Capital Ideas

To Hedge or Not To Hedge...

Kylie Charlton — Thu, 05 Mar 2009 20:08:50 +0000

The temptation for social entrepreneurs to accept funding in whatever currency it is offered can at times be overwhelming when financing resources are limited and there is an overwhelming need to continue to serve the community in which you work. Understanding the consequences of foreign currency funding is however critical to managing the financial risk that arises from accepting foreign currency debt and to being able to answer the question – “to hedge or not to hedge”.

So, what is the financial risk of accepting foreign currency debt?¹ In simple terms, foreign currency debt requires ongoing servicing and repayment in a foreign currency thus exposes your enterprise to movements in foreign exchange rates. Consider the following example:

A social enterprise in Country A borrows US$100,000 today for two years at a rate of 15% per annum payable quarterly. At the time of borrowing the exchange rate US$1 = A25 and thus the social enterprise receives A2,500,000. If over the term of the loan the exchange rate remains stable at US$1 = A25 interest of A93,750 per quarter (US$3,750)would be paid by the social enterprise.

If Country A experiences a depreciation in its currency against the US$ immediately after the disbursement of the loan to, say, US$1 = A35 then the quarterly interest payment would increase to A131,250 (US$3,750). Furthermore, on maturity of the loan the social enterprise would need now to repay A3,500,000 (US$100,000). Thus, the depreciation in the exchange rate would result in a 40% increase in the amount of local currency required by the social enterprise to service the foreign currency loan.

In the case of an appreciation of the currency of Country A to, say, US$1 = A20 the servicing burden of the foreign currency loan would actually decrease by 20% with a quarterly interest payments being A75,000 (US$3,750) and repayment on maturity being A2,000,000 (US$100,000).

Unfortunately it is impossible to accurately forecast foreign exchange rates and thus it is necessary to look at how to protect against devaluation in the local currency when considering a foreign currency loan. In a perfect world, social entrepreneurs would have the same suite of market and over-the-counter financial instruments available to them as large corporations to manage foreign currency risk. Albeit, the world and financial markets are far from perfect and the tools available to social entrepreneurs to manage foreign exchange risk are extremely limited and are often prohibitively expensive.

Two instruments that are offered by banks and may be helpful for some social entrepreneurs are:

1. Forward Foreign Exchange Contract: An agreement to purchase or sell an amount of foreign currency at a future date at a predetermined price. This contract allows you to fix and know with certainty the local currency cashflow obligations associated with a foreign currency loan.

2. Foreign Exchange Options: Arrangement in which a party acquires (upon payment of a fee) the right but not the obligation to buy or sell a specified amount of a currency on a fixed date and at a fixed rate. An option therefore allows you to protect against a currency depreciations but take advantage of a currency appreciation.

Note that both the above instruments require a relationship to be established with a bank offering foreign currency derivatives plus approval to be granted by the bank to enter into such contracts. Securing approval can be expected to be challenging for many social businesses given the credit requirements imposed by banks.

For social entrepreneurs that work in markets with a dual currency – such as Peru where US$ and Peruvian Solos are actively used – and who are able to generate revenue in US$ it is may be possible to create a natural hedge for a US$ loan. A natural hedge will occur if the size of the loan is consistent with the US$ revenue stream. For example, if you have a US revenue stream of $50,000 per year then any US$ loan would be sized to allow you to meet all payments associated with the loan from the US$ revenue stream.

So back to the question - to hedge or not to hedge? Ideally for a social entrepreneur the answer is always to hedge, the harsh reality is however that given the limited instruments available and the generally high cost of such instruments it is often difficult to do so. The best current approach for most social entrepreneurs to manage foreign exchange risk is therefore simply to avoid it by avoiding foreign currency loans. If you do however elect to move forward with a foreign currency loan be sure do all you can to understand and, to the extent possible, minimize the financial risks associated with depreciation in the local currency.

Join us in our next entry for a few thoughts on selecting between short and long term funding sources.

1. Note that grants or equity funding are not typically subject to the foreign exchange rate risks that are inherent in foreign currency loans.

In respect of grants, as there is no ongoing financial servicing or repayment obligation there is no exposure to currency movements. The only exception to this would be if you have a foreign currency grant commitment from a funder that is to be disbursed over a period of time. In this case, the local currency received at the time of disbursement will depend on the foreign exchange rate prevailing at the date of disbursement which depending on whether the currency has depreciated or appreciated may be higher or lower than that anticipated.

In respect of equity, equity investors in a social enterprise should always fully absorb the foreign currency risk associated with their investment and impose no burden on a social enterprise to offer any protection in respect of the foreign currency risk of their investment. For example, an equity investor whom acquires 10% of a social enterprise in Country A for A5,000,000 which at the time of purchase requires an investment of US$100,000 (US$1 = A50) accepts the risk that whilst the their investment may increase in value in terms of the domestic currency a depreciation in the currency of Country A may adversely impact their investment return. Thus, if the equity investor divests of their 10% interest for A6,000,000 at a time when the currency of Country A has depreciated to US$1 = A66 they will realize only US$90,000 and have made a foreign currency loss on investment of US$10,000.

