Choosing the right legal form for your social enterprise

By Marcus Coetzee, 1 February 2016.

Introduction

Many social entrepreneurs are just starting their journey to change the world.

Soon they will need to decide whether they should formally register an organization.

There are those social entrepreneurs that intend to raise donations to support their efforts. For these entrepreneurs, the choice of legal form is fairly straightforward; they just need to choose which type of non-profit organization to register.

Then there are those social entrepreneurs that want to start a social enterprise, and derive the majority of their income from the sale of goods and services. For these entrepreneurs the choices are more complicated. This is because social enterprises can adopt the legal form of either a business or non-profit organization.

Social entrepreneurs frequently turn to the internet for advice on this issue and end up even more confused.

The internet has lots of information on the characteristics of each legal form. Unfortunately, it does not provide clear advice to social entrepreneurs on whether they should choose one of the non-profit or for-profit legal forms for their enterprise.

The internet is also full of misinformation about the tax laws and the conditions under which certain types of social enterprises can lose their Public Benefit Organization (PBO) accreditation from the South African Revenue Services (SARS).

This article aims to clear up some of this confusion. It encourages action not bureaucracy.

It will present a definition of a social enterprise and list the various legal forms available to social enterprises in South Africa. It will show how much opportunity there is for social enterprises with either type of legal form. This will help to dispel some misconceptions.

This article will encourage social entrepreneurs to reflect on their own agenda and how they expect their enterprises to earn money. Finally, it will encourage social entrepreneurs to launch a brand and immerse themselves in their work. The best legal form for their social enterprise will emerge; it does not have to be decided upfront.

What is a social enterprise?

A social enterprise is an organization that generates the majority of its income through business activities and utilizes its profits to further its social (or environmental) purpose. Social enterprises are a result of a convergence between non-profit organizations starting to apply business principles, and businesses striving to have a social impact. Social enterprises are becoming more popular throughout the world.

Social enterprises can have different legal forms

Social enterprises can adopt a variety of legal forms, and this is what makes this topic confusing.

They can assume one of South Africa’s “non-profit” legal forms (Nonprofit Company, Nonprofit Trust or Voluntary Association). Examples of such enterprises include Greater Capital, Fix Forward and Social Enterprise Academy.

They can also assume one of the “for-profit” legal forms (e.g. Cooperative or Company) that can be privately owned. Examples include Shonoquip, GreenPop and Siyavula.

It is also possible for social enterprises to adopt a combination of a non-profit legal form and a for-profit legal form (i.e. to set up two inter-related entities, one a for-profit and one a non-profit). These are called Hybrid Social Enterprises. Good examples include Deaf Hands at Work, WildLife Act and NICRO. Hybrid models are currently fashionable, and are frequently being chosen for the wrong reasons.

Despite the terminology of “non-profit” and “for-profit”, social enterprises with either of these legal forms are able to engage in business and profit-making activities.

Social enterprises with a non-profit legal form

Social enterprises with a non-profit legal form have more flexibility than most people think. They can generate an income from a variety of sources. They are unlikely to lose their PBO accreditation, provided they remain focused on their social agenda and don’t undermine the tax base. They can also receive investment funding.

Social enterprises with a non-profit legal form can do many of the things that a traditional business can; they are not as limited as people think.

They can sell their goods and services directly to their beneficiaries (e.g. Social Enterprise Academy and Iyeza Express). They can become suppliers of businesses, government and foundations (e.g. Greater Capital and the Centre for Justice and Crime Prevention). They can operate as intermediaries in the B-BBEE space (e.g. Clothing Bank, Relate and Fetola). They can also receive sponsorship (e.g. Cape Town TV) or help link businesses with markets (e.g. Fix Forward).

Many of these enterprises have received S30 (PBO) and S18A (DDO) accreditation from SARS. This gives them certain tax advantages and makes them more attractive to Corporate Social Investment (CSI) departments. However, a common fear is that they will lose their PBO and DDO accreditation if they engage in business activities. For various reasons, these risks are being dramatically overestimated. The revisions to the Income Tax Act in 2006 have provided much needed flexibility for social enterprises.

