Boosting your growth with hybrid fuel
What’s the ideal engine to speed up your social vehicle? And which fuel do you need to run it efficiently? While many social entrepreneurs are not aware of their options, there is a suitable funding model for everyone. Time to investigate which instruments the social finance market has in stock for you. But don’t forget: Before you choose, ask yourself what you really want from your investors.
Speak to any social entrepreneur who successfully raised impact investment and you will hear several truths. One is that there is a right time for scaling. Another one is that you shouldn’t raise capital unless you really need to. To attract investment is not a gold standard that you have to chase in order to be viewed as a great social entrepreneur. On the contrary: it comes with risks and side-effects, so it’s good to study the leaflet and consult your inner doctor before taking the pill. Do you want just the check and that’s it? Or do you seek advice, expertise and network on top of the money? Are you willing to get a partner aboard who shares profits and losses? Or is a less engaged loan provider rather your cup of tea?
One piece of wisdom is that all financing instruments have their pros and cons – and so do the investors who provide them. Which instrument is the right one for you, is mainly a matter of plans, profiles and preferences. Even a combination of several instruments can be the perfect fuel for a powerful social engine. Therefore – unless you want to risk not seeing the wood for the trees – take a good compass in your hands before you go out in the wild.
Here is some guidance how to find your best way through the thick forest of social finance.
“North”: The legal form
In most countries, there is no such thing as a legal form specific to social enterprises. Instead, they often sit between two stools: should they go for a non-profit or a for-profit
structure? For an organization wishing to achieve social impact AND financial profit (no matter how moderate), this state of play is certainly not ideal. It also limits the choice of
financing instruments. If you have a non-profit entity, for example, your options are basically grants and donations. Depending on the country you are domiciled in, you may also be allowed to take on a loan.
For-profit structures, vice versa, have many choices for repayable instruments, but typically a much lower ability to secure grants and donations. To solve this dilemma, many social enterprises decide to go “hybrid”: They separate their activities into (1) those that are able to generate income and profit, and (2) those that are high-impact but will never become self-sustaining. This kind of legal set-up is called “structural hybrid” or “hybrid organizational model” (see box). Of course, there’s an additional effort in running two entities instead of just one. But if you strive to scale your impact and need larger sums of capital from outside, walking the extra mile might pay off: The entire universe of funding opportunities opens up.
“West”: The business model
The right legal structure largely depends on the business model. If your activities will never create income, don’t worry about hybrid structures or for-profit entities. Yet if a part of your business has the potential to break even, you have what it takes to attract investment.
Impact investors’ motivations are rather simple: In addition to impact, they want to see a reasonable chance to achieve a positive financial return. In other words: they will scrutinize the size of the surplus that your activities promise to create. Will your income exceed costs within a reasonable time? Will you be able to pay back capital and provide a positive financial return? If the answer is yes, you have their attention.
Imagine you’d have a free choice of financing instruments, which one would you take? There are two basic instruments and one “hybrid” form: debt, equity and mezzanine. And they come with risks and side-effects. Equity investors, for example, become real partners who share profits and losses of your enterprise. But they will also have their share in decision making. Also, to exit their investment at some point in the future, they will need to sell their shares. Debt providers, on the other hand, want fixed repayment schedules and often a security or guarantee for their loans. This is something your enterprise may or may not be able (or willing) to give. Otherwise, loan providers are rather passive and usually don’t possess voting rights. Also, once the loan plus interest is paid back, their investment automatically ends.
So what’s the best solution for you? Similar to the dilemma of legal forms, social enterprises are sometimes stuck in the middle: neither equity nor debt fits well to their profiles. Then it’s time for a “hybrid” solution: mezzanine. Mezzanine (also called “quasi-equity”) is very flexible and combines features of debt and equity. Investors and investee simply agree on what these features should be. For example, investors could receive a share in the social enterprise’s revenues instead of fixed interests and repayments. This gives the social enterprise much more flexibility in terms of cash flow, especially in the early phases of growth. Otherwise, the investors could be more like debt providers in their features. This specific model is called a “revenue sharing agreement”. But there are many other ways to structure a great solution. If you are interested in digging deeper, FASE has several case studies for you in stock.
“South”: The stage
When striving through the woods, social entrepreneurs often realize that legal form and business model are not carved in stone. They may change over time. Some organizations start out as non-profits and finance themselves through donations, grants or unsecured loans. Later, they become scalers and require different types of financing and organizational structures. Then impact investment comes into play. But which one is the right instrument? Equity often fits well to early-stage companies with a high risk and high return profile. Loans are usually better for more mature companies with a stable, predictable surplus and the ability to make reliable repayments. Mezzanine, on the other hand, may be a great fit for social enterprises with other profiles, for example with slower growth and a more limited potential for surplus. So the direction that your compass needle will show also depends on the stage of the lifecycle. Therefore, before filling your tank with equity or debt, check out if there’s not a chance that it may run better on hybrid fuel.
“East”: The impact
The fate of pioneers can be tough. High impact ventures are not necessarily every investor’s darling. The more disruptive their business model, the more risky their future income and the investors’ returns, too. Not many social enterprises can offer both, high social AND financial returns – at least not in their early stages. As a result, certain types of investors are hard to come by. Today, the vast majority of them prefers financial returns in-line with the market. They basically compare your social enterprise’s risk-return profile with those of traditional companies. Good news is that there are also other investors around: they favor impact over financial outcome. To demonstrate this, some use specific incentive mechanisms embedded in their financing models. For example, once a social enterprise achieves pre-defined milestones for impact, it gets a financial reward. These so-called “impact incentives” or “pay-for-results” mechanisms are another hybrid feature that enriches the social finance universe. It can also make life easier for social enterprises with exceptionally high impact.
Find your personal compass
Now that you had your first trip through the social finance forest, how do you feel? Enthusiastic or tired? Best to keep a firm eye on the four cardinal points – legal form, business model, stage and impact. Then your compass will help you to find the best way through the financing bushwhack. It’s certainly not trivial to see the wood for the trees. But with an open mind, you’ll get a wealth of support out there that keeps your social engine efficiently fueled for your mission.
Links and resources
- “FASE case studies”, examples of hybrid financing models in practice: http://fa-se.de/en/case-studies/
- “In search of the hybrid ideal”, an insightful article by Echoing Green and Harvard Business School: https://ssir.org/articles/entry/in_search_of_the_hybrid_ideal
About the author:
Christina Möhrle started her own shop as a freelance writer and journalist in 2012 to specifically promote social entrepreneurship and impact investing. Since 2014 she additionally takes care of FASE’s communications, papers and blogs. After 15 years as a manager in investor relations, structured finance and venture capital, helping to build the social finance ecosystem has become Christina’s passion and profession.
This blogpost is presented by FASE in collaboration with Siemens Stiftung and it’s part of a series of Blogposts, Webinars and Website content that we will provide on our website within the next weeks and months.
We will cover the following topics:
- Why using a self-sustaining business model?
- Testing your idea in the market
- Getting the business plan ready
- Approaching investors
You can find the first blogpost of this series >> here.
The Financing Agency for Social Entrepreneurship GmbH (FASE) is an Ashoka initiative and supports selected social enterprises in raising growth capital. FASE identifies investors and financiers of the entire spectrum ranging from private investors, family offices, foundations, social investors and banks. FASE puts an emphasis on building hybrid deals combining several investors with different financing components. www.fa-se.eu