Equity-like capital for social ventures

Contents

Introduction 3 Executive Summary 5 Project overview 6 The Market of Social Ventures 8 The Equity-like capital gap 19 Proposed social fund structure 30 Investor types for social fund 51 Implications for policy 57 Appendix 1: List of interviewees 62 Appendix 2: Source documents and further reading 65 Appendix 3: Background on Bridges Community Ventures 66

This exploratory study was completed in July-September 2004 with a grant from the Phoenix Fund. Author: Laura Howard Editor: Michele Giddens

For more details, please contact: Michele Giddens ([email protected]) Bridges Community Ventures 1 Craven Hill London W2 3EN 020 72625566

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Introduction

Purpose of this study Bridges Community Ventures (BCV) has undertaken this exploratory study to investigate whether there is a need for a new kind of equity-like capital to support the growth of social ventures and whether there is an investment model that could create more substantial and sustainable flows of investment into social ventures and complement existing sources of funding like donations and loans.

About Bridges Community Ventures BCV is the UK’s first community development venture capital company, established to invest in ambitious businesses in the most under-invested parts of England (www.bridgesventures.com).

BCV invests in ambitious businesses that are located in and economically linked to deprived areas in England. To be eligible to be considered for an investment a business must meet the following 3 criteria: - Location - Based in the most deprived 25% of areas in England. - SME - Independently owned with fewer than 250 employees and an annual turnover not exceeding £25M - Economic Links - Connected with the local economy by employment, market or supply chain

BCV looks for businesses with the following attributes: - Clear business objectives - Strong management team - Compelling business proposition - The potential to deliver attractive returns

Deal parameters: - Stage - Bridges Community Ventures is a generalist investor, investing in a range of industry sectors and stages. - Sector- All sectors considered with emphasis on manufacturing, services, media, retail and leisure - Deal size- From £150k - £2 m in terms of our portion of a transaction

Why BCV undertook this study

In its first year of operations, BCV came across a significant number of socially-motivated companies who applied for investment but could not be financed using the venture capital funds currently under management. Approximately 10% (c. 40 applicants) of BCV’s deal flow in the first year came from businesses that had an overriding social goal to their work. There was no obvious place to refer these deals. Rather than continuing to turn them away, BCV has decided to engage in this research to examine alternatives to provide funding for these important ventures.

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Why couldn’t BCV finance these businesses from existing funds? The investment model BCV and uses is a traditional venture capital approach in which we buy shares in companies for a period of 3-5 years, during which time we work with the companies to grow the businesses and make them more valuable. At the end of this time, we do not typically get repaid by the companies but instead sell our shares by floating the company or by selling it onto someone else.

This model is not appropriate for social ventures, where the social mission is core to the business and so, even if the business is profit-making, it is not profit-maximising. The financial returns from such businesses are often lower than their mainstream private sector equivalents and they usually are not comfortable aiming to sell onto another business or issuing shares on an ordinary exchange because the social mission may be compromised by the new owners’ desire to maximize profits.

This means that the exit route used by venture capital funds, (including community development venture capital) is not available. As a result, if BCV tried to invest in social ventures, it would usually have to seek a return through repayment of capital from the company and that would be at rates of return that would be burdensome and possibly detract from the social mission.

Methodology BCV completed over 40 interviews as part of this study and held a consultation roundtable to gather comments from experts and practitioners in the sector. We also conducted desk research and telephone interviews with practitioners in the USA.

Thank you Bridges Community Ventures would like to express its thanks to all who kindly allowed us to interview them in the production of this report. A list of interviewees is available in Appendix 1.

Presentation of findings The bulk of this report is based around a working presentation which was used with interviewees and at the consultation roundtable. We have added further explanatory comments and sources in the notes below each slide. The animated PowerPoint version of this presentation is also available by emailing [email protected].

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Executive Summary

Momentum is growing in the social enterprise sector. Patient Capital1 funds have been set up and are making their first investments. In 2003, seven social enterprises ranked among the Inner City 1002. A new social enterprise centre has been set up at the Said school of business in Oxford. The Global Entrepreneurship Monitor (GEM) Project has started tracking social entrepreneurship. The Government is launching a new legal form for social enterprises (the Community Interest Company). Several in-depth pieces of work on aspects of social enterprise have been completed or are close to completion.

On the investor side there is also momentum. There has been increasing interest in SRI3 and ethical investment. Investors have bought ethical shares in companies like Café Direct and the Ethical Property Company. The new Community Interest Tax Relief accounts offered by Charity Bank and Triodos bank have been heavily subscribed.

However, there is still a disconnect between social investors and social ventures. A large proportion of social enterprises still cite lack of availability of external finance as one of the main barriers they face to expanding trading revenue4. As well as facing difficulty attracting funds, social ventures also frequently need support in the complex balancing act they perform in trying to deliver both social and financial value.

BCV undertook this research project to explore whether there was an opportunity to learn lessons from the venture capital sector to work on this issue. We believe we have identified an opportunity to bring social investors and social ventures together.

Establishing a social venture fund would support social ventures by using innovative equity-like financing instruments to avoid the problems that some social enterprises face when issuing pure equity. It would also help them build their social ventures by providing business building support tailored to the specific challenges that social ventures face. Finally, it would make the space more visible and accessible to social investors whilst delivering a return to that makes the fund sustainable and able to attract more funds in future. We see this as an important first step in establishing a new social investment asset class for investors.

Our recommendation is that a pilot social venture capital fund should be established to demonstrate that there is sufficient market demand and that social ventures can be sustainable. This will have both a social purpose and an educational purpose that will bring more social ventures into the space and provide comfort to investors that promised returns will be delivered.

1 For a definition of Patient Capital see page 25 2 The Inner City 100 is a yearly business index and research initiative which locates and celebrates the 100 fastest-growing inner city enterprises in the UK. 3 SRI = Socially Responsible Investment 4 32% of social enterprises cited lack of available external finance as a barrier to expanding trading activity – Bank of England report on financing social enterprises 2003

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Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

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Project Overview

Purpose: • Bridges Community Ventures is undertaking an exploratory study to understand the need for a new kind of equity-like capital to support the growth of social ventures Key questions: Market of Social • What are the types of social ventures that could be supported with Ventures equity-like capital? How large is the market of these ventures?

Equity-like capital • What sources of capital are currently available to social ventures? gap Is there currently a need for additional types of risk capital?

Equity-like capital • If so, what are the vehicles that could best provide this risk vehicles capital? How would these vehicles be structured?

Investor • What type of investors would invest in this capital and what is the proposition investor proposition?

Implications for • What are the actions that government or other players should be policy taking to promote the growth of the social venture sector?

Bridges Community Ventures (BCV) has undertaken this exploratory study to investigate whether there is a need for a new kind of equity-like capital to support the growth of social ventures and whether there is an investment model that could create more substantial and sustainable flows of investment into social ventures and complement existing sources of funding like donations and loans.

This report attempts to answer the questions shown in the slide above in the order in which they are posed. For a full reading of the report it is necessary to see both the slides and the accompanying notes. However, an animated version of the PowerPoint slides is also available by emailing [email protected].

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Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

78

Equity like capital would only be suitable for high potential social ventures

• Social ventures have a social and/or environmental a purpose core to their business model which may compromise their ability to raise equity-like capital from conventional providers of equity

• These ventures include: – Social enterprises - revenue generating but not profit distributing b – Socially driven businesses - revenue generating and profit distributing with a social mission • High potential social ventures are also planning significant growth and are highly scalable with the potential to deliver some financial return as well as high social returns

a) Throughout the rest of this presentation we will use the term “social” for both social and environmental impact (b) as per DTI definition – profits are principally reinvested and not distributed but a reasonable level of profits could be distributed

Bridges Community Ventures (BCV) has experience in investing in venture capital type businesses that are located in and have strong economic links to deprived areas. Venture capital type businesses are those that are high potential i.e. fast growth and scalable. This is a small subset of the small and medium enterprise (SME) population.

In this study we are focusing on the equivalent subset of high potential socially driven business and social enterprise as we consider that these are the ventures for which equity like finance will be appropriate. For those that seek to operate one unit or to grow slowly and organically, grants, patient capital and loans are likely to be the most appropriate forms of financing.

For the purposes of this study, we have defined Social Ventures as organisations that have a social or environmental purpose integrated into their business model and are either: - Revenue generating social enterprises – non-profit-distributing organisations [i] that generate over 75% of their revenue from trading[ii] - Socially driven businesses – mission driven organisations that are, or I where very early stage) are likely to become, revenue generating and profit distributing but whose social mission compromises their return or availability of external equity finance.

High potential social ventures that would be appropriate to the kind of funding we are considering would also have a high growth potential, and be highly scalable organisations of the type that in the privates sector are funded by the traditional venture capital industry.

