Preserving and Enhancing Impact: Corporate Forms

PRESERVING AND ENHANCING IMPACT: CORPORATE FORMS

Susan Mac Cormac Morrison & Foerster

October 2016

Disclaimer

These materials were created in October 2016 for the use of the impact.tech community. The laws detailed within are subject to

change and these materials may not be up to date long after October 2016.

For an updated document, please email Jennifer Caballero at

[email protected]

Additional impact resources can also be found at: mofo.com/impact

Morrison & Foerster LLP 1

Presentation Overview

1. Traditional Corporate Forms

2. Traditional Debt and Equity Instruments

3. Hybrid Corporate Structures

4. New Corporate Forms


PRESERVING MISSION: TRADITIONAL CORPORATE FORMS

This section will address the options, strategies and limitations of anchoring mission in socially-driven businesses within the existing framework of

traditional for-profit corporate forms. Such forms include the Delaware “C” corporation, limited liability companies and partnerships, and cooperatives and

employee stock ownership plans (“ESOPs”).


Delaware “C” Corporation

• As the preferred business entity for entrepreneurs and investors, the Delaware “C” corporation offers several mechanisms to anchor mission, including:

• Business Judgment Rule

• The business judgment rule operates as a broad presumption that the decisions of directors, absent a breach of fiduciary duty, are in the best interests of the corporation

• Fiduciary duties do not mandate that all management decisions be made for the purpose of maximizing immediate shareholder wealth

• The business judgment rule provides significant freedom to pursue mission-aligned corporate activities that are made in the best interests of the shareholders and corporation, i.e. mission-driven decisions that simultaneously improve the corporate brand and long-term profitability



• Shareholder/Voting Agreements • The ability of mission-aligned investors to encourage positive impact

and control mission drift can be augmented by voting or shareholders agreements. Such agreements can include:

• Agreement between management and owners regarding the purpose of the corporation

• Provision that requires shareholder vote for change of mission or super-voting rights for one class of stock

• Information rights • Requirement of measurement and reporting on impact • Requirement of maintenance of “B Corp” status • Establishment of committee to review impact • Provision that requires shareholders to vote for conversion to new

corporate form under certain conditions (new forms discussed in Section 4)



• Charter Provisions • Certain corporations have taken the step of embedding the promotion

of mission in their charter • There is less legal risk in states with constituency statutes

• As with constituency statutes, where embedded mission-protective provisions and fiduciary duties conflict, fiduciary duties likely to prevail



• Further Charter Provisions • Separate class of stock for impact investors • Protective provisions

• Class vote for change to business plan which include purpose • Class vote budget that has material expenditures that do not advance

mission • Class vote for sale

• Distributions to impact investors • Redemption if material deviation from mission

• Include guarantor provision for redemption • Change of conversion ratio if material deviation from mission • Board representation • Information rights for impact



• IP Licensing • Valuable IP may be held by a mission-aligned founder or affiliated non-

profit entity and licensed to the corporation • The licensing agreement may then contain provisions whereby if the

licensee violates certain agreement terms or acts inconsistently with the prescribed mission of the corporation, the licensor can either increase royalty rates or terminate the license

• But consider impact on M&A (i.e. the “spurn-out”)



• The aforementioned strategies to preserve mission assume operation of a corporation in the ordinary course of business

• The effectiveness of these mechanisms may be compromised once the sale of a corporation appears imminent and inevitable

• In such instance, management may be required to maximize shareholder value by selling to the highest bidder or face litigation for breaching their fiduciary duties pursuant to Revlon


Limited Liability Companies and Partnerships

• Limited liability companies (“LLCs”) and partnerships also present distinct advantages for mission preservation due to their contractual flexibility

• However, state variations in LLC and partnership statutes may limit their suitability for anchoring mission (i.e. California LLCs are not an appropriate vehicle as discussed below). Delaware mission-protective options include:

• Expressly elevating preservation of mission over return to equity holders by contractual agreement and eliminating traditional fiduciary duties

• Waterfall distributions structured to return money to related non-profits or mission-aligned investors first

• Stacking the boards of directors, membership, or partnership with mission-aligned individuals

• LLC membership class voting and protective provisions related to mission

• Change of control, “tag-along” and “drag-along” provisions related to mission, specifically requiring approval from mission aligned investors


• However, LLCs and partnerships also implicate certain general disadvantages as compared to corporations that may make it harder for a social enterprise to raise outside funding and scale impact.