Managing a Competitive Tender Process - for Debt or Equity

Kylie Charlton — Tue, 17 Feb 2009 18:10:28 -0800

In our previous post we outlined the requisite materials to be prepared in advance of a capital raising process. Once those materials have been compiled, the next step toward raising capital is to initiate a competitive tender process.

A competitive tender is a formal process wherein bids, more frequently known as term sheets, are requested from potential investor regarding the amount and type of capital that you would like to raise, including associated terms and conditions. For example, if you want to develop relationships with two new lenders in raising $5 million of debt, you may contact ten potential lenders, with the hope that five will present term sheets, and then you will choose two of the most attractive which together provide $5 million.

The keys to managing a successful competitive tender process are not significantly different than managing any project or transaction. In order to be successful, both in terms of efficiency and effectiveness, you need to have a well-researched project plan, and must continuously manage all stakeholders in moving towards the same goal.

This process is perhaps best approached by starting from the end goal, and moving backwards through to the initial step.

1. What is your goal?

a. Capital

i. Debt vs. equity: What type of capital do you want to raise? Debt (senior, subordinated), equity (common, preferred) or a hybrid security?

ii. Amount: How much capital does your business require to support its plan?

iii. Timing: By what date do you need to raise the required capital?

b. Investors

i. Criteria: What are your key criteria in selecting investors? Are you focused solely on the financial terms offered or do you want to consider the potential strategic value-add from the investor?

ii. Example: In raising equity capital, an investor may require a board seat depending on their percentage ownership of the company; if so, you will want to consider the value that investor's board representative will add to the company. In considering new lender relationships you will want to evaluate the ability of that particular organization to grow with your business, and increase its support over time.

2. Building a timeline?

a. Research: In researching potential investors you want to understand the time required for them to consummate a transaction. This can be done through a formal process, where you compile a target list of investors and contact them with a brief initial overview regarding your goals, and inquire as to their process and timetable; or you can informally attempt to conduct this research and incorporate certain general assumptions as to investor timelines.

i. Example: Most lenders should be able to consummate a transaction within a two month period, and most equity investors in three months. Many factors can, however, extend the capital raising process: these include the complexity of the transaction, the investor's knowledge of the particular business or industry, and perhaps most importantly, the date at which the investor can begin reviewing the transaction. While most investors can complete a transaction in the aforementioned time periods, many are so busy with current transactions that you have to wait several weeks to move through the queue.

b. Typical example: A typical timeline for a transaction should be similar to the following:

i. Initial review - 2 weeks

ii. Phase 1 due diligence - 2 weeks

iii. Phase 2 due diligence - 2 to 4 weeks

iv. Review, negotiate and select term sheets - 1 to 2 weeks

v. Negotiate final terms and conditions - 2 to 3 weeks

3. Initiating and Managing the Process

a. Initial communication: Send an email/letter to all potential investors with a brief outline of your goals for the capital raise (include details such as amount, type, criteria in evaluating investors, etc.). Include a specific time table similar to the above example where dates outline each major step fo the process; this allows you to keep the investors accountable and moving promptly through the process. Also, provide a brief presentation (see previous post) or overview of the organization

b. Phase 1 materials: For those investors that are interested in receiving additional materials after their initial review send them your business plan, full company presentation, financial projections and FAQ (if you have)

c. Phase 2 materials: After investors review all of your prepared materials they will likely come back with particular questions (these are the questions that you should keep track of and add to your FAQ as appropriate - see previous post)

d. Review and negotiate term sheets: Create a matrix with each of the key criteria that you want to use in evaluating the proposed term sheets (amount, cost, timing of final decision, strategic value-add, etc.) to help make an informed decision

e. Managing for efficiency and effectiveness: To reiterate, while the above timeline outlines an ideal process, certain transactions can require many months to complete, whether due to prolonged legal negotiations, issues identified in due diligence, etc. Your goal in managing a successful competitive process is to keep all potential investors moving along with the desired timeline. You can do this by focusing on a few key areas:

i. Process: Ensure that you are well-aware of each investor's process: ask about recent transaction timelines, how many approvals are required and how are those processes structured, how often/why are deals rejected, etc.

ii. Communication: Stay in appropriately frequent communication so as to keep tabs on each investor's current status

iii. Preparation: Be well prepared for questions by having materials ready and available, so that investors are not able to blame you for delays

iv. Research: Speak to other companies that have worked with these investors so that you can understand their particular areas of interest or focus

