February 19, 2013

STREAT’s ahead: funding social impact with equity

Melbourne-based, social enterprise STREAT took an out-of-the-box approach to expansion attracting equity investment and doubling its capacity overnight.

You couldn’t meet Bec Scott for more than a few minutes without knowing she wanted to create something remarkable. From day one, she has been driven to see her brainchild, STREAT, a social enterprise providing homeless youth with a pathway to long-term employment in hospitality, quickly achieve sufficient scale to become self-sustaining through its own business income.

This is an audacious goal given the cost of the wrap-around social support but one that Scott is driven to prove is possible. The idea for STREAT was seeded between 2004 and 2006, when Scott and co-founder Kate Barrelle worked for KOTO, a training program and restaurant providing Vietnamese street youth with life and job skills. During this time they became increasingly convinced of the power of social enterprise to improve the wellbeing of the world’s most vulnerable people.

In 2007, Scott visited similar projects in Thailand, Laos and Indonesia as part of a study tour funded by the Vincent Fairfax Fellowship in ethical leadership program. It was from these experiences and research that STREAT was born.

In just a few years, Scott had demonstrated the effectiveness of STREAT’s model which provides wrap-around support alongside training and work opportunities initially in its Melbourne-based coffee carts. The support provides the 16-25 year old trainees with both work and life skills to help them get their lives back on track.

It’s not an option, not to grow… we’ll have to take risks, sometimes big ones.

After the pilot-program in 2009, STREAT opened its doors in 2010 and by 2012, 41 trainees had come through the program. The results were excellent; 27 had moved into either jobs or full apprenticeships in retail or hospitality businesses elsewhere.

Scott was always clear about her goal of reaching sufficient scale to become self-sustaining. “It’s not an option, not to grow,” says Scott. “We couldn’t just run a handful of coffee carts, and add some new carts from time to time. I realise this means we’ll have to take risks, sometimes big ones; but I’m OK with that.”

Seizing the opportunity

So when the opportunity came early 2012 to acquire another, larger social enterprise – which would double STREAT’S capacity for social impact overnight – Scott seized it.

That opportunity was Melbourne-based enterprise: the Social Roasting Company (SRC), which consisted of three cafés and a wholesale coffee roasting business. For three years, SRC had been turning a small profit, whilst employing people that had been excluded from the labour market – including refugees, migrants and the long-term unemployed.

Shead knew Scott had both a deep passion for the cause and strong business acumen.

However, Sydney-based Fair Business which ran SRC knew that overseeing the enterprise from 900kms away had constrained its ability to grow. Without sufficient local networks and knowledge, Fair Business CEO Alex Shead had struggled to “crack the Melbourne market”. Despite trying, he hadn’t been able to raise funds to support the business. Also, it was more costly to run it from a distance; it required more people, and extra travel expenses.

Having met Scott at a social enterprise event a few years previously, Shead contacted her to see if STREAT would be interested in buying the business. For Shead, it was critical that SRC was sold to someone who wanted to achieve a greater social impact – not merely to run a successful café. Shead knew Scott had both a deep passion for the cause and a strong business acumen.

Importantly, there was alignment between the two ventures. STREAT saw SRC as a well-run business that was suited to the STREAT model: it had grown to be a stable, profitable enterprise with a loyal customer base. Shead recognised STREAT as having a good model for addressing homelessness. Although the model was different from SRC’s, there was strong brand alignment as SRC was known in the community for its social impact alongside its quality food and coffee.

Together Scott and Shead negotiated a sale price of $274k for two cafés (one in Flemington, one at McKillop St in the CBD) and the coffee roasting business attached to the Flemington café. Fair Business chose to sell the third café privately.

So STREAT needed to raise $300k to make this deal viable – $274k for the purchase, plus additional funds to cover legal and other transition costs. The expansion, if it could be achieved, would mean STREAT would more than double in capacity overnight.

The challenge of raising funds for non-profits

Non-profits traditionally attract finances in one of three ways: community fundraising, grants, or debt. In this instance, the downsides of each seemed insurmountable.

Community fundraising involves seeking donations from the community. The benefit of this is that funds are not tied to any particular purpose, and do not need to be repaid. The major downside is that fundraising is slow; raising $300k through donations could take a long time and significant effort.

Grants from philanthropists, foundations, or government are another option. They also do not need to be repaid, but there is an extremely short supply. Attracting $300k through grants would be a slow, uncertain process – requiring time-consuming applications and relationship building.