• These drawbacks include: • Pass through tax treatment

• Inability to offer highly-liquid equity grants as compensation

• Higher risk profile as a result of contractual flexibility

• Not all states allow for similar flexibility to contract around fiduciary duties – recent changes to the California LLC statute in 2014 imposed traditional fiduciary duties on California LLCs


Limited Liability Companies and Partnerships

Cooperatives and ESOPs

• Cooperatives and ESOPs present unique ability to preserve mission based on their democratic corporate governance structures

• For example, “one member, one vote” provisions with regards to key corporate governance issues and appointment of leadership ensures mission alignment with the entity’s membership or employees

• However, the de-coupling of the amount of capital invested and influence over decision-making will be unattractive to large outside investors, making scaling of cooperatives and ESOPs more difficult


PRESERVING MISSION: TRADITIONAL DEBT AND EQUITY

INSTRUMENTS

This section will address the strategies and opportunities available through use of traditional debt and equity instruments to anchor mission in social

businesses. We focus on key investment terms familiar to entrepreneurs and investors to stimulate co-investment through (1) convertible debt and (2)

preferred equity financings.


Convertible Debt • Use of convertible debt is a typical financing mechanism for early-

stage entrepreneurs and investors

• To preserve mission, key strategies include:

• Portfolio company and lenders agree on the scope of mission at the time of the investment

o Mutually confirm how the company will memorialize the mission – in a new corporate form, charter, shareholders’ agreement and/or purely in a note purchase agreement and note

• Affirmative and negative covenants regarding mission. o Affirmative covenants – e.g., Borrower shall use the proceeds of

investment only in a mission-aligned fashion

o Negative covenants – e.g., Borrower shall not change its business plan, which plan shall be mission aligned; Borrower shall not incur any material capital expenditures for activities that conflict with mission


Convertible Debt

• Include violation of mission in the definition of “event of default.”

o To avoid issues of cross-default with other debt instruments, this can be altered to trigger prepayment as opposed to default

o If borrower fails to pre-pay, mission-preserving contractual remedies for the debtholder can be included, such as a board takeover

• Interest rate increases or prepayment in the event of “mission creep.”

o If the borrower takes certain action deviating from the mission, higher interest rates or prepayment automatically applies

• Removal of automatic conversion mechanisms o Conversion will not be automatic in the next round of financing if

mission creep exceeds a certain threshold • Reporting Requirements

o Include detailed requirements regarding reporting on mission and impact with financial reporting required to note-holders


Convertible Debt

• These strategies implicate a key question – who determines the permissible level of mission creep before penalties are triggered? The alternatives for making such determination include:

• The holder of the debt can make a determination that there has been a material deviation from the mission agreed at time of investment, to which the company can object and then forward to a designated third party

• The company may appoint a special committee of the board tasked with oversight of mission, which committee reports to the board (and investors) if there has been material deviation

• The company and investors can agree to establish mission based on a third-party standard (e.g., certain scope on a B Labs audit)


Preferred Equity

• Traditional equity investments in the form of Common or Preferred Stock are also frequently used by entrepreneurs and investors, including social entrepreneurs

• Strategies to anchor mission can be established by the social enterprise’s founders at the time of the company’s formation or required by investors in later stages of investment


Preferred Equity

• Key protective provisions include:

• Voting Agreements

o Requiring by contract approval from certain investors for actions which are mission (or not mission) aligned

• Separate classes of stock for mission-aligned investors and founders. o Class approval for material change in business plan (including

mission) o Class approval for sale of the company and triggers for drag-along

rights o Class approval for any action out of the ordinary course that could

have a material impact on mission • Provide board representation (and designated director approvals) for

mission-aligned investors


Preferred Equity • Redemption rights in the event of material deviation from mission

o If Company deviates from mission, Company must repurchase investors’ shares or face certain penalties if unable to do so

o If mission creep or change of mission occurs and company is unable to honor redemption rights, contractual remedies may include board control until redemption price is paid

o Option of “secondary sale” or sale to a co-investor who serves as a guarantor in the event of mission deviation

o Use of the aforementioned redemption rights provisions may have a chilling effect on co-investment options, particularly outside of “impact” space

• Investor rights agreements including information rights regarding mission and impact together with reporting of financial information


Preferred Equity

• Change of conversion formula (preferred to common) in the event of material deviation from mission

o Can have formula which allows for conversion ratio to increase (i.e. more common shares upon conversion of preferred shares) in the event of “mission creep.”

