and funding for start-ups
This is the text of a presentation I gave to a network of angel investors, comprising both start-up founders and potential investors, in October 2020.
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Good afternoon everyone.
Today I would like to talk about a number of topics that are close to my heart and that I'm very passionate about, in a way that's very practical for start-ups.
Some background about me. I have a history in corporate transactions and for the most part of my career I have been a transactional lawyer with large law firms. About 3 years ago, I transformed my practice and began to focus on responsible business, ethical business, impact investing and the governance structures that go along with these. I am fascinated with the broader theory of the corporation, with its place in the economy, and how it's evolving rapidly as we as a society change. Many of you are either investors or founders of start-ups, embryonic enterprises through which you want to make your idea a reality, which is the essence of the corporation.
Purpose and the law
From the very early days of the corporation, the aim was to make manifest a higher vision. It was in 1250 that Pope Innocent IV established the idea of a 'fictive person' as 'immortal, who sues and is sued, has a seal of its own, who makes regulations for those natural persons of whom he is composed' and the first medieval corporations were universities, monasteries, churches and guilds (Graeber, David. 2014. Debt: The First 5,000 Years, Brooklyn: Melville House. p.304).
All of these early corporations had purpose built into them.
Later on, the Dutch East India Company and the British East India Company became well known early corporations and they came to symbolise a concept of the corporation as an adventure, an exploration to find riches from faraway lands. With these corporations, came the idea of profit-seeking and returns to those who had risked their capital.
And from there the corporation evolved into the model we are familiar with, which is an enterprise, with its own legal person status, responsible for complying with laws and contractual obligations, run by managers or executives, supervised by directors and responsible to shareholders, who are entitled to a return on their investment and the promise of limited liability. .
That's also sometimes called the 'shareholder primacy' model – that idea that a corporation exists to maximise shareholder gains and directors are directly responsible for protecting and managing their interests.
But, first, this shareholder primacy model as a matter of law applies less in Australia than in other countries like the US and secondly, it is falling out of fashion. It's established law in Australia that the duties owed by directors of a company generally mean they have to take into consideration more than financial matters – which could include a non-financial purpose and could include the interests of multiple stakeholders.
The duties of directors we are talking about here are expressed in the Corporations Act as 'the duty to act in good faith in the best interests of the company' (Corporations Act 2001 (Cth), s. 181(1)). Which in Australia, does not mean just the shareholders.
There were two parliamentary committees in the early 2000s that looked at the duties of directors and came to this conclusion. The Corporations and Markets Advisory Committee (CAMAC) concluded in 2006 that directors' duties gave directors 'sufficient flexibility to take relevant interests and broader community consideration into account'. A Parliamentary Joint Committee on Corporations and Financial Services reached a similar conclusion that same year.
So much for the law. Since then, the issue of the corporation's rightful place in society has come under scrutiny again and again. In Australia, we had the expression 'social licence to operate' emerge. This is based on the idea that a corporation doesn't just exist with a certificate of incorporation from ASIC, it also relies on a licence given to it by society and has a contract with society.
That expression made it into a draft of the 4th edition of the ASX Corporate Governance Council's Principles and Recommendations which is a governance guide for ASX listed entities which they must either comply with or explain why they're not complying.
We had the Financial Services Royal Commission, around the same time, where in the Final Report, Commissioner Hayne on the one hand utterly slammed the big banks for their greed and on the other hand spoke about how if a board is really governing a company in accordance with the law, this shouldn't happen, because the best interests of the company really means over a long period of time, everyone concerned with it, not just shareholders. He said (at page 403, Vol 1):
The longer the period of reference, the more likely it is that the interests of shareholders, customers, employees and all associated with any corporation will be seen as converging on the corporation’s continued long-term financial advantage.
That Royal Commission looked into not just whether the financial institutions were breaking the law or guilty of misconduct, but whether they were falling short of community expectations. Now there were some referrals from the Royal Commission to ASIC for offences but by and large the conclusion was that they were doing more of the latter than the former. Certainly, while a number of directors resigned, there were no actions taken by ASIC against a director for breach of a duty to act in the best interests of the corporation.
So, we come back to the question. Is the law around how companies are governed really enough to provide the right framework for a company that wishes to pursue a non-financial purpose in addition to profit? Or will a company fall back on the shareholder primacy model as a default? And what do our communities want?
