Impact investing was created to revolutionize capital markets. Instead, we are replicating them. This needs to change. The good news is, the structures we need to reform the capital system already exist.
COVID provides an opportunity for impact investors to step into a leadership role within capital markets, as the amount of private and public capital needed to save the global economy is put into stark relief. The question is, are we going to revolutionize capital markets to make them more accessible and inclusive? Or are we going to continue to replicate the current system?
We always seem to find excuses to avoid tackling structural issues in our capital system that perpetuate the asymmetry of access, equity and power. Now is the time to re-examine how we are allocating capital rather than just what our capital is funding—or more bluntly reassessing what type of world our capital is building.
As unicorns stumble, investors warm to revenue-based financing for ‘zebras’ and ‘Clydesdales’
The impact investing community needs to focus on three big ideas: redesigning risk capital, incentivizing impact in deals and funds, and committing to communities through distributed ownership. Here’s a blueprint for how we start—first, with redesigning risk capital.
I’ve been working with early-stage funders for more than a decade, helping them create and adapt financial structures to the needs of social enterprises and have recently helped found a female angel investing group in South Africa called Dazzle (a name inspired by Zebras Unite). Through this work, I’ve compiled a wide range of options for funders and social enterprises that address the fundamental limitations of traditional debt, equity and grant funding options and begun developing an evaluation system to help funders and founders evaluate which structures are suitable for them. The purpose of this work is to help these “alternative structures” come off the impact investing sidelines.
Helping companies tap ‘alternative capital’ for sustainable growth
There is no magic bullet when designing funding for small businesses, but having a range of customizable tools that meet the complex and changing needs of social organizations is a key part of the solution. Below are 10 options for how to make that happen.
1. Revenue-based financing. Traditional venture capital equity reigns supreme in early stage risk capital, including in the impact investing ecosystem. But typical debt and equity timelines and compensation structures may not slower-growth impact enterprises and often compromise impact missions. An increasingly common alternative is revenue-based financing: loans that are repaid as a percentage of revenue with a cap on the amount repaid or the repayment timeline.
Adobe Capital in Mexico uses revenue-based debt to allocate capital into growth impact enterprises since 2012. These agreements are convertible to equity based on the amount of debt outstanding. The value to entrepreneurs is that they provide access to less-dilutive risk capital and which doesn’t require follow-on fundraising if the company establishes its cash flow or qualifies for a bank loan. Contrary to traditional debt, the agreements offer flexible payment schedules and initial grace periods well suited to early growth stage social enterprises.
For Adobe Capital, competitive returns in Mexico run through social ventures
This approach is gaining ground. At a recent African Business Angel Network (ABAN) conference, six of the ten funders attending my workshop on alternative early stage financing had already begun or had plans to begin using revenue based financing agreements in 2020. Village Capital found a similar level of investor interest in revenue based structures during their work on Capital Evolving.
2. Dividends-based financing. The structure is similar to revenue-based agreements but repayments come from a company’s net income rather than revenues. I recently structured a deal using this mechanism with Dazzle, where we provide small-ticket financing to female entrepreneurs. Our latest investment is a revenue-generating company that helps automate government processes in South Africa. To support the business, we used a self-liquidating preference share to help her grow that revenue base in the short term while maintaining ownership of her business in the medium-to-long term. For Dazzle, the cash flow-based payments we receive will enable us to reinvest in other female entrepreneurs, rather than waiting for an exit many years down the line.
This was the first deal of its kind in South Africa, and so it took considerably more work than a more traditional structure. But now that we have a template, we will be able to use it as part of our toolkit when considering future investments.
3. Equity redemptions. Redemptions allow founders the option to repurchase some or all of an investors’ shares in their company at a predetermined rate. Unlike revenue and dividend-based financing, which are typically more suited to growth-stage businesses (generally post-revenue), equity redemptions work for very early stage companies that need to sell significant ownership stakes during seed equity rounds.
Candide Group is a thought leader in non-dilutive structures equity redemptions, as well as revenue and dividend-based financing. Candide calls them “structured exits,” meaning there is a clear path to an exit with a capped upside for investors. Investors trade some financial upside for more certainty around liquidity. Or as Candide puts it, “More singles and doubles, fewer failures and home runs.”
4. Venture debt. The instrument offers non-dilutive benefits to entrepreneurs and investors by mixing mezzanine-like debt returns with warrants, or the right to purchase equity. In 2015, Barclay’s launched its “High Growth & Entrepreneurs” fund, backed by £100 million from the European Investment Bank, to fuel job creation and drive growth in the U.K. economy by providing venture debt capital to growth-stage businesses. The bank increased the fund to £200 million the following year. In Kenya, Equalife Group is piloting an impact-focused venture debt fund.
