Hunton Law

Legal Counsel for Nonprofit & Tax-Exempt Organizations

Legal Counsel for Nonprofits, Foundations & Social Enterprises

Program-Related Investments

Earlier this year, the Internal Revenue Service released proposed regulations that provide guidance to private foundations on program-related investments (PRIs).  The proposed regulations include nine new examples of permissible program-related investments.  While the proposed regulations have yet to be adopted, the new set of examples demonstrates the expanded potential of PRIs to drive capital towards nonprofit and for-profit enterprises in the US and foreign countries. 

Private foundations, otherwise limited in the types of investments they can make, have been allowed to make PRIs since 1969.  Properly structured, a PRI can fulfill a private foundation’s legal obligation to make qualifying distributions for charitable purposes.  An investment will qualify as program-related so long as its primary purpose is to further charitable and other exempt purposes.  Neither the production of income nor the appreciation of property can be a significant purpose of a PRI, and a PRI cannot be used to fund legislative activities (lobbying) or political campaigning.  Since 1969, PRIs have typically been used for programs involving economically disadvantaged individuals and deteriorating urban areas. 

The new examples illustrate that PRIs can be much more flexible philanthropic tools than PRIs of the past.  Notably, the range of eligible PRI recipients is broader, and includes 501(c)(3) organizations, 501(c)(4) social welfare organizations, domestic and foreign business entities, and domestic and foreign individuals.  The range of investment types is wide, encompassing equity interests, straight debt, convertible debt, credit enhancement, and other forms of financing.  A significant purpose of a PRI cannot be income production or property appreciation; however, the possibility of a high rate of return does not automatically disqualify an investment as program-related.     

What does a PRI look like under the new examples?  A private foundation can provide seed capital (debt, equity, or some combination) to a for-profit venture that is seeking to generate social and financial returns.  This type of social enterprise would be one that few traditional investors would view attractive, yet holds promise for significant positive social impact.  The PRI can help establish and strengthen the venture’s creditworthiness, eliminating a significant amount of perceived risk and attracting further commercial investment.  The PRI can also spark a self-sustaining revenue model, whose benefits would continue to further the foundation’s charitable purposes.

The proposed regulations demonstrate the use of PRIs  in new contexts and with new forms of financing.  By providing more detailed guidance on what will qualify for a PRI, the new examples are generating discussion and interest among those seeking to give away capital as well as those seeking to access capital. 

Contrasting the Flexible Purpose Corporation

Like the benefit corporation, the flexible purpose corporation is a new subtype of stock corporation available in California as of January 1, 2012.  In an earlier blog post I discussed the key features of the benefit corporation.  I turn now to discuss the flexible purpose corporation and a key feature that distinguishes the new subtypes.

Both the benefit corporation and the flexible purpose corporation pursue social and economic objectives.  What’s different about the two forms is how they go about pursuing these dual purpose-profit goals.  A look at the language describing directors’ fiduciary duties to the corporation helps illustrate this difference.  

The directors of a flexible purpose corporation must perform their duties in accordance with the fiduciary duties of care and loyalty, as in a traditional corporation.  In addition, the directors of a flexible purpose corporation may consider and give weight to those factors that they deem relevant, including the purposes of the corporation as stated in its articles of incorporation, the short-term and long-term prospects of the corporation, and the best interests of the corporation and its shareholders.  (See CA Corporations Code section 2700.)

The directors of a benefit corporation must also perform their duties in accordance with the regular fiduciary duties of care and loyalty.  In contrast to the permissive language used in the flexible purpose corporation law, the benefit corporation law requires directors to consider the impacts of any action or proposed action upon all of the following: shareholders; employees and workforce; customers; community and societal considerations; local and global environment; short-term and long-term interests of the benefit corporation; and ability of the benefit corporation to accomplish its general, and any specific, public benefit purpose. (See CA Corporations Code section 14620.)

