This article highlights the key characteristics of different M&A transaction options, outlines strategic questions to ask to help identify the best transactional structure for your nonprofit, and reviews essential due diligence steps to follow. 

Structural Options
Mergers and acquisitions often appear similar because both are frequently announced as the combination of two organizations. However, the differences in these transaction structures carry significant legal implications, so understanding those distinctions is essential for deciding which is best for your nonprofit. A subsidiary restructuring is another frequently used option.

Merger
A merger is a legal combination of two or more entities into one. In a merger, the surviving corporation assumes all the non-surviving entity’s rights, assets, and liabilities. A nonprofit merger offers the advantage that any bequests or future gifts will go to the surviving organization. While this could be a significant benefit for organizations with a history of regularly receiving such planned gifts, many nonprofits do not have a history of receiving such gifts. Additionally, mergers come with the notable downside that all potential future claims and liabilities will persist within the merged entity. 

Acquisition (or Asset Transfer)
Unlike a merger, in an asset transfer acquisition, there is no automatic legal succession to all rights and obligations. Instead, only the transferor’s specifically identified assets and liabilities are transferred. The actual legal nature of the transaction is often a dissolution under applicable state law, where the asset transfer occurs as part of a dissolution proceeding. Acquisitions or asset transfer transactions are popular choices for organizations looking to expand their programs and assets but want to avoid the risk of taking on another organization’s liabilities. However, a nonprofit must take reasonable steps to address known and unknown liabilities before dissolving. 

Subsidiary Restructuring
Some organizations opt to bring another organization under its control through a subsidiary restructuring while continuing to operate as separate tax-exempt nonprofits. This structure might be chosen to keep the liabilities of different programs separate or to maintain distinct brand identities, while also benefiting from the cost efficiencies of a combined legal structure that often includes a cost-sharing or shared services arrangement. A subsidiary restructuring can be achieved by making one entity the sole member of the other. The “parent” nonprofit, as the sole member of the subsidiary, would have specific statutory rights regarding the “subsidiary” nonprofit, such as the right to elect the subsidiary’s directors and approve certain key corporate actions or transactions (e.g., mergers, asset transfers, dissolutions, and amendments to the certificate of incorporation). Additional rights may be granted to the member through the subsidiary’s certificate of incorporation or bylaws. However, the subsidiary’s board of directors is the legal fiduciary body responsible for overseeing the activities of the subsidiary, and appropriate corporate formalities must be maintained to ensure separation of liability between the parent and subsidiary. 

Strategic Questions
Deciding if a merger or acquisition is the right next step for your organization involves asking specific key questions.

• Will the transaction allow us to accomplish our mission better?
  Consider whether the transaction will help the organization enhance its services and program offerings or expand the reach of its programs.
• Will the transaction improve our operational and financial efficiency?
  Combining two smaller organizations or bringing a smaller organization’s programs into the operational framework of a larger organization can reduce the administrative costs necessary to support the combined programs.
• Do the organizations have sufficiently compatible organizational cultures and values?
  This question is particularly relevant if certain staff members or board members will move from one organization to the other as part of the transaction, which is often — though not always — the case.
• How much would the transaction cost in legal and other fees?
  For smaller organizations, complex transactions may not be practical or cost-effective. In addition to internal approvals, which may include approval by the board of directors and any voting members, some states also require Attorney General or court approval. Additional regulatory approvals may also be needed, depending on the organizations involved (e.g., state and federal education agencies for schools). That said, combining two organizations’ programs under one legal entity (or other unified structure) could be a worthwhile upfront investment for long-term savings and mission optimization.

Key Due Diligence Considerations
Nonprofits considering a merger or acquisition should thoroughly review key risk areas before moving forward. Although the due diligence process will differ based on the nature of the transaction and your nonprofit’s role in it, the following are important issues a nonprofit should examine regarding its counterparty. 

Financial Health
Look for fiscal stability, donor concentration risks, and hidden liabilities.

Tax and Regulatory Compliance
Make sure the other organization has historically fulfilled its tax and compliance obligations. 

Governance and Operational Health
Confirm whether the other organization followed good governance (e.g., annual conflict of interest disclosures, maintaining minutes of Board meetings) and operational practices (e.g., proper management of HR matters, internal financial controls, and data security).