5. Equity and debt guarantees. The tool enable funders to utilize their balance sheets to significantly affect the amount of capital available to SMEs and start-ups, while keeping the cost of capital low. They are particularly useful for funds piloting new capital instruments. Examples of guarantees are abundant; however, it is still woefully under-used by impact institutions with large balance sheets.
6. Factoring. This type of financing allows businesses to sell their accounts receivables at a discount to a third-party funding source to raise capital. Factoring serves as an alternative to traditional loans, because factoring funders evaluate a business’s customers’ ability to pay, rather than the business’s own financial qualifications and status.
Latin America has become a pioneer in this type of financing, which is being accelerated by the adoption of e-invoicing. Business factoring platforms in the region include TREFI (Peru), Mesfix (Colombia), Innovafunding (Peru), and Facturedo (Chile). Other platforms like Argentina-based InvoiNet offer reverse factoring, or supply chain financing, which increases the speed of financing for suppliers.
7. Forgivable loans. Amid COVID, we’ve seen large swaths of capital being allocated as forgivable loans—effectively debt that is converted to a grant—with built-in incentives for companies to maintain workforce levels. Having clearly defined metrics like this agreed upfront helps ensure that the capital creates the desired social and environmental impact. Such convertible structures are also more flexible and adaptable and can be applied to any combination of equity, debt or grants.
8. Convertible grants. Such grants convert to equity. They differ from convertible debt (debt that converts to equity) agreements in that, if a founder does not raise follow-on investment capital, the grant stays as a grant. There is no repayment requirement. This means that the funders using this instrument must be ready and able to use grant capital.
The Oxford University Innovation Fund has used convertible grants (grant to equity) for years to allow very early-stage companies to develop their ideas before seeking investment capital. If a grant beneficiary is successful in fundraising follow-on equity capital, then the university is able to recycle its capital to invest in new innovations.
9. Recoverable grants. The instrument, a favorite of Echoing Green, converts to debt. The nonprofit uses this structure to support its fellows and recycle capital for future fellows. Payback for Echoing Green’s recoverable grants is triggered when an organization achieves a valuation of $5 million or more, or reaches $2 million in revenue during a fiscal year with net-profit greater than $0.
Forgivable loans, convertible grants and recoverable grants only work for a specific type of funder and enterprise. But given the scarcity of grant funding, using these structuring mechanisms makes it possible to recycle capital, which could encourage grant funders to take larger risks (i.e. fund more moonshots.)
10. Holding companies and evergreen funds. Impact fund’s don’t have to adhere to traditional limited-life structures with arbitrary exit timelines. Evergreen funds and holding companies offer more flexibility for fund managers and entrepreneurs. But it has been extremely difficult to fundraise for as potential limited partners struggle to understand them. Many of the deal structures mentioned above can lead to multiple liquidity events throughout an impact fund’s life. There is a need for more fund managers to better articulate the liquidity profile of these funds for LPs and for LPs to be willing to listen and evaluate them alongside more “traditional” fund structures.
The New Alternatives: Holding Companies that Build Assets and Impact of ‘Infinite Duration’
i(x) is an example of a permanently capitalized holding company. i(x) was founded by Warren Buffett’s grandson, Howard W. Buffett, in the same style as his grandfather’s signature holding company. i(x) makes equity investments off of its own balance sheet, without the timeline pressures of an investment fund. It’s backed by 30 wealthy individuals and family offices, who are all shareholders and whose investment capital is used to seed other equity investments.
Scaling alternative capital
Cutting small and flexible checks, as these structures allow, can be time consuming and costly from a due diligence standpoint. That’s a key reason many of these transformative mechanisms have remained relatively niche. To implement them at scale, the impact investing sector needs to take advantage of new technologies, like blockchain, artificial intelligence, connected devices and satellite imagery to ease and improve deal structuring.
Whether it’s using automated due diligence, blockchain-based fund management or alternative credit scoring algorithms, there are substantial opportunities to leverage emerging technologies to help push “alternative” financing into the mainstream.
Redesigning risk capital is essential to creating capital markets that are accessible and inclusive. If we want to revolutionize how capital is allocated, to whom and for what, we need new rules, and we need more players to be willing to break the mold of the legacy institutions to design capital that truly works for funders, founders and communities.
Aunnie Patton Power is a university lecturer on Impact Finance, an advisor and an angel investor. She is currently writing a book about how we need to redesign impact financing to work for funders, founders and communities. You can find her online or in the virtual halls of the University of Oxford, the London School of Economics or the University of Cape Town.