Money, Money, Money: Traditional Financing or a New Wave of Crowdfunding?

By: Samantha Gross

April 2017

Steve Jobs once said, “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance.”  Perhaps in avoidance of sounding cynical, Mr. Jobs does not address the other half of the equation – money.  The reality is that entrepreneurs need initial financing to get a business up and running.  In fact, about 80% of startups fail, mainly due to lack of capital.  With more and more startups vying to enter the market, investors are setting higher benchmarks to protect their money.  The result: great difficulty for first-time entrepreneurs without substantial personal resources and connections. 

Traditional paths for financing have included investments from personal savings, friends and family, the elusive angels, and the sophisticated venture capitalists.  In recent years, four different types of crowdfunding have paved a new path for raising seed capital.  Financial analysts all agree that the type of financing an entrepreneur accepts is extremely important and involves much thought; however, the best type of capital-raising method is still contested.  This blog post evaluates the benefits and risks of so-called “smart money” and “dumb money” for an average entrepreneur starting with absolutely no leads for financing.

“Smart Money”: The Value of Human Capital

            “Smart money” typically refers to investments from those, who are experienced, well-informed, and well-connected – popularly known as angel investors and venture capitalists.  Such investors often take active roles in their portfolio companies, as advisors, board members, or endorsers, which can open different doors for entrepreneurs.  In other words, “smart money” provides both financial and human capital.

Established business owners, experienced investors, and financial advisors all express the importance of finding the right fit, when entering into a financing deal.  There must be a covenant of honesty, trust, and transparency because the relationship between a seed investor and entrepreneur can last up to six or seven years.  Thus, a great benefit to obtaining money from friends and family, angel investors, and even venture capitalists is the support provided by the person backing an entrepreneur’s sweat and labor.  Nevertheless, such options are not always readily available, especially since the competition among startups is currently hot and heavy.  As a result, a new path for funding has emerged, referred to as crowdfunding.          

What Type of Crowdfunding?

            It is important for an entrepreneur to recognize that there are four different types of crowdfunding, and carefully understand the process of each before proceeding full speed ahead.

1.      Donation Based Crowdfunding

            In donation based crowdfunding, the contributing person gives money or other resources to the entrepreneur without anything in return, simply because they support the idea.  This type of crowdfunding has proven successful for social causes and charity organizations.  However, this option is not necessarily sustainable for a business, which needs a larger amount of capital at the initial stage.   

2.      Rewards Based Crowdfunding

            In rewards based crowdfunding, the contributing person gives money to the entrepreneur in exchange for a reward, typically some good or service.  A famous example of rewards based crowdfunding was Zach Braff’s campaign to raise money for his film “Wish You Were Here.”  He raised $3.1 million on Kickstarter, and gave his backers access to the film’s production in exchange.

3.      Equity Based Crowdfunding from Accredited Investors

            Entrepreneurs can raise money and issue shares over the internet from accredited investors, individuals who either have a net worth over $1 million (excluding a primary residence) or an income of at least $200,000 for the preceding two years.  However, entrepreneurs, who have yet to establish connections within the investor world, may face the same difficulty in raising funds from accredited investor crowdfunding as they would from angel investors or venture capitalists.

4.      Equity Based Crowdfunding from Unaccredited Investors

            On May 16, 2016, Title III of the JOBS (Jumpstart Our Business Startups) Act came into effect, making it possible for entrepreneurs to raise money in exchange for equity from the general public, not just accredited investors.  The idea behind the act was to allow more startups, which do not necessarily fit into the angel or venture capitalist model, to receive funding from a larger pool of investors.  Whether this relatively new option is actually beneficial and useful for entrepreneurs is still uncertain.

Benefits of Crowdfunding

            In 2015–2016, donation and reward crowdfunding raised a total of $5.5 billion, while equity crowdfunding under-performed in comparison, only raising a total of $2.5 billion.  The bottom line is that entrepreneurs, who may not be eligible among angel investors and venture capitalists, can access funds relatively quickly through crowdfunding.  Reaching a diverse investor pool from around the globe is an attractive advantage.

Disadvantages of Crowdfunding

            In contrast to the “smart money” of angel investors and venture capitalists, financial experts sometimes refer to equity based crowdfunding as “dumb money” – mainly because such financing does not provide the added expertise of a well-seasoned investor committed to advising his portfolio clients.  Rather, the relationship is reduced to an online portal of many investors, willing to make small investments in all sorts of businesses.