[i] ‘A social enterprise is a business with primarily social objectives whose surpluses are principally reinvested for that purpose in the business or the community, rather than being driven by the need to maximise profits for shareholders and owners’ ‘Social Enterprise: A Strategy for Success, 2002’ [ii] The Bank of England report on Social Enterprise funding 2003 estimates that 47% of social enterprises get >75% of their income from trading 9 Social ventures are a subset of social entrepreneurship High social return High financial return

Socially Traditional Charities Revenue Generating Social Enterprises Driven business Business Potentially Profit Trading Breakeven - Profitable - No Trading sustainable - distributing - Revenue All Revenue Surplus Profit Maximizing Revenue 75%+ trading socially And Grants from Trading not distributed revenue driven

SOCIAL VENTURES

Ethical Prop Co.

Progreso Green-works FRC Group Cafés Ltd

Reclaim CREATE Greenwich* Café Direct

Social Enterprises as defined by the DTI Profit distributing = distributions to owners NB Greenwich Leisure distributes profits to its members/stakeholders only To show graphically the subset of the social entrepreneurship space that we are looking at in this report, we have mapped it on a spectrum ranging from high social return and zero financial returns on the left to pure profit maximisers aiming for high financial return on the right. Social ventures sit in between these two ends of the spectrum and consist of both social enterprises and socially driven businesses. We have mapped some social ventures on this spectrum as examples. More details on some of these follow below: Green-Works is a recycling organisation that collects unwanted office furniture from businesses and redistributes it to schools, charities and community groups. Green-Work’s turnover in 2003 was £493,000; it is expected to increase to £1million in 2004. It is a company limited by guarantee. Green-Works generates 96% of its own income through fees charged to members for the collection and removal of their furniture and the revenue received from the sale of the furniture. FRC Group is a revenue generating social enterprise that provides a one- stop furnishing service to social landlords. The Group has started other ventures like Bulky Bobs and Revive which have been highly cash generative but these profits are not distributed to shareholders, but reinvested in the business. Café Direct aims to get small coffee producers a better price for their crops and greater opportunities for their communities. Its turnover in 2004 is projected to be around £15 million. Café Direct is a public company limited by shares. In 2003, the company decided to raise £5M from individual ethical investors through an alternative share issue on Ethex, the alternative matched bargain share trading system run by Triodos Bank, in order to invest in its brand, repay borrowings, fund working capital and invest in computer systems. Source: SEC Access to finance guide, BCV interviews 10 How big is the Social Venture market?

Social Socially Enterprises driven business 6% of the UK 5,300 social 500 social population is enterprises (a) businesses that engaged in some 47% receive have “ethical >75% of their kind of activity missions or ethical income from that has community outcomes” (c) trading (b) or social goals 50 mission driven (not all revenue businesses around generating) (e) Bristol alone (d)

Source: a) DTI 2003 Social Enterprise Mapping b) Bank of England 2003 Report c) nef “Ethical Pioneers” Report (d) Andy Friedman Mapping Work on Mission Driven Business - Bristol University (e) GEM report on entrepreneurship 2003

We have compiled existing market sizing data and have noted the overlap between the different estimates as detailed above. Social Enterprises The Social Enterprise Unit at the DTI is currently conducting a mapping project to ascertain the number of social enterprises in the UK. The preliminary estimate for this figure is 5,300.[i] A separate piece of work done by the Bank of England [ii] estimates that 47% of social enterprises generate over 75% of their revenue from trade. We acknowledge there is a difference between the methodologies of these two pieces of work so this figure serves only as an estimate of the market size. Socially Driven Business It is very hard to size the market for socially driven business. A report by New Economics Foundation (nef) [iii] estimates there are 500 “ethical pioneers”, however there is significant overlap with the Social Enterprise sector as counted in the DTI statistics above. A research project done around Bristol on mission driven businesses identified 50 businesses in the Bristol area alone, which implies that the number nationally are likely to be substantially more than the 500 used in our analysis. [iv] The social and community sector Mapping work done by the Global Entrepreneurship Monitor (GEM) project in 2003 identified that 6% of the UK population is involved in some activity that has community or social goals. It is important to note, however, that the definition used of this activity was far broader than social ventures alone. [i] DTI 2003 Guidance on Mapping for Social Enterprise [ii] Bank of England 2003: “Financing of Social Enterprises” [iii] nef: “Ethical Pioneers” [iv] Andy Friedman and Mary Phillips, Management Research Centre, University of Bristol: “Mission- Oriented Entrepreneurs” 11 Not all social ventures will benefit from equity-like investment

High potential Social Ventures: Approx. 150-180 a

Social Ventures: Approx. 3,000 (revenue generating)

Potential Social Ventures: Approx. 5,800 5300 social enterprise + 500 socially driven business

a) based on ~5-6% of SMEs looking for venture capital external financing (Bank of England report – financing of social enterprises 2003)

Narrowing the market – a statistical approach To gain some idea of the size of this market from the available data, we have defined high potential social ventures as high growth potential ventures. These are a subset of the overall pool of revenue generating social ventures, as only a limited number of organisations will be suitable to receive equity-like investment provided in a venture capital model.

In the private sector, roughly 5-6% of Small and medium sized enterprises (SMEs) will access venture capital finance [i]. A comparable percentage in the social venture market would give a market of 150 – 180 high potential social ventures.

Narrowing the market – a consultative approach Our interviews revealed a discrepancy of opinion across the social enterprise sector on the number of social ventures that could benefit from equity-like capital. As we interviewed different groups, a few main “stars” were mentioned again and again.

Some interviewees were convinced that hundreds of high potential social ventures exist. Most interviewees agreed that at least a small number of high potential social ventures existed that would be suitable for this funding initially

It is the experience of the mainstream venture capital sector that supply of capital drives demand. We believe that if there were an appropriate source of equity-like capital is available, more high potential social ventures would become apparent or may be created. There are indications of this in initiatives such as the London Business School’s participation in the Global Social Venture Competition, in which MBA students submit business plans for social ventures, many of which will have great difficulty raising funding to get started. [i] Bank of England 2003 “Financing of social enterprises” 12 There is anecdotal evidence of a number of social ventures unable to get funding

• Banks - Banks see applications from numerous social enterprises that they cannot lend to because they have no equity on their balance sheet.

• Ethex – Triodos (runs a matched bargaining trading system for ethical shares) is approached by many social ventures which are too early stage to issue shares as this is a lengthy and costly process which requires significant due diligence.

• BCV – In its first year of operation, 40 deals came from social ventures which could not be financed using the venture capital funds still under management.

• Foursome – about 10-20 deals a year cannot be financed because the social mission would reduce the amount of financial return that is expected and this is not possible give the funds under management.

Source: BCV Interviews

Narrowing the market – an anecdotal approach

Some examples of the anecdotal evidence collected in the course of the research for this report are described above.

It seems likely that the number of social ventures will grow in future as the pipeline of social ventures is being built through patient capital funds like Adventure Capital and Futurebuilders that seek to seed and grow social ventures.

There are also a growing number of MBA programmes specialising in social entrepreneurship from which entrepreneurs will emerge that wish to develop socially driven businesses. Filling the gap for equity-like capital is also likely to allow more success stories to emerge which in turn will generate more social enterprises. BCV’s conclusion from this research was that new high potential social ventures are likely to emerge in at least three main ways: 1. New entrepreneurs entering the field – experienced entrepreneurs or talented graduate students who have an appetite to set up businesses that have a social purpose as well as financial goals. Life Water Ltd., discussed later in this report, is an example of these. 2. Corporate venturing by proven social enterprise successes – such as the new ventures established by the FRC Group, on the back of its core activity. 3. Entrepreneurial ventures set up by established charities such as Oxfam’s Progreso Cafes Ltd. 13 The need for equity-like capital has been backed up in our interviews

“Subordinated debt would be an ideal instrument as it would have a risk sharing element but would avoid diluting our shareholders” Wyndham James – Progreso Cafes Ltd

“Many organisations who approach us would definitely benefit from equity-like funding because of the management involvement and risk sharing but we can’t provide it” Naomi Kingsley - London Rebuilding Society

“There is no obvious source of funding for high impact, high growth social enterprise ideas” Steve Wyler

“My start-up (social business) ventures would go to business angels – but they are fragmented and informal. There is nowhere else to go for seed capital or high risk money” Tommy Hutchinson - Kikass

Source: BCV interviews

Both referrers and social ventures expressed interest in our work and felt there was a real need for equity-like capital.

It is our conclusion that the social venture sector appears to be held back in its growth through a lack of diverse funding mechanisms.

14 Case study 1 – trading venture of a charity: Progreso Cafés Limited

Business description • Progreso is a chain of fair trade cafés which are being set up as a new venture by Oxfam. • It has a dual aim to generate some revenue for Oxfam as well as to create awareness of fair trade issues. • No trading revenue has yet been generated since the business is in start-up phase.

Financing gap • Progreso will be able to attract some loan financing from banks like Triodos or Charity Bank. • However, as half of the shares in Progreso will be given to coffee growers from developing countries, Progreso does not wish to issue further equity because it would dilute the ownership stake of the growers.

Funding requirements • Progreso has not yet determined how it will structure its funding but equity-like capital is interesting to them: • They require an instrument that will finance the roll out and scale up of the business without risking losing control of the social mission. • Oxfam may be interested in minimising its own risk

We have assembled some examples of social ventures that would be suitable for equity-like capital investment. They come from different life stages reflecting the different ways equity-like capital could be used and also the need for the equity-like capital funding vehicle to balance its portfolio.

