Money Buzz 1/04
More and more investors are jumping on the responsible-investing bandwagon, choosing mutual funds based on nonfinancial criteria, from those that shun tobacco, alcohol or weapons-related investments to those that factor in environmental concerns. Assets in funds using one or more of these strategies went from $40 billion in 1984 to $2.34 trillion in 2001, says the World Resources Institute, a Washington, DC, environmental research and policy group, which estimates more than 230 mutual funds incorporate socially responsible investment (SRI) strategies.
Despite the proliferation of SRI options, it's still a costly proposition, according to a recent study of SRI mutual funds by Wharton finance professor Christopher C. Geczy and graduate student David Levin. "Socially responsible investors can sacrifice as much as 31 basis points of performance per month, or 3.7 percent [per] year," says Geczy. "Over 30 years, that's a huge amount."
Some give up more than others, says Geczy. "Market indexers, who mimic the S&P 500 through a combination of SRI funds, sacrificed 5 basis points [per] month, or 0.6 percent [per] year, for eschewing non-SRI funds. But investors who choose actively managed funds pay a heavier price."
With VC investment just starting to show signs of life, it's still a good time to look at other funding options. But where to go? Informal investment may be the key, according to a report by the Global Entrepreneurship Monitor (GEM), a research program that assesses the national level of entrepreneurship. "The aggregate amount of informal investment is enormous," says Paul Reynolds, professor of entrepreneurial studies at Babson College, which cosponsored the report with the Ewing Marion Kauffman Foundation. "It ranges from someone who gives their kids $500 to start a venture to someone investing millions."
Already, nearly 1 in 20 adults report investing money in entrepreneurial businesses, with 50 percent of those proceeds going to companies owned by relatives, reports the GEM, which advocates tax incentives that would further fuel the growth of informal financing. "A lot of this is family money," points out Reynolds, "so if you can get a tax benefit for providing funding for your children to go to college, why not have an officially recognized tax savings or benefit for helping them start businesses?"
Unfortunately, that idea is still in its infancy. The good news? Informal investment weighs in at a hefty 1 percent of GDP, or approximately $100 billion, in the United States-and not all of it is earmarked for junior or the spouse, says Reynolds. "Twenty-five percent goes to a neighbor, friend, colleague or someone the investor knows, and between 15 and 20 percent goes to a stranger with a good idea," he says. "That's why networking is so important."
While the Financial Accounting Standards Board (FASB) has yet to issue its long- awaited rules on expensing stock options, it has taken a first step. It recently announced that rather than designating one particular option-pricing formula, the board's rules will enable companies to choose a valuation model. Unfortunately, the two options-a "binomial" valuation model or the more commonly used Black-Scholes model-are far from ideal, says Thayer Watkins, an economics professor at San Jose State University in San Jose, California.
"Both are based on certain assumptions unlikely to fit most companies," explains Watkins, who points out that, among other things, the Black-Scholes method assumes the company's stock will not pay dividends during the life of the option. "And the binomial model assumes the stock price can either go up or down by a specific percentage, but in actuality, it can stay the same or go up or down by a little or a lot," he says.
With an increasing number of companies-more than 350, according to a recent article in The Wall Street Journal-pledging to deduct stock option expenses from the profits and a potential FASB ruling that may mandate it, how will companies choose between the two methods? "Companies will try both methods and choose the one most to their advantage-but neither is likely to be accurate," maintains Watkins. He says there's no clear solution to the underlying problem-that while options should be deducted as an expense, there's no general way to evaluate them. "It's a very awkward situation."