            Another major disadvantage is the rather heavy regulatory scheme.  For instance, the maximum offering amount is $1 million in a twelve-month period, the investors are subject to limits with regard to the amount of capital they can contribute in a twelve-month period, the companies are subject to disclosure requirements as well as restrictions in advertising, and the crowdfunding must be conducted through a registered portal.  It remains to be seen whether all this red tape is worth it or even feasible for an entrepreneur lacking in resources.

Debt Funding May be a Lifesaver

            While financial analysts are not convinced about the benefits of equity based crowdfunding from non-accredited investors, there may be some great potential from Title III debt crowdfunding.  For small businesses with cash-flow, debt crowdfunding works well because payments do not usually start immediately and are based on a percent of revenue; as a result, businesses are not burdened with fixed loan payments.  Ultimately, debt crowdfunding can be cheaper and faster than going to a bank with the added benefit of marketing exposure through a crowdfunding portal. 

            Financing options are distinct and numerous; nevertheless, it is up to the entrepreneur to find the best means for a happy start-up ending.

Are Your Mobile Application or Website Terms of Use/Privacy Policies Legally Enforceable?

By: Joseph P. Glackin

April 2017

In this day in age, more and more businesses are utilizing websites and mobile applications as their point of contact with their target audience/consumers. This post will analyze some of the agreement types in which privacy policies and terms of use agreements are conveyed within the aforementioned mediums. In doing so, it will analyze the enforceability of these agreement types, and make a final recommendation on how businesses should protect the enforceability of their agreements with their users. However, before discussing the agreement types, it is important to first understand some of the underlying contract principles.

Fundamental Contract Principles

            An essential element under basic contract formation principles is a mutual manifestation of assent. Manifestation of assent describes words or acts that objectively show that there has been consent to a contract between parties. Where assent to terms is passive, the question of contract formation turns on weather a reasonable person would be on notice of the terms at issue. If a reasonable person was on notice but did not read the terms, a contract would still be enforceable.

Browswrap v. Clickwrap Agreements

A recent 2015 decision out of New York in Berkson v. Gogo LLC provided a comprehensive review of the law to date on both browsewrap and clickwrap agreements. In summary, browsewrap agreements are agreements in which a user accepts a website’s terms of use by browsing a site or using an application. Clickwrap agreements are agreements in which a user accepts a website’s terms of use by clicking an “I Agree” or “I Accept” button, with a link to the agreement being readily available. This case also helped establish a set of general principles for internet and mobile application contracts.

These principles being:

1)              Terms will generally NOT be enforced if (a) no evidence that the website user had notice of the agreement; or (b) a hyperlink to the terms is buried at the bottom of a webpage.

2)              Terms will be enforced if design or content of a website or application encourages the user to review the terms.

Browsewrap Agreements

Browsewrap agreements refer to a contract or agreement covering access to use of materials on a website or downloadable product such as a smartphone application. In most cases, websites typically have a hyperlink to their terms and conditions, and notify consumers/users that by simply using the website, running an application, or accessing information, a user is agreeing to be bound to the aforementioned terms.

If a user is agreeing to be bound to certain terms simply by using a website or an application, there is no manifestation of assent. In practice, this means that a user can continue to use an application or website without actually visiting the webpage of terms or even knowing that the terms are of existence. This is counterintuitive to a reasonable person having notice of the terms, and thus is hard to be held as an enforceable contract. Taking this into consideration, courts have generally come to a consensus that browsewrap agreements are generally only enforceable if users have both a reasonable notice of the terms and have assented to those terms.

Reasonable Notice of Terms

In the 2014 decision of Nguyen v. Barnes & Noble Inc. the court stated that the “validity of a browsewrap agreement turns on whether the website puts a reasonably prudent user on inquiry notice of the terms of the contract.” Courts tend to look at the design and content of a website or application and the agreement’s webpage in finding whether a reasonably prudent person would be on inquiry notice of the terms. In addition to the inquiry notice requirement, in Small Justice LLC v. Xcentric Venures LLC, a Massachusetts Court looked at the “conspicuousness and placement” of a link to the terms and conditions, and took “other notices given to users of the terms of use, and the website’s general design” into consideration to determine whether a reasonably prudent person had inquiry notice of the terms.

