Financial Innovation and Equity Crowdfunding

Equity crowdfunding

• Crowdfunding is a collective resource-pooling practice used to organizations that aggregate rather small amounts of capital in a limited time-frame from many individuals who share a common interest in a specific idea, project or business. It’s a form of alternative finance that operates via online marketplaces. This kind of investments covers a great variety of sectors and it’s widespread mainly in U.S.and Europe. It can be divided in four branches (equity, debt, reward and donation-based), with the first one that is considered to be the most adequate for generating impact opportunities.
• Equity crowdfunding is the process whereby people invest in an early-stage unlisted company in exchange for shares in that company. In this way investors enjoy the rights to receive dividends, to make follow-on investments and to vote. They stands to profit if the company do well, but the opposite is also true, andthey can lose some of all of their investment. It is usually subject to capital markets and banking regulations and is therefore restricted in terms of funding amounts, geography and marketing possibilities, limiting the possibility of impact initiatives being funded via equity crowdfunding.
• To receive these investments, a firm presents itself on some specific platforms, explaining its goals and the money target to be reached before the end of the program. If the project is successful, the firm get the earnings and goes on with the business plan, otherwise, investments are not finalized and investor doesn’t lose his money. Start-ups always look for more capital, but they need to be attractive to gain investors’ attention, and this can happen through researches and analysis about investors preferences, according to their values and engagement.
• The current total value of equity crowdfunding deals rests around $1.7 billion annually, but this type of investment is following a growing trend and that number is expected to rise to $5 billion by 2022.
• Democratization of capital: the final outcome of the project depends only on a market-driven valuation of the quality of the business plan without any effect from asymmetric information and exclusivity.
• System resilience: by expanding the concentration of wealth from traditional financial services to inter-connected crowdfunding networks, any future financial shocks may be dissipated thanks to a larger, more defensible footprint.
• Real rates and prices: fluctuate according to crowd demand (more realistic) rather than the perceived interest of a few financial experts.
• Funding diversification: SMEs and investors are able to diversify their respective funding sources and destinations in terms of both sector and geography.
• Financial stability: crowdfunding generates the possibility for investors to receive a tangible return and this makes it less likely that funding flows will stop.
• Big data: crowdfunding platforms are capable of developing real-time Big Data for socio-economic trends and patterns. Cooperation with the public sector could lead to a more efficient allocation of public funds and incentives based on crowd activities.

Advantages Risks

Entrepreneurs:

• Reputation management: an individual client, shareholder or competitor could tarnish their reputation through social media and other web channels.
• Business impact: crowdfunding platforms should establish a minimum standard of social and environment responsibility as a value proposition for investors and quality endorsement for entrepreneurs.

Investors:

• Fraud: crowdfunding space may become an easy target for fraudsters after the advent of more liberal financial regulatory frameworks
• Valuations: risk of under-/over-valuations due to false assumptions.
• Follow-up: communicating with a large group of disparate stakeholders is difficult, especially if they have equal voting right
• Investor risk: acceptable risk in crowdfunding is difficult to monitor.
• Business impact: achieving transparency over the allocation of invested funds may be difficult, since crowdfunding addresses private markets without standardized reporting systems.

Regulations

Regulation and legislation should aim to protect investors while stimulating market efficiency and transparency. Today because of incumbent investor protection, regimes exclude a large number of potential investors. Crowdfunding provides new and different opportunities to ensure transparency and protect investors.

In Europe, crowdfunding is largely regulated by national law, since investors try to escape the high administrative and financial costs of European legislation, but this fragmentation makes cross-border transactions impossible (or too much expensive for SMEs). For this reason, potential investors are currently excluded from crowdfunding opportunities solely based on their geographic location.

Challenges for the future

• Impact measurement: today crowdfunding platforms have limited or non-existent monitoring and evaluation activities, and none for impact. Investors should ensure that their issuers allocate funds raised in a socially and environmentally responsible manner. An acceptable solution may lie within due diligence and a light monitoring process following investment.
• Ticket size: some argue that the risks involved in impact investing are greater than those in typical venture capital investments. As a result, there is concern that the market for equity crowdfunding for impact will be constrained by low average ticket size.
• Education: the lack of financial and technological know-how in the social sector is indicative of an education-related challenge. In addition, social entrepreneurs will need internet and social-media fluency to support a successful campaign.
• Social entrepreneur protection: equity crowdfunding platforms will need to establish mechanisms to protect entrepreneurs from excessive financial and reputational risks.

Loan types

Secured Loans

• This describes a loan where the principle sum is guaranteed by collateral assets, which can be repossessed in case of default.
• Usually these incur lower interest rates.
• Assets can be repossessed.
• Assets are needed in the first place.

Given the need for collateral, secured loans are often seen in the shape of mortgages, which can help early stage social enterprises reduce one of the largest costs of many businesses: renting premises.

