Entity Choices for Social Enterprises

Entity Choices for Social Enterprises

By Jeremy Chen

Social Enterprise Entity Choice InfographicThis article is intended to be a general overview of entity choices available for social enterprises looking to form an entity in California. This article does not address all of the issues and considerations that a social entrepreneur should consider in making the most appropriate choice for their company; for that legal counsel should be consulted. Rather, this article is a general discussion of the main issues associated with each entity form, such as tax consequences, management structure, corporate governance, liability protection, and ease of obtaining financing from outside investors.

A social enterprise based in California has six main options to choose from. California has two corporate forms specifically designed for social enterprises, the Benefit Corporation and the Social Purpose Corporation. A social enterprise may also use adapted forms of the nonprofit corporation, the limited liability company, and the traditional corporation to fit its objectives. Lastly, a social enterprise may also operate as an unincorporated company such as a sole proprietorship or general partnership and obtain a third-party certification of its commitment to addressing social and environmental problems.

  • Nonprofit Corporation (with a For-Profit Subsidiary)

The nonprofit corporation has the most regulations to consider in conducting income-generating activities. The defining feature of a nonprofit corporation is its tax-exempt status, which is governed by federal Internal Revenue Code Section 501(c)(3). That code section requires the organization to operate primarily for charitable or public benefit purposes, and prohibits profits to be earned for the benefit of any private individual or stakeholder.

The nonprofit corporation, however, can be adapted for some social enterprise purposes by creating a for-profit subsidiary that generates profit to fund the nonprofit corporation. Another benefit of this hybrid structure is that the for-profit subsidiary can attract mission-driven investors, while the nonprofit maintains its ability to receive donations without jeopardizing the nonprofit’s tax-exempt status.

The primary downside of the nonprofit/subsidiary form is that operational expenses and resources are doubled in order to maintain the necessary separation between both entities. The nonprofit and subsidiary must maintain separate financial accounting and business records, and business transactions between the two organizations must be at arm’s length. Thus, this hybrid requires more resources and expense in trying to maintain a business separation for the nonprofit to preserve the nonprofit’s tax-exempt status.

  • For-Profit Corporation (with Third-Party Certification)

Typically, social enterprises are set up by forming a traditional C corporation or limited liability company and adapting it for social enterprise purposes by voluntarily submitting the company to a third-party assessment and certification of its business practices and mission-based objectives. The third-party assessment provides the social enterprise with measureable goals, while the certification provides some measure of accountability (i.e. a company that is certified one year will have to explain to its stakeholders and customers why it failed to be certified the next year).

On the other hand, social enterprises face many corporate governance issues that may hinder cohesiveness between the company’s for-profit purposes and its mission-based objectives. In short, the third-party certification alone has its limitations as it is a voluntary process that does not embed mission-based objectives into the company’s DNA. As such, the following corporate governance issues may arise:

Directors’ Duties – Directors of a social enterprise are not afforded the same legal protection for their decisions as directors of social enterprise-specific forms. Generally, directors of a traditional corporation can be exposed to possible shareholder derivative lawsuits for not maximizing profits. As such, founders of a social enterprise should be careful in selecting directors, officers, and investors that share the same values as them to avoid disagreements and possible derivative suits when social or environmental goals are pursued to the detriment of pure profit maximization.

Succession Planning – Maintaining a company’s social and environmental goals is difficult after a founders’ exit or sale of the company because those goals are not a part of the company’s DNA. There are other ways to maintain the mission-based goals by creating different classes of stock (e.g. super-voting common stock) and by adding special provisions in the bylaws. These methods can be complex, and an attorney should be consulted.

Equity Financing – As a quick note, traditional investors are more likely to invest in traditional corporations than they are to invest in social enterprise-specific entities forms because there is less accountability to mission-based objectives. Moreover, equity investors, who want control in the operation of the company can disrupt mission-based objectives if they are not like-minded about the social enterprise’s mission.

  • Limited Liability Company (with Third-Party Certification)

A social enterprise can be formed as a limited liability company (LLC) and adapt it with a third-party certification. One of the greatest benefits of the LLC is its flexibility in management structure. The founders can draft an operating agreement (i.e. agreement between the members of the LLC about how the company will be run) to include accountability measures that are self-imposed and embedded into the DNA of the company. The LLC also provides limited liability protection and pass-through tax treatment of profits, where profits are taxed as the members’ personal income.

A significant downside of this form is its inability to attract investors. Many investors are less willing to invest in LLCs because there is less accountability and certainty with the way the company is run compared to the certainty that the more rigid corporate form provides.

  • Unincorporated Business Associations (Sole Proprietorship and General Partnership)

Sole proprietorships and general partnerships are the most flexible forms as entrepreneurs are free to operate the company without LLC or corporate formalities. Further, profits pass through the company and are taxed as the entrepreneur’s personal income. These entities are best suited for companies that are small or closely held where the entrepreneurs all share the same dedication to their missions.

There are, however, many downsides with unincorporated business associations. Most importantly, an unincorporated business will not have limited liability protection leaving an entrepreneur personally liable for the debts of the company. Further, unincorporated companies will have trouble getting outside financing because many institutional investors are reluctant to invest in companies that do not have the institutional certainty of the corporate structure. Eventually, most unincorporated businesses that want to scale up will ultimately incorporate to manage its growth, intellectual property, employees, investors, and other assets.

  • Social Enterprise Entity Forms (Benefit Corporation and Social Purpose Corporation)

The Benefit Corporation and Social Purpose Corporation were specifically designed for social enterprises. These two forms are taxed the same as and offer the same limited liability protection as C corporations. One of the main differences from C corporations is that these forms protect directors’ business decisions to a greater degree than C corporations to pursue social and environmental goals. Founders also have greater ability to embed their values and mission-based objectives into the company because these forms have built-in mechanisms to enforce accountability.

In regards to outside financing, these forms can better pinpoint financing from mission-driven investors that share and understand the founders’ mission. On the other hand, because these are new forms, traditional investors are more likely to take a wait-and-see approach with these new entities to see what the return on investment can be given that profit-maximization is not necessarily the primary goal.

Further discussion of Benefit Corporations and Social Purpose Corporations are available here: “What is a California Benefit Corporation?” and “What is a California Social Purpose Corporation?”

  • Low-Profit Limited Liability Company (L3C) – Not available in California

Lastly, the Low-Profit Limited Liability Company (L3C) is worth considering as an option for social entrepreneurs who are less focused on generating profit. The L3C is a modified LLC designed to attract private philanthropic investments and program-related investments (PRI) by severely limiting the company’s profit motives. This entity form requires the company to operate in furtherance of a charitable purpose and is prohibited from having a significant purpose to produce income. As such, this form is very limited in its ability to attract investors other than PRIs and private investors. This entity is ideally suited to serve as a substitute for the non-profit/for-profit subsidiary hybrid entity.

The L3C is not available in California, but a California-based company could take advantage of this form by forming as a L3C in another state that offers it.

In closing, these are the main entity options for social enterprises that want to generate profit in a socially conscious and socially responsible way. These entities may not be appropriate for every company because there are many other considerations to take into account. As such, it is recommended that the founders or directors of a company consult an attorney and other professional service providers to assist in making the best decision for the company.

Disclaimer. The contents of this article are not legal advice, and are provided only for informational purposes. This article provides only a general discussion, and does not include all relevant information regarding the topics and issues addressed within it.

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