Assent to the Terms

In order for a court to infer assent and hold a browsewrap agreement as enforceable, an individual user or consumer may impliedly accept terms by their conduct (such as accessing the site or service), and purchasing a product or service from the website or application. Recent trends have pointed out that courts are more likely to enforce browsewraps against corporations and businesses, and are less likely to enforce against individual consumers.

Clickwrap Agreements

Unlike browsewrap agreements, clickwrap agreements require an active role by individual users, where a user has to click a box stating “I AGREE” after being presented with terms of agreement, but prior to downloading or making a purchase. This affirmative action of clicking “I AGREE” manifests assent. In most cases, courts have enforced clickwrap agreements. However, more recently courts have expanded the inquiry to look at whether the terms were reasonably communicated to the user (i.e. effectively fulfilling the aforementioned reasonable notice requirement). It has been noted that the box that a user has to click needs to be clear and concise, and that checking it constitutes assent to the terms. Simply displaying a “Download” or “Proceed” button is not sufficient. The court in Specht v. Netscape Communications Corporation, in the 2nd Circuit, stated “a consumer’s clicking on a download button does not communicate assent to contractual terms if the offer did not make clear to the consumer that clicking on the download button would signify assent to the terms.”

Scrollwrap Agreements

Scrollwrap agreements are clickwrap agreements with an added attribute. This attribute being that a user is presented with the entire agreement or terms of use and must physically scroll to the bottom to find the “I Agree” or “I Accept” button. This adds another layer of protection in making sure a user has reasonable notice of the terms, and thus makes the contract that much more enforceable. With this being said, courts tend to favor enforceability with scrollwraps, as notice is clear and assent is satisfied via clicking a certain box.

Recommendations and Best Practices

A. The Scrollwrap Agreement

            After much research, it is recommended that a company utilizing a mobile application should heavily side with cautionary measures. These cautionary measures are sufficiently fulfilled with the use of a scrollwrap agreement. As previously mentioned, in this approach a user has to confront an agreement, scroll down to the bottom of the aforementioned agreement, check a box agreeing to be bound, and click a button confirming assent to the contract.

B. “YES” Button in Response to Asking if User Agrees to be Bound

Another viable approach is being more user friendly, but is just as valid in proving explicit assent. In this approach users would be asked to click on a button marked “YES” in response to a statement asking if the user agrees to be bound by a unilateral contract such as “Terms of Use” and the agreement is presented to the user above the button in the form of a hyperlink.

For added protection, it would be recommended to mandate that a user, in some way or process, be unable to click yes unless they have successfully navigated to the hyperlink taking them to the terms of use page. However, this may frustrate users as it requires them to actually navigate to the hyperlink.

Scaling Startups without Sacrificing CEO Sway: Should Founders Consider Adopting Snap Inc.’s No-Vote Stock Structure?

By: Jennifer Kay

March 2017

Snap Inc.’s February 2017 S-1 Registration Statement with the U.S. Securities and Exchange Commission reveals that the tech giant behind Snapchat intends to issue no-vote shares in its Initial Public Offering. With the advent of no-vote shares, start-up founders may be enticed to offer company equity to investors that would provide capital gain and dividend benefits without granting any voting rights to such shareholders. Although Snap’s no-vote share model is theoretically advantageous for company founders seeking to retain control over their brainchild, Snap’s unprecedented, unorthodox stock structure is unlikely to gain traction in the startup community, as most companies lack Snap’s level of bargaining power to convince potential investors to buy shares without voting rights.

While SEC and stock exchange rules permit issuers to sell no-vote shares as a means of allowing founders to retain control of their company, such stock is rarely issued and typically only issued after an IPO, as one company’s no-vote shares would theoretically be less valuable than their competitors’ single-vote shares. Still, the potential of the no-vote share model will be tested by the success of the shares’ sales in Snap’s IPO and Snap’s audacious proposal is presumably only possible because of its wildly-popular mobile app, Snapchat; the extraordinary, multi-billion dollar valuations of Snap in past financing rounds and as offered by rejected acquirers like Mark Zuckerburg; widespread public interest in the mobile app market; and the company’s seemingly-unbounded growth. These factors have contributed to the founders’ demonstrated belief that they will still be able to garner record-setting IPO stock sales without offering voting rights with company shares.

