Spring 2018

Lawyers and entrepreneurs are not always the most obvious allies. Lawyers are often perceived as the people who say “No, you can’t do that,” or “That’s impossible.” Entrepreneurs, on the other hand, see themselves as the ones who say, “Yes, why not?” and “Anything is possible.” And they’re right.

By Professors Dana Brakman Reiser and Steven Dean
Illustration by Mike Austin

But it doesn’t have to be this way. The law can be an incredibly powerful tool and one that should be harnessed to help social enterprises thrive. In fact, when it comes to social entrepreneurship—for-profit ventures dedicated to generating both social good and financial returns—the law is particularly important.

Work in this area of the law began in earnest less than a decade ago when state legislatures created a variety of legal forms specifically designed to accommodate social enterprises. Now more than 30 U.S. jurisdictions offer at least one of these forms to entrepreneurs seeking to blend mission and profit. They go by various sound-alike names, like the benefit corporation, social purpose corporation, and Delaware public benefit corporation. They represent a laudable first step, by legitimizing dual-mission ventures as part of the larger business environment. They have not, however, resolved the fundamental obstacle social entrepreneurs face in raising capital. Our work on social enterprise law boldly plants a flag on the territory first tamed by this initial wave of specialized forms, demonstrating how much more the law has to offer social enterprise.

But first, we must begin by explaining what we mean by social enterprise.

Social Enterprise 101

A social enterprise represents neither unfettered greed nor pure altruism—it’s somewhere in the middle. But that explanation conveys little about the role such organizations play in today’s economy and less about what they might become in the future. Even Goldman Sachs—a paragon of financial success—touts its “commitment to finding effective and innovative ways to tackle economic, social, and environmental challenges.” Concluding that Goldman Sachs pursues a social mission alongside its profit imperative, or that it maintains a dual or blended mission, would render the concept of social enterprise meaningless.

There is transformational potential in for-profit ventures dedicated to generating both social good and financial returns. Such firms want to earn profits for their owners (who are their founders, at least initially) but also have a deeply rooted commitment to benefiting society or the environment. More important, unlike a merely ethical for-profit venture, they (at least sometimes) demonstrate a willingness to trade profit for gains in social good.

Patagonia is one of the best-known such ventures. An outdoor clothing and gear manufacturer, Patagonia proudly declares its mission to “[b]uild the best product, cause no unnecessary harm, use business to inspire and implement solutions to the environmental crisis.” Without any elaboration, that affirmation would be hard to distinguish from the Goldman Sachs statement above and countless other mission statements. In describing its insistence on balancing profit ambitions with its other aims, though, Patagonia goes further, including numerous efforts to “ensure that Patagonia products are produced under safe, fair, legal, and humane working conditions throughout the supply chain,” protecting workers and the environment on the way, and issuing public disclosures about its impact and activities.

TOMS Shoes and Warby Parker have popularized the one-for-one approach to blending profit making and social purpose. By pledging that “[e]very time a TOMS product is purchased, a person in need is helped” or that “for every pair of glasses sold, a pair is distributed to someone in need,” these for-profit companies distinguish themselves from competitors and attract customers.

Social enterprises really abound, however, at the smaller end of the spectrum of businesses—far from household names like these. Harvest Power, a for-profit sustainable waste processor and organic consumer products manufacturer, states its founding vision is to “create a more sustainable future by helping communities meet challenges at the intersection of waste, agriculture and energy in the 21st century.” Nisolo, an apparel and shoe manufacturing business, offers employees in Peru above-fair-trade wages; healthcare benefits; and skills, health, and financial literacy training as part of its goal to produce “ethically made” fashion items. A browse through any airline magazine, community newspaper, or business case competitor list will reveal additional examples of medium-sized, small, and micro businesses blending profit and purpose to varying degrees.

The Capital Access Challenge
Social enterprises all share the challenge of access to capital. Their promise will go unfulfilled if their founders cannot access the capital they need to survive and scale.

Access to capital suffers in the absence of trust, and faithlessness can run in either direction. An investor would be a fool to give her money to someone styling himself as an entrepreneur but offering no assurances he would devote himself to creating value for the firm and, in turn, the investor herself. An entrepreneur would be just as foolish to give up control to investors he believed intended to use that power to appropriate for themselves all the value he created in starting the company. Even in the traditional business realm, if entrepreneurs and investors cannot trust each other, capital will not flow.

The dual mission at the core of social enterprises makes this already vexing problem much harder. Socially oriented investors need to be convinced not only that they can earn returns, but also that they can trust an entrepreneur’s social commitments—and those of any fellow investors. The last thing such an investor wants to be is a sucker, enduring lower financial returns supposedly to generate social good and instead watching her funds being frittered away or padding the pockets of others. Social entrepreneurs not only worry that an investor might use control to pillage a venture’s finances, but also need assurances that investors will not literally sell out or simply stop trying to change the world once big profits become attainable. If dual mission business owners cannot resolve these high-degree-of-difficulty trust problems, capital will remain elusive.

The first generation of specialized legal forms for social enterprise were designed to free entrepreneurs from the concern that the law would conspire with market forces to strip them of their social mission. The forms do little, however, to ensure that social entrepreneurs seeking capital and investors keen to contribute to generating a combination of financial and social returns can find and trust each other.

Fortunately, the law remains a fertile field for the second generation of innovations required to respond to the challenge of capital access. These tools are not limited to specialized organizational forms, but include options as varied as hybrid financial instruments, targeted regulatory regimes, and discerning transactional design. Collectively, these legal devices demonstrate that the law can be a potent and nimble ally of social enterprise.