The mandatory language used in the benefit corporation law and the permissive language used in the flexible purpose law could be viewed as an advantage or a disadvantage, depending on the viewer and the circumstances.  One might see an advantage to using the benefit corporation form because the mandatory language requires directors to take into account a range of factors.  Alternatively, one might see an advantage to using the flexible purpose corporation form because the permissive language provides directors with discretion to consider a range of factors in their decision-making. 

We have yet to see how courts will interpret the fiduciary duties for the new corporate forms, but in the meantime, directors of benefit and flexible purpose corporations have more robust statutory support to pursue social mission and benefit. 

The Launch of Impact Law Forum

Impact Law Forum, an attorney practice group that I am cohosting with Natalia Thurston of Social Venture Law, held its launch meeting last Thursday in San Francisco.  The forum is designed to support the nascent community of attorneys advising social enterprises, nonprofits, and sustainable businesses in the Bay Area.  Attendees at Thursday’s meeting demonstrated multidisciplinary and tri-sector backgrounds, as varied as the social sector itself – from policy advocacy to transactional corporate law to legal aid to entrepreneurship.

Natalia and I had several reasons for convening this group.  The social enterprise sector is expanding and evolving rapidly, yet the development of resources and networks to support social enterprise attorneys lags behind the pace of the sector.  Several other groups and initiatives similar to Impact Law Forum exist, but they tend to be short-term, sporadic, or informal.  No law firms or formal legal associations exist for social enterprise.  Many social enterprise attorneys (by choice and/or necessity) practice solo or in small law offices. 

The forum provides an opportunity for attorneys practicing in the social impact sector to connect, share resources and networks, offer guidance, ask questions, and discuss relevant legal issues, legislation, public policy, and case law.  The forum will align its values with those evolving in the social enterprise sector, with content driven by the goals and interests of its participants practicing in this dynamic legal climate.  Meeting topics, format, frequency, and other specifics will be determined by forum members.

Our first meeting was a success, despite occurring at the same time as the Giants were playing in the World Series (couldn’t have planned that better).  Kate Ettinger, a health ethics entrepreneur and advisor to social enterprises, kicked off our meeting with a set of thought-provoking questions.  Natalia then presented a background of social enterprise, which led naturally into group discussion and comments.  I shared a client story and raised additional questions to the group, and discussion continued until the close of the meeting. 

If you are an attorney, legal professional, or law student interested in joining the forum and receiving invitations to upcoming meetings, please email me.

What is "Social Enterprise"?

Just back from Los Angeles, where I attended a 1.5 day summit hosted by Social Enterprise Alliance.  At various moments, speakers and attendees paused to reflect on the term “social enterprise” – where it came from, where it might be going.

What does “social” mean to you?  What does it mean when you hear it in: social media?  Social responsibility?  (Corporate) social responsibility?  Social network?  Social enterprise?

Clearly, “social” can mean any number of things, depending on who’s saying/writing it, who’s hearing/reading it, the words that immediately precede or follow it, and the general context of its use.

How about the term “social enterprise”?  What does that mean to you?  Using the power of the market to drive benefits to society and the environment?  Leveraging business models, strategies, and principles to strengthen local communities, restore the environment, and create jobs for people who need them most?  Selling products and services with the explicit goals of improving health outcomes, education, human rights, and/or economic justice?  For-profit?  Nonprofit?

By this point you’ll have learned: (a) I’m not going to give you my definition of social enterprise; and (b) I like asking questions more than I like giving answers. 

So then why would I refer to myself as “legal counsel for social enterprises”?  A risky move, in light of the different meanings of the phrase.  On one hand, I might have thought that the use of “social enterprise” in my materials would help with the weeding out process, leaving only the most hardcore social purpose innovators as my clients and colleagues.  Maybe.

On the other hand, I might take advantage of the vagueness and looseness of the term to cast a wide net for my business.  That is to say, in theory, that a 501(c)(3) public charity that considers itself a “social enterprise” would be just as likely to hire me as a Fortune 500 corporation that also calls itself a “social enterprise”.  Mission accomplished!  I have a range of corporate clients, from the 100% donor-supported charity end of the spectrum, to the 100% profits-to-insiders end of the spectrum.  Maybe, maybe not.

