My heart inevitably sinks when a client asks the ever popular question “What form of legal entity would be best for my for-profit enterprise?” The entrepreneur’s excitement is contagious but answering is never easy. There are so many variables that determine where a start-up might end up no matter how researched the assumptions and projections might be. And yet, a choice has to be made.
For the growing number of social entrepreneurs, it has become even more nuanced. There are three new legal forms emerging to satisfy the “Impact Investment Revolution” in our midst (the Flexible Purpose Corporation, the Benefit Corporation and the Low-Profit Limited Liability Company or L3C), and Illinois is considering the creation of a fourth, the Benefit L3C. While each is designed to accommodate ventures that pursue social and environmental benefits attractive to impact investors, social entrepreneurs should consider a variety of factors before using the traditional LLC or corporation.
Summarizing the similarities and differences of each of the new legal forms is no straightforward task. Each state that has adopted one or more of the alternative new forms has slightly different requirements and there is no real case law to date analyzing how state specific legislation is to be interpreted since these legal forms are so new.
In general, the Flexible Purpose Corporation permits the founders of a for profit corporation to establish a blend of business and charitable or social objectives that are not profit maximization or asset growth oriented. The board and management of the Flexible Purpose Corporation are then charged to act with those blended objectives in mind and to report to the shareholders on its success or failure in achieving them.
The Benefit Corporation differs slightly in that it is a for profit entity that is required to advance a general public benefit in addition to any other purposes adopted as a business corporation. The Benefit Corporation may also have as a purpose the creation of one or more specific public benefits. The directors have an affirmative duty to consider the effects of their decisions on all of the corporation’s constituencies (shareholders, customers, suppliers, the environment, the community) and an annual benefit report prepared by an independent third party describing efforts to create the public benefit during the preceding year must be filed with the Department of State and distributed to shareholders.
In contrast, an L3C is usually formed to create a presumption of eligibility for program related investments (PRIs) from one or more foundations or to lock in a charitable mission when the founders have a set of investors who will support that mission. See my earlier post “Private Foundations and New Regulations Regarding Program-Related Investments”. The L3C is, by definition, a low-profit limited liability company which significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the IRS Code of 1986, as amended. No significant purpose of the L3C can be the production of income, the appreciation of property or one or more political or legislative agendum within the meaning of Section 170(c)(2)(D) of the IRS Code of 1986, as amended.
The L3C therefore goes further than the Flexible Purpose Corporation or the Benefit Corporation in that both of those are set up to be money-making enterprises that also have social or charitable mission(s). The L3C can operate a business but producing income or maximizing appreciation of assets cannot be a significant purpose of the venture and if it becomes clear after formation that income or appreciation is the focus, the L3C will immediately cease to exist as a low-profit LLC although it will continue to exist as a limited liability company.
Note that “B Corporations” are not a corporate form but rather a certification mark available to all three of the above forms and even traditional for profit corporations. The certification or brand can be obtained from the nonprofit organization called B Lab and requires achieving a specific score after the B Lab evaluation of a variety of factors including the entity’s treatment of its employees and successful evaluation of socially responsible goals. See http://www.bcorporation.net for more information on B corporations.
With the above in mind, reverting to the age old “Who”, “What”, “Where”, “When” and “Why” analysis is probably the best way to analyze the alternatives. Throwing in a “How” or two will help even more.
Looking at the “who”, entrepreneurs, investors and consumers each have characteristics that may make one choice unavailable or at least inappropriate. For example, if the founding principals consist of one or more non-profit corporations rather than individuals, a Benefit Corporation may be desired although such an entity would be unable to elect pass through “S” status which may prompt a closer examination of the L3C model. If attracting foundation PRIs is a large part of the business plan, that too might suggest that the L3C is the proper vehicle. In contrast, if the initial or anticipated future investors articulate the desire to consistently build profits along with a material positive impact on society or the environment, the L3C requirement for “low-profit” expectations will be violated and the L3C status possibly challenged. The Benefit Corporation would be a better choice for such investors especially where enough time has simply not elapsed for anyone to determine how low the “low profit” requirement really is.
The “what” and the “where” is a close examination of the intended business activities and cross border implications, if any. Some activities are more fundamentally socially or environmentally beneficial than others and some are clearly charitable at their core. At the same time, while you can form a legal entity anywhere that the chosen structure is permitted and file for authority to do business in any state of operation, PRIs, bonds and grant programs are often geographically specific.
