L3C Archives - socentlaw

PROFIT + PURPOSE

Over the last year, I’ve been lecturing at Harvard Law and Stanford Law about structuring social enterprises for impact. I always have people asking me to see the slides, but have never publicly shared the slides. Today I’m releasing those slides to the public.

This is meant to be an introductory presentation that touches on the possible legal structures for social entrepreneurs. The presentation discusses Corporation, B Corp Certification, Benefit Corporation, Flexible Purpose Corporation, L3C and Nonprofit legal structures. Within each legal structure, the presentation touches on Formation, Management, Taxation and Capital.

Click below to access the presentation. Leave your feedback in the comments section. Thanks!

 

B CORPS: FIRMS WITH BENEFITS

Originally posted in The Economist

 

By: Matthew Bishop

He likes to do things differently. Yvon Chouinard changed his favourite sport, mountaineering, by introducing reusable pitons (the metal spikes you bang into the rock face and attach a rope to). Climbers often used to leave pitons in the cliff, which is environmentally messy, another of Mr Chouinard’s peeves.
In business, Mr Chouinard, the founder of PatagoniaOriginally posted in The Economist He likes to do things differently. Yvon Chouinard changed his favourite sport, mountaineering, by introducing reusable pitons (the metal spikes you bang into the rock face and attach a rope to). Climbers often used to leave pitons in the cliff, which is environmentally messy, another of Mr Chouinard’s peeves. In business, Mr Chouinard, the founder of Patagonia, an outdoor-clothing firm, says he believes that well-treated employees perform better. (He wrote a book called: “Let My People Go Surfing”.) Before it was fashionable, Mr Chouinard preached a philosophy of sustainability and long-term profitability that he calls “the slow company”.

On January 3rd Patagonia was anything but slow in becoming the first firm to take advantage of a new California law designed to give businesses greater freedom to pursue strategies which they believe benefit society as a whole rather than having to concentrate on maximising profits for the next financial quarter. According to Mr Chouinard, the new “benefit corporation”—usually referred to as a B Corp— creates the legal framework for firms like his to remain true to their social goals. To qualify as a B Corp, a firm must have an explicit social or environmental mission, and a legally binding fiduciary responsibility to take into account the interests of workers, the community and the environment as well as its shareholders. It must also publish independently verified reports on its social and environmental impact alongside its financial results. Other than that, it can go about business as usual.

The B Corp is a deliberate effort to change the nature of business by changing corporate law, led by B Lab, a non-profit outfit based in Pennsylvania. California is the sixth state to allow B Corps; the first was Maryland, in April 2010. Patagonia was followed immediately by another 11 Californian firms, including Give Something Back Office Supplies, Green Retirement Plans and DopeHut, a clothing retailer. Across America, there are now several hundred B Corps. Before Patagonia, the best-known was probably Seventh Generation, a maker of green detergents, paper towels and other household products.

California’s B Corp legislation took effect alongside a new law creating the “flexible purpose company” (FlexC), which allows a firm to adopt a specific social or environmental goal, rather than the broader obligations of a B Corp. Another option in America is the low-profit limited liability (LC3) company, which can raise money for socially beneficial purposes while making little or no profit. The idea of a legal framework for firms that put profits second is not confined to America. Britain, for example, has since 2005 allowed people to form “community interest companies”.  Similar laws are brewing in several European countries.

The impetus for all this comes from people like Mr Chouinard, who believe that existing laws governing corporations and charities are too restrictive. For-profit firms, they argue, often face pressure to abandon social goals in favour of increasing profits. Non-profit firms and charities are needlessly restricted in their ability to raise capital when they need to grow. This prevents socially minded organisations from pursuing their goals as efficiently as possible. Existing laws for co-operatives and mutual companies are inadequate. Hence the need for B Corps and other novel structures, goes the argument. There is no tax advantage to being a B Corp, but there is to some of the new legal structures.