For many companies, raising capital can be an extremely time consuming process, as the timelines we have outlined are not met for various reasons, as previously noted. If managed professionally, with the same rigor as any similarly important project, raising capital can be done in an efficient manner. While risking the consequences of self-promotion, I feel compelled to note the reasons why quality financial advisors can be of significant value in competitive tender processes, including:

- Experience in managing capital raising processes (including knowledge of particular investors due diligence processes and areas of focus)

- Established relationships with investors (leading to more expedient interactions)

- Knowledge of market standards for terms and conditions of comparable transactions (to be leveraged in investor negotiations)

- A dedicated team with requisite experience, allowing your internal staff to focus on your company's operations

Each of these factors can assist in executing transactions in the aforementioned 2 to 3 month timelines; as opposed to poorly managed processes, which can lead to not only extended time requirements, but also result in less than optimal terms for your company. Our next post will address the financial challenges in managing foreign exchange (FX) risk.

Compiling an Information Package for the Capital Raising Process

Kylie Charlton — Mon, 02 Feb 2009 22:36:04 -0800

Our last post suggested conducting your own due diligence on potential financiers before engaging them to discuss the capital needs of your organization. In addition to conducting research as preparation for those discussions, another question to be addressed is what information potential financiers will require to make a decision on your request for capital.

A financier's due diligence process can generally be categorized in the following stages:

Introductory meeting
Initial due diligence
Final due diligence
Negotiation of terms and conditions

Each stage of the financier's due diligence process requires an increased level of information from your organization. In that regard, it is prudent to compile an information package for your organization before engaging potential financiers. Creating an information package prior to engaging financiers will allow for more efficient interactions throughout your capital raising process; particularly as you are likely to interact with many different parties, each with different processes. Developing a strong package allows you to streamline those interactions and more effectively address potential questions.

The content of an information package typically include the following:

Business Plan (Word)
Financial Projections (Excel)
Company Overview presentation (PowerPoint)
Frequently Asked Questions (Word)

A business plan is the most crucial element of an information package. While we could dedicate multiple blog posts to the drafting of a solid business plan, I want to simply highlight here the key areas to be addressed, and provide an outline including those topics of most interest to financiers. A solid business plan can be drafted in 15-25 pages, and while it should present the optimism inherent in your vision, it should offer a considerate view of both the opportunity and challenges ahead. For social enterprises you should also ensure that your business plan appropriately addresses the social (or environmental) impact created by your organization, along with potential metrics by which you can assess that performance.

1. Executive Summary

a. This should include one brief paragraph from at least each of the following sections; the sections should read generally in the order listed below, and total 1-2 pages.

i. Company Overview (this i and ii are purposefully switched relative to the order that follows below as 2 and 3)

ii. Market Opportunity and Competitive Landscape

iii. Products and Services

iv. Management Team and Governance

v. Financial Plan

2. Market Opportunity and Competitive Landscape

a. This section tends to be data intensive; use tables, charts and graphs wherever possible in order to more effectively convey such information; examples include charts/graphs exhibiting market size, and tables outlining certain attributes of your organization relative to your competition

3. Company Overview

a. Background on the company

b. Historical performance

4. Products and Services

a. Examples/profiles of target customers

b. Summary of product offering (tabular format)

c. Discussion of operational structure (can also be included as separate section)

5. Growth Strategy

a. Strategic plan (major goals, and the initiatives that will allow you to reach those goals)

6. Management Team and Governance

a. Bios of key senior management and board of directors

b. Organizational chart

7. Financial Plan

a. Summary 3-5 year financial projections including income statement, balance sheet and cash flow; include a table of key assumptions and perhaps a high and low case scenario in addition to the base case

b. Key performance metrics (tabular format)

8. Risk Analysis

a. Identify the key challenges, or risks, that may be incurred in attempting to achieve your goals. There is no need to hide this information from potential financiers. They are going to ask the question regardless of whether it is offered to them so it is better to be well prepared, and to exhibit that you have considered such challenges, and have plans to mitigate such issues.

Financial projections are a similarly important piece of an information package, and as noted above, should be included in summary form in the business plan. As mentioned in our previous post, for most financings five year projections are ideal, however shorter term projections can be appropriate for shorter term financings. As also noted previously, you should be prepared to back up the key assumptions used to generate the projections.

We have referenced the need for a strong elevator pitch several times on this blog. While a solid two minute pitch may be enough to obtain a meeting with a potential financier, certain organizations may request that you send materials briefly summarizing your organization and the financing opportunity prior to agreeing to a meeting. This is where the company overview presentation offers value.

In compiling an information package, we typically recommend creating a comprehensive PowerPoint presentation that provides a solid overview of the organization in 15-25 slides (for larger organizations, or more complex financings, you can add additional information in appendices if necessary). The benefit of using PowerPoint is the ability to then easily customize this large presentation into other forms, including an "introductory" presentation which can be created by cutting down the comprehensive presentation to 5-10 slides. A PowerPoint presentation is also beneficial both in providing a document that can be walked through or projected on a screen during a meeting, and it allows data/charts to be more easily digested in a less text intensive format as compared to a Word document. The categories that should be addressed in the company overview presentation are similar to those noted above in the business plan.