Social enterprise has no clear definition.  For the time being, I’m comfortable using the term to describe those organizations and companies that I believe in and want to work with, and that want to work with me.  At some point, I might shift my use of the term, or start an altogether new tagline for my practice.  But that’s part of the beauty of our social sector work: it’s an ever-evolving, forward-thinking, innovator-driven field.  Arguing over a definition is not going to hold back an entrepreneur who is laser-focused on inventing, manufacturing, and distributing a product that will save the lives of millions.  The lack of a certain definition will not grind our work to a halt, because there is plenty to be done and not enough time to do it.  So let’s go forth.

The Last Thing on a Nonprofit Founder’s Mind?

You are passionate about a social or environmental issue.  You have identified a problem that needs fixing – you have personally lived or witnessed this problem, and you cannot wait any longer to start tackling it.  You have a plan, a solid business model, to address the root of this problem.  How are you going to accomplish this?  Start your own tax-exempt nonprofit organization.  Get the tax-exempt status you deserve, provide your donors with the ability to deduct their charitable contributions from their income taxes, enjoy the “halo” effect and public trust that nonprofit status affords.  The last thing on your mind is: “what are the alternatives to starting my own nonprofit?”

Thinking about alternatives to forming a new nonprofit organization is an important exercise for any founder.  It can also be sobering, painful, and annoying.  But it’s still important, and I would go so far as to say it’s necessary and critical to the health and sustainability of a new organization. 

Why consider alternatives to a new nonprofit?  The scarcity of startup funds for new nonprofits; the difficulty raising funds and sustaining levels of funding; the competitive landscape of the nonprofit sector; the myriad compliance requirements that tax-exempt organizations are subject to, including the initial tax-exemption application and state filings, ongoing federal and state filings, the public support test, restrictions on private inurement, private benefit, fundraising, earned income, governance structure, and other activities; scrutiny and oversight by the IRS, state tax board, and state charities regulators.  The list goes on.

After a thorough examination of the challenges, it may make sense to go with an alternative, such as:

  • fiscal sponsorship
  • starting a project under the umbrella of an existing organization
  • volunteering
  • becoming an employee of a nonprofit
  • remaining an unincorporated association

Several well-established resources on the topic of nonprofit formation, and alternatives to nonprofit formation, include:

Nonprofit and For-Profit Hybrids

I am excited about a new project that I am working on with Embrace, an organization working to advance maternal and child health by providing innovative solutions to the world’s most vulnerable populations.  I will be assisting Embrace in my capacity as a volunteer member of Full Circle Fund, which provides strategic planning and capacity building assistance to nonprofits and social enterprises. 

Embrace is committed to making significant improvements in maternal and child health.  Over 20 million low-birth-weight and premature babies are born each year and over 4 million die within their first month of life.  Without access to modern medicine, many babies born in developing countries die of hypothermia, as they are unable to stay warm enough to survive.  Skin to skin contact between mother and infant is the most effective way of regulating the infant’s body temperature, but in practice it can be very difficult for mothers in developing countries to provide this care.  Many mothers are working, traveling to and from work, caring for other children, or suffering from childbirth complications or other trauma related to disaster-relief and post-conflict situations. 

To date there has been no safe or feasible solution to ensuring that these babies survive through the first weeks and months of life.  Embrace has developed a product that meets this critical need: an infant-sized sleeping bag made of a phase change material that maintains a baby’s body temperature for up to 6 hours.  The warmer costs a fraction of the price of existing solutions and functions without a continuous supply of electricity.  Embrace distributes the warmer to populations in need, partnering with other organizations to carry out the distribution and to provide training and education on maternal and child health issues.  Embrace is also working on creating new innovations and technologies that can further advance positive health outcomes in developing countries. 

Embrace’s legal structure is designed to advance its social impact goals.  It consists of two separate legal entities, a 501(c)(3) nonprofit organization and a for-profit entity.  The for-profit has access to more robust capital markets to scale up its commercial operations, which consist of the manufacture, distribution, and research and development of health innovations.  The nonprofit has an ownership interest in the for-profit, giving it a stake in the for-profit’s commercial activities while furthering the nonprofit’s charitable purpose of improving health. 

