A quality food-based business has the ability to provide solutions to our nation’s numerous social and environmental issues. However, entrepreneurs of such ventures have a significant lack of access to the funds they need to get off the ground, let alone grow. Written primarily for people managing socially responsible food businesses, Raising Dough by Elizabeth Ü is a guidebook to resources, strategies, and lessons that will benefit any entrepreneur and their supporters, investors, and partners. Ü is a social finance expert, and her descriptions of case studies and personal experience will lead readers through the many stages of a new business, from choosing an ownership model to understanding funding sources like loans, grants, and even crowdfunding. This book is an irreplaceable guide to sustainable finance, and it lays out the tools and planning required to help your small, food-based business launch and thrive.
Choosing an Entity Type
Before you begin the process of raising capital from outside investors, you will need to make some decisions about how to legally structure your business. The entity type you choose affects your capacity to fundraise, and not always in the ways that you might expect. “Choosing an entity is about finding the possible in a sea of perceived constraints,” says Joy Anderson of Criterion Ventures, a business that offers what it calls Structure Lab training sessions to help social entrepreneurs consider the benefits and implications of various structures. “Legal structures are often a deafening thud in the moment when people are thinking about what is possible. ‘Really? We can’t do that?’ people say, thinking their venture can’t take grants if it’s structured as a for-profit entity, or that it can’t make a profit as a nonprofit. Often, these statements are radically erroneous.”
The entity type you choose can also impact your ability to keep your values embedded in the venture as it evolves over time. Marjorie Kelly is director of ownership strategy at the consulting firm Cutting Edge Capital, where she works with companies to design ownership and capital strategies that maximize social mission. She is also a fellow at Tellus Institute, where she directs a number of large research consulting projects in rural development and impact investing. “Choosing an entity structure is not primarily a legal exercise,” she emphasizes. “You end up with a legal structure, but it’s really about how you manage human relationships and identifying the purpose of the business. You start there. What are you trying to do?”
There are many for-profit entity options to choose from, each of which might offer benefits in some areas and disadvantages in others. As if choosing an entity structure weren’t confusing enough to begin with, a social entrepreneur can consider additional options above and beyond the usual for-profit models. This chapter covers the basic entity types in three categories: nonprofit, for-profit, and newer social enterprise structures that are available in a growing number of states. You’ll go through a series of questions to help you determine which entity might be the best fit for your venture, given your values and intentions. While the majority of this book is designed to help entrepreneurs who choose for-profit or social enterprise structures, it is entirely possible that a nonprofit might best serve your goals.
Nonprofit organizations can—and often do—engage in social enterprise activities that generate revenue with the purpose of furthering their charitable missions. Nonprofits can even generate “profits” from their operations, but this net income must be reinvested into the organization to further its mission. There are some major benefits to choosing a nonprofit entity structure, assuming your venture meets the legal qualifications to become one. Eligible nonprofits are exempt from federal and state income-tax requirements, and gifts to nonprofits are tax deductible to individual donors, giving them added incentive to support you. Foundations are far more likely to make grants to nonprofits rather than for-profit entities. The social “brand” of a nonprofit is also immediately clear to prospective supporters: your organization is committed to its mission.
However, you severely limit the number of financing tools at your disposal if you choose a nonprofit structure. Many of the financing tools covered in this book (including the entire equity section) work only with for-profit entities. Even if it is technically possible to make debt investments in nonprofits, many people are simply more comfortable making gifts to nonprofits and investing in for-profit businesses. Meanwhile, more and more for-profit businesses have deeply social missions at their core. As Marjorie points out, “You can operate a social mission company within any entity type, for-profit or nonprofit.” As the line between nonprofit activities and for-profit activities gets blurry, it can be confusing to understand which model might be the best fit.
Red Tomato is a nonprofit with a mission of connecting farmers and consumers through marketing, trade, and education and through a passionate belief that a family-farm, locally based, ecological, fair trade food system is “the way to a better tomato.” Many of the marketing activities that Red Tomato engages in on behalf of the farmer network it serves resemble work that a for-profit farmers’ cooperative might have done. “I have been a co-op groupie my whole life,” says Michael Rozyne, the organization’s founder and executive director, who seriously considered a for-profit cooperative model for Red Tomato. Having cofounded and worked for nine years growing Equal Exchange, a worker-owned cooperative that imports and markets Fair Trade coffee, chocolate, and snack foods, he has intimate knowledge of how to run a food business that way. “But I decided in the mid-1990s that Red Tomato would be better as nonprofit rather than as a farmers’ co-op. We work in the public interest, not only for the interests of our farmers, although worker democracy and influence is still a critical part of our culture,” he explains. In his experience many of the farmers’ cooperatives were conservative marketing entities, sometimes becoming dominated by the interests of one or two farmers with particularly strong voices. “We wanted to be able to focus on the best quality and the best programs, including educating the public, buyers, and growers, no matter what it takes.”
