Social entrepreneurs require different types of financing at different stages of their endeavours. Venture philanthropy is the type of funding that social enterprises need in the early seed stages, whereas impact investors kick in at the start-up and growth stages, when there is a proven business model and some track record.
Due to the risky nature of venture philanthropy, investors at the seed stage are often philanthropic ones who do not demand a financial return. Impact investors, on the other hand, invest in companies and organisations with the intention of achieving both a societal impact and financial returns.
Investors at the seed stage are often philanthropic ones
The ultimate objective of impact investors is to plan, oversee and execute the investment and the exit strategy while leaving behind a social enterprise with a stronger business model that is capable of attracting and managing the resources it needs to achieve its social impact mission in the long term.
There are five key steps that impact investors and social entrepreneurs should follow during the investment process to ensure a successful relationship and maximise social and financial returns:
1. Deal screening
The first step of the appraisal process is a preliminary screening of the available investment opportunities to eliminate social enterprises that do not fit the overall investment strategy.
At this stage, the impact objectives set by the social enterprise must match the impact investor's overall strategy to pass the preliminary screening.
The impact investor must also assess the needs of the social enterprise from the perspective of non-financial support to ensure that the social enterprise's general needs can be efficiently and successfully addressed by the impact investor's core non-financial support strategy.
2. Due diligence
During the due diligence step, impact investors carry out detailed screening and analysis of the social enterprise's business plan.
To assess the potential social impact, the investor must first have a detailed understanding of the social enterprise's current and expected social impact. During this stage, it is helpful if the social enterprise has already developed a theory of change to show how its activities lead to the desired social change. Otherwise, the impact investor can include theory of change development as part of its non-financial support.
One common mistake leading to investment failure is to overestimate the capability of charismatic management teams
The impact investor should also check whether the social enterprise has an impact measurement and management system that works sufficiently well. If not, it should include the development or improvement of such a system in the budget.
Impact investors should also analyse the management and governance of the potential social enterprise. One common mistake leading to investment failure is to overestimate the capability of charismatic management teams.
3. Investment decision and deal structuring
In this step, the impact investor and the social enterprise define a set of terms and conditions that specify their agreement.
At this stage, the impact investor should ensure that the leaders of the social enterprise are deeply committed to the organisation's social mission, are on top of the business plan and its future needs, and have the necessary skills and expertise to execute their plans effectively.
To minimise the risk of failure in deal structuring, the impact investor can start with stepped investments in target social enterprises – for example, by completing small investments in multiple social enterprises to get to know the organisations and build mutual trust. Financing instruments can also be structured to reduce risk and incentivise the social enterprise to reach its goals.
4. Investment management
Monitoring the social enterprise's advancement towards achieving its impact and financial goals is an integral part of the investment process. As a general rule, to measure the impact of the enterprise, the impact investor should assess output indicators more frequently than outcome indicators.
The social enterprise should report on its progress towards achieving the indicators every quarter, every 6 months or every year throughout the investment period. It is advisable to agree on reporting requirements up front and to align with co-investors to eliminate the burden of multiple reporting responsibilities.
At the social enterprise level, it is important for social entrepreneurs to verify and value the impact for key stakeholders. Key stakeholders, especially beneficiaries, should be regularly involved – at least once during the investment period – to verify that their expectations are met. Verifying and valuing results and impact with the involvement of the key stakeholders is the best reality check to assess the value created by the investment.
The data collected and analysed should be used to implement any necessary changes, such as providing additional or different non-financial support and developing corrective actions should there be any deviation from the agreed plan.
At a certain point in time, the impact investor can no longer add value to the social enterprise. This is when the relationship should be ended. An impact investor will aim for the social impact to be either maintained or increased after the exit and try to avoid exiting under conditions that cause the impact to decrease. Obviously, the achievement of a financial return is also an important factor to take into consideration.
In order to safeguard the social impact of the investee after the exit – and consequently of the impact investor itself – the impact investor should assess whether the potential new investors have a positive interest in the investee's social mission and what their expectations are with regard to financial returns.
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