Most modern companies have built into them the reporting obligations and metrics not so much of churches, monasteries and guilds but of the East India Companies. But communities, and founders like yourselves, and increasingly investors don't want plundering and pillaging as a business model.
And we see that backlash:
the introduction of legislation that requires business to pay closer attention to non-financial risks, like the Modern Slavery Act 2018 (Cth) – which has no penalties for failing to report or misreporting risks of modern slavery in supply chains and operations
a sharpened focus from Australian regulators on non-financial risk and impacts, including the Reserve Bank of Australia (RBA), the Australian Prudential Regulatory Authority (APRA) and the Australian Securities and Investments Commission (ASIC)
significant changes in reporting frameworks requiring companies to begin making more detailed disclosure of non-financial risks and impacts, particularly climate risk and modern slavery risks in operations and supply chains. In tandem, there is a worldwide towards sustainable development gaining universal acceptance in the form of the Sustainable Development Goals, providing a framework for action and increasingly a basis for reporting
increasing community pressures on companies to consider their nonfinancial impacts
increasing investor focus on ethical behaviour as well as products and services that serve a greater good;
non-binding but highly persuasive codes of conduct (such as the ASX Corporate Governance Principles and Recommendations which recommend that the board of a listed entity should, when identifying and managing risk, consider non-financial risks such as 'social risks', which relate to the risks of negative consequences to a listed entity where the entity or its activities adversely affect society)
statements by influential business associations (such as the US Business Roundtable and the UK Institute of Directors which seek to enlarge the definition of 'purpose' of a corporation beyond maximising shareholder returns)
developments that have increased litigation risks to longer-term environmental and community concerns, particularly notable in the area of climate change.
[List adapted from Noel Hutley, SC and Sebastian Hartford Davis, Climate Change and Directors' Duties – Supplementary Memorandum of Opinion, 28 March 2019 . This memorandum issued by the authors in 2019 broadly summarises developments since they issued a legal opinion in 2016 on the relationship between climate change and directors' duties. I have expanded these developments to cover non-financial risks broadly, in addition to climate risk.]
My view is that the law is definitely flexible enough to allow for a company to pursue a non-financial purpose but the governance and operating models we have inhibit it tremendously, because we tend to focus on efficiency, productivity, financial growth and financial performance. Purpose needs to be embedded at every operational level of the enterprise from senior management down to customer-facing employee; in policy and practice across the board in employment (remuneration, incentives, promotions, hiring, grievances, training), procurement,
marketing, customer interface, complaints handling, compliance, risk, legal, finance and so on.
Purpose and governance
So, as a founder, let us say you are passionate about making a difference not just making money. You are wise to the advantages too of incorporating purpose well – it will create happier employees and suppliers, it will attract customers, it will burnish your reputation, it will differentiate your brand, it will lead to better governance, and it will open you up to a class of investor known as the impact investor.
So let's look at some models for purpose.
Let's start with social enterprises. What's a social enterprise?
According to Social Traders Australia, these are businesses that trade to intentionally tackle social problems, improve communities, provide people access to employment and training or help the environment. They are profit-making but they channel additional profits back into their purpose.
They have three features:
The enterprise has a clear and defined primary social purpose, environmental or other public benefit.
The enterprise derives a substantial portion of its income from trade.
The enterprise reinvests 50% or more of annual profits towards achieving the social purpose.
Social Traders Australia estimated in 2016 that there were 20,000 social enterprises in Australia, Of these, the majority (73%) are small businesses, 23% are medium sized and a minority (4%) are large organisations. They are relatively immature, with 38% being in operation for more than 10 years and 34% between 2 – 5 years. Social Traders certifies social enterprises. It's $500 annually for the certification and it allows for the recognition of social enterprise status.
The benefits of Social Traders certification is that your enterprise will have a better opportunity to obtain government contracts, especially in the State of Victoria where we have a whole-of-government social procurement framework that encourages procurement from social enterprises and Aboriginal businesses. Becoming Social Traders certified attracts an annual fee of $500 (excluding GST) and makes it easier to be recognised as a social enterprise. The certification is really about proving those three things. For a start-up, you can forward project your financials to show that you will derive a substantial portion of revenue from trade.
Now onto B Corporations, which are a bit more complicated. B Corporations are enterprises that are certified by B Lab Australia & New Zealand which is a not-for-profit organisation. They started in the US in around 2007 as a response to the very shareholder-centric models of business and governance that exist there. There are currently about 3,500 certified B Corporations in over 70 countries.
