Analogizing this to startup companies can be illuminating. Having founded and run several startups, as well as having advised founders as either an attorney or board member, it has become clear to me that while a variety of factors are needed for an enterprise to be successful, there are several key factors that virtually every startup need to exhibit and embrace in order to be successful.

Accepted wisdom is that most startups will fail. So what makes the outliers successful? In my experience, there are five key factors, and I share them here.

1. Don’t start with a product, start with an open mind.
Thanks to lesson from the book the “Lean Startup,” the days of “if we build it, they will come” has thankfully passed. Most companies are founded on a “big idea,” whose founders are, understandably, passionate and committed to pursuing their dream. So what goes wrong? One survey of failed startups determined that 42% of them identified the “lack of a market need for their product” as the single biggest reason.

The brilliance of the concept that an entrepreneur should develop a “minimal viable product” – build something small, fast and cheap, and then test it – is its simplicity. Remaining nimble, flexible and open-minded cannot be overstated. (Equally important, of course, is to make sure the appropriate inventions assignment agreements and contractor agreements are drafted to ensure that your company properly owns everything your employees and contractors create).

2. To build a viable business, you need to build a successful team.
Psychological research is rich in the documentation and study of dysfunctional groups (think of Tolstoy’s “unhappy families”.) In the world of startups, many failures are due to discord among the founders. Although most founders are people with high hopes and good intent, when you bring into the mix the differences of personality, background and skills, combined with variation in expectations, conflict is to be anticipated. In most cases where the founders fail to resolve or work around these differences, the demise of the company is not far behind.

Thus, instilling teamwork skills and practice into your company culture is the key to its success. From a legal framework, a “founders” or shareholders agreement that delineates the rights and remedies of shareholders should disagreements or conflicts arise is also essential.

3. When adversity strikes, resilience is essential.
Things will go wrong, terribly wrong with your startup. This is not due to bad luck, rather it is part and parcel of launching a new enterprise. Startups operate in a rarefied environment in which market conditions, competition and circumstances (both macro and micro) are constantly in flux. Startup teams must possess the ability to change products, adjust to the changing landscape of competition, shift industries, rebrand the business, or even tear down a business and start all over again.
Resilience in the face of the headwinds of adversity is essential. There are many studies examining what makes one individual more resilient than another. One commonly identified trait is referred to as the “internal locus of control”. Simply put, resilient individuals believe that “they,” and not their circumstances, are the driver of success. So when things go wrong, roll with the “punches” and remain focused on success.

4. Keep your friends close, and your advisors closer.
I have helped many startups screen and engage advisors. Advisors and board members can make a significant contribution to a startups success. By providing an imprimatur of credibility, imparting insightful wisdom, making key introductions, or raising seed capital, an advisor can give the startup the foundation it needs to keep on track.

Unfortunately, the reality is that most advisors will not workout. He or she may overpromise, lose interest, or become consumed by competing commitments. You can insure that your advisor agreements provide adequate equity and/or incentives to secure the advisor’s engagement, but also have reasonable “cliffs” and milestones to warrant that compensation is tied to value received.

5. Show me the money!
All too often I have seen the never-ending pursuit of founders for money become the crucible that becomes too heavy to bear. Thus some very good ideas and promising companies fail to get very far. Since raising money is so challenging, my advice is to ask for more money than you think you will need, take money when you can get it, and in most cases use a convertible note to quickly (and cheaply, relative to other approaches) bring in the money so that you can focus on growing your company.

Once you have the necessary funds to get things underway, make sure you are disciplined in your spending. That means keeping overhead in line with your cash, recruiting key first employees with a modest (but competitive) salary and a generous equity grant. (And if you don’t have an equity compensation plan/strategy in place for key employees, stop reading this and go get one!)

Increase your odds of success.
Launching a startup is a momentous endeavor, and one that promises both excitement and heartbreak. While there is simply no “formula” that guarantees success, keeping in mind some of the above lessons may increase your odds.

