About Social Finance

Social finance uses traditional financial tools and instruments, in sometimes novel combinations and often unique ways, to increase the amount of capital to marginalized entrepreneurs and for-profit and not-for-profit Social Purpose Organizations (SPOs) so that they can start, scale, grow, or improve their impacts. Social finance activities range from microlending and impact investing to loan guarantees and insurance products to new financial models and theories that have positive social outcomes.  Social Finance actors include credit unions and banks, impact investment funds and financial intermediaries, foundations, insurance companies, real estate brokers and mortgage lenders, impact investors, social finance advisory services, and governments.   

Over the past 3 decades, unprecedented advancements in the process of entrepreneurship, specifically around technology and innovation, have occurred. Much of it at the hands of serial entrepreneurs-turned-investors, which meant that traditional finance also saw advancements; and social finance has benefitted from those advancements. Many social finance products are derived from their traditional counterparts but shift from “profit maximization” as the sole function to a dual function of impact and profit creation. For centuries, financial instruments have been largely siloed into two categories, debt and equity, but with the advent of new financial tools two more categories, hybrid instruments and outcomes contracts, are also important to mention in the context of social finance.

Debt Instruments

A debt instrument is a fixed-income asset that legally obligates the debtor to repay the lender the principal plus interest according to predefined contractual terms. These terms include interest rate, repayment schedule, collateral (if applicable), maturity date, and any covenants. Common debt instruments include loans, leases, bonds, mortgages, credit cards, and lines of credit. Through a social finance lens, some of these instruments look like:    

• Microloans – microlending or microcredit is mainstream in economically poor countries, where traditional financing was not available to people because of lack of credit, collateral, or integration into the formal economy. Small unsecured loans are given out to individuals or groups and the loans are paid back by the collective to reduce delinquency. That is, if one person cannot pay back, the rest of the group must cover that repayment. For example, Muhammad Yunus’ first loan in 1976 was for USD$27 to 42 women in Bangladesh to buy materials to produce garments. Microlending in Canada has a much bigger price tag, usually above $1,000, but helps people overcome those same barriers to financial inclusion.

• Low-Interest Loans – some lenders are not just interested in the profit (which comes from higher interest rates) but instead balance the need to be sustainable with the impact they wish to create in the community. Thus, they can afford to charge lower interest rates than traditional lenders.

• Impact-Adjusted Loans – these instruments use the financial mechanics on a loan to increase the impact that the lender desires, while benefitting the debtor by a reduced interest rate. For example, if the loan to an SPO was meant for growth, and part of that growth was to hire twenty new staff, an impact-adjusted loan could have the following conditions: if below 50% of new hires were female that the interest rate would be 6%; however, if more than 50% were female, the interest rate would drop to 5.5%; and, if more than 60% were female, the interest rate would drop to 5%; and if more than 75% were female, the interest rate would drop to 4%.

• Green Bonds – a green bond is similar to a traditional bond, they are contractually obligated to provide a series of interest payments of a fixed amount and also repayment of the principal amount at maturity, with one key difference: green bonds are designed and structured exclusively for projects working towards environmental or climate change solutions. When an issuer offers green bonds, they are expected to update investors with not only the financial expectations and returns but as well as the environmental impact created from the project.

• Community Bonds – just like green bonds, community bonds are contractually obligated to provide a series of interest payment of a fixed amount and also repayment of the principal at maturity, with one key difference: the money that is invested into a community bond does not have to be spent on environmental or climate change solutions. The most common community bonds, like that of CSI in Toronto, is to purchase real estate, a secured asset, which makes returns via rental charges to pay interest, while the asset appreciates in value, making repayment of the principal attainable.

• Impact Mortgages – just like regular mortgages, impact mortgages are secured by a physical asset like a house, a building, or other real estate property, but have a social goal in mind.  Whether the mortgage is from a big lender like Vancity or ACU to a social enterprise or non-profit to secure a building with a reduced interest rate or other concessions, or to an individual facing housing barriers using other market dynamics to redistribute risk and return, impact mortgages have the opportunity to play a huge part in Canada’s social finance landscape.

Equity Instruments

An equity instrument is any contract that evidences a residual ownership over the assets of an entity after deducting all of its liabilities. Because debt is prioritized in the case of dissolution, equity instruments are seen as riskier but with the potential of a much bigger return. Common equity instruments include public company stocks that are traded on a stock exchange like the TSX, and private company common shares, preferred shares, and stock options. Through a social finance lens, some of these instruments look like:   

• Common Shares in an Impact Startup – technology companies can also be impactful on our society, culture, or environment, like clean tech companies. Just like regular tech companies, they require startup capital that often starts with local angel investors. Today, there are thousands of individual angels that focus their equity investments on the impact they want to see in the world. To do this, they choose an impact area and find companies working in that domain, then they invest in, for example, the common shares of the company, thus diluting the ownership portion of the founders.   