A frequently asked questions document is not necessary when compiling an information package, but we do recommend keeping a comprehensive list of all questions asked by potential financiers. If certain questions continue surfacing, and they are not appropriately included in the other documents within the information package, then you may want to create a brief FAQ document to provide responses to those particular queries.

Solid drafts of each of the aforementioned documents will provide an immense benefit in streamlining your interactions throughout the capital raising process. We hear from many of the CEOs with whom we work that raising capital is the most time intensive of their many responsibilities; hopefully some of the information here will help make that process a bit more productive. In our next post we will advise as to how you can run a competitive tender process in order to obtain the best terms and conditions when raising debt or equity capital.

Inside the mind of a financier...

Kylie Charlton — Sun, 18 Jan 2009 14:47:08 -0800

What goes on inside the mind of financier as they listen to a social entrepreneur pitch for funding?

Every financier will have there own set of investment criteria and process but there is are a few "standard" lines of questioning that can be found entwined within the thoughts of any financier. To be aware and able to proactively address these will greatly assist your conversations with any potential financier. In a large part these questions simply go deeper into aspects of the "elevator pitch" we talked about on January 5.

1. What is the vision and mission for the social enterprise?
2. What is the unique business proposition - product or service?
3. What is the three (or five) year business strategy?
4. What is the operating plan through which the business strategy will be operationalized?
5. Who is the management team and what is their experience?
6. What is the market environment and who is the competition?
7. What internal and external risks could threaten the business strategy or successful execution of the operating plan?
8. What are the sources of finance for the business and is the the business plan fully financed?
9. What are the projected social and financial returns?
10. Will the social enterprise be successful?

So what additional questions arise depending on whether you are pitching for a grant, debt or equity? You may recall from our blog entries during November and December the basic differences of each of these forms of capital are:

A grant is a gift upon which social return is anticipated.
Debt is a liability of the social enterprise and requires repayment with interest according to pre-agreed terms and conditions.
Equity confers ownership of the social enterprise and over time an equity investor expects to be able to execute upon an exit strategy that provides for return of capital plus financial and social return on their capital.

Thus, in addition to the 10 questions outlined above, debt investors want also to understand the "debt servicing capacity" of your social enterprise. That is, how will the social enterprise generate sufficient surplus cash to meet scheduled principal and interest payments due on any loan. Debt investors typically use a standard set of financial ratios to assess the debt servicing capacity of a social enterprise. These ratios are often incorporated as financial covenants into the loan term and conditions and thus you should learn what they are and how they are calculated.

Equity investors want to understand what plausible exit strategies may be available for their investment and how other owners are aligned around exit strategies. Remember that it is the performance of the social enterprise combined with a strongly executed exit strategy that ultimately drives the success of an equity investment.

In summary, while there are some standard lines of questioning you can expect it is important that with each and every financier with whom you plan to speak that you do your homework. Find out as much about each financier as you possibly can before you initiate conversations:

What are their investment criteria?
What is their investment process?
What information do they require? Do they need information in a specific form?
What due diligence do they conduct?
In whom have they made prior investments? Why did they invest? If possible try to talk to prior investees to gain insight into the working practices of the investor.

A little due diligence on your side about financiers prior to initiating conversations with them will allow you to enter into conversations well prepared. It also allows you to make an assessment of whether or not the financier is indeed one that you want to enter into a relationship with. Know that preparation goes beyond being able to address the above it should also include preparation of standard pitch material - business plan and company presentation. One of our colleagues from Unitus Capital, Brooke Randall, is going to join us in our next blog entry to talk more about these standard pitch materials which sits side by side with the elevator pitch and financial model we chatted about in our blog entry on 5 January.

"Show me the money"

Kylie Charlton — Mon, 05 Jan 2009 12:00:00 -0800

The refrain “show me the money” was made famous by Tom Cruise in the movie of Jerry Maguire and is a refrain that causes any potential financing source to cringe. Unfortunately, it is a refrain that is heard all too often under the disguise of many different words in initial conversations with potential financing sources as social entrepreneurs and businesses struggle to be able to clearly articulate their external financing need. The ability to be able to clearly articulate your financing need is critical to successfully progressing conversations with grant, debt and equity providers alike.

So where does one start?

First and foremost it is essential to be clear on your strategic goals and objectives, target market, business proposition and operating plan. One of the first items I often ask social entrepreneurs when we commence discussions of their financing need is for their “two minute elevator pitch”. In these two minutes I want to be able to obtain a bird’s eye understanding of their social enterprise:

· What are they going to do?

· What is the need for their planned services or products?

· How and with whom are they going to do it?

· What will be the social impact?

· Why will they be successful?

