#10 Retiring Business Owners Flood Market

Broken road closed due to flooding sign

Part 1 – Stream of retiring business owners holds threat of mass liquidations and untold job losses. But there is a solution.

A largely unrecognized, systemic problem is hurtling toward our still fragile economy — the baby boomers who built it are now leaving it. They are putting their companies up for sale, resulting in an unprecedented glut of businesses on the market. There is growing evidence that the majority will go unsold, resulting in shutdown and liquidation of those businesses, with the commensurate loss of jobs and economic value to their communities.

The numbers tell the story

Around 75 million baby boomers are on the verge of retirement. For the next fifteen years or so, an average of 10,000 people a day will reach age 65.

This is significant because about 60% of all small businesses in the U.S. are owned by boomers and it’s estimated that two-thirds of those businesses will be put up for sale in the next five years. That’s many hundreds of thousands of companies and several trillion dollars in value. Surveys reveal that beginning with the last quarter of 2012, and increasing ever since, the desired retirement of the owner is the primary reason for selling a business. And since businesses with fewer than 20 employees make more than 50% of all U.S. jobs, that trend could spell huge trouble for communities everywhere.

Where are the buyers?

For businesses up to around $1 million in sales, the average buyer is typically an individual who wishes to be an owner-operator. Institutional buyers, like corporations and investment funds, are normally only interested in buying business with more than $50 million in sales. So even in “normal” times, buyers are thin on the ground for many small businesses. But flood the market with small businesses and you quickly overwhelm the ability of an already inadequate pool of buyers to absorb them.

As a result, a large number of those businesses will simply be shutdown (current estimates run as high as 80%), with the loss in value to the owner, the employees and the community.

Who has a vested interest?

The scale of the problem demands a systemic solution, as individual buyers can’t be materialized out of thin air. So the premise we start from is that an institutional solution it is called for. But who? And why would they want to? How?

We begin by asking who has a vested interest in seeing those companies remain alive and contributing to local economies. The employees might become the buyer (and sometimes do), but they usually lack resources, both money and skills.

What about the children or grandchildren of the retiring owner? Historically, only about 30% of second generation family members have attempted to take over, and less than half of that in the third generation. Those numbers have gone down in recent times and does not account for the high failure rate for those who attempt it. Thus family members are not a viable solution.

Another group with a vested interest is the community itself. The closure of every business has a financial impact on the community. The most obvious is the loss of the tax dollars that local governments need to provide services. However, the loss of payroll dollars is even more problematic.

The multiplier effect says that each time a dollar is spent locally it winds up being re-spent anywhere from 2 to 15 times. If I spend part of my paycheck at a local restaurant, the owner might use that money to pay a local accounting firm, which uses it to pay a local graphics company for promotional materials, which uses it to pay a local IT services firm, which uses it to pay employees, who continue to recirculate the money.

Thus every new dollar injected into a local economy multiplies into many dollars and generates tax revenue. The loss of a dollar has the opposite effect. That’s why local economic development efforts focus on job creation and retention.

Therefore the constituency with the greatest vested interest in solving this problem is the community where the business is located. And as a group, they have the resources and skills to achieve that goal. They just need a track to run on and guidance on how to accomplish it.

The biggest obstacle they face is succession, i.e., the handover from the business owner to a successor manager. Many small business are owner-dependent and may not be salvageable, but for those that are, how can the community take over the business and keep it productive?

A structure that works

For the community to acquire the business, some legal vehicle is needed to serve as a joint ownership mechanism. For-profit corporations are a logical vehicle in that they are capable of owning other businesses, and the corporation in turn can be jointly owned by multiple owners. Those owners can be individuals, other businesses, non-profits and government entities, i.e. just about anybody in the community. This provides us with the optimum ways of aggregating financial resources to buy a number of local small businesses.

For-profit corporations set up for the purpose of owning other businesses are called “holding companies.” The most famous example is Warren Buffet’s Berkshire Hathaway, one of the largest public companies in the world.

Berkshire Hathaway is a public company, which means its shareholders can buy and sell their shares on the open stock market just about anytime they want. That type of investment is generally referred to as “liquid”, i.e. it can be readily converted into cash whenever the owner wants to sell.

Normally ownership in small businesses means the exact opposite. Owners can have a very difficult time selling their interest, generally characterized as illiquid. The illiquid nature of small businesses makes it a problematic investment.

If only a community holding company could be designed to buy small, privately held businesses, yet provide shareholders with the liquidity of a public company!

The BDC solution

It just so happens there actually is a type of corporation specifically designed to be a public holding company for small private businesses. It’s called a Business Development Company.

BDCs were created by Congress in 1980, following encouragement from the venture capital industry to establish a means that would allow the general public and not just the wealthy to own a piece of VC funds that invest in small businesses. BDCs were designed to be public companies that can be owned by anybody, with a mandate to invest in, own or provide loans to small businesses. Thus they are a hybrid of a public holding company, a venture capital company and a commercial lender.

For more background on BDCs and their use for achieving benefits to communities, see Part 2 of this article. For a more in-depth exploration of BDCs, see Venture Capital 2.0 – The VC world is about to be disrupted – by something it created more than 35 years ago.

In addition, the concept of a community owned entity that provides a broad benefit to the community and all stakeholders is an idea that fits a more progressive vision of the purpose of corporations in our society. The article Capitalism 2.0:  7 Reasons to Believe the Transition has Begun explores this new approach to corporations and its relevance in using BDCs to support local small businesses.

Part 2: Retiring business owners lack buyers for their companies — how can a BDC address this problem?

In Part 1, we discussed how the flood of retiring baby boomer entrepreneurs is creating a glut of businesses for sale, overwhelming the ability of the market to absorb them. The resulting shutdowns can have dire consequences for local communities and economies. We introduced a special kind of public holding company called a BDC as a way for communities to purchase those companies and retain their jobs and services.

Because a BDC is designed to be a public company, it can raise an IPO, conduct follow on public offerings, as well as raise money privately. Therefore a community centric BDC should be able to raise the funds necessary for an acquisition campaign to buy local businesses for sale.

