3
Form versus function
CHOOSING THE RIGHT STRUCTURE
Social enterprise leaders consistently report that finding the best legal structure for their ventures is among their very greatest challenges.
Indeed, it is almost impossible to discuss social enterprise without getting mucked up in the distinction between nonprofit and for-profit organizations. As you may have picked up from some of the definitions we quoted in the introduction to this book, some people in this field hold that the defining feature of a social enterprise is the income-generating commercial activity that supports the social mission of a nonprofit organization. This view is not without some underlying logic. After all, in a market system that awards divine rights to owners, how could a business that is owned by anyone other than the community as a whole put a social purpose at its absolute forefront?
That’s a very valid question, we think—one that sets the standard quite high for what constitutes a for-profit social enterprise. But in fact, some companies organized as for-profits are consistently and unquestioningly driven by their social mission ahead of (if not completely instead of) shareholder enrichment. In our view, these organizations are clearly social enterprises.
40We submit that the defining feature of a social enterprise is not its form but its function. In every nuance of how a social enterprise is born, grows, and becomes sustainable, its common good purpose trumps all. Once this is understood, then the enterprise’s form, most specifically, its for-profit versus nonprofit status, becomes a matter of strategy toward the accomplishment of the social mission rather than a question of mission itself.
■ UNLOCKING THE SECOND PARADOX
If the common good is your function,
then your choice of form is merely a strategy.
In order to understand the strategic implications of your choice of form, you should first scan the existing landscape of organizational options. We would separate the landscape into two simple groups: social enterprises and non-social enterprises (or NSEs, for short).
Social enterprises, of course, we have already defined: businesses whose purpose is to change the world for the common good. We can then define non-social enterprises, simply, as everything else. At least three kinds of organizations fall within the NSE world. While we are not particularly interested in NSEs as such, they have the same array of forms as is available to social enterprises, each with certain strategic advantages and disadvantages, as we will see.
41So much for the world of NSEs. It’s even more important to understand the social enterprise landscape. Our friend and mentor, Mal Warwick, provides a wonderfully simple analysis that separates social enterprises into four distinct quadrants, defined by their form and their methods, but unified always by their purpose.
The social enterprise landscape
(The world according to Mal Warwick)
42
Quadrants 1 and 2 correspond to the revenue-generating model. In quadrant 1, Warwick points out, are parking garages operated by nonprofit hospitals to help underwrite their budgets and a plethora of other for-profit enterprises launched by nonprofit organizations to make money, pure and simple. Quadrant 2 holds remarkable ventures such as Newman’s Own, Working Assets, and Give Something Back, all of which operate profitable businesses and dedicate most or all the profits to support a range of social-sector organizations.
Warwick contrasts these revenue-generating enterprises with the enterprises in quadrants 3 and 4, which are established primarily to address one or more social problems. Quadrant 3 includes organizations such as Goodwill Industries and Rubicon Programs, both of which engage in business to provide training and jobs to people who would otherwise face barriers to employment, and environmental organizations such as the Environmental Management Institute, which operates as a business but is organized as a nonprofit. In quadrant 4 lie those enterprises established as for-profit businesses but whose natures are centered on their social missions. Warwick cites ShoreBank as a prime example of a quadrant 4 enterprise—a precedent-setting bank operated and regulated like any other but dedicated to creating “economic equity and a healthy environment.”1
Why Form Matters
Form is a strategic decision because it creates the foundation on which the structure is built and the environment in which the structure exists. Form affects
- How and by whom you are governed
- How transparently you go about making and communicating decisions
- 43 The level of support you can expect from your community, from government, and from allied organizations in your social purpose space, and therefore your ease of doing business
- Whether and how you are taxed
- Most profoundly, everything about your capital structure, from your access to and use of capital to how profit is redeployed—all of which determines how aggressively you can invest in the growth of your enterprise
These issues are tightly interwoven. Access to capital is exponentially more important as social enterprises prepare to go to scale. Financing a social enterprise is inextricably tied up with the choice of a legal structure and the tax implications thereof. It’s a complicated discussion that is becoming more so as creative legal, finance, and accounting minds work to develop new models to bring funding to social enterprises.
To do justice to this topic, we turned to Allen Bromberger, the leading attorney in the emerging and highly specialized field of social enterprise financing. In recognition of his passion and brilliance in this field, he was recently awarded the 2008 Leadership Award by the Social Enterprise Alliance. He has a great way of turning arcane legal constructs into vivid, simple concepts you can work with. He graciously provided a primer on this topic for our readers.
44Strategic Implications of Social Enterprise Forms
By Allen R. Bromberger
Because social enterprises often seek to pursue business and nonbusiness objectives within a single entity, it is hard to fit them into traditional legal forms.
