Most investors, startups and social enterprises think that the only way to get commercial financing is either through debt or equity.
But this is not true.
Traditional funds and lenders dominate the financing space, and they have their own restrictions and limitations. These constraints force them to use either direct equity or debt. And since they finance the majority of transactions, most other investors must follow their lead.
But it does not have to be that way.
Right structure, right company.
Each investor and each company have their own expectations and requirements. Finding the right structure and the right company makes life easier and more enjoyable for both. And if you are an impact investor, the right structure can increase both the chances of achieving that impact and its scale.
Alternative structures
There's a whole world between debt and equity. Let us first look at the obvious qualities of traditional instruments from the perspective of investors and founders.
For the investor, equity means an uncertain exit, but one with a chance of upside. For the founder, it is the most expensive form of financing. On the other hand, debt capital offers no upside for the investor and places an undue strick payment and collateral burden on the startup, often making it inaccessible to most founders.
The assumption that investment must be pure equity or debt is simply a missed opportunity.
Instead, we need to create tailored structures.
One way to start is to think creatively and blend the different types of instruments.
Mezzanine financing is one such option and a good example. The name mezzanine is derived from the fact that mezzanine financing sits in the middle (mezzo) of a company's balance sheet between equity and debt.
It is a customized mix of debt and equity that allows for flexible loan repayments (e.g. based on revenues) while still giving the investor some leeway for an upside. Partial loan repayments mean faster de-risking for the investor, while leaving more equity with the founders.
Below are more such creative structures and information on the circumstances under which they may be suitable.
But before we dive into these structures, let us go over a few tips that will help you choose the right structure.
Tip #1: Know your goals
Once you know your return goals and time horizon, you can break them down into components and create customized structures that match your risk/return expectations.
For example, if you are a public agency or foundation, you may have the flexibility to invest for a longer term than typical funds, or you may have the option to accept lower financial returns in exchange for higher impact outcomes. On the other hand, if you are a commercial investor, you may have more flexibility in structuring than a public entity or traditional foundation.
Tip # 2: Know your investment object
Understanding the specifics of each business and entrepreneur will lead to compatible structures.
Cash repayments of a loan may not feasible for a research and development company that may take several years to bring its product to market. However, such a company may be able to make "in-kind" or accrued interest payments that can supplement the loan amount, as is the case with convertible bonds or some mezzanine structures. If the company you are investing in operates a seasonal business, it may not be able to make fixed loan payments, but may very well be eligible for variable payments based on a percentage of sales.
Tip #3: Know your options and be open to the conversation.
Educate yourself on the financial options available to find the right mix for you. This requires education not only on the part of the investor and the company, but sometimes on the part of the legal team as well.
We mustn't forget that no one started with these structures, they were created with the creativity of the parties involved out of real needs to make the investments work. The world of financing offers a wide range of possibilities, and working with the right advisors will open up new horizons and options.
Flexibility unlocks great investment and impact opportunities.
Unfortunately, we're not taught how to do it. Below are some examples of innovative structures that impact investors are using for targeted impact and as fit-for-purpose structures.
Structure #1: Redeemable equity
This structure is designed to build wealth in disadvantaged communities.
Founders receive a call option, which is an option to repurchase their shares at a predetermined price. This price is usually a modest money multiple of the investment amount. Standard VCs seek at least three times (3x) as a money multiple for their return. However, if you are a foundation or mission-driven organization, you can settle for 1 or 2 times as long as you also meet your impact goals.
A variation of this structure is to give the option to buy the stock not to the founders, but to the employees of the company, based on predetermined criteria. This distributes the wealth created from the company's success to a larger disadvantaged community.
The bonus is that you have now built in an incentive for the founders and employees to make the company succeed, just as a VC would with employee stock option pools.
The investor can still earn a return, but has a capped upside that is traded for impact. The company grows, and the wealth remains with the founders and the employee community.
Structure #2: Forgivable loans
This structure can replace grants as loans with some return and built-in impact incentives. Repayment of principal and interest is inversely tied to impact outcomes.
As impact increases, the lender (e.g., a foundation) can lower the interest rate and decide to forgive some or all of the principal. The trigger levels for all of these mechanisms are specified in the loan documents.
Funders may reclaim all or part of the loan, which alternatively would have been a grant, and reuse it for new investments in a similar structure with inherent outcome incentives.
Grantors also typically cannot do much once the grant is disbursed, other than deny a new grant if results are not achieved. This structure provides the right incentives to the grant recipient.
The advantage to the recipient (and to the funder) is that, unlike grants, which can often be used in very restrictive ways once they are disbursed, forgivable loans give entrepreneurs the flexibility to manage their business and achieve results based on lessons learned during implementation, rather than being stuck in a deadlock to meet grant requirements.
Structure #3: Revenue-based financing
Also known as RBF, this structure provides an alternative to fixed loan payments, typically as a percentage of the company's revenue. The total repayment amount is often a set multiple of the amount invested.
RBFs can also be coupled with an equity kicker to give the investor some upside potential. Or the balance of the loan can be treated as a convertible bond. RBFs are a real panacea for early-stage companies that are too early for banks and not aggressive enough for VCs. The structure aligns the interests and needs of investors and founders.
The benefit to the investor is that partial repayments de- risk the investor before an exit. IPOs or strategic sales are sometimes not realistic exits for impact companies. As in the case of redeemable equity, such an exit may also not be preferred by either founders or investors. Revenue-based financing vehicles are also considered "structured exits" where the exit is built into the investment, in this case by repaying the investment in the form of a loan.
Go beyond debt and equity.
If we limit ourselves only to equity or debt, we miss out on potential investors, investments and great businesses that can make the world a better place. There is always a middle ground that works for everyone.
Once we understand that there are more tools and options, we can be more flexible. We need to recognize that every company and every founder is different, and that different impact goals work better with certain structures.
Innovative financing structures can lead to more matches between investors and companies, and much more impact.