Contracts
Determine which agreements require affirmative consent to be transferred and which should and can be terminated, versus those that would be critical or beneficial to continue. 

Legal Proceedings
Review for any active or potential lawsuits or legal proceedings and evaluate their possible impact after the transaction.

Staffing/HR Considerations
Assess potential retention risks, including any necessary adjustments to ensure equal treatment among similarly situated staff members after the transaction.

Assets & Liabilities
Make sure you understand the assets and liabilities of the other party, including whether it holds clear title to its key assets (such as real property and intellectual property).  

Reputation
Verify that the other organization has a trustworthy reputation among its stakeholders and the public. 

Whether your organization aims to enter a strategic growth phase or establish a home for your key programs before winding down, nonprofit mergers and acquisitions can be an effective tool to help you reach your goals. By understanding how different M&A options impact your ability to achieve your objectives, your nonprofit can confidently step into the next phase.

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While there is no actual codified definition, MRIs are generally understood to be risk-adjusted or “prudent” market-rate investments.  It is a financial vehicle made out of the organization’s investment assets (e.g., its endowment) rather than its program assets.  Unlike its counterpart, the Program Related Investment (PRI), which has the primary goal of accomplishing a charitable purpose, an MRI seeks to generate a market rate of return on capital while also furthering a social purpose.  Put another way, PRIs offer solutions where the markets do not have a solution, while MRIs use the power of the market to create impact. 

It’s important for foundations seeking to establish their investment strategy to understand the key legal and structural differences between PRIs and MRIs.  Since the requirements to qualify as a PRI are more stringent than an MRI, a PRI avoids being classified as a jeopardizing investment, and can be counted towards a foundation’s annual distribution requirement.  

An MRI, on the other hand, is a commercial investment that also has a goal to create social impact but is not subject to the stringent standards of the PRI.  Consequently, an MRI does not count towards a foundation’s annual requirement and is not excluded from the rules governing jeopardizing investments.  In addition, in calculating the amount of a foundation’s five percent annual distribution requirement, MRIs are not excluded from the foundation’s assets, as is the case with PRIs. (For an in-depth discussion of PRIs, please read Are You Looking to Make an Impact? Consider a Program Related Investment).  

While the rules governing the MRI are not as rigid as those governing PRIs, there are a few key ones that MRIs must comply with. The “Jeopardizing Investments” rule, found in Section 4944 of the Internal Revenue Code (“Code”), imposes an excise tax on private foundations that invest “any amount in such a manner as to jeopardize the carrying out of its exempt purposes.” A private foundation and its management may be subject to excise taxes for making a jeopardizing or imprudent investment.  Because the Jeopardizing Investments rule applies to MRIs, MRIs must be comprised of prudent investments.

MRIs must also comply with the “Excess Business Holdings Rule.” Section 4943 of the Code states that a foundation, together with its disqualified persons, may own no more than twenty percent of the voting stock of a business enterprise (some exceptions may apply). 

Since MRIs are not treated as a charitable activity but rather as commercial investments, they must meet the prudent investor standards under state and federal law.  The applicable State-enacted version of The Uniform Prudent Management of Institutional Funds Act (UPMIFA) applies a standard for prudent investments whereby “each person responsible for managing and investing an institutional fund shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.”  In addition, UPMIFA lists a number of factors that must be considered, if relevant, when making an investment.  Most states have adopted a form of UPMIFA. 

Developing an MRI Strategy

The board of an organization that is considering embarking on an MRI strategy should, as a matter of good governance, consider its rationale. Whether as a stand-alone policy or a policy that is incorporated into the organization’s investment policy, drafting a written MRI Policy should be the board’s first step.  The discipline of drafting an MRI policy will ensure that everyone is in agreement when it comes to incorporating MRIs into the overall investment strategy. 

The substance of the MRI Policy will depend in part on the organizational view of MRIs and their purpose.  Some may view MRIs from a programmatic standpoint, wherein the MRI serves as a tool available to the organization in implementing its philanthropic strategy.   Other organizations may view MRIs from an investment perspective and consider it as an opportunity to make a market rate investment that also happens to foster social impact.    

The following is a list of important questions that should be asked when drafting an MRI Policy. 

• Why Does the Organization Want to Make an MRI? 

