Steps to Create a Community Investment Fund

Steps to Create a Community Investment Fund

The following is an excerpt from “Community Investment Funds: A How-To Guide for Building Local Wealth, Equity, and Justice,” a joint project of the National Coalition for Community Capital and Solidago Foundation. The handbook can be downloaded in its entirety here.

No single formula exists for creating a community investment fund. But in this section, we’ll walk you through the important questions that will inform your decision-making and guide you through the process of setting up a fund.

The critical areas for setting up your fund follow these three questions:

  • Who’s on your team?
  • What are your fund’s objectives?
  • What’s your business model?

Since the first question involves putting together a team here’s a suggestion: Focus on this area first and skim the rest for now. Once your team is in place, download “Community Investment Funds: A How-To Guide for Building Local Wealth, Equity, and Justice,” and review it as a group as a team-building exercise.

1.) Who’s on your team?

Starting a local investment fund is a long-term endeavor. It takes time, planning, and a committed team of forward-thinking community builders. While the expertise, networks, and other attributes of individuals are important, team building begins with the right organizations at the table. People may come and go as their jobs and lives change, so having key anchor or springboard institutions committed to the team will ensure continuity and longevity — and potentially some seed funding.

Anchor institutions include grassroots organizing groups deeply rooted in the community, nonprofits, CDFIs, local community foundations, or other place-based entities such as hospitals, universities, or even corporations. These institutions have the resources to engage in long-term planning and can help open doors. More important, they’re often motivated to improve the long-term well-being of their communities.

You’ll want to round out your team with representatives from the following entities (some of which are anchor institutions):

  • Financial institutions, such as banks/credit unions, CDFIs, loan funds, and other traditional lenders, which can impart sound business thinking to your fund
  • Philanthropic institutions, such as community foundations and donor networks, which can help mobilize early capital contributions
  • Major community nonprofits, such as churches, food banks, or grassroots groups, which can help to identify the top needs of the community
  • State and local government agencies, which can help integrate the fund into their economic development strategies
  • Health care providers (hospitals, home health care, mental health professionals, etc.) and educational institutions (universities, continuing education, entrepreneur-focused organizations), which in many communities are the largest employers

It’s important that the team reflect the community members that the fund aims to serve, and prioritize their input.

Initially your team will be all volunteer. But finding some early funding, even if just for business planning by a consultant, will be invaluable. Engaging an attorney and a finance expert can help structure the fund properly.

Keep in mind, however, that not all attorneys and finance people will be a good fit. Look for those with expertise in the field of funds who are also simpatico to the objectives of making funds community friendly. It’s common, unfortunately, for conventional legal or financial professionals to advise that community finance strategies are impossible or not advisable.

One person on your team will need to step forward as the project champion. Your leader should be committed to running things at least through launch and early fundraising efforts. The leader will act as point person for scheduling meetings, delegation to committees, finding and managing consultants, and other leadership tasks.

Other factors to consider as you build your team are the members’ personal strengths, work experience, networks, and leadership styles. There will be plenty of work to do, so a team with only leaders and without implementers could stall. Think about how to ensure that all the following attributes and roles are covered as you recruit members to your team.

 

Key Attributes Key Roles
Visionary Leadership
Problem solver Marketing/Community outreach
Influencer Finance/accounting
Doer Logistics/operations
Bridge builder Advisory
Barrier remover

 

2.) What are your fund’s objectives?

Once you’ve assembled your team, the fun part begins. What’s your fund’s purpose? Among the questions you’ll want to answer as precisely as possible: What is your theory of change? What geographic area constitutes your community focus? What’s your economic mission? What kind of risks and rewards do you want to provide to investors?

Theory of Change

A theory of change is “a comprehensive description and illustration of how and why a desired change is expected to happen in a particular context.” It goes beyond what your fund does, and helps define how your actions will achieve your long-term goals. Figuring this out is a great team-building exercise and will help keep your priorities aligned and focused.

Geographic Focus

What are the appropriate geographic boundaries for your community investment fund? How local do you want your local fund to be? Define an area that fits well with your envisioned market of investors and businesses.