In addition, if the BDC is a public company (they can be private), it can use its own shares as some or all of the currency needed to purchase those business. That is, a BDC can use cash, stock or both to purchase a company. In fact, properly structured, the portion of the purchase done with the BDC’s stock can result in a tax deferment until the seller later sells the BDC shares it received. For retirees, this can spread out their tax liability for selling their companies, and potentially realize a greater gain than an all-cash purchase, if the shares of the BDC grow in value while they hold them.

That deal structure can apply to other businesses for sale. They are being impacted by the glut created by the retirees as well, and thus they face the same increased difficulty in finding a buyer, much like any homeowner would in a down market, regardless of their reason for wanting to sell their home. Thus a community based BDC could buy those other businesses as well and retain them as an asset of the community.

A community BDC can entertain other kinds of small business investments as well. Companies needing capital to grow and create new jobs are a viable constituency that such a BDC could support. Likewise startups, the intended target of the original BDC legislation, could receive funding from a community centric BDC. Such efforts could be married with local economic development efforts, like a community small business incubator, to provide the critical funding such startups need to get off the ground.

And because a BDC is also allowed to do commercial lending, that opens up additional ways that a community BDC can support its local business. Unlike a bank that very rarely takes an equity position in the companies it lends to, a BDC is free to structure any kind of a deal, capital or credit. For example, that might include a multi-party transaction with a community bank that usually needs collateral to back its loans, the collateral possibly being provided by the BDC, and/or the BDC can take a subordinated position to the bank in a joint loan. There are many options.

In addition to providing financial support, a BDC has a legal obligation to “make available management support” to its portfolio companies. Most small businesses that are not part of a national chain have virtually no external support system or resources. It often is a sink or swim environment. Clearly, having an acquired or funded business go under is not in the best interest of the BDC and its stakeholders.

The BDC, therefore, provides a spectrum of support services to its portfolio companies including, at minimum, mentoring, monitoring and advising. In addition, it can provide shared services like accounting, legal, payroll and insurance that help to reduce costs to the individual companies. General and cross-marketing is another area where a BDC can provide support to its portfolio companies.

Benefits to sellers, investors and the community

A community BDC is that rare thing that works for everyone. Some of the key benefits to the various participants are outlined below.

Benefits to Sellers

  • Sale is generally faster and easier than finding, being evaluated by, and negotiating with a private buyer, if one can even be found.
  • By taking advantage of a stock swap option, sellers could realize a substantially larger gain than with a conventional sale and less money has to be raised by the community to acquire those companies.
  • BDCs have the flexibility to structure the sale on the seller’s terms.
  • The process can be entirely transparent to all.
  • The community BDC’s goal is NOT to pay the lowest price but to keep the business local and operating.

Benefits to Investors

  • Small investors can support their local economies while building wealth for themselves.
  • Investment is in a public company, therefore shares are liquid (freely tradable).
  • Risk is spread through ownership in multiple businesses.
  • Investor confidence is enhanced through transparency and proximity.
  • Companies have access to business support services that can improve operations and profitability.
  • Investors receive a double bottom line benefit – financial gains and a healthier local economy.

Benefits to Communities

  • Retain viable businesses that provide the community with useful goods and services.
  • Job retention and creation.
  • Maintenance and enhancement of tax revenue.
  • Recirculation of money as a result of local ownership boosts all local businesses.
  • Thriving business districts attract more business.
  • Helps ensure a healthy mix of businesses to counter market-specific cycles.
  • If the community wants its BDC-owned businesses to be more socially and environmentally responsible, it can elect to have the BDC and all its portfolio companies adopt triple bottom line policies and procedures.

Thus a community centric BDC can be a very flexible financial institution that can not only be used to address the critical problem of businesses possibly being shut down and jobs lost, but can help to expand local business and create new jobs, and even to make them model corporate citizens in sustainablility.

BDCs can be the most flexible tool for providing financial and other resources to local businesses that has ever been created. (I explored this idea in greater depth in the article BDCs: An Untapped Tool for Local Investing?)

How would a community establish its own BDC?

There are two ways a BDC can be set up and managed:

  • Internally managed: BDCs can legally be administered internally just like any other public company.
  • Externally managed: They may be managed externally in a fashion similar to the way a venture fund is managed by a separate venture capital management company.

In either case, there are at least three ways that a community could set up its own BDC to address the needs of its local small businesses, whether to serve as a vehicle to acquire the companies being sold, or to provide investment and/or credit to others. They could:

  1. Start from scratch and form their own BDC corporation, get it approved with the SEC as a public company, arrange for an IPO and conduct follow on public and private offerings, and use the funds so raised to support their local small businesses. This is the hardest path and the least efficient. There are a lot of legal complexities involved, even though the process itself is fairly straightforward.
  2. Join forces with other communities that likewise have an interest in establishing their own BDC in a “fund of funds” approach. Each community would set up a subsidiary under this joint BDC to serve as its own virtual BDC for that community. (My company, Commonwealth Group, has coined the term Virtual BDC™ or VBDC™ to describe these entities.)  Each of the communities can raise their own funds to be primarily directed to their local effort. However, all investors get stock in what would wind up being a much larger public company than might be achieved for a single community BDC. That would increase the likelihood of interest in the public market to buy shares in that group BDC, and likewise spread the risk over many more companies. This approach achieves an economy of scale in that only one parent BDC company needs to be set up, go through all the legal steps to become a public company and list its shares on the stock market. As with the first option, the process is straightforward once understood.
  3. Lastly, a community can work with a BDC that has already been set up to provide a home for multiple VBDCs. My company, Commonwealth Group LLC, has established a company for that purpose. Called Commonwealth Capital, it has been formed to provide a common umbrella for others wishing to establish their own BDC effort but who don’t want to invest the time, expense and effort involved in going it alone.  Commonwealth Capital was formed as a California benefit corporation and fully embraces sustainability and triple bottom line for itself, its VBDCs and all their portfolio companies. Commonwealth Group serves as the external management firm (both fund management and administrative management) for Commonwealth Capital.

For options 1 and 2, Commonwealth Group can consult with others to establish their own, or partner with local organizers who would like to establish their own BDC.