There are only four conditions where a social enterprise can lose its PBO and DDO accreditation: i) the enterprise is no longer philanthropic; ii) its primary activities are no longer for public benefit; iii) the business activities are unrelated to the core purpose of the enterprise and start taking over its agenda; iv) the business activities generate substantial income and start undermining existing taxpaying businesses. (SARS clearly explains these conditions in its guide for non-profit organizations.) These are some of the few instances where a hybrid model is recommended.

Social enterprises are also able to receive investment. We already know that donations are one form of investment. But these enterprises can also receive loans. For example Fix Forward has recently received a R2.5 million loan from the Industrial Development Corporation’s Social Enterprise Fund to help it scale its social impact.

Some social enterprises in Europe and England have even received quasi-equity investment, which is funding in return for a share of profits from a particular income stream over a set period. However, this form of return on investment is not possible in South Africa for non-profit legal forms, as they are prohibited from distributing/sharing profit in any way, and may only remunerate, at a reasonable rate, for services actually provided. Instead these organizations are encouraged to adopt a hybrid model in order to implement such contracts.

The non-profit legal form is used frequently by social enterprises. It offers considerable flexibility for social enterprises and is typically associated with stronger governance structures. It can function as a business. Unfortunately, too few social enterprises have been able to tap into its full potential.

Social enterprises with a for-profit legal form

The for-profit legal forms provide the opportunity to run a much leaner and more flexible social enterprise. They enable private ownership and control, and have reduced bureaucracy.

However, one of the common arguments against social enterprises with a for-profit legal form is that they cannot access philanthropic funding. Social entrepreneurs tend to believe that this is a magical pot of money that they should easily be able to access because their work has a social purpose. Unfortunately, the grass is not greener on the other side. There are also over 130,000 non-profit organizations competing for these same funds.

There are no rules anywhere in the Income Tax Act that prevent a business, foundation or government department from paying a social enterprise to deliver a set of social outcomes. They just need to record it as a normal business expense and this requires a certain alignment of the expense with the business’s income production.

Even CSI departments are not bound by this rule. It is just the current convention to donate to nonprofit organizations that have PBO status and can provide them with a S18A certificate.

Neither do the B-BBEE codes require that a business must donate to a non-profit organization. For example, the socio-economic development code is primarily concerned with uplifting “previously disadvantaged” people out of poverty and helping them to participate in the economy. The code does not specify whether this help must take the form of a donation or expense.

There are a variety of ways in which social enterprises with a for-profit legal form are able to earn money. For example, Siyavula was sponsored by Vodacom to help learners in approximately 100 schools practice and improve their maths and science skills. GreenPop is frequently paid to help with green campaigns. Shonoquip sells wheelchairs, and Citizen Surveys conducts research on social issues for the government.

These social enterprises also make attractive impact investments for two main reasons. Firstly, investors are able to acquire equity. Secondly, investors believe that these social enterprises are more likely to have profitable business models. For example, Impact Amplifier recently facilitated an investment deal for Biogreen – a social enterprise with a solid business model that converts used cooking oil into biodiesel. In term of this deal, Business Partners provided the funds for the enterprise to expand in return for some equity.

Impact investment provides significant opportunities to these social enterprises. JP Morgan estimated that the market was worth $60billion last year and is growing rapidly. Furthermore, a 22% of the market is estimated to be in Sub Saharan Africa.

However, here is an important side point. A number of impact investors have complained that South African social enterprises do not have business models that appeal to impact investors. Fortunately, we are seeing an increase in support services (e.g. Impact Amplifier, Life-Co UnLtd, Bandwidth Barn and U-Start) that are able to help social enterprises to achieve this.

There is the concern that foundations and CSI departments don’t want to work with social enterprises that have a for-profit legal form. There are instances where this is justified (e.g. a tax exempt foundation is prohibited from donating money to anything but a tax exempt entity). However, and as we have shown, there are other methods of paying a social enterprise to achieve a set of outcomes. There are also signs of a global shift where donors are becoming more interested in results than legal forms.

A common desire of these “for-profit” social enterprises is how to convey their philanthropic intent. Fortunately, there are a range of things that these enterprises can do to achieve this.