• Preferred Shares in a Co-operative – investments of up to $1.25M are made by Canadian Co-operative Investment Fund (CCIF) into established co-operatives, for example, though any accredited individual or entity could do the same. These shares are different from the membership shares with voting rights that define the co-operative model. The preferred shares are guaranteed to be paid back before any other equity investment.

• Purchasing Stock in Public Company focused on Impact – there are a plethora of impact companies that have gone public through an IPO (Initial Public Offering), even in Canada and their stocks are available on the TSX. Purchasing those stocks as a retail investor is very simple, just like any other stocks. The benefit of equity investing in a publicly traded company is its liquidity.

Hybrid Instruments

Hybrid instruments have characteristics of debt and equity or transfer from debt to equity at a specific event. The 4 common hybrid instruments withing social finance include convertible notes, SAFEs, Revenue Share Agreements, and Shared Earning Agreements.

• Convertible Notes – convertible notes came into existence to benefit the investor with the possibility of increased returns and tax savings, while not burdening the investees with negotiating early-stage valuations needed for equity instruments. Convertible investments occur at an angel or seed rounds and start off as typical debt instruments, which pay interest and have maturity dates, but then change to equity shares (common or preferred) at a specific discount rate and valuation cap, typically at a Series A event or acquisition, before the maturity date, when valuations are better able to be determined. From a social finance perspective, the same advantages of convertible notes benefit impact investors and social enterprises.

• Simple Agreement for Future Equity (SAFEs) – SAFEs act like convertible notes in that they sit as a liability for the company on its balance sheet and convert to equity at a future event, but they do not have maturity dates or pay interest, so they cannot be called debt.  They are a fairly new instrument that came out of Silicon Valley’s first accelerator, YCominator, to increase the success rate of the startups they invested it. Cash flow remains the number one killer of companies, and maturity dates and interest payments take money out of the company, reducing its cash position. Sophisticated tech investors agreed that the small amounts of interest payments were not worth the risk of failure, so they crafted a more “simple” agreement that focuses on just two factors, how much money is invested and the valuation cap. From a social finance perspective, the benefit given to the invested company and its increased chance of success make the SAFE preferable over convertible notes.

• Revenue Share Agreements (Rev-Shares or RSAs) – Rev-Shares became popular for investors that were experiencing cash flow issues themselves. Equity investments in private companies struggle with liquidity, which means investors cannot reinvest into other opportunities as their investments are sitting in other companies waiting for returns. The agreement can have either a debt instrument or equity stake in the company, where the investment collects a percentage of the revenue or gross profit each month or quarter. Rev-Shares work for companies with existing sales channels and a constant income of cash. The return is not endless, it either has a predetermined amount of cash repayment or a specific amount of time.  From a social finance perspective, Rev-Shares are great for impact investors and/or funds that need the cash flow to be able to have continued investment opportunities. However, taking topline cash out of any social enterprise without understanding the cost structure of the organization is recipe for potential disaster.

• Shared Earnings Agreements (SEALs) – SEALs are an adaptation of Rev-Shares, closer to a profit-sharing partnership, that uses a long-term approach, usually lasting the lifetime of the business. Where Rev-Shares take top-line money out of the company, which increases its chance of having cash flow problems and thus failure, the goal of a SEAL is to align the interests of the investors and founders in a wide variety of unknown outcomes, while giving founders full control of their business. SEALs take a percentage of the bottom-line, economic value that goes to founders through salaries, dividends, and retained earnings. SEALs were created by former founders who viewed the investment landscape as being investor-centric and short-term, both of which can be to the detriment of any business. From a social finance perspective, SEALs align the best with the long-term approach needed for successful business through partnerships.

Outcomes Contracts

Outcomes contracts are social finance pay-for-performance instruments created for public-private partnerships to fund and test new ideas in social services. The two main instruments are Social Impact Bonds and Community-Driven Outcomes Contracts.