In option 3, Commonwealth Group already has a BDC and has the structure and expertise in place to help others form VBDCs under it. Commonwealth Group is seeking to establish VBDCs with partners interested in addressing the problem of small business owner retirement, as well as investors and business owners interested in taking advantage of our solution.

At this time we are particularly interested in sellers who have professional management in place or sellers who can be replaced with a manager(s) to run the business. For those satisfying that succession requirement, we are prioritizing acquisitions with sellers who are willing to take stock in Commonwealth Capital as a public company BDC.

See www.commonwealthgroup.net for more information.

Michael Sauvante is Executive Director of Commonwealth Group LLC, the only firm specializing in the use of BDCs for small business investments. Commonwealth Group has formed its own California benefit corporation “fund of funds” BDC that can partner with others wishing to form their own BDC, including impact investors. To learn how you might use BDCs for your particular objectives, go to www.commonwealthgroup.net. You can also join the only LinkedIn group dedicated to BDCs here.

#9: Capitalism 2.0:  7 Reasons to Believe the Transition has Begun

 

Cap2-0-cartoon

For decades now, the wealth and income increases in this country have gone to a small elite. Much of the blame for that has gone to corporate America, which has driven down wages, laid off millions, shipped jobs and factories overseas and dodged taxes at an astonishing rate. Wall Street has become a symbol for greed and sociopathic behavior. The game is rigged; people are fed up and want change.

Change is indeed in the air, but for the better or worse? Actually both, and that is good. As is often the case in nature, decay begins within and shows on the surface as the affected organism dies.

So it is with many of society’s old institutions. They may appear bigger and more powerful than at any time in their history, but that is just the bloat of decay.

Wall Street’s version of “greed capitalism” may appear to be omnipresent, especially through its influence over politics, its success in getting elite-friendly legislation passed, its control of the media, and its vast amounts money, gained at the expense of Main Street, now starving for adequate financial resources.

But there is new life stirring around the bloated body of greed capitalism, and it marks the beginning of the end for that old corporate regime. Driven by a shift in consciousness, it manifests as bottom-up, group-driven efforts, replacing the old top-down, authoritarian model. In other words, we are the solution.

But is a new people- and planet-friendly friendly form of capitalism, one we might call Capitalism 2.0 still just a gleam in the eye, or have we actually begun transitioning from idea to implementation? To find out, let’s go back half a century.

1. Moving money

The shift likely started in the 1960s when the socially responsible investment (SRI) trend was born out of the social struggles of the civil rights movement and a growing environmental awareness (themselves group efforts).John Elkington, a leader in the SRI movement, introduced the term triple bottom line in 1994 (social and environmental bottom lines, in addition to financial). He, along with others, began pushing corporations to be more responsible citizens to society and the planet.

Wikipedia’s entry under the now more common label of “impact investing” says this “refers to investments ‘made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return.’ It is a form of socially responsible investing that serves as a guide for various investment strategies.”

Ultimately, shareholders will dictate the direction that the companies they invest in will follow. And the more money that pours into SRI/impact investment funds, the sooner business will no longer be dominated by greed capitalism. It is estimated that screened investments with a double or triple bottom line element is now the fastest growing investment sector, rapidly approaching $10 trillion in assets under management!

On the flip side is the “divestment” movement (i.e., extracting from an investment), primarily from the carbon industries. Since its beginnings in 2012, the fossil fuel divestment movement has succeeded in getting more than 800 institutions worldwide, including universities, faith organizations, local authorities, pension funds and foundations to commit to divesting from fossil fuels. Perhaps the most symbolic action came in September 2014 as the heirs to Rockefeller oil fortune withdrew fossil fuel investments in the $860 million Rockefeller Brothers Fund.

More recently, Norway became the first country to dump fossil fuels as the divestment movement heats up. Norway’s Government Pension Fund Global reported that a total of 114 companies had been dumped because of their risk to the climate, according to The Guardian.

This movement is having a huge impact on the carbon industries. Divestment is likely one reason why oil and gas companies are seeing their share prices plummet alongside the drop in oil and gas prices, causing many of them to abandon new and existing projects that are no longer viable. Coal companies have been filing for bankruptcy at levels never dreamed of just a very short while ago. Meantime, renewable energy projects are exploding, as the price of renewable energy rivals fossil fuels, and in most cases without subsidies.

2. Political pressure

While the impact investment and divestment movements have not been very visible to the general public, a new phase of awareness has exploded onto the public’s consciousness.

It began on September 17, 2011 with the birth of the Occupy Wall Street movement. For the first time in modern history, the disparity between the haves and the have nots (which Occupy brilliantly characterized as the 1% and the 99%) became front-page news. The main issues raised by OWS protestors were social and economic inequality, greed, corruption and the undue influence of corporations on government—particularly from the financial services sector.

Even though Occupy has not translated to the same direct political clout demonstrated by the parallel protest movement of the Tea Party, it nonetheless has probably influenced society on a deeper and broader level than the Tea Party, and will likely have greater staying power and influence over time.

Occupy’s influence is visible in protests today, linking causes from incarceration rates and excessive policing (especially of the poor and minorities) to wage disparity and more. For example, out of Occupy came the living wage movement that has been sending shock waves through corporate America, impacting even the largest employers like WalMart and McDonalds. Where minimum wage proposals have been on the ballot in recent elections, they have won by overwhelming margins, cutting across the political spectrum, even in conservative states.

And while the push for a substantial increase in the minimum wage has barely moved in Congress, multiple cities have embraced a $15 minimum wage and New York and California lead the states in adopting $15 minimum wage programs.

Income inequality and the outsized influence of the wealthy became a central theme of the 2016 election, on both the right and the left, driving the campaigns of both Donald Trump and Bernie Sanders. Regardless of the outcome of that election cycle, most observers predict that this theme will drive politics for the foreseeable future.

3. Local focus

Decentralization efforts are also moving the transition to Capitalism 2.0 forward. One is the rapidly growing local investment movement (i.e., investing in local businesses rather than Wall Street), as chronicled by Michael Shuman in his book Local Dollars, Local Sense and Amy Cortese in her book Localvesting. This is a modern day version of a community barnraising.

