MEMO TO INVESTORS: KEY NOTES AND CONSIDERATIONS FOR INVESTING IN STEWARD OWNED ENTERPRISES
Please note: Neither AOA nor any of its employees are registered investment advisors. This article is not investment advice and is for educational purposes only.
Dear Investors -
Have you heard about steward ownership yet? If you haven’t come across a steward ownership investment opportunity, you will soon. This memo is a framework for why and how to consider investment in a steward owned businesses.
Steward ownership represents a paradigm shift in how privately held companies are owned and governed that protects independence and mission for the long term. It also represents an evolution in how these companies are financed. We believe that investors who are participating in private markets should:
Be aware of the dynamics of steward ownership, and how it compares to conventional ownership forms.
Understand the ins and outs of investing in steward-owned companies, and what to consider in the due diligence process.
Be clear about how to think about asset allocation to steward-owned companies.
If you are an active investor in the private markets, then this memo is for you.
The Dynamics of Conventional Ownership vs Steward Ownership
The traditional way that equity investors interact in private companies (often) looks like this:
XYZ Co. raises money from investors. In return for cash, XYZ grants investors two things:
Governance/control rights. The right to vote on key issues which require shareholder consent. If the investor is especially big or important, they might even get a board seat or a special advisory role to influence the company direction.
A share in the economic pie. Often this takes the form of a payout during a sale or major liquidity event, but depending on the maturity of the company, it may also include dividends along the way. Secondary market liquidity (selling shares to another private investor) is frequently limited or non-existent.
In short, investors get access to governance rights and economic rights. In practice, this sets up a feedback loop that centers shareholder priorities above all else. Investors who are primarily motivated by economic return may use their governance rights to apply pressure to management in an effort to prioritize said economic return. Even if that pressure is not explicit (and often it’s not), it still exists. Ultimately, the CEO reports to the shareholders, knowing in the back of their mind that the one key metric that their collective “boss” is using to measure their performance: ROI.
On the ground, this shareholder primacy can take many forms, and often it comes at the expense of the other non-investor stakeholders in the company: for example, cutting employee benefits, transitioning to less family friendly scheduling policies, lowering supply chain quality standards, or pursuing unsustainable growth in order to position the company for a bigger exit.
Steward ownership changes this paradigm by disconnecting governance rights from economic rights. Investors are granted economic rights, but control and votes remain locked up with a “steward owner,” such as a trust, which provides broad discretion to active participants in the business (i.e. employees) to run the company as they see fit within the boundaries of their purpose.
Further, where a conventional company may be incentivized to sell in order to create short term liquidity for shareholders, steward-owned companies are incentivized to stay independent forever in order to preserve their purpose and benefit all their stakeholders (including investors) over the long run.
In short - steward ownership sets up a system that treats company profits not as the primary end goal, but as the means to achieve a much broader set of goals in service of a core purpose. Profits are often reinvested in growth and mission and/or distributed among multiple stakeholders connected to furthering the purpose including investors, employees, and community.
However, in order to make this big vision a reality, investors need to participate. We have seen a huge increase in interest in steward ownership from impact investors over the past few years, and we predict this will continue.
The rationale for investing in steward owned companies is clear:
You can earn a competitive return on your money.
You will help finance companies that are endeavoring to make the world a better place by treating their employees well, taking care of the environment, implementing good supply chain practices, etc.
You will help local and regional companies stay independent, making a dent in the massive consolidation that is happening across industries.
You will show other companies considering steward ownership that the path is doable, which will accelerate the movement.
The Ins and Outs of Investing in Steward Owned Companies
As you consider investments in steward owned companies, you will want to do due diligence as you would with any other investment. Here are some specific considerations to keep in mind for your steward owned company diligence process:
Some steward-owned businesses have unique organizational and governance structures. Take time to learn about each company’s governance structure, process, and rules. While they may seem confusing at first, they are actually a feature, not a bug. These unique organizational and governance structures allow the company to pursue its purpose for years to come.
