Impact investing insights – part 1

Money is fungible, yet you may have heard financial professionals talk about “types” of money when discussing investment opportunities.

These days there arguably is more than one type of money with the growing popularity of cryptocurrencies, but that’s not what the investment folk are talking about. They are referring to the intention behind the money, rather than the money itself.

In the first of this two-part series, we introduce the concept of impact investing as a source of funding for entrepreneurs who wish to move beyond a pure profit motive. Social entrepreneurship is firmly a capitalist concept but is nuanced towards the social good.

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Corporate matchmaking

Entrepreneurs seeking capital must understand the drivers behind the investment decision of the investors they are approaching. For example, a social enterprise that prioritises job creation or assisting the environment above profits may not find it easy to raise money from traditional funds which seek to maximise return for a given level of risk.

Capital raising is like corporate matchmaking. If the parties are not compatible, the relationship either never kicks off or ultimately ends in disaster.

Naturally, businesses with primarily a profit motive can (and usually do) create jobs and act in an environmentally responsible fashion, all whilst achieving a return that is attractive to any investor. Although these companies have a positive impact on the world around them, the point is that the primary motive is one of profit rather than other measures.

Companies that promote social advancement, potentially at the expense of ultimate profitability, need to seek capital from impact investors. This goes back to the “type” of money argument – financiers use this as slang to talk about the mandate of the fund in question.

Patient, but tough capital

Social challenges are typically not quick or easy to solve. If they were, the challenges wouldn’t exist in the first place. Impact investors have “patient capital” which means they take a long-term view and aren’t necessarily interested in return on investment in the early years.

Using a “mission-lock” clause in a company’s founding documents can be effective in trying to attract this type of capital. Such a clause protects the social purpose of a company against possible attempts by shareholders to seek a profit motive above all others. This gives protection to investors that the company will focus on a strategy that is in line with the investors’ mandate.

Of course, there’s far more to impact investing than simply drafting some legal documents and putting them in the cupboard. Impact investors must ensure that their funds are being used correctly. The underlying intention may be to improve society, but don’t make the mistake of thinking that this is the warm and fuzzy side of capital markets.

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A unique challenge for entrepreneurs

Impact investors are looking for robust systems and reporting on impact KPIs. These KPIs will look a little different to what you might be used to in a profit company. The concept of Social Return on Investment (SROI) looks at factors beyond the numbers, including social and environmental measures. Assigning a financial value to the social impact is a topic all on its own, creating challenges around measurement of net job creation and the knock-on financial effect for families and governments.

In some ways, impact businesses present a greater challenge for entrepreneurs than profit-motive companies. Founders sometimes make the mistake of believing that a good cause is enough. Unfortunately, social entrepreneurship is far trickier than that.

A good example is that while the founders and hopefully the staff do see the bigger impact, the employees still need to pay off their bonds and school fees and will demand market-related salaries. It’s therefore critical to ensure that the company is adequately funded.

To achieve a sustainable ecosystem, the business cannot rely on grant funding alone. This is typical of non-profit organisations which often end up shutting down when grant funding dries up. Instead, the enterprise must be able to generate enough profits to become self-sufficient.

The goal here isn’t to scale and exit in five years, but rather to build self-funding legacy business that achieves a social good.

Seeing it in practice

TOMS Shoes was launched in a Venice Beach apartment in 2006. Founder Blake Mycoskie pioneered the One for One model when the business launched: for every pair of shoes sold, a child in a developing country would also receive a pair of shoes.

It was a simple concept that worked. By 2019, TOMS had donated 95 million pairs of shoes. However, things had evolved beyond shoes, with projects linked to sight restoration and safe water. The company recognised this by moving away from the One for One concept to rather commit to invest a third of net profits in a specific fund for social projects.

It’s not as snappy as One for One from a marketing perspective, but it gives the company more flexibility to fulfil its social purpose in most effective way. The company has a Chief Giving Officer who oversees this element of the business.

If you want to see examples of how fascinating the KPIs for a business like this can be, download the most recent TOMS Global Impact Report.

In part two of this series, we will unpack how social entrepreneurs should consider structuring their endeavours. The optimal capital and governance structures can easily be the difference between success and failure.

This article is a collaborative effort between The Finance Ghost and Arete Advisors – all rights reserved.

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