Creating Risk Capital for Social Initiatives August 2003

1. Creating Risk Capital for Social InitiativesAugust 2003

2. Context and Introduction The Need for a Social Capital Market in Canada Looking for Opportunities: Parallels in the Private Sector Conclusions and Next Steps for SCP

3. Who is SCP?: Our Mission • Invest in and support social enterprises that employ at-risk populations • Help these organizations to grow and eventually exist without external funding • Help these organizations provide improved social outcomes and financial self sufficiency for the individuals they employ • Be a catalyst for encouraging other innovative approaches to funding social initiatives in Canada

4. What is a Social Enterprise • The term Social Enterprise can mean many different things. For SCP, a social enterprise is a businesses that balances a double bottom line: • The Financial Bottom Line • The business operates like a private sector enterprise by selling goods or services to its customers • The business strives for at least break even and, in some instances, for limited profitability • The Social Bottom Line • The enterprise balances its financial mission with a clearly defined social mission • For SCP, the social mission revolves around the creation of quality employment opportunities for members of disadvantaged or at-risk populations • These jobs must be provided in the context of a supportive environment that helps employees work towards personal and financial sustainability

5. Types of Social Enterprises • Historically, SCP has taken a narrow definition of Social Enterprise but going forward we will work with a broader range of Social Enterprises: • Our narrow definition of Social Enterprise includes: • Businesses that create employment in a supportive environment for identifiable at-risk populations in any geography (e.g. at-risk youth, psychiatric survivors) • These businesses employ groups who have significant employment barriers such as skills deficits, psychological issues, or substance issues • Our broader definition includes Community Economic Development (CED) Enterprises: • Businesses that create employment in geographically identifiable, economically depressed communities • Unemployment in these communities is considerably higher than the national average often as a result of the loss of primary industry which supplied the majority of employment in the area (e.g. forestry, fisheries) • The individuals in this community may not have inherent employment barriers beyond those created by their geographic location and their current training

6. Who is SCP?: Our Approach Using Venture Capital Principles To Invest in . . . Social Enterprises With a Vision of . . . National Network of Successful Social Enterprises That. . . Employ Thousands of People

7. Who is SCP?: What We Bring to the Table Experience • Significant research into, and experience with, social enterprises in both Canada and the United States Expertise • Internal expertise in business and social mission strategy, operations, entrepreneurship, and community economic development Capital • Significant initial funding in place and several funding partners available to provide additional capital Partnerships • Strong operating partnership with international strategy consulting firm, The Monitor Group • Close relationships with regional co-funders such as Community Ownership Solutions (COS) in Winnipeg • Have, and continue to seek, additional partnerships with private, public and social sector thought leaders

8. Context and Introduction The Need for a Social Capital Market in Canada Looking for Opportunities: Parallels in the Private Sector Conclusions and Next Steps for SCP

9. Our Study As part of our catalyst role we undertook a study to find innovative approaches to funding social initiativesin Canada. The study consisted of several components: • Study existing research from Canada and other countries related to social investment • Learn from the experiences of other social capital providers in Canada and internationally • Interview leading thinkers in the area of social initiative financing • Focus predominately on the United States and the UK • Study parallels between private sector capital markets and the market for social capital with the help of RBC Capital Markets • Look at opportunities to adapt financial vehicles that fund unique private sector organizations to fund social initiatives • Create next steps for SCP based on our findings • Highlight questions that still must be asked and answered • Create a specific action plan for SCP based on our findings

10. Goals of this Study Overarching Goals • Look for ways to create a more buoyant capital market for social initiatives • Expand the type and number of financial instruments available to fund social organizations • Expand the total pool of capital that is available for social initiatives Social Enterprise Goals • Understand the unique aspects of financing social enterprise • Create new financing vehicles specifically for social enterprise • Expand the total amount of funding available for social enterprise

