Director of Portfolio, Acumen
Innovative Financing Structures
Since the term “impact investing” was first coined almost a decade ago, the space has grown to become a $100 billion industry. As investors and entrepreneurs continue to explore the dynamics of their roles and relationships, one thing has become clear: traditional VC financing structures do not always fit social startups’ needs, nor do they always yield the expected results for these investors. As a result, entrepreneurs and investors must work together to create innovative financing solutions that better fit their goals.
Developed markets have a well-established cash continuum, which successfully finances startups from their creation, through angel investors, all the way to large cap private equity or IPOs. In many emerging or frontier markets, this constant flow of growth capital or secondary buyers simply doesn’t exist. In addition, certain social enterprises are not structured to reach scale or generate a liquidity event for their shareholders.
Take agriculture, for example. Agriculture entrepreneurs are desperately in need of capital but smallholder agriculture is a sector where traditional financing structures don’t fit. They might not only disillusion investors, which are unable to get their money back, but also undermine the farmers’ social impact. Most of the world’s poor are farmers and agriculture is their (or their communities’) livelihood. Many social enterprises are looking to partner with these farmers (or their associations) to help them better connect to global markets and, in the process, grow their margins, increase the quality of their crops, and improve their yields through better or more innovative farming techniques. These businesses need capital to grow and become sustainable to ultimately improve the living conditions of these farmer communities.
These companies are not, however, intended to reach massive scale or have strategic buyers take out their early stage investors; they are most impactful if they become livelihood businesses that can sustainably maintain their social missions and the communities they serve. Thus, forcing them to scale beyond their capabilities or regions can create tension in the operations and for the management teams, and can potentially compromise the mission and even lead to failure. Given the dynamics outlined above, most agriculture entrepreneurs have not been successful in finding sufficient pools of capital for their different stages of growth because even most impact investors need to complete their investment cycles, exit their capital, and generate acceptable financial returns.
Considering this challenge, investors like Acumen started experimenting with more innovative financing structures designed to align with these businesses’ growth and cash flow trajectories. These structures act similarly to debt or equity instruments in their risk/reward profiles and in the governance rights they offer, but with self-liquidating payout mechanisms over defined horizons and non-disruptive schedules to the companies’ cash flows and missions. What I mean by this is that these structures target the same returns as traditional debt or equity, but (particularly in the case of equity) do not need an external purchaser to facilitate the exit of the investors. They are structured in a way through which the company (with its cash flows) repays shareholders during a certain period of time until either the shareholder obtains an agreed upon return, or the schedule of repayments ends. They are not simple term loans because they grant governance and decision rights to the investors, and they do not have rigid repayment structures but rather flexible ones that are aligned with the companies’ cash flow generation. This gives the company more space to operate and only repay when they have generated cash.
We are seeing more and more examples of investors deploying capital via these structures out of both their equity and debt funds. In the case of equity instruments, mandatory redemptions or mandatory distributions based on revenues, profits, or cash flow generation have been the most common. In the case of debt, revenue-based straight or convertible loans and debt/mezzanine based on profits with flexible payments are being used more frequently. These are structures that use self-liquidating repayment schedules in more versatile ways but with the same rights as equity or mezzanine debt investments.
Thanks to the creativity and openness of both impact investors and entrepreneurs, these structures are allowing the sector to push forward and help all stakeholders succeed. However, as in everything, there are challenges. The primary one that startups are now facing with these structures is the preservation of their cash flow. Healthy cash flow is a rare commodity in the early stages of startups, and it must now be used to pay down investors. We are trying to solve for this with more flexible or longer-term structures, but I still encourage you – as entrepreneurs, investors, and advocates for impact investing – to always understand the needs of your companies and the goals of your investments. Continue to think outside the box, challenging the status quo through innovative ways of partnering that can allow capital to fill gaps, support businesses looking to change systems, and create new markets.