Capped Returns

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Description

The idea of capped returns, proposed and discussed by Joshua Vial the Enspiral Foundation and community, is to accept private investments but to cap their possible returns, after which the funded resource is ceremoniously donated to the commons, with attribution to the investor(s).


Ben Knight:

"We settled on a mechanism called “Redeemable Preference Shares,” which was exactly what we were looking for—a way of providing a fair return to investors while also protecting our social mission. Within two months, we had raised $450,000 from a small group of investors. Our lead investor is Sopoong Ventures, a social venture fund based in Seoul. The name Sopoong is an acronym for “the social power of networked groups,” and the fund is a perfect partner driven by the same vision and values as we are. Our investors have been an amazing addition to our team, providing much more than just money.

Redeemable preference shares are a fairly conventional financing instrument, but aren’t widely used in the startup world. “Redeemable” means that the shares are not traded externally. Instead, the shares are eventually purchased (“redeemed”) by the company with an agreed-on return, after an agreed-on period of time, provided the company is producing sufficient surplus. In our case, setting up the investment mechanism meant creating a new class of impact-investor shares. These shares sit alongside the worker-member shares in the cooperative, which are non-financial governance shares. The interests of the company and the interests of investors line up." (http://www.yesmagazine.org/new-economy/how-a-worker-owned-tech-startup-found-investors-and-kept-its-values-20160426)

Discussion

Joshua Vial:

"Business has become so good at growing that it has deeply corrupted our governments and media. It has weakened the critical constraints on growth, and our planet is starting to look like a barrel of flour full of weevils, headed for collapse.


There are two paths in front of us – option A is to transition to a steady state system where the amount of total growth is (at least) balanced by the amount of total contraction. Option B is to collapse, when a system which can only function by growing hits the limits of a finite planet.

Option B lacks appeal so let’s not dwell on that too much. Let’s explore option A.


Here are some design constraints I’ve been exploring for possible solutions to help migrate to a steady state economic system.

  • No (initial) dramatic regulation changes – our political systems are too deeply captured
  • Cheap to start and experiment with
  • Easy to copy and improve
  • Provide better options for investors and businesses than the current system (else why would they switch)
  • Serve the commons – the current system can’t co-opt the good bits of the idea and keep working at odds with the health of the whole


Those constraints are kind of daunting, but I have found them useful to focus my thinking. In particular there has been a lot of work done by people looking at the fundamentals of our monetary system as the root cause of growth addiction. I think the theory is sound but the experiments or proposed solutions I’ve seen always fail one of the constraints.

The ideas below are not a comprehensive solution by any means, I think they show promise and are worth sharing as early stage prototypes needing a lot more work.


THE IDEA: CAPPED RETURNS

It’s pretty simple – Whenever investors or entrepreneurs receive equity in a business the total returns on the equity are capped. The returns should be fair but they do not result in a perpetual claim on the profits of the venture.

The implementation is pretty simple as well. Whenever a company issues shares, it writes a matching call option where it is required to repurchase the shares at an agreed upon price.

Sounds like crazy talk, right? Why would anyone do this kind of deal, and why would it matter if they did?


WHAT HAPPENS WHEN ALL THE SHARES ARE REPURCHASED?

A big party!

In this model a company has two types of shares – financial shares which yield returns until they are repurchased, and governance shares which only have voting rights and do not expire. This is pretty simple to set up in a company constitution.

When the financial shares are gone all that is left are the governance shares and now 100% of the profits from the venture are available for the organisation’s social mission. These profits are controlled by the (governance) shareholders through the company directors.

Without the financiers’ boot on their necks, the directors are now free to be much more creative with how they spend profits. They could invest in making their company the best possible place to work, or fund ambitious social impact projects, or invest significantly in the commons.

The company still needs strong governance and checks and balances to prevent things like inflated salaries or inefficient operations, but these are solvable through mechanisms other than owners optimising for profit.


HOW IS THIS BETTER FOR INVESTORS?

Capped returns aren’t better for all deals or investors, but they will be for some.

If you are trying to maximise financial returns, then a perpetual claim on profits is better than a capped return. You would only take the capped return if no other options were available.

This investment structure will open up deals for businesses which weren’t fundable before — good businesses with great financial prospects that could generate healthy returns but would never raise traditional equity.

Some of these businesses are launching in developing economies where liquidity options such as an Initial Public Offering or acquisition aren’t possible. Others are early stage ventures which aren’t shiny enough to return a Venture Capital fund in one go, so miss out on angel funding.

Others are impact driven businesses with no interest in being acquired or maximising the dividends they pay to shareholders. They exist to change the world through achieving their social mission.

Capped return investments can also dramatically change the risk profile of investing in an early stage business by agreeing on payment terms that are a share of revenue and look more like a capped royalty than traditional equity.

In short, these types of deals can be better for investors by opening up deal flows that were inaccessible before, and by changing the risk profile of early stage ventures. For investors who want to keep the social mission at the fore or invest in the commons, it is a much better model.


WHY WOULD AN ENTREPRENEUR CARE?

Starting a company is not a rational act. It is an act of unreasonable conviction and passion, a belief that you can see something that few other people can, and that your vision is true. The art of entrepreneurship is balancing this unreasonable conviction with the humility to listen to the world and adapt accordingly.

