Individuals we interact with in the world of impact investing are often different from those traditionally working in international development whether in NGOs or development agencies.
To understand the types of entrepreneurs, it is vital to understand the objectives which drive their actions. Entrepreneurial objectives are primarily affected by two factors:
Risk Appetite – To a large extent, entrepreneurs’ risk appetite governs their decisions. For example, risk-averse business managers may tend to settle for higher number of sale units with lower selling price, relinquish a greater share in profits for minimizing interest payments, or hesitate to opt for a business model with high operational gearing (higher fixed costs as compared to variable costs). On the contrary, entrepreneurs with a high risk appetite have a penchant for exploring new markets, experimenting with changes in business produce, or opting for unprecedented strategies. This appetite for risk defines the objectives of a particular business person and how they are likely to conduct the business. In developing markets, high risk appetite is not merely a norm but also a requisite. Walking on unexplored vistas, operating in the absence of documented industry data, and commencing something new which never happened on the local level involves risk.
Time Horizon – Another factor that influences entrepreneurs’ objectives is their preference for short or long term gains. Compare, for example, a retail business selling established brands and another providing life insurance service. It takes an entirely different temperament level for the latter. Whereas a retail business can start earning profits from next month, the life insurer generally needs multiple years before it starts generating positive cash-flows and accounting profit. Entrepreneurs set their objectives on the basis of their preference for short or long time horizons.
As different they are for investors, equity and debt themes of capital also have different implications for entrepreneurs. An entrepreneur is likely to select the form of capital which best suits their objectives. It is vital to view different components of the equity and debt themes through entrepreneurs’ eyes:
- Returns – Debt is cheaper than equity for business owners. Since debt-providers lend against a security and are entitled to receive regular payments, they demand lower return on their capital than equity-providers. Risk-averse managers prefer not to borrow too much for the sake of keeping both the financial and operating gearing to the minimum. Increased debt results in lower interest cover (profit before tax + interest cost / interest cost).
- Collateral – Large amounts of debt involve collateral, which may be a fixed charge over a tangible asset (or group of tangible assets). Businesses operating in the services sector, or those with low levels of fixed assets, face problems when it comes to offering debt security.
- Ownership – In equity is embedded a greater stake than in debt. Debt providers are sole lenders, while equity providers are owners of the business. Depending on their preferences, entrepreneurs may find it unacceptable to share business ownership with someone.
- Time – Generally, debt is temporary while equity is perpetual. Debt covenants end on redemption or the occurrence of any pre-agreed event, the control over which rests with the entrepreneur. On the other hand, equity-providers cannot be forced out of ownership. For example, shareholders’ decision either to sell their stake or retain for another five years is outside the entrepreneur’s sphere of influence.
These are the considerations that may affect an entrepreneur’s choice for a particular form of capital. Few may also prefer hybrid instruments, i.e. convertible debt. This may take the shape of bonds that can be converted into equity after a certain time period or on occurrence of a pre-agreed event. These allow entrepreneurs to enjoy the benefits of both equity and debt according to their need over a longer time period.
Like investors, entrepreneurs have their own concerns about financial partners. These concerns are likely to be low if debt has been used to finance the business. This is because debt covenants contain all the terms and conditions in written form, signed by both parties. Consequently, there is less space for surprises. Further, debt does not dilute control by transferring a share of stake to the debt provider. Therefore, in the case of debts, entrepreneurs’ concerns are usually low. Then, they only need to ensure positive cash in-flows to meet interest-payment obligations.
Equity may be a cause of concern for business owners. Firstly, it dilutes control. Equity providers may incorporate such terms in the agreement, where occurrence of an event can transfer control (or a major part of it) from entrepreneurs to investors. One example of this is an investor having high management position as a result of huge business losses. Secondly, equity providers come with expectations of either dividend payments or capital appreciation. It can be problematic for entrepreneurs if a business is unable to generate positive cash-flows despite earning accounting profit. In this case, the business will be unable to meet the dividend expectations of investors. Conversely, few investors expect capital appreciation over time. If the business has failed to generate net profits over more than one accounting period, entrepreneurs may start feeling the pressure. Thirdly, the business may feel a need for second-round funding, in which case entrepreneurs are concerned if their existing financial providers can finance the prevailing needs. Finding investors and initiating negotiations involve both time and substantial costs. Moreover, bringing in a new investor may equate to further dilution of control.