Similarly, a growing number of “buy local” campaigns promote supporting local businesses instead of chains that export the gains to remote headquarters.

Complementary “local “currencies are also proliferating. These, like the Berkshares in Massachusetts and the small-business oriented Wir Bank in Switzerland (which has assets of almost $5 billion), provide an alternative means of exchange alongside the national currency. The concept, which has a long history of success stretching back to ancient Egypt, is explored in-depth by euro architect Bernard Lietaer and Stephen Belgin in their book New Money for a New World, and in the book The End of Money and the Future of Civilization by Thomas Greco.

4. Collective ownership

On a parallel track is the collective ownership/cooperative movement chronicled by Marjorie Kelly in her book, Owning Our Future: The Emerging Ownership Revolution. All kinds of cooperatives are being launched, many in the local food movement, not to mention the most pervasive type of coop in the country – credit unions, key beneficiaries of the “Move Your Money” campaign to get citizens to remove their money from the Wall Street banks and place it with local financial institutions.

One of the most successful business enterprises in the world, of any kind, is the Mondragon Corporation, a federation of worker-owned cooperatives based in the Basque region of Spain. It has grown to be the 10th largest Spanish company in asset turnover and employs more than 74,000 people in more than 250 organizations in finance, industry, retail and knowledge. The region it serves has essentially zero unemployment and it is recognized worldwide as the ideal coop model.

5. New financial alternatives

There is a growing interest in the concept of public banking, i.e., banks that exist to serve the public rather than just wealthy shareholders (they may be owned by governments or some form of a non-profit organization). Germany is a leader here, with its vast network of locally controlled, non-profit community owned public banks(Sparkassen), credited with making Germany’s small and mid-size companies some of the healthiest in the world. Those Mittelstand (small and medium) companies contribute about 52% of Germany’s total economic output and 19% of its exports . One of the leading proponents of public banking worldwide is Ellen Brown, as detailed in her book The Public Bank Solution: From Austerity to Prosperity.

Another collaborative “group” investment paradigm that has seized the public’s interest is crowdfunding, an outgrowth of another collective undertaking, social networking.  Laws governing investing in small companies have barely changed since the 1930s, yet a groundswell demand for crowdfunding from entrepreneurs and the small business community pushed Congress to pass a rare, overwhelmingly bipartisan bill, the 2012 JOBS Act, which authorized small private companies to make investment solicitations to the general public.

6. A better venture capital model

Venture capital has long been the domain of the wealthy. But recently a concept called a business development company (BDC) has been rediscovered. Created by Congress in 1980, BDCs were originally intended to “democratize” venture capital by providing both capital and credit to small businesses via a public venture capital company that anybody, not just the rich, can own.  The original vision for BDCs was co-opted by Wall Street-controlled financial firms into serving only the upper tier of the kinds of companies that Congress had in mind.

But that is about to change. BDCs are poised to replace the old venture capital model, a topic explored in depth in my article Venture Capital 2.0: The VC world is about to be disrupted – by something it created more than 35 years ago.

Think of a BDC as a combined public venture capital company (its shares can be traded on a stock exchange) a commercial lender and a holding company. For example, when a BDC is used to foster local investment, local investors invest in the publicly traded BDC, which in turn invests in, buys or lends to local small companies. In this application, the community becomes an owner in local businesses, yet investors retain the liquidity offered by a public company. This provides a unique investing opportunity unavailable through any other means.

Efforts are already under way to use BDCs to focus on local communities and their mainstay small businesses. Commonwealth Group, has established a “fund of funds” BDC called Commonwealth Capital that will serve as an incubator for other BDCs, until they are large enough to be standalone public companies. Commonwealth Capital was formed as a benefit corporation (described below), so that it and all the companies it supports may pursue a more socially and environmentally responsible expression. We can assist others in establishing their own BDC, freestanding or under Commonwealth Capital’s “fund of funds.”

7. More than the financial bottom line

In recent years, advocates have encouraged state legislatures to create new forms of for-profit entities that are allowed (even mandated) to pursue double and triple bottom line objectives.

The first of these (Vermont, 2008) resulted in a new type of limited liability company (LLC). Called low-profit limited liability companies (L3Cs), they were created to bridge the gap between non-profit and for-profit investing by providing a structure that facilitates investments in socially beneficial for-profit ventures. Ten states have adopted them so far.

An even more widespread structure has emerged related to for-profit entities, such as LLCs, corporations and partnerships. It began with a non-profit organization called B-Lab and their independent B Corporation certification. These “Certified B Corporations” pledge to pursue triple bottom line objectives and are audited on an ongoing basis to verify they are meeting the certification requirements. Etsy is one of the first B Corps to go public representing a paradigm shift for a Wall Street listed company.

However, as I pointed out in an article I published in 2008, Rewiring Corporate DNA, if society truly wants to change corporate behavior to make corporations more socially and environmentally responsible, tinkering at the edges is not enough. We need to change the underlying statutes that form the legal basis for corporations.

The folks at B Lab recognized this problem as well and engaged attorney William Clark to draft a model set of statutes that could be used to craft state legislation defining a new class of for profit corporation. (History will likely owe Clark a great deal more recognition for his role in bringing about what is described below. I for one am very grateful for his contribution and that of his collaborators.)

The goal was to establish statutes that would sit alongside conventional corporate statutes but with four key differentiating elements. They would:

  1. Mandate that the corporation pursue a material positive impact on society and the environment.
  2. Mandate that the directors and officers consider the interests of all of the corporation’s stakeholders.
  3. Mandate that the corporation provide its shareholders with a periodic published report demonstrating that the company is pursuing that public benefit purpose.
  4. Provide a legal protective “firewall” for the directors and officers that allows them to pursue that public benefit objective without risk of being sued for making decisions and pursuing strategies that might include other than pure financial factors.

The true game changer came in 2010 when, through the efforts of B Lab, Clark and others, Maryland created a new legal category of for-profit corporation called the benefit corporation, a for-profit corporation that “includes positive impact on society and the environment in addition to profit as its legally mandated goals.” With the adoption of those new statutes, the country now had a government recognized (not just third-party certified) corporation with a purpose that transcends pure profit.