Founders are deeply attached to the businesses they create. Many realise that they aren’t the people to lead the business over its whole lifecycle but they still care about what happens after they step away. They care about the people, the customers, and the mission.

Capped returns are a way of preserving that which is most dear while still accessing capital and receiving fair compensation for the sacrifice and value creation of launching a successful business.

Financial incentives matter, but with adequate access to capital to fund the next venture it really doesn’t matter if an entrepreneur makes 1 million or 100 million.


When I first started Enspiral I made a clear decision to give the whole thing away – to generate opportunities instead of money. It worked. I am now flooded with opportunities, and in a similar financial position to when I started. I’m very glad that I structured things that way, but as an entrepreneur it isn’t the sort of deal I would do over and over again.

When setting up Dev Academy my co-founder and I agreed on capped returns for ourselves and our investors. Time will tell how it plays out, but from my point of view it feels like a good balance between giving everything away and fair compensation.

The biggest problem with our current system is that the growth path of successful companies very often end up with an IPO or acquisition by a listed company. No matter where they start, companies tend to end up in a profit maximising system with incentives to externalise as many costs as they can onto society. In this model, a few win while society loses.

The shares in those public companies never expire. They transition from being a vehicle for fair compensation to investors and entrepreneurs to becoming licenses to extract wealth from society that are sold to the highest bidder. There are dividends being paid out today on shares in companies where every person who took the risks and put in the capital to start it up has been dead for 100 years. The returns have become divorced from their original connection to meaningful inputs to the business.

If capped returns became the norm of business then the growth path of a successful enterprise would be to pay back its founders and investors early on in its lifecycle (first decade or two). Then there would be a big celebration as the business became a freehold impact venture with a binding mandate to serve wider society.

There would still be motivations to grow, but they would be far less than our current system. We would increase the net amount of energy going towards the commons and positive social impact.

We could make a decent dent in financial inequality, as investors would need to work harder to find new deals for their upcycled capital instead of passively living off ‘financial extraction licenses’. This post on the founding story of Ford has more thoughts on the relationship between perpetual returns and inequality.


Building a small ecosystem of capped returns is all well and good, but it won’t make much of a difference in the grand scheme of things. This idea has the most potential for impact if it becomes the new norm and displaces indefinite returns significantly – maybe entirely.

To do this, it would need to move from niche ecosystem to wide spread movement, similar to the alliances around climate change and other major social movements.

It would be easy to create a mechanism where a company’s constitution mandates that its surplus is either spent on the social mission or reinvested in capped return vehicles, similar to how the GPL locks IP into the public sphere. This would create an ecosystem of capital legally bound to a capped returns social impact model – a self-reinforcing engine of positive change.

Add in a commitment to transparency, like Buffer’s transparency dashboard, some basic workplace democracy, and a simple brand like Fairtrade, and you have the basis of a low-cost network uniting investors, entrepreneurs, staff, and consumers to out co-operate traditional business.

Combined with a sustained political movement to plug the costs externalised by businesses (a long battle in its own right), this would create a playing field where the capped returns business ecosystem has a the following sustainable advantages:

cheaper capital – capped returns fundamentally lowers the value of capital which means that it is a better deal for businesses needing investment. The compounding capital in the ‘once in, never out’ ecosystem can handle the supply side and make capitalism more efficient. a stronger social contract – because the ecosystem is contributing to the health of the whole rather than destroying it It would also be possible to play with other dynamics such as procurement policies weighted towards capped returns suppliers, or IP which is put into the commons but only accessible to companies in the capped returns ecosystem. Combined, all of these could create an economic ecosystem which is more effective and efficient than the current one. The good thing about business is that when you are better, you usually win.

At its core, reaching scale would be about building a broad-based movement around the immorality of an extractive economy, and demonstrating a viable alternative that people could participate in. The new economy could out compete the current one and would eventually displace ‘anti-social enterprise’.

THE INSPIRATION

I first bumped into parts of this idea in 2012, in a blog post on revenue share royalties as an investment model in developing economies (which I’ve never been able to find again, please share if you can).

This prompted me to start hacking on some internal experiments with Enspiral folks which I called Fairy Gold. Since then this approach has influenced how I’ve been structuring deals, particularly Dev Academy.

In 2013, there were some panels at SOCAP talking about Demand Dividends, which are royalty-based financing with a cap. I also bumped into Luni from fledge who was doing capped returns as part of his impact accelerator.

Indie.vc made a splash in early 2015 when they launched a fund with capped returns (conditional on the founders not selling out), and I’d encourage you to checkout Bryce Robert’s thinking on the topic, which is quite different to mine: here, here, here and here.

Sacred Economics and the New Capitalist Manifesto have been pretty influential in my thinking and I highly recommend them.


WHAT NEXT?

There are a lot of “ifs” in this post, and the idea needs refining and experimentation. The lifecycles we are talking about are relatively long, and it would take many people from different backgrounds collaborating over decades to see if this could work.

But the opportunity is huge. Our economy is one of the most powerful systems in human society, and it is currently causing a lot of damage. If we can shift the fundamentals of our economic system from extractive to generative, it would be difficult to overstate the impact we’d have on our world.

I am up for more experiments. The only deals I’m considering anymore are ones where the returns are capped. I would love to collaborate with anyone else who is exploring this space." (http://joshuavial.com/capped-returns)


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