Debt financing involves taking a loan from a bank or funder with agreed repayment rates. Whilst debt can enable rapid expansion since funds are readily available, the major concern is that funds must be paid back according to a repayment schedule – which can be risky if the business expansion returns a surplus that is lower than expected. Given the size of the proposed expansion (doubling STREAT’s capacity overnight), Scott recognised this was a significant concern.

Equity: a novel solution

On the advice of her mentor Paul Steele, a former private equity investor and now CEO of philanthropic trust, donkey wheel, Scott explored equity as an option.

In an equity deal, investors purchase an ownership stake and receive a share of the profit. Investment would provide STREAT with the additional capital required. As opposed to debt, a major strength of equity is that the risks of failing are shared between the operator and the investors. At the same time, the business will likely forego a degree of control, due to diluted ownership.

The challenge, of course, is how you enable a non-profit to expand through equity as there is no clear ownership structure that can be sold and any surplus cannot be distributed to investors.

Steele proposed that STREAT establish a for-profit entity called STREAT Enterprises that would own the purchased businesses. STREAT could then sell shares in STREAT Enterprises to finance the purchase.

Figure 1: The proposed for-profit entity which would own the purchased business.

 

Scott decided this was worth pursuing, and together with Steele convinced STREAT’s board that it was a viable direction for the enterprise.

Balancing the three factors: the equity sale price, the amount of equity sold, and the expected financial return is one of the challenges of structuring an equity deal. STREAT knew that the more equity it sold the less control it would have over the organisation. If it sold less than 50%, for example, it would retain full control. Ideally it wanted to sell shares worth $300k to cover the whole expansion. If it sold less than $300k, it would need to raise additional money elsewhere, or use its own capital. However, the less equity you sell for a higher price, the greater the amount of income you will need to generate to pay dividends to investors. The range of possible equity sales is constrained by the profitability of the enterprise’s business model.

Scott decided to sell 50% of the equity in STREAT Enterprises for $300k to retain control and raise sufficient funds to cover the entire purchase. Projecting forward on how the businesses would perform, Scott indicated to prospective investors that they could expect a financial return between 7 and 12%, over the first three years. This meant that STREAT Enterprises (incorporating the two cafés and the coffee roasting business) would need to generate on average $42k pa in profit to repay investors.

Attracting investors

STREAT was selective in seeking investors. It decided to only look for investors that would use the return for purposes that aligned with its values and positively contributed to society and the environment. Also, STREAT would only accept investments of at least $50k to limit the number of stakeholders and therefore the amount of work involved in maintaining relationships.

STREAT found four investors who fitted the bill: the McKinnon Family Foundation, donkey wheel, Small Giants, and SRC’s previous owner, Fair Business. Each investor had an interest in ‘blended value’ – for-profit organisations that aim to have a substantial social impact. As a result, the most important factor for all investors was that STREAT achieved its social goals – and that the acquisition would increase the overall social impact. However, an expectation of return was also important since the investors wanted to see more deals like this promoted across Australia. Additionally, two investors (donkey wheel and McKinnon) were Private Ancillary Funds (PAFs) investing their corpus (the money sitting in the foundation) – and so needed the returns to exceed the 5% pa minimum that they are obligated to distribute each year.

The make-up of the board briefly became a point of contention. Originally, STREAT wanted to maintain full control of board appointments. Whilst none of the investors sought seats on the board, they did want to ensure there was a formal means for raising issues – and so negotiated that board appointments would be made by a vote of the owners according to their level of ownership.

Figure 2: Investment in the newly created for-profit STREAT Enterprises

 

Clarifying the finer details amongst investors

As is often the case, the finer details of the deal’s structure contained the most interesting points. The management agreement between shareholders outlines how STREAT (the original non-profit) would be the exclusive manager of the three businesses owned by STREAT Enterprises. For these services, STREAT receives a management fee of 12% of business revenue each year. Procurement is through STREAT to take advantage of its buying power (since it owns multiple cafés).

Legal firm Holding Redlich provided pro bono support to draw up a shareholders agreement, which outlined that all shares are ordinary shares with each investor entitled to their share of the dividends paid. Shares are transferrable, and hence investors are able to exit if they find a buyer for their share. (Approval is not required by the other owners.)

The results speak for themselves

The risks in the deal were substantial, especially given that Scott did not yet fully understand the café business.

…later in 2013 they will hit 50 trainees pa: double their previous numbers.