If the business will be capitalized primarily by invested capital (capital provided with the expectation that the investor will receive a financial return), a business corporation or limited liability company (LLC) is probably a better choice than a nonprofit charity as the mother ship for the enterprise. On the other hand, if the venture will be primarily financed by donated capital (capital for which no financial return is expected), a nonprofit mother ship will probably be best, especially if the “investors” want or need tax deductions for their contributions. But rarely will one entity suffice for a true social enterprise. Usually a combination of entities is required.
Using Nonprofits for Social Enterprise
Nonprofit corporations cannot issue shares and cannot distribute profits to “owners” the way that business corporations or LLCs can. However, nonprofits can issue debt and pay interest to lenders. So long as the rate of interest is commercially reasonable, and the purpose of the debt is to further the charity’s interests rather than those of the lender, it does not matter that the lender is motivated purely by a profit motive. A charity can even create different classes of debt, each with different economic rights based on different financial arrangements.
Another significant challenge for charities that operate businesses is Unrelated Business Income Tax, otherwise known as UBIT. UBIT is a tax on income to the charity that comes from an “unrelated” business activity. A charity’s income is subject to UBIT—which means it is taxed at normal corporate tax rates—if it comes from a trade or business that is regularly carried on and that does not contribute to the charity’s mission in any important way other than through the production of income. Certain activities, such as publishing or advertising, are treated as unrelated income by the IRS regardless of whether they are related to the charity’s purposes, and revenues from those activities are therefore automatically subject to UBIT.
Using For-Profits for Social Enterprise
Using a for-profit entity as the vehicle for social enterprise offers a number of business advantages. It avoids all of the restrictions of using a charity, and it allows the organizers much greater flexibility in raising capital. In addition to debt, business corporations can issue shares and pay dividends, they can enter into profit-sharing arrangements with other businesses, and they are not subject to the “reasonable compensation” rule or UBIT. A primary disadvantage of a business corporation is the fact that contributions to the business are not tax deductible, and contributions by the business are deductible only up to 10 percent of net income.
A stickier strategic implication of the for-profit form is that of governance. The managers of a business corporation have a fiduciary obligation to run the company in the best interests of the shareholders. Because the interests of 46shareholders is typically interpreted to mean the shareholders’ economic interests, most experts agree that the pursuit of financial gain for the benefit of the owners is the primary function of a business corporation. A case can be made, however, that the shareholders’ interests in a social enterprise include the accomplishment of social outcomes, especially when the shareholders themselves have included a provision to that effect in a well-drafted shareholder’s agreement. In such a case, the managers’ duty would extend to producing social outcomes as well as profits.
Another business form that lends itself to social enterprise is the LLC. LLCs differ from corporations in that they are formed and owned by “members” rather than “shareholders” and they offer pass-through tax treatment. That means that the income and expenses of the business are reported as though the members had incurred them directly, and any profit or loss is taxed at the ownership level, rather than the entity level. Thus, if one member of the LLC is a business corporation, and another is a charity, the business corporation would pay tax on its profits, but the charity would not (assuming the business is related to the charity’s purpose).
LLC laws in virtually every state allow great flexibility in structuring governance and management, much more so than the laws that govern business corporations or nonprofit corporations. LLC members have wide leeway to allocate profit and loss and management powers among themselves however they see fit, and as with business corporations, different classes of membership are permitted, each with its own economic rights.
LLCs are well-suited for enterprises with a limited number of investors and relatively low investor turnover. However, 47if shares are to be offered to the public or if frequent investor turnover is expected, a business corporation will probably serve better than an LLC.
Using a Joint Venture for Social Enterprise
Nonprofit corporations, business corporations, and LLCs can all participate in joint ventures. So, for example, a charity and a for-profit company can form a joint venture using an LLC as the vehicle for the enterprise and use the operating agreement to specify the rights and obligations of each member. Each member is bound by the rules that govern its own existence, so the charity may not use the joint venture to confer an undue economic benefit on the for-profit cov-enturer, nor may the business corporation use the joint venture to do something that it could not do directly, but in most situations, this is not a problem.
The participants in a joint venture do not, of course, have to create a separate entity as the vehicle for a joint venture. Many so-called joint ventures are created by agreement only, using such vehicles as grant agreements, financing agreements, management agreements, joint operating agreements, leases, licenses, corporate sponsorship agreements, or contracts for services.
Allen Bromberger has been an innovator in developing new and unique forms for social enterprises because he understands the conflicting advantages and disadvantages of the existing non-profit and for-profit choices. His knack is for creating structures that offer social enterprises the best of both worlds because neither form is perfect.
