I work for a non-profit organization. Because we cannot provide a return to investors, we cannot raise investment capital, and must fund our operations out of revenue and philanthropic donations. This is a severe constraint on our ability to grow and execute on our mission. Yet operating as a for-profit enterprise could put that mission at risk if profit and mission clashed. A new book written by Brooklyn Law School professors Dana Brakman Reiser and Steven A. Dean addresses this issue by proposing a variety of mechanisms that would allow socially oriented for-profit enterprises to raise investment capital while preserving their social mission.
What is a Social Enterprise?
The concept of social enterprises that exist both to make a profit and to serve a specifically social or environmental purpose is not new, and many would claim the mantle. (After all, Exxon-Mobil and Facebook no doubt believe they are serving an important social mission.) This book, however, is directed at the businesses that give social mission a greater priority than profits, rather than at enterprises that simply seek to do well by doing good. There has been an increasing interest over the last decade in the use of the for-profit business model as a way to achieve scalable positive social impact by creating businesses that are funded by investment capital, but that nevertheless prioritize social outcome.
Traditionally, however, for profit businesses and the capital markets that fuel them prioritize the interests of shareholders over the interests of other stakeholders. Whether or not the law absolutely requires such prioritization (there is a lively debate over this question), it certainly encourages it. As a result, many observers see the law as an obstacle to be overcome in structuring social enterprises that raise investment capital.
Using the Law to Promote Social Enterprise
The authors of this insightful book take a very different tack; they suggest that we can use the law as a tool to facilitate investments in social enterprises. They characterize the chief obstacle to such investments as one of trust, and suggest that legal tools can be used to build the necessary trust (in the sense of “trust but verify.”) More specifically, socially-minded entrepreneurs and investors are each prone to suspect that the other is, or may become, more interested in the profit side of the equation. So a socially-minded investor may be hesitant to invest capital with a social intent (perhaps at a concessionary rate) if she suspects that the founder of the business may suddenly become more interested in a big payday than in satisfying the business’s social mission. By the same token, the founder may be concerned that once she takes on equity investors, they may begin using their rights to push for greater financial return, at a cost to social return.
Mission Protected Hybrids
The book proposes a number of mechanisms to bridge this gap. First, they suggest a new corporate form, the Mission-Protected Hybrid (MPH—the acronym we see on speed limit signs because the entity form checks your “profit speed”). They recognize that there is already a first generation form, the benefit corporation, which has been adopted in 35 US jurisdictions and Italy, which seeks to address this issue, but believe that these statutes do not go far enough. (In the interests of full disclosure, I helped to draft a number of these statutes, including Delaware’s version, have written a book about benefit corporations, and work for B Lab, a non-profit organization with an explicit goal of expanding the availability and use of the benefit corporation.)
Benefit corporations allow directors to treat social and environmental goals as having the same importance as financial goals. The MPH takes this one step further by requiring that social mission outweigh profit motive, and by adding an expenditure requirement that the MPH spend more on social mission than profit-seeking. The loosely defined form would also give shareholders and regulators significant powers to enforce the social mission obligation. These obligations and enforcement provisions create trust by assuring both investors and entrepreneurs that the company will not diverge from the mission as circumstances change. As with most of the book, the discussion (intentionally) raises as many questions as it answers. The authors’ goal is clearly to spur thinking and creativity, not to establish a final one-size-fits-all form.
The authors believe that the creation of such a hybrid will be difficult in current political circumstances, and their second big idea does not require legislative action. They suggest a hybrid instrument, flexible low-yield convertible debt (FLY paper—another pun, because the notes force corporations to stick to their mission.). The basic idea of FLY paper is to concede a low yield, allowing businesses to put money back into the social mission, but also allow the investors to convert into common equity (at a punitive conversion rate) if the company strays from mission (this prevents the common equity from unfairly profiting from the low interest rate that was meant to contribute to a social purpose, not to the shareholders’ wealth).
FLY paper is a genuinely original idea that the authors have written about elsewhere. I am not aware of its having been used, but it would be a particularly good candidate for a foundation making a mission related investment as an alternative to a first loss security. Lawyers or investment banks practicing in the space would be well-advised to try to and be first movers on a debt instrument along these lines.
A Tax Credit
Because their first two big ideas may not work to create trust in a small retail investor who has no interest in enforcing MPH provisions, and no ability to negotiate a bespoke FLY paper note, the authors introduce a third concept that might work to create assurance for retail investors. This is important because these investors can now be reached through small fundraisings of the type encouraged through new regulations that create rules for crowdfunding and loosen the requirements for mini-IPOs. The idea is to create a federal tax status that creates a 2-for-1 tax deduction for mission related profit up to $250,000, but that also imposes a high tax at the shareholder level for investment returns. Thus, as with FLY paper, there is an incentive to keep to the mission, but a disincentive to abuse that privilege by turning the tax break into increased shareholder return. This actually seems like a piece of legislation that might be passed with a total dollar ceiling as a demonstration project, and gain bipartisan support. Because it might lead to the creation of for-profit entities to focus on issues now addressed by charities, it might well be revenue neutral, or even positive.
Birth to Death
The book also covers metrics that can be used to regulate mission (including a significant discussion of tools made available for measurement and certification by my employer, B Lab), and a discussion of how mission-based companies can responsibly engage in exit transactions. The authors recognize that to some extent, exit is the whole ballgame: “Legal creativity can prevent the specter of exit from undermining the trust required to capitalize social enterprises. In fact, structuring exit has formed the core of each of this book’s proposals.”
This well-written and thoughtful work thus covers fundraising by mission-based companies from birth to death. In doing so, it highlights the unique problems that these enterprises raise, but also suggests that lawyers can play an important role in solving these problems. Given that the solutions to many urgent social and environmental issues may require significant capital, I hope that business lawyers take notice of this book, and use it to spur their thinking.
This review first appeared here in my Linked In Pulse blog.