• Social Impact Bonds (SIBs) – poorly named as SIBs are not bonds because their repayment of investment is dependent on the successful achievement of predetermined, measurable social impact outcomes.  Thus, if those outcomes are not achieved, investors do not receive a return or full repayment, and may only receive partial repayment depending on how the SIB is structured. SIBs are most often created by government, the “outcomes purchaser”, wanting to see outcomes improve in a particular area that they have internally determined. Through an RFP process, a service provider is identified, and a collaboration ensues to create the SIB. Once programming and outcomes are defined, investors are sought out to pay for the upfront capital. Upon successful completion, the government repays the investors’ investment plus a return.

• Community-Driven Outcomes Contracts (C-DOCs) – C-DOCs function very similar to SIBs, the difference being that the beneficiary community determines the outcomes, not the outcomes purchaser (i.e., government). Because social problems are inherently complex and interconnected, C-DOCs allow for multiple outcomes purchasers for separate, specific, measurable outcomes, through one program or intervention. For example, a C-DOC for the installation of geothermal heating has both a training and jobs creation component for the installation and maintenance of the systems, as well as an environmental component for the reduction of energy usage for heating. A specific outcomes purchaser may be only interested in the environmental outcomes, while another may be interested in the social side.

The aforementioned social finance instruments are invested into SPOs, though the corporate structure of any given SPO will determine what instruments can or cannot be invested. Non-profits, for example, do not have equity to sell to investors and therefore cannot take on equity investments. There are also different ways or vehicles to invest any given instrument into an SPO.

---

Impact Investing

Impact investing is an investment strategy that aims to generate specific positive social, cultural, or environmental benefits in addition to financial gains. Using any of the above instruments, impact investors – from government funds to credit unions to everyday people – can invest directly into an SPO or there are different vehicles that they can go through to invest indirectly. The opportunities for SPOs to get impact investment include:

• Direct Investments – anyone, incorporated entities, credit unions, or individual people, can directly invest their money into debt instruments for SPOs, as well as any publicly traded SPO’s equity. There are certain regulations around private equity direct investments if you are not an accredited investor, unless there is a government program that supersedes those regulations like Manitoba’s Community Enterprise Development Tax Credit Program, or you are a friend, family member or business associate of the person looking for investment. An SPO may have an investment minimum threshold, purposefully, or a high share price that also may disqualify some from making a direct investment.  

• Equity Crowdfunding Platforms – still fairly new to Canada, but Frontfundr is the leader, these platforms are Exempt Market Dealers who complete due diligence on the companies that are listed. Many social enterprises use equity crowdfunding platforms to promote investment into their cause and build a following, as well as to verify and legitimize their early-stage ventures to impact investors who may not have the appropriate skills to do the necessary due diligence. These platforms democratize equity investing which, in Canada, has been mostly used as a mechanism for the wealthy to enrich themselves more.   

• Microfinance Loan Platforms – the best known is Kiva, which allows anyone in the world to loan small amounts of money to low-income entrepreneurs and students in economically poor countries.

• Place-based Impact Funds – smaller funds, often started by local government, foundations, and private investors that deploy impact capital locally to address the needs of their social entrepreneurs or communities, when philanthropy or other financial intermediaries are unable to do it. Rhiza Capital for the Sunshine Coast in BC or Edmonton’s Social Enterprise Fund are great examples.

• Private Equity Impact Funds – the largest portion of impact capital being invested in Canada is through private equity funds. These can be family offices (like Dragonfly Ventures), corporate venture capital (like Telus’ Pollinator Fund for Good), or large funds for specific impacts (like Renewal Funds, which has $240M in assets under management for environmental innovations and sustainable consumer products). Whatever the case, these funds are either privately funded or raise money from wealthy accredited investors, and then use the pooled money to make impact investments into SPOs.

• Publicly Traded Impact Vehicles – newest to the social finance scene in Canada, Kizmet Impact Capital has created a publicly traded impact fund in order to democratize impact investing at scale. As mentioned above, private equity investing is only for the wealthy, but public equity does not have those restrictions, as they have many more regulations to adhere to, so anyone can invest into a publicly traded company.

• Impact Investing Exchange Traded Funds (ETFs) – a growing number of North American investors (retail investors, pension funds, banks, foundations, etc.) are placing billions of dollars into socially responsible or ESG (Environmental, Social, and Governance) funds. These portfolios select stocks based on a company’s ESG practices and performance, along with more traditional finance measures.  

• Charitable Foundations – Canadian registered charities hold ~$519B in assets, 80 of which each have over $1B in assets and an additional +3700 have at least $10M worth of assets under management. While only a portion of these foundations have impact investment mandates that directly benefit SPOs, it is important to note that in the social finance world, this money could be used as a catalyst to increase private capital through a blended financing pool, which would eclipse the Canadian Government’s Social Finance Fund of $755M.