The Buzz Around Hybrid Entities and Social Enterprise

Have you heard the term hybrid entity? Social enterprise or venture? Venture philanthropy? Or impact investment? All of these terms relate to a concept that has been getting more attention of late: blending for-profit and nonprofit characteristics for accomplishing social benefit. Many people think this opens up a lot of new opportunity for doing good by incorporating the best of both worlds: a socially beneficial mission accomplished in manner that allows for some profit and therefore can attract investors who otherwise wouldn’t participate.

However, there are those who view this concept skeptically, and point out that hybrid entities, social ventures and the like can come with complicated baggage: private benefit issues when working with 501(c)(3) organizations, uncertainty as to treatment from the IRS, and detraction from more traditional charitable activities in the midst of an economic downturn that already has many nonprofits reeling. Also, uncertainties and conflict can arise between the for-profit investors and those who want to put the social mission first.

L3Cs Versus Benefit Corporations

There are two fairly well-known entity forms that have been created in the last few years that embody this hybrid concept: (1) L3Cs and (2) benefit corporations.

(1) An L3C is a variation on a limited liability company, with the general requirements that it:

  • significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of the relevant Internal Revenue Code provisions, and would not have been formed but for the accomplishment of those purposes,
  • doesn’t have the production of income as a significant purpose, and
  • will not lobby or participate in political activity.

(2)A benefit corporation is a type of corporation that must create public benefit, and allows or requires directors to consider the non-pecuniary interests of various stakeholders in determining what is in the corporation’s best interests. Generally, the corporation must report annually to the public and shareholders on the creation of public benefit, and measure this benefit against a third-party standard.

The forms have their similarities, but it is important to point out a key difference. LLCs are inherently flexible by design, and it is already possible for LLC members to draft an operating agreement that allows an ordinary LLC to pursue charitable or socially beneficial purposes primarily, and have profit as a secondary motive. However, the traditional body of law that controls business corporations does not clearly allow for this pursuit of other purposes or motives outside of the context of maximizing profit; while directors do get great latitude under the business judgment rule, consideration of other interests could be viewed as a violation of fiduciary duty to the corporation and to shareholders.

Some states have adopted constituency statutes that specifically allow for other interests to be considered (for example, those of creditors, employees, or others), particularly in the context of a sale, but many states have not done so. So a benefit corporation can be seen as filling a need in marketplace, whereas L3Cs arguably do not. Rosemary E. Fei, A Guide to Social Enterprise Vehicles, Taxation of Exempts (January/February 2011).

Choosing a Form:  Be Mindful of Mission

In choosing a form, organizations always need to be mindful of their mission, and what is necessary to accomplish it. For many organizations, particularly those with more traditional charitable purposes and operations, the nonprofit corporation likely will work just fine. If organizations do wish to include for-profit owners or investors, an LLC or L3C will be a simpler choice than a benefit corporation, which requires annual reporting to the public and shareholders about its created public benefit. Or there are other nonprofit/for-profit combinations that could potentially serve their purposes.

However, a benefit corporation may be a better fit for organizations that want to include for-profit investors on a larger scale, or that are interested in the transparency element of public reporting. For example, a Wall Street Journal article from earlier this year indicates that Patagonia has organized as a benefit corporation under California law. The company places a high priority on sustainable and renewable production methods, and its CEO said that they’re “trying to preserve for the long-term the way our company is run.”

Colorado so far has not enacted any legislation around hybrid entities. L3C legislation was introduced in 2010, but was postponed indefinitely early that year. Benefit corporation legislation was introduced in 2011 and 2012, and a modified version was considered during a 2012 special session but did not advance. However, the bill’s sponsors indicated that a benefit corporation bill will likely be introduced in 2013.

What do you think is the most important potential benefit of using a structure like an L3C or a benefit corporation?

What do you see as the most challenging or concerning aspects of a hybrid structure?

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