If you tuned into KALX, Berkeley’s 90.7 FM station, at noon today, chances are you heard Cutting Edge Capital’s Vice President Brian Beckon compellingly break down community capital on Method to the Madness with Lisa Kiefer, a weekly show that showcases the innovative spirit of the Bay Area. Click play below to learn more about the world of community capital.
I was recently at Women and the Environment, an amazing conference in Santa Barbara hosted by Pacific Standard Magazine and the awesome folks at LoaCom. I was fortunate to attend, speak, and hear about the great work being done, and the great work still to do, on environmental and social justice issues, much of which is being led by women. I addressed the conference participants along with Tracy Gray of 22 Group and LA Cleantech Incubator, Shally Shankar of The Schmidt Family Foundation, and Sharyn Main of the Santa Barbara Foundation on capital financing options.
Often at conferences I talk about the different ways to utilize community to raise capital. But this time I wanted to focus on how community capital strategies are part of social and environmental justice solutions and to discuss why who is allowed to invest matters. In other words, I wanted to discuss why the impact of community capital is about much more than just the money. Here are my notes from my remarks at the conference:
We at Cutting Edge Capital like to call our solutions “community capital” strategies. What are community capital strategies? Investment offerings that are open to both high net worth individuals and institutions, and to community (non-accredited or retail) investors.
The current model for capital raising, even in many social and environmental justice enterprises, is to reach out to the wealthiest accredited investors in our networks when capital is needed. That model is not wrong, but choosing only that approach means that enterprises are missing the opportunity to engage all supporters (regardless of their wealth) and missing out on the impacts that flow from doing so.
Community capital strategies democratize our economy in a variety of ways. Here are some of the impacts community capital offerings can have on investors, enterprises, and the broader community:
Community Investors. Community capital offerings allow everyone to invest in alignment with their values. Currently, non-accredited or community investors are not permitted to invest in most private enterprises, including social and environmental impact companies. Most people are limited to putting investment dollars into Wall Street offerings: publicly traded stocks, mutual funds, and money market accounts. Offerings that are open to community allow those members to invest in businesses, cooperatives, nonprofits or other enterprises that offer innovative solutions, are committed to good environmental practices, and/or are supporting social justice missions. It is the practice of so many impact organizations to reach out to community to help shape their missions and the foci of their work. We need to ask ourselves: why do we leave those community members out of the investment opportunity when it is time to implement the ideas the community helps define?
Entrepreneurs/Enterprises. How do we increase equity and access to capital for women and people of color? This is a question we in the impact capital space have been trying address from the start. To date, much of the focus has been on getting more women and people of color in front of existing traditional, institutional, and accredited sources of capital. However, community capital is an alternative to traditional capital that can organically level the playing field. When a broader segment of community is invited to invest, those investors will be more diverse than most existing high net worth investors and funding institutions. Entrepreneurs that receive funding will likely reflect the community that is investing in them. Community members will choose entrepreneurs that speak their language (literally and figuratively), echo their values, and are committed to impacts that solve problems in their community. In other words, if more women and people of color are investing, more women and people of color are likely to receive funding.
Community. When community members invest in local businesses those enterprises can use that capital to thrive and grow — creating jobs and a more vibrant local economy. Any returns generated by those businesses go back to local investors. This creates a cycle of community investment, impact, wealth creation and (hopefully) community reinvestment. The process is one of reinvestment and does not extract resources out of the local economy.
So, how do we do we achieve this? Investors (both accredited and community) need to search out and ask that investment offerings be open to community investors. Enterprises and entrepreneurs (and supporting organizations) need to explore how to make investment opportunities open to community investors.
There are a number of tools that Cutting Edge Capital has identified (as offered in our community capital toolkit) that work for enterprises at various stages of growth including: Direct Public Offerings, Regulation A+ Offerings, Regulation Crowdfunding, and Community Investment Funds. We are happy to talk about how your business or enterprise can use these tools. Click here to set up a free consultation.
There has been a lot of controversy lately surrounding Title III platforms that has been giving crowdfunding a bad name. To offer some clarity, it is helpful to understand the difference between crowdfunding, the JOBS Act, and Direct Public Offerings.