11. Our Basic Premise • Canada has developed a strong social safety net that provides funding for various forms of social services • The majority (approximately two thirds) of this funding is provided by the government with the rest being provided by a combination of individual, corporate and foundation funding • One issue with the current system is that there is an over-dependence on a relatively small set of funders • As a result, external factors such as government cutbacks or economic downturns have a disproportionate impact on the social sector • Also, with such a small pool of funders, there will be limited variation in the risk/return profile of the initiatives that are funded • Another issue is that social initiatives are almost entirely dependent on one form of financing – the grant • Even if this one form of financing were as effective as possible, the result of such limited financing options is that only projects with one particular risk/reward profile are funded • Moreover, as government funding becomes less available or economic hardships constrain corporate and individual giving, budgets for social initiatives are squeezed • Therefore, SCP believes that a much more dynamic Social Capital Market must be created • This capital market should include a variety of financing vehicles for social initiatives similar to the array of financing vehicles available in the private sector • Moreover, these vehicles must be created such that they attract more funding and support for a wider array of innovative social initiatives from a broader array of funders • The risk of not taking creating this market is that we stifle entrepreneurship and creativity around solutions to significant social problems

12. Financing Social Initiatives: The Traditional View • Historically the different sectors of the economy have been thought of as distinct and separate silos governed by with rigid conventions that limit interaction and forms of cooperation Policy / Regulation Social Service Profit Government Charities Foundations Private Sector • Charities raise money from governments, corporations, foundations (and individuals) • Charities carry out narrowly defined programs based on societal need and of funder stipulations • Charities preserve funding by staying within the narrow definitions of a charity as provided by the government • Raise money from wealthy individuals • Donates money to registered charities as defined by the government • Charities carry out social programs that are in line with donor’s expectations • Private sector conducts business • The purpose of business is predominately to generate maximum profit • Businesses provide some of that profit to registered charities in return for an improved public image • Government raises tax dollars • Registers charities and foundations based on a rigid and outdated set of criteria • Provides grants to charities to carry out social policy

13. Illustrative The Social Capital Market: A New Guiding Framework • A new approach to thinking about funding for social initiatives is to look at each of the sectors and the organizations within them as part of a market spectrum within which overlap and cooperation between the sectors is possible Pure Social Returns Blended Returns Pure Financial Returns The Social Capital Market Community Venture Capital Social Venture Capital Labour Sponsored Funds Commercial Lending / Private Capital / Public Capital Potential Funding Instruments Government, Foundation, Corporate Grants Community Loans Potential Types of Enterprises Social Purpose Businesses Community / Small Business / Cooperatives Larger / Higher Growth Business Charities Government Charitable Foundations Participating Funders Private Sector

14. Types of Risk Capital for Social Initiatives • Within this broader spectrum some of the most important yet under-provided financing vehicles for social initiatives (risk capital vehicles) can be created Risk Capital

15. Illustrative Canada Relative to Other Markets: Social Capital Market • Currently, the Canadian environment does not encourage the creation of these risk capital vehicles and therefore Canada lags significantly behind the United States and other markets in the creation of new social capital financing Blended Returns Pure Social Returns Pure Financial Returns The Social Capital Market Government Funding Traditional Foundations Progressive Foundations / Venture Philanthropy Community Capital / Co-op Development Venture Capital Commercial Lending / Private Capital / Public Capital Very strong government funding Relatively small number of innovative foundations providing risk capital Relatively small community finance sector Canada More limited direct government funding Large and relatively innovative foundation sector Fast growing community investment sector United States Relatively strong government funding Some innovative foundations Emerging community finance sector with strong government support Britain Area of Strength Developing Area

16. The Environment for Social Investment Outside of Canada • In contrast to the Canadian market, the United States and, to some extent the UK have a fairly vibrant risk capital market for social initiatives • The creation of risk capital for social investment has been made a priority in the US and other markets through favorable tax and regulatory regimes • US financial institutions are required to invest a portion of their profits back into the community giving rise to many community venture capital companies • Social investors in the United States are often provided with tax incentives • In the UK the promotion of social investment has been made an explicit priority by the government • But while the concept of risk capital for social initiatives has been quite ground breaking the ways in which the money is raised and invested is quite simple • With few exceptions, money is raised and invested through very typical debt or venture capital vehicles • The key difference is that investors are usually asked to accept lower than average returns relative to a traditional venture capital fund in exchange for social benefit in addition to some tax or regulatory benefit

