Articles

Emerging Legal Forms Allow Social Entrepreneurs to Blend Mission and Profits

Tuesday, March 11, 2014
by Marc J. Lane

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Social entrepreneurs throughout the nation are preparing to gather for this year’s Social Enterprise Alliance Summit 2014. Many are learning that their choice of legal entity can make a big difference for them—in funding, governance, and signaling—as they seek to drive positive social change. The two most popular legal forms, each designed with the mission-driven venture in mind, are the “low-profit limited liability company” or “L3C” and the “benefit corporation.”

Low-profit limited liability company (L3C)

The L3C is a new, for-profit entity form available to social entrepreneurs who seek the legal and tax flexibility of a traditional LLC, the social benefits of a nonprofit organization, and the branding and market positioning advantages of a social enterprise. The L3C is a potent tool to attract private capital to ventures with modest financial prospects, but great potential to make a positive social impact.

The opportunity turns on an under-appreciated feature of the Tax Reform Act of 1969. It’s widely known that the law obligates private foundations to distribute at least 5 percent of their assets every year for charitable or similar purposes, helping explain the feverish competition for grants among charities. But the 1969 law also created an attractive alternative for foundations to satisfy their 5 percent payout obligation, the “program-related investment” or “PRI.”

A PRI can take a variety of forms—a loan, a loan guarantee, a line of credit, a linked deposit, or even an equity investment, so long as it’s for qualified purposes and meets other technical requirements. Most L3Cs are organized primarily for charitable or educational purposes, and those purposes qualify. But an amendment to Illinois’ L3C law, which recently was unanimously passed by the state’s Senate, would extend the L3C’s reach beyond charitable and educational organizations to include religious, scientific and literary organizations, organizations that foster national or international sports competition, and organizations which seek to prevent cruelty to children or animals, all PRI-permissible purposes under federal law. I was privileged to draft both the existing legislation, which itself was unanimously passed by both houses of Illinois’ General Assembly, and the pending amendment.

Like any other LLC, the L3C shields its owners from debts of their enterprise and affords them flexibility in governance and tax planning—but with one striking difference: An L3C’s articles of organization are required by law to mirror the standards for program-related investing imposed on foundations by the Tax Reform Act of 1969. So the business form itself gives the foundation comfort that the target company’s purposes and activities are constrained by statute to accommodate PRIs.

Because the foundation seeks social impact over economic rewards, it forgoes market-rate returns. And by taking on higher risk in exchange for lower financial returns, the foundation’s investment can be leveraged to attract private-sector investment that otherwise might not be tapped to support the social venture.

Not only can a foundation’s financial commitment to an L3C’s mission draw urgently needed private investment into the social sector; it also can elevate the foundation’s role to that of a social venture capitalist which has a stake in both the viability of the enterprise and the social impact it delivers. Just as important, the L3C establishes clarity and consistency in ordering mission-vs.-money priorities so that the venture’s stakeholders’ disparate objectives, including the foundation’s fiduciary duties, can effectively be harmonized, giving each investor the benefit of its bargain.

The benefit corporation

The benefit corporation is a new class of for-profit corporation chartered to create a material, positive impact on society and the environment, and to report on its overall social and environmental performances as vetted against an independent third-party standard.

The officers and directors of benefit corporations are protected from shareholder claims when corporate decisions reflect the non-financial interest of a company’s workforce, community and environment at the expense of financial returns to shareholders.  In demanding greater transparency and accountability of its management, the firm is expected to more easily attract funding from social-impact investors and the loyalty of consumers who favor socially responsible and sustainable companies.

The L3C and the benefit corporation are useful platforms to help empower social  entrepreneurs who are tackling society’s most vexing problems. I’ll be honored to unpack real-life L3C and benefit corporation successes when I present “Social Enterprises from Conception to Operation:  The Legal Issues” at Social Enterprise Alliance’s 2014 Summit.

Peterborough's problem was daunting: Sixty percent of prisoners serving short-term sentences historically had gone on to re-offend within a year after their release. But policymakers were confident that a solution was within their reach. They attracted private investment to pay experienced social service agencies to provide intensive, multidisciplinary support to short-term prisoners, preparing them to re-enter society and succeed outside the penal system. - See more at: http://www.chicagobusiness.com/article/20131007/OPINION/131009850/a-new-kind-of-futures-contract-for-illinois#sthash.ThgxeiFt.dpuf

The world's first social impact bond, or SIB, was introduced in 2010 to fund innovative social programs that realistically might reduce recidivism by ex-offenders in Peterborough, England, and, with it, the public costs of housing and feeding repeat offenders. Prudently building on the strengths of that initiative, Illinois Gov. Pat Quinn is rolling out SIBs to help solve some of the state's most vexing social problems.

A SIB isn't a traditional bond where investors are guaranteed a fixed return but a contract among a government agency that agrees to pay for improved social outcomes, a private financing intermediary and private investors. SIBs shift the risk of experimenting with promising but untested intervention strategies from government to private capital markets, with public funds expended only after targeted social benefits have been achieved.

Peterborough's problem was daunting: Sixty percent of prisoners serving short-term sentences historically had gone on to re-offend within a year after their release. But policymakers were confident that a solution was within their reach. They attracted private investment to pay experienced social service agencies to provide intensive, multidisciplinary support to short-term prisoners, preparing them to re-enter society and succeed outside the penal system.

The government decided which goals would be supported, but exactly how those goals would be achieved was left to the private sector. It was the investors, through a bond-issuing organization, who ultimately endorsed the allocation of investment proceeds — how much would be invested in job training, drug rehabilitation and other interventions.

If the Peterborough plan eventually shrinks recidivism rates by 7.5 percent or more, the government will repay the investors' capital and share the taxpayers' savings with them, delivering up to a 13 percent return. If the target isn't hit, the investment will have failed and the government will owe the investors nothing.

Illinois' SIB effort was spearheaded by the state's Task Force on Social Innovation, Entrepreneurship and Enterprise — the governor's think tank on social issues, which I am privileged to chair — with support from Harvard University's John F. Kennedy School of Government, the Rockefeller Foundation and the Aurora-based Dunham Fund. A request for information issued by the Office of Management and Budget on May 13 yielded responses from service providers eager not only to reduce recidivism here but also to create jobs, revitalize communities, improve public health outcomes, curb youth violence, cut high school dropout rates and alleviate poverty.

Now the governor has issued a request for proposals intended to spur better outcomes for Illinois' most at-risk youth — by increasing placement stability and reducing re-arrests for youth in the state's Department of Children and Family Services, and by improving educational achievement and living-wage employment opportunities justice-involved youth most likely to re-offend upon returning to their communities.

Kudos to Mr. Quinn for bringing SIBs to Illinois. May they soon start delivering on their promise.

- See more at: http://www.chicagobusiness.com/article/20131007/OPINION/131009850/a-new-kind-of-futures-contract-for-illinois#sthash.ThgxeiFt.dpuf
The world's first social impact bond, or SIB, was introduced in 2010 to fund innovative social programs that realistically might reduce recidivism by ex-offenders in Peterborough, England, and, with it, the public costs of housing and feeding repeat offenders. Prudently building on the strengths of that initiative, Illinois Gov. Pat Quinn is rolling out SIBs to help solve some of the state's most vexing social problems. - See more at: http://www.chicagobusiness.com/article/20131007/OPINION/131009850/a-new-kind-of-futures-contract-for-illinois#sthash.ThgxeiFt.dpuf

Marc J. Lane is a Chicago attorney and chairman of the Illinois Task Force on Social Innovation, Entrepreneurship, and Enterprise.


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