Since then, more than half (29) of the states and Washington, D.C.-, have adopted benefit corporation statutes (most of them based on Clark’s model statutes)! Even Delaware, the state with the most public companies registered, is promoting its own form called Public Benefit Corporations. The majority of state legislatures, in both red and blue states, have agreed that corporations need to have a larger purpose than solely making money. Such fast and widespread adoption represents a sea change in support of the public’s desire to have corporations be more responsible to society and the planet.

The ramifications of benefit corporate statutes cannot be overestimated. They represent the single biggest shift in corporate law in our nation’s history – a quiet revolution! Yet it is probably the single strongest indicator that we have begun shedding the old greed capitalism model. When legislators of both red and blue states recognize the need for more socially and environmentally responsible corporate behavior and are willing to codify that into law, we can be confident that change is underway.

It is important to note that these new benefit corporation statutes offer entrepreneurs an additional option for incorporation. They do not require existing conventional corporations to adopt benefit corporation goals, although they may adopt them if the shareholders vote to convert (usually requires a super majority approval). Nonetheless, it is likely that once benefit corporations become more visible, there will be subtle and overt pressure on conventional corporations to adopt the benefit form of corporate governance.

History bears this out. One related set of laws in particular provides a template for the far-reaching effect of legal changes that at first seemed inconsequential. The Emergency Planning and Community Right-To-Know Act (EPCRA) under Title III of the Superfund Amendments and Reauthorization Act (commonly called the “Toxics Reporting Act”), mandated that companies publicly report the toxic chemicals they generated and what they did with them. There were no further requirements beyond the reporting. Simply tell the world which ones you handle and how you handle them. But in retrospect, this set of laws is considered by many to be the most successful environmental legislation ever!

The results of that simple sounding legislation were stunning. By having to tell the world about their use of toxic chemicals, corporations were embarrassed into radically altering their behavior. Company after company raced to paint themselves as more responsible than their competitors. It’s probable that more toxic cleanup has resulted from the anticipated public pressure (often not forthcoming but nonetheless feared) than by all previous environmental legislation.

Applying that same logic to benefit corporation codes, we anticipate that companies that become benefit corporations will want to tell the world, with the expectation that it will enhance their public image and translate to increased sales and a higher share price. Market forces (i.e., capitalism in its truest form) may very well drive the adoption of this alternative code more effectively than any mandatory action ever could.

Already corporate thought leaders are embracing benefit corporations as the future. Industry heavyweights Sir Richard Branson and Salesforce CEO/Founder Mark Benioff have joined forces to actively promote benefit corporations and Certified B Corporations in a program they call Born B. They describe Born B this way:

The startup community is a powerful driver of disruptive innovation, creativity and change in the business world. New companies have the opportunity to manage their businesses in progressive and innovative ways from the start, rather than backwards engineering them when they become large and complex. When a new company embraces and integrates social and environmental purpose into its core business model from inception, it has the opportunity to vastly improve its ability to address long-standing global challenges. Companies who do this will realise significant benefits for their investors, shareholders and customers. We call this being ‘Born B’.”

So far, the many thousands of companies formed as a benefit corporations are all still privately held. To date (April 2016) no benefit corporation has gone public, but that will be changing soon. Commonwealth Capital plans on going public sometime in 2016, at which time it will likely be the first public benefit corporation BDC in the country and very possibly the first public benefit corporation of any kind.

Commonwealth Capital intends to adopt triple bottom line practices for itself, either as a Certified B Corporation or equivalent. In addition, any prospective portfolio company wishing to receive funding from, or be acquired by, Commonwealth Capital shall be required to likewise adopt practices equivalent to those advocated by B Lab, whether or not they are benefit corporations or L3Cs. Certain others will be required to be incorporated as a benefit corporation, in addition to conforming to B Lab-like practices.

Commonwealth Capital’s business model entails creating many other BDCs that all will be benefit corporations. And any portfolio company that plans on going public will be required to be a benefit corporation as a condition of an investment by Commonwealth Capital. Thus by Commonwealth Capital’s efforts alone, the number of public benefit corporations could grow rapidly. Once they do, investors in Wall Street will finally have an alternative to the old, profit-only companies. As benefit corporations proliferate, pressure will mount on conventional companies to convert.

The increase in public benefit corporations will drive the need for new ways of valuing such public companies. To date there are no commonly accepted metrics for establishing the value of the social and environmental bottom lines that are comparable to the metrics for financial bottom lines. This is a key point.

People and organizations perform according to how they are measured. Managers of public corporations are currently measured and rewarded for short-term profits, which results in many behaviors that are detrimental to society and the planet.

So we must develop ways to value the social and environmental dimensions. In so doing, we will drive corporate behavior in new, more sustainable directions. With that, Capitalism 2.0 will truly begin to soar.

The ramifications of benefit corporations will be far reaching. When I called for this kind of change to corporate statutes in 2008, the prospects for such accelerated transformation to occur within just eight years were dim to say the least. The rapid expansion of the benefit corporation and Certified B Corporation movement shows that massive change is already underway. Business might, sooner than expected, become the servant and not the master of society. Capitalism 2.0 is much closer than we think.

Michael Sauvante is Executive Director of Commonwealth Group LLC, the only firm specializing in the use of BDCs for small business investments. Commonwealth Group has formed its own California benefit corporation “fund of funds” BDC that can partner with others wishing to form their own BDC, including impact investors. To learn how you might use BDCs for your particular objectives, go to www.commonwealthgroup.net. You can also join the only LinkedIn group dedicated to BDCs here. Vari MacNeil contributed to this article.

#8 BDCs are poised to replace venture capital

BDCs, created by the venture capital community 35 plus years ago, are poised to replace venture capital with what we are calling Venture Capital 2.0. See this LinkedIn Pulse article by Michael Sauvante, Chief Architect of Commonwealth Group. The full article is also posted below

Venture Capital 2.0 – The VC world is about to be disrupted – by something it created more than 35 years ago.

