By Leila B. Boulton
How do impact investors perform due diligence on the socially-oriented enterprises they're considering funding? That was the topic of discussion at a private workshop organized as part of the Impact Investing Collaboratory during the 16th annual Lifestyles of Health and Sustainability (LOHAS) Forum held last month in Boulder, Colo.
The due diligence workshop involved two panelists and approximately 20 accredited investors, wealth managers and entrepreneurs. These included the CEO of a local residential and commercial solar system designer and integrator, and the head of a fair trade clothing company that imports handmade and naturally-dyed garments from India.
Moderator George Deriso, a director at Toniic, a San Francisco-based international impact investor network, began by explaining that due diligence in impact investing requires learning about the investment candidate, mitigating investment risk, setting the stage for a mutually beneficial relationship between the entrepreneur and the investor, and understanding the optimal deal structure.
He said due diligence needs to be a "full lifecycle endeavor" that should include five key elements:
? sourcing the deal and determining who the deal flow partners will be
? screening the deal to find out if it meets the investor's financial and impact goals, as well as the investor's criteria in terms of geography, industry and investment size
? examining the details of the deal, including business plans, financial statements, corporate bylaws and other documents
? determining which deal structure will yield the best return and which structure is right for the investment (e.g., equity, debt, quasi-equity or blended capital)
? monitoring and evaluating the deal on an ongoing basis to ensure the entrepreneur meets key metrics in a timely manner
After Deriso's introduction, panelist Aubrey Hornsby described his view of due diligence in impact investing. "Due diligence to me means engaging the mind intentionally in a very deliberative process in order to make vital decisions about what you're going to do with your life and your money," said Hornsby, who serves as managing partner of Boulder-based Localization Partners Consulting, a fund founded in 2011 to help develop local food enterprises. Hornsby said his group has a clear focus on rebuilding the infrastructure of agriculture for local economies.
"For us that's impact," he said. "It's different for a group that wants to alleviate world poverty as a screen to assess whether they're making an impact."
The other panelist, Robert Fenwick-Smith, told the audience that due diligence is the start of a long relationship between the impact investor and the business that's trying to generate a positive social or environmental benefit. "You're not buying a company, you're joining a partnership with individuals who are trying to start a business that's going to have social impact," said Fenwick-Smith, founder and managing director of Aravaipa Ventures, a Boulder-based investment firm with a focus on Colorado early-stage green and sustainable businesses.
Fenwick-Smith said he can only start doing "real due diligence" once he's a partner in the business. He said he would rather write a check and start working with the company than spend a lot of upfront time reviewing financial records and market analyses.
"Over the next three to six months, you'll find out pretty much everything you need to find out," he said. "Then if you have to write it off, it's no more expensive than the due diligence would have been."
Rather than poring over financials, Fenwick-Smith says he bases most of his investment decisions on whether he likes the entrepreneur's green technology, thinks the business model is sound and believes the company can become profitable in the long run.
Show Me The Money
But some audience members said they valued detailed financial statements as a way to gauge whether impact entrepreneurs were thinking realistically about the prospects for profitability. After all, the financial success of the enterprise influences whether the impact goals will be met.
One investor said she preferred to review current financials, rather than projections. Others agreed that pro forma financial statements were of little value because passionate impact entrepreneurs are prone to overestimate revenues and underestimate expenses. It's also hard, if not impossible, to assign a monetary value to devotion to a cherished social or environmental cause.
Audience member Kathleen Leonard, a vice president of investments at UBS Financial Services and head of the Boulder-based Leonard Social Investment Group, said she always looks at the financials because they reveal weaknesses in the businesses she's evaluating and "provide insight into where to probe further."?
Demonstrating that due diligence in the impact investing space is an ongoing process, panelist Hornsby said he holds weekly sessions with the companies his fund invests in. During those sessions he helps the entrepreneurs understand the basics of margins and ratios, become market-driven companies and ask the right questions of their customers. "These sessions become incredible experiences for mutual learning," he said.
When To Say No
One investor told the group that he avoids enterprises where he thinks the CEO is overpaid or isn't putting in sufficient effort. He said these can indicate a lack of willingness to make the business' core social or environmental cause a top priority.
The investors seemed to agree that good chemistry between impact investors and entrepreneurs is essential for a successful long-term relationship. Panelist Hornsby said he also looks for "emotional intelligence and passion" in entrepreneurs because it gives them the fortitude to weather the challenges of running a startup.
Moderator Deriso suggested that impact investors get to know their potential investment candidates well. Something as simple as taking entrepreneurs to lunch can be part of the due diligence process. "Let them order and observe how they treat the wait staff," he said.