The Jumpstart Our Business Startups (JOBS) Act, was initially signed into law on April 5, 2012. Though many identify the JOBS act with crowdfunding, crowdfunding accounts for certain sections of the Act contained in what is known as Title III. Title III permits entrepreneurs to solicit up to $1M of investment capital for their small business as long as all transactions were conducted through a registered crowdfunding online platform, but with no regulatory review.
Crowdfund Capital Advisors reported that by the end of 2016, 21 crowdfunding portals launched a total of 186 campaigns. Of these 186 ventures, 105 closed, with 49.52% of these campaigns hitting their minimum funding targets. Collectively, these 52 ventures were able to raise a total of $13,115,477. Meanwhile, surveys have found that many Title III offerings have failed to comply with the SEC’s disclosure requirements Given the low success rates and spotty compliance of Title III crowdfunding offerings thus far, the term “crowdfunding” is getting a bad reputation in the investment community.
And yet, investment crowdfunding as a democratic way to raise capital is much broader than Title III of the JOBS Act, which have been around for decades.
One key advantage of DPOs compared to Title III crowdfunding is that DPOs are reviewed by securities regulators, which reduces the risk of fraud or noncompliance and therefore allows investors to invest with more confidence. Most DPOs rely on one of two strategies known as the intrastate strategy or Rule 504. Recently, as discussed in Brian Beckon’s blog post, the SEC revised some of its rules in order to make DPOs easier. For example, Rule 504, which allows for a raise from multiple states, were previously limited to $1 million per year. The SEC increased that limit to $5 million (effective January 20, 2017) to facilitate regional offerings.
Additionally, as an added protection to investors, updates to Rule 504 include “bad actor” disqualifications. These will prevent any person charged with fraud or persons linked with other criminal activity from soliciting investment using this rule. This bodes well for the future of investment crowdfunding via DPOs, even as Title III platforms are facing challenges.
Community capital is about empowerment of communities. It is a set of strategies that allows ventures to raise capital from their ideal investors within their own community, allows anyone of virtually any economic class to invest in their community, and allows communities to build wealth though a cycle of investment, growth, profit, and reinvestment. As I wrote in a separate post, Community capital can be raised directly through direct public offerings (DPOs) and Title III exempt crowdfunding, or indirectly through community investment funds (CIFs). Of these, CIFs have several significant advantages: scalability, efficiency, diversification, and opportunity for liquidity.
With this much going for them, one may wonder why CIFs are not far more common than they are. One would think that every community should have a least one CIF. Yet most do not – at least not yet. Setting aside cultural factors that I noted in my previous post, the other key reason for their scarcity is the regulatory environment. A CIF must navigate through two layers of securities law. The first, and more commonly understood, are the laws that regulate the offering of an investment to the community. This is regulated at the federal level by the Securities Act of 1933 and by each state’s securities laws. In essence, a CIF must do its own DPO to raise investment. While this must be done carefully, it is not so burdensome as to prevent CIFs from flourishing.
But there is a second layer of securities law that is unique to investment funds and presents another challenge. The Investment Company Act of 1940 (the 1940 Act) imposes burdensome regulations on an entity that raises money from investors and then invests that money in other companies. This is the law that regulates mutual funds, and the compliance costs are well into the six and seven figure range for funds of that type. Among other requirements, such a fund must conduct a full registration under the 1933 Act.
However, the 1940 Act also includes a number of exemptions. And that is where the opportunities lie for a small CIF that cannot afford 1940 Act compliance. With all that in mind, the following are four models for a CIF that can raise capital from its community without running afoul of the 1940 Act:
Charitable Loan Fund
The simplest (and by far the most common) type of CIF is the charitable loan fund. This is because the two key federal securities laws noted above (the 1933 Securities Act and the 1940 Investment Company Act) both have a blanket exemption for charitable organizations. To be clear, this does not work for other types of nonprofits, such as cooperatives and mutual benefit corporations. The entity must be truly charitable—basically a 501(c)(3) organization. Most states also have an exemption from securities offering registration for charitable organizations, though a few do not, including California.
With those exemptions, it can be relatively straightforward to set up a charitable loan fund – with good legal guidance, of course. It is still a securities offering, which requires comprehensive disclosure of all material facts, risk factors, state level review (in some states), and so on.
There are two key limitations of this model. First, the assets of a charitable organization may only be used for charitable purposes. And charitable is not the same as socially beneficial. While an analysis of what makes a loan charitable is beyond our scope here, let it suffice to say that a charitable organization needs to be careful, so as to avoid jeopardizing its charitable status.
A second limitation of a charitable loan fund is that it can only raise debt investment, not equity, because no one can own a charitable organization. Moreover, a charitable organization is forbidden from sharing profits with investors. And while a charitable fund could in theory raise debt investment and deploy it in equity investments in other local business, that kind of leveraged equity investment is considered too risky and therefore an unwise strategy. So, charitable funds generally only make outgoing loans with little or no opportunity for capital appreciation. Then, after subtracting a spread to cover its operating costs, the fund typically pays its investors a fairly low interest rate, again with no opportunity for capital appreciation.
And yet, the charitable loan fund is a very effective model for community investment and there are many success stories. Here are a few charitable loan funds that appear on CuttingEdgeX.com, along with their funding focus:
- Our Katahdin: Economic development in the Katahdin region of Maine
- PV Grows Investment Fund: Sustainable agriculture and food businesses in western Massachusetts
- EDFC: Economic development in Mendocino and Lake counties in California
- Northern California Community Loan Fund: Mission-driven enterprises northward from California’s central valley
- RSF Social Investment Fund: Social impact investments throughout the US
Real Estate Fund
The purchase by a fund of real estate is most likely not a securities transaction at all; and even if it is, the 1940 Act provides an exemption for funds that invest in real estate. Therefore, a real estate CIF need not be concerned about 1940 Act compliance. On the other hand, there is no exemption from the other federal or state securities laws for a real estate fund, so a true real estate CIF typically must raise capital via a state-registered DPO.
A real estate CIF can be a powerful tool for urban or rural revitalization. The concept is simple: The community invests in a fund that acquires, renovates and leases out properties that have become blighted. A portion of the profits may be reinvested in further revitalization, but any remaining profits are distributed to investors. As a result:
- New businesses are attracted to newly renovated properties;
- Property values rise as blight is eliminated;
- Safety improves, as more workers and customers generate more foot traffic;
- City tax revenues rise as all those people spend more money locally;
- Local investors share in the profits of the business and reinvest in the community.
While there are, of course, many real estate funds, it is still rare to find one that is open to community investment (that is, including non-wealthy investors). One example that we love is Fulton Street Investors, a real estate CIF in Fresno, California. Their vision is the revitalization of Fresno’s downtown core – an area that has suffered economically since the 1970s. With help from Cutting Edge Capital, they have launched an intrastate DPO, which means that it is open to investment by any California resident – though they intend to specifically target Fresno area investors. And like any DPO, it is open to the wealthy and non-wealthy alike. They will utilize the funds raised in the DPO to purchase, renovate and lease properties along the Fulton Street corridor in downtown Fresno.
We believe this model has enormous potential, and we hope it will be replicated in every city in need of urban revitalization, as well as in rural areas that could benefit by allowing the community to invest and participate in its own rehabilitation.
Diversified Business Fund
There is no general exemption from the 1940 Act for funds that make equity investments in other companies. To be sure, many modestly-sized funds do invest in other businesses: hedge funds, private equity funds, and the like. What those all have in common is that none of them is open to non-wealthy investors. In other words, they are not community investment funds.
But there is a way to build a true community investment fund that can invest in equity positions in other companies (along with other types of investments) and share profits with its investors. This model begins with Section 3(a)(1) of the 1940 Act, which excludes from the 1940 Act’s coverage any fund that is not primarily in the business of investing in securities, and where investment securities comprise less than 40% of the fund’s total assets. As we’ll discuss further below, this type of fund will necessarily be fairly diversified; hence we have called it the “diversified business fund.”
The first requirement is that the fund is primarily in some other business besides investing. In other words, the fund’s investing activities must be supplemental to another primary purpose. There is a lot of flexibility in the kind of primary business that would support this type of fund, but three business types that would work particularly well are a start-up incubator, a business accelerator, and a co-working facility – or some combination of those. The fund could also be in the primary business of providing education or other services.
