are a handful of exemption strategies that could work, but each of those strategies requires a fund to squeeze into a business model that may not align with what is needed.
In that context, we think the humble PIF deserves another look. The PIF fits within the charitable exemption from the 1940 Act because of the charitable remainder component. But even so, it can do what no other type of investment fund can do: It allows any number of investors of any level of wealth to pool their resources into a community-scale fund that can make equity investments in local businesses (along with any other kind of investments), with profits from those investments shared among the investors. No regulatory review is required, because of the securities law exemptions, which makes it efficient to set up. It’s like a local mutual fund without the regulatory burden.
There is, of course, the downside that the investors can’t get their money back because of the charitable remainder element. But that charitable remainder also brings a tax deduction, along with the knowledge that contributions will eventually go to a charitable cause. And depending on how the fund is invested, the years or even decades of income from a PIF may be far more valuable than the remainder interest. If the need arises, that life income stream can be transferred to another beneficiary.
Some may also argue that the assets of a PIF, being in a sense charitable assets, must be invested in a conservative way that does not accommodate the kind of small business equity investments that we are contemplating here. However, this argument is rooted in a false myth that fiduciary standards require charitable assets to be invested for capital preservation or for maximum financial return. While state laws vary, the general rule, as spelled out in the Uniform Prudent Management of Institutional Funds Act, is that charitable funds should be invested in a manner appropriate to the organization’s purpose – which could mean investing in local businesses, even if there is a higher risk of loss. The IRS recently underscored this point in a 2015 release on mission-related investing.
So a PIF can be much more than just a planned giving device that will eventually benefit the charitable sponsors. It can truly be an engine for local economic development that offers the benefits of investment to anyone in the community in an equitable and inclusive way. To date we are not aware of any PIF that is actually being used as a vehicle for community capital – that is, as a way for anyone to invest in the success of local businesses. However, in recent conversations that we’ve had, this idea has sparked significant interest, and we expect to see such a reimagined pooled income fund in action soon. So stay tuned.
Of course, nothing written here should be taken as legal, investment, or tax advice. If you would like to schedule a consultation with one of our principals at Cutting Edge Capital, click here.
In this webinar, Kim Arnone and Brian Beckon discuss community capital, investment funds, opportunity zones, and local control.
If you have any follow-up questions or would like to schedule a one-on-one consultation call please email us at firstname.lastname@example.org.
Elizabeth Warren’s recently proposed Accountable Capitalism Act (“ACA”) has ignited a lot of controversy, with supporters hailing it as the way to save capitalism, while others argue that it will destroy capitalism. In my view, while it is a step in the right direction, there is a better way to solve the problem – more effectively and with less controversy.
But first, let’s take a quick look at what the Accountable Capitalism Act would do. Most significantly, it would require any corporation with over $1 billion in revenue to obtain a charter from a newly-created Office of US Corporations. This charter would expressly require the corporate board of directors to consider the interests of all the corporation’s constituents, including shareholders, customers, employees, and the communities in which they operate.
As our friends over at B Lab have reported, the ACA would essentially require that large corporations become benefit corporations. The benefit corporation is a new type of corporation authorized in recent years by legislation in several states. A benefit corporation is much like a regular corporation except that its management is explicitly empowered to consider the interests of constituencies other than its shareholders, it must provide an annual report to shareholders based on a third-party standard, and its managers are protected from liability when they do consider those other constituencies.
Both of these solutions — the benefit corporation and this proposed new federal corporate charter – are attempts to fix what Forbes describes as a “source code error in the operating system of capitalism” – the notion of shareholder primacy.
Shareholder primacy, sometimes referred to as shareholder value maximization, refers to the idea that a corporation’s sole purpose is to maximize profits for its shareholders. It has been cited as supposedly requiring that a corporation disregard the impacts of its actions on its employees, on the environment, and on the broader community in which it operates if any of those are in conflict with the maximization of profits. And, it is believed, a corporate director or manager who acts in a way that benefits some other constituency but doesn’t maximize profits may be personally liable to shareholders.
It’s easy to see how the notion of shareholder primacy can lead corporations to act in a sociopathic way, with single-minded devotion to profit at the expense of all else. Stock-based compensation to corporate managers incentivizes this myopic focus on shareholder profit, and fear of personal liability for doing otherwise strikes fear into their hearts. Given the enormous wealth and power held by corporations, it is also easy to see how this could cause great harm to all other constituencies, including employees, communities, and the environment.
Not surprisingly, the notion of shareholder primacy has been widely criticized. The late Cornell law professor Lynn Stout, in her 2012 book The Shareholder Value Myth, explains how putting shareholders first not only harms the public, but also harms corporations and their investors. Jack Welch, the former CEO of GE, famously described it as “the dumbest idea in the world.” It is frequently cited as the main reason wages have been stagnant for the past four decades, even as the wealthy have become far wealthier.
So what is the solution? The benefit corporation and Elizabeth Warren’s proposed federal corporate charter both seek to solve the problem by creating a new type of corporation that isn’t saddled with the myth of shareholder supremacy. And yet, while I applaud the good intentions behind both fixes, they share one critical flaw: They implicitly acknowledge that shareholder primacy is the law of the land. But is it?
