Not All Traditional Investment Models Work for Emerging Markets. It’s Time to Test New Ones.
In emerging markets, entrepreneurs of growth-stage companies often struggle to access financing. Debt is hard to come by and securing equity often requires giving up significant company ownership in return. Recognizing a need for alternative funding models to raise capital for businesses throughout Southern Africa, Linea Capital is working with USAID to test an innovative revenue-based funding model.
By Matthew Mitchell, INVEST Senior Partner Specialist, and Emily Langhorne, INVEST Communications Specialist
Debt or equity? It’s a difficult decision for the entrepreneurs of growth-stage companies, especially for those in emerging markets where debt is hard to come by and securing equity often requires persuading investors to engage with local market risks — and giving up significant company ownership in return.
These barriers prevent small and medium-sized companies from accessing the capital they need to grow. That’s problematic because these businesses drive economic growth, increase employment, and improve the standard of living by providing goods and services locally.
Five years ago, Julia Price, Colin Hundermark, and James King began to think seriously about the hurdles that growth-stage businesses in South Africa face in accessing capital.
“The traditional debt and equity space, particularly in risk-averse environments like here in Africa, has a serious affliction,” explains Price. “The debt is limited and often unavailable to growing businesses because banks and traditional lenders — rightly so — require a lot of collateral, either personal or business security, which these high-growth, entrepreneurial companies and their founders typically don’t have. Banks don’t typically have the natural appetite to fund growth-stage companies in their earlier stages, but these are the companies that we hope will move the dial on things like job creation, women’s economic empowerment, clean energy, and more. On the other side, there’s equity, which typically tends to be the funding mechanism of choice for growing companies. However, in an environment where investors are risk-averse and valuations are under pressure, many businesses must give away a lot equity in early fundraising rounds, and it becomes very hard for them to recover it later.”
With heavy ownership dilution, entrepreneurs often lose control over the direction of their company, making it difficult for them to create jobs, empower staff members to hold equity, or raise future capital rounds to fulfill their vision for their business.
Recognizing a need for alternative funding models to raise capital for businesses nationally and throughout the continent, Price, Hundermark, and King came together and founded Linea Capital, a capital provider with the dream of creating financing models that, as they phrase it, “restore the balance between the owners of ideas and the owners of capital.” (Hundermark and King now participate in the business on a non-executive basis.)
Recently, Linea has partnered with USAID’s Southern Africa Regional Mission and USAID INVEST to test an innovative funding model in South Africa that aims to establish and scale a new revenue-based finance asset class. Unlike other funds that may provide revenue-based loans alongside their traditional equity or debt mandate, Linea will not only focus exclusively on providing revenue-based financing, but it is also developing a tailored financing instrument for growth businesses in Southern Africa. Furthermore, the exclusive revenue-based financing mandate of the company allows them to restructure fees away from the traditional “2 and 20” venture capital model.(Where two refers to the standard management fee of two percent of assets annually, and 20 means the incentive fee of 20 percent of profits above a certain threshold known as the hurdle rate.)
Solving the Debt and Equity Dilemma with Innovative Financing
Unlike traditional venture capital equity funds, Linea’s revenue-based financing model generates returns for investors through a percentage share of future revenues. Each portfolio company has an individualized repayment plan tailored to its growth strategy.
Investors can either take their repayments and exit, or they can retain capital in the model, which is recycled and invested into new companies. The possibility of reinvestment of the original funding means the model has the potential to be both sustainable and scalable.
To attract additional institutional investors and venture capitalists, USAID is providing a tranche of first-loss, catalytic capital. If an investment doesn’t turn out as forecasted, this capital protects investors, absorbing the losses until they have been repaid their contributions. This catalytic capital plays an important role in crowding in private-sector investors who might otherwise perceive a new financing model without a well-established track record as too risky, particularly in an emerging market.
Because launching any investment model, especially an innovative one like Linea’s, comes with operating costs, USAID is contributing additional funding to subsidize the model’s operating cost. This funding will enable Linea to pilot the model and build up an asset base.
While other organizations have created revenue-based financing products for African businesses, such as approving loans based on the use of revenue-based metrics, Linea’s model will formally set up a new asset class that complements traditional forms of financing rather than displaces them. Linea aims to prove that its model can play alongside established venture capital and private equity funds and co-invest in their already vetted portfolio companies, creating alternative and diversified financing sources for businesses and reducing the due diligence costs for Linea’s investment pipeline.
When selecting portfolio companies, Linea will use economic, social, and corporate governance as well as “do-no-harm” principles as criteria. Once companies have been selected, Linea will typically not take an equity stake or active board seat — although it may take a board observer seat — leaving the control in the hands of their founders.
A Winning Firm That Almost Didn’t Apply
Although Linea’s mission perfectly aligns with USAID Southern Africa’s goals for mobilizing private investment into small and growing businesses across Africa, the firm almost didn’t apply when USAID’s INVEST initiative released a Request for Proposals (RFP) seeking firms that could catalyze and accelerate the deployment of private capital in the region. To demonstrate that improved investment strategies could increase both social and financial returns, USAID and INVEST sought to work with financial providers and firms who needed assistance in fundraising or deploying capital into businesses that generate development impact.
