Taking a different approach to financing: Revolving Funds

Money makes the world go round, and even the brightest ideas need investment. One way is finding a venture capitalist, business angels or incubator to generate seed fund for your enterprise in the make. Another less practiced option is taking part in a revolving fund.  Well, it’s time to pay extra attention to this last mechanism. In these times of fewer options for subsidy, banking sectors are not interested in risky innovation projects and tend invest sustainable, so a revolving fund just might be the solution.

What is a revolving fund?

A revolving fund is a financial instrument where means for risk financing are utilized from a fund. Revolving means that the funds invested will eventually flow back as interest or gains on participation will be made available for a new (innovative) project/investment. This is in contrast to subsidies, which can only be handed out once and without issuing a refund. Turning to a revolving fund structure becomes interesting when the investment has a longer payback or when the capital market cannot wear the associated risks. Due to the fact that a revolving fund gathers a package of different projects, it therefore has the flexibility to incorporate more risky and innovative projects. In this way, a revolving fund can be a ‘nursery’ for innovations. The two leading questions in a revolving fund are:

• What is market failure that is tackled by the fund?
•  What is the purpose / problem that is being solved / stimulated by the revolving fund?

A revolving fund is characterized by setting aggressive selection and performance targets as criteria for top projects to succeed. A revolving fund could be a vehicle to overcome barriers like risk averseness and lack of deal flow. This mechanism has the following strengths:

• More projects are fulfilled, and faster
• It provides an opportunity to invest the same money, several times
• It is not a subsidy, hence the loan character appeals to the responsibility
• The ecosystem creates a platform for knowledge sharing; content and personal involvement leads to better results;
• And last, it stimulates the entrepreneurial mindset

But with strength, comes weakness. So what might be the risk you encounter when dealing with a revolving fund?  Besides being managed well, the fund must also be balanced well. The reality might be opposing social and financial objectives, pushing pressure on the short term outcomes instead of the longer term focus, which is often required when dealing with system changes. Linked to this is that managing a revolving fund requires specific knowledge: knowledge on how to generate the right ecosystem to make sure the projects within the fund grow (otherwise the fund will shrink rapidly and will have no revolving character at all). This knowledge is spread thin and work in progress. At the same time, the organization of the fund management implies overhead, which upfront is hard to assess in numbers, partly because the lead time to establish a revolving fund vary from a couple of months to years.  But the most important clause is that the beneficiary of the fund, the inventor or start-up, must assure the refund. Meaning that the innovation indeed will be scalable and has a proper return on investment .  Therefore, it is important to select the right criteria. On this point, advice differs. And more important, it should be customized to the sector you are working in.

Still interested? To have an effective revolving fund, there are some rules you have to obey. The four most important are:

1)      Answer the two questions mentioned earlier to be clear on the objective and focus

2)      Have transparent selection criteria that define the projects eligible to the revolving fund

3)      Create a structured supporting eco-system that is occupied with the funds management

4)      Recognize that not every project in your fund will be a success: the hope is re-creating deployable resources, but due the innovative high-risk profile, there is a chance that not all projects will succeed. So create a buffer for this.

Source:
Vliet, L. van, Groenewoud, R. and Berendse, S. (2012) Revolving Fund factsheet (in Dutch)