• Dividends to become cumulative in the event of material deviation from mission

• Preferential waterfall provisions rights for mission-aligned investors

o Waterfall provisions can provide priority to mission-aligned investors

o May face IRS issue issues if foundation/non-profit investors have lower priority in waterfall

o Additional option is to change the waterfall and or the return (e.g, change 1X to 2X or change from non-participating to participating preferred) in the event of deviation from mission


PRESERVING MISSION: HYBRID CORPORATE STRUCTURES

This section will address the different variations of “hybrid” corporate structures and the unique challenges and opportunities they present to social

entrepreneurs and investors.


Hybrid Corporate Structures

• In general, a hybrid entity refers to a close relationship – via equity ownership, funding or contract – between a non-profit and for-profit entity

• We will discuss five types of hybrid entities:

(1) a for-profit maintaining contractual relationships with a non-profit

(2) a non-profit as a minority investor in a for-profit

(3) a for-profit operating as a wholly-owned subsidiary of a non-profit

(4) a non-profit operating as a subsidiary of a for-profit; and (5) a non-profit investment in a for-profit impact fund



In each of these models, the non-profit, for-profit and investors must consider the following: • Both entities must track and document the flow of funds, the flow of

services and resources and the flow of IP between the non-profit and the for-profit

• Documentation takes the form of intercompany agreements including an IP license agreement, services agreement and/or resource sharing agreement

• In terms of flow of funds, there are various options: • The entities can make loans to the other; however, interest on loans will

likely be Unrelated Business Income Tax (“UBIT”) to the non-profit

• Better alternatives are dividends on equity held by the non-profit in a for-profit subsidiary and royalties on license agreements



• The documentation must ensure that the for-profit always pays at least market rates to the non-profit in all three cases (for funding, services/resources and IP)

• Independent verification of “market” for the industry in which the entities are operating is recommended

• There also must be good governance, specifically disinterested directors on the boards of both the non-profit and for-profit

• Such disinterested directors typcially form a special committee of each board, which committee approves all intercompany agreements and monitors all relations between the non-profit and for-profit

• Management is required to report on the flow of funds, services and IP to the special committee on a quarterly basis; amendments to the intercompany agreements are usually required as the hybrid evolves over time


Contract-Based Relationship

• The most frequently used hybrid corporate structure involves a specific contractual relationship between a non-profit entity and a for-profit entity – the relationship only exists so far as dictated by specific contracts between both entities

• Among other items, the two entities may contract for the provision of specific services or products, the sharing of resources (i.e. office space or equipment), or use of IP


Contract-Based Relationship

• Key aspects defining the relationship between the two entities include:

• No ownership of equity in for-profit by the non-profit

• No shared employees

• Often no overlapping board members and no need for a special committee of disinterested directors (although if there are overlapping board members, such members must recuse themselves from voting/approving the agreements between the two entities)

• The for-profit must pay market rates for the services, products, or IP it receives from the non-profit


For-Profit Wholly-Owned Sub of a Non-Profit

• This form of hybrid structure occurs where a for-profit entity is held as a wholly-owned subsidiary by a non-profit entity (501(c)(3) public charity)

• This form contains several key advantages including the relative ease of structuring and improved corporate governance – mission alignment is created through oversight of the for-profit by the non-profit and there is reduced potential for conflict with investors


• Key structural, strategic and corporate governance best practices include:

• The non-profit and for-profit must have separate and distinct functions – the entities cannot be in competition with one another

• Organizers must carefully consider whether all employees are employed by the non-profit entity, the for-profit entity or both

• All flow of funds, services/resources and IP is documented between the entities, with the non-profit paying no more than market and the for-profit paying at least market

• Typically the non-profit retains the right to nominate a majority of the directors on the for-profit board. Each entity should have a special committee comprised of at least two independent directors whose function includes evaluation of potential self-dealing between the entities

• Awareness of potential UBIT and compensation issues with shared employees

For-Profit Wholly-Owned Sub of a Non-Profit


Non-Profit as Minority Investor in a For-Profit

• Another structure involves a non-profit with a minority ownership stake (typically 20% or less) in a for-profit. Such an investment may be structured as a program-related investment (“PRI”) by foundations


Non-profit minority ownership in a for-profit implicates several challenges including : • Greater difficulty for the non-profit to ensure that the for-profit

remains aligned with the non-profit’s mission unless it is established as a PBC or other new corporate form

• However, the for-profit can create a different class of stock with protective provisions for the “founder” non-profit

• Mission can also be linked through a license agreement

• Potential conflicts between the non-profit and for-profit investors • Redemption rights for non-profit “founder” and other non-profit can

dampen enthusiasm for mainstream investors • Impact on exit opportunities for the for-profit investors • Need for intercompany agreements and increased importance of

independence in governance and management of each entity • Careful management of UBIT issues

Non-Profit as Minority Investor in a For-Profit


For-Profit Establishment of a Non-Profit

• A for-profit entity may also establish a non-profit entity (structured as a 501(c)(3) private foundation

• Although the for-profit cannot formally own the non-profit, it can maintain control through funding and governance of the entity

• Although this form is straightforward from a legal structuring perspective, it is typically favored by large corporations (i.e. Google.org) and not mission-driven social enterprises


• Key corporate governance best practices are similar to those raised by non-profit ownership of a for-profit and include:

• Maintenance of corporate governance independence – board member overlap should be kept to a minimum

• Issues raised by resource and employee sharing • Awareness of potential UBIT issues

For-Profit Establishment of a Non-Profit


Non-Profit Investment in a For-Profit Impact Fund

• An additional opportunity available to non-profits involves investment in a for-profit impact investment fund

• This raises difficult legal structuring challenges and is less commonly-used than other hybrid corporate structures


Additional key structuring best practices include : • Use of a corporation entity to protect non-profit investment from UBIT

issues (“Corporate Blocker”) • Non-profit invests through the Corporate Blocker (which is the General

Partner of the impact fund) • Non-profit’s share of the Corporate Blocker is considered dividend income

(i.e. not UBIT) • Individual managers co-invest with corporation in the General Partner • Clear inclusion of mission and mission-related terms in the Partnership

Agreement including: • Mission as part of the purpose • Agreement from Limited Partners (“LPs”) to focus on mission in investment

selection, diligence and reporting • Possible agreement from LPs to reduction in financial return for impact. • Required reporting

• Limited ability to attract ERISA LPs

Non-Profit Investment in a For-Profit Impact Fund


PRESERVING MISSION:

NEW CORPORATE FORMS

This section will address new corporate forms created to help social entrepreneurs and investors navigate the gap between traditional for-profit and

non-profit entities. To address balancing social mission against pursuit of profitability, each corporate form contains different approaches to key issues

such as fiduciary duties, reporting and accountability mechanisms, and interaction with existing state corporation law.


Low Profit Limited Liability Company • First introduced in Vermont in 2008, low profit limited liability

companies (“L3Cs”) exist in eight states and their adoption has been considered in several others

• By definition, an L3C must advance mission over profitability – it is principally designed to assist for-profit companies with a primarily charitable purpose and offers a lower rate of return to its members

• Have not garnered widespread support from entrepreneurs or funding from foundations

• However, L3Cs provide good exemplars and ideas for incorporating social and environmental purpose into traditional LLCS (in DE and CA)


Low Profit Limited Liability Company • Although L3Cs present a new vehicle through which social

entrepreneurs may seek program-related investments (“PRI”), several important risk factors should be considered including:

• Foundations can already make PRIs in LLCs and corporations. • L3Cs are not eligible for 501(c)(3) tax-exempt status • No IRS ruling or attorney tax letter has been issued for either regular

for-profits or L3Cs • L3Cs do not address private benefit issues • Non-elective nature – due to its statutory definition, a mission-driven

LLC with a charitable purpose created in a state with a L3C statute could unintentionally become subject to L3C requirements


California Social Purpose Corporation

• The California Social Purpose Corporation (“SPC”), formerly known as the Flexible Purpose Corporation (“FPC”), is a new corporate form integrated into the existing California Corporations Code effective as of January 1, 2012

• Overall, the new entity seeks to provide an extra “safe harbor” in addition to the business judgment rule – SPC management may consider environmental and social factors, in addition to shareholder value, in both ordinary course of business and change of control situations without incurring liability for breaching their fiduciary duties



The SPC differs from a traditional Delaware “C” corporation in five areas: • Defined Social Purpose

• A SPC must name one or more social or environmental purposes in its charter as agreed upon by management and its shareholders

• Social purpose must be contained within categories enumerated by the non-profit code including promotion of the positive, or minimization of the negative, impacts of the corporation’s actions on employees, customers, community, and the environment

• The management or board of a SPC must consider the social purpose in addition to maximization of shareholder value in the course of its decision-making

• The social purpose cannot be changed without a two-thirds vote of each class of the corporation’s shareholders



• Corporate Governance and Protection from Liability • Broad discretion to boards and management in terms of weighting

mission and profitability in decision-making • Directors and management are shielded from liability when making

decisions involving trade-offs between maximization of shareholder value and promotion of the social purpose in both ordinary course of business and change of control situations

• Conversion of Other Corporate Forms • An existing public or private corporation under any jurisdiction (LLC,

partnership, or other entity) may convert into a SPC with a two-thirds vote of each class of voting shares

• Dissenters’ rights are granted in the event of a material change in the SPC’s social purpose or conversion without consent



• Reporting • A SPC is required to publicly publish regular reports with the objectives,

goals, measurement and impact or return on its stated social purpose • “8-K-type reporting is also required if there is a company action that

would have a material impact on mission or financials • No requirement of measurement by third-party standards but must

employ “best practices” in terms of reporting • Required public disclosure on web-site or other medium

• Enforcement • Shareholders retain traditional enforcement rights with respect to

enforcing the social purpose, i.e. removal of directors • Third parties do not have enforcement rights


Social Purpose Corporation/Public Benefit Corporation

• Flexible Purpose Corporation, renamed Social Purpose Corporation in 2015, was drafted over two and a half years by a non-partisan group of corporate attorneys

• First introduced in 2009 in California • SPC provides a safe harbor – in addition to the business

judgment rule – that requires boards and management to emphasize shareholder-agreed social and/or environmental purposes in the charter



• SPC differs from traditional corporation as follows: • Fiduciary duty to the mission • Additional protection to the board and management

in promoting such social and environmental goals • Mission protection (2/3 class vote to change agreed

purpose) • Increased accountability via annual shareholder and

public reporting • Detailed provisions for conversion, merger, sale,

and consolidation (including dissenters rights)



• SPC is substantially similar to the Public Benefit Corporation introduced in 2013 and adopted in Delaware in 2015 with only two material exceptions:

1. PBC requires broad public purpose in addition to

the specified social and/or environmental goals, while the SPC only requires at least one shareholder-agreed social or environmental goal

2. SPC requires greater accountability and reporting than the PBC



• Both the SPC and PBC have been designed for use by both small social enterprises and by larger public companies

• The first PBC, Laureate Education, filed an S-1 with the SEC to go public in October 2015, but has yet to list its shares and start trading

• A second PBC will result from the closing of the $10.4B merger of Danone and WhiteWave Foods


Benefit Corporations • First benefit corporation was written into the Maryland

statute in 2010 • Exists in 30 states plus the District of Columbia with

significant variations in legislation among the states • States use different names for the new form, including

Benefit Corporation, Public Benefit Corporation (CO), Social Purpose Corporation (WA, FL), and Sustainable Business Corporation (HI)

• In some states, the benefit or public benefit corporation is a form of non-profit corporation while in others it is a form of for-profit corporation


Benefit Corporations • Generally, unlike PBC and SPC, these statutes bake “goodness”

into legislation – a company’s board and management have a fiduciary duty to a list of social, environmental and governance goals (borrowed from the “B Corp” certification survey) in addition to financial goals

• In most states, benefit corporation provisions are an “add on” to the corporations code • Not creating a new and distinct legal entity, but fashioning a

designation for “normal” corporations • This has resulted in unintended conflicts between corporate

law and benefit corporate law that apply to the same entity (e.g. issues with the “benefit director” and the “enforcement proceeding.)


MoFo + Impact Investing For over 20 years, Morrison & Foerster has offered a cutting edge legal practice, representing social enterprises, hybrids, and impact investors.

Our clients include:


Susan Mac Cormac • Corporate partner and Co-chair of the Impact, Energy, and Clean Technology

Groups at Morrison & Foerster

• Co-chair of the Working Group for the Social Purpose Corporation in California

• Founding board member of the Sustainability Accounting Standards Board

• Board member of Business for Social Responsibility, member of Ceres President’s Council and the Board of Directors of Earth Genome Project, and advising board member of the Committee Encouraging Corporate Philanthropy’s Strategic Investor Initiative

• Named by the Financial Times as its 2015 “Most Innovative North American Lawyer” and as “Attorney of the Year” by California Lawyer in 2012 and 2016 for social enterprise and impact investing work

• Professor of Social Enterprise Law at U.C. Berkeley School of Law

• Clients include Omidyar Network, RSF Social Finance, Revolution Foods, Brightpath Capital Partners, Etsy, Medicines360, SoftBank, and Goldman Sachs


Q&A and Follow-Up Questions Contact information: Susan Mac Cormac Partner, Morrison & Foerster [email protected] For more information on corporate form and impact investing, check out our resource center and blog MoFo Impact Resource Center: http://www.mofo.com/impact MoFo Impact Blog: http://impact.mofo.com
