Put It In Writing: Contracting Norms In Impact Investments

How do impact investors document their intended impact? How do companies put impact into written contracts? In a collaborative project with Penn Law’s Entrepreneurship Legal Clinic, we set out to build evidence around these questions. Our research team, consisting of Dr. David Musto and Dr. Chris Geczy of Wharton, Dr. Jessica Jeffers at the University of Chicago, Booth School of Business, and Anne Tucker, Georgia State University College of Law, are studying impact targets, legal structures, and performance of private equity funds with a social or environmental mission.

Starting last fall, four Penn Law students also supported this work through the Social Impact Fellowship. All week we’ve published a series of blog posts from those students, reflecting on their experience and what they’ve learned thus far. In today’s piece, Anne Tucker shares insights about the exciting study.

“Put it in writing” is common business advice. It speaks to framing expectations and accountability.

Fund and portfolio company level contracts form the backbone of impact investment deals. What goes into an impact investment deal?  First, a manager forms an impact fund and writes a prospectus—which is half invitation to invest money in the fund and half explanation of why you should invest in the fund and what risks you face if you do.

Interested investors review the prospectus and, if persuaded, sign an agreement investing their money in the impact fund, subject to the terms and conditions stated in the agreement. If enough investors do the same, the manager has raised an impact fund. Now it is time to invest the money in social enterprise companies by building a pipeline of possible portfolio companies. The impact fund and portfolio companies negotiate investment terms and sign a contract.

To collect our data, we read impact investment contracts—at the fund and portfolio company levels—and note the presence (or absence) of standard private equity and venture capital contracting terms. We also note contract provisions unique to impact deals, such as impact measurements.  We further analyze the flagged provisions to understand the beginning, middle and end of an impact contract (whether at the fund or portfolio company level). We review terms like voting rights, ownership percentages, financial rights, fiduciary duties, etc. to understand how the parties’ structured their relationship at the outset of the investment.  We also observe what rights or obligations the parties have regarding ongoing information, monitoring, operational control rights and opportunities for contract renegotiation. The last terms bucket describes the parties’ right when the contract is ending and include investment exit and sale rights, contract termination, and breach rights.

With this data, we explore two simple questions:  how are impact deals similar in structure to traditional private equity/venture capital (pe/vc), and how are they different?

Investigating the difference reveals how parties put impact in writing—how purpose gets baked into a deal.  Demonstrating impact integration and enforceability addresses a common skepticism in impact investment, namely are impact investments really different or is it just “greenwashing”? Investigating the similarities sheds light on another common question, are impact investments a good investment, meaning will they earn a competitive return?

The legal documents that create an impact fund—the prospectus, the investment agreement or operating agreement—should protect both profit and purpose. We are specifically interested in the tension or complimentary relationship between contracting for profit and purpose, or at least how inserting a second objective changes contracting dynamics. For example, the fund manager wants to ensure that it has latitude to invest in social enterprise and won’t face investor ire for not investing in oil or pharmaceutical companies. Investors want these provisions too as assurance against greenwashing or being bamboozled by a wayward manager. Impact funds also seek to earn a return for investors, so traditional payment terms like drawdowns, waterfall compensation, carried interest, and liquidation priorities validate the investment (money) side of impact investing.

Investment agreements between the fund and portfolio companies also protect profit and purpose and raise similar questions of balance. The impact fund, as the investor, wants to promote the company’s impact so it may negotiate for impact measurements and operational monitoring rights through veto rights or board representation. The fund also hopes to make money when it exits the portfolio company and may do this by negotiating how and when the fund can sell its investment 5-7 years down the road. The social enterprise wants funding so it can operate, grow, and run the impact-generating business. The portfolio company may negotiate for terms that protect its ability to pursue impact along with profit. It may also want to preserve the managerial influence of the company founders.

Our data demonstrates the delicate balancing act between contracting for profit and contracting for purpose. After our initial review, we can identify ways in which impact agreements mirror PE/VC, and ways in which they deviate.

Our next publication will fully explore these similarities and differences, drawing upon prior PE/VC finance literature as a comparison. We are also working on modeling our evolving theory of impact contracting, informed by our research. The growing WSII database will be a knowledge hub of impact investing and social enterprise serving as a resource for academics, impact investment funds, foundations, and impact-motivated investors.

Download a Report of All Of Our Research Insights From This Series

Anne Tucker is an Associate Professor of Law at Georgia State University College of Law.  Professor Tucker works with WSII fellows and researchers to build the contract terms database. In Pursuit of Good and Gold: Data Observations of Employee Ownership & Impact Investment, 40 Seattle U.L. Rev. 1 (2017) (with Chris Geczy, David Musto, & Jessica Jeffers) is our first publication examining impact investment contract terms.