However, she identified the biggest risks in the transition and successfully mitigated them. To prevent staff leaving, Scott reduced job uncertainty by offering everyone in the business a new contract. She also promoted awareness amongst staff of the social impact, and made it clear that this was not a hostile takeover. To reduce the risk that customers left, she made a big push on PR and media, and wrote a letter to all customers explaining why the acquisition was happening, attached it to every menu, and posted it in each café’s front window.

To ensure STREAT had the capacity to expand successfully, Scott focused on creating and maintaining a stable core team and a stable culture. She also brought in a new staff member that had substantial experience in successfully scaling up another food-based business.

As a result, STREAT has expanded its social impact; it is already able to take on 50% more trainees than previously. Scott and the team are confident that later in 2013 they will hit 50 trainees pa: double their previous numbers.

Relied on relationships of trust

What allowed Scott to take this unconventional step, and prove wrong the naysayers who had thought she was overreaching, were the relationships behind this acquisition.

The trusting relationships enabled the deal to move quickly…

Steele, the behind-the-scenes deal-maker, was a long-time confidante and advisor to Scott. “Working in the same building, Paul has become one of my most trusted supporters. Without him, I wouldn’t have even known this was possible. Additionally his advice and oversight was critical in fine-tuning the details of the deal.”

The four investors in the new business had each known either Steele or Scott personally for many years before this deal was on the table. “The trusting relationships enabled the deal to move quickly, even though some of the financial projections and valuations were essentially ‘back-of-the-envelope’ calculations.”

As far as the financial returns went, investors either trusted Scott and her ability to deliver, or Steele’s appraisal of Scott’s abilities and business model. “Danny [Almagor, Small Giants co-founder and CEO] had been part of the social enterprise scene with me for years,” said Scott. “He knew STREAT and how it operated back-to-front, well before this deal was on the table. And that meant he was already keen to be a part of it, before the details had been decided.”

Most people who meet Scott recognise her ability to build strong relationships. In part it is her authenticity: she clearly believes with all her heart that STREAT’s audacious goals are possible. To some extent it is her ability as a communicator: honed in a previous job explaining complex scientific concepts to young people. And partly it is a genuine love of people – meaning that she makes those around her feel heard and valued, and builds relationships that last.

Lessons for social entrepreneurs, investors and supporters

Scaling social enterprises will almost always require its entrepreneurs to take risks, and choose paradigm-challenging approaches. Scott did not let the norms of the non-profit sector limit the potential of STREAT’s mission.

… they will add even more value through connections and expertise.

She also demonstrated that one of the most valuable skills of an entrepreneur is the capacity to create and sustain trusting relationships – relationships that you can lean on and that will support you throughout the journey.

A less expected benefit for STREAT in this deal was how the investors became a supportive network for the enterprise. More so than grant investors, these investors care about the ongoing health of the business. STREAT’s investors became useful as a sounding board and as moral support. “Into the future, I expect that they will add even more value through connections and expertise,” said Scott.

The deal also exemplifies a clear opportunity for impact-mindful investors. By investing in social enterprises, investors can use their corpus as well as their disbursements – thus enhancing their social impact. Many philanthropic funds invest their corpus in traditional assets (such as property, stocks or government bonds) – often through a third-party investment manager. They then disburse an amount each year in grants to help community organisations have an impact. In Australia, Private Ancillary Funds are required to disburse 5% of their corpus each year.

In this deal, investors chose to invest their corpus in STREAT, rather than in traditional commercial assets. This meant that they were able to have an impact through their corpus, as well as their disbursements. If more investors took this approach, they would potentially be able to significantly increase their impact.

Scott valued Steele’s moral support and his experienced advice.

Finally, we see that supporters have an important role to play in equity financing and other social finance deals. In this case, Paul Steele played multiple roles – supporting Scott in some key ways:

  • Building capacity; he was an ‘expert’. To expand as STREAT did requires important capabilities – such as financial modeling and the know-how to structure the legal entity.
  • Attracting investors; he was a ‘connector’. The network around a social enterprise is often small and it can be hard to find investors. Steele was able to champion the deal, and attract investors from his own network.
  • Providing due diligence; he was a ‘credible advocate’. Investors seek reassurance that the social enterprise and the deal have been comprehensively tested and verified. In this deal, Steele’s credibility was important; investors trusted his assessment of risk and return and of STREAT’s business model Scott’s abilities.
  • Supporting the social entrepreneur; he was a ‘mentor’. Structuring a deal like this can be challenging and Scott valued Steele’s moral support and his experienced advice.

If you’d like to know more, contact us on consulting@socialventures.com.au