To fulfill the performance requirement for B Corp Certification, a company must complete the B Impact Assessment. The B Impact Assessment (BIA) is a free, confidential platform designed to help measure and manage a company's positive impact on four areas: workers, community, customers and environment. The BIA assesses the impact of both day-to-day operations and business model. Responses to the BIA will provide a total numeric score. B Corp Certification requires a minimum verified total score of 80 out of 200 across all impact areas.
It's a complex, high-quality, well-developed assessment model. It takes large organisations well over a year to meet the standards. Smaller organisations have an advantage because you can build into your policies, procedures and systems the necessary requirements, from the ground up. Because the B Impact Assessment measures performance over the past twelve months, only companies that have at least one year of operations are eligible for B Corp Certification. Companies under one year are eligible for Pending B Corp Status. Certification fees start at A$500 per year for sales up to A$150,000 and scales up to A$50,000 for companies with revenue of over A$1BN. A company with revenue of up to $2M will pay A$1,000.
How do these models overcome the hurdles of embedding purpose that I talked about? For a start, the enterprises that are social enterprises or B Corporations have a clearly defined non-financial purpose. In the case of Australian B Corporations, the enterprise, if it's a company, is required to state the purpose in the company's constitution and to require directors to take into account multiple stakeholder interests in their decision-making. That's legal, because it doesn't interfere with the legal framework of directors' duties we discussed but it does create a particular situation for directors of such a company.
There is a question of whether becoming a B Corporation and amending the company's constitution to include purpose and expressly requiring directors to factor in multiple stakeholder interests increases liability for directors if they do not do these things The conclusion I have come to is that there is somewhat of an increased risk for directors in this position. However, it needs to be recognised that in the past few years, the standard of care that expected of directors of all Australian companies is higher, because of increased focus on non-financial risks and impacts by legislators, regulators, reporting frameworks, the community and investors.
There has been a shift and this shift has broadened the scope of issues that directors need to consider in decision-making and therefore elevated the standard of care expected of a reasonable director. As time passes, the gap between the standard of care expected of a B Corporation director faces and that of the generic 'reasonable director' will close.
There are also practical ways to mitigate risks for directors – many of these will apply to larger companies but some examples:
developing non-financial risk appetites, and ensuring the board actively positions itself to hold management accountable to operate in the interests of non-financial stakeholders and within stated non-financial risk appetites
having board policies that requires that relevant non-financial risks and impacts to be communicated to the board. The board should require reporting from management that has a clear hierarchy and prioritisation of non-financial risks and non-financial stakeholder interests
ensuring that discussions of the board and board committees (particularly the board risk committee) canvass non-financial risks and the interests of non-financial stakeholders, and that these discussions are appropriately minuted
ensuring the board and board risk committee meet regularly and for long enough to enable proper discussion and resolution of non-financial risks and issues relevant to the interests of non-financial stakeholders
preparation of adequate induction materials for new directors which include proper reference to the interests of non-financial stakeholders
training for directors that incorporates education and awareness of the interests of non-financial stakeholders
a board charter that references the constitutional clause and specifies that directors should appropriately consider the interests of non-financial stakeholders in decision-making.
[Several of the suggestions in this list are drawn and adapted from the findings and recommendations in ASIC's Corporate Governance Taskforce - Director and officer oversight of non-financial risk report, ASIC Report 631, 29 October 2019. The report resulted from ASIC's review of the corporate governance practices of Australia’s largest financial services companies.]
In general, for start-ups, there are challenges in ensuring good governance, particularly in dividing the role of board from management; ensuring the board does not end up in the weeds of operational management, ensuring the CEO / founder doesn't end up chairing the board if that's not her position; ensuring . enough time, diligence and commitment from the board; ensuring the right skillset and so on. One of the advantages of using these models is that you can access passionate directors, ones who are aligned to your purpose.
Purpose and funding
Funding is a major issue for a start-up obviously. Trying to manage the intersection of funding and purpose creates an additional challenge.
I am going to mention that the British Academy has begun a major research programme called The Future of the Corporation which is a review of the role of business in society.
The research suggested a need to develop a new, more human framework for the corporation around well-defined and aligned purposes, complemented by ethical cultures and commitments to trustworthiness. Professor Colin Mayer, the Academic Lead for the programme, drew together the research and defined the purpose of business as: Profitably solving the problems of people and planet, and not profiting from creating problems.
