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.
-Deldelp Medina. Executive Director of Black & Brown Founders
Convertible note (A convertible note is a form of short-term debt that converts into equity, typically upon a future financing round) with no interest, no maturity date, co-developed community impact incentives, and transparent repayment option after fixed holding period.
Community Development Financial Institutions are designed to lend to individuals, organizations, and businesses in under-resourced communities, offering financial education, business coaching, and low-interest rate loans that increase economic potential and help build wealth.
Any person or other entity (such as a firm or mutual fund) who commits capital with the expectation of receiving returns.
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:
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:
Is there demand in your market for this type of investment? If so, do you have the flexibility with existing funds to launch this type of program? If not, do you know how much money you would need to raise, and the sources of these funds? Have you identified what internal capacity you need to manage this line of work?
A CDFI seeking to develop the internal capacity to support BIPOC makers and manufacturers through an Impact Note needs a dedicated team – preferably staffed or advised by BIPOC community members – emboldened to build the fund’s infrastructure and manage its portfolio while simultaneously researching, developing, and proposing new investments. A CDFI may choose to begin by establishing an accelerator program that prioritizes the specific needs of manufacturers of color and directly invites underrepresented BIPOC entrepreneurs to apply. The fund should consider a simple application and onboarding process, then follow up with strong, consistent technical assistance to applicants.
A CDFI will need to be prepared to mentor BIPOC business owners through an accelerator or other mentorship programs until they are ready to apply for funding. The majority of the work is ensuring that companies are ready to receive funding, have viable growth potential, and that they are led by entrepreneurs with strong character and commitment. To get new and emerging entrepreneurs positioned for funding, they need long-term support partners at their local CDFIs.
The fund should begin by raising capital from sources that are aligned with the longer-time horizon required for equity investing. CDFIs should know that once Impact Notes are converted into equity, they may not receive any payments until the company reaches a liquidity event, which could be seven years or more.
How can CDFIs and other community lenders tap into the right capital sources to enable character-based lending?
CDFIs should consider securing funding from within their city and state’s economic ecosystem – building relationships with foundations, endowments, social impact investors, venture capitalists and private equity firms, as well as the US Treasury CDFI Fund. Thoroughly research partners’ missions and align your requests with the company’s stated DEI goals and values.
We know that a lot of great work is happening out there supporting BIPOC manufacturers and we want to hear about it! Our goal is to build a network of practitioners that can share information, resources, insights, and help celebrate the achievements being made. Please fill out this form to let us know what you’re working on.
