I once had a venture capitalist tell me he’s a “value investor—just like Warren Buffett.” I thought it funny. Buffet—the Sage—tends to like companies with lots of tangible assets that can be bought for less than book value. This gentleman had just given close to a million dollars to a firm whose worldly possessions were four Macbooks and a couple of thousand lines of code. Upon further investigation, however, I learned what he meant: Like Buffet, he likes a good deal.
Thinking through impact investing, it struck me that there was a way for commercial and impact investors, as well as social enterprises, to take advantage of good deals by filling the real financing gap enterprises often face: Series B—often referred to as the “valley of death” for start-ups.
For those unfamiliar, the concept of valuation and “series” (or rounds of funding) within venture capital is a somewhat interesting proposition: How do you value something without any tangible assets, usually no free cash flow, and in many cases no revenue? The answer: It’s all relative.
“Valuations” (estimates of what the company and its potential are worth) are dependent on the series and the general sense of what the market is telling investors they must pay. Investors have a rough idea of what they are going to pay because they know what was paid for a “similar” business at a “similar” stage of development. Series A is easy, and cheap. Investors are largely funding hopes and dreams: a management team, a minimally viable concept, and a search for a revenue model. By the time a Series C financing round begins, however, a company often has predictable revenue, backlog, and, hopefully, earnings. In short, it is starting to look like a real company. Series C valuations can also carry big numbers—median valuations in 2014 were roughly $139 million, according to Pitchbook, a service that tracks such things.
Series B companies, meanwhile, are generally far from being an actual business. While they often have a proven concept, traction with users, and, importantly, a business model that is starting to make sense, they usually have large gaps—in org charts, customer bases, and/or product lines—that they need to raise capital to fill. Even start-ups with really solid commercial prospects often find it hard to raise this crucial round; for social entrepreneurs, it can be all but impossible.
In short, Series B is a pain in the butt. As venture capitalist Fred Destin wonderfully describes it on his influential blog, Open Source Venture Capital:
Series B is hard for a simple reason: suspension of disbelief fades and is replaced by an increasingly cold, hard look at milestones and progress. Series B is the round where the rubber meets the road, where the promise has to be met with numbers and projections. Series B is the round where hard nosed investors drive ownership up before your company really starts to scale. Series B is … the no-man's land of the startup build phase.
But what if a company had the characteristics of a Series C company—justifying that $139 million valuation—but was only asking for a Series B valuation, which is roughly $37 million? That would be a pretty good deal.
For example, consider a firm focused on creating solar battery charging stations in Lesotho. It has a promising start and raises money from one of the outlets focused on incubating social entrepreneurship, such as Echoing Green, Hub Ventures, or USAID’s Development Innovation Ventures. It gets a prototype going, and through trial and error it develops a decent business plan and a pilot program that shows some traction. What would it do next? Nothing, because subsequent investors are few and far between. Less than seven percent of impact investors invest in early-stage business, according to a recent survey by JP Morgan/GIIN. Mainstream venture capitalists tend to “think local” and are generally afraid of investing in places like Lesotho. By nature, venture capital is a risky proposition, as the vast majority of investments fail, and issues like currency convertibility, governance risk, and shaky legal systems common to places like Lesotho add even greater uncertainty. Moreover, according to the same survey, most impact investors like to invest at Series C and beyond.
But what if they did invest in social enterprises at that crucial B stage? The firms would get much-needed capital. And since impact investors have the ability to offer capital at a discount to market rates, firms should be able to raise capital during the next round at a much lower valuation.
What’s in it for impact investors? Mission and stature. An oft-stated goal of impact investors, especially in emerging markets, is to prove that certain socially beneficial investments are not as risky as they seem. By getting attractive returns in areas where other investors fear to tread, they would pave the way for the less intrepid. This kind of play explicitly subsidizes and lowers the risk of the investment for the next round—it’s about the closest thing to a free lunch on Wall Street (unless of course you are a hedge fund manager, and then lots of people give you a free lunch, and tickets to the Rangers, and rides on their helicopter…).
Meanwhile, commercial investors might come for the deal, see the real commercial potential of some of these businesses, and be more likely to invest the next time a deal comes up outside of their comfort zone.
Series B financing also allows impact investors to punch above their weight. At present, there are roughly $60 billion assets under management (AUM) in impact investing. Take out the money geared toward housing and microfinance—two areas venture capitalists won’t play—and that goes down to roughly $37 billion. Not a lot to go around. Of the remainder, most managers say they are focused on “scaling,” which roughly equates to growth capital (Series C and beyond) in the purely commercial world. As such, they are competing against close to $1 trillion in AUM for deals, much-bigger-name brethren, and no requirement for reporting on social gain—a hallmark of impact investing that can often cost investees a lot to produce.
With Series B financing, it’s a different story. The benefits would be immediately tangible: Commercial investors get a good deal, all things being equal, making them more likely to invest in a social enterprise; social entrepreneurs get much needed funding; and, impact investors become, well, more impactful.