Social Enterprise Law Rebooted

Only the lawyer’s creativity limits the means by which law can nurture trust between social enterprise investors and entrepreneurs. For an organizational form to do this work, it will need to go further than benefit corporations and their kin, which merely declare that state law will not interfere when investors and entrepreneurs reach a consensus to balance mission and profit. The hands-off approach of these forms offers scant assurance that any such consensus will endure, so adopting them does little to promote investment in social enterprise. But a specialized form could be built to provide such assurances.

We propose one such framework: a mission-protected hybrid (MPH). This new legal form would integrate two principal layers of security for a social enterprise’s mission. The significance of the first—the fact that an MPH must prioritize its social mission—can be difficult to appreciate. That impact-first orientation establishes a vital presumption. Profit may still trump mission in a particular situation, but not without reflection and an affirmative choice. In a sense, that emphasis on mission inverts the traditional corporate focus on profit. The second level of protection follows charities’ lead in shielding mission through a set of interlocking enforcement mechanisms, including curbing payouts. Exiting the MPH form and converting into a traditional business would free a venture from the impact-first imperative but at the price of a portion of its assets, which would be transferred to an organization still committed to the MPH’s former cause.

Together, those features not only permit but also protect a pairing of social mission with profit. Without reliable commitments, investors and entrepreneurs will remain on the sidelines, understandably reluctant to find themselves left holding the proverbial bag should their counterparts trade mission for money. The MPH builds on the success of the first generation of specialized entities by providing the oversight they lack. Policing the prioritization of social mission, however, will be resource intensive. In the real world of significant resource constraints, identifying alternative paths to address the trust deficit is even more important than modifying specialized forms.

Fortunately, the pool of possible options extends far beyond organizational forms. The flexible low-yield (FLY paper) debt instrument we propose fashions a convertible note that addresses the trust problem faced by social entrepreneurs and potential investors. Its below-market yield identifies socially committed investors, who would make different investments were profit their foremost concern. These investors are in turn assured of the entrepreneur’s bona fides by conversion rights triggered if the entrepreneur sells out. In the event such a transaction occurs, the investors would have the right to convert their debt investment into the lion’s share of the venture’s equity. As a result, no such sale would occur without first securing the consent of the FLY paper holders. Unlike the first- and second-generation specialized forms, FLY paper makes no attempt to offer comprehensive protection for a venture’s mission. Instead, it eliminates the sellout as a stand-alone—but significant—threat.

Sophisticated financial instruments such as FLY paper could accomplish much that the first generation of specialized forms has not, but they are costly. They might never be within the reach of investors and entrepreneurs of modest means. New federal regulations targeted at crowdfunding seem tailor-made for small-scale social enterprises that want to raise equity capital, but those rules offer no mechanism investors can use to identify committed social enterprises.

A third strategy for preserving a balance between social mission and profit would fill that gap. We propose a tax regime, styled SE(c)(3), that pairs an elective tax benefit for mission-related expenditures with increased taxation of dividends and capital gains. This combined tax benefit and tax increase rewards fidelity to mission while putting a price tag on faithlessness. Opting into the SE(c)(3) regime would allow even a shoestring social enterprise to signal its resolve to prioritize mission. A higher tax burden on profit taking makes shareholder greed its own punishment.

Like traditional charities and for-profit ventures, social enterprises can fill almost every conceivable niche. Because of that diversity, crafting a single yardstick to test whether any given venture’s commitment to mission measures up presents a daunting task. Moreover, the stakes are high. A reliable metric could anchor every one of the proposals described here, from SE(c)(3) and FLY paper to the first- and second-generation specialized forms.

Exit: The Ultimate Test
These issues come into clear focus when the time comes for an exit. The fatal flaw in the first generation of specialized forms lies in the ease with which ventures can embrace those forms, only to cast aside the commitments they impose. The MPH borrows from the charitable playbook to prevent those easy exits. FLY paper enhances social mission’s durability with financial engineering (and without government intervention) by targeting greed.

But many, if not most, social enterprises will face transitions without these mechanisms in place. Again, the law offers a variety of tools to assist entrepreneurs and investors who are navigating the shoals of exit. Contexts as diverse as venture capital finance, small-business sales, and even the misunderstood tale of Ben & Jerry’s takeover by Unilever offer lessons in using the law to prevent a sale from becoming a sellout.

The social enterprise law innovations we identify focus on raising capital, and will not solve every problem faced by double-bottom-line ventures. Our efforts should, however, dispel the misconception that the best the law can do to help social enterprise is stay out of the way. Well-designed legal interventions can affirmatively promote trust among investors and entrepreneurs, bringing together like-minded individuals with the resources and drive needed to build successful social enterprises.

This article was adapted from Social Enterprise Law: Trust, Public Benefit and Capital Markets (Oxford University Press, 2017).

Dana Brakman Reiser is a professor of law at Brooklyn Law School and an expert on law and finance for social enterprises. Her scholarship has appeared in Boston College Law Review, Emory Law Journal, Indiana Law Journal, and Notre Dame Law Review, among other publications, and she has written extensively on nonprofit accountability and governance. She graduated from Harvard Law School and was a legal fellow in the Office of the General Counsel of Partners HealthCare System, Inc., and a law clerk to the Hon. Bruce Selya of the U.S. Court of Appeals for the First Circuit. She is a member of the American Law Institute and was an associate reporter for its Principles of the Law of Nonprofit Organizations.

Steven Dean is the vice dean and a professor of law at Brooklyn Law School. In addition to his social enterprise scholarship with Brakman Reiser, his work focuses on tax law. He is a coauthor of Federal Taxation of Corporations and Corporate Transactions (with Professor Brad Borden) and has also studied tax havens, tax complexity, and tax shelters. He graduated from Yale Law School and previously worked as an associate at two global law firms. He is a member of the executive committee of the New York State Bar Association’s Tax Section.