Progreso Cafes represents the start up of a new social venture by an established charity, Oxfam.

15 Case study 2 – socially driven business: Tropical Wholefoods

Business description • Tropical Wholefoods is a fair trade socially driven business that supplies dried fruits and snack bars • Turnover has grown at roughly 50% p.a. for the last 3 years • Margins are close to 30%

Financing gap • Has had difficulty in attracting equity because providers are uncomfortable that the strong social mission will interfere with financial returns • Needs to expand but reluctant to take on more debt as its level of gearing is at the maximum management feel comfortable with • Debt also fails to give enough cash to fund growth. Equity would enable a step change in terms of the size of the company

Funding requirements • Fast moving and stageable • Some involvement at board level, but not prepared to compromise social mission • Some business building assistance would be welcome • 5-7 year investment with exit strategies of floatation or repayment

Tropical Wholefoods is a for-profit but not a profit-maximising business, set up for the purpose of achieving a more equitable deal for producers in developing countries. It is an example of a business that is set up with a social mission but a clear desire to operate professionally and commercially from the start.

16 Case study 3 – socially driven business: Life Water Ltd

Business description • Life Water Ltd is a young company producing and marketing Belu mineral water, a new ethical brand of water • 100% of its net profits (after operating expenses) will be spent addressing global and local water problems • Turnover has grown at roughly 90% p.a. for the last 2 years • Belu was launched at Waitrose in the SE of England in April 2004.

Financing gap • Life Water Ltd. is seeking £700,000 in capital for a second round of financing for the company • The first round of financing was extremely difficult – the company found that funders were equipped to deal with pure charities or pure businesses but not businesses with a social aim • The company may not have got off the ground had they not met Gordon Roddick, who put in a personal loan along with seed capital from Hal Taussig and Josh Mailman plus a grant from Unlimited

Funding requirements • Fast moving and stageable • Some involvement at board level, but not prepared to compromise social mission • 3-5 year investment with exit through repayment out of increased revenues

Life Water is an another example of a new entrepreneurial venture that is set up at the outset to be commercially and professionally run.

In this case, however, the model is to maximise profits but to give all these profits away for social purposes. Life Water Ltd. is a UK registered business. The profits from the sale of Belu will be given to the Belu Foundation (see below). The Belu Foundation will in turn oversee the allocation of the funds to NGO’s and others working on water development projects.

Life Water has encountered a real challenge in raising funds because it is neither a charity nor a simple for-profit business. Its founders say they feel there is no model of financing out there to support them.

17 Case study 4 - larger social enterprise: Ealing Community Transport (ECT)

Business description • ECT Group provides a range of community and public transport, recycling and engineering services for local authorities, public sector bodies, charities, individuals and private sector organisations. • The group’s turnover for the year to March 2004 was forecast to be £22 million. • Today, ECT’s turnover comes almost entirely from contracts for services as it has moved into sustainability

Financing gap • ECT is unable to issue equity because of its ownership structure. • ECT finds it easy to get loan financing for its asset backed ventures but more tricky to attract financing into non asset backed ventures

Funding requirements • ECT needs a funder who is willing to take on risk without issuing equity. In exchange, ECT is comfortable with giving some revenue royalty as long as it is properly structured and ring fenced from other operations.

Ealing Community Transport is an example of a well-established social enterprise that needs to attract investment into non-asset backed ventures it is setting up.

These sorts of investments provide a potentially lower risk investment in a social venture than the earlier stage case studies above.

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Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

198

How Social Ventures are currently financed

Social Enterprises Socially Driven Businesses

• Grants still remain the main source of • Much harder to gather data on this financing sector of the market • When external financing is used, it is • Some traditional venture capital funds mainly loans will invest in socially driven businesses, – Loans are mainly secured: unsecured but only where financial return is not loans had been accessed by only 9% compromised by social return (Triodos, of social enterprises Foursome) – Where unsecured loans are accessed, • Some social businesses have raised they come with high interest ratesa. capital by issuing shares through an APO Only some loans offer repayment (alternative public offering) holidays • Only a small proportion of Social Enterprises had accessed equity financing (7%)

Source Financing of Social Enterprises – Bank of England 2003, Whitni Thomas 2003 a) Lending to the social enterprise sector DTI 2004

Work done by the Bank of England on financing of social enterprises (2003) identified the financial products currently being used by social enterprises:

A breakdown of the financial products applied for by those respondents who had sought external finance shows few social enterprises apply for equity capital in the form of share issues or venture capital Bank overdraft 57% Loan from bank 57% Loan from CDFI 33% Share issue 5% Venture Capital 5% Asset finance 27% Other 15%

When debt products are used, they are frequently secured loans – few social enterprises have long term unsecured loans Overdraft 26% Leasing 21% Secured loan 17% Credit cards 15% Unsecured loan 9% Mortgage 8% Factoring 1% Other 2% 20 Grants are the main source of financing but are inadequate for all financing needs

Social enterprises use grants However, grants are as a major source of finance insufficient

• Only 48% of those surveyed in the Bank of • Restrictions on the use of funds England report said they accessed external • Less available for infrastructure sustaining finance investment • “most forms of social enterprise require • Committed for limited time period grant support during the start-up and • Bureaucratic application process initial trading phases, although the extent of the required support varies” Smallbone • No enforcement of financial discipline or 2001. access to business expertise • In a survey done by at Durham University of social enterprises: • 39% said they received grants from Europe • 49% from regional and central government • 33% from the local authority. Source: Bank of England “financing of social enterprises” 2003

If social ventures grow towards sustainability or establish themselves as sustainable entities from start-up, issues arise with the use of grant funding alone. Grant finance is unlikely to provide the cash required to fund the growth of high potential social ventures because of its limited time horizon and focus on programmes rather than infrastructure sustaining investment. Grants also tend to come in small chunks which means that raising a sum can involve completing several time consuming application processes.

Finally, the total sum of grant money available will never be enough to sustain a fast-growing social venture sector and other, purely charitable organisations will tend to attract the scare resources that exist.

It seems to BCV and is widely accepted in the social enterprise sector that grants alone cannot be enough for this sector to grow an flourish.

21 The loans available to social ventures are also insufficient for all financing needs

“Debt financing never stretches to fund Loans are insufficient marketing or sales-force expenditure. We need funding to enable the company to make a 'step-change' in terms of size & • Generally only secured loans are scale.” available Tropical Wholefoods • Loans are not generally available for long term ventures as few loans offer “Debt funding could only provide up to payment holidays 70% of our funding needs so we had to • Loans are not available for risky turn to equity” ventures – CDFIs target low default Ethical Property Company rates • Loans cannot be used to fund 100% of “We can’t get financing easily for the cash needs of a venture investments which aren’t asset backed” • Loans do not come with additional capacity building support Ealing Community Transport

Source: Bank of England “financing of social enterprises” 2003, BCV interviews

Businesses in the private sector typically have a mix of debt and equity on their balance sheet, particularly if they are a high potential venture as it is difficult to grow on debt alone. The slide above explains some of the reasons for this.

Companies that apply to BCV for funding are willing to give up some of their shareholding in return for getting long term capital that is willing to take some risk. This is even more necessary in the longer timeframe that social ventures typically operate under.

Interviews with fast-growing social ventures confirmed that they felt unable to realise their growth potential through use of loans alone.

22 Commercial equity is unavailable or unattractive to social ventures

Commercial Equity is “There is a disjoint between investors and social ventures: even ethical funds unavailable / unattractive couldn’t understand their (Café Direct’s) requirements” • Commercial equity is unattractive to Robin Murray – Twin Trading some Social Ventures • Fear of loss of control and mission “We could not get equity finance as investors were nervous about our trading drift if goals of equity investors are subsidiary being part-owned by a charity” for-profit • Unfamiliarity with equity Patrick Nash - Teachers Support Network •Prevented by legal structure • Commercial investors will not supply In lots of instances the key need of the SV is equity. Social Ventures in this equity position currently either can’t fund • Lack of exit strategy business or they would find a provider of patient capital like Adventure Capital or • Risk / returns tradeoffs Future Builders unacceptable for-profit maximising Charles Middleton - Triodos private investors

Source: Bank of England “financing of social enterprises” 2003, BCV interviews

BCV’s experience on providing commercial equity for social ventures gives an illustration of the gap for equity-like capital for social ventures.

In its first year of operations, about 10% (about 40) of BCV’s deal flow came from socially-motivated companies. Many of these social ventures are run by able entrepreneurs and have the potential to grow substantially, however we found that we could not finance them using the venture capital funds we currently have under management.

When BCV evaluated applications for social ventures, we found that financial returns would be limited as there was either no provision to exit the investment by selling the business to another investor or another company (which is how venture capital funds typically get their money from investments) or because financial returns would be otherwise compromised by the social mission.

BCV was also unable to find another place to refer them for the type of funding they sought. We found that many had to piece together funding packages composed of small individual sums from a large number of different funders (in one case, the company had capital from as many as 12 different organisations), all of whom require different application and due diligence processes, and offer varying terms and structures of finance.