Those who believe it is the law of the land may be surprised to learn that the notion has never been codified into any statute; and no court has ever ruled that it is the law in any general sense. Quite to the contrary, the well-established business judgment rule explicitly protects managers of a corporation for actions taken in good faith pursuit of the corporation’s best interests – even if those actions don’t necessarily maximize profit for shareholders. It is important to recognize that there are many things that may be in the corporation’s best interests but don’t maximize profits (at least not in the short term), such as R&D, new product development, employee training, community engagement, reductions in environmental footprint, and supporting local charities.
And yet, the notion that a corporate manager’s sole obligation is to maximize profits has become so widespread that it has become the de facto standard for corporations across America since the 1990s. In other words, even though it is not the law, the widespread belief that it is the law has contributed to the concentration of wealth, the impoverishment of workers, and environmental harm – as well as reduced long-term profitability of American corporations, as we’ll see in a moment.
In this context, a solution that implicitly validates this dangerous and destructive myth of shareholder primacy is a solution that just might do more harm than good. A better solution is to explicitly reject the myth altogether, and not just for certain kinds of corporation, but for all corporations.
While this may sound revolutionary, it is not. In fact, the notion of shareholder primacy only gained widespread acceptance in recent decades; it was not always that way.
The corporation as a type of legal entity came into existence as a means of achieving social purposes. The Hudson Bay Company, for example, was chartered in 1670 for the purpose of promoting trade, not for the purpose of enriching shareholders. Early corporations did pay dividends to their shareholders, but that was because investors needed some incentive to invest the capital that corporations needed. The dividend was a means to an end; it was never the primary purpose.
Shareholder primacy as we know it only came into prevalence in the 1980s and 1990s. Milton Friedman, probably its most famous proponent, preached that a narrow focus on maximizing profits would lead to improved corporate performance. And yet, history has shown otherwise. Author and economist James Montier has compared average corporate performance during what he terms the era of managerialism (1940 to 1990 – that is, before shareholder primacy took hold) and the era of shareholder primacy; and he has shown empirically that the single-minded focus on profit in recent decades has led to lower corporate performance. He points to several mechanisms for why this is so, including reduced funding for research and development (because more of a corporation’s profits are paid out to investors), lower employee satisfaction (because compensation is reduced and because their idea of the purpose for why they are there has become confused), and more focus on short-term results rather than long term results (because both corporate lifespans and manager tenures have gone down).
Black Rock, the biggest private asset manager in the world (with over $6 trillion under management), understands this, perhaps better than anyone. Its CEO Larry Fink penned a letter this past January to corporate CEOs explaining that it is time for all companies to make “a positive contribution to society.”
So how do we bring about a repudiation of the myth of shareholder primacy? It would be nice if there was a Supreme Court case confirming that shareholder primacy is not and never was the law of the land. That would lay the matter to rest. But it is unlikely that a case of that sort will work its way through the appellate process and reach the Supreme Court. Another solution would be for state legislatures to amend their corporation laws to explicitly state that managers will not be liable for actions taken in good faith after balancing the interests of all the corporation’s constituencies.
But we should remember that the pickle we are in is not because of bad laws, but because of widespread, albeit mistaken, beliefs about the law. In other words, it is a cultural problem. That being the case, there are ways in which we can all help bring about the demise of the shareholder primacy myth without waiting for any laws to change. We can write about it and speak about it. We can remind corporate managers that they can and should consider the interests of all constituencies. Business owners and managers can ensure that their own businesses adopt a more balanced perspective. We can include an express statement of corporate purpose in charter documents for our legal entities even if they are not formally organized as benefit corporations.
Running a business is never easy, and raising capital is typically even harder – made more so because investors have come to expect that shareholder primacy is the law of the land, and some work hard to insert priority rights to protect the financial investments they manage. While that may lead to quicker short-term profits, it does not lead to a healthy company. Our collective challenge is to help investors and corporate managers to understand that a balance must be struck that honors intellectual capital, human capital, stakeholder capital, and financial capital. When any one of those takes precedence, there are unintended consequences that damage the entire ecosystem of capital.
Circling back to Elizabeth Warren’s Accountable Capitalism Act, I note that it includes some other excellent ideas. For example it would:
Require that at least 40% of the board of directors of these new US corporations be elected by the corporations’ employees – thus putting more control in the hands of those who care most deeply about the corporation’s purpose.
Restrict sales of company stock by its directors and officers for three to five years – which is intended to better align their interests with long-term shareholders rather than short-term shareholders.
Prohibits US corporations from spending any money on lobbying without 75% approval by both its board of directors and its shareholders.
Yet even if the ACA does not actually become law, our hope is that it furthers a very important conversation about the role and purpose of corporations in our economy. We can no longer take bad ideas for granted as simply the way things should be. We need to envision a better way.
Naturally, nothing here should be considered legal, investment, or tax advice. If you would like to like to discuss capital raising or entity structuring with one of us at Cutting Edge Capital, click here