Social EnterpriseIf you’ve decided to create a new for-profit social enterprise, you now have many corporate forms to choose from.

Over the past 35 years, the landscape has changed dramatically since what arguably is the best known values-oriented company, Ben & Jerry’s, was formed. Not only are social entrepreneurs increasingly using traditional corporate entity in new ways to ensure a focus on mission, but leading impact-driven businesses and investors are pioneering complex for-profit/nonprofit hybrid structures, and dozens of states now offer a variety of new corporate forms that more fully enable businesses to balance public benefit and financial return.

A central paradox facing social entrepreneurs is that their successes also create problems: Growth in revenue, new equity partners, a merger, or going public often put negative pressure on the company’s social or environmental mission that may be key to the company’s growth to begin with.

Selecting an alternative corporate form, or innovating a more traditional structure, can empower and incentivize directors and officers to pursue the organization’s mission despite such pressures.

Some of the new forms also move focus on mission from something that is permitted or “nice to have” to something that is required both in the ordinary course of business and in change-of-control situations. These forms also tend to reduce the risk that directors and officers will face the threat of litigation from shareholders alleging a violation of their traditional fiduciary duty to maximize shareholder value.

CHOOSING A CORPORATE FORM: SEVEN QUESTIONS TO CONSIDER

Selecting the proper corporate form is both an art and a science, and there’s no one-size-fits-all structure that’s better than the rest. That said, you’ll save yourself time, money, and headaches if you pick an appropriate corporate structure at the outset.

Among the questions to ask:

  • How quickly do you want to scale?

If you are operating a small, locally-oriented, or community based business that plans to focus on local needs, the LLC or L3C structures are fairly easy and inexpensive to setup and manage. If you have goals of broader national or even international change, then a then a traditional C corporation or Delaware Public Benefit Corporation (PBC), which are more familiar to investors that will help you scale, would be a better choice.

  • How risk-averse are you?

Every startup social venture has associated risks; however, if you are more risk averse, a traditional C corp or LLC with strong protective provisions will offer you security and allow you to pursue mission. If you are comfortable with greater levels of risk, consider the more untested low-profit limited liability company (L3C), benefit corporation, or Delaware PBC.

  • What will be your sources of financing?

If you’re most interested in program-related investments, consider creating a L3C, LLC, or mission-oriented C corp. If you’re seeking equity investors with fewer constraints, consider a C corp or Delaware PBC, structures that investors are more familiar with.

  • Do you have an aligned investor class?

If so, you may feel more comfortable utilizing the benefit corporation form since there is less risk of disagreement or confusion between management and shareholders. If not, you might prefer a C corp or Delaware PBC with strong mission protective provisions and less uncertainty over fiduciary duties.

  • How important are profits compared to mission?

If profits are less important considerations, an L3C or LLC might be a good fit since fiduciary duties can be prioritized (excluding California LLCs). If shareholder value is important, you’ll want to become a Delaware PBC, California SPC, C corp, or LLC, which better allow founders to raise capital and negotiate a profitable liquidity event.

  • Would you like to sell your company? If so, do you want to preserve mission beyond the sale?

Selling a C corp or an LLC is more straightforward since buyers know these forms. Selling a benefit corporation, L3C, or Delaware PBC raises questions of how to value the “social” component of the business since there have so few sales to date. While this may also be a problem for mission-driven C corps, it is arguably less so.

  • Would you ultimately like to take the company public?

Thanks to its favorable business climate, Delaware is home to about half of all publicly traded companies in the United States. The first wave of Delaware PBCs are now filing to go public; however, most mainstream investors and underwriters still prefer the traditional C corp for public companies.

CORPORATE FORMS: WHAT YOU NEED TO KNOW

Traditional Forms

C Corporation

Quick Facts:

  • The most popular corporate structure in the United States – for companies and investors.
  • Legal in all states. Preferable to incorporate form in Delaware because of developed corporate laws.
  • Directors generally have a fiduciary duty to maximize shareholder value, especially at times of sale. However under the business judgment rule, they also have a responsibility to act in the best interest of the corporation, broadly defined, so there is wiggle room and sufficient flexibility to align the company’s social goals with its business goals.
  • Mission can be emphasized and, to some extent, codified via the use of shareholder rights in charter (e.g., protective provisions) and shareholder agreements.
  • Impact investors are also including mission requirements in convertible notes, SAFEs, and equity.