The resulting financial structures reflect the constraints and methodologies of the funders rather than the financial needs of the company. Reliance on these multiple sources of small sums of finance has created a crippling time burden for management both during fundraising and in meeting ongoing reporting requirements.

23 Mapping the specialist funders suggests a gap remains

Potentially Profit Trading Breakeven - Profitable - No Trading sustainable - distributing - Revenue All Revenue Surplus Profit Maximizing Revenue 75%+ trading socially And Grants from Trading not distributed High default revenue driven risk

Foundations, Government Grants (100%) Impetus (venture philanthropy 4m)

Futurebuilders (public services 125m) Patient Capital Adventure Capital (community 2.7m) (50%) Foursome Venturesome (2m) (40m) Equity and equity/like CDVC Funds capital Gap for equity-like capital Regional (10-20%) funds* Objective 1 and 2 funds* Loans LIF (6m) Low default(1-10%) London Rebuilding Society (0.5m) risk CDFIs and Banks (Triodos 50m, Charity Bank 10m)

•Regional funds invest up to 250K and Objective 1 and 2 funds target areas of social deprivation •Source: McKinsey report for Unltd

We have mapped out the landscape of funding providers that fund different organisations within the spectrum we used earlier in this report ranging from pure charity to profit-maximising business. On the left axis we have laid out the type of product that is provided from high default risk (grants are not repaid at all) to low default risk (historic loan default rates in CDFIs have been low). The reason loans are lower risk than equity is that in the event of a liquidation, loans would be paid out first, and then equity-like investment. Finally the residual payment would be paid to equity holders. Patient capital is sometimes forgiven so the risk of loss here is greater than pure equity. We believe there is a gap in equity funding provision for social ventures that has not been addressed by current providers. Within the patient capital and equity-like capital space, providers have remits which will fulfil many of the funding needs of social ventures, but only in specific areas: Adventure Capital – will invest patient capital in community-based organisations (community enterprises) and does not operate at the socially driven business end of the spectrum. Adventure Capital has funding from the Government and several RDAs. Futurebuilders – will invest in non-profit organisations seeking to develop capabilities to deliver public service contracts and does not operate at the socially driven business end of the spectrum. Investment comes from Government funds and funding is both loans and grants. Venturesome - provides patient capital and some equity-like capital mainly operating at the charity end of the spectrum but has made some investments into socially driven businesses like Café Direct. It is a fairly small fund of £3M which has been raised from CAF, Barclays Bank, the Lloyds TSB foundation and the Tudor Trust. 24 What is Patient Capital?

Patient Grants Pure Equity Equity-like Loans Capital

• Long term in nature

• Lengthy interest and capital holidays are available

• Financial returns are sub market and range from -50% to 10%

• Usually structured as either debt (e.g. partially recoverable loan) or long term grant with no explicit exit strategy

Source: SEC Access to Finance Guide, Home Office report on Patient Capital

We believe it is important to distinguish between equity-like capital and patient capital. In general, patient capital is less commercial than equity-like capital, meaning that it does not necessarily require full repayment of the investment. While patient capital providers may experiment with royalty payments and other features associated in this report with equity-like capital, the core tools used in patient capital are grants and low interest loans.

So far patient capital has been provided by organisations with charitable or governmental funding bases like Adventure Capital, Futurebuilders and Venturesome, as well as some foundations.

The Home Office report on Patient Capital 2004 defines it as: - A long term financial investment with terms and conditions that do not require immediate repayment. - The funder anticipates both a financial and a social return - Structured mainly as loans with different repayment structures and often includes holiday periods - Grants are also a feature and may be made alongside loans to help reduce financial risk - Can include “returnable grants”

25 What is Equity-like Capital?

Patient Grants Pure Equity Equity-like Loans Capital

• Like private equity, investors share risks & returns - greater business success resulting in higher social and financial returns

• Investors provide management expertise and hands-on involvement

• Long term engagement

• Expected returns on individual investment 5-30%

• An example of equity-like capital: — Subordinated debt with royalty payments that rise with revenue

Equity-like capital is a financial instrument which has characteristics of both debt and equity:

- It is more commercial than patient capital and would deliver a positive but submarket financial return combined with social return. - Like traditional equity, investors share in the risks and returns of the venture e.g. by receiving interest payments which rise as revenue rises. - In the event of liquidation, the rights of the investors are subordinate to those of lenders on the assets of the venture. - The investors take a long term stake in the success of the venture by giving long term loans of 5-7+ years.

The difference between equity-like capital and traditional equity is that equity-like capital is not centrally based on ownership of the shares of the company which avoids problems that social enterprises have historically had with issuing equity. Equity-like capital is structured as subordinated debt, which has equity-like features.

26 Features of different funding instruments

High risk Low risk Patient Pure Equity- Grants Loans Capital Equity like Expected loss 100% 20-50% 10-20% 10-20% 1-8% %

Return on a Variable up to 0 -50% - c.10% No limit Fixed 5-18% investment 30% Undefined 5-7 yrs Term of Often short Repayment Depends on Depends on SV Fixed term investment periods holidays success success Low (except Some Involvement High (through High (through venture (through Low in business board) board) philanthropy) partners) Royalty, Exit of IPO, sale, n/a Repayment repayment or Repayment investment buyout APO Liquidation None/ None Residual Subordinate First priority rights subordinate Structured in Through Voting rights No No loan No ownership agreement

Source: BCV Interviews, Home Office report on Patient Capital, Social enterprise in the balance CAF 2004

This table sets out the different dimensions and rights of the different financial instruments described in this report. The rights categories are loosely taken from a paper by Jim Brown: “Designing equity finance for social enterprises”: - Expected loss - the amount of money the funder would expect to lose, on average - Return - the amount of interest/upside the funder would be targeting, on a specific investment - Term of investment – the length of the funding - Involvement in business – how much the funder helps to build the business - Exit of investment – how the funder gets their money out at the end of the investment - Liquidation rights – what happens in event of bankruptcy - Voting rights – whether the funder has a right to vote on the board

27 U.S. experience is encouraging

• Between 1999-2002, $230 million was invested in mission driven deals: • 63% of funds invested in Social Businesses • 37% of funds invested in Social Enterprises (~ $50 million invested in not-for-profits)

• In 2002, number of VC social/environmental deals grew at 19% vs. 13% growth in overall VC deals

• Typical deal size = $250K - $3 million

• In 2002, social/environmental investments represented 6.2% of total # of VC deals and 0.6% of total capital invested

Source: 2003 Columbia Business School Research Initiative on Social Entrepreneurship (RISE) report

As the slide above explains, research done in 2003 by Columbia Business School indicates that there is a growing level of socially-driven venture capital in the US. The types of business invested in include both elements of what we are terming social ventures, with 37% going into non-profit distributing social enterprises and 63% into social businesses.

While there will be some differences in terminology and these figures cannot be taken as an exact picture of this sort of investment in the UK, they do indicate a growth trend. However, in the context of the overall venture capital sector in the US, which invested over $18 billion in 2003 alone, the scale of social venture capital in the US is tiny.

28 2 Examples of US Social Venture funds

• Rockefeller Foundation’s Program Venture Experiment (ProVenEx): – 250 deals reviewed, 11 investments made since 1999 – 6 in socially beneficial business and 5 in social enterprises – Expected returns between 3-10%

• Investors Circle (an angel group of 100 social investors) – Screens 350-700 social ventures per year - 50-70 deals are presented to angel network – Deals are both for-profit and non-profit – $90 million invested in 150 deals since 1992 – Returns between 5-14%

Our research found a large number of venture philanthropy funds in the US. These are funds that “invest” in non-profit organisations ranging from pure charities through to social enterprises, but do so mainly in the form of grants and are funded through donations not through investment themselves.

We found a less than ten social venture funds and angel groups that genuinely sought to achieve both social and financial returns through investment in social ventures. So this is a fairly undeveloped field in the US.

The two examples in the slide above are closest to what is proposed in this report, although neither is directly similar. ProVenEx is an initiative of a large foundation and invests in social ventures internationally. Investors Circle is an angel group rather than a fund.

We conclude that there is no one model that could be imported to the UK to provide equity-like capital for social ventures.