The depth of information that can be conveyed in these two minutes is admittedly minimal. The level of excitement around the strategic vision and the entrepreneur’s ability to execute upon this vision that can be generated and conveyed in these two minutes is however substantial and can be a determining factor in if and how discussions progress with potential financing sources. Over time, these discussions will provide an opportunity to fully detail the ins and outs of your social enterprise.

Secondly, a social entrepreneur should be able to clearly articulate their external financing need:

· How much money is needed?

· Over what time period is money required?

· How will the money be used?

· How will money be returned to investors?

· What is the social and financial return to investors?

· How and when does the enterprise become self sustainable?

It is not sufficient to simply say you need money to develop and grow (aka, “show me the money”). It is critical to be able to talk clearly of the external financing need; it is not necessary, albeit helpful, to be able to articulate the form and structure of financing you are seeking.

Financial modeling is typically not the strong point of a social entrepreneur. However, it is a necessary evil to be able to clearly communicate your financing need. Every social entrepreneur needs financial forecasts for a minimum of three years and preferably for a five year period. These forecasts should clearly lay out all assumptions (such as revenue, operating costs, capital expenditure and economic factors) and be capable of producing output in the form of standard financial accounts (profit & loss, balance sheet and cash flow statement). Ideally, you will also be able to overlay a social impact forecast into the financial model.

Be aware that it is not enough to just have a set of financial forecasts. You must also be able to speak about them knowledgeably and be prepared to defend your forecasts as you move into due diligence with a potential financing source. Be prepared to provide external references or data points to support your assumptions, and be sure to know what your key revenue and cost drivers are and what the major external factors are that will positively and adversely impact upon your forecasts. Remember that potential financing sources are not only concerned about adverse factors that may threaten their investment but need also to fully understand those factors that have the potential to accelerate the success of your operations as these may very well give rise to additional financing needs.

A social entrepreneur that is able in an initial conversation with a potential financing source to successfully generate excitement around their strategic vision and ability to execute upon this vision, as well as articulate their external financing need, is well positioned to be invited to pitch for financing. Join us in the coming weeks to talk about how to prepare for a financing pitch and learn a little about what goes on inside the head of a potential financing source as they assess financing pitches from social entrepreneurs.

Financing Alternatives: Debt, Equity and Grants (Part 3)

Kylie Charlton — Wed, 24 Dec 2008 17:06:28 -0800

Welcome to our third and final entry on the theme of “Financing Alternatives: Debt, Equity and Grants”. Equity is the focus of this entry and is perhaps the form of capital that is currently attracting the most attention in the world of social enterprise.

So what is equity? Equity can be defined as the amount invested into a social enterprise by the business owners (also referred to as ‘shareholders’) plus the profits (or minus the losses). Equity plus liabilities (including debt) are used to finance the assets of the social enterprise and together form its financial life blood. Note that while equity invested for a social enterprise includes donated equity (donations) and shareholder equity, our discussion today focuses on shareholder equity.

The big question is: “How to responsibly incorporate shareholder equity into the capital structure of a social enterprise?”

This question has been a topic of discussion for some time but recently came to the attention of many following the launch by Professor Muhammad Yunus of his book entitled “Creating a World Without Poverty”. Earlier this month, Marc Danegard hosted a wonderful discussion on Social Edge– Social Capital and Social Business: New Definitions – that provided a concise summary of the definition proposed by Professor Yunus for a social business. This definition encompasses a number of criteria, but the most topical to our discussion is that of zero profit distribution to investors in social businesses - investors may not take profits out of the social business after having their investments paid back. This concept is alien to traditional equity investors who demand capital gain and/or profit distribution on their investment as a reward for the risk of investment. The challenge then is to find ways to incorporate equity into the capital structures of social enterprises that are attractive to both social entrepreneurs and return seeking social investors. A solution of this type would open the doors of equity for social entrepreneurs and would substantially increase the universe of capital available beyond donated capital from philanthropists or capital that could be attracted if Professor Yunus’s zero profit distribution criteria became a core characteristic of equity investment in social enterprise.

As with most things in life, there is no easy solution or a one size fits all solution. The negotiation and structuring of a shareholder equity investment depends less on "industry standards", "legal boilerplate" or "structural rules-of-thumb" and more on more on the need to strike a balance between your needs and concerns and the investment criteria of the potential shareholder. Equity can be an extremely valuable and powerful element of the capital structure of a social enterprise if the correct balance can be struck.

