Entrepreneurs building businesses in smaller towns and low-income communities often lack the personal credit profile or assets to access the capital they need from banks and investment firms to grow their companies.
Income-based financing — where investors provide equity in exchange for a percentage of revenue — has become a solution championed by foundations and social impact investment firms as an affordable option for underserved business owners in the US. It’s an approach that can create a partnership between a business receiving funding and its investors, because both do better when the company does better.
Income-linked investing is also more entrepreneur-friendly by giving them “an opportunity to gain funding without having to give up ownership,” which can happen with private equity or venture funding, says Chat Reynders, Reynders CEO, McVeigh Capital Management. a wealth management firm based in Boston.
About four years ago Reynders McVeigh began advising Founders First Capital Partners – an income-based lender and advisory firm – on a fund that would allow individual investors, family offices and foundations to provide income-based financing in exchange for an annual return of 7%.
Founders First’s funding arm (it also runs a nonprofit small business growth accelerator) had already tested the concept in a fund launched in 2016 with several smaller foundations and family offices, says Kim Folsom, founder, chairman and CEO of San Diego. firm and an entrepreneur herself who founded seven companies.
Folsom’s goal at Founders First, she told Reynders, “is to become Goldman Sachs for different companies,” supporting “different entrepreneurs [to] grow successful middle-market businesses that create jobs and wealth in communities that are often left behind.” At the same time, Folsom said, the firm can provide “attractive returns for mission-minded investors.”
Penta recently spoke with Reynders and Folsom about income-based financing as a long-standing but revolutionary approach to investing and how it can create social and economic equity.
Establishing a Partnership
Income-based financing was attractive to Reynders — who manages about $100 million in impact investments for clients — as a mechanism for getting money into “funding deserts” across the country “where there are BIPOC and women owners who just they don’t have access to capital and they don’t have any real leverage,” says Reynders.
For entrepreneurs who don’t work in New York or San Francisco, accessing venture funding can be very difficult, for example. “We thought it was important to find ways to finance and nurture some of these businesses in a way that works for them,” he says.
Income-based financing offers entrepreneurs more flexibility than a standard bank loan and outperforms equity financing from a venture fund—if it’s even possible to get—because a venture or private equity investor will expect the owner to sell the company or eventually take it public, a phenomenon that ends up drawing local capital away from the cities and towns that need it, Reynders says.
For investors, revenue-based financing “allows you to be a financing partner with these businesses because it takes into account the reality of the markets,” he says. “There are going to be stronger revenue quarters and weaker revenue quarters, and if you can get that across with the entrepreneur you’re working with, that creates a good solution for your clients if they understand that this is what they’re investing in and that creates a great opportunity for the entrepreneur who is suddenly off the hook.”
Change Catalyst Fund
Businesses that Folsom guarantees funds are “lightweight” with a minimum of five years of revenue and gross profit margins of at least 40%. Companies in the fund must also be “geographically challenged” (meaning not in New York or San Francisco), run by diverse owners and succeed with “small amounts of capital,” she says.
Some of the businesses where the fund invests offer solutions for large companies. Examples include Onshore Technology Group in Chicago, a black women-owned business that provides compliance services to large pharmaceutical companies such as Pfizer and Moderna. Another, 3PO in Jersey City, NJ, offers treasury management services.
Reynders says the firm worked with Folsom to design a financing mechanism that would enable individuals, family offices and foundations to receive a reasonable return for the risk they are taking, providing “real social value” to entrepreneurs who have little places to return. for capital.
The seven-year fund, which will eventually reach $30 million, today includes about $5 million from investors who are clients of Reynders McVeigh and who each invested about $250,000. Investors have an opportunity to invest in the fund every quarter for its first three years. They pay no management fees to invest and get an annual return of 7%. In the second half of the fund’s life, the internal rate of return can be higher as the principal is also paid off, says Reynders.
The firm’s investors like the steady yield for an investment that’s a little riskier than a normal bond, he says. For example, a seven-year US Treasury note currently pays about 3.1%.
The Change Catalyst Fund can provide a sustainable return because Founders First is taking on the risk that the revenue streams from the underlying companies will change. The fund manages this by assembling a diversified portfolio of about 35 businesses, some of which have contracted income, Folsom says. This allows for more consistent income and therefore, consistent returns.
Future funds
Founders First currently works in five regions (California, Illinois, Texas, New Jersey and Pennsylvania), but plans to expand to 10 over the next five years.
It will also create more Change Catalyst funds that will target investors with increasingly large asset pools. The second fund, which will be between US$50 million and US$75 million, will be targeted at institutional investors, including impact investment funds and registered investment advisers.
A third fund, which will be at least $100 million, will target large corporations and pension funds looking to invest for social impact.
The social impact this funding could achieve will be significant, Folsom argues. A generation ago, high street retailers and hotel chains and other non-technological businesses essential to the economy grew to become among the largest companies in the US and significant contributors to the US economy.
“The funding that we’re providing to these various businesses in the form of six- and seven-figure capital infusions puts them on track to be the next major street businesses that are in the $20 million to $50 million to $100 million range.” million US dollars. businesses that can support that level of growth,” she says.