Impact investing insights – part 2
- Capital raising, Impact investing, Social enterprise, Social entrepreneurship
- April 11, 2021
In part 1 of this series, we discussed the importance of matching investors to opportunities.
For example, in the world of impact investing, social entrepreneurs need to raise “patient” capital to successfully execute an impact plan. This isn’t about achieving a 10x return in 3 – 5 years, but rather about experimenting with various models in the hope of creating a sustainable commercial ecosystem around a specific project.
We also looked at the importance of robust systems and the capability to report on impact KPIs in addition to the more usual profit and growth metrics. This is important for two main reasons:
- Impact investors have specific mandates when investing their funds, which are often contributed by wealthy families and philanthropic organisations as part of a desire to drive impact in fields like environmental sustainability and job creation.
- Funding structures sometimes reward social entrepreneurs for achieving impact targets, in the form of reduced interest rates, payment deferrals or other benefits.
In this second article of the series, we will take a more detailed look at how projects like these are structured and funded in practice.
Getting off the starting blocks
Where available, grants are an ideal way to plant the seed of a successful social enterprise. Unfortunately, grant-funded projects frequently battle to scale, resulting in a localised rather than broader impact. More on this later.
Grants are inevitably awarded for a specific purpose and there are strict reporting requirements linked to this award. Most projects that start this way are structured as non-profit organisations (NPOs) which can work well in the initial phases but frequently become problematic later on.
The biggest risk is reliance upon grant funding. The decision to allocate grant funding to a project sits with the managers of that particular grant. If they decide that they don’t like the project anymore, or if the source of funding dries up for any reason, the social enterprise can be stopped in its tracks.
In any business, absolute reliance on a single source of funding, revenue or technology is a major red flag. Grant funding for NPOs is no different.
Sustainable ecosystems need sustained funding
Critically, social entrepreneurs aspire to build legacies and ecosystems that will stand the test of time. As entire communities can become reliant on these projects, sustainability is critical above all else.
Dependence on grants is simply not a sustainable structure. Grants can be the firelighters in the braai that kick things off and allow entrepreneurs to experiment and develop the model, but the firelighter always burns out long before the meat goes on.
The wood and charcoal must come in the form of blended finance – the likes of soft loans and convertible instruments. Interestingly, impact investors may even prefer hybrid instruments to pure equity, as the not-for-profit nature of the investors can sometimes preclude them from having too much equity exposure.
Entrepreneurs can use this to their advantage, provided the project is set up correctly. NPO structures can become a hurdle to raising funding. A common structure is to have two entities: a NPO and a for-profit company, with a service level agreement (SLA) between them.
The SLA ensures that the operations of the social enterprise work as they should, with the structure able to attract grant funding and blended finance. The mission lock can be contained in the SLA, giving comfort to funders and investors around the governance of the project and the use of funds. In many cases, the intellectual property is held in a separate entity to the operations, with a licensing agreement between them.
Funding recipients also need to consider tax implications. Whilst NPOs typically do not pay tax, the use of for-profit companies will naturally attract tax liabilities linked to profit. Matching the funding to the tax implications can assist in driving a more efficient tax structure.
Through hybrid debt instruments, entrepreneurs can raise the required funds without letting go of too much of the equity. Where equity deals are necessary, the valuation techniques differ considerably from the usual start-up methodologies, often incorporating social impact measures into the analysis.
Companies like Sopact assist social enterprises with impact reporting through driving stakeholder engagement and helping to ask the right questions. Creating this reporting infrastructure is key to successful fundraising initiatives and ongoing positive relationships with investors.
Importantly, impact investors still seek a financial return in addition to the impact measures. This isn’t a charity. Hybrid or convertible instruments are popular because of the flexibility they give to investors, enabling conversion upon the achievement of specific milestones or the optionality to convert to a grant, while achieving underlying financial returns in line with the investor’s mandate.
Can it be done with the usual commercial funding structures?
Whilst anything is certainly possible, commercial loans are far more onerous in their economic requirements than impact funding structures.
Typically charging higher rates, requiring much earlier payments of interest and capital and not considering any metrics beyond financial performance, commercial funding structures are unlikely to be suitable for most impact projects. Sometimes, impact funding can even become zero cost structures if certain criteria are met, with funding costs waived upon the achievement of specific impact targets.
Grants exist. Impact investors are active in the market. With the right structure in place, why not take advantage of this in creating a legacy?
Examples of investors
At one end of the impact spectrum, there are funds that focus on equity stakes but include sustainability considerations in the investment decision. For example, The Hatchery focuses on AgriTech businesses that can have a positive impact on food security in Southern Africa.
At the other end, there are global funds that offer grants and risk capital, aiming to achieve broad impact in strategically important regions. For example, the Global Innovation Fund is headquartered in London and invests in innovations that can make a positive impact on global poverty at scale. The fund provides numerous case studies on its website which are worth a look.
This article is a collaborative effort between The Finance Ghost and Arete Advisors – all rights reserved.