NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

A few months ago I sat on a Net Impact panel discussing the topic of social ventures. During the Q&A time, the topic of funding came up.

A student asked a question along the lines of, “Is there a way for social ventures to attract the type funding that has traditionally been available only to for-profit businesses?”

My response: “If I asked you to consider investing in a company that offered below market rate returns and had a high probability of failure, would you make an investment?”

The room was silent. After a minute, the student said, “No.” And so did most everyone else.

The response shed light on the issue at hand. Most people will not invest in a social venture because at the end of the day, people, even those who are socially conscious (I mean, these were students at a Net Impact conference!) want to maximize returns on their own financial investments.

Even as I think about my own investing behavior, it’s hard sell for me to put money into a business that promises minimal to no return with a high-risk of business failure. I’d much rather give to charity. Perhaps I’ve been just too conditioned with my background in finance.

I recently talked to Kevin Jones, a Founding Principal of Good Capital and Co-Founder of the SoCap conference, about the state of the social capital markets and he confirmed what I see in myself and others. In his own experience, a lot of investors can give charitably, but cannot fathom making an investment in a social venture that does not have an appropriate risk-reward tradeoff.

So, what does this mean for social ventures? Will they never be able to attract the appropriate funding necessary to achieve significant scale?

Currently, there are a few options for social ventures seeking to raise sizable funds, none of which are particularly appealing.

Option 1: Hope that the growing class of social investors will reach a critical mass

Today, there is a small, but growing subset of investors known as social or impact investors. Brian Trelstad of Acumen Fund defines this group as the following:

We define a social or impact investor as someone who takes a double (or in some cases triple) bottom line approach to their capital, and attributes real value to the social or environmental return in their investment decision-making. They will often, but not always, be willing to exchange a lower economic return for potential social or environmental impact

There is no doubt that social investors are a real class of investors. As Trelstad puts it, social investors “are part of an emerging asset class that can generate serious deal flow, test new ideas, or expand into new market and in the process contribute to solving some of the most intractable environmental and social problems of our time; certainly a reasonable return on investment by most measures.”

However, the challenge that I see is that that these types of investors hold only a fraction of the total available investment capital. Currently, even large social investments funds are only able to invest capital in the range of $1 to $2 million in social ventures. This class of investors is indeed growing, but it is questionable if this class will reach that critical mass that is needed to help bring social ventures to scale – especially considering the business environment that we are in today. Social ventures may have to wait a long time for this to happen.

Option 2: Seek out and rely on donor funding

If social ventures cannot attract enough funding from investors, where else can they turn? Donor funding? This approach may seem counterproductive to the base of the pyramid movement, but the reality is that many social ventures are relying on donor funds for capital today.

The problem with this approach is that many social ventures take on a for-profit legal form, which makes it hard to attract donor funds. Contributions to for-profits are not tax-deductible; contributions to non-profits are.

Also, by seeking out donor funds, a social venture has to compete with traditional non-profits. And it is a highly competitive landscape in the non-profit world. Personally, I don’t think this is the solution to the funding problem.

Option 3: Compromise on social outcomes in order to improve profitability

This is not ideal, but unfortunately, a lot of social ventures are forced down this route in their efforts to raise funds to scale. In many cases, a social venture starts moving up the pyramid – to the middle-to-upper class population – to improve profitability. And in the course of doing so, they reduce or even exit entirely communities that need their products or services the most. This is not a good outcome.

Bleak picture, right?

These three options are not the only paths forward. There are a lot of people out there that are trying hard to create alternative options. I am optimistic about a new type of corporate entity has recently formed called L3C, which stands for low profit limited liability company. It’s not perfect, but it is a promising corporate form that may open up more doors for social investing. I’m also hopeful about the role of governments and their agencies in financing social ventures.

More of L3Cs and governments in follow-up posts.