Key items for discussion with any potential shareholder and which should form part of your analysis of a potential equity investment include:

Concerns of the Social Enterprise

Management control
Ability to manage mission drift
Stock allocation to management, staff and community
Adequate financing
Future capital requirements and dilution of future capital raisings;
Investors exit strategy; and
Intangible and indirect benefits of an investors participation, such as access to key industry contacts and future rounds of capital

Concerns of the Potential Equity Investor

Current and projected valuation of social enterprise;
Level of risk associated with proposed investment;
Alignment of proposed investment with investors investment objectives and criteria;
Projected levels of return on investment;
Liquidity of investment and exit strategies in the event of distress or failure of the social enterprise (ie. "Downside Protection");
Protection of the investors ability to participate in future rounds if company meets or exceeds projections ("Upside Protection");
Influence and control over management strategy and decision making;
Registration rights in the event of a public offering; and
Rights of first refusal to provide future financing.

Concerns for Both

Retention of key members of the management team (and recruitment of any key missing links);
Resolution of any conflicts amongst a syndicate of investors;
Financial strength of the social enterprise post-investment; and
Tax ramifications of the proposed investment.

From the above, negotiating an equity investment is no small task. Be sure to enter into discussions of equity with a strong team of advisers familiar with equity and able to provide an unbiased opinion of the proposed investment and its structure.

Also remember that the introduction of equity requires that a social enterprise be organized and registered as a legal form capable of accepting shareholder equity. For example, a non-profit legal entity such as the 501(c)(3) in the US does not allow for shareholder equity. For social enterprises that have been established as non-profits unable to accept shareholder equity, the introduction of shareholder equity requires “transformation” to an appropriate legal form.

In an attempt to summarize the last few weeks we have put together the below table that seeks to highlights a number of the typical differences between grants, debt and equity.

	Grants	Debt	Equity
Amount	· Varies	· Typically no more than 3-5 times equity although highly dependent on the type of social enterprise	· Varies
Purpose	· Grant monies are often restricted to a specific project rather than being able to be used broadly by a social enterprise for operating and capital expenditure	· Operating, working and capital expenditure	· Operating, working and capital expenditure.
Repayment and Servicing	· No repayment required	· Principal must be repaid according to an agreed schedule along with agreed interest	· Exit strategy that allows investors to realize return of investment
Covenants	· Reporting	· Reporting and financial	· Reporting
Events of Default	· Typically limited to compliance with the grant purpose and laws	· Non-payment of principal or interest, non-compliance with covenants, cross default, etc	· Downside protection
Security	· NIL	· Fixed or floating asset charges may be requested by a lender	· Typically NIL
Board Representation	· Some grant makers will require a board seat especially if they are one of the primary funders of a social enterprise	· NIL	· Board seat or ability to nominate a board member to provide influence over key strategic and management decisions
Ownership	· NIL	· NIL	· Yes along with voting rights in proportion to ownership

Wishing you all a wonderful holiday season wherever you are around the world and look forward to joining you on Social Edge in 2009! Our first entry in January will look at how social entrepreneurs can move beyond the catch phrase - “show me the money” – made famous by Tom Cruise in the movie Jerry Maguire.

Financing Alternatives: Debt, Equity and Grants (Part 2)

Kylie Charlton — Mon, 08 Dec 2008 19:34:58 -0800

Welcome to our second entry in a series of three that will hopefully shed some light on the differences between debt, equity and grants for a social entrepreneurs. Our last entry (November 23) focused on grants while today we move on to looking at debt. We will finish the month discussing equity.

Debt can be simply defined as money that you borrow to run your business. Generally speaking, debt can be divided into two categories:

Long Term Debt Financing usually applies to assets you are purchasing for your social enterprise, such as equipment, buildings, land, or machinery. With long term debt financing, the scheduled repayment of the loan and the estimated useful life of the assets extends over more than one year.

Short Term Debt Financing usually applies to money needed for the day-to-day operations of the social enterprise, such as purchasing inventory, supplies, or paying the wages of employees. Short term financing is often referred to as an operating loan or short term loan because scheduled repayment takes place in less than one year.

The single defining difference of debt versus grants is that the borrowed money must be repaid and, more often than not, entails the payment of interest. Debt financiers require a borrower to have a clearly defined and proven revenue model that can be relied on for servicing of the loan.

Aside from loan repayment, what are some of typical terms and conditions that one can expect to see in a loan agreement:

Amount
Purpose
Final date of maturity
Interest rate
Other fees
Principal and interest payment schedule (ie. amounts and payment dates)
Financial, operating and reporting covenants
Events of default
Form of security

Remember that the cost of finance for any loan is not just the interest rate but also must take account of any upfront or additional ongoing fees that may be charged as part of the loan. For example, the interest rate on a three year loan may be 10% per annum but the annual cost of financing if there is a 1% upfront fee plus a 0.25% annual administration fee would be 10.58% (10.0% + 0.25% + 1.0%/3).

Be aware that one of the keys to developing a successful and long lasting relationship with any lender is ensuring you meet the financial, operating and reporting covenants. These covenants effectively serve as “leading indicators” to a financier of the health of the social enterprise thus non-performance against covenants is almost certain to spark relationship strain between a borrower and financier.