Unsecured Loans

• An unsecured loan is issued with no collateral to guarantee the creditor’s repayment. Therefore this type of loan relies on the borrower’s trust- or creditworthiness.
• Due to higher risk to the creditor, a higher interest rate will usually be demanded.
• Traditional banks may not be as receptive to unsecured loan requests for social impact investment purposes with no track record of viability, i.e. at an early stage.

Unsecured loans might be more suited to scaling up workforce and working capital, and therefore productivity with the expectation of higher revenue.

Considerations:

• Given that the impact investment market as of yet is not fully developed, companies seeking funding at an early stage may still face uncertainty as to when or if they will be generating income. This needs to be taken into account when applying for a loan that requires regular interest payments early on
• Given the aim of social impact, lenders may be more lenient on loan terms relative to the wider business world. In particular, social lenders may prioritize impact over financial return compared to mainstream institutional lenders.

Revenue Participation Agreement

What is a Revenue Participation Agreement?

It allows the investor to collect part of the revenues from a charity or social enterprise invested. This solution helps those organizations where the share capital is not possible due to the legal structure, and also for those in which debt financing is too expensive. The sale of a Revenue Participation Agreement establishes a relationship of buyer and seller, while in a loan we find a relationship of a borrower and lender. The risk of the investment is shared between the investors and investees, and the investors are rewarded for the investment made. The investor will decide whether or not to invest based on the likely levels of the future revenue streams.

This financial instrument guarantees a share of revenues, not profit. The investee is not worried about profitability, which may lead to zero returns to the investor: there may be incentives to manipulate information just to avoid paying out if we consider the profit instead of the revenues.

The risk of a loan in lower than the risk of investing in a Revenue Participation Right: with a loan, it is always possible to get something in case of default, whilst with this mechanism it is not possible. So, it is expected that the investors require a higher return. Usually, investors expect a target IRR of around 10% and determine the return on projected future cash flows based on that.

Revenue Participation Agreement

What types of Revenue Participation Agreements we may find?

There are two types:

Returns linked to gross revenue: a specified share of gross annual revenue is given to the investor;§ Returns linked to incremental revenue: the investor receives a share of gross annual revenue less restricted grants, and/or annual revenue above a certain level. In the first type, if there is already a certainty about the viability of the investee, we may consider this agreement similar to a preference share; in the case of a startup, the approach is closer to an equity risk. In the second type, the risk faced by the investor is higher, given that only the revenue streams from “trading” activities are considered and/or only get returns above a certain threshold. Nevertheless, the second type is closer to an equity approach.

It is very important that the seller knows his profit margins very well. If the margins are not that large, the seller may not be able to cover the business expenses due to the loss of a percentage of revenue over time.

Revenue Participation Agreement

What the advantages over debt and equity, both for the social enterprises/charities and for the investors?

The investor uses the gross income to determine the IRR, but it is worth noting that only money coming from the unrestricted income can be transferred to pay back the investment. Those who offer grants, which is considered as a stream of restricted income, would not enjoy seeing their money being used to pay these investments.

A problem that may arise in the market is the potential adverse selection, where there is a big chance of strong organizations rejecting deals because they consider it to be too expensive and weak organizations accepting any deal. It is crucial that the forecasts are as accurate and realistic as possible, given that the IRR depends entirely on it. The margin of error considered by the investor in those forecasts are used when deciding how much the IRR should be.

Social Enterprises and Charities Investors

• The amount paid to the investor (the cost ofcapital) is tied to revenue/performance and itis not a fixed installment;
• Less costly and quicker than raising equity;§ Useful if share capital is not possible.
• No legal barriers due to the composition of the investee;
• Given the riskiness of the investment, there isan opportunity to get higher returns. Hybrid of grants and loan

Hybrid security: single financial security that combines two or more different financial instruments. In impact investment is usually seen as a combination of grants and debt.

• The grants are given in the form of granted capital which does not require interest payments nor repayment in the end of the period.
• The financing may include some form of interest payments align with outcome goals and needs.

Most common example: Recoverable Grant

Definition: Loan that only needs to be repaid if the invested company reaches a pre-determined success outcome. In case of failure to meet the success requirements, this loan is converted into a grant.

Some practical examples already implemented:

Access Foundation: it supports the development of enterprise activity to grow and diversify income. They do this with 2 main programs:

1. A combination of grants and loans in 45£m blended finance, which helps to bridge the gap between charities/social enterprises and social investors. The loan fund which includes a grant subsidy allows the fund manager to make smaller loans and absorb more risk, or unsecured loans.
2. Grant funding for capacity building and investment readiness programs from the 60£m endowment.

Clean Vehicle Assistance Program: it helps lower-income families in California to buy electric or hybrid cars. It combines an initial grant for the down payment of the loan with monthly installments using fair interest rates.

