How Charity Funding Could be More Venture-like

I'm currently standing for election to the General Council (a.k.a. Executive Board) of Crosslinks, a Christian missionary society. One of the reasons for this is that I believe that charities have a lot to learn from the way businesses are run. Something that I've recently been thinking about is how funding for charitable projects could be more like funding for start-ups.

V-Cs vs Charities Today

On the face of it, V-Cs and charities are hugely different. Charities receive donations, and use those funds to work towards some worthwhile purpose, but one that generally does not make large profits. Start-ups receive seed or venture capital funding in order that (hopefully!) the company will grow, make large profits, and hence deliver a good ROI.

However, today, giving to charity is far more project-based than organisational. What I mean by this is that we now prefer to support "tsunami relief in Asia", rather than (as previously) Oxfam or Christian Aid. We feel more involved in the work, and have a clearer idea of where our money is going. Transparency is becoming more important. Goal setting and satisfaction are key to convincing donors that our project is worthy of their money.

It seems to me that charity donors are becoming increasingly similar to company shareholders. Of course, the return on our investment comes not in the form of monetary dividends or increased share valuations, but rather in the successes achieved by the projects we support. The demand for transparency, and the availability of information (everything from easily accessible charity accounts, to Google Earth views of project areas, to YouTube videos issued by project members) means that donors can be far more involved in projects. This can only be a good thing.

Today, many volunteers for charities are asked to raise their own support, i.e. convince their contacts to pledge the requisite amount of donations to pay for the overheads of having that volunteer on the project, and perhaps pay them a stipend. Charities become organisations that have a particular focus (perhaps a geographical area, such as East Africa, or a well-defined purpose, such as clearing landmines), and have contacts and expertise in their focus-area. They can help volunteers (who have their own funding) to best achieve their projects' goals.

Proposal: Seed Fund for Charities

Here's my proposal: create a fund, similar to a venture fund, that is financed by donors. The fund would have a well-defined focus and a well-qualified board, in order to evaluate potential project investments. People with good project ideas come to the fund, with the equivalent of business plans, showing what money is needed to start the project off, what goals the project has, and how measurements will show whether those goals have been satisfied. The fund invests over, say, a period of five years. During this period, it provides advice, (or uses its network of contacts to provide this), and in addition provides the seed funding to employ a professional fund raiser to make the project self-sustaining. After the five years, the project is evaluated, in the same way a start-up is, in order to ascertain whether it can be "sold on" (or perhaps, "spun out" is better, since no profit is gained) to be self-sufficient, whether it needs a little more funding/time to become so, or whether it should be wound up.

This is different from social enterprises in that there is no monetary return on investment. Ultimately, it is still about charitable giving. The key is to better enable projects to hit the ground running, and have a significant impact sooner, rather than the uncertainty of beginning a project with "just enough" money. It also means that the usage of donors' money is overseen by an independent, experienced board, rather than by (potentially) inexperienced volunteers.

Existing charitable organisations still have a significant role in this paradigm. Today, they provide expertise and contacts to volunteers, yet have no control (really) over what self-funded volunteers do. In my model, the charity acts as a service provider, for example, helping with the administration tasks of a project. Remember that after the first five years, the fund will bow out, and it will be "normal" donors who fund the project! Donor relations are hugely important. Expertise in the particular area the project is intended for is also crucial.

How is this fund different from grant-making bodies? In part, it is not: grants may well imply supervision, similar to that the fund would provide. However, my proposal is that the fund is financed by donors, like you and me, rather than government or other large entities. Of course, there is no reason that corporates could not get involved, showing how their charitable giving is being well-invested.

But isn't this fund like one of today's charities, which takes donations, and then uses them however it sees best? Of course, that is the aim. They key here is that the fund provides seed finance. It allows projects to get started, even if they have significant up-front capital expenditure. It then guides them to maturity, before letting them loose, either on their own, or under the umbrella of another charity. Today's charities aren't built around that model, though some, like Cancer Research UK, are becoming more V-C-like.

It's also important that the donors to the fund are kept very up-to-date about how their investment is performing. In my view, many charities fail here. The Internet has provided huge opportunities for cheap communication between donors and project volunteers. Let's use it. If a charity today doesn't have a fan page on Facebook, at least one blog on its activities, volunteer updates on Twitter, YouTube videos showing how projects goals are being met, and a regular e-mail to its supporters, it's falling behind the times. This is where this fund differs from a V-C, in that the only way ROI can be measured is how people perceive their money is being used. There is no single figure that can be labelled as the fund's "return". However, just because the return is not monetary does not provide an excuse for less shareholder involvement: it implies the need for more!

Why is this paradigm important?

• It allows donors to contribute to promising projects that are just starting out.
• It separates the tasks of financial investment from the on-the-ground activities of the project (why should volunteers helping with refugee work be expected to be good finance directors?).
• It provides clear structures and requirements on transparency for projects that are funded.
• It encourages projects to become self-sufficient, or else have clear timescales by which they are wound down.
• It frees traditional charities from the dichotomy of funding their back-office functions versus charitable activities, by allowing them to be specialised service organisations that are contracted by projects carrying out charitable activities.

Conclusions

• Existing charities need to become more service-oriented, being contracted for their expertise by projects (possibly funded by charitable seed funds).
• Volunteers can come to such funds to gain start-up capital, contacts and advice, and have their project proposals vetted.
• Communication between project volunteers and donors is of paramount importance in an age where greater transparency is the order of the day.

This idea is very much a work in progress. Please comment and tell me where I'm wrong!

Update (19/04/2009): Serena Fassó pointed me to Social Venture Partners Calgary, who do roughly what I've described! Note that this type of scheme differs from Social Venture Capital, which normally involves capital that is ethically invested, but still has the objective of achieving financial return.

