1.5 Institutional Investment
Community shares can provide the foundations for building a robust capital structure in a society. Some societies may be able to raise all the capital they require from individual members. But, more often than not, community shares act as a lever to access institutional investment. This investment might be in the form of grants, loans or equity. The institutions might be public funding bodies, social investment specialists, banks, ethical investment funds, charities, and corporations, including other societies.
Institutional investment is defined here as investment by institutions that exceeds the limits voluntarily imposed on individual shareholdings by members, usually 10% of the share capital of the society. The purpose of voluntary limits is to prevent societies being overly dependent on individual members. Where an institutional investor is providing more than 10% of the capital of the society, safeguards need to be established to protect the interests of ordinary members. Institutional investors often take comfort from community shares. Community shares demonstrate community support for the enterprise, and its services. It provides some financial security for institutional lenders, knowing that they are higher up the list of creditors than shareholders. It is proof of the long-term commitment by members to make a success of the enterprise and to see it through any difficult or challenging period.
Institutional investment is usually welcomed by societies, subject to concerns about the impact it might have on members’ investment and the dangers of over-dependency on a single source of investment. These concerns depend on both the nature and the scale of the investment. The focus here will be on three types of institutional investment - grants, loans and equity – and on a scale range from 10% to over 90%, of total capital required.
Institutional grant funding generally poses little concern, especially when it is public funding for public interest initiatives. Dependency on grant funding is less of a problem when the grant is for capital purposes, rather than revenue activities of the society. Capital grants have a positive impact on societies by lowering the cost of capital. Even when a capital grant exceeds 90% of the total capital required, it is unlikely to have an adverse effect on a society, unless it diminishes the motivation of the local community to become members and investors in the society, or it leads to a society taking on a capital investment project that is much larger than it can support in revenue terms.
By comparison, institutional lending poses a number of concerns and should be treated with caution, whilst recognising that debt is an essential part of the funding mix for most businesses. Approached correctly, lending can be flexible, responsive, and in some cases cheaper for a society in the long run. Institutional lending to societies generally takes three forms; secured longer-term capital finance for fixed assets, shorter-term finance for working capital, and bridging loans. Other forms of debt finance, such as overdrafts, factoring and corporate credit cards, are not considered here.
Secured longer-term capital loans, for terms of five years or more, are typically used to finance the purchase of fixed assets, where community share capital and the resale value of the fixed assets are seen to reduce the risk of the lender. Lenders may be willing to lend up to 80% of the total capital required by a society, especially for a fixed asset such as property that is unlikely to depreciate quickly in value. Payment of interest and repayment of capital for secured loans takes priority over any payment to shareholder members, or to unsecured creditors such as suppliers. The payment of loan interest will reduce the amount of surplus available for community benefit, share interest and withdrawal. Loans may also be more expensive than community shares. High proportions of secured debt in the overall capital financing package will increase the effect of these drawbacks for a society.
Shorter-term loans, for up to five years, are usually made to provide working capital, enabling a society to purchase stock, or meet staffing costs in the early start-up phase of a society's operation. This form of lending provides a safety net for societies that have unpredictable or large fluctuations in their cash flow requirements, or simply lack cash when they start. Such loans should be restricted to an amount the society can realistically repay from cashflow within the lifetime of the loan.
Finally, some institutions may be prepared to provide bridging finance. Such finance can help societies that need to act quickly to secure the purchase of fixed assets, or where they might be involved in a competitive bid for the assets, and do not want to publish a community share offer providing full details of their capital plans. Alternatively, finance may be needed to fill a temporary cashflow deficit caused, for instance, by VAT payments or delays grant funding. Bridging loans are so called because they bridge a gap in finance, so are usually very short term, and comparatively expensive. In the context of community shares, bridging loans are usually replaced by the proceeds of a successful community share offer. The society needs to be confident that the problem is only temporary, or that it will be able to raise sufficient community share capital to replace, or reduce, the bridging loan to a viable level.
All forms of debt finance will usually be subject to legal agreements which may contain covenants that restrict the freedom of the society. The two most common covenants are to establish security over a society’s assets, and to require directors to seek permission from the institutional lender before entering into any further debt finance agreements.
Societies should be cautious of accepting loans for more than 50% of their total capital requirements. For loans of between 25% and 50% of their total capital requirements, caution should also be exercised if the cost of the loan is significantly above the maximum interest rate payable on community shares, and or where the lender requires full capital repayment in less than five years. In such circumstances a society’s members and prospective members should be fully informed about how the loans might affect their financial interests.
Debt finance can be highly effective in addressing any shortfalls in funding raised through a community share offer. Section 4.5.4 recommends that societies making a time-bound offer set three fundraising targets; a minimum, an optimum, and a maximum amount. Debt finance can be used to fill the gap between the amount raised and either the optimum or maximum fundraising target. However, this can only be done if the lender agrees to adjust their loan to fill any shortfall from the targets. Some institutional investors may want to charge a higher fee for making such an arrangement, to ensure that their costs are covered.
In comparison to loans, institutional investment in the form of equity, is usually a better option for societies, especially if institutional investors accept the same terms and conditions on their shares as individual members. Sections 3.2.7 and 4.5.6 recommend that the maximum amount of share capital held by individuals should be voluntarily limited to no more than 10% of the total capital required, if this amount is less than £1m. The legal maximum limit for individual holdings of withdrawable share capital in a society is £100,000. This limit does not apply to societies investing in the share capital of other societies. So, if an institutional investor wanted to invest more than £100,000 in the share capital of another society, it would need to be structured as a society, with the requisite powers to invest in other societies.
Where it proposed to allow an institution to purchase more shares than the voluntary maximum limit, the society should adopt the following procedure. If the institutional investor is seeking preferential terms of withdrawal or share interest, these terms must be clearly stated in the offer document. If this offer is being made by an established society, with existing member shareholders, then the society should seek their members’ approval before offering these preferential terms. In all instances, societies should seek to recruit at least 20 members, the minimum number of members required to justify the term community shares (see Section 1.2.2).. For a new society with fewer than 20 members, it is sufficient to set out the terms of the agreement with the institutional investor in the offer document. Prospective members can then decide for themselves whether the agreement is acceptable.
If the institutional investor is prepared to accept equal terms to other members, then it is sufficient for the society to simply state this in its offer document, noting what proportion or amount the institutional investor may invest. As a matter of good practice, societies should give preference to ordinary members over institutional members if the offer is over-subscribed. This needs to be agreed in advance with the institutional investor.
Institutional investors agreeing to equal terms should limit their requests for withdrawals to an amount no more than the maximum any other member may request, or may be granted. So, if a society has a voluntary maximum shareholding limit this would also be the maximum amount that an institutional investor could apply to withdraw. If the amount of share capital available for withdrawal is restricted, then institutional investor should only be allowed to withdraw capital on the same restricted terms as other members.
For example, if a society is seeking to raise a maximum of £250,000 in community shares, it should adopt a voluntary maximum shareholding limit of £25,000. Institutional investors may be allowed to invest up to the legal maximum of £100,000 or more if it is also a society with the powers to make this sort of investment. However, unless the institutional shareholder has agreed preferential terms with the society, it should agree to limit withdrawals to £25,000 in any one period, if it has invested more than this. If the society has received requests for withdrawals exceeding the amount it has available for withdrawal in that period, then it should devise a fair way of rationing withdrawals that should be applied equally to all withdrawal requests.
Where a society is using an open offer to generate liquidity to fund share withdrawals, any preferential terms held by institutional investor members should be made clear to applicants in the offer document.
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