Set the Course: Rules of the road for financing scale

Every organization undergoes an evolution of capital over time. But how do you ensure that that evolution supports your scaling goals instead of the whims of available capital driving your goals?

The organizations we interviewed used three interrelated mindsets, or rules of the road, to set their course and make decisions about the best mix of external capital and internal/operational levers. So, before selecting your tactics, keep these elements top of mind:

1. Ensure Cash Follows Use

Generally, the most effective financing strategies stem from the organization creating a clear strategic direction and then working to find funders and sources that fit that strategy. This clarity allows social enterprises to make choices at each stage of their scaling journey about the best sources and types of capital, whether it be capital that allows for flexibility to test and iterate, to assess and prove impact, or to crowd in key stakeholders critical to scale. In the most sophisticated cases, financing serves an integrated function of both achieving a strategic goal and sustaining the organization.

In the early stages of Living Goods’ evolution, it raised flexible capital from philanthropic funders that allowed it to test and iterate its model. As it reached a point where it needed larger sums of capital to fuel scaling of its proven model, Living Goods (LG) evolved from focusing on only individuals, foundations, and corporations, to pursuing bilateral and multilateral funders. Although typically more constrained, this funding allowed LG to layer on larger tranches which it hopes to continue to grow over time. Looking ahead, LG seeks to further engage domestic governments to work in partnership on delivering health outcomes. It is pursuing this long-term strategy, in part, through the exploration of results-based financing in Uganda. LG believes this strategy could unlock a pathway to engage local governments more directly in performance-based contracts by creating a simple replicable mechanism to increase accountability of service providers and to allow the government to contract key outputs — rather than focusing on inputs and processes. In Kenya, LG is also working closely with government to develop a contracting template for community health that the government can then use to contract non-state actors for delivery of niche services that would complement existing infrastructure and strengthen the health system. This is inherently a lengthier, more customized process but one that LG believes is necessary to change systems around the developing world to effectively respond to health challenges. (To learn more about Living Goods’ approach to scaling, read their scaling snapshot.)

2. Beware the Mission-Financial Sustainability Balance

Many social enterprises think about using revenues from their own work to drive towards sustainability, ideally to unlock new forms of capital needed to scale (e.g., impact investment capital) or to become less dependent on external capital. Social enterprises can make significant progress toward achieving operational self-sufficiency or sustainability. Yet there are very often natural limits in an organization’s ability to pursue this objective without sacrificing mission goals. Many of those who have navigated these natural limits have emerged with increased clarity that enables them to pinpoint a more feasible balance. In turn, they become more proactive in accepting only funding relationships that are aligned with this clarity.

In 2012, Root Capital launched a strategy for scaling impact that focused on growing and diversifying its loan portfolio. Knowing that margins on loans to small and growing agricultural businesses were small, one of the goals of this strategy was to achieve a high enough loan volume to become operationally self-sufficient. Root Capital funded this strategy by bringing in additional loan capital at the top of its capital waterfall — i.e., those expecting the greatest return. After two years of executing the plan to significantly grow and diversify its loan portfolio, Root Capital began to see that many of its new loans were going bad. Its aggressive scaling plan to achieve operational self-sufficiency had pushed Root Capital outside of the natural limits of its market. Root Capital decided to write off the bad debts, but also mined the data it had to understand the drivers of risk and impact. This data analysis turned into a framework called the Efficient Impact Frontier. The framework allows Root Capital to pinpoint an efficient goal point when trying to blend financial and social return at the portfolio level and to communicate this with clarity to stakeholders, including investors and funders. (To learn more about the Efficient Frontier and other value for money metrics, read here.)

3. Maximize Financial Pivot-Power

Every social enterprise has experienced times when things didn’t go according to plan. While the enterprise had set out a strategy for scale, it found itself needing to make a pivot. Those who navigated these pivots most effectively were the ones with a funding mix that allowed for maximum ‘pivot-power’ — often meaning flexible capital, diversified funding sources, and/or excellent funder relationships that allowed for key course corrections. Many pivots also resulted in the pursuit of new strategies that required different funding mixes, which meant letting some funders go and pulling in different ones to ensure alignment to the new strategy. While this is never an easy process, we saw many examples of organizations adopting transparent, data- driven approaches to bringing their funders along through their pivots.

In the above example, Root Capital had pivot-power. In addition to the loan capital it took on, it had also built a strong foundation of philanthropic funders who were in the funding mix because they could tolerate more risk and were deeply mission-aligned. As Root Capital pivoted, these funders were an important backbone. Root Capital continues to evolve its scaling strategy, focusing on scaling by building more value-chain partnerships in high-need areas in the agricultural sector, in addition to executing field building work. This evolution has required Root Capital to realign its funding mix, including losing some funders and growing the lower part of its capital waterfall through more subordinated debt and additional philanthropic capital. The process has helped “to deselect some one-issue voters” as founder Willy Foote puts it, but has also led to some funders doubling down on their commitment to Root Capital. Those who do remain are more mission-aligned.

These three mindsets — ensuring cash aligns with use, being cautious of mission and sustainability trade-offs, and maximizing pivot-power — are important ways that entrepreneurs can ready themselves for the inevitable roller coaster journey of financing their scaled impact. The rest of the articles in the Money Matters section detail specific internal and external financing strategies — lessons and advice that entrepreneurs have shared with us. As you read them, we recommend that you do the following:

• Look for analogies for things you are exploring. What have other ventures tried that could be appropriate for you?
• Analyze your own strategic objectives and assumptions. Read a section with your team and work to understand how the issues are playing out within your own work. What are you doing to learn what’s working best?
• Consider the broader strategy (i.e., bringing in flexible capital) before jumping into specific tactics. You may find more than one way to achieve your goals.
• Remember that funders too have evolving mindsets and that there are few written rules of the road for what will be most effective. Be as clear and proactive as you can about what you are currently trying to achieve and have confidence that eventually you will find funders who align with your evolving objectives.

Read next: Find Flexible Capital, Taking Control of the Value for Money Narrative, or return to see all articles in Money Matters.

This article was written by Catherine Clark, Erin Worsham, Kimberly Langsam, and Ellen Martin and released in March 2018.