“When” is a determination of the planned exit of either the founders or specific staged investors which may suggest starting out as one kind of entity and evolving over time into another kind of entity which is permitted in most states if the requisite shareholder/member consent is obtained. The transition is not intended to be as difficult as a non-profit to for profit transformation (which, in Pennsylvania, require Attorney General and Orphans’ Court participation). “Why” is really another examination of the social/environmental/charitable mission and the expectations of all principals along with the individuals or programs the principals intend to benefit with the new endeavor. And, finally, an old fashioned projection of just “how” much money is needed at different junctures of the anticipated growth cycle is key.
LawForChange at http://www.lawforchange.org features some interesting content on the variety of legal structures available on a state by state basis. There are certainly pros and cons of using each structure and I sincerely wish you well in your efforts to choose which will be best. Forget what I said at the beginning of this post and feel free to call me if I can be of any help.
As the calendar year comes to a close, all corporate entities, profit and nonprofit, look to their books and make end of year decisions to best avoid the pitfalls of the clear and concise (NOT!) Internal Revenue Code (the “Code”). Private foundations have a unique challenge in their efforts to avoid excise taxes which are imposed on them, as well as their managers, in accordance with Section 4944(a)(1) of the Code if it is found that such foundations made investments that jeopardize the private foundation’s exempt purposes. Such “jeopardizing investments” generally occur when foundation managers fail to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the private foundation.
On May 21, 2012 the Service published proposed regulations that provide nine new examples of types of private foundation investments that qualify as Program Related Investments (“PRIs”). PRIs are not classified as investments which jeopardize the carrying out of exempt purposes of a private foundation because they possess the following characteristics:
a. have as the primary purpose the accomplishment of one or more charitable or educational purposes defined by Section 170(c)(2)(B) of the Code;
b. do not have as a significant purpose the production of income or the appreciation of property; and
c. do not further one or more of the purposes described in Section 170(c)(2)(D) of the Code (relating to prohibited political activities and lobbying).
To be certain both the foundation and the recipient of the PRI are on the same page (and to also prove the foundation is exercising “expenditure responsibility” to the Internal Revenue Service), a private foundation must secure a written commitment from the recipient of the PRI which specifies the purpose of the investment and contains an agreement by the organization:
a. to use all amounts received only for the purposes of the investment and to repay any amount not used for these purposes back to the foundation, provided that, for equity investments, the repayment is within the limitations concerning distributions to holders of equity;
b. to submit, at least once a year, a full and complete financial report together with a statement that it has complied with the terms of the investment;
c. to keep adequate books and records and to make them available to the private foundation; and
d. not to use any of the funds to carry on propaganda, influence legislation, influence the outcome of any public elections, carry on voter registration drives or make grants that do not comply with the requirements regarding individual grants or expenditure responsibility.
Examples of acceptable PRIs in the proposed new regulations are based on published guidance and on financial structures that had previously been approved in private letter rulings. The regulations do not modify the existing regulation but illustrate certain principles and current investment practices. Where the examples in the older regulations focused on domestic situations principally involving economically disadvantaged individuals in deteriorated urban areas, the new examples include a broader range of opportunities that might be presented to a private foundation.
The new examples demonstrate that a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration and promoting the arts. Several examples also demonstrate that an investment that funds activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for individuals in poverty, may further the accomplishment of charitable purposes and qualify as a PRI. One example specifically illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI. Another illustrates that a private foundation’s acquisition of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI and two examples illustrate that the private foundation’s provision of credit enhancement (such as a deposit agreement or a guarantee) can qualify as a PRI.
As a result of the new examples, the Service has made it clear that the recipients of PRIs do not need to be within a charitable class if they are the instruments for furthering a charitable purpose.
Thus, an investment in a for-profit that develops new drugs may qualify as a PRI if the for-profit business agrees to use the investment to develop a vaccine distributed to impoverished individuals at an affordable cost. Similarly, the purchase of equity in a benefit corporation or L3C that engages in the collection of recyclable solid waste or a below market rate loan to allow a social welfare organization formed to promote the arts purchase a large exhibition space may each also qualify for a PRI from the right foundation.
The new regulations should provide private foundation boards and managers in the second half of 2012 with the additional assurance they needed to make PRIs not only to traditional non-profits but to for-profit, benefit corporations and L3Cs with an articulated social enterprise consistent with the foundation’s exempt activities. Rejecting traditional boundaries between nonprofit and for-profit sectors, the PRI regulations can help encourage the most creative business minds achieve ‘double bottom line’ (financial and social) and sometimes ‘triple bottom line’ (financial, social and environmental) results. By expanding the base for PRIs, we move beyond traditional conception of society as divided neatly into three sectors (business, nonprofit and government) help develop a new forth sector that encompasses elements of both business and nonprofit sectors.