Investing in just your town may not be at a large enough scale to facilitate the fund’s financial success. But expanding the geographic range has risks and challenges too. Your region may begin to overlap with other funds that could be competitors. If you expand your region too far, you’ll be less capable of intimately knowing the businesses you’re serving, and your investors will be less capable of establishing their own relationships with the businesses.

As your team works through this step, clarify whether your geographic boundary pertains solely to your target businesses, your target investors, or both. Do you want to allow investment from residents outside your region?

Economic Mission

Your economic mission will flow from your theory of change. But there are other questions to ask: Which social or economic problems are you trying to solve? What kinds of local businesses do you wish to support? Or do you prefer focusing not on businesses at all but rather on nonprofits, municipal projects, or individuals?

The answers will require an analysis of your local economy — its history, strengths, needs, barriers, and existing infrastructure. This analysis might take the form of formal research or asset mapping.

Addressing Gaps

A fund’s economic mission will acknowledge the unique capital challenges facing target businesses. A common response from traditional funding sources when presented with the proposition of a community investment fund is: “There’s already plenty of money in (your region’s name here), we just need better businesses to lend to.” To which we say: it’s not a pipeline issue, it’s an access to capital issue!

Even if capital were theoretically available for every worthwhile business, which is rarely the case, it’s often not the right kind of capital. In many regions, lending resources are abundant, yet your team may determine that debt financing is not always the best form of capital for the types of businesses you want to support. You may want to fill the gap with more “equity-like” investment structures.

A final consideration regarding mission: how will it resonate with a critical mass of local investors? What issues do people care deeply about? Is gentrification driving local residents out? Might it be worthwhile to conduct some focus groups of potential local investors to find out?

Risk and Return

Balancing risk and return is a core issue for every fund — and the subject of the next set of questions. How much risk is the fund prepared to tolerate? What kind of returns are needed to attract investors? Ultimately, these decisions must be presented to the target investors: Are they prepared to lose their money, and how much money do they want to make?

A community investment fund may want to take on enough risk to serve businesses that cannot access more mainstream sources of capital, but not so much risk that business failures wipe out the fund. Balancing investor risk with the community’s values is not easy. No one knows for sure how likely it is that a given portfolio of companies will succeed or fail. Even the best research cannot predict the future. Any number of unforeseen factors can impact a company’s market, management, or prospects. To mitigate these risks, a fund should develop expertise in a particular sector, learn as much as it can about applicant companies and entrepreneurs, specialize in one or two styles of local investing, and focus on first-rate execution.

How else can you mitigate risk? A well-defined geographic community can help by making it easier to understand local market conditions, get to know local entrepreneurs, and tap into the “wisdom of the community.” You could focus on existing businesses that wish to expand, rather than startups. Or if you want to fund startups, you can provide mentoring and technical assistance as many CDFIs do. Wrap-around services like these can be valuable for growing businesses as well. Hands-on, relationship-based lending has helped keep default rates low for CDFIs, for example.

Now let’s turn to anticipated rewards. If your fund makes loans that generate a fixed interest rate of a share of revenues, and makes a reasonable assumption about the default rate, you can probably estimate likely returns. But if the fund makes equity, or equity-like, investments, the return will be very uncertain. Most of the securities your fund holds will be difficult, perhaps even impossible, to resell. For some securities, like stock, you have no idea what an eventual payout might look like until there’s an actual liquidity event — for example, if the business is sold. (It’s also possible to make equity investments that allow the entrepreneur to buy back the shares over time, eliminating the need for a sale of the company.)

Unfortunately, little data exists on the return rates of direct local investments within a particular community. This means that most of your investors must be willing to accept returns below market rates, at least at the early stages of the fund. Perhaps the smartest strategy is to promise small, and deliver big.