For-profit and nonprofit hybrids such as Embrace are demonstrating significant positive impact despite occupying two traditionally distinct sectors.  These hybrid models face challenges, particularly with regard to legal status and access to capital.  The good news is that efforts are underway to support the growth of hybrids, including the development of new legal forms (such as the low-profit limited liability company) and financing vehicles (such as social impact investment).  Gradually, these efforts and others will make it easier for entrepreneurs to pursue mission without having to make trade-offs between social and financial goals. 

What is a benefit corporation?

Whether you are a nonprofit or for-profit or something in between, you have probably heard the buzz about a new corporate form in California called the “benefit corporation”.  I’ve been answering a lot of questions from current and potential clients about the benefit corporation and other types of social purpose legal structures (e.g., flexible purpose corporation, tandem structures, low-profit LLC or L3C), so I’ve outlined the basics of the California benefit corporation in this post. 

As of January 1, 2012, new start-ups and existing entities can take advantage of a new corporate form which allows directors to put purpose in front of profit.  New start-ups can incorporate as benefit corporations (by filing Articles of Incorporation with the CA Secretary of State), and existing entities can convert to become benefit corporations (by vote and amendment of organizing documents).

How is a benefit corporation different from a regular corporation?

You might be surprised.  There’s been a lot of publicity about the benefit corporation (at least in the social sector) – this buzz implies that the new corporate form is substantially different from the regular corporate form.  It’s not.  Also, the benefit corporation is often referred to as a “hybrid” legal form or structure, implying that it is half nonprofit, half for-profit.  It’s not that either.  The benefit corporation is a traditional, for-profit corporation with a key difference: its directors are allowed to prioritize social and environmental objectives ahead of profit.  (I don’t mean to imply that the benefit corporation is not an important step towards greater social and environmental responsibility in the private sector – it most certainly is.  I discuss positive impact below.)  I do think it’s worth mentioning that the major features of traditional and benefit corporations are the same, including one key similarity: a benefit corporation is still taxed in the same way as a traditional corporation, i.e., there is no tax advantage associated with carrying out social or environmental objectives.  Contrast this to the preferential tax treatment that many charitable nonprofit organizations are granted as a result of carrying out activities that the IRS deems worthy of tax-exemption.

If the corporate forms are not so different, what’s special about the benefit corporation?

The following features distinguish a benefit corporation from a regular corporation:

1)      the organizing documents of a benefit corporation must state a general public benefit, defined as a material positive impact on society and the environment, and may also state one or more specific public benefits

2)      benefit corporation directors are mandated to consider the impact of corporate actions on shareholders, employees, customers, the community, the local and global environment, and the interests of the corporation itself

3)      the benefit corporation’s ability to accomplish its stated public benefit is assessed on an annual basis against an independent, credible third-party standard

4)      the benefit corporation is required to report its overall social and environmental performance in an annual benefit report, distributed to shareholders and available to the public on the corporation's website

Why adopt the new form?

Despite the similarities between traditional and benefit corporations, the new corporate form is a big deal.  And despite the more stringent reporting and third-party assessment requirements for benefit corporations, the new corporate form will be an attractive and worthwhile option for many corporations that pursue social and environmental goals.  I think what gets people excited is that the new corporate form marks a significant shift from the deep-rooted corporate principle that directors have fiduciary duties to maximize shareholder value.  The law in California and a growing number of other states finally recognizes those entities that embed a social purpose into their business model and holds those entities accountable to that purpose.  Directors have protection from shareholder attacks regarding corporate actions such as resisting a takeover or prioritizing among social, environmental, and financial goals.  Shareholders have rights to hold the corporation accountable to purpose as well as profit.  Other benefits include greater public trust and goodwill, the ability to attract investors interested in social returns, and the positive social and environmental impact created by the corporation’s activities.

There’s so much more I could go on about, and I will do so in future posts.  As always, please contact me if you’re interested in continuing the conversation.