29

Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

309

Different vehicles could be used to provide Equity-like Capital Socially-driven Social venture Ethical stock angels capital fund market • Network to facilitate • Conducts due diligence on • Enables Social Ventures introductions between deal-flow of social to retain control angels and Social Ventures investment • Mobilises capital from • Still nascent - currently • Provides business building individual investors being examined by P3 expertise and contacts as • Some APOs have been capital* well as funding accomplished on Ethex • Mobilises capital from high • Mobilises capital from a e.g. EPC net worth individuals variety of sources Limitations: Limitations: • Significant time and cost • Angels have to conduct due to go through share issue diligence on each process investment, no coordinated Angels and Ethex are nascent • Not all Social Ventures business building resource but Social Venture Capital are able to issue share (SVC) does not yet exist in the capital UK

Source: BCV Interviews * P3 capital is the new name for Susten8

There are several types of vehicles that could provide equity-like capital or pure equity to social ventures: Angel money - provided through a “band of angels” organisation accesses funds from high net worth individuals who wish to invest in ethical business. This would typically be invested at a very early stage or “seed level” A social venture capital fund - would access funds from both high net worth individuals and larger organisations like foundations. This would typically be invested as the organisation wanted to grow in scale. The nascent ethical stock-market, Ethex, accesses smaller amounts of money from a larger group of individuals and potentially some institutions like fund managers that wish to invest in ethical business. An organisation would issue shares when it had reached a large, stable state. We believe that these vehicles are complementary to one another as all are needed as an organisation grows. Angel capital and Ethex are both being examined and developed at present. What is currently missing from this continuum is a social venture capital fund: - A social venture fund would attract high net worth individuals who do not wish or do not have time to perform due diligence on investments. Commons Capital in the US rose out of the Investors Circle group of angels for the same reason. - Another benefit of a social venture fund is that other pools of capital, such as foundations can be accessed. Although foundations do make some loan and Programme Related Investments, this has been hampered by lack of expertise in the financial investment area. - Finally, the VC model helps the social ventures to build their business expertise in a way that is not possible in the IPO model and is not coordinated in the angel model. 31 2TheThe routes ventureroute taken taken lifecycle by bysocial socially and enterprises providers driven businesses startingof patient as The11 routeroute route takenremaining towards in the sustainability grant private funded sector capitaland start-up andcharities equity-like social enterprises funding

Potentially Profit Trading Breakeven - Profitable - No Trading sustainable - distributing - Revenue All Revenue Surplus Profit Maximizing Revenue 75%+ trading socially And Grants from Trading not distributed revenue driven

Incubation Unlimited (10K) Susten8 Business –social Angels Venturesome angels Start-up (100K) Adventure Capital Social VC Fund Venture Expansion Impetus Future Capital (500K – 1M) builders

Foundations Growth Retained earnings APO on Public (1M+) act as equity Ethex markets

Life stage from incubation – growth from paper by Whitni Thomas Oct 2003

SLIDE IS BEST VIEWED IN SLIDESHOW MODE FOR FULL EXPLANATION Companies have different funding needs during their lifecycle. In the private sector, a typical company might follow the stages on the right as it gets larger - from start up to IPO. Funding would be provided by: - Business angels – early stage - Venture capital – growth stage - And then a public offering – mature stage This diagram presents a vision of stages of financing which could operate in a similar manner for a start-up socially driven business or social enterprise although there are limitations on this at present: - Ethical angels (nascent, being developed by Charlie O’Malley at P3) - A social venture capital fund (not in existence yet) - Floatation on ethical stock market (being developed by EPC, Triodos and others but currently the secondary trading market is weak) Social enterprises which grow out of charitable organisations could take one of 2 routes - Gradually grow from needing large amounts of grant finance to sustainability through trading revenue - OR remain entirely funded by grants Different organisations would seed and develop these ventures and the social fund could then fund them to the next level – or potentially syndicate with the organisations to co-invest. Once they have reached sustainability then their retained earnings will act as their equity and act as a buffer for future funding requirements. Some organisations will continue to be funded by grants. 32 We recommend a small fund is established to prove the concept

• £5m fund Size and range • Investment range £100k-£1M • Approximately 10 deals, 10-20% of total appropriate deal flow

• Investment base: HNWIs, foundations and Investors government • Attempt to raise grant funding to support the fund’s capacity building activities and establish an entrepreneurs club for social angels • Investment terms: debt with royalties / debt with Investment terms warrants • Expected returns 3-5% p.a.

We believe there is an exciting opportunity to create a demonstration fund that would show that return could be made in this space and attract more investment capital into the sector, thereby reducing the equity gap for social ventures.

Because the size of the market is unproven, we recommend the fund starts at a small pilot level initially.

A blend of commercial discipline (to attract private capital) and social awareness (to understand the specific challenges of social ventures) is required.

33 The concept fund would aim to invest in a small number of model deals

r o t c Approx. 10 e s r Model Deals o f ls e High potential Mod e Social Ventures ol R Approx. 150-180 a

Social Ventures: Approx. 3,000 (revenue generating)

Potential Social Ventures: Approx. 5,800 5300 social enterprise + 500 socially driven business

a) based on ~5-6% of SMEs looking for VC external financing (Bank of England report – financing of social enterprises 2003)

The pilot fund would choose deals that would act as role models for the sector, which would in turn stimulate more entrepreneurs to set up social ventures. Because the fund will be picking winners from a larger group of eligible social ventures, some ventures will be rejected. There is also a danger that some of the social ventures backed will be unsuccessful, as is the case with many start-ups in the private sector. The sector needs to get comfortable with these facts for the fund to be successful.

34 The fund should target high potential social ventures

Financial return high potential social ventures High financial return

Low financial return

0 Low social return High social return Social return [Diagram based on conversations with Peter Wheeler of Futurebuilders and New Philanthropy Capital]

This report has focused on high potential social ventures. The graphic in the slide above reinforces this by showing the part of the social venture market that we recommend the fund should target. While this fund is not designed for fully commercial ventures, which achieve maximum financial return, it is focused on those that have a growth pattern high enough to achieve some financial return for investors and which produce a high degree of social return.

This does raise a clear challenge for any such fund. While it is relatively easy (at least in retrospect) to measure the financial success of the fund, identifying and measuring social ventures in terms of their social returns is difficult. There are numerous studies and tools out there for measuring social return but few are well understood by potential investors in a fund like this and none are generally accepted as a market standard.

A social venture fund would need to work hard to remain at the cutting edge in terms of evaluating and measuring social impact.

35 The fund would maximise social value within financial constraints

• Maximise social returns within financial constraints

• Invest in “winning” high-impact social ventures that can act as role models – Innovative –Replicable – Scalable with bold growth prospects – Delivering attractive enough returns to make the fund deliver 3-5% overall

• Hands-on involvement including a board seat

• The fund would diversify across different life stages to create a balanced portfolio – Some seed capital – Mainly growth phase – Some larger social ventures / purchase of shares on Ethex

• Longer-term investment (5-7 years)

The pilot fund would aim to deliver the maximum social value possible within financial constraints that will enable the fund to be sustainable and attract future capital from investors.

A good analogy for how the investments within a pilot social venture fund would deliver value is that of a locomotive: - In the proposed social fund the engine of value is social return and the carriages are financial return. - In other ethical or socially beneficial funds such as BCV’s existing funds or a fund like Foursome, the engine of value is financial return and the carriages are social return.

36 The fund would diversify across different life stages to create a balanced portfolio

STAGE EXAMPLES Early Stage Progreso – a chain of fair trade coffee shops being created by Oxfam Proposed financing structure: convertible sub-debt with revenue royalties Development Tropical Wholefoods – a fair trade supplier of snack bars Capital and dried fruit Proposed financing structure: convertible sub-debt with revenue royalties

Later Stage Ealing Community Transport – a provider of social and community transport Proposed financing structure: sub-debt with revenue royalties

Diversified commercial venture capital funds invest in a mixture of early stage and later stage investments to balance the portfolio, as early stage investments are likely to deliver great financial return but they are very high risk, and later stage investments are less likely to be risky but they will deliver lower financial return.

We recommend that the social venture capital fund follows a similar model to create a balanced portfolio of social ventures.

This is key to the success of the fund. If it is concentrating in a series of early stage investment in which the whole capital is at risk, then the likelihood is that the fund will not make positive returns for investors.

Having said that, repayment rates on ordinary loans to social enterprises compare very favourably with loans to private sector SMEs in that social enterprises tend to exhibit higher rates of repayment. It seems fair to extrapolate from this an assumption that social ventures are also likely to show greater stability and that complete loss of capital may occur in less cases than is generally seen in the mainstream venture capital sector.

This fund will be a much lower return fund than private sector venture capital but arguably, is also somewhat lower risk.

37 Returns would vary across the investment portfolio

Investment performance, fund performance % IRR

30% 20% 20% 3-5% across fund 5% 5% 5% 5%

Return of Interest capital + royalty Failure of business Interest coupon, no royalty revenue Interest + royalty only + APO

Note: Returns are after management costs – estimated to be 4% of fund per annum (further capacity building could be supported by grant funding)

If the fund made 10 investments, this is a likely prediction of how the investments would perform. As discussed on the last page of this report, when we consider downside risk, figures from the CDFI industry suggest that social enterprise loans have very low default rates which makes it slightly less likely that the fund will lose its investment than if it invested in the SME market. However, the model shown above is based on the experience in mainstream venture capital.

When we consider upside potential, returns are expected to be less spectacular than for-profit venture capital because of the unlikelihood of a trade sale or an IPO which is where larger returns are made.

In our calculations we have assumed: - 2 investments might fail (as per the rate in the private sector) - 1 investment might just return the capital, with no interest - 4 investments might give 5% interest but no additional revenue from a royalty - 2 investments might give additional upside from a royalty - 1 investment might also give convertible share which the fund would sell, giving further upside Our calculations indicate that overall the fund would return 3-5% after a management fee of 4% had been deducted.