Debt can be a very effective way to reduce reliance on grant funding although requires focus be provided to ensure that the terms and conditions of the loan are appropriate for the borrower. Debt financing is not suitable if the servicing obligations of the loan places your social enterprise under undue financial strain or detracts from your ability to achieve your social goals. As with any form of financing, be sure to approach debt financing with your eyes fully open and with the assistance of a trusted adviser who has the financial experience and know-how to ensure any loan arrangement entered into is suitable for your social enterprise.

The use of debt by social enterprises has increased in recent years as sustainable revenue models have been developed and established proven track record. There is however still a long way to go for debt to be common place in the capital structure of social enterprises for as at today debt to social enterprises largely remains the business of niche financiers. Niche financiers have raised debt funds with the specific objective of providing loans to support social entrepreneurs working across such activities as microfinance, fair trade, alternative energy or affordable housing. It is also becoming increasingly common for foundations to package all or a portion of support in the form of a loan and this trend is likely to increase with the increasing pressure on foundations to undertake Program Related Investments (PRI) and the advent of new legal structures as the L3C. We have also seen over the course of this decade the entry of commercial finance into some of areas of social enterprise however the level activity as yet is miniscule. We expect that as the understanding of social enterprise throughout the mainstream finance community improves an increasing flow of commercial finance will become available. A key to this occurring will be the fostering of improved communication between social enterprises and commercial finance providers so that both parties gain knowledge of the needs and requirements of one another and are able to act accordingly.

In a future blog entry we plan to talk more about the attributes of a successful pitch for finance which provide some insights into the mind of a financier. In the same way that the success of a social enterprise is dependent on knowing the client, the success of seeking financing is premised on knowing and responding proactively to the needs and requirements of the potential financing source.

Our final entry in December will look at equity and we will also in this entry seek to pull together the three entries on “Financing Alternatives” into a table that summarizes the general characteristics, pros and cons of each.

Financing Alternatives: Debt, Equity and Grants (Part 1)

Kylie Charlton — Sun, 23 Nov 2008 21:50:55 -0800

The array of financing alternatives for social entrepreneurs has increased substantially over recent years. Traditionally, grants from philanthropic individuals and organizations have been the primary source of funding in combination with capital of the social entrepreneur and the generosity of family and friends. Social entrepreneurs today however have a menu of financing options available to them that not only includes grants but extends to debt, equity and hybrid financial instruments displaying characteristics of all three.

The momentum driving increased financing alternatives is a result of new entrants into the world of philanthropy coupled with changing practices in philanthropy, alongside the rise of social investors. Philanthropists are seeking to maximize the impact of philanthropy by introducing a heightened level of accountability to grantee organizations; social investors are looking for both financial and social returns. The catch phrase of “doing well while doing good” has advanced beyond concept only, and has been absorbed into the practice of philanthropists, social investors and, in some cases, mainstream investors. Some philanthropists continue to solely provide grant funding to their beneficiaries while others are adopting a wider scope of financial activity. For example, Omidyar Network is a philanthropic investment firm that makes both investments and donations. A number of organizations (such as ACCION International, Grameen Foundation and Unitus) that traditionally provided grants for microfinance have also expanded the scope of their financial support beyond grants to debt and equity. Similarly, organizations that in prior years have been focused on providing debt to microfinance institutions (such as Blue Orchard) have expanded their focus to include both debt and equity. There are also a large number of social investment firms (such as Bridges Ventures, Good Capital, or Root Capital) that are seeking to increase the flow of investment capital to social entrepreneurs around the world.

In parallel, social entrepreneurs around the world have expanded their use of new legal structures as they sought to increase and optimize access to capital. No longer is it a given that social entrepreneurs will structure and operate their activities as a non-profit or non-governmental organization. Social entrepreneurs may be seen operating as registered for-profit companies that balance their social mission with financial objectives. For example, many microfinance institutions around the world have “transformed” from non-profit organizations to regulated, for-profit financial institutions that continue to pursue their social mission while now being able to access new sources of capital – primarily equity – that was previously inaccessible to them. A number of countries have also introduced or are actively introducing hybrid legal structures that combine characteristics of a non-profit and for-profit such as the Community Interest Companies that came on stream in the United Kingdom in 2005.

So, with an array of financing alternatives available and increasing financial sophistication of philanthropists and social investors, how is a social entrepreneur to decipher what is best to not only meet immediate needs but to build a long term capital structure able to provide a sustainable flow of capital for both working capital and expansion? How do each of debt, equity and grants fit into the capital structure and financial strategy of a social entrepreneur? Let’s start looking at these questions firstly from the perspective of grants.

Grants are a well known source of capital to social entrepreneurs around the world and have been the primary source of capital until recent years. Sources of grant capital vary from government agencies, corporate foundations, endowment funds, high net worth individuals, non profit organizations to private foundations.

