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As a social innovator while planning your impact you should calculate the amount of financing you will need to manage to produce the kind of social impact you hope to have. Once you have quantified how much funding you need to raise, you are ready to decide which funding option to choose.
Social innovators have access to three basic kinds of finance which we will explore in this article: Philanthropy, Equity, and Debt.
Philanthropists are most interested in the social impact that they will create by donating to your venture. They don’t care about financial returns or getting their money back. They will be focused on how you can create positive social or environmental impact and how you will measure this.
Philanthropy comes in two main forms: grants and donations.
- Grants usually come from an institution such as a government body or a foundation. They may be ‘restricted’ (i.e. agreement terms of what you can do with the funds) or ‘unrestricted’ (i.e. may be used for general purposes).
- Donations are gifts from members of the public, often as part of a public fundraising campaign. Donations are usually for general purposes.
For many social ventures, philanthropy is the default funding option. Firstly, many social ventures don’t have a commercial business model therefore, the choice is clear: if they need to raise external finance, they can only raise philanthropy. Secondly, if you are incorporated as a non-profit legal entity, you will not be able to raise equity (non-profits do not have shareholders and therefore cannot issue shares). Unless a non-profit is willing to raise debt (which carries the risk of bankruptcy), philanthropy is also the only option in this case.
Even social ventures with a commercial business model often start out with some grant funding. It is the cheapest and often easiest source of initial start-up funding for socially mission-driven organisations. However, the supply of grant funding is limited, unpredictable and very hard to keep coming year after year. We generally recommend that social ventures raise their earliest funding from grants and donations as it is relatively easy to do so because it is the cheapest form of funding. Be cautious that you don’t take on a series of onerous conditions with each grant that prevent you from implementing your social mission in the way that you wish. Grants often come with strings attached, based on the donor’s own requirements, which may be a distraction or take you off track. Avoid the trap of doing work that isn’t part of your mission just for the money.
Once your venture reaches a certain size, continuing to fund it through grants and donations becomes increasingly more difficult. Grants often only last a year or two before you have to find a new donor, leaving even established organisations constantly exposed to the risk that a grant funder may suddenly withdraw or cease to renew. ‘Donor fatigue’ is a frequent problem. Even if you raise grants, you should be examining the alternatives in case you eventually outgrow the capacity of the philanthropic sector.
Equity investors purchase partial ownership of your business. They want both financial return as well as social impact. They will ultimately intend to get a financial return by selling their shares to future shareholders at a higher share price than they originally paid. They, therefore, care about your growth prospects and the long-term profitability of your venture. Equity investors are usually willing to take more risks than debt investors.
Equity is the most common way for early-stage ventures to raise external finance. Raising equity involves selling a percentage of your company (as shares) to outside investors. Shares in a venture give the shareholder the rights to their proportional part of the venture’s distributable profits, through payment of ‘dividends’. It is important to note that the venture is under no obligation to pay out dividends. Most early-stage ventures don’t pay dividends as they need to reinvest all available cash for growth. Payment of dividends to Ordinary Shareholders is normally barred for as long as there are any other forms of investment outstanding. It is a safer form of capital for ventures to raise than debt because dividends are only paid if the company has the profits to pay them, whereas interest must always be paid – regardless of profits earned. Shareholders are always paid last in any payout (such as if the company were to be sold or liquidated), behind all other creditors of the company, including debt providers. For this reason, equity is often the only form of capital that is suitable for early-stage, high-growth companies. Therefore, equity investors usually expect a higher return on their investment than debt investors because they are taking a higher risk and waiting longer for any payback.
There are two kinds of shares you can offer, Ordinary Shares and Preferred Shares. Ordinary shares are the shares awarded to founders, senior staff and sometimes the very earliest investors in a company, often at the ‘friends and family’ stage. Ordinary shares get paid last in any pay-out or profit distribution, behind Preferred Shareholders and all other creditors of the company. Preferred shares are the type of shares normally issued to new investors in a company. They rank ahead of ordinary shares in the event of any pay-out to shareholders. They may also have special voting rights and veto rights above the Ordinary Shares, giving them greater control over major decisions such as whether to issue more equity, raise debt, sell the company or merge with another. Preferred Shares are a form of permanent loan that converts into Ordinary Shares at the option of the Preferred Shareholder, or upon the incurrence of a special event such as the company being listed on a stock exchange. Each Preferred Share specifies a ‘conversion rate’ which dictates how many Ordinary Shares the Preferred Share may be swapped for. Despite this, Preferred Shareholders still have shareholder voting rights as if their shares had already been converted into Ordinary Shares.