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Form, Function, and Finance
Not surprisingly, several of these trade-offs have to do with the issue you’ll grapple with time and again as you move your enterprise to scale: financing growth. Billions of dollars in trust funds, foundations, and endowments are issued to nonprofits for the necessary work of delivering social services in the traditional manner. This work has its place—and its limitations. Often, it has relieved symptoms of social ills, but not to the elimination of the social ills themselves. If we consider only nonprofit forms, we will be limiting our access to the investments necessary to achieve the goals desired. We will not be able to take advantage of the institution we seek to engage.
For-profit businesses have at their heart an investor, an operator, and a customer. The vast majority of investment dollars reside in the for-profit arena. We need to attract the level of investing that will allow for scale. Depending on the capital intensiveness of your industry and the capital requirements of sustainable, scalable growth, availability of capital alone may be the deciding factor on form. It certainly was for the founders of Evergreen Lodge, as Lee Zimmerman explained to us:
We kind of let the business dictate whether we were going to go for-profit or non. It turned out to be a lot easier to show banks business plans for a real business. We also thought that it was a better model for the youth program that we wanted to do as well. The bank process is also a lot quicker than trying to get money from foundations. Banks are just faster.2
We predict that as more and more social enterprise leaders pursue serious scale, we will see more and more adopting the for-profit, LLC, or joint venture forms or even the new forms, 50such as L3C corporations or B corporations, that are emerging even as we prepare the final draft of this book.
The L3C designation, created in Vermont in 2008, allows for the creation of a hybrid between a nonprofit organization and a for-profit corporation. The entity would be a low-profit company with charitable or educational goals. The B corporation is a private designation given to organizations that pass comprehensive and transparent social and environmental screens and then institutionalize these values by amending their corporate governing documents to incorporate the interests of employees, the community, and the environment.
As unique forms of enterprise emerge, financial innovators are emerging right alongside them. At the forefront is the Good Capital organization led by our friends Kevin Jones, Tim Freundlich, and Joy Anderson. Good Cap is raising a private equity fund to invest institutionally in for-profits and nonprofits. Good Cap’s innovation is a form of financing that acts like venture capital to the enterprise. However, unlike venture capital, it is actually structured as debt without recourse, with no claims on collateral assets. Investors are paid a contractual return if and when the enterprise hits certain benchmarks of doing well (financial performance) and doing good (mission delivery).
Jones and his colleagues are constructing a form of financ-ing that works regardless of the nonprofit or for-profit form of the enterprise. It is crafted to meet the interests of the investor, not the constraints of the organization’s form, according to Jones:
It’s attractive to a particular kind of investor who doesn’t just factor in risk and return. These investors factor risk and return and their impact on the world and the impact 51of their money in the world, so it becomes a much more philanthropically motivated investment. They apply an investment screen against realistic pro formas of future performance that we’re holding these enterprises to and are expecting compliance to. And yet that’s a validator of something more. They’re not investing with us to make a lot of money.3
The moral of the story? If you want to make the greatest possible impact on the common good, you must remain open to all possible corporate forms and choose the one that fuels your enterprise’s mission-delivery growth.
■ PRACTITIONER’S TIP
All things being equal (and they usually are not!),
choose the form that finances growth.
The Final Implication of Form
Perhaps more than anything else, and more than most of us would care to admit, the choice of form affects the organizational mind-set when the hardest decisions have to be made. Jim Fruchterman, president of Benetech (which happens to be one of the strangest social enterprise forms of all, a nonprofit 501c[3] that was spun off by a for-profit Silicon Valley high-tech company and now has a wholly owned for-profit subsidiary of its own), makes a brutally honest distinction:
I get asked a lot by people, “Should I start a for-profit or a nonprofit?” And we are having a lot of debate these days about hybrid organizations. But if you divide your choices into “Am I a business with a social focus, or a nonprofit 52with a business method of action?” ultimately when those two bottom lines are in conflict, your organization form determines which one of those dominates. So you have to choose one or the other. And of course everyone says, “Well, we don’t ever want to have to choose.” Well, yeah, you don’t, but there will be a day for almost every organization where you do.4
The very phrase “nonprofit” is actually an unfortunate accident of vocabulary that we wish would disappear altogether. It’s a moniker that seems to imply that “not profitable” is an acceptable condition for a social enterprise or that “not striving to be profitable” is an acceptable strategy.
Regardless of organizational form, profit is the most undirty word in the world when it is said in the context of social enterprise. Says Clara Miller, president and CEO of the Nonprofit Finance Fund: “You don’t make a business profitable by having for-profit tax status, and you can’t operate a business if it is unprofitable, even if it has nonprofit tax status.”5
■ PRACTITIONER’S TIP
Whether an enterprise is for-profit or nonprofit in form,
“not profitable” is never an option.
It is true that many if not most nonprofit social enterprises have not achieved sustained profitability. That’s not okay. Without profitability, they will continue to rely on public subsidy, and with public subsidy engrained in their financial models, they will never achieve the scale that we need to change the world.