Flexible investment structures that prioritize employees and customers alongside entrepreneurs and investors are proving useful in helping companies preserve good jobs through the COVID-19 pandemic.
Volatile markets, job losses, and bankruptcies are here. While we wait for the public health and political solutions to address Covid-19, impact investing can drive results for all stakeholders with a combination of bold new investment structures and philanthropy.
“We should be impatient on social impact and be willing to take our foot off the gas on financial returns,” says Deborah Burand of the Grunin Center for Law and Social Entrepreneurship at NYU Law.
Burand advocates for a seismic shift in investor priorities. “Structuring should provide flexibility for the beneficiaries, not just the investor and entrepreneur,” she says. Investors in the U.S., India and Latin America are using are revenue-based financing and zero-interest debt to achieve that balance.
“Our No. 1 key performance indicator is creating quality living-wage jobs,” says Jonathan Tower of Arctaris, a Boston-based impact investment firm that focuses on the U.S. “The pandemic has left a lot of companies economically destabilized. While the Paycheck Protection Program kept many of these companies alive, they still can’t use those funds for growth capital or job creation.”
The Arctaris Impact Fund uses royalty-based financing agreements, which provide repayments at regular intervals similar to debt and, like equity, provide the entrepreneur with flexibility and align incentives to revenue-generation and good business performance.
These instruments can be structured more like debt, where the entrepreneur makes regular repayments – say 2% of gross revenues on a quarterly basis until the principal is repaid, plus some predetermined premium. Or the investment can mimic equity, where after some initial repayments, the balance converts into an equity stake.
The Arctaris Impact Fund supplements its revenue-based loans by partnering with private, philanthropic, and public sector funders to meet the needs of community businesses and fund employee support programs. This blended capital stack is critical to achieving impact.
Arctaris typically partners with a community bank that has identified a local business that needs additional capital. Arctaris then issues a five-year promissory note and a royalty security that are subordinate to the bank loan. The borrower makes principal and interest repayments on the note and makes variable repayments on the royalty security, generally 1-2% of incremental top-line revenue growth until they reach the predetermined repayment amount.
“The borrower can repurchase the note and the royalty security at any time, and most Actaris borrowers have done so by the third year,” said Tower. He expects, however, some borrowers may need the full five-year term post-pandemic.
Hybrid models are more critical than ever. “Fixed payments in traditional debt are hard for a company that has volatile performance and cyclical sales, and entrepreneurs are loath to accept lower equity valuations during economic crises,” Tower explains. “Royalty-based financing works in all seasons because it removes the biggest impediment to getting a deal done: the valuation negotiation with the entrepreneur.”
Revenue-based financing can also be a potent tool to sustain jobs and aid recovery in even the poorest, hardest-hit communities. After surveying jobholders in India, Upaya Social Ventures, which invests in small and growing businesses for the poorest of the poor, realized it had to step in and help its 22 partner businesses preserve the 16,000+ jobs in its portfolio.
Upaya felt its traditional patient equity model was a mismatch for this particular crisis, namely entrepreneurs’ sudden need for liquidity. Upaya instead harnessed philanthropic contributions to establish a Stabilization Fund in April to extend revenue-based financing to at-risk companies.
A typical Stabilization Fund investment is $25,000 transferred immediately to the company to be deployed against specific operational targets and job preservation with a six-month loan repayment grace period. Investees agree to repay between 2-5% of gross revenues until they repay 1.1x the original loan amount. Upaya expects full repayment to take between three to five years to achieve. Whatever Upaya recoups from its investments will be recycled into future small business investments.
Upaya’s entrepreneurs acknowledge this grace period is critical for them to pivot and weather the economic slowdown. The implied interest rate is less than half of commercial alternatives. As of September, Upaya’s investee companies, using the funds to pay salaries and even provide food subsidies, had sustained 98% of their jobs.
If models like Arctaris and Upaya – that span investments from thousands to millions of dollars – can cater to small business needs for steady growth and job creation, why aren’t more investors deploying them? “It’s very difficult to do these kinds of deals, with a focus on impact and jobs, without a blended capital stack,” said Patrick Mullen of Arctaris. “If you are at all risk averse as an investor this won’t make sense, and it takes more effort to structure. But our product meets businesses where they are, and we’ve been able to bring together private, philanthropic, and public capital to meet their goals.”
According to Mullen, the pandemic’s silver lining is greater commercial bank interest in making the effort to use revenue-based financing and blended capital stacks to achieve both financial and social returns.
Recoverable grants are an entrepreneur-friendly tool that can help expand the pipeline of high-impact enterprises. One organization has eliminated its own investment vehicle to focus on recoverable grants.
Incubation and technical advisory are critical to small business sustainability, but undervalued, says Ben Powell of Agora Partnerships, a non-profit that supports entrepreneurs in Latin America. He recently wrote about the Delta model, in which foundations provide zero interest-rate loans to entrepreneurs who participate in Agora’s accelerator program. If entrepreneurs repay within 12-24 months, they are eligible for follow-on investment and Agora keeps the original capital as an unrestricted grant to assist other entrepreneurs.
“We’re trying to socialize funders to realize that entrepreneur support organizations are absolutely critical. They need to be financed,” said Powell. When the capital is returned, “we can say with certainty that we earned that money. We did something that is very difficult to do – we found an amazing company that is solving social problems, we invested in them, and we got that money back.”
In Agora’s early years, the team operated a venture fund and an accelerator program. Powell recalls how exhausting it was. After seven years, Agora decided its core competence was acceleration, not investing, and it wound down its fund. Powell’s team has spent the past several years building a coalition of different stakeholders to create this patient landscape. Foundations commit grants to Agora that will be on-lent to entrepreneurs that meet Agora’s criteria. Agora then accelerates these businesses through hands-on technical advisory in the areas of market access, human resources, sales, budgeting, and strategy. Those who repay can explore follow-on investment from the foundation partners or other impact investors who know and trust Agora’s due diligence.
“This focus has worked well for us as our roughly 300 companies have raised $110 million dollars. That is not us investing,” said Powell.
Powell says the Delta structure is a win-win-win: the structure generates social impact and evidence that their grants catalyzed scalable businesses for foundations; it provides follow-on investors with a pipeline and streamlines due diligence; and entrepreneur support organizations like Agora have the financial flexibility to focus on identifying and providing technical assistance to grantees.
Most of all, small business entrepreneurs get an injection of liquidity on friendly terms and the space to focus on their operations and job creation. Powell hopes the Delta model will eliminate “this horrible hamster wheel of always looking for money … that is so disheartening for entrepreneurs.”
Let’s be collectively wiser than in 2008. Small business jobs fell 40% during the 2008 recession – a damaging blow because small businesses employ half of the private sector workforce. We can learn from the past and instead resuscitate small businesses and the labor market with patient capital powered by creative philanthropy. Revenue-based financing and zero-interest debt may be just the impact investing tools needed to foster patience on financial returns and impatience on social impact.
Bhakti Mirchandani is director of responsible investing at Trinity Wall Street and serves as an advisor to Upaya Social Ventures. Sachi Shenoy is co-founder and chief impact officer at Upaya Social Ventures.