Pathways to Patient Capital: Impact Note

This guide is part of the Urban Manufacturing Alliance’s (UMA) Pathways to Patient Capital initiative. Black, Indigenous, and People of Color makers and manufacturers face barriers to effectively financing their business’ growth.

These Action Guides provide actionable steps that community-based lenders and individuals can take to provide non-extractive capital to makers and manufacturers of color.

The Urban Manufacturing Alliance is a national coalition of organizations and individuals that are building manufacturing economies fit for the 21st century. Our collective goal is to create pathways to middle-class jobs, spark homegrown innovation, and ensure that cities and towns continue to be the places where we make things.

UMA’s Pathways to Patient Capital initiative uplifts how policy and practice-based change with community-based lenders can move quality capital into the hands of makers and manufacturers of color. This Impact Note Action Guide is specifically for innovative Community Development Financial Institutions (CDFIs) and other community-lending practitioners who have a dual commitment to racial equity and financially supporting manufacturing businesses – beyond traditional lending (debt) products. 

According to the U.S. Census Bureau, 90% of manufacturing firms are white-owned, 4.6% are owned by Hispanics, 4.5% by Asians, and less than 1% are Black-owned. Black-owned manufacturing firms are more likely to be new (less than three years old) and less likely to meet traditional lending criteria. Therefore, presumably there is demand in your market for this type of investment. If your lending institution has the flexibility with existing funds to launch this type of program, we invite you to consider using this impact-driven method to specifically build support for BIPOC makers and manufacturers, as this program effectively subverts systematic barriers.

In this Action Guide we focus on equity investments – specifically ICA’s Impact Note – which allow lenders to (1) participate in the long-term growth of a company via an equity stake, (2) maintain the option to be repaid after a predetermined holding period, and (3) align on community-impact incentives. These allow the borrowing company to regain a portion of the equity when specific impact milestones are achieved. While there are similarities to typical venture capital investments (discount, valuation cap, higher amount of investment), the investment terms and the impact milestones are co-developed and support the sustainable growth of a business while keeping the company control in the hands of the owner.

“I’m not anti-VC, I’m pro-revenue.”

-Deldelp Medina. Executive Director of Black & Brown Founders

What is it?

Convertible notes (or convertible bonds) are hybrid securities with both debt- and equity-like features. The convertible noteholders receive the stated coupon and principal, as well as the option to convert the notes into shares of stock over time. This product also allows the company and the investor the opportunity to co-develop milestones which trigger further investment and/or conversion.

Why is this Important?

For an early-stage business to grow quickly, debt financing is often not the right type of capital, or it’s unavailable altogether. Debt financing requires short-term payments, which takes funds out of a company instead of reinvesting in its immediate growth needs. Patient capital like the ICA Impact Note allows companies to reinvest cash-flow back into its growth while aligning its use of capital with the investor. The Impact Note also includes co-developed impact milestones – the investor returns equity ownership back to the company as these milestones are achieved.

Who is doing this well?

“One of the biggest detriments to capitalism is short-term thinking. As responsible stewards of capital, we must find a way to invest with longer time horizons while keeping all stakeholders in mind. The ICA Impact Note is a tool for investors who are seeking to align their financial and societal vision with their portfolio companies and are willing to be patient to see the results.” – Yui Ueno, Senior Director of Investment

ICA

ICA is an Oakland-based Community Development Financial Institution (CDFI) dedicated to partnering with, advising, and investing in overlooked and under-resourced Bay Area entrepreneurs. ICA has 25 years of experience supporting small businesses to scale their operations and access the capital they need to strategically grow. Their mission seeks to close the racial and gender wealth gaps, and every investment is structured to deliver social returns for the community. Presently, they do this work through education offerings, advising, and direct investment. As a non-profit, their work focuses on creating wealth-building opportunities for underrepresented entrepreneurs and their employees through the growth of company valuations, profit-sharing, employee ownership, and improved benefit programs.

ICA’s newest investment vehicle, the ICA Impact Note, is an innovative structure that incentivizes social impact milestones–like employee equity ownership–as they grow their businesses. There are five milestones in the Impact Note, tailored for each company depending on its focus and stage of growth which includes job creation, health and retirement benefits, equity ownership for workers, profit distribution, and diversity. 