Note that for any fund concerned about ambiguity over how the SEC would view its primary business, there is a procedure in section 3(b)(2) of the 1940 Act for seeking an SEC ruling that the fund is primarily in the business of something other than investing in securities.
The second requirement of this model is that no more than 40% of the entity’s total assets consists of investment securities. Fortunately, there are several types of investments a diversified business CIF can make that are not counted as investment securities for purposes of the 1940 Act. These include:
- Majority-owned subsidiaries: If the fund acquires a majority ownership position in a target company, that won’t count toward the 40%. Note that while such an investment would ordinarily be treated as a “security,” it is specifically excluded from the definition of “investment security” for purposes of the 1940 Act. One challenge here is that the entrepreneur behind a potential target company may (understandably) not want to give up a majority position in their company. That concern can be addressed through two sub-strategies. First, the equity structure of the target company can be designed to ensure the entrepreneur has majority voting power even with a minority ownership position. The second is that the investment can be coupled with a redemption right giving the entrepreneur the right to re-acquire a majority position at some time in the future.
- Real estate: As long as it is directly held by the fund, real estate is not a security at all, as noted earlier. A syndication interest, or an interest in a real estate partnership would likely be an investment security. But real estate that the fund owns for its own use or to lease to others would not be.
- Secured loans: For purposes of the federal securities laws, not every loan is a security. Where a loan is privately negotiated between lender and borrower, is not offered broadly to potential lenders, and is secured by assets, it will probably not be deemed a security at all, so it will not count toward the 40% threshold.
- Non-securities assets: The fund may also invest in equipment and other assets that are not securities.
So, as long as at least 60% of the entity’s total assets comprise these types of assets that are not counted as “investment securities,” the diversified business CIF will meet the second requirement. The remaining 40% or less can be any other type of investment, including minority positions in portfolio companies, as well as publicly-traded stocks, bonds and other investment securities. From an investor’s point of view, one key advantage of the diversification inherent in this model is that it may very well reduce the fund’s risk and make it a more attractive investment.
We note that this is the same exemption relied upon by Warren Buffet’s Berkshire Hathaway (which typically acquires majority positions in its portfolio companies); but here it’s applied on a community scale and not limited to wealthy investors. We also note that while business accelerators and other similar organizations in the US have often provided funding to their clients, to our knowledge none of them has yet done so using community capital. Therefore, the model as described here has not yet been utilized as of this writing, though CEC is in discussions with several organizations who are interested in the model.
Registered 1940 Act Fund / Business Development Company
We now come to the fourth model: A CIF could embrace, rather than avoid, the 1940 Act. While this strategy will clearly be out of reach for a small fund for cost reasons, it may be that a true community investment fund targeting a larger metropolitan area could achieve the scale necessary for full compliance with the 1940 Act to become cost-effective.
We won’t dwell on this model, except to point out that Calvert Foundation, through an affiliate, has offered a menu of Calvert mutual funds for several years. While they don’t have a specific geographic focus, they do have a strong social mission, and their success suggests strong potential for this model to serve large communities.
An interesting variation on the fully registered 1940 Act fund is the business development company (BDC), a type of investment fund that provides managerial assistance to its portfolio companies. While this model is technically an exemption from the 1940 Act, the BDC is exempt from only some of its more burdensome requirements. It must still register its offering with the SEC under the 1933 Act. And yet, a BDC with a state or regional focus could make financial sense. We will be observing a few BDCs (such as Hill Capital in Minnesota) with an eye toward the potential use of this model as a true community investment fund.
Other Possible Strategies
There are a number of other exemptions from the burdensome requirements of the 1940 Investment Company Act, each with its own limitations. At Cutting Edge Capital we will continue to explore alternative strategies that may work for community investing. Here are some possibilities:
- An intrastate fund: The 1940 Act includes an exemption for a fund of up to $10 million where all investors reside in the same state where the fund is based. While this sounds promising, it has two key limitations: First, it must be a “closed-end fund”—meaning that the fund has a specified life (say, 7 years); investors come in at one time and are cashed out at the end of the fund, with little opportunity to come in and out of the fund during its life. Second, this is not a self-executing exemption; rather, the fund would need to request an exemptive order from the SEC, and the SEC would have the power to impose any requirements they believe are needed to protect investors. This exemption has rarely, if ever, been used.