The RFP was broad. Usually, development agencies put out an RFP with a prescribed solution. Because USAID Southern Africa wanted to discover a breadth of market-based approached that could benefit from catalytic capital, it flipped the RFP model on its head. It asked offerors to explain their solution and how USAID’s catalytic capital could support it. This approach aligns with USAID’s Private Sector Engagement Policy, which encourages Missions to put private sector actors in the driver’s seat, letting them identify market-based solutions that could become viable with development agency support.
“A client of mine, who had an interest in Linea’s mission, forwarded the RFP over to me,” says Price. “I had a call with my two co-founders, and we thought, ‘This is interesting. This could be the break that we’ve been looking for over the last few years.’ At the same time, I really did feel like we were a wild-card entry. It is easy to be intimidated by the prospect of working with USAID, particularly for smaller actors in emerging markets. There may be other early-stage organizations, like Linea, that don’t submit a proposal because they feel the competition is meant only for the ‘grown-up’ firms. It makes me wonder if USAID is missing out on innovative initiatives because there are lots of early-stage entities doing interesting things who may feel that way.”
However, Price and her colleagues felt heartened by the structure of INVEST’s RFP. The RFP defined examples of the types of projects that would be considered, such as operational support to build pipelines and capacity of local partners, first-loss capital for blended finance vehicles, and start-up support for new vehicles aiming to build an ecosystem around novel types of financing for small and medium-sized enterprises in the region.
“Without those distinctions, I might have felt that our solution wouldn’t be considered as a possibility,” says Price, “but when I saw the RFP objectives set out, the penny dropped for me. I thought, ‘Hey, we can do those things.’ Having that clarity in the document helped us understand what USAID wanted, and I think it helped me overcome the intimidation aspect, too.”
Once Linea entered the subcontracting negotiations, Price says that all feelings of intimidation disappeared. The INVEST team was helpful with the paperwork required, and from the start, the process felt collaborative.
“It never felt like we were being taken into the headmaster’s office and told how it needed to be,” she says. “It was really about discovery. We were impressed by the caliber of the people and the way the process was conducted. If I were a U.S. taxpayer, I would be proud of the way USAID and INVEST work with applicants around the world and the rigor with which they conduct the due diligence process.”
Despite her initial hesitations, Price found the entire procurement process — from proposal submission to subcontract negotiations — a rewarding experience.
“If we had not been successful, we would have been disappointed, but the whole process was incredibly valuable for us,” she says. “Having the opportunity to think through what we would do with the capital that USAID could provide and coming up with creative ways of structuring it was very useful for us. I think firms like ours could help to increase the number of applicants by educating the market around us about the need for this type of capital and partnership and the positive influence that working with USAID has had on us as a team and business.”
The Value of Learning
Blended finance interventions such as catalytic capital can help international development organizations draw in private investment that aligns with their impact agendas. However, finding the right private-sector partners and providing them with the right incentives for collaboration is essential for a successful cross-sector relationship.
“The private sector and development sector have different objectives, and that’s okay,” says Price. “A key objective of the private sector is to make money, to get the best experts in the field and pay them for experience they already have to develop innovative solutions to meet needs in the market. The opportunity to generate profits creates the incentive to construct powerful platforms, build technology, develop skills, and ultimately drive job creation. The private sector can go a long way in deploying development finance in-country with their local intel, proven business models, and on-the-ground distribution networks. On the development side, part of the definition of success is the learning. Collaboration between the two sectors is powerful where both sides are incentivized to ensure both business growth and learnings are a success.”
In the case of launching a new revenue-based financing model for South Africa, part of the success — for both Linea and USAID — is finding out whether the model works and whether its success varies regionally. If it doesn’t work, then USAID and Linea can learn how to alter the model or investment strategy to reach their goals.
If the pilot of the revenue based-financing model proves successful, Linea could potentially expand the model across the Southern Africa region, which would increase development impact while creating additional revenue for companies, returns for investors, and profits for Linea. By working with USAID to pilot models and learning about their strengths and weakness, firms like Linea can thus set themselves up for a future of implementing and scaling innovative, successful investment strategies.
Are there other ways that development agencies can entice more private sector offerors to work with them?
Potentially. Price thinks development agencies can start looking to other forms of compensation and incentivization as a way of motivating more private-sector firms to collaborate.
“I’m particularly interested in models where impact can trigger additional compensation for private sector firms,” she says. “Perhaps there are alternative financial incentives that can be structured so that where the offeror achieves additional layers of impact beyond the expected performance, such as a gender-lens impact or impact in a different part of continent, they receive additional commercial reward. That reward incentivizes offerors to put time and effort into finding the deals that create the most impact, not just enough deals that meet the requirements of the contract. In this way, development agencies and private sector are further aligned to mutually beneficial outcomes.”
This post is made possible by the support of the American People through the United States Agency for International Development (USAID). The contents of this blog are the sole responsibility of INVEST implemented by DAI and do not necessarily reflect the view of USAID or the United States Government.