Corporate governance is the framework of rules and practices by which a board of directors ensures accountability, fairness, and transparency in a company’s relationships with all stakeholders (financiers, customers, management, employees, government, and the community.
Corporate governance framework consists of (i) explicit and implicit contracts between the company and the stakeholders for distribution of responsibilities, rights, and rewards; (ii) procedures for reconciling conflicting interest of stakeholders in accordance with their duties, privileges, and roles; and (iii) procedures for proper supervision, control, and information-flows to serve as a system of checks and balances (business dictionary).
Why Sound Corporate Governance Matters
It is important for an entity to have robust corporate governance because it is a risk management tool. It gives all stakeholders some comfort that, at some future date, if or when stakeholder interests diverge, stakeholders will continue to be accountable to each other to the extent spelled out in the governance framework.
Corporate governance frameworks are more important for impact or social ventures as it is usually in the governance framework that impact objectives and expectations are spelled out. Impact entrepreneurs spell out their values or define their mission and investors who are aligned with those values can show their support through financial investment.
Entrepreneur View
Sound corporate governance can assist founders and management in attracting the “right type” of capital for their ventures. For social entrepreneurs who care about bringing in capital from investors who share similar values or care about impact outcomes, outlining expectations is critical to preserving those values over time.
Investor View
Investors generally like well-structured corporate governance frameworks because they are one component of risk mitigation tools. In traditional investments, investor risks are mostly financial and reputational. In impact investing, investor risks include, financial, reputational, and values alignment. A framework that defines the enterprise mission as well as how such mission will be protected over time can influence an investors investment decision.
Governance Elements
Mission related governance provisions can be included in a company’s formation or charter documents. Before registering a company, a social entrepreneur should develop a solid business plan that includes the following: (i) clear definition of the product or service as well as the company’s social objectives, (ii) the strategy for meeting financial and social goals, and (iii) the process for measuring both business and social success. This is critical because in some countries where profit with purpose business (“PPB”) forms are available, a decision can be made to register as a PPB . In countries without PPB business forms, a social entrepreneur can include provisions in the company’s charter as well as be smart about the types of investors to target. Additionally, entrepreneurs and investors can agree on the minimum Standards of Business or Ethical Practices and elect to include Corporate Citizenship Policies in the investment documents.
In countries where the potential of the company Board of Directors being sued is a real, it is possible to include mission as part of the company’s “Best Interest Statement” or the company’s “Statement of Corporate Purpose” .
For example, under US law, corporate directors have a fiduciary duty to make decisions in the “best interests” of the company, which is often interpreted as maximizing shareholder return. Directors are often advised that pursuing mission at the expense of shareholder return risks litigation and perhaps even personal liability. Companies may be able to minimize the risk of director litigation and better protect their mission and values by specifying in the Company’s charter what they want directors to consider in their decision-making. This could mean specifying, for example, that one or more of the following must be considered as part of a “best interests” analysis: the company’s mission; stakeholders other than owners; and ethical or environmental considerations. The parties may also want to explicitly permit the Company to accept lower acquisition offers if the lower offer would better advance the Company’s mission.
In any event, mission-aligned investors generally need assurances regarding mission-related expectations. Such assurances can be in the form of a company’s registration form or provisions in charter documents – for example incorporating as an alternative entity. Clearly defining social or environmental goals in charter documents will align the interests of investors and entrepreneurs, as well as avoid potential misunderstandings over time. Articulating the mission brings a shared understanding of what the mission is and can surface differences in values and priorities between the company and investors early on. If the mission is not spelled out, both parties may mistakenly think they have a shared understanding.
If mission is not captured in formation and charter documents or in Standards of Business frameworks, mission goals can be included in investment term sheet provisions. These provisions can take many forms including:
- formal written language in the investment document – If a business lacks a formal statement of its social and/or environmental mission, or investors want changes in the language of such a statement, requiring the description of the mission, in a formal written agreement side agreement or statement at the term sheet stage may be helpful. [link to legal language]. Drag-Along Rights have been used in the impact context to mandate conversion to an alternative entity after deal closing. This can be in a situation where there is no time for going through the alternative incorporation process or when an entity’s management wants to defer the decision until after they have closed the deal (link to language).
- use of investment proceeds provision – when the company and investors agree that the investment serves a defined social or environmental purpose and earmark investment capital, in whole or in part, for that purpose, including a formal written statement at the term sheet stage may be helpful [link to use of proceeds language],
- mission related metrics approvals can be part of Investor voting rights – Investors in preferred stock generally require that the company secure the approval of the preferred stockholders to take certain actions. The parties could agree to expand the traditional list of approval items for investor preferred stock to include impact-related actions (e.g. changing the company’s purpose).
Although less common, company founders can demand similar voting rights as part of a special class of founders’ shares. Founders, for example, may hold preferred shares with voting rights that allow them to veto any change of control they view as not aligned with the company’s mission.
If founders hold the voting rights, investors may try to negotiate for a provision that requires founders to buy (or find a buyer for) the investor shares that would have been sold in a vetoed transaction, at the price offered in that transaction. Conceptually, these rights could also apply to a capital raise, with founders reserving some period to find more mission-aligned capital, even after the board has approved a funding round.
Founders and investors will need to agree on the areas that the voting rights will cover [link to language below], as well whether a simple majority or super-majority of rights holders will be required to block changes.
- Board mandate of oversight over the mission objectives and outcomes – a company’s founders and investors who share the same vision can protect against “mission drift” over time – including through a change of management or ownership. Agreements concerning corporate decision-making as well as restrictions on stock transfers can help to keep a company’s mission on track. An impact investor or a representative of the social entrepreneur can have a seat on the Board to safeguard the mission objectives. Within limits, the company’s board of directors can empower a committee or director to oversee mission-related decisions [link to language below]
- Stock transfer restrictions as a way to protect against mission drift – Mission drift describes a situation when an entity moves away from its mission. Mission drift happens over time and could be set into motion by one or many decisions that an organization needs to make on a daily basis. A company’s founders and investors can protect against mission drift – even through a change of management or ownership. Agreements concerning corporate decision-making, measuring mission objectives, as well as restrictions on stock transfers can help to keep a company’s mission on track. Founders and investors may choose to adopt policies related to general corporate citizenship and ethical conduct [link to stock transfer restrictions language];
Additional Resources
The intersection of traditional venture capital and impact is gaining momentum as traditional venture investors understand that there are highly profitable companies that also have a social mission. Founders of impact companies want to access more traditional pools of capital because there is more money in traditional investing than there is in impact investing. Unfortunately, it can be a time-consuming process to educate traditional investors, who have not previously invested in impact companies, about the different impact registration forms or specific impact related provisions and how these do not automatically translate to lower financial returns. Founders of registered BPP companies have to decide whether approaching traditional venture is worth it
Contributors
- Patience Ball, Toniic.