Can Purpose Driven Companies Keep Their Commitments Through an Exit?

When a company is sold, the price paid by the buyer should equal, roughly, the expected future cash flows that buyer expects to receive from the business.  This amount is equivalent to the fair market value and should rightfully be expected by the existing shareholders, barring any pre-commitments from them to not optimize for shareholder value.

Where the process gets interesting is how each buyer assesses those future cash flows.  If the company believes the future cash flows of the business are more than anyone else outside of the business believes, it can be sold to the public through an IPO (not technically a sale, but a liquidity event for shareholders all the same).

Aside from an IPO, the two main buyers of companies are strategics (larger companies in the same industry) and financial sponsors (private equity).   They both are able to pay more than the business would earn as a standalone private company, but for different reasons.

Strategic buyers believe they can increase the size of those future cash flows based on their own capabilities. So, when Clif bar sells to Mondelez,  Mondelez can pay a higher price than a buyer who does not already have a global snack food business because Mondelez expects to increase Clif's sales once it integrates the brand into existing sales, marketing and distribution channels.   Revenues should increase, and costs can be reduced as functions such as production, operations, accounting and legal all get centralized to the larger company.  As a result, the future cash flows of a Clif bar owned by Mondelez are assumed to be higher than the future cash flows of a Clif bar owned by the Whitebark Pine Foundation, for example. (Clif has a longstanding relationship with Whitebark, part of a commitment to support American forestry.  One could imagine a world where Clif simply sells itself to Whitebark so that all the profits go directly to the foundation).

Private equity buyers, in contrast, create value by increasing financial leverage.  A typical company being sold will not have a lot of debt, meaning the shareholders of the business own the right to substantially all the future cash flows of the company.  An individual small company is not able to borrow as much money at as attractive a rate as a large private equity firm.  When buying the company, a typical PE firm would add in debt to reduce the amount of equity in the business.  This debt needs to be paid first, but it also costs a fixed amount, so that – if all goes well -  as the business continues to grow and cash flows increase, the debt gets paid off by a portion of this cash, and then all subsequent cash flows of the business are shared among a smaller number of shares, thus increasing the free cash flow per share for those remaining shareholders.  

Both strategies have risks but both also result in the ability for the optimistic buyer to pay the seller of the business an amount larger than the business is worth as a standalone company.  And, also more than if the business is sold to a benevolent actor wishing to keep the company operating as is.    

The question I am struggling with is how a buyer who wants to keep a commitment stakeholder focus can also compete on price with these traditional buyers of businesses.  This is a vital question for stakeholder capitalism.  

Clif Bar, like many other companies in the past twenty years, started and operated as an independent company with a deep commitment to balancing profits with commitments to employees, community and planet.   Investors in Clif knew about these commitments, and accepted the tradeoff of potentially lower shareholder profits for the benefit to these other stakeholders.

There are thousands of purpose driven companies, like Clif Bar, today.  If the owners of these businesses do not sell to stakeholder committed buyers there is an overall limit to the size of the market for purpose driven companies.  

These stakeholder commitments cannot endure when a shareholder maximizing firm such as Mondelez (or private equity) buys the company. They may not erode immediately, but over time they must because Mondelez and traditional private equity firms are committed to a different goal - to optimize for shareholder return.

That isn't my opinion or a negative judgement, it is their own operating model . Mondelez has made a commitment to their shareholders to protect their interests above all other stakeholders. The legal and moral duty of the executives and directors of Mondelez is to work to fulfil that commitment, just the same as Clif Bar executives and directors were working to fulfil their own commitment.  Asking them to do otherwise is asking them to be deceptive to their own investors.

So, what do we need to believe in order for great companies like Clif bar to have an exit, and also to maintain their a stakeholder focused business model?

The first, most obvious answer is ask the seller to accept a lower price.  Fine. While there is some debate about whether a corporate Board can legally do this (Skadden Arps memo here, and Sullivan and Cromwell's memo here), let's put that aside and say even when legal, many (most?) shareholders and Boards will have a hard time choosing less money, particularly if it is significantly less.  Reliance on benevolent actions of a few acting against their own economic interest is not a great long term strategy for the industry.

Before moving to other ideas, I should put forth a second flavor of the 'take less money' argument that does not require benevolence: pre-commitment devices.  Companies can enshrine the commitment early in their operations - locking themselves into a decision whereby they cannot sell the company later to any buyer that does not keep the stakeholder model.  This can be done in a variety of ways, including through a Perpetual Purpose Trust.  

Founders and early shareholders may chose to do this even if optimizing solely for profits if they believe such a commitment could improve the business fundamentals going forward by, for example, attracting customers and talent, such that the subsequent fortunes of the company are greater, even when discounted by the lack of ability to sell to a buyer that would eliminate those commitments.  It aligns interests going forward between shareholders and the stakeholder commitments, as all parties want to optimize for economic value within the constraints governed by the pre-commitment.

Let's put aside the concept of a pre-commitment and a sale that takes a lower price. How could a stakeholder buyer still match others on price?

1) If the new owner creates the value by virtue of buying the company. This could be because of the buyer's brand, operational structure or expertise.  Say, for example, in five years, the family office of Gary Erickson (founder of Clif Bar) buys a very small snack food company.  It is reasonable to assume the new leadership will be able to improve operations in a way that increases the value of the company, even when keeping stakeholder commitments.

This mechanism for value creation is analogous to the strategic buying the company: when the assets of the buyer are added to the assets of the seller additional value is created.  

The challenge today is we don't have any scaled purpose driven companies. The traditional value add of a strategic buyer (distribution support, scaled services, etc) are not present for any buyer that would hold on to the stakeholder commitments.

2) If the transaction itself results in higher future cash flows.  This is analogous to the financial leverage in the private equity model. If the new buyer adds financial structure to the business, it could reasonably expect free cash flows to increase, just the same as a private equity firm would.  

I believe this is path is open today. In the past decade, a new capital market has developed for impact investors - deep pools of capital that are looking to invest in stakeholder driven businesses, and willing to accept a lower return in exchange.  A buyer of a stakeholder business could stack different pools of capital together to compile a competitive offer on the basis of this concessionary capital.  

No bank is willing to lower interest rates to large private equity firms because of their social purpose, but many foundations, family offices and individuals do for purpose driven companies today.  Say a deal needs $50M in debt - a buyer could get $10M at 0% rate in a PRI from a related non-profit foundation), $20M at 2% from a community development fund or purpose driven bank, and $20M at 5% from mission aligned family offices. The blended rate of capital is significantly lower than commercial operators could receive, allowing the potential acquirer to put in a competitive bid.

Values are expensive. If we want companies to pay employees more, internalize environmental externalities, and support local communities, the incremental costs will come from shareholder returns.  I resisted that notion for a long time, but believe it is necessary to concede this point to design a market system which accommodates more types of capital, with different risk/return/impact goals.  

We have already seen impact investing grow significantly in the past decade, without all the tools needed for investors to properly judge when and how they make impact / financial tradeoffs.   As the industry matures, the market will more efficiently stack different pools of capital -  and also provide more reliable information for customers and employees, current and potential - to support stakeholder models at scale, including through the exit process.