17. The Results of This Investment Environment • While directly comparable statistics are difficult to find, the most obvious and direct result of the efforts in other markets to drive social investment has been the creation of significant amounts of social risk capital relative to Canada Risk Capital Government accounts for 65% of social funding Foundations are relatively small and often donor driven Nascent – used by a handful of innovative foundations Loan programs exist but are relatively limited Little venture financing exists. Some Labour Sponsored Funds and others provide limited socially motivated funding Foundations make up a large portion of social funding. Still tend to be donor driven but demonstrate some creativity VP market is nascent – few players exist in market Market more advanced - national coordination taking place Growing market – promotion of social enterprise has been made a government priority with an assigned cabinet minister Tend not to be as active as in other markets Make up large portion of funding. Show significant creativity Original VP market – several players exist Several hundred loan funds manage over US$3bn Over 50 CDVCs exist across the USA Dozens of VCs exist that invest in social business

18. Why This Matters • The failure to foster an environment which encourages the creation of risk capital through social investment leads to: And. . . Which Leads to. . . And. . . Lack of Social Investment Institutions Few Social Investment Vehicles Less Risk taking and Innovation Limited Social Investment Expertise • Financial support for social initiatives comes mostly from government agencies and traditional foundation or corporate philanthropists • Support almost always comes in the form of a grant for a program of a registered charity • The only value proposition to philanthropists is in the form of a tax receipt • Traditional forms of financing tend to be conservative and based on programs • There is little or no incentive to take risks or try new solutions because failure results in the withdrawal of funding • Long term sustainability and working capital is nearly impossible to secure • Little or no expertise exists in Canada around creative financing and social investment • Even a decision to change the environment today, Canada will continue to lag behind other markets because no expertise has been created • The net result is a much less vibrant and creative set of approaches to important social and cultural issues in Canada

19. What Could be: The Spectrum of Financing Institutions • By encouraging social investment several different financial institutions could be created in Canada that would support a wide range of innovative social initiatives Risk Capital Financing Loan Financing Equity Financing For Profit Non Profit For Profit Non Profit • Subordinated Debt funds • Community Bonds • Loans from Financial Institution • Community Loan Funds • Community Banks • Government Loan Programs • For Profit CDVCs • Social Venture Capital Orgs • Angel Investment networks • Non-profit CDVCs (e.g. SCP, Community Ownership Solutions) • Venture Philanthropists

20. What Could be: Resulting Financial Options • The resulting financial vehicles could help to create a more dynamic capital market that provides financing alternatives which exhibit a variety of investment characteristics and financial / social motivations

21. Context and Introduction The Need for a Social Capital Market in Canada Looking for Opportunities: Parallels in the Private Sector Conclusions and Next Steps for SCP

22. Drawing on Private Sector Learnings • While the Social Capital Market in Canada remains underdeveloped, several unique structures do exist in the private sector that take creative advantage of existing tax laws and regulations: • We hypothesized that some of the unique structures used in the private sector could be used to create more investment in social initiatives • We decided that one of the best ways to study different structures was to go to the very organizations that have been creating unique capital structures in the for-profit sector for decades • We approached RBC Capital markets to request assistance from their corporate finance division to research potential parrellels between the social capital markets and the private sector capital markets • RBC generously donated the time of 3 of their team members • Together RBC and Social Capital Partners undertook an initial four month research project

23. Overview of the RBC Research • The main thrust of the research was to look into tax driven capital structures that are used in the for-profit sector • Each of these structures took advantage of tax breaks offered by various governments • These tax breaks tended to be used to promote specific industries • Other tax breaks were associated with particular legal incorporation structures • The industry specific tax driven structures are most often used to fund companies in the for-profit sector that are unable to generate typical market returns • These organizations are in industries such as film, sports, and mining exploration • The tax breaks that are specific to certain legal structures tended to be used to attract investment from certain types of investors • These structures included Limited Partnerships which attract high net worth investors looking for tax losses and Labour Sponsored Investment Funds which attempt to attract small investors to the venture capital market

24. Overview of Social Investing Models • The key premise of our work with RBC was that there could be a way to apply tax laws such that investors could invest in organizations that provide strong social returns while receiving financial returns closer to those found in typical investments Economic Returns / Risk Profile Low High Charitable Foundations High Community Loan Programs CDVCs Social Returns Socially Responsible VCs Environment / R&D Funds Labour Sponsored Fund Sector / Regional Focused LP “Pure” Equity Investor None