It’s helpful for an organization to consider what it believes is the key objective for entering into an MRI strategy.  The organization should consider what it hopes to accomplish by making an MRI.  If the full board is in agreement regarding the rationale or objectives for entering into MRIs, it will help support the development of a uniform set of metrics used by the organization when assessing the success of MRIs in achieving those goals.

• Does the organization have the skills and staffing within the organization to carry out an MRI Strategy?  

In order to implement an MRI, organizations will need to rely on individuals with various expertise including investment, programmatic and legal experience.  Executives and the board should determine whether they can utilize in-house staff or board members, or whether they should consider engaging consultants.

The board should take into consideration if it will require a legal opinion that the potential MRI does not qualify as a jeopardizing investment. The size of the MRI relative to the organization’s investment portfolio may be a factor for consideration when determining whether a legal opinion is warranted.  

• Who will be responsible for oversight?  

Prior to entering into an MRI strategy, the board should consider who will be responsible for oversight of the strategy.  If the organization is considering the MRI as a key tool in accomplishing its philanthropic objectives, it may make sense to have both an advisor with programmatic experience as well as one with investment experience onboard. 

On the other hand, if the foundation views the MRI primarily as a market rate investment that also has social impact, a person or committee with investment experience, guided by a board-approved statement of social impact objectives, may suffice.  The investment committee of the board may be an appropriate oversight body for this responsibility when aligned with the foundation’s MRI objectives.  

• What will the balance be between investment risk and social return?

In advance of embarking on an MRI strategy, the board should determine whether it is willing to take a greater financial risk (while still complying with UPMIFA) to the extent the social returns of the investment have the potential to be great.  It may be that, regardless of the potential for social impact results, the board’s appetite for investment risk will remain the same.   Making a riskier investment may require altering existing investments within the organization’s portfolio in order to comply with UPMIFA’s requirement that each individual investment be reviewed in the context of the entire portfolio, in accordance with prudent investor standards.   

Consider the scenario in which the financial rewards are substantial, but the social impact is not as significant.  The answer to these questions will largely depend on how the Board views mission-related investing and why it has decided to enter this arena.  A board would be well-advised to determine in advance of entering into an MRI how it feels about risk and what the appropriate balance is in guiding its MRI strategy.  

• How will the organization measure the success of a Mission Related Investment? 

In reviewing the performance of an MRI, members of the board and management of the foundation should discuss how they intend to measure success.  The foundation could establish that success is based on the investment generating a minimum level of return, while achieving a loosely defined social impact.  For example, investing in a clothing manufacturer that uses environmentally friendly dyes for its fabrics could result in generous returns to its investors but only modest results in terms of reducing harmful environmental impact.  

With a benchmark focusing significantly on market rate returns, an investment that generates modest financial returns but generates substantial social impact may be considered unsuccessful because the return on investment was too low.  The members of the board should consider how much of a social impact they are looking to make through any MRI.   

In Conclusion

The philanthropic sector has come to understand that aligning investments with mission and values can be financially rewarding.  A greater number of foundations have decided to take a portion of their endowment and invest it in ways that align with their mission. Some have decided to invest their entire investment portfolio or endowment in line with their mission.

I predict that in the next few years we are going to see a dynamic shift in the way funders and their boards view their fiduciary obligations. Foundations contemplating entering into MRIs would be well advised to create a policy that articulates how MRIs can be thoughtfully carried out to achieve the desired investment and social objectives.

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What is a PRI?
A PRI is a type of investment made by a private foundation with the primary goal of accomplishing its charitable mission.  It can take many forms, including equity, debt or a loan guarantee.  PRIs were codified as part of the US Tax Reform Act of 1969. This landmark legislation changed the regulatory landscape for private foundations in many ways.  Under the terms of the Act, certain excise taxes are imposed on private foundations for making “jeopardizing investments”, which are investments that jeopardize the foundation’s ability to carry out of its exempt purposes. However, the Act specifically carved out PRIs as an exception to the jeopardizing investment rules.

PRIs are treated more favorably than other types of foundation investments.  Unlike non-PRI investments, PRIs count toward the private foundation’s annual requirement to distribute, for charitable purposes, an amount equal to 5% of the fair market value of its assets,  other than those which are used (or held for use) directly in carrying out a foundation’s exempt purpose (known as the annual minimum distribution requirement).  This treatment reflects the view that PRIs are more akin to grants as they are motivated by the goal of accomplishing the foundation’s mission without regard to their return on investment.

