Why the right investment terms are essential for healthy social ventures

Imagine a young food company with a commitment to fair-trade ingredients and to paying a living wage for all employees. It’s enjoying rapid success: retailers and customers are snapping up its products. On the other hand, it’s sinking capital into sustainable ingredients and timely payments to producers months before revenue arrives. And in order to preserve its mission-first ethos, it wants to hold on to board seats.

Entrepreneurs often complain that early-stage venture capital—which can provide above-average returns to investors—leaves them strapped. Yet a common complaint from early-stage investors is that they take all the risk, only to get punished when later rounds of capital come in. The structure of business-as-usual deals reinforces these patterns.

Conventional debt or equity financing often isn’t a good fit for social ventures that don’t want to squeeze their suppliers to ease cash flow or are unlikely to reach an exit point in the near term (or ever). But what is? As the social venture space grows, entrepreneurs and investors are looking to alternative investment structures that allow ventures to scale while advancing their environmental or social mission and providing a return.

Impact terms ease the way for alternative investments

Traditional deal structures based on debt or equity are well-defined but not suitable for many impact-focused ventures. These ventures face a dilemma: like other startups, they can’t access debt without predictable cash flow; at the same time, they don’t fit the parameters of most private equity deals. They may have to build out infrastructure, resulting in relatively high upfront costs and slower scaling; they may have a hybrid business model that doesn’t fit the mould; and their social and environmental mission may not match well with fast growth or even an exit.

Alternative structures can balance the needs of investors and social entrepreneurs, but both parties need practical guidance about the options, while their lawyers and advisors need documentation to get comfortable with unfamiliar term sheets. This is why Toniic maintains the Impact Terms Project (ITP)—a library of innovative deal structures designed for impact entrepreneurs and the people who invest in them. Created in 2015, it’s a free, publicly accessible portal with ready-to-use frameworks, definitions, term sheets and case studies created by investing and legal experts. It can be adapted for funding deals around the world, including emerging markets.

The ITP’s goal is to lower barriers for investors who want to go deeper into impact investing

The ITP’s goal is to lower barriers for investors who want to go deeper into impact investing while increasing access to capital for early-stage enterprises and removing obstacles to transactions. It contains tested-and-true alternatives that serve social ventures’ and investors’ needs, including revenue-based financing, steward ownership and blended finance.  

Revenue-based financing: a flexible form of alternative investment  

Revenue-based financing (RBF) is a good funding option for many mission-first, small to medium-sized enterprises that aren’t yet profitable. This structure allows investors to get returns even when the company is not planning an exit because they receive payment from the company instead of new investors, as in an IPO, or from another company in a merger or acquisition.

RBF can be structured as debt or equity depending in large part on local law, but with either structure the investor’s returns are tied to the company’s performance. The negotiated return is typically a multiple of the initial investment. The company pays investors a certain percentage of revenues plus interest until the investors reach the target return.

The faster the company pays back, the better the internal rate of return. This has a handful of advantages for the company:

• The timing and sizing of payments sync up with the company’s revenues.
• There’s no dilution to ownership or control since investors don’t take equity or voting board seats.
• The company pays a percentage of gross revenue and isn’t as likely to suffer a cash crunch.

Meanwhile, investors earn an ongoing return and are incentivised to help the company grow. The RBF model is a fit for high-margin companies; other structures in the ITP are more suitable for other ventures.

One example of an enterprise that would benefit from RBF is a startup that was funded by friends and family, and is now attractive to investors. The just-profitable company generates strong 35% margins, is growing at 50% a year, and needs capital to sustain that growth. While the growth is strong, the revenue timing varies. Without cash flows that debt investors demand, the startup’s only traditional option is equity; however, not only is the company unlikely to be acquired, the management does not want to lose control of its mission.

By issuing revenue-based financing, the company can get flexible capital and investors can get equity-like returns without requiring a future sale or stock offering, allowing the startup to keep growing and ensure positive impact.

Steward ownership preserves company mission

In 2018, Organically Grown Company (OGC) —a distributor of fresh, organically grown produce based in the United States—needed a long-term ownership solution that would allow it to scale while remaining purpose-driven and independent.

It sought an alternative ownership structure in the form of a Perpetual Purpose Trust (PPT), along with financing solutions that would enable OGC to exit its retiring owners and early employees while preserving its mission. The company, a former co-op that later transitioned to an employee stock ownership plan, used debt and equity to buy back its shares from employees and growers and transferred them to the newly established Sustainable Food and Agriculture PPT, which runs in perpetuity.  

Companies that prioritise purpose over financial performance survive longer, are trusted by customers and offer higher salaries

This is an example of steward ownership, an alternative structure that ensures decision-makers have the best interests of the company at heart, with two underlying rules:

• Governance and voting rights in a business are held by people connected to its mission (like employees).
• Profits are primarily reinvested or donated towards advancing the company’s purpose.

This structure is attractive for founders and impact investors who are concerned that future investors or management might reduce the company’s impact.

Studies show companies that prioritise purpose over financial performance survive longer, are trusted by customers, offer higher salaries and retain employees longer. Companies from small to large have found steward ownership beneficial for long-term sustainability, including Bosch, Novo Nordisk, and Mozilla.

Blended finance can catalyse ground-breaking ideas

Companies with system-challenging ideas and entrepreneurs in emerging markets often have trouble attracting commercial capital. For those that have cash flow and are looking for investment, rather than relying entirely on grants, a blended finance deal may be the solution.

Blended finance has mobilised $140bn in impact financing to date

Blended finance combines multiple types of investment, with three characteristics:

• Impact is a motivating factor in the transaction.
• Financial returns are expected.
• Public or philanthropic capital acts as a catalyst for the addition of private capital. 

Blended finance can have various structures—including junior equity (stock issuance that is subordinate to a company’s other stock), grants or technical assistance for entrepreneurs, as in an incubator—that reduce the risk for private investors.

According to Convergence, the global network for blended finance, the approach has mobilised $140bn in impact financing to date.

The benefits of alternative investment structures  

Alternative investment structures have strong appeal for growing social enterprises because they can be highly tailored to the needs of the company. They’re also a good match for impact investors who want an ongoing relationship and don’t need an exit. And contrary to a common view of deep impact investing, they do not have to mean concessionary capital.

These structures would be more widely used if they could overcome their “chicken and egg” problem: investors, entrepreneurs and legal experts aren’t sure how to handle them because they haven’t encountered them before. The ITP removes this barrier and reveals the benefits for companies and investors. 

The first step is getting comfortable, and that’s what the ITP is all about. Take a look for yourself and find a tailor-made solution for your company or submit your deals to help other mission-driven companies looking for solutions.

John Berger is director of operations & impact solutions at Toniic.

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