25. Assessment of the Need for Tax Driven Structures • Social enterprise and other non-profits are unlikely to generate sufficient profitability to attract investors on the basis of the economic return alone • Without encouragement such as preferential tax treatment, social initiatives are unlikely to attract funding beyond what is currently provided through governments, foundations and corporations • As a result, non-profit organizations would have to benefit from various eligible tax deductions in order to generate new pools of capital and appeal to new types of investors • The viability of a proposed structure would be highly dependent not only on the tax credits available but also on the specific social cause and the potential for strong social returns Based on financial models in Canada, the U.S. and internationally, RBC believed that there may be an opportunity to utilize a structure driven by various tax credits and deductions to attract incremental financing

26. Conclusions from the Study However, despite initial optimism, we discovered that under the current tax regime it would be difficult, if not impossible, for most social initiatives to utilize tax driven financial structures to raise new risk capital from a more varied group of funders • The system of tax credits is generally ad hoc and highly variable amongst different industries and provinces • There is little concerted effort on behalf of governments to encourage non-traditional investment in social initiatives • The Federal government has used tax incentives to promote investment in other industry sectors such as film, professional sports, and mining exploration but not social investment • Some provincial governments have started to use limited tax incentives to generate investment in CED projects • The ability to use tax credits would be highly dependent on the geography and type of business and therefore would not likely be the basis for a concerted investment strategy • Therefore, the opportunity to create unique, tax driven, financial vehicles in Canada appears very low today given the current tax environment • Facilitation of these financial vehicles would require government commitment to fostering blended return financing for social initiatives

27. Assessment of Opportunity for Tax Driven Structure The target market for such a vehicle will depend on the magnitude of the eligible tax deductions provided Current Charitable Donations Model “Tax-Driven” Model • Charitable donations eligible to be deducted in computing taxable income • 46% tax savings (assumed tax rate) in year of donation • Deductions provided through combination of flow-through of operating losses and business/regional specific tax credits • 46% tax savings as operating losses are realized (timing uncertain) plus other available tax credits Tax-Deductions Provided Alternative A: “Donor” Tax-Driven Model Alternative B: “Investor” Tax-Driven Model • Tax Credits < 100% (but  46%) • Tax Credits > 100% • Individuals, businesses, and government interested in funding non-profit/charitable organizations • Individuals, businesses, and government interested in funding non-profit/charitable organizations • Individuals interested in realizing additional tax deductions combined with potential upside from participation in underlying businesses • Social return as secondary consideration Target Market • Specific social cause • Reputation/brand and track record of specific charitable organization • Efficiency of deriving social benefit with funding provided • Specific social cause • Reputation/brand and track record of specific charitable organization • Efficiency of deriving social benefit with funding provided • Economic returns (magnitude, timing and certainty) • Reputation/brand and track record of investment manager • Nature of underlying investments Investment/ Donation Considerations

28. Summary of Investment Features Several structures could potentially offer tax advantaged social investment Summary Applicability to SCP Structural Feature • Opportunity to increase after-tax dollars through a tax deferral mechanism by allowing the investor to keep significant portion of taxes payable, which can be invested for up to 10 years at a minimal return in order to fund the future tax liability Tax Deferral O • Repayment of 100% of investor’s original investment at termination provided by a forward agreement with a financial institution with additional upside potential provided through the underlying portfolio of investments Principal Protection P • Investor can deduct 100% of operating losses renounced to the Partnership, resulting in potential income tax savings of up to 46% • Downside protection is provided through the reduction of money-at-risk for the investor Tax Deductions P • Investors are allowed to apply various different tax credits in calculating income tax payable assuming that the underlying businesses are targeted by the Tax Act in supporting growth in such industries (i.e. SR&ED, CRCE, LSIF) Investment Tax Credits O/P • Utilize specific tax credits available to certain institutions (i.e. banks) and pass through these benefits to investors Institution-Specific Tax Credits P