There were 8 principles that the British Academy identified in a 2018 report as being necessary for a new model of purposeful business and these were:
law: reform of the essential nature of the corporation, including a focus on replacing profit with purpose as the key driver for enterprise and realignment of directors' duties accordingly
regulation: new powers and accompanying laws for regulators to enforce corporate purpose particularly for regulated industries
ownership: requirements on shareholding and corporate ownership to support corporate purpose
corporate governance: corporate governance rules that truly embed purpose
corporate finance: rules for corporate finance to ensure fundraising that coincides with purpose
measurement and performance: development of standardised measurement and reporting frameworks for corporate purpose and
investment: norms for investment that incorporate ESG considerations and impact investment concepts.
This underlines the need for funding and finance of a purpose-led enterprise to be aligned with the purpose.
While there are particular investors, investment managers and investment funds that focus on niche areas, finding the right match for your start-up on top of just trying to convince investors to invest – it requires commitment to your purpose.
The responsible investment sector is hugely diverse, there is a plethora of investment approaches used, all in addition to fundamental financial analysis. There are fund managers and super funds who apply ESG integration, screen companies (e.g. tobacco), use sustainability themed investments (e.g. clean energy funds and green property), engage actively with companies and making impact investments whilst also generating strong financial results.
The RIAA (Responsible Investment Association of Australasia) has a handy tool, a spectrum that explains the differences between traditional investment, responsible investment (from ESG integration through to impact investing) to philanthropy, that shows the difference.
I don't want to go into the different sorts of responsible investing here. I will touch on a couple of funding areas.
One is equity crowdsourced funding. Crowd-sourced funding (CSF) was legalised in Australia in 2017. It is regulated under the Corporations Act and the Australian Securities and Investments Commission Act. Generally, our crowd-sourced funding regime aims to reduce regulatory requirements for public fundraising while maintaining investor protection measures. These include allowing simple offer documents instead of full prospectuses.
Companies that may utilise the crowdfunding regime are unlisted public companies and proprietary companies with less than A$25 million in assets and annual turnover. Eligible companies will be able to make offers of ordinary shares to raise up to A$5 million in any 12-month period.
Obligations and investor protections that apply to crowd-sourced funding offers include:
an investor cap of A$10,000 per annum per company for retail investors
the provision of a crowd-sourced funding offer document containing minimum information and a prescribed risk warning; and
a five-day cooling-off period.
The offer must be made through an intermediary that holds an Australian financial services (AFS) licence. There are a number of intermediaries that specialise in CSF.
ASIC has issued Regulatory Guide 261 Crowd-sourced funding: Guide for companies (RG 261) to assist companies seeking to raise funds through crowdsourced funding to understand and comply with their obligations in the new regime.
I don't have specific experience in crowdfunding for start-ups as an adviser but I am an investor in solar energy start-up DC Power Co which when I invested was the largest equity crowdfunding campaign in Australia, they raised A$2.5 M from 17,500 investors in April 2018 and then in a second round they raised A$1.6 M from 1,688 investors (through Birchal). They have an interesting story, a lot of learnings, in terms of trying to convert their investors to customers. They have only had 20% conversion, and they are focussing on their market offering.
Another funding route I want to quickly mention is the Impact Investment Ready Growth Grant funded by the Government's Sector Readiness Fund for social enterprises, that's A$7M provided by the Federal government and administered by Impact Investing Australia, which provides grants to social enterprises to enable them to build capacity.
The point I wish to make here is that social enterprises, while deriving revenue from trade, can have access to government money. Here the aim is to target very early stage start-up social enterprises so they can build capacity and reach a stage of seeking investment funding.
The Federal government had said in January 2020 that it was committed to supporting the sector to become investment-ready and build capability. Of course, investors in this sector still want reasonable risk-adjusted returns which are not always forthcoming. The Australian government's Social Impact Investing Taskforce identified this as a challenge in its interim report of January 2020,20 but with COVID interrupting things, there remains no clear coordinated effort or policy guidance from government as to how these will be tackled.
Thank you for your time, there certainly has been a lot to get through. I'd be pleased now to take any questions.
4 November 2020
For more information on this article, please contact Geraldine Johns-Putra
Principal Lawyer, Geraldine Grace
Tel: 61 (0) 411 183 968