You’re a social entrepreneur because you want to make a positive impact in your community. But as in any other business, funding is a key challenge that you must address in order to successfully structure your venture and meet your goals. When considering the type and source of funding to pursue, several important factors will help you make the right decision.
Consider whether the funding source is aligned with your vision for the venture. For example, if your primary goal is to have a measurable impact on society, and profits are not the be-all and end-all of your vision, then it’s important to ensure that investors agree with your goals. This is relevant for many types of investment, but is especially critical when you bring on investors in exchange for equity. If you are interested in creating a business that operates on more than one bottom line, you may want to explore impact investors who have priorities beyond profits alone.
THE EXPECTATIONS AND SOPHISTICATION OF THE FUNDER
Investing in young and growing companies is a fundamentally risky endeavor. However, stories about ventures that explode and make people into millionaires abound, and these create excitement about opportunities to participate. But when you are deciding whether to accept money from someone, it’s important to ensure that they understand the fundamental risks associated with your venture. Therefore, you should only accept money from friends and family after very direct conversations indicating understanding about how things can end up. Do not make guarantees! Of course you want to assume things will turn out for the best, but with any friend or family member interested in investing, be sure to play out the scenario where things don’t go as planned.
DECISION-MAKING AND CONTROL
If you are worried about bringing on new people who will have a say in the venture — if you are worried about giving up any level of control — then it makes sense to avoid taking investments in exchange for equity in the company.
In an ideal world, someone would give you a bunch of money for whatever purpose you wanted without any obligations in return. Unfortunately, this situation is rare. Funding tends to come with some level of ongoing obligation to the funder. For example, in the context of a debt arrangement, you are obligated to pay back the money borrowed along with accumulated interest. Similarly, with an equity investment you are obligated to provide a portion of your profits to the investor, and the investor may have the right to participate in company decision-making. It is important to understand such ongoing obligations and to consider whether you feel comfortable with them.
BENEFITS BEYOND THE CASH
In its most basic and limited sense, funding is about receiving money. However, while money is obviously important to pursuing the goals for your venture, you need not think of funding sources in such narrow terms. After all, many funding sources carry very significant additional benefits. For example, an investor might bring subject-matter or business expertise, or help forge connections to important strategic partners. Other funding sources allow you to test your market fit and gain a network of supporters. Funders are more than ATMs. They also have the potential to open doors that might otherwise remain closed.
With these considerations in mind, let’s dive into the menu of funding options for your social venture.
Crowdfunding, as it sounds, means obtaining money from a large number of people. It comes in several forms, including:
- rewards-based crowdfunding, where each funder receives a good, service, or other perk in exchange for their money;
- equity crowdfunding, where the funder gets a piece of the pie;
- debt crowdfunding, where the funder receives a promise to be repaid with interest; and
- donation-based crowdfunding, where the funder gives a gift to the venture, which can be tax deductible in the nonprofit context.
Beyond where the pros of debt and equity crowdfunding overlap with those of their traditional counterparts, a well-structured crowdfunding campaign can provide numerous benefits beyond raising money. Crowdfunding provides an opportunity to test the market for your venture, and test your messaging. A successful crowdfunding campaign will also create a network of support and raise the profile of the venture. Finally, crowdfunding can be an important bridge to raising additional investment by demonstrating “proof of concept” to other potential investors.
Overlooking again where the cons of debt and equity crowdfunding overlap with those of their traditional counterparts, it’s important to note that many crowdfunding campaigns have led to horrible PR for ventures that were unprepared to follow through on early success. For example, if you have thousands of people buy your product right away, but then you are unable to fulfill promised orders, the damage to your venture’s reputation significantly outweighs the benefits of a good start. Additionally, crowdfunding generally does not provide you with the opportunity to screen the individual personalities of investors, so it’s hard to know what the expectations of each might be — especially in the context of equity crowdfunding.