Here are some ways your team might consider maximizing social impact, while managing risk:

  • Know your sector well enough to judge the future performance of your portfolio businesses
  • Screen out exceptionally high risks, like pre-launch companies, or at least only allocate a small portion of assets to such high-risk investments
  • Invest only in entrepreneurs and companies you know reasonably well
  • Place clear, stringent performance standards on all clients, and develop clear plans in advance for what happens if anything goes wrong
  • Provide technical assistance (or connections to technical assistance providers) to help client businesses address potential weak points and take advantage of opportunities
  • Create a portfolio of local businesses that are buying and selling to one another, so that the success of each boosts the others
  • Encourage your investors, especially if they include anchor institutions, to buy from the supported businesses, because as “brand ambassadors” they can increase the businesses’ chances of success

Unaccredited Investors

Whether to include unaccredited investors in your fund is an important choice. From our perspective, this is a defining feather of a community investment fund. But the inclusion of unaccredited investors in a fund presents federal compliance challenges — and operational challenges. Your fund could end up with hundreds, even thousands, of unaccredited investors rather than a few dozen accredited ones. The more people involved, the more administrative hassles, the more customers to “care for and feed,” and the more things that can go wrong.

However the suggestions and examples provided here illustrate that the inclusion of grassroots investors also brings myriad benefits. Grassroots participation can generate community excitement about local businesses, which in turn helps them — and you — recruit more investors. Small investors are usually less demanding about the rate of return and more appreciative of the community’s social return on investment than wealth investors (including those who profess to be “social impact” investors). Grassroots investors can also mitigate the risks of your businesses failing. By becoming “brand ambassadors,” who buy the products and help spread the word about portfolio companies, they become part of a virtuous circle that improves the chance of success for the businesses, which in turn improves returns to the fund.

3.) What’s Your Business Model?

Among the current examples of community investment funds, target fund amounts range from $2 million to $50 million, although most tend toward the lower end of the range. Setting a target amount for your fund will be an iterative process among your team members that answers these questions:

  • How much can we reasonably expect to raise from our community?
  • Is it enough to make significant change in our community?
  • Are there enough investment opportunities to deploy a significant amount of the fund?
  • Do we have the ability to manage the expected activity at the envisioned scale?

To answer the first question, your team can take a page from the nonprofit fundraising world. You might construct a table to estimate the number of investments you’ll need at varying amounts to reach your target. This online tool is a great example.

Once the number of investors and size of the fund are generally agreed upon, evaluate the potential impact of your fund and what will be the costs to manage it. The potential impact will be determined by the size, number, and types of investments you make. For example, will you focus on startups and early-stage businesses that need launch capital in amounts of $10,000 to $100,000? These are typically more risky investments and may be best structured as equity or equity-like investments (perhaps convertible debt). Or will you focus on established businesses that are seeking growth or transition capital? These investments may be larger ($150,000 to $500,000), and could take the form of debt or royalty agreements. Or perhaps you want to do some combination of all of the above to meet the needs of your community as well as to diversify your portfolio.

Again, there’s no right answer or magic formula to follow. It really depends on your theory of change and the economic mission, as well as the business needs and investment appetites within your community. This is the stage where it may be beneficial to engage legal, financial, and tax advisors to help your team work through the details. The Operational Structure Checklist on the National Coalition for Community Capital’s website will help you identify these and other cost drivers associated with designing, launching, and managing your fund.

What’s Your Legal Structure?

This section on legal models for community investment funds will provide the information you need to decide on the best structure for your fund. Some key questions you’ll want to answer:

  • Will you include unaccredited investors?
  • Will you focus on certain types of businesses that carry special legal challenges, such as real estate?
  • Will you be structuring investments as debt, equity, revenue share, or some combination thereof?
  • How many investors do you anticipate?
  • Will you be sharing profits with investors?
  • What are the regulatory burdens imposed by your state?

What’s Your Operational Structure?

The final step in defining your business model is to determine the human and financial resources required to manage the fund’s day-to-day operations. This will depend greatly on the legal structure you choose, and the sized and extent of your financial goals. While it’s beyond the scope of this website to describe all the forms your operational structure could take, we offer some insights below into the legal and compliance costs that accompany various fund types. We also share some important questions your team might answer to determine your fund’s initial framework and management team.

You will need an attorney to help set up your fund and to operate compliantly. How much you need to budget for that work will vary considerably by the type of fund.