Pros

Cons

A solid body of case law makes litigation predictable.

Investors are familiar and comfortable with the C corp structure.

Easiest of models to engage in M&A and to take public.

Mission is “permitted” when it does not detract from shareholder value as opposed to being required.

If the company is “in play” in connection with sale transaction for sale, directors may have to prioritize maximization of shareholder value above all else, which can jeopardize the company’s social mission if the buyer has little or no interest in keeping or maintaining it.

Limited Liability Company (LLC)

Quick Facts:

  • A limited liability company has characteristics of a corporation, partnership, and sole proprietorship.
  • Like a partnership or sole prop, it has pass-through taxation, but it also affords its owners limited liability similar to what is found in corporations.
  • In the operating agreement, equity holders can agree to mission and create a mission-first company or a company that considers mission while focused on profitability.
  • Legal in all states.

Pros

General Consideration

Cons

A flexible corporate form that allows founders to contract for many things. For example, in creating an LLC the founders can structure returns related to certain mission-aligned investors first.

Shareholders can stack the board with directors who support the social mission and modify waterfall/liquidation, voting and operations to ensure mission-focus.

LLC rules can vary significantly from state to state. For example, Delaware LLC laws also allow an LLC to contract for lesser fiduciary duty and elevated social goals, but California bars recently amended legislation to prevent LLCs from elevating social goals obviating traditional fiduciary duties.

Can be difficult to attract top-notch talent who want stock options.

Not as an attractive of a corporate form to investors.

New Forms

While a traditional corporate form may remain the best option for you, you are also able to convert into one the following new corporate forms, which enable businesses to balance public benefit and financial return.

Low-Profit Limited Liability Company (L3C)

Quick Facts:

  • Originally envisioned as bridging the gap between traditional 501(c)3 non-profit and for-profit corporate structures.
  • Legal in Illinois, Kansas, Louisiana, Maine, Michigan, North Dakota, Rhode Island, Utah, Vermont, and Wyoming, and the federal jurisdictions of the Crow Indian Nation of Montana and the Oglala Sioux Tribe. Repealed in North Carolina in 2014, but existing L3Cs continue to operate.

Pros

Cons

An L3C is legally obligated to advance its mission over profitability.

By law, foundations must distribute 5 percent of their assets annually for charitable purposes. One way to accomplish this is with program-related investments (PRI). In its articles of incorporation, an L3C must mirror the federal tax standards for PRI. This helps the organization attract investments while also providing a return on investment.

While many tout the ability of L3Cs to attract program-related investments (PRI), no IRS ruling or attorney tax letter has been issued regarding the acceptance of PRI, making some foundations hesitant to invest in them.

Foundations can already make PRI into corporations and limited liability companies.

In states with L3C statutes, an LLC with mission can be governed by regulation even if it does not elect to be an L3C.

Not attractive to investors who require any return on capital.

Benefit Corporation

Quick Facts:

  • For-profit corporate structure that requires business entities to include legislatively prescribed social and environmental objectives among their legally defined goals.
  • Directors and officers must consider the impact on the company’s stakeholders, society, and the environment, in addition to profits, when making corporate decisions.
  • Legal in Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Louisiana, Maryland, Massachusetts, Minnesota, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Vermont, Virginia, Washington, Washington, D.C., and West Virginia.
  • Differences in the model in different states are significant.

Pros

General Considerations

Cons

Social mission must be taken into account when making corporate decisions both in the ordinary course of business and in change-of-control situations.

Greenwashing — or falsely trying to present the company as an environmentally responsible organization — is more difficult because companies must use third-party auditors to review their actions and publicly disclose the audit findings.

Since state benefit corporation laws vary significantly, consider reviewing the differences closely with your attorney before choosing a state for incorporation.

Not all investors know about, or are comfortable with, the risks associated with benefit corporations.

States may change, for better or worse, their benefit corporation statutes as the legislatures seek to improve or adjust the laws.

There may be other non-legal reasons to consider a benefit corporation form; for instance, some businesses perceive marketing value in associating their brand with the benefit corporation brand.

The founders’ vision and goals for the company may impact the decision to incorporate as a benefit corporation.

Uncertainty remains regarding the extent of the directors’ and officers’ obligations to social mission – and the weighting of the elements of such mission - in comparison to their other fiduciary responsibilities.

The fiduciary duty of board members and management to a long list of ESG factors may lead to less as opposed to more positive impact.