As articulated in the company’s February 2017 S-1, Snap will have three classes of common stock: Class A common stock, Class B common stock, and Class C common stock. Class A common stock will not be entitled to any votes, while Class B common stock will be entitled to one vote per share and Class C common stock will be entitled to ten votes per share. The S-1 further indicates that the only stock being offered in the IPO is Class A common stock with no voting rights and that “shares of Class B common stock or Class C common stock sold by existing stockholders will lose voting rights when such shares convert into Class A common stock or Class B common stock as such shares are sold.”

The S-1 indicates that Snap co-founders, Evan Spiegel and Robert Murphy, hold Class C common stock entitling them to 10 votes per share, but the publicly available version of the S-1 does not specify the number of Class C shares that each founder owns. Still, the S-1 explicitly acknowledges that “Mr. Spiegel and Mr. Murphy, and potentially either one of them alone, have the ability to control the outcome of all matters submitted to our stockholders for approval, including the election, removal, and replacement of directors and any merger, consolidation, or sale of all or substantially all of our assets. If Mr. Spiegel’s or Mr. Murphy’s employment with us is terminated, they will continue to have the ability to exercise the same significant voting power and potentially control the outcome of all matters submitted to our stockholders for approval.”

Accordingly, start-up founders may seek to mimic the no-vote share model to preserve company control and safeguard the company from activist investors or unfriendly takeovers. That said, start-up founders should understand that they would need to have colossal bargaining power in order to garner investor demand for no-vote, or even limited vote, shares. Still, start-up founders interested in retaining control should consider trends in IPO financing models like the Snap no-vote structure to ensure that their early-stage financing agreements allow for creative equity structures that would minimize founder decision-making dilution at later stages.

https://www.sec.gov/Archives/edgar/data/1564408/000119312517029199/d270216ds1.htm

http://www.investopedia.com/articles/fundamental/04/092204.asp

https://www.forbes.com/sites/investor/2014/07/16/not-all-shares-are-created-equal-more-multiclass-stocks-to-join-google-in-the-sp-500/#150d416850cc

https://www.law360.com/articles/886185/snap-s-expected-no-vote-shares-likely-to-remain-an-outlier

http://fortune.com/2016/05/07/facebook-stock-mark-zuckerberg-sec/

http://www.investopedia.com/terms/v/votingright.asp

https://www.crunchbase.com/organization/snapchat/funding-rounds

https://www.crunchbase.com/organization/snapchat#/entity

https://www.snap.com/en-US/news/post/recent-additions-to-team-snapchat/

https://www.forbes.com/sites/jeffbercovici/2013/11/13/facebook-wouldve-bought-snapchat-for-3-billion-in-cash-heres-why/#6c1d36d543de

https://www.quora.com/How-did-Snapchat-get-traction

Efforts to Ease the Regulatory Burdens And Increase Growth Among Small Businesses and Start-Ups

By: Michael Thomas

March 2017

Starting a new business or running a small one comes with a number of hurdles that a business owner must overcome. An entrepreneur trying to get a business off the ground must have a new product, idea, or service that adds some value; find funding to support the development of the idea or product, and eventually get it to the relevant market. Similarly, a small business must continue to find ways to grow and stay competitive in a marketplace that usually includes much larger companies with extensive resources. In addition to these concerns, studies indicate that the regulatory burden plays an important role in the development and growth of small businesses.

 Data collected by the U.S. Department of Labor shows the number of businesses less than one year old increased steadily from 1994, where the number was roughly 570,000, up until 2006 when that number reached a high of 715,734. Following 2006 this number decreased rapidly, and as a result of the recession hit a low in 2010, dropping by almost 25%. Since 2010 that number has been on the rise and in 2015 the number of businesses less than one year old was 679,072, a number approaching the high point reached in 2006. The study also shows that jobs created by businesses less than one year old are trending along the same lines but with a slower rate of increase. In 1999 the number of jobs created by businesses less than one year old reached a high of 4,736,499. As a result of the recession, this number was cut almost in half to roughly 2,500,000. Following the recession new jobs created by businesses less than one year old have increased by a rate of roughly 15,000 jobs/year but this number is nowhere near the level seen in 1999. However, the data is certainly encouraging as the number of businesses/year and jobs/year are clearly on the rise. The question still remains, could these numbers be better?