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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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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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Newman’s Own Foundation needed the new law to avoid a requirement that it divest itself of at least 80% of No Limit under the “excess business holdings rule” of Internal Revenue Code Section 4943. The excess business holdings rule generally prohibits a private foundation from owning more than 20% of a for-profit company. It imposes extreme penalties on a foundation that are equal to twice the value of the holdings above the 20% limitation. In most cases, this will completely destroy the value of the “excess” holdings to the foundation. The new law creates an exception to the excess business holdings rule for foundations that own 100% of a business and devote all profits to charity.

Foundations that acquire more than 20% of a company normally have a five-year deadline to sell their excess holdings before the penalties apply. Newman’s Own originally faced that deadline in 2013 but was able to get a five-year extension that would have expired this year. The passage of the new law relieves Newman’s Own from the requirement that it divest itself of No Limit, meaning it can continue operating as it always has without interruption.

New law, new rules
The new law, Section 4943(g) of the Internal Revenue Code, permits a private foundation to own 100% of a company under the following conditions:

1. The foundation must own 100% of the shares. There cannot be any other shareholders, and the shares must have been donated to the foundation or acquired in some manner other than by purchase.
2. All profits must go to charity. The company has to distribute 100% of its net operating income to the foundation within 120 days of the end of each fiscal quarter. Net operating income is defined as gross income minus taxes, deductions directly attributable to the production of income, and an amount for a reasonable reserve.
3. The for-profit company is operated independently of the foundation. First, no substantial donor to the foundation can be a director, officer, or employee of the company. A substantial donor is someone who donates more than 2% of the foundation’s total contributions in a given year, and it includes these who donated shares or anything else of value to the foundation, if their donations exceed 2% of contributions to the foundation for the year. Second, a majority of the company’s directors have to be persons who are not also on the foundation’s board. Finally, the company may not make loans to substantial donors of the foundation.
4. Donor-advised funds and some supporting organizations cannot take advantage of the new law. Donor-advised funds and non-functionally integrated Type III supporting organizations are specifically excluded from the new law, thus are still subject to the 20% rule.

The new law, which took effect December 31, 2017, opens a world of possibilities for founders of companies that want to devote all profits from their businesses to charity, allowing them to place their companies under the ownership of a private foundation and permanently devote all profits to charity.

One way to adopt this model is to have the founder or the shareholders donate their shares to a foundation. They get a tax deduction for the value of their shares, but no buy-out. Since this is a gift, not a purchase, donating the shares satisfies the requirements of the new rule. The donations can happen anytime or even over time, but the new rule does not apply until 100% of the shares have been transferred to the foundation.

Under the new law, a total separation of the two entities is not required. The for-profit company will continue to be governed by its own board and managed by its own managers, with appropriate separation from the foundation. The new law permits the foundation, as the sole shareholder, to appoint the board, and the foundation may also hold other rights, depending on the jurisdiction where it was formed. For example, in many states, a sole shareholder has the right to inspect the books and records of the company and to sue the directors for breach of fiduciary duty (including the duty to pursue a social mission, if the company is a benefit corporation.) The shareholder may also reserve to itself the right to approve mergers, sales of assets, dissolutions, and to veto other fundamental decisions.

Profits of the business will be up-streamed to the foundation in the form of after-tax corporate dividends or, in the case of a pass-through LLC, as partnership distributions, in which case the tax on unrelated business income may apply.

We are sure to see a growing number of private foundations take ownership of profitable businesses as a result of this new law. It also offers another option for founders of mission-oriented companies who want a philanthropic exit that locks mission into the company on a permanent basis.

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Other than its unfortunate name — some will undoubtedly call it the “C3” in homage to the US tax designation for charities — the CCC is impressive. A CCC can accept equity investment, issue shares, and pay shareholder dividends, options that are not currently available to non-profits in Canada and the U.S. But a CCC can only pay out 40 per cent of its profits as dividends to shareholders. The balance has to be used to carry out the CCC’s “designated community purposes.”