THE NEW EQUITY CROWDFUNDING RULES
Until recently, equity crowdfunding efforts could only draw from a limited pool of investors who qualified as “accredited investors,” i.e., those with some deep pockets. Recently, however, the Securities and Exchange Commission approved rules allowing for equity crowdfunding from the general public as well. Some perceive this as a huge opportunity for funding social ventures, while others view it as a big risk, as opening the pool of potential investors also means managing expectations and legal formalities associated with having a lot more owners in the company (who may not be experienced investors, and may have difficult-to-meet expectations), and further, having a large number of people on the books as owners in the company could turn off larger investors.
The new equity crowdfunding rules allow entrepreneurs to raise up to $1 million in any 12-month period, with, of course, some additional rules involving required disclosures and limits on the amount of investment from any given source. One advantage of equity crowdfunding is the ability to go beyond banks and traditional investors and appeal to those consumers and supporters who may be more aligned with your mission. However, before diving into equity crowdfunding it’s important to consider the impact of having hundreds (if not thousands) of owners in the company — after all, you are still giving up a piece of the pie, and you should consider how your plans will match the expectations of the crowd.
Bootstrapping basically means paying for the setup costs of your venture out of your own pocket without outside financial assistance. This is usually how folks get started and can be a realistic long- term approach if you have low overhead and a solid revenue model. But if you are looking to scale quickly or you do not have a lot of cash to invest in your business, this is likely not the best approach.
You maintain all the control, you have no obligations to any outside parties, and you don’t have to worry about anyone’s expectations but your own.
There are limited opportunities for growth unless you have a revenue model that is built to scale on its own. And you may be missing out on opportunities for helpful outside input.
Debt generally refers to an arrangement whereby you receive money that you are obliged to repay over time with interest; in other words, a loan. The investor’s economic opportunity comes from receiving interest rather than a percentage of profits. For the investor, then, debt is less risky but comes with lower potential economic return.
You receive money without giving up control of the enterprise.
You have to pay the money back with interest. Moreover, if you cannot pay when it’s due, there are penalties; in the worst cases the lender can force your venture into bankruptcy. Additionally, if your venture does not have a significant credit history and/or assets to back the loan, then it is very likely that the loan will have to be personally guaranteed; in other words, your personal assets could be on the line if the business cannot pay back the loan.
With an equity investment, you are providing a piece of the pie to the investor in exchange for money; e.g., stock in a corporation or membership interest in an LLC. Because they now own a piece of the company, the investor generally has the opportunity to participate in the decision-making of the venture. The investor’s economic opportunity comes from the ability to share in profits. Though risky, an equity investment comes with a higher potential return than a loan.
Generally, you do not have to pay back the investor, though they do get a share of your profits.
You give up a certain amount of control and a percentage of the economic upside in the venture. To make a somewhat inflated generalization, equity investors often focus more on profits and economic growth than mission, so it’s critical that you and your investors are mission-aligned and have the same expectations for the direction of the venture. In fact, sharing control with an investor who aligns with your mission can be a pro.
If your venture seeks to solve significant societal issues, similar to the work of a nonprofit, then, first of all, thank you for being awesome! Additionally, you may be eligible for a specific type of investment known as a Program-Related Investment, or PRI. PRIs come from foundations that typically fund non- profits, and they provide the opportunity to make a return while also meeting their 5 percent payout requirement. PRIs can be structured as either debt or equity. In order to qualify for the benefits of PRI treatment, an investment must satisfy a number of strict requirements:
- The investment must be for the primary purpose of accomplishing the foundation’s exempt purpose, which might be educational, charitable, or otherwise;
- Generating income cannot be a significant purpose of the PRI (meaning would an investor seeking only profit make the investment on similar terms?); and
- The PRI cannot be used to influence legislation or political campaigns.
Funding is important. Securing money can be one of the more stressful aspects of being a business owner. But if you approach the process in a thoughtful manner, you might find that you are not only raising necessary money, but bringing on strategic partners and opening new doors to make your venture a success. The suggestions above provide a high-level overview of several common types of funding. And though we have focused on how to set up ventures as for-profit entities, many of these principles apply in a nonprofit context as well. Finally, please keep in mind that many funding options involve complex securities laws, and it is smart to work with an attorney who knows the area.