However, it is important to note that projections for a new fund like this are by their nature extremely unreliable. Any new fund would need to ensure that it had a substantial cushion built into the model to reduce the risk that investors with a strong interest in achieving their minimum financial return do not lose their capital in the early years. Once a track record is established, the fund can ramp up levels of investment or leverage into the fund.

38 As well as covering failed investments, returns must cover management costs

• Management costs include costs of capacity building for social ventures and deal costs

• These costs are typically 2-3% in the private sector

• For a social fund, capacity building is likely to be more expensive than in the private sector. Experience from patient capital funds suggests the figure could be close to 20%

• We have included 4% management costs in our sample numbers, but this may need to be subsidised to do more capacity building or to bring the return up to attract more private investors

• We recommend that the concept fund is run within an existing organisation to gain scale benefits

In commercial venture capital, funds work with investment businesses to increase the value of their investment and they often take a board seat to make sure they are involved in setting the strategic direction of the company. This work takes up significant resource and together with deal costs, this can be up to 2-3% of the funds under management. BCV has a club of investor entrepreneurs that wish to be involved in hands-on business building which help to defray this cost.

Capacity building is likely to be more expensive for a social fund because of the inherent challenges involved in managing to both social and financial targets and the differing skill set of some social entrepreneurs.

One issue with operating a small pilot fund is that the capacity building facility will impose a high operating cost on the fund. A small pilot fund would not have the scale to spread this cost across its investment portfolio and this cost would therefore eat into investors’ returns. This points towards accessing some kind of grant or subsidy to enable capacity building to be accomplished and also trying to gain some scale by running the fund within an existing organisation. A club of social investor entrepreneurs could also be formed to assist with the capacity building.

39 Capacity building would include business building as well as sector education

• Business building is required to create sustainable social ventures – There is a lack of support for entrepreneurial social ventures that is specifically tailored to the inherent challenges of a hybrid organisation – Private venture capital funds also work with their investees to build their businesses

• Sector education required is to generate a larger flow of deals and investment into the sector – Many social enterprises are unfamiliar with the concept of equity investment and other non grant forms of funding – Many investors unfamiliar with the concept of social investment

• A concept fund would use its network of social investors to help to build the social ventures and act as a proof of concept to educate the sector

Capacity building will have two components in a new social fund:

Business building - Our experience is that social ventures need more than money. Research by nef (Homeopathic Finance 2001) cited many other barriers to the development of social enterprises including a management expertise gap. This has been echoed by other reports such as “Social Enterprise in the Balance” as well as by our interviews with social ventures themselves.

Sector education – investors are unclear about the concept of combining their investment with their philanthropy and will require educating before sizeable funds can be attracted into the sector. Social entrepreneurs are also unlikely to be familiar with venture capital type financing and may require significant education before they are ready to take the financing.

40 Where would social entrepreneurs and deals come from?

Social sector Private sector

•Trading arms of Social •Mainstream Where charities Venture entrepreneurs entrepreneurs • Grant dependent social Capital • Business schools come from enterprises moving Fund • Social business plan towards sustainability competitions

• Unlimited • Foursome Where deals •Venturesome •Banks come from •Impetus • Mainstream venture • Adventure Capital capital • Futurebuilders • Triodos

Where would social entrepreneurs come from? We expect some social ventures to come from the grant dependent social sector however we also expect new entrepreneurs to enter the social venture space who aim to achieve both financial and social value from the beginning of the venture. Evidence of interest in this is emerging from UK business schools like LBS which are holding social business plan competitions

Where would deals come from? In the private sector, a VC fund would seek syndication partners for deals which it could not perform alone and it would work with the venture to assemble funding from these partners. It may also pass on deals to other parties which are more appropriate for the life stage of the venture, maintaining contact to invest at a future date.

We would expect the fund to perform a similar function for social ventures. The pilot fund could co-invest with providers of patient capital such as Adventure Capital, Futurebuilders or Venturesome. It could also invest a larger amount of money in a follow-on round after a seed investment by one of these funds. The pilot fund could also work in a partnership with CDFIs such as Charity Bank or London Rebuilding Society to provide a finance package including some loans as well as equity-like financing.

41 What is the value proposition to social entrepreneurs?

They get They give

• One-stop shop to obtain • Some upside if the business funding does well • Business building expertise • Capital that shares in the risk of the venture • Savvy but social investors who are willing to take a lower financial return • Appropriate process in place for deal making

What is the proposition to entrepreneurs? Entrepreneurs have to weigh up a lot of factors when choosing funding. This is the value proposition of equity-like capital to them in return for giving the fund some upside:

- One stop shop - The fund could either provide the total investment they need or help them raise capital from a variety of providers by forming a syndicate with other funders - A like-minded investor – Our research shows that it is very important to social entrepreneurs that their mission is protected and it will be very valuable to them to have an investor who shares their social as well as their financial goals - The fund should be staffed with experts in financial and social business to offer business building expertise - Although the fund expects a return, it should be willing to wait for the return and take a high level of risk - The investors are both business savvy and socially minded and willing to take a slightly lower financial return because of the strong social benefits of the business

42 Different types of equity-like capital

Debt with • A royalty is the ongoing right to a percentage royalties of sales or profits for the term of the loan • Helps fund to exit investment • No equity dilution for company

Debt with • A loan which converts into equity at a warrants prearranged price • Guarantees exit for fund • Can only by used by CLS structured companies

We recommend that 2 types of equity-like capital be utilised to invest in social ventures. Both are also used in the private sector in mezzanine funds and by CDFIs like Shorebank (where this is called “risk capital”) - Debt with royalties takes a percentage of the revenue or profit that the social venture makes over a 5-7 year term. This additional royalty helps to repay the principal of the loan from the fund and give the fund upside to compensate for the riskiness of the venture. This instrument would be suitable for social enterprises that cannot issue equity or social businesses where equity dilution is a concern - Debt with warrants or convertible debt, is debt which converts into equity at some point in the future. This would be used if a company was planning to float on Ethex at some point in the future, when the equity would be sold to new shareholders and the fund would get its money back.

In a social venture it is probably better to use debt with a royalty on revenue rather than a royalty on profit because it is less likely that the fund and the venture will get into a discussion on how profits are used (for social or financial purposes) if the royalty is taken from revenues.

43 Case study on revenue royalty (1)

Revenue projections for Social Business - equity-like funding need of 0.25M

10

9

8

7

6 Best case 5 Realistic case £ M Worst case

4

3

2

1

0 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10

We have done a case study on a social business. The best case line is the revenue predicted in their business plan and we have run 2 other scenarios which show what would happen if business didn’t go quite according to plan.

44 Case study on revenue royalty (2)

Repayment schedule for 0.25M equity-like funding - best case with 5% coupon and 1.5% revenue royalty

10 IRR: 29% Coupon 5% 8 Royalty 1.5%

6

Revenues PBT 4 £ M Repayment schedule % of PBT

2

0

-2 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 Revenues 1245678999 PBT 0.03 0.06 0.19 0.25 0.30 0.50 0.55 0.60 0.90 0.95 Repayment schedule -0.24 0.00 0.07 0.09 0.10 0.12 0.13 0.14 0.15 0.15 % of PBT 36% 35% 34% 24% 24% 23% 16% 16%

The royalty payments are laid out in the table below. Note that the achieved return over 10 years is quite high - in this scenario the fund would be getting 4x its money back in exchange for funding a risky venture. The internal rate of return (IRR) on this is 29%

45 Case study on revenue royalty(3)

Repayment schedule for 0.25M equity-like funding - realistic case with 5% coupon and 1.5% revenue royalty

6.00 IRR: 20%

5.00 Coupon 5% Royalty 1.5%

4.00

3.00 Revenues PBT

£ M Repayment schedule 2.00 % of PBT

1.00

0.00

-1.00 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 Revenues 0.90 1.69 2.77 3.36 3.84 4.39 4.71 5.04 5.22 5.57 PBT 0.03 0.05 0.14 0.17 0.19 0.31 0.33 0.35 0.52 0.56 Repayment schedule -0.240.000.050.060.070.080.080.090.090.10 % of PBT 0% 39% 37% 36% 25% 25% 25% 17% 17%

Here the royalty payments are not quite as high as the revenue of the venture has not risen as fast as predicted. In this scenario the fund would be getting 3x its money back and the IRR on this is 20%.

46 Case study on revenue royalty(4)

Repayment schedule for 0.25M equity-like funding - worst case with 5% coupon and 1.5% revenue royalty

2.50 IRR: 5% Coupon 5% 2.00 Royalty 1.5%

1.50

Revenues PBT 1.00 £ M Repayment schedule % of PBT

0.50

0.00

-0.50 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 Revenues 0.90 1.23 1.57 1.71 1.82 1.93 1.98 2.04 2.08 2.12 PBT 0.01 0.01 0.03 0.03 0.03 0.04 0.05 0.05 0.07 0.07 Repayment schedule -0.24 0.00 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04 % of PBT 0% 26% 22% 20% 13% 13% 12% 8% 8%

Here the royalty payments are not high at all as the revenue of the venture has only risen slowly. In this scenario the fund would be getting 1.3x its money back and the IRR on this is 5%.