Many founders set out with a vision to create change in their community through their business, but may feel pressure to shift their focus while growing and fundraising in a competitive landscape. When a company receives investment through the ICA Impact Note, the business defines the measurable social impact they want to create. As companies meet these impact milestones, the investor returns equity ownership back to the company by increasing the valuation cap or discount used when the note converts into equity. The value returned to the company can range in the hundreds-of-thousands of dollars depending on the size of the company.

Fund size:
$10 million dollars in investment capital with the goal of raising and deploying another $25 million in the next five years.

Investment Channels:
There are two investment channels: Growth Fund (larger companies and larger investment amounts ranging from $200,000 to $1 million) and Seed Capital (smaller companies with $50,000 maximum investment). The Growth Fund is mostly for companies that graduate from ICA’s main accelerator program (the amount depends on company need), and the Seed Capital is currently only for companies that go through ICA’s early stage accelerator program (the “Lab”).

Investment evaluation:
ICA mitigates risk by providing technical assistance through its accelerator programs and developing deep relationships over multiple months or even years before making an investment. In addition to programming, ICA performs a robust due diligence process. Investments are made in companies that have a high potential to become both financially sustainable and generate lasting social impact via job creation and wealth generation for the employees.

Mechanics of the Impact Note:
The incentive structure adjusts the valuation cap and discount instead of using an interest rate. A 25% to 50% increase in the change to the valuation cap can result in a significant amount of equity retained by the company. As each of these impact milestones are met, the valuation cap and discount are adjusted by a predetermined amount, shifting financial returns for the investor into social returns for the community. The amount to be adjusted per milestone is negotiated on a deal-by-deal basis.

Seed stage equity investments are projected to have a seven-10 year waiting period before the investor sees a liquidity event (or “exit”), in other words, any cash return. An exit could be through an acquisition, merger, or IPO of the company. Many impact lenders and investors have experimented with ways to generate earlier liquidity for investors, such as revenue-share payments or interest payments before conversion. These solutions generate cash for investors, but reduce operating margins for the entrepreneur and take valuable growth capital out of the company at an early stage—when cash is needed most.

The call option in the Impact Note was added to address this liquidity issue for investors while still maintaining the equity upside over the long-term. The call option is exercisable any time after a predetermined holding period (at least five years for ICA), whereby the principal value is repaid at no premium over a predetermined number of months (24 months for ICA). Companies will be given plenty of time ahead of any intention on executing the call option.

Compared to traditional convertible notes, this liquidity option is more patient, predictable, and transparent for founders:

• Patient: Option is only exercisable after a predetermined holding period
• Predictable: Longer repayment period (no balloon payment)
• Transparent: Terms are negotiated ahead of time and clearly outlined in the Note

By giving investors an option for liquidity, the ICA Impact Note provides mission-focused investors with much-needed flexibility. The Impact Note is designed to convert into a long-term equity investment, with the goal of reaching a more traditional liquidity event that generates a multiple on the initial investment, in addition to generating outside social return on investment.

“The objective of the call option is not to generate returns on capital—there is no interest rate or premium—but to provide investors the ability to mitigate risk on the initially invested capital. This allows investors to deploy capital in early-stage companies where the exit risk is typically deemed too high. This means funds like ICA can keep investing in small businesses that are typically overlooked by conventional financing sources, and allow underrepresented, undercapitalized founders in Oakland and the Bay Area to grow and flourish.” – John Gough, Chief Investment Officer

ICA’s Impact Note is available for use across the investing landscape, and is designed to be fully customizable for varied social impact goals and expected financial returns. The Impact Note allows users to adjust all quantitative aspects of financial and impact metrics to meet their preferred criteria including:

• Valuation cap
• Discount
• Period of time before call option may be executed
• Period of time of amortization in the event call option is executed
• Incentive structure based on social impact
• Social impact metrics (e.g. number of jobs, % of profits to be shared with employees, diversity of management/board metrics, etc.)

If you are inspired to develop convertible programming for your community lending enterprise, here are the steps to take: