Considerations on Legal Structures for Impact Enterprises

Disclaimer: My aim is provide you with a broad understanding of legal structures for impact enterprises, please consult with legal and tax experts before making a decision.

As an impact investor, I received a lot of questions about the right legal entity for impact enterprises. Should the enterprise be incorporated as a limited liability corporation? An LLC (CV — in Indonesian legal parlance)? A foundation? My friends who are in the policy-making circles also have similar questions: should the government create a new type of legal entity for social enterprises? If yes, how should it look like? These are not straightforward questions and each enterprise should consider the available alternatives before making a decision: what are the objectives for having a certain legal structures? What are the options available in the country? And what would the stakeholders think?

The Objectives

There is no single legal structure for all impact enterprises. It depends on what the founders want to achieve with the structure. Typical objectives that I have heard are:

1) Strengthening commitment to social impact cause

Some founders want to establish practices like having a dual mission or dual (or even triple) bottom line reporting mandate, limitation distribution of dividends¹, limitation of ownership to parties meeting designated criteria, certain CSR (corporate social responsibility) commitments, or similar measures that ensure orientation of impact is achieved. This is a valid concern as mission drift is a real risk that needs to be anticipated and dealt with early.

2) Participation of the communities

In this case, either the founders want to involve the communities as co-owners of the business, or the communities themselves are the one establishing an impact enterprise.

3) Signalling to market

A social enterprise label attached to certain types of legal entities are increasingly appealing to the millennial customers of the business, and also to impact investors.

4) Attracting a diverse set of funders

Equity, debt, and grants exist to support impact enterprises. In general, for-profit business can obtain equity and debt, while non-profit ones rely on grants. How to allow a business to legally access different kind of capital?

5) Work around regulatory restrictions

Examples: restrictions on land ownership by private companies, restrictions on one company running multiple business lines

6) Potential tax benefits

There’s a notion that impact enterprises should be taxed at a rate lower than regular businesses. Most government officials recognize the societal benefits of impact enterprises, but making regulations on tax breaks that are not prone to abuse is very challenging for any government.

The Options

After considering the objectives of the entrepreneurs, the next step is to evaluate the available options within the legal system where the enterprise is operating. In general, there are three types of legal structure configurations to choose from:

1) Legal structures specific for social or impact enterprises

Some countries have implemented laws for socially responsible enterprises to register as a distinct entity. In the UK, Companies (Audit, Investigations and Community Enterprise) Act 2004, defined CIC (Community Interests Company) as social enterprises who want to use their profits and assets for the public good. A CIC’s profits are fully taxable unless it can be shown that the terms of the contract are such that, in tax law, the organization does not amount to a taxable trade.

In the United States, A benefit corporation (not to be confused with B Corp, which is a private sector’s initiative) is a traditional corporation with modified obligations committing it to higher standards of purpose, accountability and transparency. There is no tax benefits for a benefit corporation.

2) Existing legal structures

If the legal structures similar to the above are not available in your country, you can simulate it using existing legal structures. There are two bases that you can use: limited companies (or PT in Indonesia) and cooperatives. I would exclude foundation as they are in most cases not the right basis for impact enterprise, and I also ruled out partnerships or LLC because it does not fulfill most of the objectives in the previous section, while at the same time is difficult for equity investors to invest in.

Limited companies is, of course, the most common form of companies. Almost all large companies have this structure, as it is flexible enough to incorporate the requirements of the founders and investors. However, in most cases grant money can’t go to a limited company. It is also cumbersome, albeit technically possible, to accommodate a large number of shareholders.

Rangsutra, a 13 year-old impact enterprise based in India, managed to do just that. Its founder, Sumita Ghose set up Rangsutra Crafts India, with a paid up capital of Rs 50 lakh (around USD 70k), with 1000 artisans put in Rs 1,000 (~USD 15) each for a quarter of the shares in the company. Three of the six board members are artisans. This structure still exists today, and there are some public documents available in the company’s website that give some ideas how to governance process works with such a large number of shareholders.

Cooperatives are less flexible than limited companies in many aspects, but still many large companies like Royal FrieslandCampina and Rabobank are cooperatives, so it should be a viable base entity for impact enterprises.

Limited companies and cooperatives can also use private sector certifications like B Corp to signal intent to commit to impact mission, or embed the mission in their articles of association.

3) Tandem (or combination) legal structures

If existing single legal entity options are also not suitable, then multiple legal entities can be formed. The most common case is when a Company is set up as limited company, and a foundation is also set up in parallel to receive grant money. Another combination that less common is limited company and cooperative, to allow for collective ownership and flexibility of a limited company.

In some countries, foundations are allowed to own shares in for-profit companies or vice-versa, and there are rules allowing cross-ownership between limited companies and cooperatives too. In any case whether cross-ownership is there or not, there should be a very clear agreement between these entities to prevent any change of management control that can be detrimental to the company and its impact missions.

Point of View of Investors

In general, legal structure does not matter much to lenders, as their main considerations are the debt-servicing ability of the company and their collateral.

With equity investors, it’s a bit more complicated. They are not picky about the legal structures per se, but as long-term partners of the Company, they would like to ensure the following aspects are well-covered:

1) No conflict of interests of the entrepreneurs and management

Having more than one legal entities might skew the interests and attention of the entrepreneurs on one entity over the other. It could be exacerbated if, for any reasons, the investors can get to invest in one entity only. If this arrangement is not avoidable, then the risks can be mitigated by inserting specific clauses in the Shareholders Agreement to ensure alignment of interests of all parties.

2) Senior team with clear accountability

This is especially a potential issue with community-owned legal entity, such as a cooperative, who has democratic voting rules. Each country has a different law on cooperatives that might or might not allow modifications to the decision-making rules. For example, in some states in the US, cooperatives can issue memberships to a separate class of “investor members”, who can be allowed limited additional voting protections related to transformative events, such as mergers, acquisitions, or the dissolution of the cooperative.

3) Flexibility in running the business

The missions need to be not too restrictive to allow for different business strategies, but specific enough to keep the sense of purpose alive.

4) Minority shareholders protection

Many equity investors invest in minority stakes and would ask for affirmative rights on certain voting matters, liquidation preference, drag along and tag along rights, and other common private equity terms. If the enterprise wish to attract such kind of investors, the legal structure should allow for this.

5) Clear governance process

Clarity of roles and responsibilities of senior team and the board of directors is mandatory, even though having multiple legal entities means you have multiple CXOs and multiple boards, there should only be one organization structure for management and one board of directors.

6) Limited burden of legal costs and additional reporting requirements

This could be a problem when the Company is small, so maybe best to start with a simple structure and evolve once it grows.

7) Value capture can follow value creation — for both investors and entrepreneurs

Investors should be able to get their exits the way they want it. In some structure like cooperatives, IPO is not possible. If the Company plans to raise money again in the future, the objectives of the future investors (still hypothetical at this point) also need to be considered.

Closing Remarks

Having the right legal structure from the beginning is important, but not as important as entrepreneurs often think. I have seen a bright young entrepreneur who, out of idealism, set up his Company as a cooperative² and could not scale up due to lack of external capital. It is perfectly fine to have strong principles, but keep the structure simple in the beginning. Don’t lock in too early, with the options to change it later as business and organizational values evolve.

[1] For example, Yunus’ social business principles: no loss, no dividends

[2] A real cooperative, with low-income women as members. This is unlike faux cooperatives commonly used by Fintech companies who could not get regulatory license to operate as financing companies