- Microloan fund: An exemption is available for a fund that makes “small loans”—a term that appears to be interpreted by the SEC to mean personal and consumer loans, not business loans. One possible example: A solar fund could use this strategy to make loans to homeowners to finance rooftop solar installations.
- Manufacturer/seller loan fund: Another exemption covers a fund in the business of lending to manufacturers and sellers of merchandise or services.
Finally, we should mention one more strategy that may not be a true CIF, exactly, but might be used to achieve a similar result: the investment club. This is where a group of investors pool their resources into a single entity (typically a limited liability company) to make investments. As long as every member of the club is actively engaged in the management of the club (i.e. votes on investment decisions, etc.), the club will not be deemed to issue securities to its investor/members, and therefore it will not be subject to the 1940 Act. Because of the requirement that every member of the club be actively engaged in management, it usually works best for smaller groups of investors; but it can be open to anyone, wealthy or not.
All of the Above
Of the models described above, there is no “best” model. At Cutting Edge Capital we envision a more localized economy in which every community is served by a constellation of community investment funds of various types, each of which responds to a need in the community. For example, a real estate fund could build workforce housing, if housing is in short supply; a charitable loan fund could lend to agricultural and food-related businesses; and a diversified business fund could invest in homegrown tech start-ups.
Together with DPOs by local ventures, these CIFs would contribute to a vibrant community capital market in which everyone can participate on a level playing field, and help build a more equitable and prosperous community.
Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to schedule a consultation, please visit www.cuttingedgecapital.com or email us at email@example.com.
There’s a refrain we’ve been hearing recently at gatherings of community organizers: “Nothing about us without us is for us.”
While these words echo a centuries-old Latin slogan (“nihil de nobis, sine nobis“), they reflect a profound truth as relevant today as it has ever been. Their meaning is something like this: “Don’t try to solve our community’s problems for us. We understand our problems and their solutions better than anyone. We simply lack the resources and tools to solve our problems. You can help us by providing those resources and tools.”
The distinction is subtle, yet critically important. It’s about community empowerment.
In the world of impact investing, wealthy (yet conscientious) investors and institutions seek to invest in ways that help to improve the plight of others, typically while still making a good return on their investment.
And while this type of impact investment is certainly a good thing, the “impact” too often addresses the effects of underlying systemic problems without addressing the underlying problems in any meaningful way. By continuing to concentrate wealth (and reinforce the class distinctions between the haves and the have-nots), this type of impact investing could even exacerbate the very problems they seek to remedy.
The Community Capital Solution
What if there was a type of impact investing that had the power to solve some of the underlying systemic problems and bring about positive improvements in the economic structure of our economy? As my partner John Katovich explained in a Huffington Post blog, investing in institutions of community capital does precisely this. Community capital refers to community-focused investment opportunities that are open to the public, including both wealthy and non-wealthy investors; in other words, everyone can participate in community capital.
Why is this so important? It’s because most investment opportunities are available only to the wealthy, and investment opportunities beget more opportunities, and so on. The non-wealthy have very few options, and those few options typically pay a much lower rate of return than that earned by wealthy investors. But community capital is much more than just a way for a venture to expand its pool of potential investors. It is part of a revolutionary change in the structure of the local economy, because:
- It allows ventures to raise capital from their own community, rather than putting their fate in the hands of the wealthy institutions and investors who currently control the economy.
- It allows everyone everywhere to invest in their local community, in local ventures, in something that’s meaningful to them.
- When the community invests in local ventures, those ventures grow, hire local workers, generate profits locally, and pay those profits to community investors who can then reinvest. It’s a cycle that allows the community – any community – to build wealth.
- With broadly shared ownership and participation, the community can now channel resources to where they are most needed. The community is empowered to solve its problems, leveraging the abilities and experience of all its constituents.