Foundation managers looking to expand their impact may find that PRIs offer significant advantages over traditional grant-making. For example, grants are not repaid, whereas PRIs allow private foundations to make an impact, while generating some degree of financial return that can be recycled for use in a future grant or investment, thereby deepening the foundation’s impact. Traditional grants are also generally limited to charitable grantees (e.g., public charities), whereas PRIs can be issued to any entity pursuing a project that aligns with the foundation’s mission, including for-profit companies.

How do PRIs work?
To better understand how a PRI works, consider this hypothetical:
X is a private foundation with the mission of creating better living conditions for those living in poverty.  X decides to make a $1 million loan to Y, an organization that builds affordable housing for those living below the poverty line in the city of Z.  The loan is made at a below market rate, meaning that X could receive a better interest rate if it invested the funds somewhere else at a market rate.    X is making the loan for the reason that the loan furthers its mission.  As a result of the loan made by X, other investors begin to make loans to Y as well.  As a result, Y is able to build thousands of affordable homes for individuals living in Z.  Eventually, Y repays the loan to X.  Because of the repayment, X is able to use those resources again to make other investments or grants that advance its mission.  The funds are recycled for future use.

How does an investment qualify as a PRI?
To qualify as a PRI, an investment must meet a three-pronged test:

• The primary purpose of the investment must be to further one or more exempt purposes of the foundation;
• The production of income or the appreciation of property may not be a significant purpose of the investment; and
• The PRI cannot be used to fund electioneering or lobbying activity.

The first two prongs of the test warrant further examination.  The first prong, commonly known as the “primary exempt purpose test,” is subjective in that it is specific to each foundation.  It is actually a two-part test.  First, the investment being considered must significantly further the foundation’s exempt activities.  Second, the contemplated investment must be such that the foundation would not make it but for its relationship to the foundation’s exempt purposes.

The second prong of the test states that the production of income or the appreciation of property cannot be a significant purpose of the investment.  This test is more difficult to prove and often generates some degree of confusion.  After all, it is not always easy to determine that return was not a significant motivator is making an investment.  The easiest example of an instrument that would pass this test would be a below-market loan to an organization.  However, PRIs are not limited to loans.  As the Internal Revenue Service and Treasury Department has indicated in previously issued guidance, there are a number of forms a PRI can take, including equity investments, and loan guarantees.  In the final regulations issued by the IRS regarding PRIs, a common element to all of the examples included is that they all have the ability to generate some degree of financial return.  The use of PRIs can be a very effective way of deploying philanthropic capital.

Who uses PRIs?
With all of the benefits of engaging in a PRI, it’s surprising to learn that many private foundations do not use PRIs.  In fact, according the National Center for Family Philanthropy, as of 2017, less than 2% of the country’s more than 87,000 foundations use PRIs.  The larger players in the philanthropic world use them regularly.  For example, the Ford Foundation, a widely recognized trailblazer in the sector, has established a $200 million dollar pool of resources within its endowment for use as capital for PRIs.  On an annual basis, it awards nearly $17 million in PRIs.  In 2020, the Gates Foundation allocated in excess of $10 million to PRIs. The largest foundations avail themselves of this strategic philanthropic tool regularly. But what about the others?  When PRIs are used in concert with more traditional means of philanthropy, it can lead to a more powerful strategy with greater impact.

If a private foundation determines that deploying capital through a PRI should be a priority, the foundation may need to allocate resources toward building a team with the financial and legal knowledge to engage in a PRI strategy.  Effecting a program-related investment requires a fairly significant level of due diligence in order to ensure that the criteria are fully met, and include expenditure responsibility oversight requirements similar to that required of certain foundation grants. In some instances, the use of third-party advisors may prove critical to an effective PRI strategy.  Given the potential for PRIs to have a multiplier effect on social impact, foundation board members and management who have not yet delved into the world of PRIs should consider evaluating whether impact investing through PRIs would enhance programmatic success.

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Most business deals start with a term sheet setting forth the material terms and conditions of the agreement. For the social enterprise deal, provisions relating to social impact, values, or mission, are important to impact investors and entrepreneurs alike.