Hybrid of grants and loansMain challenges for hybrid financing:

• There is a financing gap in early stages of grow. Enterprises are too small for more commercial investment and too large for philanthropic financing.
• Prevailing mentality in the financial industry still thinks that there is only two different possibilities: capital is given without expecting any positive financial return or there is no capital repayment.
• Legal structure is still not ready for this innovative financial instruments.
• Setting up a hybrid financing vehicle or mechanism implies the need to align objectives.

Why do we need grants and not just loans when financing SPOs?

1. Grants may be essential in the very early and proof-of-concept stage, because entrepreneurs need risk-free incentives to get things off the ground in the beginning and to scale to a larger market
2. Grants may be useful for specific purposes, for example when enterprises are entering in a completely unknown market or for well-established enterprises when they want to large scale monitoring and evaluation methods to create awareness of their impact.

But one thing is agreed by most of the investors, grants should not be given in perpetuity to SPOs. Grants should be in place to create incentives for growth and close some investment gaps in this financial industry.

Vision stagekey challenges key needs

High degree of risk and sweat equity

Access to support and capital

Limited financial resources

Develop budget forecats and articulated financial goals (thatalign with social ones)

Overly dependent on a few funding sources and most of themare donations

Define social outcome metrics and means of collection

At this stage, the impact venture has an elevated need for external financing in order to enhance development its, yet it lacksretained earnings

The majority of the businesses with a social impact represent for investors a high-risk investment mostly due to lack of pastinformation. Due to this, very few impact ventures can take equity investment, thus, it would be hardly possible to grantinvestors a large financial return.Due to this, equity crowfunding seems to be the most suitable especially because of its collective aspect. Moreover, it offersthe possibility to offer non-financial rewards like invitation to events or merchandise. The only drawback is that it might bedifficult to attract the necessary amount of crowfunding investors without investing time and capitdal in a crowfundingcampaign.

Another feasible instrument is a hybrid of grants and loans, in particular convertible grants, because it creates incentives for entrepreneurs to take on risky projects that may have positive impact. The iinitial grant is crucial for enterprises in the vision stage because they have no assets nor credibility to secure loans.

Start-up stagekey challenges key needs

Difficulty in managing cashflows

Reinforced need for adequate financial management skills and capabilities within social enterprises

Building financial capacity

Need to support all the costs related to the initial phase of their activity.

Balancing social and financial objectives

Developing a timeline for addressing social issues

The social enterprise has been operative for a few years yet the main issue is that revenue merely covers for operating costs.

The majority of impact venture in this stage of their lifecycle struggle with the management of cash flow that adds up to the difficulty to invest in new assets.

A solution to this could be represented by unsecured loans. This will allow investees to obtain a loan without the obligatio to secure it to na asset. This seems feasible because in this stage not many impact venture own assets nor have the necessary capital to obtain it. Another advantage for the social enterprise is that it allows to negotiate the terms of hte repayment yet the interest rates of unsecures loans tnd to be high.

Growth stagekey challenges key needs

Managing the bottom lines and building ethical organisations, inside and out

Growth Capital (EXPAND)

Ensuring there is the equipment and infrastructure to build growth

Reliable and diverse funding schemes

Achieving financial sustainability goals

Debt and Equity capital in different formsIn this stage, impact venturea have managed to further develop their products or services and are aiming at gaining long-term financial stability. In order to do that, it would be advisable to purchase an asset.

Social banks offer commercial mortgages with guidelines similiar to the ones of general banks. These share similar risk as failing to repay will lead to the sell of the asset but unlike high street banks, social banks take more into account the social apect of the enterprise.

Hybrid of grants and loans for the growth stage, gap between philanthropic capital and social investors (too big for philanthropists and too small for social investors)

Moreover, companies are looking for financial sustainability, they need to growth, but senior debt requires them to take a higher interest rate, to accept covenants. Also, if the cost of debt is acceptable but the risk of a floating interest rate is too high, then quasi-equity can be a good solution. It only requires a share of the revenues, which allows the company to control how much to pay back.

They do not pay more than what they can afford.

Scaling stagekey challenges key needs

Managing the bottom lines and building ethical organisations

Growth Capital

Ensuring there is the equipment and infrastructure to build growth

Reliable and diverse funding schemes

Achieving financial sustainability goals Debt and Equity capital in different forms This stage refers to the possibility for the impact venture to make proper use of their financial stability to explore expansion possibilities. The social enterprise might decide to undertake new social projects or to target new markets. The impact venture will shift focus from short-term survival to long term planning.

Crowfunding seems to be a suitable option at this stage too as Financial sustainability is often mentioned as one of the main barriers to a scaling trajectory, and a financinggap has been identified for early-stage social enterprises wishing to scale.