Community capital might be thought of as a separate asset class and an essential component of any investment portfolio, because it serves as a counter-balance to the global gyrations of the Wall Street-dominated economy while contributing to a healthier local economy.
Note that while we mainly use the term “community” in the sense of a geographically defined area, it could also be a dispersed community based around a common affinity or goal, such as renewable energy, biodynamic agriculture, or arts education.
What are the mechanisms for raising community capital? In general, a venture (nonprofit or for-profit) can raise capital from their community either directly or indirectly. The direct approach is sometimes referred to as investment crowdfunding, a term that includes both direct public offerings (DPOs) and Title III exempt crowdfunding. The indirect approach to community capital is where a community investment fund (CIF) aggregates investment from the community and then invests in local ventures. (See our separate post on several models of legally compliant community investment funds, including the charitable loan fund, the real estate fund, and the diversified business fund.)
While Cutting Edge Capital is best known for our work with DPOs, we also work with a number of CIFs, and we believe that a healthy local economy will feature a thriving mix of both. A CIF can be a particularly important component of a healthy local economy for four key reasons: Scale, efficiency, diversification, and liquidity.
- A CIF can be more scalable because it can potentially raise an unlimited amount of money and finance an unlimited number of local ventures. Note that we don’t use “scale” in the Wall Street sense of bigger transactions. In a CIF, the transactions should always be at a human scale, but we need a lot more of them to truly change the economy and to create a culture of community investment.
- A CIF can be more efficient because each investor only needs to do due diligence once on the fund, and then the fund handles due diligence on outgoing investments.
- A CIF is more diversified when compared to having each investor invest in one or a small number of local ventures.
- A CIF may be in a better position than individual ventures to offer its investors liquidity (i.e., a way to sell the investment). A CIF can be set up to redeem investors who need to exit the investment.
Community investment funds and individual DPOs (or other types of investment crowdfunding) are not mutually exclusive, and there will always be a need for DPOs, particularly for ventures who prefer a direct connection with investors. Indeed, CIFs could play an important role for organizations conducting a DPO by:
- Making a small short-term loan to cover the costs of a DPO.
- Lending to the business on the strength of the equity raised in the DPO.
- Providing a sounding board to the venture on pricing and other terms of their DPO.
- Investing in the DPO early to seed it and inspire others to follow.
- Investing late in the DPO process to backstop it and ensure its success.
- Providing liquidity to DPO investors by purchasing their investment if they need an exit.
A Problem of Culture
Even though the mechanisms to raise community capital are available, they are not commonly used. Cutting Edge Capital has specialized in DPOs for years, and we have helped build several successful community investment funds. And yet, these are the proverbial drop in the bucket compared to what is needed to significantly move the needle toward a more equitable and democratic economy.
What is standing in our way? In short, the problem is that in the US we lack a culture of community capital. Most investors (both wealthy and non-wealthy) are unfamiliar with DPOs and other legal strategies of community capital. Unfortunately, so are most investment professionals and lawyers. (After all, they don’t teach these strategies in graduate school.) This unfamiliarity breeds skepticism, which is probably the biggest barrier to widespread adoption of the strategies of community capital. And making matters worse, the non-wealthy (those who don’t meet the SEC’s definition of “accredited investor”) have been trained for decades to see themselves as unqualified to invest.
This is where visionaries, philanthropists and impact investors can make a big difference. To change the culture so that community capital is as ubiquitous as a corner convenience store, we need visionaries and thought leaders to help educate their communities about the game-changing potential of community capital. We need philanthropists to donate to nonprofit organizations who are seeking to promote community capital in their local areas. We need investors who will invest in the structures of community capital (for example, as founders of community investment funds), as well as investing alongside community investors to give credibility, strength and momentum to this revolution. And, of course, we need innovative leaders to make it happen.
Together, we can build an economy in which every community is served by a constellation of community investment funds of various types, along with DPOs by local ventures, which together contribute to a vibrant community capital marketplace in which all can participate on a level playing field, and together build a more equitable, prosperous, and empowered community. In other words, this is the ultimate impact investment.
Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to set up a consultation, please visit www.cuttingedgecapital.com or email us at firstname.lastname@example.org.