For most of the fund described in Determining the Optimal Legal Structure for Your Fund, the lion’s share of initial legal costs will go toward the selected capital-raising strategy, particularly if that strategy is a direct public offering registered with state securities regulators (or, in the case of a Regulation A offering, which allows you to raise up to $50 million from the general public, with the federal SEC).For an exempt charitable offering, these costs could be as little as $15,000 to $20,000; a direct public offering registered with a state might cost around $25,000 to $35,000 (and somewhat more for real estate funds, because of additional regulations that apply). For a Reg A offering, it could be $50,000 to $75,000 plus considerably more in notice filing fees if the offering is nationwide.

For most of these options, the ongoing compliance costs in subsequent years can be fairly minimal, perhaps a few thousand dollars annually. But for a fund that has conducted a Reg A offering, the ongoing legal costs are higher, perhaps $20,000 or more, plus the costs of an annual audit. A fully registered offering, such as for a business development company or a registered mutual fund, would likely incur $100,000 or more in annual compliance costs. A mutual fund, due to its heavily regulated nature, would also likely incur another $200,000 in annual compliance costs.

A host of other expenses will be required to start and run a fund. Another way to look at the cost of different types of funds is to consider the size at which they become cost-effective. In other words, at what scale to the fund’s revenues cover the operating costs and provide the desired return to investors? Here’s our hunch based on what we’ve seen:

  • Charitable loan funds can achieve break-even at around $1 million to $2 million in portfolio size, if they’re part of an existing nonprofit such as a community foundation or a community development corporation. The fund then can use the nonprofit’s infrastructure and staff, with only incremental additional operating costs.
  • A stand-alone exempt fund that hires its own staff might need to reach around $10 million in assets before it breaks even — or higher if it’s offering very-low-interest loans along with technical assistance.
  • A fully registered mutual fund would likely need to have at least $20 million in assets to break even.

These, of course, are rough ballpark numbers and don’t take into account cash-flow issues or any of the peculiar challenges that arise when a fund is doing something innovative. Most of the costs of setting up a fund will be incurred before revenue comes in, which means there are special needs for start-up funding to cover the initial costs, including any operating losses until the fund breaks even.

As a business, your fund will have ongoing operational costs. These will be determined by your answer to four questions:

  • Who will manage the fund?
  • How will the voice of investors and community members be included in investment decisions?
  • What’s the lifetime of the fund?
  • What’s the level of risk you’re assuming?

The first question concerns management. Some models of community investment funds, such as a charitable loan fund or a pooled income fund, can be run within existing nonprofits. An investment club requires the active management of all member-investors. Democratically-run structures rely on member votes. Other structures may require the involvement of a registered investment advisor.

You can bring down your costs if you can hire, part-time, an existing manager associated with an established CDFI, a fund management organization, or another financial professional in your region. Some funds have partnered with CDFIs or other such experts to manage the fund. Their proven investment expertise and familiar with your community’s needs might facilitate your fund’s quick set-up and launch, and their professional credibility will build confidence with potential investors.

Regardless of whether you source management from within your community or bring in an outside expert, mission alignment will be critical. As noted earlier, you’ll need good legal counsel whose responsibilities include making your operations as transparent to the community as possible.

On the second question, the decision to include a large number of unaccredited investors increases costs of marketing, communications, and accounting, and a further decision to engage many of these people in your operations will add to the costs.

The third question focuses on fund longevity. Will you have a defined end point for investments in/out of the fund, or will it be designed to operate in perpetuity? A fund with a short lifetime will be less complicated to administer and manage, although this might hamper the fund’s ability to deliver on its mission. Balancing budget with mission is an important challenge.

The last question, on risk, also fits into the operation cost picture. Among the risks to consider:

  • The fund is launched but no one invests
  • The fund is launched and funded, but not enough businesses in your region seek investment
  • The fund is launched, funded, and deployed, but more businesses fail than anticipated.

Use the Operational Structure Checklist on NC3’s website to help identify the new and existing resources you may need in order to launch, manage, and maintain fund compliance. Check out our Directory for examples of existing community investment funds. And for consultancy or other hands-on resources to help you get started, contact NC3 directly.