The Social Impact Bond made its debut in 2010 with the purpose of aligning initiatives and investors around social impact objectives. Since then, a number of impact instruments linking impact goals to terms and conditions of financing have been introduced into the market.
The central argument behind impact-linked financing is about incentives: both impact enterprise founders and funders respond to incentives, so financially incentivizing impact helps ensure desired outcomes, whether that’s access to basic services for hard to reach populations or affordability of essential products for vulnerable communities.
There are four key options for thinking about linking financing to impact. In brief:
- Cost of capital: Interest rate rebate, margin step-down, outcomes-based payments
- Funding disbursement: Impact milestone tranched disbursements
- Ownership: Impact-linked vesting, Equity earn-back
- Convertibility: Impact-milestone-linked convertibility
Cost of capital
For impact-first investors that can be flexible with the financial returns they require, interest rate rebate is a way to incentivize deeper impact. This option encourages entrepreneurs and businesses to prioritize impact in the short-term or focus on lowering costs for their customers and end users.
An example of an interest rate rebate is UBS Optimus Foundation’s six-year impact loan to the Jacaranda Maternity Clinic chain in Kenya, which has three sets of outputs they use to adjust the interest rate:
- Level of clinical care: this is measured by how much time it takes to perform an emergency C section after they have identified the need for the procedure;
- Population served: this is calculated as the share of the patient population that is on public health insurance, and
- Customer satisfaction survey.
UBS Optimus Foundation chose these outputs by aligning their own impact goals as a foundation with those of the business, being careful not to restrict the sustainability of the business.
A margin step-down is a similar option for equity investors. In this case, an equity investor would agree to reduce the rate of return on their investment if the investee achieves specific milestones.
Finance-first investors can also use impact-linked financing that is built around the cost of capital. They may require an external outcome payer to participate in the deal if the impact-linked financing requires a financial trade-off, however.
Social Impact Incentives (SIINCs) and Social Impact Bonds (SIBs) exemplify how outcome payers can engage in impact-linked financing contracts.
An advantage of deals that don’t require outcome payers is that they are often simpler to negotiate and close. Because UBS Optimus Foundation didn’t require an outcomes payor in its deal with Jacaranda, it sped the time, effort and flexibility of the deal, compared to more complex impact-linked structures it has been part of, like Social Impact Bonds.
Funders can choose to tranche an investment or a grant based on financial, social or environmental milestones, meaning they can disburse funds as impact goals are achieved. Tranching can help funders reduce their financial, social and environmental risk and ensure that the organization or project they’re backing achieves incremental impact goals before disbursing additional funding.
Impact tranching signals to impact enterprises that their funder cares about both its financial and impact performance.
The Global Innovation Fund used impact trancing in one of its deals, requiring that its investee meet two criteria before disbursing a second slug of capital:
- The portfolio company had revamp its procurement practices so that it was sourcing from at least seven target impact groups, and boost total procurement from target impact groups to 20% for six months before a second tranche of capital would be disbursed.
- Onboard at least 4,000 target beneficiaries to the portfolio company’s proprietary platform.
These impact milestones stood alongside financial milestones such as levels of revenue and profit to be achieved.
The key in impact tranching is getting the milestones right. GIF brings on an economist to support all of its impact-linked deals, who gets to know the company and can help determine appropriate and achievable milestones that align with both investee and funder interests.
When investors make an equity investment, share vesting schedules are often part of the terms. Business founders typically would have to agree to a vesting schedule for their shares in the company, so that if the founder decided to leave the company, their remaining unvested shares could be used to recruit a new operator.
Traditionally, vesting schedules are time-based or financial-milestone-based, but there is also an option for making them impact-milestone-based.
Another option is ownership-related impact-linked financing: incentivizing founders to earn back an investor’s shares through the achievement of impact milestones. This is called an equity earnback. In this case, the investment contract would spell out the percentage ownership that could be redeemed by the founders and the specific milestones that must be achieved for them to do so.
In equity earn-backs, aligning impact milestones to financial performance makes sense for both impact-first and finance-first investors. Depending on how the deal is modeled, incentivizing founders to achieve additional aligned-impact should also grow the company and increase its value. Thus, even though the funder ultimately gives up ownership, their shares also become more valuable.
Cases where impact milestones create a financial trade-off, on the other hand, may require an impact-first investor who is willing to reduce their return in exchange for social impact achievements. Alternatively, a public or philanthropic funder could compensate the investor for their concessions, such as loss of earnings. Transactions where public or philanthropic funders collaborate with investors in order to catalyse (additional) impact are known as blended-finance.
In impact investments that have a convertibility clause, such as forgivable loans or recoverable grants, funders have the option to base conversion triggers on either financial or impact milestones.
For example, a recoverable grant could have its repayment clause linked to impact milestones, such as the percentage of women employed by the company or percentage of low-income customers. Hitting milestones would mean the funding remains a grant; not hitting them would trigger the conversion to repayable capital.
With a forgivable loan, funders can specify milestones that would reduce the principal owed or even trigger the entire loan to be written off.
Impact-linked convertibility clauses can be based around relative impact performance rather than “all or nothing” milestones so that investees are incentivized for each additional “unit” of impact. Staggered impact milestones are also an option.
Of course, linking financing to impact is not the right option for every impact deal. But for founders and funders flexible enough and committed to driving deeper impact, such structures can be powerful tools for aligning impact and financial incentives.
Aunnie Patton Power is a lecturer at the University of Oxford, the London School of Economics and the University of Cape Town, as well as an advisor and angel investor. Her book, Adventure Finance, aims to help founders and funders navigate the spectrum of funding options that blend profit and purpose.