The Deliberation: How Impact Investors Evaluate What Venture to Fund

Published: Jun. 8, 2016

By Naki B. Mendoza for Devex Impact

About Powering Agriculture

Powering Agriculture: An Energy Grand Challenge for Development supports the development and deployment of clean energy innovations that increase agriculture productivity and stimulate low carbon economic growth in the agriculture sector of developing countries to help end extreme poverty and extreme hunger.

The pitch has been crafted, the speech has been rehearsed and the entrepreneur takes to the stage to prove why their business is the next breakthrough enterprise. Seated opposite them is a row of inquisitive investors ready to evaluate why their capital should fund the proposed venture.

Devex looked into the so-called art of the pitch—practical advice from a group of donor-funded startup social entrepreneurs on what makes for a strong pitch to impact investors. Now the flip side. How does it square with the preferences of their counterparts? What types of strategies, competencies, business models and experiences are impact investors looking for in a social enterprise worthy of commercial investment?

Again, the answer is not black or white, but rather a multitude of shades of gray. Investors fund all types of social enterprises through a variety of mechanisms, each of which has its own targets, objectives and risk profiles.

But some key takeaways offered by a group of impact investors sheds light on the criteria and metrics that shape the funder’s perspective.

Three social investment groups — the Global Innovation Fund, Acumen, and Root Capital, which specifically targets small-to-medium sized agricultural businesses — offered their take on a panel at the United States Agency for International Development’s Ag Innovation Summit in Washington, D.C., last week.

Market trends

Several broad trends have been shaping the impact investing space, according to the group. Chief among them is the growing number of funders and financiers who are investing in social impact as the practice becomes more mainstream. The result is that there are more opportunities and options for entrepreneurs, which is generally a positive outcome.

“But we are also maturing,” said Elicia Carmichael, director of business and product development at Root Capital. “Our standards and underwriting requirements are becoming stricter.”

More rigorous investment criteria may seem daunting for early stage entrepreneurs who depend on commercial capital to grow their models, she said. And it perhaps contributes to a common misstep cited by social enterprises of compromising vision for capital — accepting investment from a fund whose objectives do not align with their core business model. But ultimately, more refined standards better serve the interests of both entrepreneur and investor by producing more robust models when the match is right, Carmichael said.

Another trend that has caught investors’ attention is a focus on distribution. Technological inputs and innovations, groundbreaking as they may be, only go so far as the capacity to disseminate them to core markets—often a disparate network of smallholder farmers spread across hundreds of miles, in the case of agriculture.

“It’s relatively easy to create a new technology, but the hardest part is distributing it,” Carmichael said. Social innovators have been responding to this gap by developing more holistic business models for the agriculture sector. “It used to be about the idea, now it’s [more] about the deployment,” she said.

One component that investors look for to reach scale and achieve social impact is an innovative distribution and delivery model. In addition to a technological offering itself, other criteria that draw investor attention are the cost effectiveness of the product and the availability of alternatives in the market, according to Rakesh Apte, an investment director for the Global Innovation Fund.

It takes an ecosystem

For equity investors such as Acumen, a decision to invest must also take into account broader factors of the market’s enabling environment. They too have a dual objective of achieving impact at the smallholder level and generating commercial returns. But unlike debt investors who are repaid through interest, the payback for equity funders is less clear. Returns come from successful exits, so their investments therefore often hinge on businesses that build ecosystems as much as they do products.

“It’s about building a large-scale business that will attract capital,” said Sean Moore, a portfolio director at Acumen. “You need to build a business that is attractive to other businesses down the road.”

Acumen, for example, has been moving slightly away from funding direct technological inputs in favor of models or innovations that promote broader credit extension or market information services, Moore said. Those types of models, said Acumen, address wider market needs and foster more business partnerships across different sectors. In the case of agriculture—an industry subject to the systemic risks of climate change and shifting weather patterns—a key criterion is whether a business has investments in climate change in order to help it target the market, said Moore.

Central to the decision to invest are the competencies and experience of the enterprise’s management. Impact investors are targeting business models ready for growth, much of which is determined by the team at the helm. “It is incredibly important that the team has experience in the industry at hand,” said Carmichael.

For impact investors who are sector agnostic, betting on the management team is equivalent to betting on the business itself.

“Being early stage venture investors, it always comes down to the management teams,” said Moore. “We are betting on them to figure things out as they go along because you are investing before there is a proof of concept.”

Financial literacy need apply

The jump from grant funding to commercial capital—either debt or equity—can be bumpy at times and investors set out to measure a social enterprise’s ability to manage that transition.

One indicator, said Apte of the Global Innovation Fund, is capital efficiency. Being a recipient of many donor grants is not necessarily an advantage if you are not lean and efficient in how you use the funds. Free money, he argued, can be wasted or squandered. “How would you spend grant capital if it were [conditional]?” he noted.

Another important criterion, according to Carmichael, is whether a business has a track record of taking ownership of its own financial management.

“One of our big challenges is entrepreneurs coming to us with informal financial statements,” she said. For startups, a lack of financial literacy can stem from an over-reliance on incubator services. Too often, Carmichael said, startups allow incubators to take over the financial portion of their business. If investors find themselves working closely with incubators early on in an application process to understand the financials of a business it raises an immediate red flag, she added. “Success means having to manage all aspects of your financials,” Carmichael said.

The timetable of funding requests can also be a factor. Generally, a logical funding trajectory for a social enterprise to follow is to obtain grant funding first, followed by equity and then debt, according to Acumen. Enterprises often see a benefit to seeking debt before equity because it expands their funding without giving up a stake in their business. But down the road, too much debt that leads to an inability to repay will ultimately make it harder to raise equity capital.

Impact investors warn that commercial finance can come with higher levels of investor engagement. “Some grants may be more hands off, but investors providing debt and equity might be looking to get more down in the weeds,” Apte noted.

And above all, they stress a tough-love approach to their decision-making. A decision to not invest means that a business is not the best for a fund’s capital, said Carmichael. “We don’t want to put you in a situation where you as the entrepreneur are not going to be successful.” Instead, commercial capital for social enterprises is meant to be custom-fit to best suit the interests of both the investor and the entrepreneur.

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