Whether these new legal forms will change business that much remains to be seen. Supporters of existing corporate law say it does not prevent firms, if they so wish, from setting social and environmental goals or rigorously reporting on their performance in delivering them—and that pursuing profit is often the best way to benefit society. Nor is it clear how much difference in practice will be made by the obligation of a B Corp to weigh interests other than profits. How does one measure such things? What counts for more: a clean lake or a happy neighbour? .
Mr Chouinard argues that making a firm’s social mission explicit in its legal structure makes it harder for a new boss or owner to abandon it. Perhaps so. B Corps will be tested in the market. Anyone who feels inspired by a B Corp’s mission is free to invest in its shares, or work for it.

 

 Photo: Wanaku

THREE OBJECTIONS TO L3C’S ANSWERED

Though many sections of the American Bar Association are in favor of L3C legislation, the Nonprofit Organizations Committee and the Limited Liability Companies, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association are planning to oppose the L3C legislation based on three primary objections. Below are the objections and the responses by leading nonprofit attorneys excerpted from their letter.

1. L3C’s are no better at receiving PRI’s than an LLC

Your letter indicates that “The L3C is no better than any other business form for receiving program related investment[s] ….”  In our view, an L3C is a better vehicle for accepting program-related investments than a standard LLC. The state-law L3C restrictions will make it easier for private foundation investors to conduct the due diligence necessary in order to complete a
program-related investment and comply with expenditure responsibility. A charitable purpose would necessarily be articulated in the L3C’s operating agreement, helping to ensure that the L3C’s purposes and operations are
aligned with PRI requirements. Persons who form L3Cs are likely to be better informed about the  requirements applicable to private foundations for PRIs and for expenditure responsibility and so draft their operating agreements accordingly.  The L3C designation automatically sets the entity apart from ordinary LLCs that may or may not be structured in  a way compatible with PRI requirements.
We agree, and understand that, L3C is not necessary for an LLC to serve as the vehicle for a program-related investment, and we have represented many foundations that have made PRIs into LLCs, but we believe that in many cases L3C will make it easier for foundation investors to make the findings that they need to make for a proper PRI and for compliance with expenditure responsibility.

Your letter indicates that “The L3C is no better than any other business form for receiving program related investment[s] ….”  In our view, an L3C is a better vehicle for accepting program-related investments than a standard LLC. The state-law L3C restrictions will make it easier for private foundation investors to conduct the due diligence necessary in order to complete a program-related investment and comply with expenditure responsibility. Acharitable purpose would necessarily be articulated in the L3C’s operating agreement, helping to ensure that the L3C’s purposes and operations are aligned with PRI requirements. Persons who form L3Cs are likely to be better informed about the  requirements applicable to private foundations for PRIs and for expenditure responsibility and so draft their operating agreements accordingly.  The L3C designation automatically sets the entity apart from ordinary LLCs that may or may not be structured in  a way compatible with PRI requirements.We agree, and understand that, L3C is not necessary for an LLC to serve as the vehicle for a program-related investment, and we have represented many foundations that have made PRIs into LLCs, but we believe that in many cases L3C will make it easier for foundation investors to make the findings that they need to make for a proper PRI and for compliance with expenditure responsibility.

2. Traunched investment results in private benefit for profit-seeking investors.

Your letter indicates that “tranched investing purposefully uses foundation funds to subsidize (and thereby attract) private, profit-seeking investors” so that such a PRI “almost inevitably results in private benefit.” Tranched financing does not lead to per-se private benefit, as you suggest.  Private benefit depends on all of the  facts and circumstances in a given situation.

In fact, a PRI (other than one made to a charity) always involves some level of private benefit, but rather than a disqualifying private benefit, it is deemed incidental to the accomplishment of charitable purposes. One example in the Treasury regulations involves a foundation making a below-market-rate loan to a “business enterprise which is financially secure and the stock of which is listed and traded on a national exchange,” in order to encourage the enterprise to establish a factory in a depressed urban area. In this example, there is clearly private benefit, since the corporation receives a below-market-rate loan from charity – but the private benefit is incidental. In any PRI investment in a for-profit entity there is private benefit, but the private-benefit doctrine involves a weighing of public good against private benefit.