“Being a nonprofit has given us a lot of flexibility to be both entrepreneurial and mission driven, not purely member driven,” says Sue Futrell, Red Tomato’s director of marketing. Like Michael she had worked with a cooperative wholesale company in the natural and organic industry prior to joining Red Tomato in 2006. “A co-op is really powerful if it’s directed by a set of goals built around its members. In the case of Red Tomato, our goals have more to do with building a larger movement, and that would have been harder to get done in an ownership structure where the owners needed to see direct benefits. I love working for a small, entrepreneurial nonprofit.”
In deciding to choose a nonprofit structure, Michael had also considered how the numbers would pencil out. From the very beginning he expected that operating Red Tomato’s multiple programs—which include significant research and educational components in addition to developing a new approach to marketing, buying, and selling local produce—would require grants in addition to the revenues their work would generate. “We strive to cover the costs of actually buying, selling, and marketing produce through the fees we charge to do that, which are about 10 percent of the price that the grocery stores pay us for the products,” Sue explains, adding:
“But we don’t expect that part of our program to cover the cost of our research into new apple production methods that reduce pesticide use, or the work to leverage what we have learned to help build the larger sustainable food movement and bring it more into alignment with our vision. We’re one of the longest-running programs in the country that pools produce to sell into wholesale channels. There’s more and more conversation now about the need to build distribution and marketing and wholesaling capacity, and we get several calls a week from people who want to know how we’ve succeeded. We’re able to answer those calls, do workshops, and even take on consulting projects because it’s part of our mission to share that knowledge however we can. Because we have donors and supporters who value that part of what we do, it fits into a nonprofit funding model. There’s no way we could do all of this on produce industry margins.”
In the case of Red Tomato, it was a clear vision of, and deep commitment to, serving the general public that made a nonprofit entity the right fit for the enterprise. If you can answer yes to the following questions, a nonprofit structure might make the most sense for your social venture:
• Is the purpose of your organization primarily charitable? In other words, do nearly all of your activities fall under the IRS definition of exempt?
• Do you intend to raise the majority of your funding for your venture from foundations and tax-exempt gifts from individuals? If so, exempt nonprofit structures are all you should consider, as they are the only entities that can raise funds from foundations and through individual gifts that are tax-deductible to donors. (Gifts to for-profit entities are not tax-deductible)
• Do you expect that your business model may need to be subsidized by outside funds indefinitely? In other words, is it unlikely to ever become fully self-supported through the revenue it can generate, even in the best-case scenario? (Note the important difference between a well-executed nonprofit venture that meets all its revenue targets and still needs to raise grants to operate and an organization that is unprofitable because it fails to meet its goals. Be realistic about your intentions. Fear that your venture may not break even is not, on its own, a good reason to choose a nonprofit structure.)
Even if you can answer yes to all of the questions above, there are some contraindications to a nonprofit structure. If any of the following are true, you (with the help of an attorney) may decide it makes more sense to choose a for-profit structure:
• A private entity (such as a person or for-profit organization) benefits from the activities of the organization. The IRS has specific regulations that prevent nonprofit organizations from providing “inurement,” or private benefit, to the creators of the organization, their families, or any shareholders. This can be tricky to determine, and you’ll need to refer back to your values. If you’re in business solely to benefit a few farmers, for instance, as opposed to having a goal to improve conditions for farming in general, a cooperative or other for-profit structure may be a better fit.
• You expect to be able to pay yourself and/or other managers a lot of money if your venture is successful. There is no shame in wanting to be able to reap financial rewards for all the hard work you have put into launching and growing a successful enterprise. And since you cannot give yourself equity shares, it might seem that paying yourself really well once the venture is thriving would be a good option. But you do need to be aware of the possibility that the IRS has the power to deem nonprofit executive compensation “excessive” (and therefore a form of inurement), in which case you and your board may be fined, and you run the risk of losing your nonprofit status. That said, the line can be a bit confusing, as nonprofits are allowed to pay their executives “market-rate” salaries, and the “market” in question can include comparable for-profit salaries.
