“Killer” financing instruments: the Good, the Bad & the Ugly
by Christina Moehrle, Social Finance Academy, November 2, 2018 /
As a social entrepreneur, looking for capital to scale and not knowing which the “killer” financing instruments are is like risking unwanted bullets in one’s chest. To avoid the “valley of death”, there are more questions to ask than just where to find the closest source of water. Here is a short guide through the prairie, with some do’s and don’ts for relative greenhorns in social finance.
Ok, not everyone is a big movie fan. And many of you have not even been born when this famous, highly successful and influential “Spaghetti Western” was launched by director Sergio Leone in 1966. But it kick-started Clint Eastwood’s acting career and catapulted him into stardom. So if you want to get your impact career flying high, too, it’s probably good to do some homework – unless you are a natural talent at shooting, of course.
Briefly to the plot: Three gunslingers compete to find a fortune, a buried cache of Confederate gold, amid the violent chaos of the American Civil War: “Blondie”, the Good (played by Eastwood), “Angel Eyes”, the Bad (actor Lee van Cleef) and Tuco “the Rat” Ramirez, the Ugly (played by Eli Wallach).
Now, before we start our social finance movie, let’s define the bounty that we are hunting: What is a “killer” financing instrument? “A „killer” financing instrument supports a social enterprise best for scaling and doesn’t kill the impact on the way.”
For those who feel that they need some training to hit the right target, we will start with a small mind game: Which financing instrument would you aim at if you had the ultimate free choice?
- Grants & donations?
- Mezzanine & hybrid?
- It depends (i.e. “I have no clue” or “I already cracked the riddle”)
As the ironic statement indicates, there is more to this mind game than meets the eye. Some questions to ask yourself:
- Which stage is your social enterprise in and what is the legal form (non-profit, for-profit, structural hybrid)?
- How much capital do you really need, how often and for how long?
- Based on your financial forecast, when will you create a surplus and be able to start repaying the capital – and how quickly?
- Do you know the side effects of these financing instruments, such as flexibility, cost, the future influence on your social enterprise, the value add from the capital providers, the need for securities?
- Are you familiar with innovative finance features such as revenue and profit sharing agreements or impact incentive mechanisms?
If you already know all the answers, feel free to lean back and enjoy your popcorn. For everybody else, here is a small guide how to enter the prairie before the plot gets really serious:
1. The Good
Like in the movie, collaboration can be vital to find the gold. Many social entrepreneurs are quite aware of the traditional financing instruments – debt, equity, mezzanine, grants/donations -, but rather clueless about hybrid approaches. “Hybrid” means that you combine different types of capital providers and/or instruments and features in one single deal. Here come some examples:
- Think about a foundation giving a grant and an impact investor giving a loan at the same time. The grant reduces the risk for the investor. At the same time, the loan makes the foundation’s grants more effective because the social enterprise has a better position to become sustainable and thrive due to the loan.
- Think about a single, patient investor who gives a subordinate, unsecured loan at a much lower interest rate than usual. The investor does this to allow the social enterprise to focus on developing its business first, instead of paying a lot of interest in the beginning. In order to catch up later on his financial return, the investor receives a fixed share in the enterprise’s future profits or revenues until the end of the loan tenure. Thus, the (re-)payments to the investor are more aligned with how (slowly or quickly) the social enterprise’s business develops.
- Think about a very impact-driven investor. He or she is willing to give a loan at a very low interest rate and combines it with an impact incentive. If the social enterprise meets certain impact milestones by the end of the loan tenure, the investor will get a lower repayment of his loan. Then, both sides benefit: the investor gets the desired impact and the social entepreneur a less expensive financing.
There are almost countless “hybrid” combinations to think of. In a recent paper by EVPA about “Tailored Financing”, there are many examples how to make use of collaborative approaches in social finance. This is important because the current landscape still has a lot of gaps and barriers to be overcome until social entrepreneurs can easily receive enough fuel. While the small EVPA leaflet series “in a nutshell” is primarily meant for potential investors, it is also very useful for social entrepreneurs looking for capital – good examples included.
Bottom line: Being “the Good” in this blockbuster means to be confident and know the entire scope of available financing instruments, including “hybrid”. Then you can make a conscious decision and avoid wasting time and resources by straying around in no man’s land.
Tips: Check out our SFA Workout finance track. There, we train muscles with targeted units about the right financial “power drinks” from both perspectives – social enterprise and investor.
2. The Bad
Entering the movie with “Angel Eyes” is calling for trouble. Not that capital providers are ruthless and have bad intentions – they may simply be very different from yours. The equivalent to the movie badass is therefore not a character, but a really bad idea: not knowing what your options are. Think twice: Once you secured a specific financing instrument, you have to live with its consequences for quite some time.
Bottom line: Better to spend some time beforehand with identifying the major features of different financing instruments, including their pros and cons. This definitely saves you from unwanted torture.
Tips: If you need a very basic orientation, you will find the lecture video “Financing Instruments and Side Effects” on our SFA learning platform. Another useful tool is the “Orientation Tree Financing Instruments” that can guide you to a suitable water source. For initial details, check out the basic chart below that was part of our SFA Workout #2:
3. The Ugly
You don’t have to be the fast-talking bandit to be able to grasp the bounty. It’s simply good to have his resilience. While it’s definitely not an advantage to be wanted by the authorities for crime, to be wanted by investors is an entirely different story – and high on every social entrepreneur’s agenda. So the equivalent of “the Ugly” is knowing how to attract the right investors and team up with them. One important clue is to first retrieve the vital pieces of information, so you know exactly where to find the treasure. In real life terms, this means to research and select investors according to the financing instruments that will serve your journey best. Who exactly provides these instruments in your region and sector? And what are their requirements and expectations? If you have full knowledge of these coordinates, it’s easier to find the tombstone and successfully dig for gold.
Bottom line: Once you know what you need, you know where to look for it – without running around in circles or getting hanged.
Tips: In unit 7 on our SFA learning platform there are videos, infographics and tools about approaching (the right) investors. Another great source is the toolkit from our friends at Ashoka & UBS, e.g. with term sheet templates for specific financial instruments. If you are still eager for more food for thought and peer exchange, plug into SFA Facebook – the right place for quick shooters in social finance.
Whatever you decide to do:
Have fun creating your social finance blockbuster!