By Aner Ben-Ami
The social enterprise community is held up as an innovative ecosystem of investors and entrepreneurs, designing businesses models as diverse as the challenges they address—from poverty in the global south, to recidivism and urban farming in the US.
How are these businesses being funded? Oddly enough, the vast majority are raising capital using the standard equity (or convertible note) term sheets that are designed to support fast-growing tech start-ups. If a company is building a water distribution system in Kenya or local food hub in North Carolina, why would they be funded using the same investment terms that were used to fund Snapchat, Instagram or Uber? When was the last time you saw an artisan sourcing project IPO or get acquired by Google?
At Pi Investments, we quickly came to the realization that we needed to redefine terms to better fit the unique attributes of social enterprises—whether it be longer timelines, lack of scalability, unconventional exits, or broader community participation. And we were thrilled to see that others in the field felt the same way. In this post I want to share some thoughts on why the equity model is misaligned with many of the businesses we are seeing, and to highlight some of the alternative structures that we and others are using to try and innovate.
Standard term sheets: what’s broken?
It's worth reminding ourselves how the early-stage equity investing model works. Angels and venture capitalists expect a large failure rate. As a rule of thumb about 15% of the companies are expected to generate 85% of the returns. At least half of the portfolio will return less than the capital originally invested. If you often hear that early-stage investors look for 10x returns, there's a simple mathematical reason for that. Those 'home runs' have to make up for all the failed investments. Take those 'home runs' away, and the fund would have trouble returning capital to investors. In essence, this means that early stage venture/angel investors should only invest in companies that have at least the potential to become big winners. As Peter Thiel puts it: “only invest in companies that can return your entire fund” (so-called “dragons”, in recent venture lingo).
If we (investors and entrepreneurs) are honest with ourselves, we should recognize that most of the social enterprises we are building are very unlikely to have the growth/scale trajectory and to generate the kind of exit that early stage investors need to make these numbers work. This doesn’t mean they are inferior businesses—they are simply designed for a different purpose and have a different path to success. If we try to shoehorn this diverse set of businesses into standard venture terms (as we're currently doing), we’ll end up with one of two outcomes:
1. Businesses that have a very real chance of being financially viable will not get funded because they're unlikely to become a home run. This is a shame, since we'd be missing out on a big piece of the investable universe of solutions. It's as if we're telling entrepreneurs - "go solve these social challenges, historically the domain of non-profits, using for-profit models. But I’ll invest only if they can look like WhatsApp/Uber/Snapchat, because I still need my 10x return. Otherwise, you should just go back to being a non-profit"
2. Businesses get pushed to aggressively pursue a growth trajectory that may be unrealistic or counterproductive for them. Investors and entrepreneurs manage to convince themselves (and each other) that the business can (and needs to) scale and exit. If investors aren't able to get their money back from these deals, they will not be able to cycle this money back into new companies. An equity investment without the exit ends up looking a lot like a grant. And despite the insistence on scalability, there are plenty of ways to achieve impact without needing to grow at the aggressive clip required by a traditional VC.
To be clear, there is absolutely a group of companies with tremendous growth and impact potential. Some of these can and do deliver fantastic returns to venture investors. There is even a growing body of evidence that points to these companies outperforming their less mission-driven peers, primarily based on their ability to attract top talent and have a deeper connection with their customers. The question which still needs to be addressed with these high-flying companies is one of mission-drift or 'mission-aligned exits' - does the company stay true to its values and mission after it gets acquired by a competitor to generate liquidity for investors. That's a topic for a separate post - my intent here is primarily to highlight the need to acknowledge companies that do NOT fit this mold and should not be funded using the same terms.
Alternative approaches: where can we go instead?
To counter this “one size fits all” approach, there is a growing group of investors and entrepreneurs that are working to develop and apply deal structures that support the growth trajectory of the business, while providing realistic returns to investors.
We refer to these alternatives as having “structured exits”, in that the path to liquidity is explicitly structured into the deal terms (as opposed to relying on an as-yet-unidentified acquisition or an IPO). In some cases, these are still structured as equity investments, but redemptions are more explicitly defined (i.e. specific terms or timeframes for the company to buy shares back from investors). In other cases, investors are paid as a percent of revenues or profits over time, resulting in structures that can be described as an equity/debt hybrid (returns can sometimes be capped at an overall multiple, like debt, but are tied to the growth of the business, like equity).
The overarching premise and intent of these structures can be summed up as follows: if an investment can realistically be expected to support the business to a point where it is generating enough profits to pay investors back, and it is agreed/assumed that a traditional exit is unlikely (or not desirable), we should be able to come up with a formula to distribute cash back to investors while providing enough breathing room for the business.
The examples of how this gets implemented are varied and evolving. Some of the examples we have seen or participated in include:
- Revenue-based loans, where investors earn a % of revenue until they achieve a pre-determined multiple on their investment (e.g. 3% of revenue, until investors earn a 2x multiple on their investment). There are quite a few variations around this theme - some including a fixed coupon debt instrument, some having a conversion option. Our investment in Big City Farms was based on these terms, and we are seeing a number of investors using variations on this.
- Equity redemptions, where the share price of the redemption by the company is pre-determined at a given multiple and shares are re-purchased over time using a % of revenue (e.g. 5% of revenue used to redeem shares at 3x the investment price). This structure has been applied by the Fledge accelerator in Seattle, as well as by David Bangs and the Seattle Impact Investing Group.
- Preferred equity, where dividend distributions are defined as a % of revenues/profits and capped at a certain multiple on invested capital (e.g. 30% of cash flows distributed as dividends, until investors earn a 2x return). This is a version of the ‘demand dividend’ work that was developed by John Kohler at the University of Santa Clara and applied by Eleos Foundation in their investment in Uncommon Cocoa (where Pi Investments also participated).
- Cashflow/equity splits, where the investment is structured as an LLC and any cash flows are distributed to investors based on a pre-determined waterfall (e.g. 90% of cash flows go to investors until some preferred return is achieved, then distributions are based on pro-rata membership rights).
These are all emerging solutions - none is perfect and none should be expected to become the ‘new norm’. There are still plenty of questions for investors and entrepreneurs to sort through, such as tax implications and the ability to raise follow-on rounds of capital (though significant progress is being made on all these fronts). These are real challenges for us to continue to tackle, but we believe the effort is worthwhile. All too often, the supposedly simple alternative – “let's just default to the venture terms we all know!” - is just poor investing.
As we continue to work on these new models, we are always looking for thought partners, case studies and co-investors, such as those in the Transform Finance Investor Network. If we are going to wean our sector off of its standard term sheet habits, we’re going to need a community of investors and founders who are willing to think differently. If you are an entrepreneur who thinks that one of these alternatives might be the right path for you, or if you are an investor with an active interest in these structures, we would love to hear from you.
[Aner Ben-Ami co-leads Pi Investments, which emphasizes community empowerment and environmental sufficiency through a 100 percent impact portfolio approach. In that capacity, he evaluates investments across asset classes, including early stage investments, private equity and debt, and real assets. Pi is a founding member of the Transform Finance Investor Network. Aner can be found on Twitter @anerbenami.