• You want to be able to sell equity to raise money for your venture or give yourself shares so that you can benefit from the upside of your venture. This isn’t an option if you choose to organize as a nonprofit. Because the state technically owns nonprofits, you cannot sell equity shares to raise capital for them. (Note: you may encounter the terms “nonprofit equity” and “philanthropic equity,” but these refer to the money that nonprofits need to build internal capacity infrastructure, as distinct from the money that they need to operate their programs. It does not actually refer to transferable equity shares in nonprofit entities.)
A word of caution: do not expect that just by organizing it as a nonprofit entity, charitable gifts will flow to your organization. You will still need to fundraise to bring those funds in, and you may find it more difficult to raise gift money than investments from people or institutions that are willing to put money into your venture in exchange for the possibility of financial returns.
Even if you have convinced yourself that a nonprofit structure is the best fit for your goals, you will still need to convince the IRS that you are eligible for one of the nonprofit entity options. The following entities differ based on qualification requirements, level of complication to set up, and sources of funds.
A public charity is a tax-exempt 501(c)(3) nonprofit corporation. This is the structure that most people think of when they envision a nonprofit organization. To set one up you must first establish your organization as a nonprofit corporation with your state, a process that involves filling out a form and paying a filing fee. The next step, applying to the IRS for exempt status, is much more involved. As defined by the IRS, public charities must receive at least one-third of their funding from the general public (i.e., through gifts from individuals) or from government sources rather than grants from foundations or investment income. And you must regularly prove that this is the case to maintain exempt status as a public charity.
If you cannot prove to the IRS that you are eligible for exempt status, by default your organization will be considered a private foundation, another kind of 501(c)(3). This entity type is usually controlled by a smaller number of people, which might be the family that provides much of the financial support to the organization or that donated the endowment that provides investment income to support the foundation’s activities. Private foundations must follow stricter regulations than a public charity, which include increased reporting requirements and lower dollar limits on gifts from individuals and corporations. They enjoy fewer tax benefits than public charities as well, and it can be harder to raise money from other foundations or individuals into a private foundation.
The most common entity structure for a nonprofit social enterprise that cannot be considered a public charity is the private operating foundation, a form of private foundation that devotes the majority of its resources to the delivery of its charitable, exempt activities rather than to making grants. The steps for starting a private foundation are essentially the same as starting a public charity, with the exception of applying for exempt status if you are certain that your organization will not qualify.
An eligible organization can reap the benefits of nonprofit public charity status without organizing a new entity, filing for 501(c)(3) status on its behalf, or filing appropriate reports to the IRS annually—all expensive and time-consuming—by choosing fiscal sponsorship. In this model (sometimes referred to as using a “fiscal agent”), an existing 501(c)(3) organization sponsors your project; all funds are raised and distributed through the sponsoring organization. Many start-up nonprofit organizations choose this model. Some 501(c)(3) organizations exist solely to provide fiscal sponsorship to other projects; others may offer fiscal sponsorship only in rare cases involving very close mission alignment. Many fiscal sponsors offer a range of services, including money management and tax reporting, financial reporting, bill paying, payroll and benefits administration, technical support such as workshops or one-on-one consulting, and the publication of annual reports. Fundraising is almost always the responsibility of the sponsored project, not the sponsor.
If you decide to look for a fiscal sponsor, you’ll have to find an organization that is a good match for your mission and your activity. Many organizations require a minimum budget, if not also a minimum amount raised toward the project, in order to consider fiscal sponsorship. The costs of fiscal sponsorship vary depending on the services rendered by the sponsoring organization and are usually charged as a percentage of the funds distributed to the sponsored project. Fees between 5 and 10 percent are typical, depending on the services offered, and you may be able to find lower rates if you have a close relationship with the sponsoring organization.
Finally, you may want to consider one of several nonprofit–for-profit hybrid models, such as launching a for-profit entity that is fully owned by a nonprofit or creating contractual agreements between a for-profit and a nonprofit. Though they can be quite complicated both legally and operationally, they can also offer flexibility not found in a pure nonprofit entity. Consult your attorney and accountant to identify all of the implications of choosing a hybrid model.
