How do social entrepreneurs get funding

Forms of financing for social enterprises

Debt, equity, mezzanine or hybrid capital? There is a wide range of financial instruments available for social entrepreneurs.What types of financing are there for social entrepreneurs?

In principle, the same financing options exist for social enterprises as for profit-oriented companies. However, due to an often lower financial return, a lack of willingness or ability to pay among the beneficiaries, as well as a higher risk in underdeveloped markets, social enterprises are often less attractive for traditional investors. Due to the social objectives, there are some sources of finance that private companies are denied, such as donations or public funds.

In corporate finance, a distinction is made between internal finance and external finance based on the origin of the funds.

Internal financing

Internal financing is generally understood to mean all forms of capital provision that take place without the use of external capital providers, i.e. from the company's own resources. These self-generated funds (also known as social business models) can often not cover the entire capital requirement, but they are becoming increasingly important in the financing structure of social enterprises.

The possibilities of internal financing in social enterprises are diverse: In addition to the revenues from the sale of services or products to their target group (e.g. consulting services, special auxiliary products), social enterprises can also generate their own funds through performance fees and subsidies from the public sector as well as membership fees. Service fees are payments by the public sector for a service provided, such as childcare places or care services. Grants, on the other hand, are a form of financial support for projects considered to be worthy of funding by the state. Membership fees are another option for internal funding, which is often found in non-governmental organizations (NGOs) who are committed to the implementation of political or social goals (e.g. Greenpeace, WWF, Foodwatch). This ensures that the organization can act independently of corporate and public money and gives it political legitimacy through its broad anchoring in the member community.

External financing

With external financing, capital is injected into the company from external sources. This capital can - depending on the legal status of the investor - be designed as donations, equity capital, debt capital, mezzanine capital or as a special form of so-called hybrid capital.

Donations are defined as voluntary and unpaid monetary or material donations for a religious, scientific, charitable, economic or political purpose. This type of financing is not linked to any specific consideration on the part of the recipient of the donation, nor can a donation be reclaimed. Donations for the promotion of tax-privileged purposes within the meaning of §§ 52 to 54 of the tax code (charitable purposes, charitable and church purposes) can be claimed as tax-reducing special expenses for the donor. A prerequisite for the issue of donation receipts is the presence of a so-called exemption certificate, the official proof of non-profit status, on the part of the donation recipient. However, donations can also have disadvantages for social entrepreneurs: For example, the time they are received cannot usually be planned, the donation can be earmarked for a specific purpose and the acquisition of donation finance harbors high hidden costs - studies estimate 25-40% of those solicited Funds out. In Germany, around EUR 4.96 billion were donated in 2014, the average donation amount was EUR 36. In addition to private individuals, possible donors include companies, foundations and the public sector:

Gmür (2012). Market and strategy of non-profit organizations - advantages and disadvantages of different groups of donors.

Equity is characterized by the fact that it is made available to the social entrepreneur for an unlimited period and that the investor's payment claims depend on the success of the social enterprise (in the form of profit sharing). Equity providers become co-owners of the company and thus participate fully in the company's profits and losses. Equity financing is therefore usually associated with certain voting and control rights for the investor, such as a seat on supervisory bodies. If the company loses, the equity is initially used to pay outstanding debts. The higher the share of equity in the company's total financing, the lower the risk for the creditors (see debt capital) and the lower the costs of debt. As a result, equity represents a certain risk buffer for the company's creditors.

In the case of corporations, there are legal requirements for a minimum equity capital upon formation. However, liability is then limited to this equity investment. There are no regulations for sole proprietorships and partnerships, as the owners are liable with their private assets. Potential equity investors can be divided into direct investors and funds. Direct investors include founders, family, friends and other private individuals as well as business angels.