States with “benefit directors” have conflicting fiduciary duties and difficulties securing D&O insurance.

Not all states have mechanisms that effectively work for converting an existing company into a benefit corporation.

Third-party proceedings can yield greater risk/liability to board members and management.

No case law or guidance on “weighting” of mission with shareholder value.

Lack of objective criteria for the audit or lack of an independent audit can lead to selective disclosure and skewed results.

Delaware Public Benefit Corporation (PBC)

Quick Facts:

  • Similar to a California SPC. For an existing entity to become a PBC, two-thirds of the existing entity’s shareholders must approve the conversion. There are less stringent reporting requirements compared to SPC. A PBC is only required to file biennial reports, which only need to be made available to the PBC’s shareholders and not the public at large, unless otherwise required by the PBC’s Charter or Bylaws.
  • Legal in Delaware.

Pros

Cons

PBC’s fiduciary duties require the company’s management and board to balance the stockholders’ pecuniary interests, the best interests of those materially affected by the company’s conduct, and the company’s public benefit (mission).

Unlike most benefit corporations, PBC’s are designed to accept impact capital as well as mainstream capital.

Unlike most benefit corporations, PBC’s are designed to go public and to engage in M&A.

PBCs have laxer reporting requirements than an SBC or benefit corporation. However, in creating a Delaware PBC, founders may mandate more frequent issuance of reports, as well as a public-reporting mandate and use of third-party certification standards in the PBC’s certificate of incorporation.

No case law or guidance on “weighting” of mission with shareholder value.

California Social Purpose Corporation (SPC)

Quick Facts:

  • Similar to a Public Benefit Corporation, an SPC must identify shareholder-agreed social and environmental goals that directors must consider in addition to profit-oriented goals when making business decisions.
  • Variations are legal in California, Florida, and Washington State.

Pros

Cons

Management must consider environmental or social factors in addition to shareholder value when making corporate decisions.

Structure offers more flexibility than a benefit corporation.

Unlike most benefit corporations, SPC’s are designed to accept impact as well as mainstream capital.

Unlike most benefit corporations, SPC’s are designed to go public and to engage in M&A.

More robust annual public reporting requirements help ensure the company remains transparent and focused on social goals.

Some argue that the SPC is too flexible of a corporate form because it can include one or 50 social and environmental goals.

Not as well known with investors because it has not been supported by any organizations or B Labs.

No case law or guidance on “weighting” of mission with shareholder value.

MEASUREMENT AND REPORTING

B Corp

A “B” Corp is not a corporate form; it is a designation similar to an “organic” label.

A company that desires to become a B Corp takes a detailed self-audit and reports to B Labs, a nonprofit entity that has been promoting greater transparency and new corporate forms.

With few exceptions, each B Corp must also pay a licensing fee to B Labs for the use of such mark.

The vast majority of B Corps do not utilize any of the new corporate forms (e.g., PBC or Benefit Corporation); however, most B Labs license agreements do require that the boards and management convert to “benefit corporation” status to retain the right to use the mark.

Others

GIIRS

The Global Impact Investing Rating System (GIIRS) provides impact ratings to companies and investment funds based on analyses of impact performance and data that can be benchmarked for comparative use.

Note: GIIRS is now apparently affiliated with B Labs (see www.giirs.org) (“GIIRS, which is powered by the B Impact Ratings System, is an online self-assessment tool that measures companies’ and funds’ social and environmental performance. GIIRS has an exclusive license for use of the B Impact Ratings System with the investment community” — http://giirs.nonprofitsoapbox.com/about-giirs/how-giirs-works/159)

SASB

The Sustainability Accounting Standards Board (SASB) develops standards to measure sustainability that are used by public corporations to disclose material information to investors.

IIRC

The International Integrated Reporting Council (IIRC) developed Integrated Reporting to allow global businesses to communicate material information about their organization’s strategy, governance, performance, and prospects.

GOING FORWARD

While this article discusses some of the pros and cons of each type of structure, lawyers and tax professionals with social enterprise experience can explain in more detail the specific advantages and disadvantages to your business.

Morrison & Foerster is one of the most knowledgeable firms in this space. The firm represents:

  • nonprofit and for-profit social enterprise companies
  • impact investors
  • venture funds

Our work spans all aspects of impact investing including advising companies on corporate forms and structuring transactions to help ensure impact.

For more information, contact impactinvesting@mofo.com.

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