There are many reasons a for-profit structure might make the most sense for your venture. You might prefer to have a wider variety of financing options at your disposal. You may want to reap the financial benefits of growing the business, or you may want to share those benefits with a wide range of stakeholders, including investors. Your reasons may be more philosophical; perhaps you want to be part of the movement that is showing the world that businesses can do well and do good. Or your venture may simply not qualify for charitable status based on the nature of its primary activities.
Whatever the reasons, it’s likely that most readers of this book will end up choosing (or have already chosen) a for-profit entity for their enterprise. This section gives an overview of each of the for-profit entity types, including cautions and fundraising considerations for each. Note that there are many additional steps involved in starting a for-profit business that are not covered here, such as registering a business name, getting a tax identification number, and securing all appropriate licenses and permits. Since each state and local government has different rules and requirements for the above, it is important to confirm the local formation process (and associated fees) for the entity type that seems to be the best fit for your business.
Sole proprietorships are the simplest for-profit business form for a single owner: you and the business are the same legal entity. There are few if any forms, licenses, payments, or taxes required to set up and operate a sole proprietorship (this varies from state to state). Sole proprietors pay taxes on all business income on their personal tax forms rather than separately for the business. This simplicity, however, comes at the expense of considerable risk: a sole proprietor is also personally liable for all business debts with this type of structure. This means that if you cannot pay any bills associated with the business or if someone sues you based on something that happens during the course of operations (let’s say your helper accidentally drops a case of your cookies at the farmers’ market, injuring a customer’s foot), your personal assets are at risk, including your home. A sole proprietor also cannot sell equity shares (stock) as a way to attract investors, though it is possible to raise money through debt from individuals or lending institutions.
Partnerships, also known as general partnerships, are for-profit structures that are similar to sole proprietorships in terms of taxation and registration, except that more than one person actively manages the business. As with sole proprietorships, the catch with this structure (and the reason they are not very popular) is that all partners are personally liable for business debts and in the event of lawsuits, even if the liabilities are due to actions of the other partner. Although states recognize a partnership as soon as two or more people begin doing business together, the people involved in the partnership should draft a formal partnership agreement dictating exactly how to handle governance, return on investments (particularly important if the partners do not bring equal contributions of cash or other assets to the partnership), dissolution (what happens if one or more partners want to leave), and other factors, such as milestones at which the partners will adopt a different entity structure. All partners are responsible for reporting their share of the partnership’s profits or losses on their personal tax returns. While partners technically can sell their interest in the partnership, this is not a very practical way to raise capital from sources outside the partners themselves, and debt is the most common fundraising option.
Limited partnerships are similar to but more complicated to set up than general partnerships. The trade-off is that it is much easier to raise capital from outside investors with this structure, as it allows for certain partners (known as limited partners) to have limited personal liability and/or management responsibility. In other words, limited partners can be passive investors, and their financial liability in the partnership is limited to the amount that they have invested in the business. In limited partnerships, there are still one or more general partners who run the business and who are personally liable for business debts and liabilities. States are more likely to require formal filings and partnership agreements for limited partnerships than for general partnerships, and again, it’s in all partners’ best interests to have a partnership agreement that clearly spells out how all parties will be treated under different scenarios, whether related to governance, return on investment, dissolution, or other factors.
Corporations are independent, for-profit legal entities that are entirely separate from their shareholders or managers. They are much more complicated to set up and maintain than the entity structures described above: you must appoint formal directors, file articles of incorporation, draft bylaws, and document all important corporate decisions made at formal meetings of the directors and shareholders. You must file a separate tax return for the corporation, in addition to filing annual reports with the state.
Corporations are relatively expensive to form and to maintain compared to the previously described structures, with most states requiring annual fees. At the formation of a corporation, the manager formally issues stock to all owners. The main fundraising benefit of choosing this entity type is that people who own stock can sell their shares of the corporation to other people. A corporation’s shareholders and managers all have limited personal liability, so long as the directors adhere to the state’s laws regarding corporate formalities.
There are two main types of corporations: C corporations pay taxes on profits, and shareholders pay taxes on any dividends they receive from the corporation on their personal tax returns. S corporations do not pay taxes on profits, but shareholders pay taxes on their share of profits whether or not they are distributed as dividends. Another important distinction when it comes to raising capital is that C corporations may issue a number of different classes of stock (such as common stock and preferred stock), to an unlimited number of shareholders, anywhere. S corporations can issue only one class of stock and can have no more than one hundred shareholders, all of whom must be U.S. citizens or residents.