The panel discussed use of the term sheet structure as a way to identify, articulate, and enshrine social values and mission into impact investment transactions. The panel also contrasted traditional term sheet provisions with non-traditional “social” term sheet provisions that establish clear understandings around mission and impact at the outset and guide the preparation of legal documents.

Speakers

Allen Bromberger, Partner, Perlman & Perlman, nationally recognized for his groundbreaking work on the development of “hybrid” legal structures that support the simultaneous pursuit of financial and social goals. Through his legal practice, as author of The Art of Social Enterprise, and as a speaker, Allen has been at the forefront of the fourth sector and social enterprise movements that have risen to recent prominence.

Teresa Pahl, Partner, Hanson Bridgett, one of the top-rated business and corporate attorneys in California, represents clients in all phases and aspects of their businesses. Teresa’s expertise includes matters involving general corporate law, securities law, and real property law, with a focus on, and passion for, assisting mission-driven companies and impact investors

This content is intended for industries across family offices, impact investors, social ventures, social enterprises, non-profit organizations, and socially responsible companies, among others. Allen and Teresa are proud to release this content to support changemakers working on protecting mission who were unable to attend.

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The Benefit Corporation

Thanks to relatively recent legislation in a number of jurisdictions, social entrepreneurs have the option of incorporating as a benefit corporation or public benefit corporation as it is known in Delaware.  Benefit corporation laws actually require a corporation to pursue a mission and to take that mission into account when conducting business.  Most jurisdictions require that the benefit corporation report to its shareholders about how it has been pursuing its mission, and some states require that report be made publicly available.  The benefit corporation does give its officers and directors a certain amount of protection when pursuing a company’s mission.  The officers and directors have the ability to focus on mission in addition to maximizing shareholder value.  However, the benefit corporation is a fairly new concept and is only now being broadly tested in the capital markets.  The recent initial public offering by Laureate Education is a prominent test case.  It is still too early to tell how the investing public will react to this new corporate entity.  It is also worth noting that Laureate Education may not be the best test case, since it has the advantage of being able to rely on the resources and network of its financial sponsors, which include private equity behemoths. Not all benefit corporations seeking to become public companies will have the backing of private equity sponsors.

Incorporating as a benefit corporation is one avenue of trying to enshrine social mission into a company’s DNA. But a close reading of these statutes reveals that they don’t actually require much. “Social purpose” is defined very broadly and is vague. And directors can fulfill their obligation by considering the social mission when making business decisions: they don’t actually have to do anything differently than they would if they were solely seeking profit. Finally, of course, is the fact that in certain jurisdictions a company can simply opt-out of the Benefit corporation designation with no consequences.

There are other alternatives available to the social entrepreneur to make social purpose intrinsic to the corporate structure without having to change a company’s corporate form.  Below we will discuss some of these methods:

Charters, Bylaws and Shareholder Agreements

One way to safeguard a social mission is to include mission related provisions in the organizational documents of a company – even a “regular” corporation or LLC.  The charter of a corporation can be drafted to contain provisions that authorize or require the organization to comply with a social mission.  A company’s bylaws can require its officers and directors to take social missions into account when performing their duties, just as they would be required to do with a benefit corporation.  For example, the bylaws of the company might authorize the directors and officers of a company that manufactures environmentally friendly products to take into account the environmental practices of their suppliers in addition to more traditional metrics like cost.

Shareholder agreements can also be used to embed mission.  A well-crafted shareholder’s agreement – essentially a contract between the corporation and the shareholders – can require the company to pursue a social mission in the course of carrying on its business, and prevent shareholders from trying to inhibit the pursuit of social objectives.  For example, shareholders agreements can be drafted to require a supermajority in order to alter provisions relating to a company’s mission, or to give non-consenting shareholders the right to sell their stock back to the company if the social mission is diminished.  Shareholder agreements can also mandate specific mission-related reporting to shareholders, and give the shareholders rights of inspection that they would not otherwise have.  Although, shareholder agreements can be amended over time, steps can be taken to make it harder to amend or remove provisions that relate to social purpose.