Regulations matter to businesses of all sizes but they particularly affect small businesses and start-ups. Many small businesses and start-ups lack the resources to devote a special department or person to compliance work. In most cases the founder acts as the compliance, finance, sales, supply chain, and development person. This makes the cost/person of dealing with regulations higher for smaller businesses. Small business owners indicated tax, healthcare, and overtime regulations as the most burdensome. The U.S. Small Business Administration does provide some helpful guidance in this area but if the owner cannot handle this work on their own, they must spend the money and hire someone to help.

Regardless of the industry or business a start-up enters, there are undoubtedly a number of laws and regulations that need to be complied with. This is in addition to any licenses and permits that need to be acquired. For a new or small business, ensuring compliance with these regulations is time consuming as well as costly. Sorting through the often difficult to read regulations takes time. A study by the National Small Business Association (“NSBA”) reports that roughly 44% of small businesses spend at least 40 hours a year ensuring they are in compliance with tax, healthcare, and employment regulations. While this may not seem like a large number it is worth considering that many people starting new business or running their own small business hold another job. When taking into account everything else that needs to be done to get a new business up and running, 40 hours a year can be a substantial amount of time devoted to understanding regulations. In addition to the actual time spent on regulations, the yearly costs small businesses spend on compliance are roughly $12,000. One of the more surprising values from the study by the NSBA was the estimated average regulatory start-up costs incurred by small business owners, $83,000. Given 55% of all businesses have gross revenues under $1,000,000 in their first year, the study highlights the considerable time and cost spent on understanding regulations and compliance by those starting and operating new businesses.

            Many small businesses indicate that regulations at the federal level cause the highest burden. In an effort to ease some of the burden, two executive orders have been signed this year by President Trump. The first was signed on January 30th, 2017 with small business owners surrounding the President and is meant to reduce regulation and control regulatory costs for private businesses. The second, signed four days later on February 3, 2017, is targeted at easing the restrictions on financial institutions. It is important to keep in mind that while these executive orders do not create new laws (very limited exceptions apply), they do set policy directives that Congress and federal agencies must follow.

            The order reducing regulations and regulatory costs has some key components listed in the directive. The order’s primary method of reducing regulations is laid out in Section 1; it states “that for every one new regulation issued, at least two prior regulations be identified for elimination.” The order also carries provisions which cap the net increase in regulatory costs at zero “unless otherwise required by law” and setting a budget for fiscal year 2018 and beyond. There are certain exceptions listed in Section 4 of the order such as regulations pertaining to national security, the military, and agency organization. While it is unlikely the order will produce any significant changes, it will hopefully result in the purging any outdated or ineffective regulations. This matters to start-ups and small businesses because it eliminates unnecessary reading and time spent understanding complexly written rules that do not apply. This can save time and money for small businesses and start-ups, allowing them to allocate it elsewhere such as revenue and job growth.

            The executive order signed February 3, 2017 seeks to “foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis.” This goal of this order is to ease restrictions on financial and lending institutions. This matters to small business owners because when the Dodd-Frank Act was passed it had the effect of severely slowing down lending by banks. This made it very difficult for small businesses and start-ups to get loans. Although the executive order imposes broad principles, it has the ultimate goal of easing regulations for financial institutions that in turn could increase the availability of capital to small businesses and start-ups.

            There are many factors that go into ensuring start-ups and small businesses continue to grow and provide jobs. Reducing the regulatory burden is simply one piece to the puzzle and will hopefully help encourage those with a good idea to start their own business and keep existing small businesses running. In addition to the actual reduction of regulations, things such as making regulations easier to understand and reducing penalties for first time offenders acting in good faith would help alleviate costs and concerns. It remains to be seen how these executive orders will play out or how long it will take for them to have an effect, but hopefully their goals are realized through continued growth for the start-ups and small businesses.

Potential for Benefit Corporations: Past, Present, and Future

By: Samantha Gross

March 2017

Patagonia, Etsy, TOMS Shoes, and Warby Parker are just a few companies out of a growing number to join the benefit corporation movement.  Entrepreneurs and corporate management of this relatively new legal status can pursue for-profit ventures, while also committing their business to a specific public benefit.  Perhaps, the popularity of the benefit corporation resulted from frustration with the historic premise of corporate law, which established that a corporation’s sole purpose is to maximize shareholder profits.  This movement away from shareholder primacy begs the question, is the benefit corporation the entity of the future?

Why are Benefit Corporations so Revolutionary?