Since raising equity is about selling ownership in a company, a key point of discussion with equity investors will be what the company is worth. This is known as its ‘Valuation’. Valuing a company is a very subjective business, and will be a matter of negotiation between you and the investors. Typically you will want as high a valuation as possible, while investors will prefer a lower valuation (i.e. to buy shares more cheaply). At the end of the day though, a company is only worth what investors are willing to pay for it. This will depend on many factors beyond just your expected future cash flow, and will include:
- Your social impact, and the extent to which social investors will give you a higher valuation because of the impact that you are creating.
- Market conditions, including the availability of equity finance in your country/sector for projects of your type.
- The maturity of your venture. The valuation of early-stage, rapidly growing ventures will be changing rapidly and it may be unwise or expensive to lock in a valuation too early.
We recommend engaging a professional corporate finance advisor to help you value your venture. If you are unable or unwilling to agree on a Valuation (perhaps because your venture is too early stage and any valuation would be too low at this point in time), a common way to resolve this is by issuing a Convertible Loan. This is a loan that converts into equity at a future date. It essentially pushes out the discussion on what your company’s share price should be until such time as the company is more advanced.
The last thing to consider is, what happens when equity investors wish to get a return on their investment. ‘Exit’ is the term for how equity investors expect to get their financial return. Most equity investors will plan to exit by eventually selling their shares to someone else. For institutional investors such as funds, they usually need to sell their shares within 4-7 years and may require your entire venture to be put up for sale at that time so that they can find a buyer. You need to decide if you are comfortable with this before taking on this kind of investor, and have a candid conversation with potential equity investors about what the ‘exit’ options are for them in due course.
The 3 critical questions you should ask every investor are:
- When do they plan to exit? (do they require a company sale at that point?)
- How do they plan to exit? (i.e. via share sale, dividends, or share buy-back?)
- What level of financial return are they hoping to achieve when they exit?
If the investor’s expectations don’t match what you’re willing to offer or think you can achieve, then be willing to walk away from the investment. It’s very important to be clear with investors about their exit plans and financial return expectations upfront, to avoid any misunderstandings.
Lastly, it is important to remember that if you take on equity, you are essentially inviting a co-owner into your venture alongside yourself. This means giving up some degree of control, depending on how much ownership you sell. New investors will have ‘shareholder voting rights’ which will be proportional to the shares they own. This means they will be able to vote their ownership percentage in any shareholder vote. There may also be some special shareholder decisions (such as whether to sell the business or merge with another venture) that may require a super-majority of shareholders (e.g. 75%) to approve, giving minority shareholders greater influence or even veto. Some shareholders may require a seat on your board, which will give them extra oversight and control. Before taking on new equity investors, decide how comfortable you are giving up some ownership/control, whether you would be willing to offer board seats to your largest investors, and how much ownership you would be willing to give up in exchange for funds. You also need to be very comfortable with the investor themselves and make sure that are someone that you would be happy to work with, and whose vision and values are aligned with yours. Never accept investment just for the money.
Debt investors lend you money which must be repaid from the company’s future profits, and their financial return is capped at the interest rate. Lenders are therefore less concerned about the long-term value of the company as long as you generate enough profit to repay the loan. They usually care more about protecting their loan and minimising any risks that might jeopardise your ability to repay. Lenders look for protections in the form of security (assets that can be sold to repay the loan) and covenants (rules governing what you can do).
Debt for social ventures is typically in the form of a loan from a bank, fund, or direct from wealthy individuals (‘angel investors’). Unlike equity, debt does not require giving up shares in your company. Debt is repaid from the cash flows of the company, together with interest, within a specified timeframe (the ‘maturity’ of the loan) and according to a specified repayment schedule. If you cannot meet the scheduled payment of interest or principal, you ‘default’ on the loan, which has the consequence that the loan investor can call in the loan and bring about bankruptcy to your company. Raising debt is riskier for the enterprise than equity because debt requires repayment whether you have profits or not. Since debt is riskier, it is more suitable for more mature companies with stable cash flow and confidence in their abilities to generate income to repay loans. Normally, only companies that are already generating positive, stable cash flow can raise a long-term loan (i.e. longer than 1 year). Lenders require seeing some proven track record and will typically only lend to companies that are already operating for several years and are profitable.
The exception to this is start-up loans made to businesses in their early stages (i.e. ‘seed round’ and earlier). These loans often come with an option to convert into equity at a later stage. Loans with this option are known as ‘Convertible Loans’. This is a common method of providing start-up capital. In the early rounds of investment, it may be difficult to put a value on the company. A convertible loan enables the investor to invest now, but take shares in the company at a later stage when the company has a more solid track record and a more accurate valuation is possible. The loan typically converts at a discount to any new share price in order to reward the loan investors for having taken an early risk on the company.
For more tips on financing your social enterprise check out Module 7 of our Social Investment Toolkit.