In spite of the growing interest of investors and donors in social entrepreneurship, funding for new, early-stage and growing ventures remains difficult to secure, leading some entrepreneurs to make decisions that may not align with the core mission of their organization.
Fundraising can have substantial implications on management decisions as well as organizational culture depending on the type of capital that is being sought and whether the organization is structured as a for-profit, nonprofit or hybrid.
To understand what these implications may be, let’s first have a look at the main types of capital – grants, debt and equity — that are currently available to social enterprises.
Grants are available to both for-profits and nonprofits, and are considered as one of the safest ways to take a social enterprise through its risky first stages. While traditional grant-making is tied to specific programs, social entrepreneurs tend to favor unrestricted grants — like those from the Mulago Foundation — which help support organizational growth as a whole. Financial support can also be awarded in the form of fellowships — like Echoing Green — which often include much-needed in-kind services.
Debt in the form of lines of credit, asset-based loans and other products from private investors or financial institutions is also a possibility for all types of social enterprises provided, and this is often a challenge, they have the cash flow to make payments.
Debt is typically not available to new or early-stage enterprises, but may be adequate for later rounds of financing. Convertible debt can be issued to for-profits, but is not often used in the social enterprise space. It functions as a debt and may convert to equity at a previously set conversion rate. Quasi-equity debt is issued as a debt whose return rate is calculated as a percentage of revenue. It works for all structures, but is especially advantageous to nonprofits, as it helps them attract private investment. Other types of instruments such as loan guarantees, whereby a guarantor assumes the debt obligation of borrower, are starting to emerge as well.
Equity investment allows for-profits to raise capital by selling shares to investors, who expect dividends. This type of financing is especially well-suited to businesses that require a high amount of startup capital, such as those that have high research and development costs. Because investors essentially become co-owners — and sometimes require a seat at the board — their mission and expectations should clearly align with those of the company. This matters especially when decisions must be made that may put the financial stability of the business in some conflict with its social mission.
Equity investments also raise the question of what types of exits are possible in the social enterprise space, since typical exits such as initial public offerings may not be possible. While there have been a few exits, most in the field agree that more are needed to build investor confidence.
Program-related investments are a relatively new player in the impact investing scene. They are made in the form of equity and debt investments by charities or foundations in countries where the legislation allows for it, and the investments must be consistent with the charity’s mission. PRIs tend to offer below market rate returns and are more tolerant to risk, and therefore help fill the investment gap for high-impact, high-risk enterprises. However they are subject to a large amount of restrictions that makes them difficult to access.
For-profit vs. nonprofits: Just a matter of funding sources?
A conventional approach to fundraising may imply that for-profit social enterprises only raise capital from private investors, while nonprofits rely on grants and donations. This is no longer true — as the impact investing space has grown, funding sources for each model have been diversifying. This should come as good news to entrepreneurs who wish to come up with non-traditional business models to achieve social impact. However recent trends indicate that several institutional and cultural barriers to successful fundraising exist.
A recent study by Zeppelin University and Siemens Stiftung that looked at social ventures in Colombia, Mexico, Kenya and South Africa, revealed that an increasing proportion of social enterprises are for-profits and hybrids, with a clear shift in that direction after 2006. What’s more, social investors mainly fund for-profit companies — they make up an average of 62 percent of social investors’ portfolios with hybrids accounting for 30 percent and nonprofits getting about 6 percent.
An analysis of applications to Echoing Green’s various fellowship programs revealed similar trends; applications from for-profits have increased by 35 percent since 2006, and for-profits consistently report raising more funds than hybrids and nonprofits. Overall, for-profits and hybrids seem to be reaping most benefits from the diversification of funding sources.
Different worlds, different languages
For some entrepreneurs, starting out as a nonprofit can be a way to safely move towards the early stages of the organization. Embrace, a low-cost infant warmer, launched first as a nonprofit, but its founders made a point of operating as a business while coming up with a sustainable business model and bringing the organization’s vision to maturity — they later created a for-profit to raise startup capital.
“Even if you choose a nonprofit status, you can still absolutely think through the lens of a business case,” said Cheryl Dorsey, President of Echoing Green, one of Embrace’s supporters.
In other cases, the nonprofit model works for enterprises that are serving the bottom of the pyramid or underserved markets, and whose revenue model may provide little to no profits. One Acre Fund, a social enterprise that provides financing, training and inputs to smallholder farmers in East Africa, has always been adamant in its choice of operating as a nonprofit even though it is working toward financial sustainability, because it operates in a context of market failure.
But for a majority of nonprofits, the reality may be different. Tim Weiss, a doctoral researcher at Zeppelin University and co-author of the study on the social entrepreneurship landscape, told Devex that most nonprofit entrepreneurs have a background in the development sector, and are reluctant to consider a for-profit model as a viable option.
“They don’t even think about other funding alternatives, because they fear that if they open up their social business for loans or other market-oriented financial tools, their social mission will be at risk,” he said.
Branching out to the private sector is also a question of speaking a common language; while nonprofit entrepreneurs often don’t present their mission and activities as potential investment opportunities, investors are not familiar with the development world either, which creates a gap that is hard to bridge, Weiss said.
This culture gap can reveal itself within all organizations seeking funding both from the private and the “third” sector, be they nonprofits, for-profits or hybrids.
“For social entrepreneurs applying for funding, audience matters. For example, when talking to impact investors, despite their ‘impact’ name, the message usually begins with the business case, since that audience can be risk averse,” Echoing Green’s Dorsey said. “When seeking funds from a foundation or other grant-maker, one leads with the impact. Each audience wants to know what will happen with their dollars, but it’s the entrepreneur’s job to show the how in way that aligns with the audience’s perspective.”
It’s not only about language; seeking funders from different sectors means having to fulfill different reporting requirements, which can strain resources and require skills that the staff may not have, such as creating a monitoring and evaluation framework. And if funders take a seat on the board, this might create tension in regards to management decisions.
“You have to create a more inflated organization that is capable to talk to these different audiences,” Weiss explained.
Is free money always good?
The appeal of free money, however, remains undeniable. Among the organizations surveyed by Zeppelin University, 72 percent of hybrids and 42 percent of for-profits include some form of free cash in their funding structure. What’s more, 71 percent of hybrids and 54 percent of for-profits indicated they were planning on seeking more grants in the future. But for Brittney Riley, Manager of Global Programs for Village Capital, which trains and funds early stage social ventures, grants don’t always come as good news.
“Any company that gets free money has to be really disciplined to use that most effectively. You’ll see some companies that have had $400,000 in grants and haven’t done really anything … That’s a warning sign for an investor,” she told Devex.
Just like with any other type of funding, the decision to seek free money should be made on a case-by-case basis, Riley said. It can depend on the company’s growth stage, the sector in which it operates, but also on its location. She said organizations operating in East Africa are generally more able to attract grants than those located in India or the U.S. Free money may also be more suited for early stage companies working in bottom-of-the-pyramid markets, and that may need more support and time to prove their case.
All these factors create substantial barriers to successful fundraising. To move forward, the social enterprise space will have to bring the private and nonprofit sectors to work together toward achieving high impact by creating new, more flexible and easier financing tools that can appeal to both nonprofit and for-profit social ventures.
To learn more about social entrepreneurship, check out our series the #SocEnt Revolution: How entrepreneurship is changing global development, which explores the entrepreneurship ecosystem, from the roles of different actors to donor support, financing and incubators, in an effort to examine what needs to be done to maximize the impact of entrepreneurship in the post-2015 era of development.