            Although benefit corporations have gained popularity, it has been slow over the last seven years.  American corporate law is centered around the theory of shareholder primacy, which mandates that a corporation honor its fiduciary duty or face legal liability.  In other words, corporate directors and officers have less discretion in determining the goals of the company, especially when at odds with generating shareholder profits.  In the landmark case of Dodge v. Ford, the court ruled that Henry Ford must operate in the interest of the corporation’s shareholders, not in a charitable manner for the benefit of employees and customers.  Entrepreneurs and members of corporate governance, who believe in corporate social responsibility, have long disagreed with such shareholder primacy mandates.  But the tables are turning.  Currently, thirty-one states have passed legislation permitting the formation of benefit corporations and seven more states are in the process.

What is the Difference Between a B Corporation and a Benefit Corporation?

            Before delving into the nuances of a benefit corporation, it is important from a legal perspective to distinguish the benefit corporation from the B corporation.  A benefit corporation is a legal status, a formal business structure like a LLC or a C corporation.  Requirements for forming a benefit corporation vary from state to state.  In general the business must file articles of incorporation with the state defining a specific social benefit, and is subsequently subject to auditing in order to ensure that the company is working towards the intended social benefit.  Traditional corporations, which decide to become benefit corporations, can amend their by laws.  Conversely, a B corporation is a status conferred by B Lab, a nonprofit created to award for-profit businesses that meet certification standards for overall social and environmental performance. 

Benefit corporations and B corporations require the same accountability and transparency, which include public reports of the company’s overall social and environmental performance assessed against a third party standard.  However, performance for benefit corporations is self-reported, whereas B corporations must achieve a minimum verified score every two years by the B Impact Assessment.  Additionally, B corporations are available to every business regardless of corporate structure or state of incorporation.  The formal legal structure of benefit corporations is not yet available statewide. 

Lastly, B Lab certification can come at a hefty price, ranging from $500 to $50,000 a year based on the company’s revenues.  State filing fees for benefit corporations are a little more modest ranging from $70 to $200.

            For companies who already have a formal business structure, the B corporation certification is a more likely option, offering access to the B Lab and B corporation logo.  However, for those companies whose primary goal is to benefit social or environmental concerns, the legal status of a benefit corporation seems more practical especially as states continue to pass benefit corporation legislation.  

What are the Advantages and Disadvantages of Becoming a Benefit Corporation?

            As James Surowiecki notes in The New Yorker, “[i]t’s what behavioral economists call a ‘commitment device’—a way of insuring that you’ll live up to your promises.”  By giving directors legal protection to consider the interests of all stakeholders, not just the shareholders, benefit corporations gain entrepreneurial and investor flexibility.  Current trends suggest that consumer demand for corporate accountability is rising.  Thus, businesses with benefit corporation status may obtain a competitive advantage by banking on consumers, who would rather purchase from a company that shares similar social values.  Moreover, employee confidence in a company that is legally committed to benefiting more than just its shareholders may produce more efficient and successful results.

            Nevertheless, several disadvantages come with this futuristic entity structure.  One is expanded reporting requirements, including an annual report to the shareholders and public.  These reporting requirements place particular pressures to ensure that the business is actually providing the specific public benefit it set out in its mission.  Another potential downside is that benefit corporations are fairly new legal entities, and the law is still uncertain on how these entities will be regulated.  Moreover, legislation for benefit corporations varies from state to state.

            Another key aspect for entrepreneurs and investors to consider is that benefit corporations, unlike nonprofit organizations, are not tax deductible.  Thus, many expenses that exist for a traditional corporation also carry to benefit corporations.

How Great is the Potential for Benefit Corporations?

            We all remember the failures of BP, Enron, and Lehman Brothers.  Perhaps, if these companies had established a mission to benefit social or environmental issues from the moment of incorporation, the resulting public harms would have been less likely.  With current social movements, there is certainly a push for corporate social responsibility, rather than waste and greed.  With traditional American corporate law finding that corporate social responsibility is secondary to maximizing shareholder profits, it will be interesting to see how legal precedent develops for benefit corporations.  Supporters of existing corporate law claim that not much will change.  However, economic theorists have found that analyzing performance through profits have deprived businesses of judging other performance indicators.  Benefit corporations have the ability to enhance their competitive strategy by incorporating social values.  So far, some of consumers’ favorite companies like Patagonia, Warby Parker, and Etsy are producing popular products, reaping profits, and simultaneously giving back to society in charitable fashion.    

