Structuring Social Ventures: Choice of Legal Structure
By: Ray Dinning, JD, LLM (taxation)
December 2, 2009
Using Traditional For-Profit Entities as the Structural Vehicle for Social Ventures in Africa: Case Studies from Africa
The more generally accepted method for structuring Social Ventures is through the use of traditional for-profit entities such as the limited liability company (“LLC”), the limited partnership, the general partnership and the for-profit corporation. New, non-traditional, hybrid structures such as the “B Corporation” and the L3C or “low income limited liability company, which share for-profit and non-profit characteristics, are rising to the forefront of social venture structural vehicles (Non-traditional for-profit entities will be addressed in Part V of this Series).
Structuring social ventures through the use of a for-profit entity as the vehicle for social enterprise, either alone or in combination with nonprofit or charitable organizations, generally avoids all of the restrictions of using a charitable organization for for-profit ventures. This structure works very well for charitable, tax-exempt organizations that desire to carry out social ventures because the social venture, business-like activity is conducted through an affiliated or subsidiary entity such as an LLC. Furthermore, the charitable organization can also conduct its charitable purpose activity in the project as well.
For example, a US public charity and a South African public charity partner together to manage a large tract of pristine, oceanfront land (2,000 acres) on the coastline of South Africa for conservation purposes. Obviously, conservation of important biodiversity marine and wildlife coastal habitat serves a charitable purpose under US tax law. In working with the local indigenous population, the charities are confronted with the need for job creation in the local community. In creating a strategy for job creation, the charities learn that the community has a tract of land adjacent to the 2,000 acres of conservation land where 11 acres of land were set aside for a small, boutique tourism development to create jobs and needed revenue. However, the community has no perceived partners or resources. The community requests that the charities intervene and assist them with the tourism development. In this situation, a South African entity, similar to an LLC, is used as the vehicle for the for-profit tourism development. This allows both charitable organizations to contribute funds, own shares, locate suitable tourism industry partners and build and operate the tourism project. The US charitable organization’s ownership in the South African entity is acceptable under US tax law. Furthermore, the for-profit venture furthers the charitable purpose of the conservation organization because it promotes education and conservation awareness and it also significantly assists the local community through job creation and micro enterprise. Aside from the ownership in the for-profit entity, the charitable organization can promote its charitable conservation purposes by providing educational tours and conservation information to the tourism project guests who seek to tour the conservation area and learn more about the ecosystem and marine and wildlife habitat.
This dual-purpose activity – which I call parallel activity – allows the charitable organization to be involved in the above example both from a for-profit ownership perspective in the tourism project and in charitable, exempt purpose activity (tours, education and conservation) for the guests of the tourism project. Thus, the project enhances the charity in multiple ways – both for-profit and nonprofit – and it bolsters and supports the organizations reputation and standing with the indigenous community because the project met the community’s need for job opportunities and profits.
For-profit organizational documentation may contain provisions that indicate or dictate the social mission and purpose of the social venture. The Bylaws or Operating Agreement can also contain the social purposes of the venture. Furthermore, provisions regarding management of the social venture can be drafted to incorporate the social entrepreneur’s vision and values into the for-profit entity. Of course, Bylaws, shareholder agreements or Operating Agreements can be amended or management, under the fiduciary duty to promote the best interests of the shareholders can simply ignore this language and act in a manner most beneficial to the financial interests of the shareholders. Thus, when using a for-profit entity to conduct social ventures – control of the management and voting at the shareholder and director level – is imperative.
For example, a charitable organization client was involved in a social venture in natural resources and energy. The charitable organization was the founder of the project. The charitable organization established a for-profit entity to manage and operate the project. The organizational documents and business plans included generous funds to be set aside for education and health for the indigenous community and environmental management of conservation protected areas surrounding the project. In order to finance the project, a venture capital company agreed to purchase convertible preferred shares in the for-profit entity. Of course, the complex legal documents contained provisions allow the venture capital company to take management control of the for-profit entity under certain conditions such as nonperformance of the project (which basically means the project was not performing financially according to projections). The for-profit nature resources project operated and performed well – but not to the projected levels in the projected timeframe. Utilizing this small exception, the venture capital took management control of this profitable project and dispensed with the social venture provisions and the funding set aside for the local community education, health care and conservation under the pretense of acting in the best interests of the shareholders.
Obviously, the lesson there is to take any and all steps necessary to protect the vision, intellectual capital and the project from exploitation. However, there is generally always some strategy that will successfully circumvent the best drafted provisions in corporate documentation. Fortunately, with the significant rise of social venture funding for social entrepreneurs, the social venture entrepreneur or charitable organization can be paired up with like-minded social investors to avoid such painful examples as noted above.
Traditional Types of For-Profit Entities:
Whether as a stand-alone entity or as the joint venture vehicle for conducting a social venture, the all-purpose entity that best lends itself to social venture activity is the LLC. A limited liability company is a privately owned legal entity that can be formed for the purpose of generating and realizing profits, pursuing a social venture purpose, or both.