For example, a social enterprise could: recruit an external board of directors that feel strongly about their cause; change their memorandum of incorporation to embed their purpose and explain how profits will be reinvested in the business; get an international accreditation saying that they are a social enterprise (e.g. “Social Enterprises: Trading for People and Planet” accreditation by the Social Enterprise Mark); openly share their financial statements and social impact reports; and consider selling shares to employees or a partnering non-profit organization.

Hybrid social enterprises are not always necessary

This brings us to a very important point. Too many social enterprises are choosing to establish hybrid models when they don’t need to. In trying to get the “best of both worlds”, they are failing to fully understand and harness the opportunities inherent in a single legal form. They are diluting their energies instead of focusing them, and doubling their bureaucratic burden.

There are strict conditions where a hybrid model is recommended. These are outlined in e-book “setting up a hybrid social enterprise” available on the author’s website.

Things to consider when choosing a legal form

There are three questions that social entrepreneurs need to consider when choosing which type of legal form to use.

The first question is how much personal control they want to have over their enterprise. Those entrepreneurs that want a high degree of control should consider one of the for-profit legal forms. In contrast, those that are prepared to share control and “ownership” may be more comfortable with a non-profit structure.

The second consideration is how the enterprise will get most of its income. If the enterprise intends to rely on donations from philanthropic funds and CSI departments then a non-profit structure is attractive. However, if the enterprise intends to earn its income from beneficiaries, businesses or the government, then a for-profit entity would also be viable.

Finally, entrepreneurs should consider whether their enterprise will pursue investment in the form of loans or equity. Related to this is whether its business model will enable it to earn the profits required to keep investors happy. If this is true, then a for-profit entity would be a better choice.

If uncertain, just create a brand and experiment, and the best option will emerge

Social entrepreneurs should start their journey by testing their theories and seeing if their social innovation (i.e. product) and business model actually works. And if not, then they should revise it until it does. They should explore the best way to generate the income they need. These activities will no doubt require lots of experimentation, research and conversations with beneficiaries and partners.

Although it is tempting to over intellectualize and plan everything upfront, these plans will seldom survive contact with the real world. Entrepreneurs should rather try and postpone the inevitable bureaucracy of running an organization (and choosing a legal form) until it is necessary. Instead focus on experimentation and developing a business model that works.

But always keep in mind that the process of setting up a non-profit legal form and getting it accredited will take approximately six months. In contrast, it is much quicker to start trading as a sole proprietor (this comes with some risk) or setup a for-profit legal form. Social entrepreneurs will need to judge their timing so that their legal forms are ready when they need it. No reason to rush out an open a bank account the moment an idea arises.

It is also important to build a brand and get people excited about it. Use social media; don’t worry about complex websites and company stationery for now.

In other words, start with passion, an open mind and a willingness to experiment. Don’t limit this by getting caught up in intellectual and bureaucratic dilemmas.

Conclusion

This article has discussed the two types of legal forms available to social enterprises. It has highlighted some of the opportunities for either to earn income and attract investment, and dispelled some misconceptions. Social enterprises can be successful as long as they learn to exploit the full potential of their legal forms and setup effective governance systems.

The personality and agenda of the social entrepreneur is as important as the anticipated business model when choosing a legal form.

There is also no single best legal form for social enterprises in South Africa. Neither will a “new” legal form give provide all the answers. It is not a magical solution that will suddenly enable social enterprises to thrive.

Most importantly, social entrepreneurs must start their journey with an open mind and a willingness to experiment. They must strive to build an engaging brand. They should focus on developing a business model that works and postpone bureaucracy for as long as possible.

Marcus Coetzee is a strategist who is passionate about social enterprises.

Thanks for the input and content quality checks from Cathy Masters (CMDS), Malcolm Boyd (Third-Sector Insights), Nicole Copley (NGO Law SA), Peter Ross (ActivPro) and Tine Fisker (Bertha Centre for Social Innovation and Entrepreneurship).

Marcus Coetzee

Choosing the right legal form for your social enterprise: insights from a strategy consultant