Debt as an Instrument for Growth in Impact Investment
Impact Investment has developed rapidly over the past decade, representing the confluence of development goals with financial sustainability and discipline. At the heart of the sector are Impact Enterprises (IEs), and it is in response to their requirements for capital to grow that the rapid evolution of the sector has been necessitated. As the early IEs have scaled, a common theme that consistently emerges is the need to leverage equity by accessing debt at the appropriate time.
The ability to service debt would imply that these IEs are generating revenue, albeit often to a limited degree. At Impact Investment Exchange (IIX), we have been working with IEs to raise capital at every stage, from seed to growth to the subsequent series of investment for scale. Similar to the appropriate equity investment in stages, IIX is taking a holistic view of assisting IEs to raise appropriate debt, providing three platforms that vary in terms of tenor, interest rate and moratoriums.
Figure 1: Integrating debt as an instrument of growth for IEs
For relatively small IEs that are generating revenue, IIX plans to launch Impact Credit, a peer-to-SME lending platform with an integrated rating of positive social and environmental impact created. For IEs that have achieved significant scale, mainstream instruments like the Women’s Livelihood Bond would be appropriate. Between the two ends of the spectrum, IIX will launch debt instruments on the Impact Partners platform. At this in-between stage, debt can serve as the ideal bridge between rounds of equity investment. Indeed, having access to such transitional capital could represent the difference between an IE continuing to thrive or closing prematurely.
Specifically, debt instruments can serve as a critical bridge to help IEs across the infamous ‘Valley of Death’ between the Series A and Series B investment rounds. This term refers to the gap in funding between equity rounds for high growth enterprises, and is evident in all start-ups, not just IEs. With enterprises being able to raise Seed capital on the basis of an idea, and Series A capital on the hope of visible yet limited ‘traction’, Series B capital represents an inflection point for enterprises.
From an investor’s perspective, the ‘Valley of Death’ is a stage of growth that still represents significant risk, even as enterprises are at their most vulnerable. At this stage, enterprises have invested in expanding the core team or and in development of the product, or possibly both. The result is a higher ‘burn-rate’ or committed operational expenditure on a month-on-month basis. Implementing the growth strategy may compel a pivot of strategy, an adjustment of growth projections, and developing a new product to take advantage of an opportunity in the market. Thrown into the mix, early investors exert considerable pressure on both entrepreneurs and enterprises to deliver on their early promise.
In this context, raising growth capital is the last thing an Entrepreneur would like to concentrate on. Unfortunately the pressure of an ever shortening ‘runway’ of when the cash will run out builds with each passing month, forcing entrepreneurs to devote energy and time to raising capital, rather than on building operational efficiency or streamlining new products. The enterprise lives or dies on their ability, and that of the team they have built, to manage both these tasks simultaneously. Inevitably, only one in five enterprises are able to transcend this chasm (Zausner, 2016).
De-risking the treacherous stage between Series A and Series B for Impact Enterprises through debt would seem to a logical step. After raising capital for Series A, IEs have typically reached a scale where they are able to service limited debt, as long as the debt is aligned with their business model. This bridge represents capital when they need it the most, extending the runway of available cash without the difficulty of negotiating terms of valuation.
From the perspective of a potential investor, debt also has its advantages. The tenor would be relatively short, especially when compared with equivalent equity instruments. The return on investment is also likely to be realized earlier than any equivalent equity investment. An option to participate in the next round of equity investment at a discount could further sweeten the deal.
Helping IEs navigate the Series A to Series B gap is an imperative, as the sector cannot afford to have only twenty percent of IEs survive to Series B. IEs should be afforded every opportunity to succeed, and appropriate debt instruments would significant increase the probability of success.
Pranay Samson
Manager, Corporate Finance
References:
Zausner, S. (February 2016, Stanford Social Innovation Review). ‘A Good Deal for Social Good’.
Originally published at impactquarterly.asiaiix.com on July 27, 2016.