How to Value an Investor's Stake

I'm currently looking at a draft version of an entrepreneurship course written by, among others, people from Cambridge's Judge Institute, and hosted by Epigeum. Something that I found particularly helpful was how to decide what percentage of a company to sell to an investor for the particular amount of money the company needs. I've summarised it here.

The Value of a Stake

If the company is seeking capital worth c, then the issue is to calculate s, the percentage of the equity that should go to the investor providing that capital.

Firstly, assuming this is venture capital, the investor will look to exit probably within five years. Call this number of years y. Let r be the amortised annual rate of return that they desire, say 45%.

Hence, we can say that when the business is sold after those y years, the investor's stake should be worth w = c(1 + r)^y, as this provides the desired rate of return.

Therefore, the stake is simply the fraction that w is of the selling price (market value), p, of the business. Of course, how does one estimate p?

The answer lies in using the Price/Earnings (PE) ratio for a similar, established, company, which details their worth as compared to their sales. Assuming that we can predict the likely earnings of the company in y years' time, then we can multiply this by the PE ratio in order to obtain p.

Investors may well discount the PE ratio, either because they do not believe it to be realistic, or because of the perceived risk, or because the expected revenue is uncertain.

As an example, assume a £1 million investment is needed, that r = 45%, and y = 5. This means that w = £6.4 million. If projected sales in year 5 are £1 million, with a PE ratio of 15, p = £15 million. Thus, the initial stake would be 6.4/15 or 43%.

Which is food for thought. It does very clearly show how VC investors "need" to take very large equity stakes in order to make the desired rates of return. Hardly surprising, but it's nice to at least vaguely understand the mathematics behind it all.

Understanding Dilution

This brings us neatly on to what actually happens when you sell the stake.

Let's say that an investor offers you the £1 million for 43% of the equity. That means that the investor is valuing the entire company (prior to the investment) at £2.33 million, and in particular, valuing the 57% stake you will be left with at £1.33 million.

Suppose that prior to the investment the total number of issued shares (all owned by the founders) is 10,000. This means that the price placed on those shares is £133/share.

Why is it not the case that the price is calculated based on £1 million for 43% of 10,000 (giving £233/share), leaving the founders' 57% stake being worth £1.33 million?

Whilst the ownership percentages would be correct, this is not done because dilution takes place. In other words, the company issues new shares to the investor, rather than re-assigning existing shares.

In the above example, given a price of £133/share, the investor must be given £1 million/£133 = 7,518 shares. Post-investment, the company will be worth a total of £2.33 million, divided into 17,518 shares. The founders will hold their 10,000 shares (as before), but these are now only 57% of the company, whilst the investor will hold 43% (17,518 shares), worth a total of £2.33 million * 0.43 = £1 million.

There you have it: the end result is as proposed, i.e. the investor bought the agreed percentage for the agreed price. The only somewhat potentially confusing part is how this is brought about by dilution, rather than share re-distribution.

Views from VCs: Notes from The Investors' Forum

Yesterday evening I attended The Investors' Forum, an event jointly organised by CUE and CUTEC in Cambridge, aiming to show that there is still investment available for start-ups. On the panel at the event were Reshma Sohoni (SeedCamp), and Laurence John (Amadeus Seed Fund), who talked about (pre-angel) seed funding; Kerry Baldwin (IQ Capital) for injections of around £1.5 million; and Simon Cook (DFJ Esprit) and Sitar Teli (Doughty Hanson Technology Ventures), for investments of £10 million or more. Alex van Someren (nCipher) moderated and gave the entrepreneur's viewpoint. Here's my notes on what they said:

• The economic downturn has affected some funding decisions. Seed funds are asking companies to try to do more with less investment, and to have working demonstrations in less time. Larger funds have been used to their companies not being able to obtain bank loans, hence there has always been a sort of "credit crunch" in that area, thus no effect. However, Sitar Teli pointed out that some businesses (such as semiconductor manufacturing) would need to take on debt at some point, and at present that type of company would not be a good investment.
• Software start-ups were more likely to receive seed funding than hardware start-ups, due to their need for smaller amounts of money. However, hardware is still an option (Laurence John).
• Proposals seeking VC investment need to show both a strong business case, but also a robust customer base. Previously investors would not have checked as rigorously as now how strong the market is (Kerry Baldwin).
• Investors did not believe that they were using the economic downturn to drive down the price they offered entrepreneurs for equity stakes.
• When coming with a proposal, it was emphasised that the amount being asked for should be planned to result in a real step change in the company. Similarly, a plan of what funding will be needed at which points in the business, and what the end dilution and valuation will be, is hugely important in order to ascertain whether an investor will even consider the company. If the end valuation means that the investment does not gain very much value, evidently investors will not be interested.
• Getting to know VCs before asking them for money was recommended. This allows them to be more confident in you at the point where you ask for investment.
• Select which VC to court carefully. There is little point going to one that invests £10 million minimum if the company only needs £250k.
• Try to court multiple investors, in order to allow the market to set a fair price for a stake in the business. Otherwise one investor can effectively set as low a price as they wish.
• The relative importance of teams versus ideas was debated. For seed funding, where ideas are at a malleable stage, the quality of the team was regarded as most important (Reshma Sohoni). For larger investments it was less obvious which was most significant.
• Experience was regarded as hugely important in obtaining large investments at the start (unsurprisingly). First-time entrepreneurs should normally start with seed funding. The exception was if there was significant, patentable IPR behind the business idea.
• In any presentation, get to the point, and explain how much investment is needed, and what it will be used for.

All sounded sensible, though valuable as it goes to show that some investor attitudes have changed, whilst others have not.