Supply and Demand Mismatch in Financing Impact start-ups: Rethinking Venture Capital
Updated: Oct 5, 2021
Impact startups play a key role in addressing the most pressing environmental and social challenges of our days. These are early to mid stage companies whose key concept is to take a challenge related to sustainability - most popularly known as SDG frameworks - and solve it for a positive impact to make a business out of it. However, while having an important role to play, these impact startup businesses often face hardships to raise capitals. A large factor to this struggle is the supply and demand mismatch in the ways in which small corporations for impact are financed. The traditional structure of investment is venture capital (VC) funds but in the case of impact companies, this structure is not adequate as VCs primarily focus on its financial gains, whereas impact companies are more focused on its sustainable development impacts. Solutions such as revenue sharing or evergreen funds seem to be more appropriate for efficient and effective investments into impact startups.
Issues with investing in impact startups through VC funds
Venture Capital is a type of financing where investors provide capital to startups during their early to mid growth phases. While these may suit the needs of different industries such as information technology companies like Whatsapp built from VC funds, this way of financing does not match the needs of impact startups.
An important need for impact startups is having a patient capital that is a long-term investment fund prepared to wait for a considerable amount of time before seeing financial returns. In other words, according to Oxfam’s description, patient capital is crucial because “most enterprises making a meaningful difference for people […] take 7 to 10 years to come close to financial break-even, as they constantly need to adapt their products […] to meet their impact and revenue goals.” The current VC fund structure does not meet this need because of its typical financing approach of an equity-only method, which consists of receiving shares in exchange for giving money for the startup. For investors, having business equity at stake means that they will want to start earning profits immediately. Thus, typically, VC firms demand a return on capital within five years and commercial or near-commercial rates of return.
Such a “growth at all costs” method puts enormous mental pressure on these firms which can potentially generate impact in the long term towards sustainable growth, but ends up chasing short-term profitability goals at the expense of their initial impact goals.
Impact start-ups also require a relatively risk-tolerant investment in order to achieve positive impacts in the long run. During their growth, these businesses could be fragile due to internal changes or external issues that may affect their area of operations as many of these businesses concentrate on developing countries. On the other hand, a striking characteristic of a VC fund is its aversion to risk, meaning it prioritises an investment that is safe and that preserves its capital, which is rather the opposite definition of impact businesses that often deal with potential risks. The current investor mindset does not allow for a proper view of the tradeoff between risk-adjusted financial returns and non-financial returns (social and environmental impacts), as they are not rated so highly on the investor appetite. To compensate for the high risks of early stage companies, investors with large investment capabilities then tend to only invest in those that demonstrated sufficient traction in their revenue.
It is a widely shared struggle for impact startups internationally to grow and scale their businesses because they need initial high capitals but they often find it difficult to access this initial financing due to the current mismatched financing structure. Thankfully, solutions to resolve the issue have been emerging, which we present a few of them below.
Rethinking structure of VC funds
As the impact business sector is growing quickly with larger traction of SDG issues, more alternatives to VC investments are being developed to eliminate the financing supply-demand mismatch in the sector. The alternative financing mechanisms tend to focus on bringing flexibility for impact startups to access capital and two of the major alternative mechanisms are revenue sharing agreement and the evergreen fund structure.
Revenue sharing is “a form of lending that involves sharing operating profits with investors as return on their investment.” This type of financing is beneficial for both investors and entrepreneurs because they share the same objective of receiving sustainable revenue. In this type of revenue sharing agreements, “the business receives a loan from investors and reimburse it by sharing a percentage in regular intervals until a target return has been achieved.” This is an interesting concept for those small impact businesses because they can pay their investors flexibly depending on how well the company is performing. It decreases the mental pressure and short-term profitability chase of impact startups by eliminating the need of “answering to investors who hold equity shares or the need to risk personal assets as collateral for a loan. A successful demonstration of this investing method is the impact startup Spensa Technologies from Indiana that operates as a precision agriculture company and has been successfully developed thanks to the revenue sharing used by the Village Capital VC fund. Their agreement gave the business the flexibility and leeway to grow and the loan from the investors had been fully repaid just two years after the revenue share agreement.
Evergreen funds is another form of investing structure and it refers to VC funds that do not have a predetermined closing date, and it allows the fund investors to provide an ongoing capital support without the pressure to exit within a time frame to reinvest it again. For impact businesses, it allows for a permanent capital vehicle where they could focus their efforts on growing their businesses more sustainably and on capital appreciation without time constraints since they have a long-term capital. For large investors, it provides an opportunity to invest in companies that have strategic returns in the long-term rather than simply its financial returns. In addition, as VC investors can remove their capital and review their investment thesis due to the temporal features of the fund, their aversion to risk is reduced. In both ways, evergreen funds are attractive for small businesses and VC firms are more willing to invest due to lesser risks involved.
Impact investing is on the rise and it is set to continue as global challenges mount such as climate change and inequality in the future. Impact startups itselves are then central to this trend as they are best situated to offer solutions to mounting challenges. However, the current investment structure of VC funds based on equity and risk aversion do not help the businesses that matter to grow. However, thanks to the search for alternative and new financing mechanisms such as revenue sharing or evergreen funds, we could perhaps anticipate a better future for these impact startups that could truly bring us a sustainable and resilient world. Echoing a statement from the Global Impact Investing Network, “the steps we take today will not only address the world’s most immediate and pressing needs, but also set in motion ripple effects far into the future.”
Author: Edgar Saint-Hillier
Editor: Khaliun Purevsuren