29. Application of Investment Features to SCP Structural Feature Summary Advantages / Disadvantages Investor Demand • SCP establishes an investment trust that invests the proceeds raised in a fixed portfolio of equity securities and a managed portfolio comprised of the targeted businesses of SCP • Approximately 50% of the proceeds raised by SCP would be invested in a fixed portfolio of equity securities and the balance would be invested in the managed portfolio • A chartered bank would enter into a forward agreement to purchase the fixed portfolio, offering investors 100% capital protection • Investors have 100% capital protection and have additional upside through ownership of the underlying businesses • Investment trust maximizes the tax efficiency by ensuring that any realization of income / distribution is characterized as capital gain / return of capital • The major disadvantage is that only 50% of the actual proceeds raised would be available for investing in the targeted businesses • High Principal Protection • SCP establishes a limited partnership that invests in the targeted businesses • Flow through of operating losses of underlying businesses results in a potential 46% income tax saving for investors • Investors may realize upside potential through ownership of the underlying businesses • However, any realization of income / distributions from the Partnership will be characterized as income and taxed at the investor’s marginal tax rate • Medium Tax Deductions

30. Application of Investment Features to SCP Structural Feature Summary Advantages / Disadvantages Investor Demand • The Fund is registered as a labour-sponsored venture capital corporation under the Income Tax Act (Canada) [the “Tax Act”] and as a labour-sponsored • investment fund corporation under the Community Small Business Investment Funds Act, 1997 (Ontario) [the “Ontario Act”]. • The Fund is taxable as a mutual fund corporation under the Tax Act and Corporations Tax Act (Ontario). The Tax Act and Ontario Act both allow an individual to invest in Class A Shares of the Fund and to obtain a personal income tax credit. • Investors have 100% capital protection and have additional upside through ownership of the underlying businesses • Investment trust maximizes the tax efficiency by ensuring that any realization of income / distribution is characterized as capital gain / return of capital • The major disadvantage is that only 50% of the actual proceeds raised would be available for investing in the targeted businesses • High LSIF Tax Credit • For instance, a chartered bank can act as an intermediary in the investment process and captures the incremental capital tax benefit entitled to banks from investing in small businesses and flows these benefits through to the investor • Investors may realize upside potential through ownership of the underlying businesses • However, any realization of income / distributions from the Partnership will be characterized as income and taxed at the investor’s marginal tax rate • Medium Tax Credits Available to Certain Investors

31. Context and Introduction The Need for a Social Capital Market in Canada Looking for Opportunities: Parallels in the Private Sector Conclusions and Next Steps for SCP

32. What Needs to Happen? If the Canadian regulatory environment does not afford opportunity to create social investment structures then what steps should be taken to create more risk capital? • Creative Thinking from Financing Organizations • Traditional philanthropists must consider new ways of encouraging innovation and risk taking • We need to re-think our focus on funding narrowly defined programs and think of ways to invest behind the most innovative social agencies and entrepreneurs • Considerable learning can be gleaned from the Venture Philanthropy movement • Creative Thinking from Members of Individual Social Initiatives • Leaders in social organizations must change the value proposition that they offer to funders • We must move away from asking for funding because it is the right or nice thing to do • We must move toward a model where funders are provided with a clear value proposition based on innovation and the creation of real social change • Consideration should be given, where appropriate, to the applicability of revenue generating social enterprise as a way of creating sustainability • Commitment from Policy Makers • Canada needs to create an environment that encourages the social capital market to flourish • Regulatory and tax laws should promote the creation of new financing organizations and vehicles the expand the amount and the types of capital available to social initiatives • Without government commitment to creating this environment, efforts of individual philanthropists and social entrepreneurs are likely to remain isolated and small scale

33. SCP’s Role In response to these broad suggestions, SCP feels that it has an active role to play within its own area of expertise to create new examples of risk capital for social initiatives • SCP has developed skills and expertise in the area of social enterprise • We will continue to play in this space with the goal of creating risk capital for these types of organizations • We will do this by trying to create new investment vehicles and value propositions for social enterprises • We do not see these enterprises as the panacea for all social issues • Where appropriate we help others create alternative and entrepreneurial approaches for other types of social initiatives • Where appropriate, we will use our learnings to help others in their efforts to advocate for changes to tax and regulatory policy that might help to create a more buoyant social capital market in Canada