So-called venture philanthropy or social risk capital funds are investment vehicles in which several donors have acquired shares and which are invested in accordance with the investment objectives of the fund. The long-term commitment of the investor as well as his purely result-dependent payment claims, which do not burden the company in difficult economic times, are seen as advantageous in equity financing. In addition, many equity investors bring additional know-how into the company in addition to financial support and make their networks available to the entrepreneur. The investors' right to have a say, which is usually associated with extensive reporting to the donors, is often seen as a disadvantage. In addition, there is no tax deduction option for interest and financing costs for equity investors.

External capital is made available to the social entrepreneur by donors outside the company. These funds (also known colloquially as credits or loans) are only available to the company for a limited period and must then be repaid to the creditor. The creditor is thus entitled to repayment of the amount made available and, in addition, usually to regular interest payments. Lenders accept no liability, but neither do they have a say in corporate governance. In order to raise outside capital, it is often necessary to provide so-called collateral, for example the registration of a land charge. In the balance sheet, borrowed capital takes precedence over equity - that is, in the event of the company's insolvency, the lenders are served first and then the equity providers.

The advantages of debt financing include design options with regard to the terms of the financing, e.g. term and repayment. In addition, the social entrepreneur does not have to give up any company shares to the investor, who thus does not have a say. At the beginning of a business activity, however, there is often no or only small financing volumes available due to a lack of collateral. In addition, the concept of social entrepreneurship with a “mixed return” from financial and social success is still unknown to many traditional lenders such as banks and cannot be mapped in the regular lending business.

Mezzanine capital is a mixed form of equity and debt capital that includes legal and economic characteristics of both forms of financing. In the classic variant, capital is made available to the social enterprise for a limited period and interest payments have to be made. However, the investor also receives a previously agreed share of the company's economic success without any voting or influence rights being associated with it.

So-called hybrid capital is a relatively new type of financing for social enterprises. These financing instruments consist of a combination of equity, borrowed capital or donations. The following hybrid financing instruments are currently used:

  • Convertible loan: Loan disbursed, which is partially waived if the agreed interim targets are achieved.
  • Convertible grant: Donation that is converted into equity if the business success is defined in advance.
  • Recoverable grant: Loan that only has to be repaid in the event of a positive corporate development. If the investment does not pay off and a repayment is not possible, the refundable donation will be converted into a classic donation.
  • Revenue sharing models: In return for the granting of a loan, the social entrepreneur gives the investor part of the turnover. The investor takes on the entrepreneurial risk and social entrepreneurs can keep their cost structure variable at the same time.
  • Guarantees: The investor secures loans, the use of which is determined in advance with the social entrepreneur (e.g. organizational development or project financing). In this way, the social entrepreneur can raise additional funds.

In addition, some special forms of social entrepreneurship have emerged in recent years:

  • Financing the person: The Ashoka organization supports specially selected social entrepreneurs for a period of three years with individually set scholarships.
  • Public-private partnerships (PPP): Contractually stipulated cooperation between the public sector and social enterprises, in which the necessary resources are brought in jointly and risks are distributed accordingly.
  • Cooperations with companies: philanthropic partnerships in which the company provides financial resources, transactional partnerships with joint activities or integrative partnerships that are strategically important for both sides.

The following figure summarizes the systematisation of the financing structure according to the type of financing form and the financing sources:

Achleitner, Spiess-Knafl & Volk (2011). Social enterprise funding structure.

Sources and literature tips //

Achleitner, A.-K., Pöllath, R. & Stahl, E. (2007). Financing of social entrepreneurs: Concepts for the financial support of social entrepreneurs.

Achleitner, A.-K., Spiess-Knafl, W. & Volk, S. (2011). In: H. Hackenberg, S. Empter (Ed.). Social Entrepreneurship - Social Business: Doing business for society.

Meehan, W. F. I., Kilmer D. & O’Flanagan M. (2004). Investing in Society: Why we need a more efficient social capital market and how we can get there. Stanford Social Innovation Review, 33-43.

The Bank of England (2003). The Financing of Social Enterprises: A Special Report by the Bank of England.

(C) Cover picture: Didier Weemaels