Venture Capital 2.0

Venture Capital 2.0

The VC world is about to be disrupted – by something it created more than 35 years ago.

After reading Chamath Palihapitiya’s article Bros Funding Bros: What’s Wrong with Venture Capital, I was prompted to introduce a concept that I predict will fully disrupt venture capital within the next five years.

Venture capital, as Palihapitiya points out, is a broken model when it comes to addressing some of society’s most critical needs and, I would add, as a financial business model as well. A victim of its own success, it has become bloated and inefficient. Average returns to investors fall well short of the glory days and the time to distribution can be as much as 10 to 14 years.

However, as Buckminster Fuller famously said “You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” If we truly want to disrupt venture capital, we have to challenge its core business model, not just poke around the edges. Fortunately there is a vastly superior business model.  And it was created by the VC industry more than 35 years ago.

The genesis

In its early days, the VC industry struggled for acceptance by the investor community. In 1978, its best year to date, the entire industry raised around $750 million, equivalent to one fund today. By 1980, it is estimated that all VC funds combined for a total of approximately $3 billion under management. Even adjusting for inflation, both those numbers are paltry by today’s standards.

Thus the industry was looking for alternative ways to raise money and came up with an idea that evolved into the Small Business Investment Incentive Act of 1980 (SBIIA – see the full text here). Signed into law by President Jimmy Carter in 1980, SBIIA resulted in a major amendment to the Investment Company Act of 1940 (Sections 55 through 65). It called for the creation of a new kind of closed-end investment company called a “business development company” or BDC.

In his signing statement, President Carter said:

“This new law will facilitate the financing of small businesses by providing needed reform of the Federal securities laws. Small businesses are essential to economic growth and to innovation. No effort is more difficult for small businesses nor more crucial to their success than raising investment capital. This legislation will provide a new statutory framework to streamline legal structures and encourage venture capital to invest in small businesses.”

SBIIA was in essence the first JOBS Act. It provided for the purpose, establishment, limitations, abilities, management and general guidelines of BDCs, which have now long been implemented and stable (in contrast to the JOBS Act). The key attribute of BDCs that created an alternative fundraising mechanism for venture capital is that, instead of a private limited partnership, a BDC can be apublic company that raises money from the general public through an IPO and follow on public, as well as private, offerings.

They were intended to democratize venture capital so that the average person, not just wealthy investors, could own a piece of them. And even though they were designed primarily as a new way to raise money for a venture fund, they also solved a huge problem that, to this day, plagues VC funds, P/E funds, angel funds and all other forms of investment in small companies – the illiquidity of private company investments!

Investors owning shares in a public BDC can buy and sell them in the open market, as with any other public company stock. Thus investors don’t have to wait until the fund liquidates its holdings in its portfolio companies before they can get their money back (hopefully with a profit).

More ways to get value from investments

In fact, BDCs are better structured to address the needs and desires of allstakeholders, including investors, the companies they invest in and the managers who manage the process. (See this matrix for a comparison.) Usually there is some asymmetry among stakeholder groups.  For example, a VC might want to sell a portfolio company, but the entrepreneur founders may not (a conflict the VC usually wins.)

A BDC does not have to sell a single portfolio company in order for its investors to realize a personal gain – it can buy and hold any investment. And if the investment grows in value, that should positively impact the share price so that investors may be able to sell at a profit.

VCs, in contrast, only make money when they sell their holdings, based on a “buy low, sell high” business model. In a typical portfolio, this occurs for only about 20% – 40% of companies. Another 20% – 40% or so fail (die), and the remainder, the ones that are unlikely to find a buyer or go public (an “exit”), are usually abandoned by the VCs.

Even though those companies may be perfectly solid, to the VCs they are “walking dead” or “zombie” companies because they cannot retrieve any value out of them, or even get their money back. Thus VCs almost never make any additional investment in them, no matter how much the companies could benefit.

Nonetheless, these companies can be perfectly good, value-producing companies within a BDC’s portfolio. And a BDC, in contrast to a VC, can even justify putting more money into them if it makes them more profitable – regardless of whether anybody wants to buy them. That greater profitability increases the value of the company under the BDC and that increase in value is generally reflected in an increase in the price of the publicly traded shares. The BDC’s shareholders can capitalize on that gain anytime they want because of the freely tradable nature of their shares.

Thus a BDC can not only realize value out of traditional “racehorse” companies, but also from solid “plowhorse” companies, provided they are generating positive revenue and are on a stable trajectory. This is a crucial change from the current VC business model that relies entirely on the buy low, sell high strategy. A public BDC can “buy, build and hold” its assets and still yield a gain to shareholders, since it can obtain value out of the majority, if not all, of its portfolio companies, whereas a VC only gets value out of a fraction of its companies.

This also means that the kinds of businesses a BDC can invest in go far beyond the much ballyhooed “unicorns” or “gazelles” sought by VCs to a far wider spectrum of companies, from raw startups to growth companies and even mature businesses.

Thus a BDC has many more ways it can create and reap value from its investments than a traditional VC would ever dream of, and that directly benefits the BDC’s owners. And it allows for precisely the kind of specialization by industry, demographic or geographic sectors that impact investors seek. (For more on impact investing and BDCs, see Capitalism 2.0: 7 Reasons to Believe the Transition has Begun.)

Where have they been hiding?

So you might ask, if BDCs are so good, why don’t we see VCs using them today and why have so few people heard about them? To answer that, we need to go back to the 1980s. The timing for creation of BDCs could not have been worse. The investor community woke up to the opportunity represented by traditional venture capital funds (as practiced in their early days) and began pouring money into them.

The amount of funds under management exploded in the eighties such that by the end of the decade, the total grew from ~$3 billion to over $31 billion (10X+). Remember the reason BDCs were created was to open up funding, which now was taking place the “old fashioned way,” through limited partnerships.

LPs are much less complicated to establish and entail far less regulatory oversight than public companies. Bottom line, VCs didn’t need the BDC option anymore and spurned them because they entailed more work and complexity than the VCs were willing to handle.