In its simplest form a grant can be characterized as a “gift” provided for the purpose of public benefit. It is not repayable to the donor nor does it give rise to any ongoing financial obligation of the grantee to the donor. A grant agreement – a legally binding contract between the donor and the grantee – will detail such things as:

Purpose for which the grantee is to use the grant monies;
How the grant monies will be disbursed;
Agreed milestones the grantee must meet to qualify if the grant is structured with progressive disbursements over time; and
Reporting requirements (including social performance metrics) of the grantee to the donor;

Donors have become increasingly focused over the years in imposing increased accountability on grantees in achieving and measuring the social impact achieved with grant money.

When a funding need arises, many social entrepreneurs will think of grant funding as the first option. For some grant funding may indeed be the only financing option available, while for others, the fact that a grant can be simplistically viewed as a “gift” that carries few strings attached is very attractive. In our experience, regardless of how and why you may come to consider a potential grant, it is critical that due consideration be given to how the grant fits into your organization from a strategic, administrative and financial perspective. Some questions that one should ask before accepting any grant are:

Will the grant money allow pursuit of established strategy or does it cause divergence from strategy?
Is the grant for general operations or for a specific project?
If for general operations, what period of time does the grant cover and what additional monies (if any) are needed to complement the grant?
If for a specific project, is the grant sufficient to cover the total cost of the project (capital cost, operating costs plus working capital)? If not, how will the balance of the project be funded?
Is there any opportunity cost in pursuing a specific project? For example, will pursuing the project require other activities to be delayed or reprioritized?
Can the grant be expected to be a one time grant or will it be the start of a long term relationship with the donor leading to a sustainable funding source?
How does the grant interact with existing or future funding sources?
Is the grant structured to maximize social impact?
Are the milestones the donor is requesting achievable?
Are the reporting requirements (including social performance metrics) manageable?
What resources are needed to meet the reporting requirements of the donor?
What is the cost of meeting such reporting requirements?

Increasingly we are seeing innovation in the way grants are structured. A few examples of innovative use and structuring of grants are:

The payment of a multi-year grant for operations paid upfront so that it can be directly managed by the grantee to support a low risk, short term loan portfolio that provided capital to support the expansion of the work of its partner organizations in emerging markets. Thus, the grantee was able to fund its immediate operating needs and also simultaneously expand the financial support it offers to its partner organizations.
Grants have been used to catalyze the flow of private capital thus enabling scale in a number of early structured debt transactions and debt and equity funds established to provide funding to social entrepreneurs. Donors recognized in these cases that their involvement in such structures and funds would directly contribute to the mobilization of sustainable private capital that would otherwise not be available to social entrepreneurs.

Non-profit organizations that have transformed to for-profit organizations have used the donated equity sitting within their balance sheets as a result of prior grants from donors and created community ownership thus sharing the potential financial upside of the success of the transformed entity with the community that it serves.

Innovation in grant making is an ongoing process and one that social entrepreneurs and donors should be encouraged to collaboratively engage in to optimize the impact – both immediate and future - of any grant.

Join us in December to look at debt and equity...

Introducing Capital Ideas

Kylie Charlton — Fri, 07 Nov 2008 12:47:50 -0800

Large, medium and small companies around the world are all actively expressing concern as to how they are going to fund their businesses as domestic and international financial markets experience unprecedented turmoil and access to capital becomes increasingly difficult and costly. Social entrepreneurs likewise are wondering how the current financial crisis impacts their ability to attract capital to support their missions and ensure the critical services and products they deliver to their clients can be continued and expanded.

Many are asking:

What is my business strategy and is it, along with my finance strategy, realistic in the current environment?
Are my current funding sources stable?
Where will new capital come from?
What will be the terms and conditions of new capital?
How can I optimize my chance to successfully obtain finance?

We do not believe there are definitive answers to these questions nor do we believe anyone has a fool proof financing strategy for businesses - social or otherwise –in the current environment. We do however believe that refining and expanding your financing tool kit is more critical now then perhaps it has ever been. Not only are social entrepreneurs operating in a world with unprecedented turmoil in the financial markets but we are increasingly seeing innovation and new levels of sophistication in capital sources for social entrepreneurs. Long gone are the days when donated capital was the only source of funding. All manner of capital – debt, equity, grants and hybrid financing – is now available from a range of traditional and non-traditional sources with new players entering the market looking for strategic (and in some cases opportunistic) opportunities.

Over the course of the next six months you will find us on Social Edge every second week with the goal of helping you build your financing tool kit through sharing some of the insights the team at Unitus Capital has gained from working with clients to raise capital. We will introduce you to different types of capital and discuss the characteristics of such; look at how to determine the financing need of your business and define a financing strategy; unveil the critical elements of a successful pitch to potential financing sources; and provide guidance on identifying and selecting financing sources and building strategic relationships with these sources.

We look forward to seeing you in a couple of weeks with the first in a three part series on “Financing Alternatives: Debt, Equity and Grants”.