Cooperatives (co-ops) are for-profit corporations that are owned and operated by the people who mutually benefit from the operations of the business. Common examples in the food world include worker- or consumer-owned retail food co-ops and farmer- or rancher-owned marketing co-ops. Co-op members themselves generally invest the start-up funds required to launch the business, though they can sell preferred stock to raise money from outside investors. Farmer cooperatives that meet certain requirements can apply to the IRS for special tax status found under section 521 of the Internal Revenue Code. This gives eligible co-ops special treatment under both federal and state securities laws, allowing them to raise money from outside investors without the burden of federal or state registration requirements. Your state may also offer securities exemptions for certain types of agricultural co-ops. In short, it can be much easier for eligible cooperatives to raise capital from the public than it is for other kinds of businesses, though you’ll definitely need to consult an attorney who is well versed in such cases to be sure what is possible in your situation.
A limited liability company, or LLC, is similar to a corporation in that it is its own entity, separate from its owners, and offers owners limited liability. Like a sole proprietorship or partnership, however, the owners report their portion of the LLC’s profits or losses on their personal tax returns, provided they opt to pay taxes that way (you do have options and can choose to have your LLC taxed like a corporation). LLCs do not have to abide by the same administrative formalities (such as holding and filing minutes of regular director and shareholder meetings) as corporations do. It is much easier to make changes to an LLC’s operating agreement than it is to make changes to a corporation’s bylaws—and for socially responsible businesses, you can include social purposes in that operating agreement, which is one way to build your mission into your entity structure without using one of the new entity structures described below. “If you put a social mission into a regular LLC, you may become subject to L3C rules [see below] unintentionally,” warns attorney Susan Mac Cormac. Depending on your state, LLCs may pay higher tax rates and fees than corporations with similar revenues. Some more traditional investors shy away from investing in LLCs for a number of reasons, including the fact that LLC operating agreements can vary widely (as opposed to the standard format of corporation articles and bylaws), making them harder to assess; that the LLC is a newer (and therefore less familiar) entity type; and that taxes from LLC investments are not always calculated in their favor.
New Entity Options for Social Enterprises
In addition to the traditional entity options described in the previous section, social entrepreneurs have three additional options to choose from. Each of the following entity types allows directors some protection from the usual expectation that they need to manage their businesses to maximize profits, even if financial gain comes at the expense of other social or environmental factors. When it comes to raising capital, choosing one of these entity structures may be good branding, with a “halo effect” potentially giving impact-oriented investors—not to mention customers—more confidence about your commitment to social mission. Ask your network of advisers, peer entrepreneurs, and investors about their experiences with these options to get a sense of how they perceive them, recognizing that this is a rapidly evolving field. These entity structures are available only in certain states, though there are efforts in more states to introduce additional entity structure options for social businesses, and you can incorporate your business in one of the states where the newer entity structures are already available.
The low-profit limited liability company, or L3C, is a special type of LLC that attempts to bridge the gap between for-profit and nonprofit entities. It was developed to make it easier for for-profit social enterprises (that is, companies with the potential to generate high social returns) to qualify for program-related investment (PRI) from charitable foundations (see chapter 19 for more information about PRI). That said, there is little evidence that this entity type has actually encouraged additional PRI activity. “The IRS did propose regulations in April 2012 that added new examples of PRI,” says Ken Merritt, an attorney in Vermont who works with venture capital and growth-stage companies, but these regulations had not yet been adopted as of this writing. This may be because the IRS requires a private ruling letter to ensure eligibility of PRI investments or because LLC structures in general are so flexible that a foundation has no reasonable guarantee that the L3C’s activities will remain as charitable as they were at the time the investment was approved. As of this writing, the IRS has yet to formally issue any guidance to foundations related to L3Cs. “The only thing you have to do is state in the articles of incorporation that you want to be an L3C,” explains Ken, who has worked with several pioneering social enterprises. “An L3C can say they’re low-profit,” he says, “but there are no transparency requirements and no standards for measuring that.”
Benefit corporations have resolved the lack of transparency and accountability issues inherent in the L3C structure. States that allow benefit corporations hold them to most of the same administrative and taxation standards as other corporations. The notable differences are as follows:
• Benefit corporations must create a material positive impact on society and the environment, and they must note this in their articles of incorporation.