CCCs are required to publish an annual “community contribution report” providing details of their social spending, community activities and dividend payments. On dissolution, the  CCC is only allowed to distribute 40 per cent of its assets to shareholders. The remaining 60 per cent has to be distributed to charitable organizations and/or other asset-locked entities.

Really the only thing missing from this hybrid is the ability to accept tax-deductible contributions directly. Companies that want to use philanthropic dollars in their enterprise – or alongside it – have to use a fiscal sponsor or a donor advised fund.

It will be interesting to see how many CCC’s are formed on the first day. In other places that have adopted hybrid business forms, there has been a rush to get a group of companies to file together. That has become a barometer for how successful the hybrid will eventually be.

Read the British Columbia Governement’s online announcement. Legislative Changes Encourage Investment in Social Capital

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The first denial (Denial 201235021) involved a “crowd-funding” platform: a contract hybrid that combined a 501(c)(3) nonprofit soliciting contributions online with a for-profit LLC that owned the technology and ran the charity’s operation for a fee of 20% of the gross revenue. The two had a close relationship and shared officers and directors. The LLC was owned by insiders of the charity, not by the charity itself, and the charity was effectively controlled by the founder who also controlled the LLC. The charity could not, or did not, provide information establishing that the fees it paid were at or below market. There was no cap on the fees, which meant that the LLC (and the CEO) could make a good deal of money if the platform did well. In addition, the contracts between the two were not negotiated at arms’ length. The IRS concluded that the arrangement lacked sufficient safeguards to ensure that the charity was operated for charitable purposes rather than the personal interests of the CEO,  the directors and the investors.

The second denial (Denial 201235023) also involved a crowd-funding platform with a similar structure wherein most of the same people controlled both entities, but in this case the IRS cited a lack of proper record keeping or financial controls and the reimbursement of the CEO’s  personal expenses as its reasons for the denial. In their decision the IRS noted that the charity merely collected and distributed contributions; it did not have any charitable or educational program of its own (merely raising money is not a charitable activity.)  As it was unable to conclude that the arrangement was designed primarily to further charitable and educational purposes rather than the personal interests of the CEO and the board, it denied the application.

On September 24, 2012,  the U.S. District Court in Washington, D.C. in  Family Trust of Massachusetts Inc. v. U.S. refused to order the IRS to grant 501(c)(3) tax exemption to a trust that supplemented the benefits that its three hundred participating  beneficiaries were receiving from Supplemental Security Income (“SSI”), Medicaid, and other governmental benefits programs. This type of trust is specifically authorized by the Medicare Act and administration of such a trust is typically considered a charitable activity. However, in this case, the trust was controlled by a single attorney, a specialist in elder law. The IRS argued that the attorney’s compensation was improper because it was tied to the size of the trust (the compensation went up as the size of the trust grew). The attorney countered that the compensation was reasonable based on his normal billing rate. The court sided with the IRS, noting that the attorney was not providing legal services to the trust at the time. The Court found that the attorney had effective control over the trust and personally benefited from it, had referred his own clients to the trust, and had operated the trust more as a commercial enterprise than a charity.  Surprisingly, the court also invoked the “commerciality doctrine”, a largely obsolete rule that says an enterprise is not charitable if it engages primarily in commercial activity. In any event, the presiding judge concluded that the trust was operated like a business, and that the attorney, as an insider, was receiving too much benefit. It refused to order the IRS to grant tax exemption to the trust, in spite of the fact that the activity of the trust was charitable.

Although these kinds of rulings aren’t binding precedent, they do confirm two things: first,  that the IRS is looking at these arrangements with a more critical eye than they have in the past, and second, that the burden is on the taxpayer to satisfy the IRS that individuals  do not benefit unduly from the arrangement between a charity and a for-profit or from the administration of a charitable trust.

The takeaway for practitioners is that any issues relating to personal benefit must be addressed up-front in the way the hybrid is structured. For a more detailed discussion, read my article published in the  Stanford Social Innovation Review  A New Type of Hybrid.

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