Capital Structure – Classes of Stock

For-profit corporations can also protect a social mission through the design of its capital structure.   For example, socially minded corporations can create multiple classes of stock that allow one class of shareholders (call it Class A) to receive one vote per share while shareholders in the other class (Class B) get several votes per share. In a common scenario, Class A stock will be held by the investors, and Class B stock will be held by the founder or others (including foundations) who give priority to the social mission and can use their voting power to protect the mission. A company can also issue a class of preferred stock that grants its holders certain rights that are different from those of common stock holders.  Those rights could include the ability to veto any policies or practices that would impair or diminish the company’s commitment to a social mission, including mission related provisions in a shareholders agreement (see above.)  In a slight variation of this approach, some social entrepreneurs have granted preferred stock to non-profit foundations.  Those foundations are able to take the company’s mission into account when exercising their rights as holders of preferred stock.

Third Party Certification

For brand focused industries, getting certified by a credible organization that develops certain standards for its members in areas such as worker impact, environmental impact or community impact can distinguish a business in a market place that is crowded with competitors all claiming to be “good” companies.  If a company is certified by such an organization, it has to maintain its standards in order to be re-certified. While being certified by such an organization does not necessarily embed mission into a company’s corporate structure, the possibility of not being recertified does make it harder to dilute any social or environmental values.  Some of these certifying organizations actually require companies to alter their governing documents in order to ensure that a corporation’s social values will endure changes in management, etc.  Many also argue that having this type of third party certification can help a social entrepreneur attract mission-driven or impact investors.  B Corp certification is an example of this type of third party certification.  Some well-known companies that use the B Corp certification include outdoor apparel manufacturer Patagonia and home products manufacturer Seventh Generation.  Other examples of third party certification include the Green Seal certification which is available to manufacturers of environmentally responsible products.  The Green Seal certification on a product helps purchasers identify products that are safer for the environment.  These are only two examples; there are numerous other standards that can be used as well.

Creative Alternatives for Safeguarding Mission

These are just the commonly used solutions to safeguarding mission.  There are other creative ways of requiring a company to adhere to its mission.  For example, lenders who are interested in social enterprise could insist on a maintenance covenant that requires the borrower to pursue its mission and provide the lender with certain quarterly metrics. Other options include restrictive provisions in long-term IP licenses, joint venture agreements, and other agreements that bind a company, make it accountable to outside interests, and are legally enforceable.

If creating enforceable legal obligations with respect to mission is important, there are a lot of tools available to the social entrepreneur or a group of investors to accomplish this.  It’s up to the company’s founders, officers and directors to pick the strategy that best fits their needs.  Sometimes one technique alone will not suffice, and a combination will be used. Experienced and knowledgeable advisors are a good place to start.

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1. Make the individual and small business tax cuts permanent.
2. Promote retirement savings;
3. Encourage saving by creating Universal Savings Accounts, expanding 529 education savings plans, and allowing families to access retirement funds to pay for the costs of caring for new babies;
4. Expand business write-offs for startup businesses and remove barriers to the growth of start-ups.

The committee’s framework is long on vision but provides no details on how these objectives will be accomplished. If legislation promulgating these objectives passes, it could affect social enterprise, which is the use of commercial and business strategies to address social problems (using nonprofit or for-profit legal entities or a combination of both). The effects may come in several ways.

1. The TCJA tax cuts for individuals had the effect of making charitable contributions more expensive for donors in the short term because the deduction, a form of subsidy, is smaller. For example, a donation of $100 will now cost the donor $80 (the non-deductible portion) instead of $60, a 50% decrease in the value of the deduction.  Making these tax cuts permanent can be expected to negatively impact charitable giving on a long-term basis. Coupled with cuts in government support for social and environmental programs, this will reduce the income available to nonprofits that are working on pressing social and environmental needs. However, the needs themselves have not gone away; in most cases, they have increased. As a result, non-profit groups will need additional sources of revenue just to keep up with demand, and the most obvious way for them to get new revenue is by engaging in commercial activities, cause marketing, joint ventures, licensing, and other ways that allow them to monetize their programs, expertise and value to society. Since all of these activities can be considered “social enterprise” (some definitely are), the obvious result will be to increase the sector’s reliance on social enterprise as a tool for revenue generation, and to increase society’s reliance on social enterprise as a method of addressing social and environmental problems.