In any case, there is  nothing in the L3C statutes that requires or even addresses tranched financing anymore than there is in the LLC statutes. L3C is now a creature of the states and American Indian nations that have adopted it, not of some promoters. Just because some promoters of L3C have talked about tranches does not mean that tranched financing is an inherent part of L3C. It is simply not in the L3C legislation

3.  Supposedly “Low Profit” companies could make significant profits.

Your letter also points to a purported “technical error” in the L3C legislation, suggesting that there is some contradiction between the requirement that “no significant purpose of  the company  is the production of income or the appreciation of property” on the one hand and the label “low-profit” and the involvement of for-profit investors on the other. But there is no such contradiction.

L3C requires that the primary purpose of the organization must be charitable, but permits the production of income to be a secondary purpose. As with a tax-exempt charity that must have a charitable purpose by law, yet also must, from an economic standpoint, have sufficient revenue to conduct operations, institutional decisions must be made with the L3C’s overarching charitable purpose in mind, but profit may certainly be the result. The fact that an investment produces significant income or appreciation is not, in the absence of other factors, conclusive evidence of a significant purpose involving the production of income or the appreciation of property.

In fact, an example in the Treasury regulations, in analyzing an investment by foundation “Y,” states that the investment “is a program-related investment even though Y may earn income from the investment in an amount comparable to or higher than earnings from conventional portfolio investments.” When assessing whether a “significant purpose” of a foundation’s proposed investment is the production of income for purposes of the PRI rules, the IRS finds it “relevant whether investors solely engaged in the investment for profit would be likely to make the investment on the same terms as the private foundation.”

Such an investment is less likely to be a PRI to the extent that for-profit investors would enter it on the same terms as a foundation. The clear corollary is that for-profit investors may enter such investments on terms more favorable to them than those under which a foundation is willing to invest. Thus, L3C can bring together foundations’ PRIs and investments on more favorable terms by for-profit investors to accomplish the L3C’s primary charitable purpose through a business that, because of its inherent risk and low likelihood of profit, simply would not be attractive solely to for-profit investors.

photo: Kate Gaensler

419 L3C’s IN THE US

According to a recent report from our good friends at L3C Intersector Partners the L3C movement is growing. There are now 419 L3Cs in the US. Below is the breakdown by state. Click here for the full report.

169 L3Cs organized in Vermont (since April 2008)
93 L3Cs organized in Michigan (since January 2009)
25 L3Cs organized in Wyoming (since February 2009)
36 L3Cs organized in Utah (since March 2009)
1 L3C organized – Oglala Sioux Tribe (since July 2009)
63 L3Cs organized in Illinois (since January 2010)
22 L3Cs organized in North Carolina (since August 2010)
8 L3Cs organized in Louisiana (since August 2010)
2 L3Cs organized – Maine (starting July 2011)
0 L3Cs organized – Rhode Island (starting July 2012)
———————————————————————————
419 social entrepreneurs blazin’ a path

Photo: Himalayan Trails

MISSION AND MONEY: A DANGEROUS MIX

Are so-called hybrid organizations such as B Corporations and Low-Profit Limited Liability Companies (or L3Cs) good models for social entrepreneurs?

Social entrepreneurs are quite excited about this new trend of mixing mission and money within the organizations they run.  You can often hear many of them proclaiming their intention to “do well by doing good,” implying that they will not only save the world but they will make money doing it. Behind the slogan, these entrepreneurs are experimenting with what we call “hybrid” organizations.  In the for-profit world, new organizational creatures with descriptions like “social business” are now prioritizing social and environmental goals equally with financial performance.  Among non-profits, social entrepreneurs are launching what are usually called “social enterprises” or income-generating businesses, like coffee shops, thrift stores, and bakeries, within non-profit organizations.

One the surface these hybrid organizations look very promising—an opportunity to have your cake and eat it too.  The reality, however, is that these hybrid organizations come with substantial risks and consequences that are rarely discussed and that need to be carefully taken into consideration from the start.

