There is a meaningful search underway for greater predictability in the impact space, a search that could soon go beyond traditional equity. Another form of investment, impact debt, might be both a good future alternative for existing equity investors, and attractive as a new type of offering for entrepreneurs and mission-driven companies.
Impact debt is a nascent but promising opportunity — a unique option for companies that have resisted equity, or felt that traditional bank debt or the nontraditional venture debt weren’t viable options. It’s a largely unheard-of area of financing (beyond traditional developing world microloans or community development bonds) that’s only now emerging as a possible area of interest. Within the impact investing market, impact debt could encourage the risk-averse capital that’s been sitting on the sidelines to finally get in the game.
A Mission-Driven Focus
At a basic level, impact debt isn’t about socially responsible bonds or financing feel-good projects. And it’s not venture debt, a Silicon Valley creation that has lending institutions financing pre-cash flowing companies in the belief that further equity infusions from large funds will keep them solvent. Nor is it a pure credit line, considering that banks restrict how much they can lend, to whom, and under what conditions.
Debt plus impact is about the convergence of mission-driven companies that are currently throwing off cash and willing to take on small amounts of debt instead of larger growth equity rounds that would dilute their equity or cost them company control. They target the same areas as the overall impact market: health, wellness, environmental solutions, sustainable job creation, medical technologies, water and agricultural resource management. And, as with most other mezzanine debt deals, impact debt allows companies generating cash to still maintain strong management teams, quality balance sheets and scalable business models.
To that extent, impact debt is about a mission-driven focus wrapped within the notions of predictability, financial engineering and basic math. For the right company it’s an easy equation: Avoid the equity dilution and onerous protective provisions, potential loss of voting rights and control, and/or the pressure for accelerated exits that often come with larger growth equity rounds. Though some companies might think twice about taking on impact debt at potential coupon rates of 10 to 14% (plus additional warrants), the calculus still might tilt toward debt as an alternative to late-stage equity where companies are far closer to exit.
More importantly, it may offer the comfort of greater predictability to potential impact investors who’ve been waiting for the impact marketplace to further mature, encouraging them to test the waters at last.
Less Volatile Returns
Mike Rose, founder and managing director at Montage Capital, has been out in front with impact debt investing. After years of experience in the debt marketplace, Rose and his partners wanted to do more for society, the environment and the community. Backed by some of their investors, they launched a carve-out fund specifically for impact debt deals. Montage still seeks out companies they would have loaned money to before, but now also targets companies that were unaware of the debt option, or that were too small or didn’t have the exit calculus to warrant a look from the larger growth equity funds.
“Impact companies are reaching the point where they’re more mature,” says Rose. “Though deal sourcing specifically for impact remains difficult, there’s now the opportunity for more stable and less volatile returns within companies that can truly afford it.”
This area of debt isn’t cheap, but it’s far less onerous than some traditional mezzanine debt funds. In fact, demand for impact debt investing should rise as more mission-driven founders and entrepreneurs discover this option.
Flexibility Means Easier Choices
HydroPoint Data Systems Inc. is a prime example. This clean-tech company raised a sizable amount of capital through its early years, yet struggled to gain traction in the emerging water management technology market. HydroPoint finally hit its stride just a few years ago in a space that now merges hardware, software, connected devices and predictive analytics to help companies achieve serious savings in outdoor (and soon indoor) water usage. Google, Walmart, Apple and Lowes are all customers.
With a debt deal, choosing to avoid the costly dilution that could come with additional large equity funding rounds — which it had already experienced — HydroPoint remained free to pursue its mission as an impact-focused business, minus more worries about timely exits and outsized growth rates. Though it may still entertain a small equity round, the company now has the flexibility to more easily choose its desired funding path and exit strategy going forward.
On the equity side, interesting opportunities with attractive upsides, the right levels of capital efficiency and strong management teams still represent the sweet spot in the relatively unaddressed market for small growth equity capital. The chance to have a controlling hand in how certain companies are built remains exciting and continues to offer a path to potentially outsized returns.
However, in terms of math and predictability, impact debt is equally positioned to make a lasting impression on the way mission-driven companies are funded in the market down the road. It might also finally represent a way for a whole new class of risk-averse impact investors to jump into the market, and for a whole new category of mission-driven businesses to scale themselves more reliably, predictably and sustainably.