In today’s world of high growth start-ups raising multi-million dollar venture rounds, it is tempting to think that all social enterprises should move fast, break things, and raise venture rounds. In this article, we argue why we believe otherwise – that the current venture round system is broken for most social enterprises.
Venture capital was possibly born with the creation of American Research and Development, whose successful investment in Digital Equipment Corporation (DEC) spawned an entire industry. The multi bagger returns obtained from that investment attracted many new players into the industry – organizations who focused on investing in small, early-stage start-ups that would (hopefully) result in returns multiple times their original investment. Fast forward to today, venture capital firms are everywhere with the largest today being SoftBank with their Vision Fund.
Current Impact funds
If we look at the impact funds in South Asia today, we see a similar model of fundraising. Many of them are Venture Capitalists or Private Equity firms who focus on investing in the social enterprise market. Like other Venture Capitalists/Private Equity firms, many of their mandates are to beat or match the market (finance-speak for them trying to earn a high return on their investment). They expect their investees to follow the “proven” method for success – raise a venture round every 2 to 2.5 years, burn cash while growing fast, and finally selling the company off (in an acquisition, IPO etc.) to unlock their investment.
This method of fundraising is incredibly useful for social enterprises with scalable business models. In these cases, such funds and expertise provided could help the social enterprise grow quickly and hence increase their impact quickly. While there are social enterprises whose fund-raising needs might suite this style of raising capital, we believe it is not suitable for majority of social enterprises. The reason is because most (70-90%) social enterprises do not have scalable business models and are better known as businesses rather than start-ups. They are unable to grow as quickly and often rely on more “traditional” business models such as cross subsidized clinics, slum schools, or training restaurants. These social enterprises are unlikely to have an “exit” for an investor and as a result are not funded. In fact, in the impact investment circles we are in, we often hear that there are not enough “investable” social enterprises – a clear sign that few social enterprises are suited for such a mode of investment.
Instead, we believe what such social enterprises require are capital injections that correspond with the growth in their cashflows, profits and, balance sheets. If we look at the more “traditional” cash-flow generating businesses globally (like the Coca Colas and Nikes of the world), they had reached their size through taking loans as and when required as they grow. Similarly, these social enterprises are usually businesses that are financially sustainable (not loss-making) and impactful. Today though, it is a pity that they are largely unable to gain access to impact capital.
Here is where building long term relationships with such social enterprises and lending them across multiple rounds of low-cost loans is extremely beneficial for society. Such access to capital allows social entrepreneurs to plan far ahead in their businesses. This spares them the worry of having to constantly raise a new round or pay extremely high interest rates, thereby fostering long-term mindset to creating impact. These loans start off as working capital loans – small with short durations. They gradually increase with every round lent to them corresponding to their growth as a social enterprise. Here is a rough guide as to our ticket size and loan length:
This model of lending also de-risks us and would be elaborated on in a subsequent article.
A lingering question that many have is whether this means we fund less impactful social enterprises this way, and if our capital could be better deployed to more effective social enterprises. A later article on how we think about impact will address this. Essentially, we still believe in providing capital to the more impactful social enterprises. However, because we look to fund thousands of social enterprises, we do not see our model as one to cherry pick the most effective social enterprises to provide capital to. Instead, we hope to raise the general “bar” in terms of how effective social enterprises are. This is done by raising our requirements for impact in subsequent loans to help the social enterprise gain sophistication in how they think about impact further down the line. This is elaborated on in this article.