Two guys are sitting at a bar discussing how they are going to quit their current jobs and start their own business. A lawyer sits next to them, overhears their happy ramblings and pipes in, as lawyers always do, that their mutual promise to devote 100% of their working energy to the new biz has to be reduced to writing. You know this joke, right?
Well, maybe not, and maybe it’s not such a knee slapper anyway. Under Delaware’s Limited Liability Company Act (the “Act”), a person may be admitted to a LLC as a member and may receive a LLC interest without making a contribution or being obligated to make a contribution to the LLC. If an interest in a LLC is to be issued in exchange for cash, tangible or intangible property, services rendered or a promissory note or obligation to contribute one or more of these items, however, the LLC’s operating agreement can and should, identify that obligation. The Act goes further and makes it clear that the operating agreement may provide that a member who fails to perform in accordance with, or to comply with the terms and conditions of, the operating agreement shall be subject to specified penalties or consequences, When a member fails to make any contribution that the member is obligated to make, the operating agreement can provide that such penalty or consequence take the form of reducing or eliminating the defaulting member’s proportionate interest in a LLC, subordinating the member’s interest to that of nondefaulting members, a forfeiture of that interest, or a fixing of the value of his or her interest by appraisal or by formula with a forced redemption or sale of the LLC interest at such value.
If only our clients made it easy on us by letting us write agreements with such detail! A more common scenario is the member who wants us to get rid of the 50% member, formerly a dear buddy, who walked out the door for whatever reason after a few months (or, even worse, walks in and plays on the computer all day doing nothing that needs to be done). Unfortunately, without an operating agreement that clearly identifies expectations with respect to contributions of services and remedies for breach, it is a challenge to argue the defaulting member forfeits his or her interest for failure of consideration as s/he might for failure to “pay” for the interest with cash or property.
While I continue to look out for case law in support of the idea of forfeiture in the context of LLCs, a recent Kansas case did address alternative remedies for breach of obligations with respect to contributions of cash. In Canyon Creek Development, LLC v Fox, the court struggled with the appropriate remedy available to a LLC when a member failed to satisfy a required capital call. The defaulting member, Fox, argued that he should not be held personally liable for the nonpayment of a post-formation capital contribution where the only remedy set forth in the operating agreement was a reduction of his ownership interest. Interpreting a statute that appears to be similar to the Act, the court ultimately agreed with Fox, making a distinction between the initial contributions (which could be in the form of cash or services, measured by their “net fair market value”) and later capital infusions which had to be in cash (unless the manager otherwise consented). The court concluded that the statutory default rule that a member is obligated to perform any promise to contribute cash or property or perform services, even if a member is unable to perform, supports the proposition that a member may be required, at the option of the LLC, to contribute an amount of cash equal to the agreed value of any initial, unmade, contribution. The court stated this was the law even where the LLC may have other rights against the noncontributing member under the operating agreement or other law. Turning to subsequent capital calls, however, the court found it significant that the remedy of cash damages, the most fundamental remedy for breach of contract, was conspicuously absent from the provisions of the operating agreement. Thus, the court concluded that the failure to include such a fundamental remedy as damages when a member fails to contribute additional capital after the LLC’s initial capitalization was not an oversight, but rather expressed a clear intent that damages are not recoverable from a member who failed to contribute additional capital after the venture was up and running. In the Fox case, the right to reduce the breaching member’s LLC interest was all that the LLC could do to punish the breaching member. No divorce, but better than a non-collectable judgment for a sum certain from my perspective.
Nobody wants a “Bad Actor” as part of its working group but, from the perspective of the founder of a startup, the Securities and Exchange Commission’s proposed “bad actor” rules may wind up causing more injury than antidote. The good news is that the SEC is proposing amendments to its rules to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D. See 17 CFR Parts 230 and 239 (Release No.33-9211; File No. S7-21-11. I agree with that effort but, since Rule 506 is one of the three exemptive rules for limited and private offerings under Regulation D, and by far the most popular, it is important that the definitions are carefully tailored. Not all “disqualifying acts” are equal, and “covered persons” and the “bad actor” disqualification should apply only to issuer’s management and controlling equity holders rather than any holder of 10% or more of the entity’s equity. And, even if those changes are not made, the reasonable investigation standard for determining whether “covered persons” are “bad actors” should be no more onerous than the current standard for accepting money from “accredited investors”. Without these changes to the proposed rules, the process of compliance will be beyond the budget and timeline of most startups.