47 The fund should develop a process to help decide whether to invest

Is this a VC No Refer to other funding business model? sources – debt and grants Yes

Is social return No Refer to mainstream core to mission? VC

Yes

Is it profit distributing? No Yes

No Social Enterprise: is it Socially driven Refer to other approaching business funding sustainability? sources, grants and Yes patient capital Fund with equity or Fund with equity-like convertible equity- capital like capital

We recommend that the fund would use a decision screen such as presented above when deciding whether to fund an investment:

Step 1: decide if the investment is a VC business model – i.e. high growth potential and scalable and likely to generate sufficient financial return. If not, refer to other funding sources like banks and grant-making organisations

Step 2: decide if social return is core to the mission and whether this is jeopardising attracting other equity-capital into the venture – if not then the venture can attract mainstream VC and it should be referred elsewhere.

Step 3: is the organisation profit distributing? A social enterprise needs to be sustainable or planning to approach sustainability to be a suitable candidate for equity-investment. The legal status will also determine the type of capital that can be used because some organisations cannot issues shares.

48 The fund must identify its social criteria when screening investments

• Overall definition: – Social impact is core to the Social Venture business model • Areas of impact for concept fund: –Poverty – Disadvantage – Community Development – Environment • Vehicle of social value creation: – Supply chain: e.g. a fair trade café like Café Progreso – Employees: e.g. Remploy employs a large number of disabled people – Customers: e.g. Bulky Bob’s recycles furniture to low income families

It will be very important for the fund to identify what are the social criteria it is using when screening investments. This is the case within BCV’s current investments where the social criteria is the location of the business and its market, employees and suppliers. Where the social impact is core to the business model this becomes even more important as this is much more subjective than location and also much more key to the return the fund is delivering.

We have suggested some areas of impact that the fund could use to specify the areas it would focus on as the social ventures we identified tended to be producing benefits under these range of headings.

It also has to be clear what vehicle the social venture will use to deliver social value, be it through its supply chain, its employees or its customers.

49 Social return should be measured to enable the fund to attract investors

• Recommend using the framework developed by New Economics Foundation – Measure what matters – Identify key stakeholders – Measure value created (Impact – deadweight) –Calculate SROI – Report and reflect

• Limitations – Can’t currently use the framework to compare social return between organisations – Framework is still being developed and integrated with the tools nef and others are developing

Source: Seminar on SROI held by nef – for more details on this please contact Jeremy Nicholls at nef

The real test of success will be the ability of the fund to raise more capital from investors at a sub-market return. However, investors taking a sub- market return will want clear evidence of the social benefit being achieved. The SROI framework being developed by nef is still in development. Key steps to measure SROI include: - Measure what matters – measure the relevant areas of impact - Identify key stakeholders – identify the key stakeholders to include during the SROI calculation process - Measure value created – this is the impact of the programme net of the deadweight which is what would have happened anyway -Calculate SROI – this is a measurement of the amount of social return created in £ terms - Report and reflect – report findings back to stakeholders and reflect on how to improve

Because the tools are still in development, it is not currently possible to use the framework to compare social return between organisations which limits its usefulness at this stage as part of the screening process, but it could be used to report back to investors on the social performance of the fund.

It is also important to be aware that the calculation of social return will have an additional cost which further reinforces our conclusion that operating costs of this pilot fund will require some form of subsidy.

50

Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

5110

There has been growing evidence of interest in ethical and social investment

Tier 3: Institutions • Henderson’s and Morley Fund Management have made investments in Ethical Property Company shares

Tier 2: Socially-driven high net worth individuals • A survey commissioned by Triodos Bank pointed towards a growing desire amongst potential investors for their savings to be used to benefit society • Ethex shares have been popular, as have new CITR accounts

Tier 1: Foundations, Government • Foundations may be able to use programme related investments (PRI) to make investments in the fund and leverage the fund’s expertise • Government may make grants available to match private sector investment

Source: BCV Interviews

There has been growing evidence of interest in ethical and social investment:

Foundations have been encouraged by the Government to invest in programme related investment as well as making grants from income. However, foundations do not always feel they have the expertise to make investment decisions.

Government has already invested in several initiatives in the social enterprise and SME sectors as a way of stimulating the market and attracting private capital into these areas (Futurebuilders, regional VC funds, CDVC funds, Objective 1 and 2 funds)

Individual investors have expressed some interest in both ethical investment through the growing importance of SRI funds and social investment as CITR1 accounts were highly subscribed and 35M has been raised by ethical and social enterprises using bond and share issues over the last 10 years2

Institutions have also made ethical investments as both Henderson's and Morley Fund Management bought shares in the Ethical Property Company.

1 CITR = Community Interest Tax Relief 2 Source: Jim Brown – Designing equity finance for social enterprises 52 However, social investment is still a new concept for many investors

Tier 3: Institutions Initially target • Unlikely to be able to maketake the the risk risk return return trade-off trade-off – would rather make an donations, then investment once • Socialinvestment returns or tooa donation hard to quantify – will only make these investments if there is track record established • Socialpressure returns from tootheir hard members to quantify to do –so will only make these investments if there is pressure from their members to do so

Tier 2: Socially-driven high net worth individuals • Theresa Lloyd’s research in 2002 found few HNWIs interested in combining their investment with their donations, however this is changing. More education is needed Target early adopters and • Whether there is available tax relief is a key factor use concept fund to Tier 1: Foundations, Government educate • PRI is something only the most forward thinking foundations are doing • Trustees are conservative and may not see the value of social investment • Easier to raise money for specific sectors, but no one sector would give a big enough potential pool of investments

Source: BCV Interviews

However, it is early days for social investment, and only a few early adopters are thinking about combining their philanthropy with their investment.

On the foundations side, this is because many trustees are conservative and wish to safeguard their endowment whilst donating their income. Because charities generally work on behalf of specific causes, it may be difficult to attract money into a general social venture fund. At this stage, however, it would not be possible to create a sector specific fund because of the size of the market.

On the private individuals side, this is because it is difficult for investors to understand a “blended” return with both social and financial objectives. Funds in the US like Acumen Fund have avoided this problem by asking for donations rather than investment however, although it has successfully attracted money, this fails to tap into the larger pot of investment money and continues to draw from the smaller pot of philanthropic money.

The fund should seek to target early adopters and use the pilot to educate the sector, seeking to brand this space to make it easier for HNWIs to understand.

We recommend institutions should be target for donations at this point and then investment once the track record is established because investment is a more difficult sell for them as they are required to maximise return on the behalf of their shareholders.

53 There is a different investor proposition for each group of investors

Tier 2: Socially-driven high net worth individuals Value Proposition: • Achieve a reasonable financial return with additional tax credit benefits whilst also achieving a social/environmental impact • Rigorous financial & social due diligence brings credibility to social investments • Share expertise and enjoy hands-on involvement with growing social ventures • Money is recycled to generate even more social benefit

Tier 1: Foundations, government Value Proposition: • Capitalises on VC expertise of making investments • Support role model scalable social ventures with social/environmental impact at core • Investment rather than donation maximises social/environmental impact • Social Ventures have access to business expertise to help them grow

There is a different investor proposition for each group of investors: Socially driven, high net worth individuals Benefits - For socially driven high net worth individuals (HNWIs), a social venture fund allows them to achieve a reasonable financial return whilst also achieving additional social or environmental impacts. There may also be additional tax credits that improve the return on investment. - The rigorous due diligence provided by the VC fund will free the HNWIs to spend hands on time with the investees helping them to build their businesses, if they desire. - The model is superior to pure philanthropy for the HNWIs because the money is recycled to create even more social impact. Challenge - The great challenge for a fund like this is to target genuine investment from HNWIs. The first response of many HNWIs to a socially driven proposition is to commit a small amount of donation and take the tax relief. Some element of this may be important to get an initial fund launched but we recommend that the target should be to raise real investment rather than drawing heavily on scare philanthropic funds. Foundations and Government Benefits - For foundations and Government, the fund allows them to support sustainable business models with social impact at their core. The fund will support “role models” for the industry which will then encourage the formation of other social enterprises. - Foundations have found making investments of this nature challenging given their organisation structure and skill-set. A fund would allow them to be involved in making investments without needing to build this specific expertise in house. - Social enterprises will have access to business expertise to enable them to scale their business, which it is impossible to provide in enough depth using current funding models. Challenges – Government does not have a budget for supporting social enterprises. Foundations continue to find programme related investment difficult to get passed by their Trustees. 54 Private individuals may also be able to claim CITR on their investments

• Private investors can claim 20% tax relief on their investments over 5 years • Investment must a) be a non-profit OR b) have a social mission • Maximum of 50% of investments to be from b) • Limited investment allowed into a company – 250K if social enterprise – 100K if social business (profit distributing) • Only some equity investments can currently be made – OK if social enterprise – Not currently allowed for social business but being amended at present • Investment timeframe must be followed to keep accreditation – 25% by end of year 1 – 50% by end of year 2 – 75% by end of year 3 (and onwards for years 4 and 5)

Creating an appropriate tier for investment from HNWIs could be greatly helped by any means that reduces their risk and/or enhances their potential return. Our research indicates that HNWIs are most concerned to feel that: 1. They will get their money back at some foreseeable stage in the future, and 2. They will get flows of income fairly regularly in the period during which they invest.

