As first published on the Living Cities Blog.
Fundraising Challenges Faced by Early-Stage Purpose-Driven Businesses
In this second blog of a three-part series, Tumml's May Samali delves into the fundraising challenges faced by purpose-driven entrepreneurs in their earliest stages of development. In yesterday’s blog post, May mapped the capital landscape for early-stage, purpose-driven businesses in the U.S.
Convincing funders to part with their money is hard – just ask any entrepreneur that has attempted to secure external seed capital. But the fundraising process is especially difficult for early-stage, purpose-driven businesses facing a “pioneer gap.” Why is this the case?
Over the next two blogs, I will explore the four main challenges entrepreneurs face when trying to raise money for their purpose-driven businesses. My insights are informed by the results of a survey of early-stage, purpose-driven companies and funders I conducted at Harvard University last year. This week’s blog post focuses on the first two difficulties confronting businesses when pitching to funders – the “goldilocks phenomenon” and the “chicken and egg” problem.
Financial Returns Are “Too Little” or “Too High”… But Never Quite Right
By definition, purpose-driven businesses contribute to solving social problems while generating profit. But, too often, purpose-driven businesses are forced to respond to funders’ discomfort with their projected level of financial returns. These early-stage entrepreneurs face a “goldilocks phenomenon” – they are accused of either making too much money or not enough money.
“Too Little” Returns
Purpose-driven businesses face an additional hurdle when pitching to traditional venture capital (VC) firms and angel investors. The dominant thinking among this group of funders is, “If you’re doing good in the world, you must be compromising my profits.” While there are some funders that are an exception to this rule, many VCs believe that purpose-driven investments cannot produce the “hockey stick returns” they are looking for. Similarly, most angel investors overlook purpose-driven businesses, believing there are inherent tradeoffs between social and financial returns. The data speaks for itself—only 5% of U.S. angels listed on AngelList are interested in “mission-driven markets.”
As a result of this bias against purpose-driven businesses, many enterprises intentionally avoid using the “social enterprise” label or terms such as “mission-driven,” “purpose-driven” or “impact-oriented” when pitching for funding. This reality is captured in a comment made by the Vice President at Core Innovation Capital, a Los Angeles-based VC firm focused on financial technology: “A company catering to underserved consumers that emphasizes its strengths as a financial technology company, rather than emphasizes the mission that informs its product or strategy, is more likely to receive traditional VC funding.”
“Too High” Returns
On the other side of the spectrum, some purpose-driven businesses with strong financial projections are dismissed as “too profitable” by funders.
Some impact investors do not fund businesses that can tap into mainstream venture capital – even though, in reality, hardly any purpose-driven businesses can access VC. As for foundations, many of their charters contain a blanket rule against providing capital to for-profit entities (including purpose-driven businesses). Foundations’ resistance to for-profit models persists, despite the creation of special financial vehicles – namely Program-Related Investments (PRIs) and Mission-Related Investments (MRIs) – that authorize foundations to provide grants or equity investments to “commercial ventures for charitable purposes.”
However, because foundations can only directly invest in for-profit entities qualified as PRIs, many foundations refrain from doing so. Foundations are hesitant to invest in for-profits due to the uncertainty of whether they would qualify as PRIs as well as unwillingness to use resources to acquire a Private Letter Ruling from the IRS. In reality, foundations underutilize PRIs and MRIs due to fear and a lack of understanding of these vehicles.
The bottom line? When it comes to financial returns, for-profit, purpose-driven businesses are stuck between a rock and a hard place.
The Chicken and Egg Problem
Entrepreneurs Need Proof Points To Get Funding, But Need Funding To Get Proof Points
The second challenge leaves entrepreneurs equally stuck. To access capital, entrepreneurs must overcome a double standard that exists in early-stage, purpose-driven financing. My conversations and survey results show that early-stage funders require more proof points from purpose-driven businesses than traditional investors require of other startups – including strong market traction, a fully-fledged business model, and revenue. These entrepreneurs must prove that social impact and financial returns can actually coincide. The frustrating result is that many funders reject purpose-driven entrepreneurs on the basis that their businesses are “promising, but too early.”
These funders overlook the fact that it takes early-stage, purpose-driven businesses significant amounts of money and time to reach the requisite number of proof points in order to receive investment dollars. As a result, most entrepreneurs cannot get past the chicken and egg problem of how to create a large enough dataset to prove their business model really works. As one entrepreneur put it, purpose-driven businesses “have to figure out a way to get one million dollars in order to raise one million dollars.”
Ultimately, there is a shortage of risk-adjusted catalytic investment capital from investors that are willing to provide the first $1-5 million to prove a concept. Given this situation, purpose-driven companies should target impact-agnostic investors in the near-term and work to build a strong business case for impact investors in the longer-term.
Check out tomorrow’s blog for a window into the third and fourth challenges constraining purpose-driven entrepreneurs during the capital raising process.
This blog post draws on original research conducted by May Samali and published in a Harvard Kennedy School Mossavar-Rahmani Center for Business and Government Associate Working Paper No. 59 titled ‘Mapping the Money: An Analysis of the Capital Landscape for Early-Stage, For-Profit, Social Enterprises in the United States’. Full citations for the data and statistics throughout this blog post are available online.
Image source: Kevin Dooley