Last week I participated in a research symposium on “Exploring Social Enterprises” at the UCLA School of Public Affairs; much of the discussion centered on organizational hybrids.  Several researchers presented truly cutting-edge findings about the consequences of choosing the hybrid organizational type.  Cumulatively, this research identified four key risks associated with hybrid organizations.

The first, overarching risk is that people just don’t know what hybrids are. Is it a for-profit? Is it a non-profit?  Is this about mission or money?  This ambiguity doesn’t just affect potential investors who, for a start, are often not sure whether these organizations are a fit for venture capital or venture philanthropy.  The ambiguity also affects board members who are not clear on whether their primary responsibility is to uphold mission or financial performance. Internally managers and staff face similar confusion and their decision-making often wavers or stagnates as a result.

Risk No. 2 is that these hybrids often have no clear systems of accountability. In traditional for-profits, everyone knows that profit maximization is the ultimate goal.  In traditional non-profits, everyone knows that social impact is the ultimate goal.  In hybrid organizations, these two goals are purportedly equal and yet they are often at odds.

The magnitude of this risk is easily understood by looking at funding flows to hybrid organizations—they are virtually non-existent. Capital flows require transparency and certainty, particularly with regard to the organization’s priorities. For hybrids with two equal priorities and no transparent system to uphold them, the risk of misalignment and failure is extremely high. Consequently, capital avoids these investments.

Over the past few years innovations such as B Corporations and Low-Profit Limited Liability Companies (L3Cs) have attempted to provide mechanisms to create this transparent accountability.  But without formal, widespread legal infrastructure to codify decision-making authority, the risk of weak accountability is too high.

Risk No. 3 is that hybrids often have difficulty maximizing either social impact or financial sustainability.  As the dichotomy between these two forces pulls social entrepreneurs in different directions, hybrid organizations often experience both internal and external pressures to lean more in one direction or the other. Non-profit social enterprises often ultimately choose social mission as their priority and find their enterprise running at a loss.  For example, the leaders of one non-profit operating a Ben & Jerry’s Partnershop decided that their commitment to employ disadvantaged youth with serious social and emotional challenges outweighed the gains in customer service that could be had from hiring more “polished” employees. The non-profit also determined that it was necessary to employ a social worker as full-time support staff for the youth in the ice-cream shop. Unsurprisingly, the Partnershop operated at a net loss.

For-profit hybrids often ultimately prioritize profit over mission and thus compromise their social and environmental impact.  The social entrepreneurs who founded Blue Avocado, makers of a line of hip reusable shopping bags, found early on that they had to make difficult choices about the level of environmental sustainability they could achieve for a competitive price. Their original hope was to create a locally sourced, fully organic cotton bag, but with a resulting unsustainable price they realized that some sacrifices on sustainability would be required to keep their social business viable.

Finally, Risk No. 4 is that as hybrids face pressures to maintain financial sustainability it will come at the price of a long-term erosion of moral legitimacy. One research study presented at UCLA investigated social service non-profits that employ their clients through jobs-training programs at social enterprises such as coffee shops and janitorial services companies. In these organizations, moral legitimacy was often questioned as clients were increasingly treated like regular employees and were “commoditized” by the business. A second study looked at the particular case of NPower, a non-profit technology provider that received substantial cash and in-kind support from Microsoft. As NPower was perceived to become more “business-like” in its operations, peer organizations questioned their non-profit integrity and social focus.

The net result is that hybrid organizations are not exactly the panacea they appear to be. Mixing mission and money is tricky business, requiring strong leadership to articulate and maintain clear priorities and accountability.  The attraction to this type of organization is rooted in our hopes of find more financially sustainable ways of creating social and environmental impact. But as social entrepreneurs explore this intriguing territory, we must also beware of serious and substantial risks.

reposted from Inc.com November 15, 2010

By: Suzi Sosa

Photo By: drburtoni

HYBRID MODEL FOR NONPROFITS HIT SNAGS

Since its founding in 2003, the GlobalGiving Foundation has used its Web site to channel more than $30 million to charitable projects like buying seeds for farmers in Zimbabwe and feeding orphaned chimpanzees.

