Capital and Control: The final two considerations for determining legal structure for your Social Enterprise.
by Peter Smith
August 15, 2012
in Articles, Benefit Corporation, Finance, Flexible Purpose Corporation, L3C, Mission, Social Enterprise, Social Entrepreneur, social entrepreneurship, Social Purpose Corporation, Venture Capital
You want to make a change with your new business venture and you’re ready to file the necessary paper work to form a legal structure, but what type of legal structure should you form? Because your idea combines for-profit considerations and nonprofit motives, you’re a little confused about whether you should form a nonprofit, a traditional for-profit, or a “hybrid” entity like the benefit corporation or a social purpose corporation. You know that I routinely help social entrepreneurs who face this conundrum, and so you come to see me to help you out.
Stop! Go and read my first post on Mission and Markets before coming to see me or reading on because this post is the follow-up to that post. It’ll help, I promise.
Now that you’ve read Mission and Markets and spent time thinking about your mission and the market you will serve, we’re almost ready to talk about legal structure. Before we do, we’ll need to have a frank conversation about two additional factors: (1) capital and (2) control. This post explains those factors. Of course, where you’ll get your capital and what choices you have about control aren’t fully separable from mission and market. Mission, market, capital and control are intertwined, each one influencing the others. After you’ve thought about all four factors, you’ll know what legal structure your idea should take on.
Capital is the life blood of any venture. Through debt, equity, or revenues, your new business will need capital. The key question is: what are the realistic options for funding your idea? The specific answers to this key question are less important, instead think big picture: will people donate to the cause or will an investor invest in my idea?
To help flesh out the above questions, I typically ask a series of follow up questions. Will the general public donate to your cause? In other words, can you demonstrate a significant and compelling social impact that the general public will freely make a donation? Or under your business plan, can investors expect a return on their money if they invest in your business? “No” is a different answer than “yes, but my social impact comes first and so financial returns may be less than an investment in a traditional businesses.”
Most entrepreneurs tell me that their business will be self-funded, at least in the beginning. That’s great, but what about in 5 years or even 10 years later? Will you need a capital infusion to increase the scale of your organization and impact? If so, then you may need investor capital.
In order to receive any investor capital, you’ll need to demonstrate a return of the investor’s money. Venture capital firms will demand a higher return on their investment than a socially conscious angel impact investor, but even the most generous angel investor will want to see a plan to return at least their initial investment. Think back to your consideration of market. Does enough need and scalability exist to seriously entice a venture capital firm to invest in your company? If so, then a for-profit structure probably makes sense because your company can offer equity to these investors—an option unavailable to a nonprofit.
If your business doesn’t have a large market to serve, and you are unsure about how to generate a return to investors, then a tax-exempt nonprofit (or maybe a hybrid model) probably makes more sense. A local soup kitchen, for example, exists to serve the needs of its immediate community. The soup kitchen story is compelling enough for donations, but because its patrons cannot pay, there’s little opportunity for investor return.
Hopefully you can now see how capital plays a significant role in the choice of legal structure for the social entrepreneur. Nonprofit organizations cannot offer equity financing. This doesn’t mean that nonprofit organizations cannot grow into large institutions; it simply means that nonprofits must secure capital through other means. Luckily, the tax-exempt nonprofit enjoys unique funding means, for example, donations and grants from local, state, or federal governments and private foundations.
Keep in mind that the hybrid corporation, the social purpose corporation or the benefit corporation, is a for-profit entity. Hybrid corporations cannot qualify for tax exempt status and thus cannot receive tax exempt donations (at least, not yet). Although these corporations, as for-profit institutions, can offer equity financing, we’ve found that some investors are skeptical or cautious about investing into these corporate structures. On the other hand, the right investors will view a hybrid structure as a positive. It all depends on the investor
Finally, the limits on what your corporation may do—who has control—is a factor that should be considered. I include this factor because entrepreneurs often overlook the corporate control structure and the unique constraints that a nonprofit and for-profit each face. So what kinds of issues should you think about with respect to control?
Generally speaking, nonprofit corporations are the more constrained business structure. First of all, because nonprofits act as trustees for the public good, every decision that a nonprofit board makes should take into consideration the impact on the public. The use of assets and operations must exclusive benefit the public, with only indirect or inconsequential benefits to private actors. Furthermore, donors may include specific limits on gifts and donations. And most importantly, this responsibility continues through winding up and dissolving the corporation—any leftover assets must be passed on to another charity or nonprofit corporation and cannot be kept by the individuals operating the nonprofit. Many entrepreneurs simply cannot accept these administrative and financial constraints.
Second, nonprofits don’t enjoy the same level of confidential operations. If keeping trade secrets is a necessary component of your competitive advantage, then a tax-exempt nonprofit may not be a good fit because nonprofit (and especially tax exempt) organizations are subject to considerable openness. For example, any interactions with the IRS, the company’s bylaws and articles of organization, its tax returns, and accordingly, its employee’s pay, are all documents required to be made available to the public.
Certainly, the nonprofit structure has significant control constraints, but a for-profit structure is not without its own control concerns. When making an equity investment, most investors require some modicum of control. If investors do not demand a board seat, which is typical, then they will demand frequent business reports and investor meetings. Like an in-law, some investors can be intrusive and meddlesome. This is somewhat understandable because they’d like to know that their money is being put to good use. Still, the point bears mention: once you accept an investor’s dollars, you’ll have to live with that investor for a long time.
In addition, the board and officers of a traditional for-profit owe fiduciary duties to their shareholder (investors). After all, the purpose of a traditional for-profit company is to provide a return to investors—an entrepreneur cannot raise a significant amount of money and then immediately pay himself and exorbitant salary. Each decision in a traditional for-profit must be justified as providing a future return for the company, expressed as a return on the bottom line. Often, such concerns put significant pressure on a founding social entrepreneur’s goals. With these sorts of pressures, will your company withstand mission drift? Be honest with yourself: does that matter to you?
The hybrid organizations have some control provisions built into them to resist mission drift from the founder’s original goals. Washington’s social purpose corporation, for example, permits a social mission to be written into the company’s articles of organization such that the officers and directors must consider the social mission when taking action, and it takes at least a two-thirds majority vote of the shareholders to amend that mission. Furthermore, the fiduciary duties of hybrid organizations are typically owed to the companies stakeholders—defined as the company’s employees, customers, the environment its local community, and its shareholders—rather than merely to the company’s shareholders.
3. Conclusion: Choosing a Legal Structure
And with that, it’s time to choose the legal structure. After addressing each factor individually, consider them together for a moment. More often than not, your assessment of mission, market, capital, and control will simply reveal the appropriate legal structure.
The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Peter J. Smith at firstname.lastname@example.org
 A nonprofit is not automatically a 501c3 or other “tax-exempt” organization. Gaining tax exempt status is a separate process that the IRS administers to qualifying nonprofit organizations.
 Yes, nonprofit organizations can offer debt that may seem very similar to equity type financing, but that discussion is for a separate blog post.
January 27, 2020