In addition, because nonprofits will have fewer resources available to them, the role of for-profit social enterprises relative to non-profit ventures can be expected to grow, since both the opportunity and need for these ventures will increase, but the ability of non-profit ventures to fill the gap will be impaired. This shift in roles will have the effect of moving more social and environmental activity out of the non-profit sector and into the for-profit sector over time. It may also lead to more innovation in non-profit cooperation with for-profit companies, and new opportunities for nonprofits to leverage their programs and expertise in the commercial or for-profit world. We can expect this to increase, for example, in areas such as health care, education, tourism, real estate development, workplace health and safety, alternative energy production and distribution, and other areas where positive social and environmental impacts translate into commercial opportunity.

1. The expansion of startup expenses also holds great promise for for-profit social enterprises. Although some for-profit social enterprises are large (some are even publicly traded), the majority of these ventures are relatively young and small, and can be expected to benefit from tax law changes that allow them to write off more of their startup expenses more quickly. However, until we understand what kinds of expenses are covered, how they are affected, and who specifically can benefit, it is difficult to say how these changes might affect the sector specifically.

One other side effect of this change may be to give for-profit social ventures a relative advantage in the marketplace compared to non-profit social ventures. This outcome is because non-profit ventures can take tax-deductible contributions, but they cannot issue shares and their ability to pay a return on capital is limited, making it difficult for them to raise working or growth capital. For-profit ventures, on the other hand, cannot accept tax-deductible contributions, but they can issue shares and can pay unlimited returns to investors. Their structure gives them access to equity capital to finance start-up, expansion, and other things that growing companies need, whereas non-profit ventures will not have access to these resources. This policy, in turn, may lead to an increase in nonprofits creating for-profit subsidiaries and joint ventures to finance their commercial and revenue-generating activities, using invested capital rather than donated capital (philanthropy.) It will also encourage greater innovation in how non-profit, for-profit collaborative ventures are carried out. As above, the devil will be in the details, which are not yet available.

1. Removing barriers to the growth of start-ups will have much the same effect as permitting greater write-offs of start-up expenses – it may result in stronger and faster growing social enterprises. Access to capital is just one area where barriers could be removed. Allowing both for-profit and non-profits easier access to capital, allowing nonprofits to pay a return to investors through new, highly subordinated forms of debt, and similar changes would benefit all social enterprises. Other changes that might have an effect include giving non-profit social enterprises greater freedom to collaborate and cooperate with for-profit entities (for example by expanding the permissible scope of such arrangements and loosening restrictions on certain kinds of compensation.) Some changes, such as allowing nonprofits access to SBA loans, would help non-profit social enterprises by giving them a level playing field compared to for-profit ventures.

Practitioners are eagerly awaiting more detail on the Committee’s proposals. The Committee has said that they hope to introduce a bill may in the next few weeks, with the goal of having something passed  — at least by the House — in September or October 2018. That may be optimistic, and the Senate has yet to weigh in on these proposals, so we will continue to watch developments in this area with interest.

Originally Published on Law360, a LexisNexis Company, July 27, 2018

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By contrast, the very purpose of a for-profit company is to further private interests and benefit individuals individually and collectively. Even where the company’s charter includes public benefit purposes, the board still has an obligation to see that the shareholders’ interests are being served. In most jurisdictions, that means their economic interest, not their spiritual or philanthropic interests.

In the world of nonprofit/for-profit tandem structures, this juggling of public interest and private interest can be a challenge. Every arrangement and transaction between the two entities has to satisfy competing and somewhat inconsistent requirements.

Are there any rules? Sure. In general, if the for-profit company is providing a concession to the non-profit, such as offering goods or services for free, or at below-market cost, there is no financial benefit to the for-profit, or its owners, and thus no private benefit. However, if the nonprofit is paying the for-profit company for goods or services or something else of value, the price has to be at or below market to avoid any private benefit: overpaying is a classic indicator of private benefit. Indirect and incidental benefits, especially non-financial benefits such as enhanced reputation, morale, or customer loyalty are treated as incidental, and don’t usually pose a problem.

In tandem structures, the private benefit issue arises most commonly when the arrangements are first being agreed to, and later whenever the two entities do business with each other.

