Social change work is hard and frustrating and wonderful and terrible; it is also, at times, funny, quirky and just plain fascinating. With this blog we hope to capture all that goes into what we do at Capital Good Fund, and we invite you to join the conversation!

Wednesday, September 17, 2014

Financing Nonprofit Growth, Part 2: The Menu Of Options

How Companies Grow
This is part two of our series on Financing Nonprofit Growth.  You can read part 1 by clicking here.

Joe The Entrepreneur
Let's start with the model with which most of us are familiar: Joe the Entrepreneur in his proverbial garage, ready to change the world.  Joe, you see, has invented something amazing--let's call it a combination kite and predatory drone, the Kite Drone--that he thinks is going to sell like chocolate in the desert (dessert in the desert, anyone?).  He puts together a business plan showing how he is going to take 1% market share in two large markets: military drones and, well, children's kites.  The financial projections are solid, the team is experienced, and now it's time to get investors; all he needs to do raise is $250,000 for a first round of funding.

As an entrepreneur, at this stage your biggest challenge is that your company is, at present, worthless: it has no assets, no revenue streams, no customers; it is just an idea, all potential energy.  Your pitch is based entirely on the promise of future earnings, and the investment is therefore inherently risky.  Lenders, such as banks, don't like risk; sure, they may make a loan to a new Pinkberry franchise or a restaurant--these are, in a sense, "cookie cutter" businesses in that the banks have seem them time and again--but they aren't going to want to touch the Kite Drone with an, um, remote control.

So what is Joe the Entrepreneur to do?  The answer: venture capital!  Venture capitalists do like risk; their business model is all about making bets on good ideas and good companies, in the hopes that they will break even on some, make a little profit on a few, and hit the jackpot with one or two.  As a result, they are less afraid of failure; if they think the Kite Drone has a reasonable chance of growing to the point that it's purchased--by either Hasbro or Raytheon, I guess--they will probably invest.
Now when a venture capitalist, or VC, invests, she does not make a loan; rather, she purchases equity, a concept that is going to prove crucial as we continue to explore nonprofit growth (spoiler alert: nonprofits cannot give away equity).  Equity is defined as "the value of the shares owned in a company," but it's much more simple to just think of it as ownership.  In other words, the VC purchases a share of the company, just like you do when you buy shares of a public traded company like Google or Apple.  The difference is that, at this stage, the company is privately held, and the shares are worthless; they only become valuable if, and when, the company is purchased by another company (think Facebook's purchase of Instagram) or when it goes public (think Twitter, Google, Facebook, etc.).  In either of those instances, the value of the VC's initial investment goes through the roof; this is why every time a company goes public, a lot of people become instant millionaires.  The shareholder can also make money in the form of dividends--basically a share of profits the owners receive if the company earns a profit (or the company can reinvest the profits into the company to keep it growing, or do a combination thereof).

Armed with these investments, Joe should now be sufficiently capitalized to go out and build prototypes, hire employees, do market research, etc.  As he gets bigger, he will start to use other financial instruments--loans and lines of credit, in particular--but let's not get ahead of ourselves.

Bob The Nonprofit Founder
Now let's imagine Bob the Nonprofit Founder, who has started Fun Finance.  There is a need for his products and services--small loans and financial coaching--and a huge market opportunity (the predatory loan industry he's going after does $100 billion in revenue).  He has also assembled a great team, put together a solid business plan and is ready to raise capital.

Just as with Kite Drones, at this stage Fun Finance is also worthless; unlike Joe, however, Bob's company will always be worthless (in the sense that no one owns it or profits from it, not in terms of its value to society!).  Bob needs money to hire staff, build data systems--all the same things as Joe--but he has one major roadblock: he can't raise equity, because as we've seen, no one can own a nonprofit.  So what does he do?  As you can imagine, as a nonprofit, he seeks philanthropic funding from a combination of corporate, community and family foundations, as well as individual donors.

This is where the issue of timing becomes paramount.  If you're Joe, you will spend a few months doing an initial round of capital raising, after which point you'll be ready to get started. It's key that this process not take too long, for a number of reasons: Joe needs to get paid, as do his staff; he may have started spending money, something he can't continue doing without new investment; and so on.  For Bob, the whole process is inordinately longer.  The nonprofit fundraising cycle can be long, fickle and frustrating.  He may start writing grants in June of 2008, win his first $2,000 grant in February of 2009, and by year's end still have only raised $30,000.

Let's now consider what Fun Finance and Kite Drone look like at the end of their first year. Fun Finance has raised $30,000 in dribs and drabs, meaning that it has been unable to hire anyone full time; Bob is a part-time Executive Director, and the rest of the team are devoted volunteers.  They had to forego a radio ad campaign because the grant came in too late and they lost their slot; as a result, they had to use less effective marketing strategies, and have only done 5 loans.  They couldn't afford a bookkeeper, meaning that a Bob and a volunteer had to spend countless hours teaching themselves; even then, someone will have to fix the chart of accounts next year, unless they again fail to raise the requisite money.  Lacking funds to build a website, they taught themselves some code and ended up with, well, a sub par product.  And finally, they couldn't afford a professional loan tracking system, and instead made due with a sloppy Excel spreadsheet.

At the start of their second year, Fun Finance approaches funders in the hopes of expanding.  Unfortunately, most of their applications are denied.  This is unsurprising: the organization has hardly done anything; its website is ugly; the team is ragtag at best; and it's not clear that Fun Finance will survive.  We'll come back to Fun Finance in the next article to see how they are doing five years later, but let's finish out this post by looking at Kite Drone.

At the end of his first year, Joe has a lot to be proud of.  With that $250,000 equity investment, he was able to do several production runs of the drone, test out and refine it, and then find a factory in China to manufacture the first retail-ready batch.  With the refined product in hand, he and his sales manager--a great hire he was able to make early on--begin visiting retailers to gauge interest. After three months, they land a deal with a regional children's toy store chain in New England.  Thanks to an up front payment for the order, Kite Drone is able to order the parts, have them manufactured and assembled, and delivered to toy stores in time for the holidays.

At the start of year two, Kite Drone has real, honest-to-goodness revenues from product sales.  They are still spending more than they earn, of course--they are investing in growth!--but now they have a track record.  Buoyed by the news, and in need of more capital to meet growing demand for their product, they do another round of equity fundraising, this time netting $1 million.

And so it's off to the races, with Fun Finance limping along and Kite Drone bounding out of the starting gate!

No comments:

Post a Comment