The chief driver for BDCs, from the VCs perspective, went away and the industry promptly abandoned its new creation. In fact, there was a grand total of three BDCs listed on Wall Street by 2000.

BDCs would likely still be languishing had they not then been discovered by Wall Street financial firms who were swimming in money and looking for additional places to put it. However, they did not look at BDCs as a way to invest in private companies like a VC. Instead, they latched onto one of the unique features of BDCs that VCs rarely utilize.

Investments ignored

BDCs were mandated to financially support (up to 70% of their assets under management or AUM) private businesses of any size and even small public companies up to approximately $250 million market cap (the opposite mandate of mutual funds). However, in addition to investments, they could also serve as commercial lenders, without any banking regulations tying their hands.

The majority of the 50-70 Wall Street BDCs formed since 2000 have focused almost exclusively on lending to their portfolio companies. They do so by borrowing at around 2% and re-lending that money, typically at 8% – 12% (sometimes higher), making profit on the spread. Some add in equity kickers to increase their yield. They are currently permitted to borrow an amount equal to their total paid in capital, i.e., 100% leverage, and are currently lobbying Congress to double that limit.

Nonetheless, given that the average Wall Street BDC has more than $500 million in assets under management, they have the same problem the VC world has today – too much money to move to concern themselves with smaller deals (which is why VCs rarely do seed funding anymore even though that was the secret to their early success). Thus like VCs, BDCs have to do larger deals per transaction and thus go after upper middle market companies, where the smallest loans are typically $5 million and up.

All in all, what they do is a far cry from what was originally envisioned by the VC industry and Congress when they created BDCs. In the 1980s it was still common to find VCs making $500K first round seed investments and BDCs were expected to do the same thing. Their intended focus was on smaller, early stage companies, something current Wall Street BDCs have eschewed.

Original and best

But therein lies the opportunity to disrupt the venture capital world. By returning to the original vision while updating for today’s realities, BDCs can not only cure a number of venture capital’s ills (as Palihapitiya notes, lack of diversity in fund management, narrow scope of fundable ideas, unwillingness to tackle pressing societal problems), but fix the broken financial model as well.

And they can piggyback on another trend that can provide the financial resources to fund this change.

There is a massive movement growing in this country behind the idea of moving money from Wall Street to Main Street, as explored in books like Local Dollars, Local Sense: How to Shift Your Money from Wall Street to Main Street and Achieve Real Prosperity (Community Resilience Guides) by Michael Shuman orLocavesting: The Revolution in Local Investing and How to Profit From It by Amy Cortese. BDCs can be a very effective tool for establishing local community venture funds, as explored in my article BDCs: An Untapped Tool for Local Investing?

This idea begins with understanding that the types of companies a BDC can invest in (or own) are much broader than in the typical VC portfolio. They include the small and mid-size companies that serve as the economic backbone of local communities nationwide.

That can cover the continuum from funding raw startups to serving as a buyer of long established local small businesses being sold by retiring owners who are part of the “silver tsunami” retiring baby boomer phenomenon. Many of their businesses are just being liquidated for lack of a buyer.

A local community BDC venture fund can allow the community to buy those businesses and retain their jobs. Such a local community BDC venture fund can be established by the community, for the community, often in conjunction with other local economic development efforts.

Such local funds need not stand or fall on their own, however, but can be combined to achieve an economy of scale that still preserves the individual local efforts. Think of it as a “fund of funds,” where a single public BDC shelters smaller local funds as divisions under its larger umbrella. This model fits well with the growing trends of collaborative economic development efforts and impact investing.

Flexible structure

This aggregation of funds can spread well beyond geography to include other common characteristics such as clean energy, medical applications, or women, minority and veteran owned businesses and other targeted groups. Thus fund managers can more closely represent the constituencies they serve, providing a pathway into venture fund management for women, minorities and other traditionally excluded groups. Likewise they can target the kinds of societal ills that Palihapitiya wished VCs would find solutions for.

When one understands what BDCs are, how they work, and how to use them to solve small business funding problems, it becomes clear that on virtually every dimension, they are far superior to the way venture capital and other small business investment models are practiced today. And the more they proliferate, the faster the day will come when they will have made the old venture model obsolete. It is all in knowing how.

Michael Sauvante is Executive Director of Commonwealth Group LLC, the only firm specializing in the use of BDCs for small business investments, including having formed its own California benefit corporation “fund of funds” BDC that can partner with others wishing to form their own BDC, including impact investors. To learn how you might use BDCs for your particular objectives, go to  www.commonwealthgroup.net. You can also join the only LinkedIn group dedicated to BDCs here.

#6 What is a BDC?

Would you like a short, 2 page pdf document that explains the basics of BDCs, that you can print and share with others? Here is one that should do the job for you: http://www.commonwealthgroup.net/doc/WhatAreBDCs.pdf.

For a self guided tour of the current Wall Street version of BDCs, go towww.commonwealthgroup.net/BDCs

For information on new versions of BDCs that focus on small and mid-size companies (rather than middle market companies), go to www.commonwealthgroup.net/what

For more on where Main Street-centric BDCs can be applied, go towww.commonwealthgroup.net/where

If you are interested in setting up a BDC (your own or a “Virtual BDC™” under ours), or are an institutional investor interested in learning more about the benefits of investing in this new type of BDC, please contact the group owner Michael Sauvante for an initial free consultation or call (650) 641-1246. (This is not an investment solicitation.)

#4 Tired of Waiting? How We Can Achieve the Goals of Crowdfunding – Today

If you are like us, you view crowdfunding as a critical tool for helping small businesses access funding. And like us, you are probably frustrated with the pace of implementation.

We decide to search for a workaround. And discovered something that may be even better. Something that fulfills the promise of crowdfunding but is readily available and can be used as an alternative or as a complement to crowdfunding.

Have you ever heard of BDCs (business development companies)? Few people have, even though they’ve been around since 1980. But for anyone hoping to implement crowdfunding, they may be just what the doctor ordered. Or more precisely, Congress, which authorized them in 1980 under the Carter administration. And the SEC has long implemented BDC rules. Translation – no waiting!