It also sent approximately $10 million in payments and loans that were never repaid to a company, ManyFutures Inc., that was largely owned by GlobalGiving’s founders, Mari Kuraishi and Dennis Whittle, former World Bank executives turned social entrepreneurs.

ManyFutures provided the technology platform on which the GlobalGiving Web site operated, and which it hoped to sell to others. But the company never broke even, even though it paid nothing for the platform, which had been donated to ManyFutures. In late 2008, GlobalGiving converted its loans into ownership of the company, paying Ms. Kuraishi and Mr. Whittle just $12,000 for their stakes.

They had invested $1.4 million. “I lost a large majority of my net worth doing this,” Mr. Whittle said. “It’s been personally very painful.”

GlobalGiving is one of the most prominent examples of the hybrid model of social enterprise that married a profit-making business to a nonprofit organization. Such dual-mission companies have sprouted over the last decade as a means of addressing the financing difficulties faced by many nonprofit groups, particularly as they need capital to expand. “It is virtually impossible to grow a social enterprise in any significant way relying wholly on donated money, earned revenue and debt financing, which are the only sources of financing available to nonprofits,” said Allen Bromberger, a lawyer with extensive experience in nonprofit financing. “These hybrid structures allow social enterprises to tap conventional investors interested in making profits while continuing to pursue their social missions.”

But like Dr. Dolittle’s pushmi-pullyu, the animal that had trouble moving because its two heads could not agree on a single direction, the hybrid model for nonprofits is proving problematic. On occasion, the need to generate returns for investors overwhelms the social mission. In other cases, the business falters altogether and cannot support the nonprofit.

Within the last two years, several ventures have split up or been dissolved. For example, World of Good’s commercial unit was bought by eBay, and its nonprofit arm is now struggling to stand on its own. Another prominent hybrid, Pura Vida Coffee, almost collapsed. And some, like GlobalGiving, demonstrate how hard it is to “cash out” of a venture that is not purely commercial. It wound up using foundation grants to prop up its losing profit-making partner.

Mr. Whittle said two things drove their decision to create a hybrid. “We looked at the philanthropy and didn’t think we could raise the capital required to support the technology, and we wanted to impose a brutal bottom-line discipline on what we were doing,” he said.

Investors have increasingly voiced concerns about hybrid groups. “This conjoined structure really has problems,” said Kevin Doyle Jones, a partner at Good Capital, one such investment firm. “Embedded in it is an inherent risk that individuals are profiting from donations that were made for public benefit.”

These entities, he cautioned, should avoid engaging in “private inurement,” or providing excessive benefit to a person who is close to or has a controlling interest in a nonprofit — though tax law says nothing about how much is too much.

Even newer models are evolving. Several states have passed legislation that permits the creation of so-called LC3 companies, which can raise money from traditional capital markets but place social benefit ahead of profit, and B Corporations, which are certified based on their ability to demonstrate that their business produces certain social goods. But Will Rosenzweig, a founder of the specialty tea company Republic of Tea and now the managing director of Physic Ventures, another firm that looks to invest in companies that bring social benefit, expressed skepticism of the new models. “I think you really have to make a choice and be a business or be a nonprofit,” he said. “It’s hard to be both.”

Concerns about the hybrid model surfaced in a very public way earlier this year when a tiny nonprofit in Seattle, Unitus, abruptly announced that it was letting go almost all of its employees and no longer accepting donations.

The award-winning nonprofit had helped commercialize the microfinance industry through its profit-making venture capital arm, which had made investments in several microfinance banks that were poised to go public, generating huge returns for investors, some of whom were Unitus board members.

There are, of course, examples of pushmi-pullyus whose two heads have learned to collaborate. In a structure reminiscent of mutual insurers of yore, members of the nonprofit Freelancers Union own the profit-making Freelancers Insurance Company, and both are affiliated with the charity Working Today. Board members of the nonprofit sit on the board of the profit-making company, and employees of both determine how expenses are allocated among the three organizations.