They are not strongly concerned with achieving high financial returns because they see a vehicle like this as designed to be exciting in terms of its social returns not its financial returns. The Community Interest Tax Relief (CITR) could act as a very helpful catalyst in this regard. The CITR is available to investors in financial institutions that back certain social enterprises and socially driven businesses, as well as enterprises located in certain deprived areas of the UK. The CITR could be used to supplement returns of the fund for investors, but accreditation comes with many conditions. Particularly difficult for the pilot fund, however, would be the investment limit of 250K or 100k if profit distributing – some target social ventures would require more funding than this, especially including follow-on investments. The CITR is not perfect for this fund as it is likely that only a portion of the investments made could be counted for the relief. However, CITR is certainly one of a suite of structures which could be considered when establishing a pilot fund.

55 A subsidy is likely to be required to attract necessary funds

Pure Venture Patient Social VC CDVC Pure Equity Philanthropy Philanthropy Capital Investment

Subsidised YES – YES – YES – govt Subsidy YES – govt No return? foundation charitable required Social return High High High High Medium No specific Funds No No Some Yes Yes Yes recycled Business No Yes Yes Yes Yes Yes building Type of Grants Grants Soft loans Equity-like Equity or Equity or investments or equity debt debt Return to No return of No return of No return 3-5% + tax 10-15% 25%+ investors capital capital of capital upside

Investors have different options when deciding what to do with their money. Most investors either choose the left most bucket or the right most bucket. The options in the middle are still nascent. The options to the left of a pure equity investment all have some kind of subsidy enabling them to attract funds from private sector / be sustainable.

We believe that a social venture fund could ultimately be self-sustaining but would require subsidy to get off the ground and produce an initial track record of investments.

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Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

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Implications for policy

• Government should support a concept fund to increase the use of equity or equity-like capital in the sector

• CITR could be extended to social VCs to tap into the pool of private investment

• The cap on return in CICs should be treated with caution as it may restrict private investment into social enterprises

• More mapping work on social businesses (those set up for a social purpose but aiming to distribute profit as well) should establish the size of the market across the UK

• Social enterprise support organisations should cover a “broad school” including social businesses

Recommendations:

The core purpose of this report has been to try to provide an analysis that may help social enterprise practitioners and support agencies. It has not taken a macro view of social enterprise policy. However, some thoughts have emerged from the research and these are summarised in the slide above and the notes below.

Government should support a concept fund – some additional subsidy or tax credit is likely to be needed to initially attract private capital into the sector. Once the market is established this could be rolled back.

CITR is a potential mechanism for providing a tax subsidy but it is unwieldy to use with its current investment limits.

The cap on dividend payment for CICs – may prevent private investors from investing in them if the cap is variable and set by a regulator.

Socially driven businesses – are an unknown quantity and more mapping work should be conducted in tandem with that being conducted into social enterprises. One possibility is to collect data on this through Companies House.

Social enterprise support organisations – tend to focus on non-profit social enterprises and it is therefore very difficult to understand and promote the idea of “social business” – where the company is set up to make and distribute a profit but its core purpose is social.

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NB see page 58 for definition of a CIC Government should support a concept equity-like capital fund

Low involvement: No involvement: Market Tax breaks for has developed, no investors involvement needed High involvement: Matched funding to encourage development of the concept fund

Pilot fund Full scale fund Marketplace of funds

Government could be involved in the development of a concept fund and then slowly roll back its involvement as the market develops.

At pilot fund stage: Government could provide matched funding or a subsidy to establish the sector

At full scale fund stage: Government could scale back its involvement to providing tax breaks attracting investors into the sector

Once a marketplace is established: Government involvement is no longer required

59 The cap on dividend return for CICs should be treated with caution

Advantages of CICs • CICs can issue shares and maintain control over their social mission • A CIC structure is an easy 3rd party verification of social benefit • CICs may still be eligible to apply for EIS tax relief

Disadvantages of CICs

• A cap on dividends to private investors. • Set at a level which optimises access to capital • Level this will be set at is still unclear

Source: BCV Interviews

A CIC is a community interest company that combines the company model with a community interest test and mechanisms to lock profits into the company

Advantages of CICS to the concept fund

CICs are attractive to social entrepreneurs as they can issue shares but still maintain control over their social mission. CICs have an asset lock which prevents assets from being distributed to shareholders in the case of liquidation although creditors would still be paid.

If a CIC structure is used, it provides an easy 3rd party verification of social benefit as the CIC has to pass a community interest test

CICs may still be eligible to apply for EIS tax relief

Disadvantages of CICs to the concept fund

CICs have a cap on dividends to private investors. This will be set at a level which will optimise access to capital but the level this will be set at is still unclear

For more information on CICs, go to http://www.dti.gov.uk/cics/pdfs/cicreport.pdf

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Outline

Project overview

The Market of Social Ventures

The Equity-like Capital Gap

Proposed Social Fund Structure

Investor Types for Social Fund

Implications for policy

Appendices List of interviewees Source Documents and further reading

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Interview Sources – Social Enterprises

Stephen Sears – ECT Patrick Nash – Teacher Support Network Robin Murray – Twin Trading Wyndham James – Progreso Cafes Ltd Adam Brett – Tropical Wholefoods Paul Harrod – Aspire Liam Black – FRC Group Phillip Angiers – Angiers Griffin Jamie Hartzell – Ethical Property Company Tommy Hutchinson – Kikass

62 Interview Sources – finance providers

Yasmina Zaidman – Acumen (US) Naomi Kingsley – London Rebuilding Society Charlie O’Malley – Susten8 Malcolm Hayday – Charity Bank Steve Wyler – Adventure Capital Hilary Brown – HMT Stephen Brennikmeyer – Andromeda Fund Nicola Pollock, James Wragg and Ron Clarke – Esmee Fairbairn Victoria Hornby – Gatsby Foundation Steven Shields – Shine Trust Richard Gutch – Futurebuilders Ray Sheath – Scarman Trust John Kingston and David Curtis – Venturesome Henry Newman – Commons Capital (USA) Sandra McDermid and Sandra Jetten – Unlimited

63 Interview Sources - experts

Jonathan Bland and Matthew Walsham – SEC Meghan Bingham Walker – Social Enterprise Unit Mark Hambly and Bob Brennan – SBS Andrea Westall, Sarah Forster, Whitni Thomas – nef Louise Willington – HMT Caroline Fiennes – NPC Charles Middleton – Triodos Bank Ali Somers – Social Enterprise London John Pepin – Independent Consultant Jeremy Nicholls – nef (SROI) Andy Friedman – Bristol University (Mission driven business) Greg Dees – Fuqua School of Business (US) Theresa Lloyd – Philanthropy UK (why rich people give) Jim Brown – Cooperative movement

64 Sources / further reading

Financing of social enterprises – Bank of England 2003 Social Enterprise: a strategy for success – DTI 2002 Patient Capital – Civil Renewal Unit 2004 Lending to the social enterprise sector – DTI 2004 Access to finance guide – SEC (still in draft format) Researching social enterprise – Middlesex University 2001 Homeopathic Finance: equitable capital for social enterprises – nef 2001 New approaches to financing charities and other social enterprises – Venturesome 2003 Nuts and bolts of near-equity investing – CDVC conference (US) 2003 A fair trade finance initiative – Whitni Thomas 2003 Social Enterprise in the balance – CAF 2004 McKinsey report commissioned by Unlimited – 2003 The performance and transformation of soft-loan funds in the UK – nef 2001 Ethical Pioneers – nef

65 Background – Bridges Community Ventures www.bridgesventures.com

• BCV invests in ambitious businesses that are located in and economically linked to deprived areas in England. – Based in the most deprived 25% of areas in England. – A small or medium sized enterprise (SME) – Connected with the local economy

• BCV looks for the following attributes: – Clear business objectives – Strong management team – Compelling business proposition – The potential to deliver attractive returns

• Parameters: – Stage - Bridges Community Ventures is a generalist investor, investing in a range of industry sectors and stages. – Sector- All sectors considered with emphasis on manufacturing, services, media, retail and leisure – Deal size- From £150k - £2 m in terms of our portion of a transaction

Background on the writers of this report This report is written from the perspective of a socially-driven venture capital company. Bridges Community Ventures (BCV) invests in ambitious businesses that are located in and economically linked to deprived areas in England. To be eligible to be considered for an investment a business must meet the following 3 criteria: -Location -Based in the most deprived 25% of areas in England. -SME -Independently owned with fewer than 250 employees and an annual turnover not exceeding £25M - Economic Links - Connected with the local economy by employment, market or supply chain

BCV looks for businesses with the following attributes: - Clear business objectives - Strong management team - Compelling business proposition - The potential to deliver attractive returns

Deal parameters: -Stage- Bridges Community Ventures is a generalist investor, investing in a range of industry sectors and stages. -Sector-All sectors considered with emphasis on manufacturing, services, media, retail and leisure - Deal size- From £150k - £2 m in terms of our portion of a transaction

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