The Supply-Demand Mismatch in Impact Investing

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In the development world, the decade of 2010–2019 will be remembered for the emergence of impact investing. Since the term “impact investment” itself was coined by The Rockefeller Foundation in 2007, the sector has been growing from practically zero¹ to USD 502 bn of asset under management in 2019. Even though it is still a just ~0.67% of the overall global financial asset management industry, the sector gets prominent media exposure through series of conferences, awards & competitions, impact reports launching, and other kind of coverage. This gives the impression that there is enough money going around, available to finance all kind of social innovations. Entrepreneurs around the world are starting impact enterprises, trying to tackle social problems around them with business mindsets, with most of them hoping to obtain investments to scale up.

However, although a lot of impact startups are succeeding in getting grant money, free incubation services, and business competition awards, many of them are struggling to raise sufficient capital to grow. It is understood that the majority of impact startups are indeed not investment-ready, either because they don’t have a good team, good impact business models, or potential to scale up. However, over the years, I have found more than a handful of gems that can’t raise money despite having all the required ingredients. They do have good products, solid and passionate teams, and good plans to scale-up and disrupt their industry. Yet many of them have not managed to attract investors. The few ones who do get investment only received much smaller amount than what they actually need. Hence, rather than focusing on growing their businesses, these entrepreneurs are distracted by the constant needs to fund-raise to stay afloat.

It is such a massive waste of good ideas and entrepreneurial talents. Ironically, I have also seen many impact investors who complained that there are not enough investible impact startups to back².

The Unique Challenges of Impact Startups

To understand why there is such a gap in the market, it is important to distinguish an impact startups from their cousins, the digital tech startups. While most tech startups can focus entirely on building great software, impact startups need to take care of so much more beyond building intellectual capital. Some examples of the activities that impact startups must undertake are:

1. Building hard assets like processing facilities, cold chain facilities, or even basic infrastructure. Things that are often taken for granted like fresh water or electricity can be a challenge in rural areas
2. Even when the business models are “asset-light”, the startups still have to build offline network or establish offline presence
3. Provide for working capital, as banks in many developing countries do not provide working capital loans to startups, especially those operating in remote areas
4. Prepare a buffer capital to go through bad times, as their businesses are often seasonal and volatile/sensitive to the natural and community risks
5. Impact startups often need to finance their stakeholders, either to buy inputs to produce so that they can supply to the Company, or for the customers to buy the Company’s products itself
6. Attract talents to remote areas. Talent and capital are the biggest challenges to impact enterprises
7. Build specialized technology that requires years of research to mature. Often after research is complete, lengthy and uncertain certification processes await

As the consequences of having to deal with the above activities, impact startups can take years to simultaneously build alliances, mobilize business partners, engage the poor, and run pilot/proof-of-concept projects. Their capital requirements are therefore much larger and more up-front than what a typical digital tech start-up would need. A traditional path of raising USD 100k seed financing, followed by a USD 1 million Pre-Series A, a USD 3 million Series A, and so on, might not work for them. Their needs for investments is more front-loaded, e.g., having the immediate need to raise USD 2–3 million right away.

Sources of Financing

All three types of investors, i.e., grant providers, impact lenders, and impact VCs can be the potential sources for the impact startups.

Getting grants is like drinking from a poisoned chalice. Grant providers either provide small amount of money, or larger amount but with less flexibility on fund usage, as the priority is the providers’ own development agendas rather than the need of the enterprises.

Impact lenders rarely come at the early stage. Their impact comes from their ability to take risks in term of giving unsecured loans or assets that traditional banks do not accept as collaterals, but most of them still require positive cash flow to begin with.

So the impact startups’ biggest hopes are with the Impact VCs — the venture capitalists of the impact world.

Unfortunately, most impact VCs also have their own limitations. Some of them are small outfits themselves, only able to give sub USD 500k or even sub 100k financing. Those who can give larger amounts can’t make investments in very early stage companies without sufficient traction in revenue, in which the impact startups cannot achieve without sufficient initial capital. The impact VCs also often follow the structure and approach of tech VCs, who invests in succession of rounds with increasing valuation. This model is not suitable for many impact startups who require high initial capital.

Another feature of typical impact VCs is their aversion to risk. While tech VCs can spread their investment and hope that one or two “home-runs” will give 100x returns while the rest of their investments going down, impact VCs hope for 3–10x returns and consequently, lower failure rates, to be able give a positive returns to their investors³.

While grant providers and impact lenders are stuck due to their mandates and rigid models, impact VCs represent the best hope as the problem is in their choice of structure, rather than in their inherent characteristics.

Experimentations

To address the financing gap issues, some impact VCs are experimenting with innovative schemes like blended financing or even a modification of the classic revenue-sharing model. There is also an experiment that runs deeper in transforming the very basic structure of a typical VC structure, by introducing a concept of impact-based incentive structure, where instead of trying to earn carry beyond a certain IRR hurdle rate, the impact VCs can earn their surplus of value addition by meeting and exceeding the target for impact.

None of the experiments are straightforward. It will be years or even decades for these experiments before their findings would be applicable. As a relevant comparison, it took twenty years for the tech VC structure to emerge and arrive at its current structure in 1950s and 1960s. Work has to be done now and it has to be conducted systematically and rapidly, ideally with the support of the funds who would act as Limited Partners as well. This is mostly a quiet endeavor, away from the limelight of large impact funds being close or deals being made, but it is nevertheless the most important undertaking, as it has the potential to unleash incredible amount of entrepreneurial energy. It would be an irony if impact VCs, used to advise its portfolio businesses on how to manage innovations, fail to innovate themselves to cater for the need of their markets.

For impact startups, do not despair when you are not able to raise capital. You should reflect on what you can improve, but it could as well be the fault of the impact investors rather than yours. After all, many of the most successful impact enterprises in the world, including M-PESA and the Grameen-style microfinance, have never been funded by impact investors. It is time for the impact investors to prove their worth to the world, rather than the other way around.

[1] Of course, impact-minded investors had existed before 2008, it was just not called “impact investors”. Since nobody conducted any study on impact investing at that time, the exact size of the sector was not known

[2] Three impact investors exited Indonesia: LGT VP, Grameen Foundation, and Grassroot Business Fund, due to difficulties in finding pipeline. Source: ANGIN

[3] It does not mean that Impact VCs don’t make any investments because of all these challenges. In Indonesia at least, as apparent in the [GIIN report, p. 102], investments do happen, more so since 2014 with 43 impact investing deals completed. But the potential is so much higher than the actual number of deals eventually made, if only the supply-demand gap can be better understood and addressed