When setting up a tandem structure, where the potential for benefitting private interest is especially acute, it is best to make sure that both entities have independent boards, so that anyone who might benefit from the arrangement or has a conflicting duty (such as a director who sits on both boards) can disclose their interest or conflict and recuse themselves from the decision. This “disclose and recuse” tactic is the best way to deal with conflicts and potential conflicts because it clears the taint of personal interest from the process. Also, the arrangement should be negotiated at arm’s length to ensure that the charity has the opportunity to protect its own interests and refuse an arrangement that is to its disadvantage. If the boards then approve the arrangement, they are presumed to be acting in good faith. Having independent boards also helps to ensure that each entity is free to pursue its own interests, and reduces the likelihood that one will take advantage of the other.

When the nonprofit and for-profit entities do business together, for example when one provides goods, services, or financing to the other, management services, space-sharing arrangements, lending or sharing employees, or other situation where something of value is exchanged between the two, a four things are important:

1.      Be Careful and Reasonable

The terms of arrangement must be reasonable and provide structural safeguards to prevent private benefit. Structural safeguards include independent boards, separate management, third-party validation of pricing, strict conflict of interest policies, shares service agreements, and escape clauses for the charity if it concludes that anything about the arrangement is unfair, improper, unethical or might jeopardize its tax-exempt status.

2.      Negotiate Terms at Arms-length

Each side should have separate counsel if possible, and the board should review and approve all major decisions after conducting appropriate due diligence.

3.      Put it in Writing

There should be something in writing that sets out the terms of the agreement between the two entities. It should include the role and obligations of each party. It should require frequent consultation. It should contain standard provisions on confidentiality, intellectual property, indemnities, and the like. This kind of agreement can be called a memorandum of understanding, a letter of intent, a cooperation agreement, a shared service agreement, or anything else that the parties want. The agreement needs to be approved (and signed) by both parties.

4.      Sharing is Caring

When resources are going to be shared, a shared services agreement is good to have. Such an agreement sets out the parties’ obligations to each other, articulates a framework for allocating costs between them to ensure that the nonprofit is never subsidizing the for-profit or overpaying for goods and services, and that costs that properly belong to the for-profit are paid by the for-profit, and costs that properly belong to the nonprofit are paid by the nonprofit. This is especially important if a relatively small number of people co-founded both entities or have effective control, as the IRS considers those kinds of arrangements to be the most easily abused.

Any time a nonprofit and a for-profit do business together, including tandem structures where cooperation and coordination are ongoing, the issue of private benefit is going to be a concern. Too much private benefit and the nonprofit can lose its tax-exempt status; too little private benefit and it doesn’t make sense for the for-profit to participate, especially if it has investors who expect a return. This is an inherent conflict that comes from blending two different entities into a force for good. Careful planning can minimize or eliminate some of the risks, but not all.

Someday we will devise a better model that allows for blending financial return and social good at all levels, with appropriate rules of the road and established norms. Such a structure could accept invested and donated capital, and engage in profitmaking activities while simultaneously accomplishing a charitable mission, with incentives aligned and internal processes designed to accomplish both simultaneously. Until that day arrives, the tandem structure is the best we can do. Tandem structures are becoming more widely used and widely accepted, and we need to make them work.

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The skeptics are now learning to never say never. Laureate Education Inc. has recently filed a registration with the United States Securities Exchange Commission for an initial public offering.  The company is a Delaware Public Benefit Corporation. Laureate is also a B Corporation, having completed the rigorous assessment and made the grade to certify as a B.

The corporation’s stated public benefit is to produce a positive effect (or a reduction of negative effects) for society and persons by offering diverse education programs online and on premises in the communities that they serve.  The initial public offering is being underwritten by some of Wall Street’s most prestigious names.  Even more striking is that Laureate Education is a portfolio company of KKR, the private equity behemoth. With KKR standing behind this IPO, there are bound to be many interested investors.

The underwriters as well as the company’s financial sponsors have taken the position that investing in a benefit corporation is, at the end of the day, no different from investing in a traditional corporation.  When the IPO closes, Laureate Education Inc. will likely become the first publicly traded public benefit corporation.  Once the first successful IPO of a benefit corporation occurs, who knows how many others will follow?  Perhaps the long-held proposition of the social entrepreneurship community that businesses can do well and do good at the same time will finally be fulfilled.

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