“It’s complicated but necessary,” said Sara Horowitz, who often jokes that she is the lowest-paid chief executive of an insurance company in America. “The structure ensures that there is no way that Freelancer’s Union could be sold for the benefit of any individuals or that the nonprofit could be abused for the benefit of the company.”

That allows Freelancers Insurance to focus on lowering the price of insurance than a conventional company could, she said.

For many hybrids, however, neither partner is achieving its mission and, as Unitus found, pulling them apart is tricky. “These tiered capital structures where you have some mission-oriented capital combined with commercial capital can be challenging,” said Laura Callanan, a consultant in McKinsey & Company’s social sector office. “When everything is going well, everyone is getting along and interests are aligned. But when financial challenges hit, the fact that there are different objectives creates questions about how the pain is shared.”

When World of Good Inc. was sold to eBay and the GreaterGood Network this year, its nonprofit half was effectively orphaned, stripped even of its name.

World of Good Inc. had been established in 2004 to help connect small artisans around the world to major retailers. World of Good Development, its nonprofit partner, was charged with developing a free online tool to help calculate a fair wage and improve negotiating power with buyers.

“Those activities needed to be done in the public interest, and so we put that tool into open-source space,” said Priya Haji, chairwoman of the nonprofit board and a founder of the company.

Traditional venture capital supported World of Good Inc. The nonprofit held a 5 percent stake in it and was to receive 5 percent of its profits. “The nonprofit’s work never benefited the business,” Ms. Haji said.

Nor did the business’s operations ever benefit the nonprofit. “They were never profitable, so we did fund-raisers to support the organization,” said Holly Boyer, a board member of World of Good Development and its former executive director. “The business would host a fund-raiser and sell products where we were part of the event and would speak and talk about our work and get half of the proceeds from the sales.”

When World of Good Inc. was sold in February, the nonprofit got a $100,000 grant from eBay and its shares were retired. Ms. Boyer said the grant was intended to help the nonprofit rename itself, since eBay purchased the World of Good brand.

Whether the nonprofit got a fair deal for its stake in World of Good Inc. is unknown. “The transaction was private, so I’m not at liberty to talk about it,” Ms. Haji said.

Pura Vida Partners, the nonprofit partner of Pura Vida Coffee, also is changing its name, the result of a similar divorce imposed by Jeff Hussey, a no-nonsense investor who took control of the company in 2009, having sunk more than $3 million into it to keep it afloat.

“The business model was flawed,” Mr. Hussey said. “Whenever you have an organization of human beings with a blurry mission you get blurry results.”

Pura Vida was created in 1998 by John Sage and Chris Dearnley, former classmates at the Harvard Business School.

They set up a foundation, Pura Vida Partners, and gave it ownership of the company. But when the company needed money to grow, it could not get access to traditional lines of capital because of its ownership structure, a problem that led it to embark on a series of complex financial transactions involving wealthy private investors, including Mr. Hussey. “There was a lot of pretzel logic and gymnastics to create financing vehicles and structures that would let us continue to grow and continue our social mission,” Mr. Sage said.

Those transactions diluted the nonprofit’s stake in the company to 9 percent by 2009, when Mr. Hussey took over. “We could either agree to the dilution or lose the business — and all the funding streams for the nonprofit that had been established through the business,” Mr. Sage said.

Mr. Hussey purchased the nonprofit’s final shares for $200,000. “I overpaid,” he said. “I had to because of the laws governing nonprofits.”

Today, the Create Good Foundation, as the nonprofit will be known, is a stand-alone charity that supports clean water and economic development projects in the areas where the profit-making company, Pura Vida Create Good, buys its raw materials.

“Our goal now is to sell coffee, wine, tea, chocolate and other things and do it profitably,” Mr. Hussey said. “There’s nothing blurry about what we do and why we do it.”

from New York Times October 25, 2010

By STEPHANIE STROM

photo: SantiMB