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The Value of the VC Model for Social Enterprises

March 29th, 2010 · View Comments · VC, socent

This past weekend was the second installment of the StartingBloc Institute for Social Innovation (held at NYU again), and it has been a great experience once again, especially as it relates to the refining of some of my previous thoughts regarding “social venture capital” and what value-add it has to the existing world of (mainly non-profit) social enterprises.

In the process of explaining to many people the interest that I and many others at StartingBloc share for the untapped potential of investment in for-profit social enterprises, it has often been difficult to elaborate why a funding model like this is even needed. Much of it stems from a limited understanding of how venture capital operates, but I have also seen over this weekend that a significant reason for confusion has also been due to weaknesses of my explanations. Thanks to those who have listened to me and explained the areas or concepts that trip you up!

Before I dive into a more detailed explanation of some of the main value-adds of VC investment and the reasons why social enterprise founders may be better suited to incorporate as a for-profit vs. a non-profit, let me just give a brief overview of what makes a VC fund a VC fund, courtesy of “Venture Capital and the Finance of Innovation,” a great textbook written by a former Wharton professor, Andrew Metrick.

  1. A VC is a financial intermediary, meaning that it takes the investors’ capital (money from limited partners or LPs) and invests it directly in portfolio companies.
  2. A VC invests only in private companies.
  3. A VC takes an active role in monitoring and helping companies in its portfolio.
  4. A VC’s primary goal is to maximize its financial return by exiting investments through a sale or an IPO.
  5. A VC invests to fund the internal growth of companies.

Now, there are several characteristics I could talk about to differentiate donor funding (non-profits) and VC funding (for-profits), but for now, let me just focus on number 1: A VC is a financial intermediary. Just as a bank takes money from depositors to loan to business and individuals, “a VC fund takes money from its investors and makes equity investments in portfolio companies (aka startups).” What are a VC fund’s investors? These would include big pension funds, banks and insurance companies, university endowments, etc. Basically, these  institutional investors are ones with LOTS of money.

At the end of the day, that’s one of the huge benefits of the limited partnership model. It enables startup companies to access a HUMONGOUS pool of capital from the billions upon billions that institutional investors have. Imagine if a startup company had to had to go directly to CalPERS every time for an investment. Instead, startups can approach VC funds, which have aggregated the available institutional capital and also have the expertise to invest efficiently. This unparalleled access to capital flows is a big factor of differentiation.

Now, I will shift from talking about traditional VC and now apply some of those previous points to “social VC” more specifically. Instead of a model where non-profit ventures have to continually be in the process of fundraising, writing grant proposals, etc., for-profit ventures can they access the capital they need through aggregated sources at discrete times, capital that has been provided from institutional investor to the startup, via the financial intermediary (aka VC fund). Granted, not all social enterprises should be going the for-profit route. That is definitely not what I am saying. However, what I AM saying is that there are distinct advantages of the VC model that would better suit some social enterprises, and that developing a funding infrastructure for these for-profit social ventures would have a beneficial impact on the total social good / social impact that we can achieve!

Please add your comments and additions to this post. I’ve only covered one element here (VC funds as financial intermediaries that give wider access to capital), so feel free to add on!

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  • Here's a follow-up from Nathaniel Whittemore, from an email exchange we had about this post. I asked him his thoughts on the for-profit vs. non-profit question and here's what he had to say:

    "For me the forprofit / nonprofit question is about who you want to be answerable to and what's best for the company. Who you want to be answerable to is a bit of a choice. What's best for the company is often clearer to me. I tend to think that if you look at the value you're creating, the question is who is buying that value? Is it the person or group who derives primary value from it, or some intermediary who is subsidizing it? The closer to the end user paying you are, the better the arguments are for being a for profit. I think basically all nonprofit tech service providers, for example, should be for-profit."

    "Nonprofit paying for a volunteer management software should be a for profit because if they're not, they can convince grantmakers instead of their customers to pay. Bad thing, usually. A group making a new type of light for rural African communities that it wants them to pay for but in the beginning needs to reduce the cost by half, it may make sense to have a subsidizer like a foundation, which would push towards nonprofit."
  • Excellent article Mark!
    As quoted from the angel investors on "Shark Tank", Money has no soul.
    In your opinion, do you see Venture Capitalists limiting their returns by investing in social enterprises? If so, I am sure the LPs would not be happy with that.

    Secondly: You mention the how Venture Capitalists make returns on their investments: by sale or IPO. However, what would be your stance on a social enterprise being acquired by a Fortune 500 for a pretty hefty premium due to its technologies or synergies etc. Do you see the VC turning down the sale to the Fortune 500 company?
  • In terms of your second point, that's a good question, though probably one that hasn't been discussed too much because there are few companies that are even close to being at that stage, given how new for-profit social enterprise investing is. I'd imagine it'd be on a case-by-case basis, though, taking into account the issues with mission and culture change that happen in all M&A but may be especially important for social enterprises.
  • Caleb, thanks for bringing up the issue of returns. Obviously, if LPs are concerned solely with financial returns, investing in an asset class with is by definition a "worse" asset class (i.e. lower financial returns), would not be a smart bet. There are a variety of investors for sure, some that care about a "blended return" incorporate both social and financial return, while there are others that are unwilling to sacrifice financial return for social return. For a good graphic of the spectrum of potential investors, you can go here: http://www.socentvc.com/wp-con.... Read the Monitor Institute it came from right here: http://www.monitorinstitute.co.... Even with that said, though, with the BoP being as large of a market as it is (read Prahalad for that!), I find it hard to imagine that great companies with great products focused on social good won't be exceedingly successful. However, it is true that this is not a proven asset class quite yet. As I mentioned in a previous post, the sector needs a "home run" or poster child of sorts, it needs to prove its worth before LPs will be willing to fork over money. But now we run into a chicken-and-egg problem again!
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