This post was written by Lila Cruikshank, recent Fuqua graduate, in September 2013.
Social entrepreneurs, like any entrepreneur, struggle with the search for investors; investors struggle to find investments that provide sufficient returns. One of the most common tensions is the “exit” – how can social entrepreneurs return capital to investors without sacrificing their social mission, or having to relinquish their ownership in a venture?
On the final day of SOCAP13, I attended a panel entitled “Alternatives for Impact Investing: How to Keep Both the Investor and Entrepreneur Happy”. On my way to the panel, I read the title to a social entrepreneur friend who responded, “It’s not possible.” Or is it?
The panel introduced a new investing vehicle called the Demand Dividend, which offers the impact investing field another alternative to equity, and with it the potential for more exits. The field of impact investing is evolving rapidly, and I think the Demand Dividend represents the promise of the field: creative solutions to seemingly entrenched problems. While creating solutions that generate both financial and social impact, why not endeavor to create an investment vehicle that can keep both the entrepreneur and the investor happy?
The panelists included Monica Brand (Acción Frontier Investments Group), Lisa Kleissner (Toniic and Hawaii Investment Ready), Jan Piercy (ShoreBank International), Emily Stone (Maya Mountain Cacao), and Jim Villanueva (The Eleos Foundation), and was moderated by John Kohler (Toniic and Center for Science, Technology and Society).
Why does impact investing need more alternatives to equity? There are three principal reasons, and the need is especially acute for early-stage investing:
- Impact investors, having largely adopted an equity-based venture capital model, haven’t seen many exits. Without the return of capital, investors will not be happy (and many more potential impact investors are on the sidelines, waiting to see more reliable exits).
- An equity-based investment model excludes a majority of social enterprises. Assembling an equity portfolio requires identifying firms that promise at least an 8-10x return, which excludes a large number of social enterprises that can generate significant social impact and modest financial returns.
- The equity model puts pressure on entrepreneurs. Assuming that a 10x return is possible and the investment is made, early-stage equity investments require the entrepreneur to relinquish some portion of ownership and control early in the company’s lifecycle, which many social entrepreneurs do not wish to do, and which strains the entrepreneur’s ability to maintain a social mission.
Equity, while an efficient investing tool, is not meeting the needs of the impact investing space, especially for early-stage ventures. Debt is an important alternative to equity, but requires a high degree of cash flow stability that can be challenging in early-stage ventures.
Enter the Demand Dividend, a flexible investment vehicle that matches payments to cash flow. After a honeymoon period, the entrepreneur returns capital to the investor by making periodic payments based on a percentage of free cash flow, up to an agreed upon multiple of the investment. (Basing repayment on cash flow rather than revenue, this variation on revenue-based financing accounts for planned expenditures.) These features provide flexibility to return capital to investors according to terms appropriate for the venture, and without the need for a large liquidity event.
The panel presented a recent Demand Dividend investment made by the Eleos Foundation. Earlier this year, Eleos invested $200,000 in Maya Mountain Cacao (MMC), an early agricultural venture operating in Belize. Eleos expects a $400,000 return within 6.5 years. After a two-year grace period, MMC will begin making payments every six months, based on cash flow. Eleos has a claim to 50% of the company’s free cash flow (FCF), higher if FCF exceeds targets, and lower if below a certain threshold. Repayment is capped at 2x the initial investment, but the term sheet includes a convertibility feature and ride-along terms provide for participation in future rounds. These features give the investor additional upside potential if MMC does well. (Want to learn more? See a term sheet template for the Demand Dividend here)
The Demand Dividend will not replace equity, but it offers an additional instrument for the impact investor’s toolset. It could be a valuable alternative in cases where a large liquidity event is not likely or not part of the entrepreneur’s vision, and where a monthly interest payment schedule does not align with the company’s expected cash flow. (Agricultural companies like MMC, for example, often receive cash only a few times a year, when the crop is exported.)
Of course, the Demand Dividend is a new tool which will continue to be tested in practice and will only work for certain deals. For example, the Demand Dividend places a premium on trust and transparency between entrepreneur and investor. Both The Eleos Foundation and MMC highlighted the importance of their relationship, which makes the model of cash flow-based payments every six months feasible. Another challenge to the model is the question of attractive business investment opportunities, which would require cash outlays and delay repayment. Such an opportunity recently arose for MMC, which triggered a board meeting to evaluate the opportunity. The Eleos Foundation also provided an example where they decided against using the Demand Dividend because the venture in question required large capital expenditures, making a cash flow repayment system too risky.
One topic of discussion throughout SOCAP13 was the question of “are we there yet? Has impact investing reached a tipping point?” The consensus was no – the impact investing field hasn’t tipped yet but impact investors continue to break down barriers, and with some more reliable successes, the field seems poised to unleash a significant amount of capital waiting on the sidelines.
Want to learn more about what happened at SOCAP13?
- Another Toniic panel at SOCAP was “Practical Steps for How to Become an Early Stage Impact Investor.” Toniic will be publishing a report presenting these findings, authored by CASE’s own Cathy Clark. To hear about the launch of the report, follow Cathy and CASEatDuke on twitter!
- Read Erin Worsham’s recent blog post, “From Money to Meaning and Three Themes in Between.”