“Access to finance is a well-recognised constraint to social enterprise development… there is a missing middle where working capital can be tight, grants insufficient and commercial finance yet unviable” – British Council
This quote from the British Council perfectly summarises a problem faced by most social enterprises today. It is echoed in various other reports from organisations such as the World Bank, AVPN, Village Capital, and ANDE, and is usually identified as the funding gap between $10,000 to $200,000. There are many names for this, the missing middle, the valley of death, and the pioneer gap. In this article, we address what the pioneer gap is and how it came to be.
Today, there are various sources of funds for social entrepreneurs to tap into. Below is a figure from AVPN’s report “Towards Inclusive and Sustainable Growth in the ASEAN economic community”. It shows the various funders available in the market (while it was a report on ASEAN, this problem is faced globally).
A clearer visualisation of this gap could be seen in the graph below:
Here, we’ll breakdown how the individual actions and choices of each of the players within this ecosystem resulted in this gap that we estimate anywhere between 70-90% of social enterprises are stuck in.
While some microfinance organisations do service this gap, most usually cap out in terms of their lending between $1,000 to $5,000. This is partially due to legal limits on how much they can lend and because their processes are designed mainly to evaluate individuals rather than scaling businesses, let along social enterprises! What might be noteworthy is that Kiva had launched efforts to lend low-cost loans to social enterprises. Unfortunately, for the past 2 years+, these efforts seem to stall at 1-2 social enterprise campaigns at any point of time (versus the thousands of active microfinance campaigns they have on any day).
With the prevalence of crowdfunding, personal grants, giving circles, and donations, individuals today form a large part of giving. Unfortunately, using this method to raise working or growth capital is often unpredictable and insufficient for social enterprises’ growth. A casual look at most donation crowdfunding platforms for social enterprises indicate each campaign caps out after a couple of thousand dollars.
For other HNIs who might give individual donations, their giving might play within the pioneer gap, but they typically do a couple of deals a year – far from the thousands required.
Foundations, Government, and CSR:
Today, most foundations, family offices, and CSR initiatives by companies tend to focus on the most impactful social enterprises, and for good reason. Logic dictates that with scarce resources, you would try to get the most from those resources. In this case, it means giving what money they have available to give to the most effective impact organisations – be it social enterprises or non-profits. However, because the world of impact is unlike that of start-ups where there is a limited amount of equity participation or debt to be raised, there is no limit to how much donations an impact organisation can receive. Hence, what happens is that the best connected and most impactful organisations get funded.
With many foundations legally mandated to give away a certain portion of their funds every year, they rarely have the bandwidth of evaluate so many deals. While they might be able to write-off grants given that are below $10,000 without much justification, higher quantum grants would probably need some form of due diligence and tracking to ensure accountability. It is easy to see why they would choose to concentrate their donations in the case of these larger grants. For example, a foundation who has to give away $5,000,000 would much rather give away $500,000 to 10 impact organisations (evaluating anywhere between 20-40 organisations) rather than $50,000 to 100 impact organisations (evaluating anywhere between 150-300 organisations).
Hence their due diligence process was designed to give large amounts of money (few hundred thousand dollars). This makes the pioneer gap an especially awkward phase where small grants that could be written off are insufficient, while larger grants with their DD processes are too cumbersome.
Many money lenders play within this gap, lending to social enterprises at interest rates (at least in India) between 15-120% per annum. In a later article we address why such high rates are being charged to social enterprises. However, it is easy to see how many social enterprises would be unable to or find it difficult to pay such high interest.
When fund raising from impact investors, today’s social enterprises often go through the same cycle when fund raising from impact investors or grant makers. They run around to various funders, building relationships with each of them over 3-6 months, before raising a round. 2 to 2.5 years out, they repeat this cycle again, with a different set of funders.
These rounds usually begin in the hundreds of thousands, thereby helping these lucky social enterprises to bypass or jump past the pioneer gap all together. (Impact investors often want to disburse hundreds of thousands of dollars because even a 1,000% on a $10,000 investment does not make much sense to them if their fund size is $5,000,000) Empirical evidence supports this. In an industry survey conducted in 2012 by Village Capital, of over 300 self-described “impact investment” funds, fewer than 10 invested at less than $250,000/company. Additionally, a Monitor-Deloitte study of African impact investors found only 6 of 84 invested at the early stage.
Unfortunately for most social enterprises, this form of funding is wholly unsuitable for them. There are two main reasons and problems for this style of fundraising:
a. Most social enterprises are unable to deliver exits or market matching/beating returns
Because of their social mandates, most social enterprises (90%+) today are often unable to compete on equal terms in profitability as their for-profit counterparts (I know there are exceptions to this, but the general rule for a small social enterprise on the ground is this). These social enterprises are often unable to deliver an “exit” for their impact investors – let alone the market beating or market matching returns often required by them. Instead, these social enterprises are usually financially sustainable (aka not loss making) businesses creating huge impact but only earn low to mid single digit returns on investments – out of the mandate of most impact investors.
b. Detracts from their core mission
Many social entrepreneurs did not sign up to be a social entrepreneur so that they can experience the “joy” of spending 3-6 months of their time worrying about capital. They started their organisations to make a difference to their communities in a financially sustainable way. Requiring many of them to waste this much time just to raise capital means less time impacting their beneficiaries.
In the same survey performed by Village Capital earlier, impact investors cite “lack of appropriate capital across the spectrum” and “lack of investable enterprises” as the top two barriers to deploying more impact investment. These are clear signs that many of the social enterprises currently in the market are not a good fit for most impact investors’ market beating or market matching mandates.
This last group consists of a mix bag of Private Equity, Bank Debt, Capital Markets, and other sources of commercial funding typically available to businesses. Unfortunately, unless they proceed to charge interest rates like money lenders, they are simply unable to earn enough per loan from social enterprises within the pioneer gap to bother.
In summary, we see that current funders in the market do not offer capital at the ticket sizes within the pioneer gap for various reasons. Because most funders either give small grants or impose minimum capital sizes, this results in a missing middle that thousands are stuck in. In the next article, we share our approach to tackling this problem – by lending to thousands of social enterprises in the pioneer gap.