Understand your rights as a stockholder in the event that the company becomes unprofitable or insolvent.
Since steward owned companies are not designed to be sold off, be very clear about how you ultimately “exit” your investment. Are there redemption windows? If so, when? And how do they work? Under what situations can the company deny your redemption requests? Is there a revenue share up to a certain threshold? If so, how does it work, and when do you expect you will “exit” based on the company’s projections? What does the downside look like?
Carefully read the financial projections, and if applicable, the cash flow waterfall (how the company uses free cash flow) to make sure that you understand and are comfortable with who gets paid when, and the parameters around that.
Understand if the company has plans to raise future capital, as such efforts could be dilutive and or introduce additional risk to your investment.
Learn about their talent attraction and retention strategy. Steward-owned businesses require executives that have a focus on both sound financial management and purpose-results.
Steward-owned companies are still normal companies operating in the world, so you will want to be comfortable with the industry as a whole, and the company’s relative position within the industry. Steward-owned companies, like any company, are still susceptible to all the issues that conventional businesses face: industry/market disruption, shrinking market share, offshore competition, etc.
How to think about steward ownership allocation in your investment portfolio
As investors, there are many factors to consider in determining a suitable allocation strategy. We will focus on three big ones: Risk Profile, Time Horizon, and Impact.
Risk Profile
The return profile of each investment is different, typically corresponding to the stage of the company. Mature, cash flowing steward-owned businesses will often issue non-voting preferred stock with an annual dividend. These act somewhat like corporate bonds, and the rates are usually at least a few points higher (which makes sense as they are more risky and illiquid than public companies). In these cases, there may or may not be underlying share price appreciation in addition to the annual dividend.
For steward owned companies that are earlier in their life cycle and not yet profitable, or not consistently profitable, the return will be higher (again, corresponding with the relative risk). A common structure in these cases is a revenue/royalty share model with a capped return (i.e. investors get 80% of all free cash flow until they hit a 2.5X multiple on their principle, and then they are out).
Another apt corollary to how a steward-owned investment might fit into your portfolio is thinking of it as akin to investing in mature real estate. These investments share many of the same characteristics: a cash-flowing, somewhat illiquid asset with a longer time horizon, and no guarantee of underlying appreciation.
Like any investment, there is risk. Keep in mind that you are investing in a private company that intends to stay private, and that your investment is illiquid.
That said, many steward-owned companies don’t have a binary outcome like many other private placements. For example - with a startup, you might make 5X on your investment or it might go to zero. With a steward-owned company you often get to share in the company’s success along the way: kind of like a private company meets a public dividend stock/corporate bond.
Consider the risk profile of each investment, and then think about what percentage of your portfolio you are comfortable allocating at that level of risk.
Time Horizon
Consider your time horizon. Steward-owned investments are typically illiquid until certain events (i.e. redemption windows, completed revenue share, etc.). You should only invest whatever percentage of your portfolio you are comfortable locking up for that time period.
Investors with a long-term outlook should know there is research showing that steward-owned companies survive longer and are more resilient during tough times compared to conventional businesses. According to one study, steward-owned companies are six times more likely to survive over 40 years than conventional companies (Børsting, C., Kuhn, J., Poulsen T., und Thomsen, S., 2017).
Impact
Since most investors who invest in the steward-ownership space may consider themselves “impact investors” you will want to learn about the company’s motivations for becoming steward owned in the first place. What is their purpose? How are they manifesting that purpose and measuring their impact? Who are their primary stakeholders? How are they benefiting those stakeholders? Does this company meet your ESG criteria as an impact investor? What we typically see is that steward-owned companies' commitments to purpose extend well beyond typical ESG commitments, and are quite attractive to impact investors.
Summary
Steward-owned businesses will become more and more common as purpose-driven owners seek ways to preserve their mission for the future. When more investors understand and participate in the steward-owned ecosystem, all stakeholders benefit.