• Benefit corporations allow directors to take into account the nonfinancial interests of stakeholders beyond shareholders (including the workforce of both the business itself and its suppliers; community and societal factors where the business and its suppliers are located; the customers of the business; and the local and global environment), and the corporation’s bylaws must reflect these interests.
• Benefit corporations must provide annual reporting on social and environmental performance as measured by recognized, third-party standards.
While the annual reporting requirement increases the amount of work for managers of benefit corporations, it may provide the added reassurance that an impact investor will need in order to feel confident investing in such a venture. Note that the benefit corporation legislation is not exactly the same in all states, so you will need to check the specific statutes in the state where you intend to incorporate. As of this writing, twelve states have passed legislation recognizing benefit corporation status, with additional states expected to follow suit.
The flexible purpose corporation, or FPC, is another type of corporation that allows its directors to consider a wider range of stakeholders in their decision making, which makes it an interesting option for social entrepreneurs who fear that shareholders may file claims that a business was not managed in a way to maximize their financial returns. As the name implies, FPCs are more flexible than benefit corporations in that board members and shareholders can choose which “special purposes” the company will pursue; these can, but do not need to, include as many stakeholders as the benefit corporation, and they can certainly include fewer. The reporting requirements for your chosen purposes are robust. Because the “flexible purpose” of this type of corporation, which must be specified in its articles of incorporation, need not include any social benefits, it is unclear whether FPC status will confer the same socially responsible brand benefits or halo effect as benefit corporation status. That said, some believe that it may be more attractive to mainstream investors, because the structure appears more similar to the corporations they are used to. FPCs may be the better choice for companies that want to focus on a very specific social benefit rather than the entire gamut of sustainability. “You could have a company primarily devoted to twenty or more factors, or you could have a company devoted to just one specific social or environmental goal,” explains Susan, who helped usher in the flexible purpose corporation legislation in California. “It can be just as socially responsible, or even more socially responsible, than a benefit corporation, depending on which goals shareholders agree to focus on,” she says. As of this writing, California is the only state that offers the flexible purpose corporation option, though Washington State passed legislation for a social purpose corporation, which is a similar structure.
Guiding Questions for Choosing an Entity Type
Now that you have a sense of what is possible, which is the best entity type for your venture? As you read through the following questions, see what resonates most closely with your intentions and values.
• How many owners does (or will) the business have? If you are the only owner of your business, you can choose to operate as a sole proprietorship or incorporate as a corporation or LLC. If there is more than one owner—and even if you are the only owner now, there will be others if you intend to raise capital by selling equity shares—your options include a partnership, a corporation, or an LLC. If you anticipate raising money from a significant number of equity investors, a corporation is a good fit.
• Is the cost of setup and maintenance of your business entity an issue? Corporations and LLCs are more costly to set up than sole proprietorships and partnerships because of state filing fees, and most states require payment of annual franchise taxes as well.
• Are you willing to commit to complicated formalities required by certain structures, at start-up and beyond? Sole proprietors and partnerships are relatively easy to set up and maintain, requiring very little ongoing documentation. Corporations, on the other hand, are much more complicated to set up and maintain. LLCs are more complicated than sole proprietorships or partnerships to set up and maintain but have much simpler reporting requirements than corporations.
• How much flexibility do you want in your business structure? Corporations are also more complicated to update if the business evolves significantly over time and you need to make adjustments to the incorporation documentation. LLCs are more flexible to update than corporations, requiring only a change to the operating agreement. Sole proprietors have the most flexibility.
• If there are risks inherent in your business, will you or your partners need to protect personal assets? In the event of major losses related to a business, neither sole proprietorships nor partnerships protect the owners’ assets, potentially putting owners’ personal property at risk. Owners of LLCs and corporations that are properly maintained are not personally liable for business debts that they have not personally guaranteed.
• How do you want taxes to be handled for yourself, your business, and your investors? If you want to be able to pass through taxable income—or write off eligible losses—to the owners, consider a sole proprietorship, general partnership, S corporation, or LLC. C corporations are subject to double taxation in that they owe taxes on profits and owners must pay income taxes on dividends they receive.
