From Social Impact Bonds to Social Venture Equity

This post originally appeared on Nonprofit Finance Fund's Blog and is co-authored by Deirdre Flynn, Associate Director, Pay for Success Program.

The Pay for Success (PFS) field has gone through astonishing changes in the years since the first contracts launched in the US. Those early projects (Rikers Island, Massachusetts Juvenile Justice, New York CEO, Cuyahoga) all only wavered from the original concept in minor ways. In brief, those projects all had payment based on a Randomized Control Trial (RCT) evaluation with the vast majority of success payments linked to the formal population-level evaluation. While the use of blended capital (philanthropy, subordinated debt, and senior lenders) was prevalent in these early efforts, in later years alternate uses of capital have been explored and implemented. In this blog post, we’ll review a project that explored non-debt funding as part of our investigation into new roles for outside financing in Pay for Success.

Third Sector is committed to examining new solutions that fit the local context, and through funding support from the Nonprofit Finance Fund (NFF) and the Social Innovation Fund (SIF), we worked with partners in San Diego to understand how innovative financing approaches could be leveraged to support veterans with service-connected disabilities. We focused on coordinating local wrap-around services with the Veterans Administration which provides vocational rehabilitation training to service disabled veterans. While the project didn’t progress to a launched contract for reasons unrelated to its innovative financing, funding support from NFF and SIF allowed continued exploration of a new financing approach that offers an alternative to the standards developed in the earliest projects.

In San Diego, we explored two new ways to use private capital to advance outcomes for those needing coordinated care around a central job training program. In both cases we explored incorporating features more common in equity financing into our project design.

The first approach envisioned having investors pay for a supplemented training program for veterans with repayment based on the future earnings growth of the participants.  Much like an angel investor or venture capitalist, the funder is betting on earnings growth, knowing that if wages don’t increase, their investment and hoped for return would be forfeit. Structurally, this arrangement is similar to a Pay as You Earn (PAYE) student loan. Monthly payments are capped at 10% of discretionary income and any debt remaining after 20 years is forgiven.  While this arrangement is not exactly an equity investment, it aligns incentives in the same way. Both the participant and the investor have the same goal of maximizing the income of the trainee over the long term.  

The second approach incorporated the use of an option, which is common in the equity financing world.  In finance, an option is an agreement where the holder has the right, but not the obligation, to buy stock at a given price at some future date. In our concept, the service provider has the option to receive a second round of philanthropic funding to expand its care coordination services if the evaluation of their impact exceeds certain predetermined amounts. For example, if emergency medical or behavioral health demand drops below some agreed to level, the philanthropic funder will provide additional funding to continue or expand services.  In this way, success payments would be used to expand services (equity expansion) rather than for debt repayment (liability reduction).

The reason we explored this mechanism was that many organizations undergoing evaluations need to use the evaluation results to raise additional funding, which could result in a suspension of services while the funding was being secured. By gaining commitment for ongoing funding at the onset of the project, and by connecting the option to receive that funding directly to the PFS evaluation results, the risk of that gap is eliminated.

It is important to experiment with novel approaches that seek to align incentives in funding for PFS projects so that providers, government, and funders can best address the needs of those most at risk in our community. NFF and SIF support have been critical to continue innovation in PFS funding. Although this project did not launch, the team’s commitment to finding a solution to real challenges in implementing PFS resulted in a greater understanding of what might be possible. Our Third Sector team takes pride in not allowing the past to constrain solutions for the future. We anticipate that these experiments in alternatives to debt financing will be tested in future projects as well as other approaches that have yet to be conceived.