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How can impact investors make the missing middle less “missing”?

By Timothy Lambert
March 21, 2023
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Entrepreneurs developing innovative solutions for pressing world challenges often end up being cash-strapped. One of the main reasons is because they fail to meet investors whose expectations are in tune with their level of maturity and the design of their impact business model. This is what is often referred to as the missing middle. In this article, we share some essential tips for investors who want to help create a level playing field and invest in early-stage ventures who seek to contribute to urgent societal goals with innovative solutions.

What exactly is the missing middle?

The “missing middle” challenge is twofold: on the one hand, the majority of social ventures are in the early stages of development, meaning they still need to validate their impact model and find a product-market fit or a suitable approach to scaling their impact. On the other hand, many investors, when entering the impact investing scene, approach it with a venture capitalist or private equity mindset. Investment teams seek to rapidly grow in Assets Under Management (AUM) by setting up time-bound funds (typically 10 years) and investing in companies with individual IRR expectations in excess of 15% to provide attractive returns to their Limited Partners.

The result is that most highly innovative and early-stage impact ventures fail to meet the funder’s risk-adjusted return expectations. Wietse van der Werf, founder and CEO of Sea Ranger Service, a social venture that creates both social and environmental impact, reflects on the difficulty to find alignment with investors.

I run a mission-driven company and instead of the highest possible returns for shareholders, my team and I are primarily interested in delivering a sustained and growing impact. During our most recent investment rounds, a number of investors, unfortunately, the ones able to provide more substantial growth capital didn’t meet these values. I feel like there is an expectation from social entrepreneurs that we can deliver market-rate financial returns, year-in, year-out and on top of that, that we also deliver substantial positive impact.

Wietse van der Werf (Founder & CEO of Sea Ranger Service)

As a consequence of this mismatch in investors’ expectations versus social entrepreneurs’ reality, impact investment capital mostly ends up going to ventures operating in more established markets, with a B2B orientation and a tech focus for scalability. Joost van Egen, who runs the social venture Healthy Entrepreneurs that provides basic healthcare in one of the most difficult parts of the world, the Sub-Saharan desert, felt this struggle first-hand.

During our investment rounds, we talked to more than sixty different investors continuously for over fifteen months. It has been an extremely challenging and time-consuming process and most investors said that our type of company wasn't for them.

Joost van Egen (Healthy Entrepreneurs)

Joost’s story fortunately is a triumphant one; he was able to find investors that understood and were willing to cater to his venture’s specific needs. However, many budding impact ventures aren’t as lucky and often end up on the so-called “bench”, leading to a huge wasted potential for scaling innovations that can significantly contribute to solutions for difficult-to-solve societal challenges or that help underserved communities throughout the globe.

Making smart investments in early-stage impact ventures

The reality is that innovative, early-stage ventures need equally innovative funding solutions and support from their investors in order to thrive. However, impact investors willing to rise up to the task can rightfully ask: how to go about supporting early-stage impact ventures?

Tip #1. Use hybrid instruments such as mezzanine instead of plain equity or debt

Early-stage impact ventures often operate in markets with very uncertain exit routes, meaning the strategy to buy early and sell at a multiple to an acquirer hardly works. In addition, the cash profiles of these ventures are less predictable than commercial ventures – this can, for instance, be a consequence of their business model (e.g., supporting migrant populations is dependent on unpredictable migration flows). Hybrid instruments like mezzanine instruments allow one to invest with more flexible terms, ensuring the investor’s returns and risks follow the development of the venture, avoiding unhealthy pressure that can create frazzled relationships with entrepreneurs and accelerate failure risks.

Check the extract from our Innovative Impact Deal Structuring course below for more insights into the pros and cons of mezzanines for investors and entrepreneurs.

Tip #2. Establish smart collaborations to make pursuing impact a revenue-generating activity

Impact ventures and investors can benefit a lot from pooling capital with different risk/return expectations to support ventures. To overcome possible trade-offs between pursuing deep and lasting positive impact and achieving viable financial returns, you may look at ways to remuneration the achievement of impacts. Social impact incentives (SIINCs) and Social Impact Bonds (SIBs) are examples of structures where an investor can achieve market-rate financial results by involving an outcome payer, usually a foundation or public agency, in remunerating the achievement of positive social and environmental outcomes. Establishing smart catalytic collaborations requires proactive engagement with your ecosystem and identifying co-investing parties that could enhance the chances of success of potential investees.

Check this other extract from the Innovative Impact Deal Structuring course below for more insights into Social Impact Incentives.

Tip #3. Provide patient capital by increasing your investment horizon

Expanding the investment horizon allows investors to invest in ventures operating in markets or with models that are unlikely to deliver fast commercial growth and exit opportunities. Releasing the time pressure helps to test and design effective solutions for more entrenched, difficult-to-solve social issues. Patient, long-term investors (7+ years holding period) and evergreen funds are better positioned to support innovative impact ventures.

Are you eager to learn more about how to structure innovative investments to support early-stage impact ventures?

There is a lot more that you can do as an impact investor to become and stay relevant to innovative social enterprises. If you want to learn more about how to structure impact investments in creative and hybrid ways to support early-stage social innovators, or if you are a social innovator seeking impact funding, make sure to check out our Innovative Impact Deal Structuring course.