• How much flexibility and/or control do you want to maintain over your business? You’ll have the most control if you operate as a sole proprietorship. The management structure of LLCs offers far more flexibility within its operating agreement than is possible with corporations, which are required to have a board of directors, who appoint officers and make major decisions. Corporation directors can decide to fire the founders, so keep that in mind if maintaining control is important to you. If you want to maximize your ability to consider factors beyond maximizing profits, consider one of the new social enterprise models.
• From whom do you intend to raise capital for the business? While lending institutions and individual investors may not care if your business is a sole proprietorship or partnership, angel investors, venture capital funds, and other institutional investors may only invest in corporations or LLCs. If you intend to raise the majority of your funds from foundations, then a nonprofit corporation makes the most sense. Be careful about choosing an entity type based solely upon what one interested funder wants. “This is the worst possible way to decide what type of entity to build,” warns Joy Anderson of Criterion Ventures. “You’ll do all this work to set it up and find that you will have the wrong type of structure for the next potential investor, and there’s still no guarantee that the first funder will actually invest!”
• Are you willing to choose a relatively new structure that may be unfamiliar to potential investors? You might be most interested in the new entity options designed specifically for social ventures. While these structures could potentially make your business a more appealing investment opportunity to certain types of investors, you may find yourself spending time and energy educating prospective investors about the new entity type you have chosen.
• What is actually possible in your state? Not all states treat all entities in the same way. Some states limit the types of businesses that can form as LLCs, for instance. Others tax LLCs as corporations. The newer entity types are not yet available in all states, although you can incorporate your business in another state that does offer the options you are looking for.
Regardless of the for-profit entity structure you pick, and whichever stakeholders you choose to consider in your business operations, financial profitability is crucial to all for-profit enterprises—social enterprises included. “You still need to make intelligent business decisions,” warns Ken Merritt, adding, “you still have to be profitable! Financial profitability gives you so much more in terms of resources to change the world, in terms of your employees, your community—profitability is a good thing.” Jay Coen Gilbert is cofounder of B Lab, and he agrees. “No margin, no mission,” is his mantra, referring to the margin a company earns on the difference between its expenses and revenues. “If you’re not running a profitable business, you’ll never get the opportunity to scale your impact, whether your strategy to scale is growing in your own good organic time or accelerating your growth through outside capital,” he says. “If you want to attract outside capital, you need to have a sound business model and operations that are exceptional, with an incredibly talented and deep management team that is able to execute and make the trains run on time.”
The IRS Defines Exempt Activities
The exempt purposes set forth in section 501(c)(3) are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. The term “charitable” is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.
Distinguishing Between Benefit Corporations and Certified B Corporations
People often use the terms interchangeably, but there’s a major distinction between a benefit corporation and a Certified B Corporation, or B Corps: in short, the differences are availability, verified performance, and access to services and support. A benefit corporation is a legal entity option available only to businesses incorporated in certain states. B Corp is a third-party certification conferred by the nonprofit organization B Lab, and it’s available to businesses in all fifty states and around the world. B Lab did help develop model benefit corporation legislation, and it works with the community of Certified B Corporations and others to marshal support for passage of such legislation in states where it does not already exist.
Both benefit corporation and Certified B Corp status may have benefits in terms of how customers and prospective investors view your company, but even here it’s worth noting the distinctions. Directors of both benefit corporations and Certified B Corps are required to consider the effect of decisions not only on shareholders but also on other stakeholders, such as workers, community, and the environment. Both are required to publicly publish a report assessing their overall social and environmental performance against a third-party standard. Benefit corporations can choose from a list of standards, and the reports need not be verified, certified, or audited by a third party; the B Impact Assessment survey is the standard for all B Corps, and the results of this survey are certified by B Lab. As of this writing, twelve states have passed legislation recognizing benefit corporation status, with additional states expected to follow suit.5
Benefit corporations need not be certified as B Corps. Furthermore, any for-profit entity type can apply for B Corp certification, a distinction that is reserved for businesses that both meet the certification eligibility requirements and pay the annual certification fee. Certification confers access to a portfolio of services and support from B Lab to help them with marketing, attracting talent, raising money, saving money, and learning from and doing business within the community of Certified B Corps.
For more from Raising Dough, see:
Reprinted with permission from Raising Dough by Elizabeth Ü, published by Chelsea Green Publishing, 2013. Elizabeth is also the host of the weekly podcast Xero Gravity for entrepreneurs and small businesses.