So what are BDCs? They are a special type of investment company created with the express purpose of facilitating the financing of small businesses — a real JOBS Act, 30+ years before the 2012 bill. BDCs are usually public companies (although they can be private) that are allowed to invest in and lend to small businesses. Think of them as public VC funds that can also lend.

Actually, what they can do goes well beyond crowdfunding. Yet the bulk of BDCs on Wall Street focus on a narrow, upper slice of their potential market and don’t address the needs targeted by the current JOBS Act, like startups and other small businesses.

The Commonwealth Group first learned about BDCs in 2013, and we have spent the intervening time examining them for possible application to small and mid-size enterprises (SMEs). We have developed a set of strategies and methodologies around the use of BDCs to provide startup, growth and mature SMEs with access to funding in a way that can be individualized for each company. BDCs can mimic crowdfunding, yet also act like a VC fund, commercial lender and holding company rolled into one.

For anyone concerned with helping raise money for small businesses, whether by a (yet to be approved) crowdfunding portal or other means, BDCs represent a whole new set of options. In fact, they may be better than the most idealized version of crowdfunding, and almost certainly better than what will be left after the SEC completes its rule making. BDC rules are in place and can be used today. One just needs to know how.

With that in mind, we have created a LinkedIn group (BDCs – Business Development Companies) dedicated to implementing this new type of BDC. We encourage you to join this group.

In addition to our website at www.commonwealthgroup.net (where you can find a good deal of information about BDCs in general and our version of BDCs in particular), we have also created this blog for publishing ongoing information about BDCs. The first three postings are a good introduction.

Our next posting will explore how BDCs can provide an alternative to a crowdfunding portal for the equivalent of Title II, III and IV offerings.

We look forward to welcoming you as a member of the BDCs group.

#3 Five things to do with a BDC*

What can you do with a BDC? Lots of things, especially the types of BDCs that Commonwealth Group envisions. These are some of our favorites. And we can provide you with at least 10 more. Contact us (see below).

BDCs can:

  1. Raise money both privately and publicly
  2. Be managed like a VC, P/E or hedge fund (externally) with similar compensation structure (fixed management fee plus profit sharing – i.e. the “carry”)
  3. Invest in and/or lend to any manner of small and mid-sized companies including startups, growth companies and mature companies
  4. Focus on a particular geographical area (for example a state or local region) or a particular industry (for example green companies)
  5. Provide client companies with the functional equivalent of Titles II, III & IV from the JOBS Act

If you are interested in setting up a BDC (your own or a “Virtual BDC™” under ours), or are an institutional investor interested in learning more about the benefits of investing in this new type of BDC, please contact the group owner Michael Sauvante for an initial free consultation or call (650) 641-1246. (This is not an investment solicitation.)

* This is the third of three discussion threads to introduce the concept of BDCs to members of the LinkedIn group BDCs – Business Development Companies

#2 BDCs – the great alternative*

BDCs are an incredibly flexible tool. Due to their statutory capabilities, we find that BDCs can serve as functional alternatives to the following entities and more.

  • Venture capital or angel funds
  • Commercial lender
  • Local economic development funds
  • Equity crowdfunding portals for Title II, III & IV
  • Crowdfunding portals for peer to peer lending
  • Holding company
  • Private equity (P/E) funds
  • Hedge funds
  • Multi-family family funds

If you are interested in setting up a BDC (your own or a “Virtual BDC™” under ours), or are an institutional investor interested in learning more about the benefits of investing in this new type of BDC, please contact the group owner Michael Sauvante for an initial free consultation or call (650) 641-1246. (This is not an investment solicitation.)

* This is the second of three discussion threads to introduce the concept of BDCs to members of the LinkedIn group BDCs – Business Development Companies

#1 How much do you know about BDCs?*

For most people, the answer is “Not much.” Even though they’ve been around for 30+ years, BDCs are a little-known entity. Below is a quick intro. Follow the links at the bottom of the list for more information.

  • BDCs are closed-end investment companies, defined in the Investment Company Act of 1940 (Sec 54-65). However, they are exempt from many of the regulatory constraints imposed by the 1940 Act.
  • BDCs may either be privately held or public companies (most are public).
  • BDCs can legally invest in and/or lend to their clients companies. Therefore they are part venture capital company, part commercial lending company and part holding company.
  • If public, they can best be thought of as a public venture capital company that also does lending.
  • BDCs are mandated to invest and/or lend at least 70% of their total assets under management to small and mid-sized U.S. businesses. That includes small public companies valued at up to approximately $250 million.
  • Most current BDCs listed on Wall Street have been formed by larger financial institutions. Given their size, they focus on the upper end of the target group mandated by Congress (middle market companies) where investments and loans are typically $5 million and up.
  • If a BDC becomes a public SEC reporting company, then investors invest in a public company and that public company invests in and/or lends to private businesses. Thus investors are provided liquidity in the form of shares in a public company and don’t have to rely on a liquidity event in the underlying private companies in order to exit their investment.
  • If a BDC becomes an SEC reporting company, then investors will have immediately freely tradable shares (if they purchase public offering shares), and shares they can sell freely after six months (if they purchase the BDC shares in a private offering under Rule 144).
  • BDCs must make available management assistance to their client companies.
  • BDCs may have no more than 25% of their assets invested in one company.
  • Since the statutes and rules for BDCs have been around since the 1980s, BDCs are fully empowered to conduct their affairs today without having to wait for any new rules to be implemented (in contrast to the JOBS Act).

For a self guided tour of the current Wall Street version of BDCs, go to www.commonwealthgroup.net/BDCs

For information on new versions of BDCs that focus on small and mid-size companies (rather than middle market companies), go to www.commonwealthgroup.net/what

For more on where Main Street-centric BDCs can be applied, go to www.commonwealthgroup.net/where

If you are interested in setting up a BDC (your own or a “Virtual BDC™” under ours), or are an institutional investor interested in learning more about the benefits of investing in this new type of BDC, please contact the group owner Michael Sauvante for an initial free consultation or call (650) 641-1246. (This is not an investment solicitation.)

* This is the first of three discussion threads to introduce the concept of BDCs to members of the LinkedIn group BDCs – Business Development Companies