Using Donor-Advised Funds to Invest in Early-Stage Entrepreneurs

Sexperto founder and CEO Nicolas Acosta pitches his social enterprise, which provides Colombian teens with free sexual health information, at Solve Challenge Finals in 2018. (Photo by Adam Schultz/MIT Solve)

Donor-advised funds (DAFs) are a rapidly growing, philanthropic giving mechanism. In 2018, they held $110 billion of capital across the United States—a 27 percent increase over 2016. Yet they have come under criticism in recent years, with some saying they lack transparency and “hoard” money, rather than distributing it to mission-driven organizations. Some believe they serve to provide a tax break for the 1 percent, while incentivizing DAF sponsors to keep the money so that they can bolster their management and investment fees.

Indeed, with no required disbursement rates, money can sit in DAFs for years before donors grant them out. While the money waits, only a small percentage is invested for impact, and even less is allocated to venture impact investing. Most of the $1 billion in assets managed by ImpactAssets, the largest DAF sponsor dedicated to impact investing, is in funds rather than direct deals. Meanwhile, few other DAF sponsors offer formal impact investing options to their clients, let alone the ability to directly invest in social enterprises.

Herein lies the real growth opportunity: What if donors could leverage their DAFs toward impact investing, specifically venture investing? We believe it would help fill the long-standing “pioneer investment gap” for early-stage social enterprises. 

Providing the Patient Capital Early-Stage Entrepreneurs Need

The United Nations estimates a $2.5 trillion annual funding gap in achieving the Sustainable Development Goals (SDGs) by 2030. Less often discussed, however, is the innovation gap. We are missing the innovative solutions we need to educate refugees, bring renewable energy to rural Liberia, or quickly and cost-effectively remove carbon from the atmosphere. Investing in early-stage social entrepreneurs and their solutions is important to bridging this innovation gap and may even help reduce the funding gap by bringing down the cost of solving the SDGs.

Though the impact investing market has grown significantly over the last decade, many early-stage social entrepreneurs still struggle to find early-stage capital—especially when they target the most underserved populations. Most impact investing dollars go to later-stage startups that work in markets with fast-growing economies, such as India, Kenya, Nigeria, or Indonesia. Often these startups target the lower-middle class with software-based products that can demonstrate large customer growth. Later-stage social enterprises such as Byju's, an India-based learning app for students, and Andela, an apprenticeship-based program that matches African software engineers with large corporations such as Viacom, have successfully raised substantial investment capital from both impact investors and traditional investors. But securing financing to scale is far more difficult for social entrepreneurs in smaller and slower-growth countries like Afghanistan or Colombia, entrepreneurs looking at post-conflict or refugee populations, or entrepreneurs with hardware-based solutions. Too many still rely on grant funding or bootstrapping, hindering their path to scale and impact, and ultimately limiting the overall opportunity for innovation toward achieving the SDGs.

Of course, this doesn’t mean social entrepreneurs can’t build investment-friendly, profitable, and scalable businesses. Rather, it highlights that the current impact investing field—most of which is premised on venture capital (VC) and private equity risk/return ratios in specific investment timeframes—isn’t well adapted to early-stage social enterprises. Early-stage social entrepreneurs require patient and flexible capital, and usually don’t conform to traditional VC growth and timeframe expectations.

Take the platform Sexperto, which provides Colombian teens with free, straightforward sexual health information and immediate access to birth control appointments in clinics that match their health insurance plans. Despite filling a critical market need, Founder Nicolas Acosta says, “It’s hard to find impact capital that’s flexible enough to meet local cultural expectations or government requirements, such as long payment terms, temporary contractual limitations, or the willingness to put up with bureaucracy.” Most of Sexperto’s current funding is from the government, but investment funding would allow it to explore additional revenue streams, such as e-commerce for sexual health needs (like condoms and HIV rapid tests), connections with specialists, and sponsored online sexual education courses—lines of business that would help the enterprise reach sustainability and profitability.

DAF capital is, by definition, philanthropic capital earmarked for social good, for which the donor receives a tax deduction without any expectation of financial return. Using DAF capital for early-stage social venture investing is therefore a real opportunity to put a growing pool of idle capital to good use. Donors don’t need to conform to “market-rate” expectations of return, within set timeframes; they can offer flexible terms to social entrepreneurs that allow them to grow to the next stage, where they should be ready for more-typical investing dollars. And although returns are likely lower than market-rate for high-growth technology venture investments, donors can still expect some return and can then re-invest their DAF monies into additional social impact ventures, creating a renewable philanthropy mechanism. This positions DAFs as an ideal mechanism for investing in social entrepreneurs who work in complex geographies and have real potential for impact.

Using DAFs for Social Venture Investing

Over the last 18 months, MIT Solve—which supports early-stage, tech-based social entrepreneurs—conducted a landscape analysis that included more than 100 interviews. Our research found that very few DAFs are invested for impact. A few make recoverable grants to nonprofit institutions, such as Prime Coalition, which then invests in climate-change solutions. These recoverable grants allow the DAFs to potentially earn their money back with upside, but they are structured overall as grants and treated as such accounting-wise. Some invest in impact investing funds, but overall, very few provide direct investments in social enterprises. Blue Haven Initiative, Autodesk Foundation, and the Quality Jobs Fund are among the pioneering exceptions, though none is wholly dedicated to venture investing in a structured way.

Given this whitespace for venture investing via DAFs, in May 2019, MIT Solve launched Solve Innovation Future, a dedicated venture fund structured as a DAF. The structure is unique in three ways: 1) It is dedicated entirely to social venture investing, 2) it will re-invest profits in future entrepreneurs, and 3) it uses semi-standard, entrepreneur-friendly term sheets to minimize transaction costs.

While this model is currently unique, families, foundations, and institutions interested in supporting early-stage social innovators can use their existing DAF capital (or move new capital into DAFs) by taking the following next steps:

1. Select the right DAF sponsor. While many DAF sponsors are exploring impact investing, donors should feel empowered to ask their sponsors for more opportunities or switch to a new sponsor that allows custom impact investments. (You can often complete a DAF-to-DAF transfer within 72 hours.)
2. Define your investment thesis. Donors should build a cohesive investment strategy by answering questions such as: What problem are we trying to solve, where, and for whom (a population, a company, a market)? What amount of risk are we willing to take? Are we looking to get your money back or make more of a return? Answering these questions will help target investments, as well as define the size and structure of each investment.
3. Think about what additional, non-financial support you can provide. Beyond investment, early-stage entrepreneurs typically cite time and expertise as their next scarcest resource. Experienced investors can provide a range of support services, not limited to acting as a formal board member or informal mentor. For example, can you connect an entrepreneur with technology experts, a leadership coach, or outsourced pro-bono services such as legal, public relations, or website building? Can you connect founders with peers who are working to serve similar markets? Can you introduce them to potential clients in your networks?
4. Work with partners. Early-stage social entrepreneurs will continue to require support and additional financing as they grow and scale. Your ability to establish formal co-investment relationships and additional, informal support networks is important to their long-term success, and thus, your investments. Can you bring in several peer funders to co-invest with you? Can you host demo days to crowd in future investments? Can you work with larger funders to ensure that they consider the founders for their next rounds?

We believe deploying DAF capital toward early-stage social entrepreneurs will unlock significant funding to address the pioneer gap, as well as help quell DAF critics. This is a significant opportunity for donors to invest in innovation toward achieving the SDGs, while creating a new and innovative mechanism for renewable philanthropy that supports donors and entrepreneurs alike.

Read more stories by Alex Amouyel & Casey van der Stricht.