An LLC differs from the traditional C-corporation in that the LLC is formed and owned by “members” rather than “shareholders”. In fact, LLC’s are more similar to partnerships than to corporations, with the advantage of limited liability for the members that is equivalent to the limited liability enjoyed by shareholders of a business corporation. Each state has laws allowing for the establishment of LLCs which generally allow great flexibility in structuring, entity governance and management. Like partners, the members have wide latitude in allocating profits and losses and management powers among themselves. Furthermore, the corporate fiduciary duties, corporate governance and corporate doctrines such as “piercing the corporate veil” have limited or reduced applicability to LLCs. This is beneficial to the social venture and its management because this will allow them more freedom to act in a more socially-beneficially manner versus acting in the best interests (or best financial interests) of the shareholders.
From an economic and tax perspective, the LLC is much better than a business corporation as a vehicle for social ventures, especially for joint ventures between a charitable organization and a for-profit business. Because LLCs are generally pass-through entities (unless they elect otherwise), all income, loss, deduction and other tax consequences pass-through to each member in accordance with the member’s interest. Thus, LLCs and their members do not incur “double taxation” (taxing income at the corporate level and then again at the shareholder level). If related to the charitable purposes of a charitable organization, the income from the LLC is not taxable so long as it is used in furtherance of charitable purposes. If the income is unrelated business taxable income (“UBIT”), the tax consequences are incurred at the charitable organization level for this income in accordance with the complex rules of UBIT in the Internal Revenue Code.
From a management and documentation standpoint, the LLC operating agreement – which is similar in function to corporate bylaws and a shareholder agreement in a single document — may contain provisions mandating social purposes or socially-beneficial values and such purposes or values can be incorporated throughout the operating agreement. LLCs, and particularly the new L3C, are well-suited for social ventures with a limited number of investors and small to mid-sized revenues. However, if shares are to be offered to the public, or frequent investor turnover is expected, a business corporation will probably serve better than an LLC. If the for-profit business is going to have significant revenue, is planned to have public shareholders or be publicly-traded or if circumstances warrant in the transaction, then a traditional business corporation may also be well-suited as the structural vehicle for a social venture.
The traditional and prevalent entity for the conduct of for-profit business in the United States is the business corporation, sometimes referred to as a “C” corporation because of the taxing provisions in Subchapter C of the Internal Revenue Code. C-Corporations are generally formed for a specific and stated “business purpose” of conducting some profit-making activity and distributing its earnings and profits to its shareholders. Generally speaking, the Bylaws of a business corporation may include a social mission, social business purpose or social values. For a variety of reasons, this language would merely authorize the corporation to pursue its social mission, however, it could not require it to do so. Only through action of the shareholders of the corporation can require the corporation to pursue a social mission or adhere to certain core set of social values. This can be accomplished by the shareholders through a shareholder resolution or through a shareholder agreement. A shareholder’s agreement is an agreement between the shareholders of a company relating to the management and conduct of business of the corporation. It can be used to enhance (or restrict) the rights, duties and obligations of the shareholders and the management and activities of the Board of Directors and Officers.
Generally speaking, the shareholders are the “owners” of the corporations through the issuance of shares of stock to represent their ownership interests. A Board of Directors is elected by the shareholders to manage the company and these directors have a fiduciary duty to operate the company in the best interests of the shareholders. Because the “best interests of shareholders” is typically interpreted to mean the shareholder’s best economic interests, most experts agree that the pursuit of financial profit for the benefit of the shareholders is the primary purpose of a business corporation. A case can be made, however, that the shareholders’ best interests can also be furthered through a social venture to achieve a socially-beneficial goal or purpose. This becomes clearer, of course, where the shareholders have endorsed the social mission or social purpose by including such a provision in the Bylaws or a shareholder agreement. In this case, the Board of Directors would have explicit authority to produce social outcomes through the social venture as well as profits. In most, if not all cases, the Board of Directors should rely on this explicit authority from the shareholders instead of an implied or undocumented social venture purpose before leaping into the accomplishment of a social venture.
For most of the reasons discussed herein (which are merely a discussion and should not be relied upon as legal advice), an LLC is generally the better vehicle for the accomplishment of social venture purposes. This is true either as a stand-alone social venture business or as a joint venture or subsidiary of a for-profit or charitable organization. In the next Part V, we will discuss joint ventures and non-traditional for-profit business entities as vehicles for social venture activity by social entrepreneurs.
B. Ray Dinning, JD, LLM (taxation) is a United States based attorney specializing in nonprofit joint ventures, social ventures, domestic and international taxation and public private partnerships. Mr. Dinning assisted Professor Michael I. Sanders with the research and drafting of the authoritative legal text in this area called “Partnerships and Joint Ventures Involving Tax Exempt Organizations by John Wiley & Sons in 1994 with later editions. Mr. Dinning holds an Advanced Law Degree from Georgetown University Law Center in Taxation – an LL.M in Taxation. Mr. Dinning has traveled around the world structuring social ventures from the grassroots to the National and International level. Mr. Dinning can be reached for questions, comments or advice at (757) 232-2619.