34. Creating New Value Propositions for Social Enterprise Investors • In our view, one of the most crucial ways to create risk capital for social enterprises is to demonstrate potential new value propositions to philanthropists and other would-be social investors Current Value Proposition Alternative Value Proposition • A grant for a specific program of a registered charity • Perhaps some ongoing intellectual support • Money to be provided as loans or equity investments in social enterprises • Perhaps some ongoing intellectual support Investor Provides Investor Receives • A tax receipt that amounts to $.46 or less on the dollar • Recognition by the charity of the donation • Anecdotal reports on how the money is being used • Requests for further money to sustain the program • The principle is returned within 5-7 years • In addition to the principle a modest return may be provided (perhaps 3-5%) • Specific social and financial return on investment reports • Recognition by the social enterprise of the investment • The Ability to re-invest the money in other social initiatives • A self-sustaining social enterprise

35. The Social Capital Market: Where SCP Will Play Investment Funding Grant Funding Social Capital Partners Social Service Social Enterprise • Either on its own or through its partnerships SCP will offer a range of funding options • These options will be tailored to fit with the needs these businesses • These funding options will include both granting and for-profit vehicles • SCP will work with social enterprises that fall close to, but on either side of the breakeven point • In all instances these enterprises will strive for breakeven over time • The speed at which they reach breakeven and the extent to which they are expected to exceed it will depend on the type of investment provided • The vehicles will also attempt to meet the return on investment requirements of SCP’s investors • However, the purpose of these vehicles will not be to make typical venture capital returns • Rather, SCP will look to create value propositions that are an improvement on the traditional tax receipt • In some instances this will mean generating returns greater than breakeven • Throughout all of our work we will continue to look at the bigger picture • We will track blended returns that include both social and financial variables

36. Illustrative Financing Options for Social Enterprise • The choice of funding vehicle will depend on the potential for returns which are, in turn, related to the stage and type of business Growth Equity / Enhanced Equity Subordinated / Enhanced Debt Stage Early/ Mid Low Interest Loans Grants Start-up Social Enterprise (50% – 103%) CED Enterprise (103% plus) Enterprise Type / PotentialReturn

37. How Might SCP Structure Itself to Create these Value Propositions? • SCP may restructure itself to create a range of venture capital vehicles for financing social enterprise in Canada. Social Venture Foundation Social Venture Fund SCP: Fund Manager Deal Characteristics • C$2M fund • Social enterprises started by charitable organizations (qualified donees) • Funding in the form of grants or very low interest loans • Enterprises strive for break-even • ROI in the form of a tax return • SROI measured around employment and sustainable livelihoods Deal Characteristics • C$5M fund • For profit or nonprofit social enterprises (non-qualified donees) • Funding in the form of equity or subordinated debt instruments • Enterprises strive for limited profits • ROI in the 3-5% range for investors • SROI measured around employment and sustainable livelihoods

38. Necessary Conditions for Going Forward • Before SCP moves ahead with a strategy to expand its work with social enterprises and CED businesses, the following conditions will have to be in place • Lead Deals • SCP will have identified 2 – 3 lead deals that could be shown to potential investors in a fund as examples of good CED investments • These companies would have a demonstrable ability to generate returns in the 3 – 10% range while creating employment in an community that has experienced some form of economic dislocation • Aligned Investor Group • SCP will have identified a group of investors who are aligned with the objectives of the fund and willing to be involved in a pilot fund • These investors would have to be willing to invest a combined total of at least C$3M • Regional Partners • In order to effectively invest in multiple geographies across multiple industries SCP will have to create a network of strong co-investors and partners • Partners will help create deal flow in specific geographies and perform some on-the-ground management duties for mutual investments

39. Questions That SCP Will Answer With the First Fund • Through our work with social enterprises SCP hopes to answer questions that will help lead the way forward to creating more social capital vehicles • Can investors be convinced that there may be advantage to viewing some investments through both a social and financial lens? • Under what conditions and using what value propositions? • What types of investors are most likely to be interested? • What types of investment vehicles should be created to allow investors to consider investment in social initiatives as a viable use of capital? • Are there specific investment characteristics that make the most sense for these types of vehicles from a risk/return standpoint? • Assuming that Social Enterprises and CED businesses are the best investment types, what are some of the key success factors for making these organizations work effectively?