What Exactly is a L3C?

By Joseph P. Glackin

March 2017

In a world where choosing the right legal structure can result in various repercussions in how your business is formally run, it is important to understand the differences between the multitude of entities that one can choose from. One legal structure in particular that is often overlooked and thus not often considered is the L3C.

L3C stands for a low-profit, limited liability company, and is often described as a hybrid like structure comprised of both non-profit and for-profit attributes.[1] This hybrid entity is designed to attract private investments and philanthropic capital in ventures designed to provide a socially beneficial objective.[2] Even though the L3C has an explicit primary charitable mission and a secondary profit concern, it is free to distribute the profits to its members just like the standard limited liability company.[3]

Also like the standard limited liability company, the L3C has the same limited liability protection for its members, the same management structure, and the same pass-through tax status and flexibility in ownership, while also having some of the advantages associated with being a non-profit organization. One of these major advantages of the L3C is the myriad of funding options coming from foundations and their program related investments.

Program Related Investments

The IRS mandates by law that foundations have to direct 5% of their assets every year to charitable purposes to keep their tax-exempt status.[4]  Foundations have two viable routes for spending this 5%: they can make program related investments, or they can make grants.[5] Grants offer no return on investment, while program related investments offer a potential return. Taking this into consideration, it is easy to understand why program related investments would be the preferred options for foundations. Program related investments means a foundation can make investments in entities with a charitable or educational purpose where making a profit is not a significant goal, which essentially describes the functionality of the L3C structure.[6] This means that funding an L3C can be treated as a legitimate program related investment by foundations.

Therefore, choosing the L3C as a legal structure can provide an influx of funding sources from a myriad of foundations looking to keep their tax-exempt status.[7] These sources of funding are not available to for-profit entities, as a foundation would lose its tax-exempt status if it were to invest in a for-profit business venture. To give you an idea of how large these PRIs can potentially be, the Gates Foundation in 2011 set up a $400 million program related investment fund.[8]

Disadvantages

Even with their seemingly obvious advantages there are also many disadvantages to choosing a L3C. One of the most prominent disadvantages is that only 8 states recognize the L3C as a business organization under their applicable state law; these states being Vermont, Michigan, Wyoming, Utah, Illinois, Louisiana, Maine, and Rhode Island.[9] North Carolina was previously a part of this list, but repealed its recognition of the business organization in 2013. However, as is an option for many other entity structures, one can choose to form their L3C within one of these states, and register as a foreign LLC doing business in that state, but this can definitely be a deterrent for many social entrepreneurs outside of the previously listed states.

Another rather large disadvantage of the L3C is the associated uncertainty of whether the entity would qualify as a program related investment according to the Internal Revenue Service (IRS). This potentially hinders the large pool of investments from foundations, as they do not want to risk losing their tax-exempt status. This often calls for a private IRS letter ruling on whether the L3C would qualify for program related investment status.[10] These private letter rulings can take time and are potentially costly to obtain, so foundations may be hindered from going through with this process entirely. However, L3Cs are required by law to outline their program related investment qualified purpose within their operating agreements. This make the IRS rulings somewhat straightforward, and the process a little easier for foundations to make program related investments in social ventures while ensuring their tax-exempt status remains in place.        

Is it Right For You?

The L3C has become a small tool for achieving socially beneficial objectives within society. With this being said, the L3C structure could be a good route for entrepreneurs with socially beneficial objectives, and a limited concern on making a return or profit.[11] If this sounds like you or your business, maybe the L3C structure is the right option for you. However, make sure to take into consideration both the advantages and disadvantages of choosing this entity structure.

Some examples of successful L3C companies are the following:

SEEDR is an Atlanta based L3C dedicated to global health, infrastructure and financial innovation. In 2009 the Gates Foundation gave SEEDR a $539,566 investment to fund the development of “a new line of insulated containers for transporting and storing vaccines and other medicines in developing countries.”[12]

Disruptive Innovations for Social Change is a Michigan based L3C formed with the intent to “help workers, employers, and communities succeed.” In 2010 Disruptive Innovations received a $420,000 investment to document and replicate a model of employer resource networks.[13]

Univicity is a California based L3C organized under Wyoming State law that utilizes information technology to improve the efficiency and effectiveness of humanitarian aid NGOs.[14] In 2011 Univicity received both a $1.32 million investment and an additional $250,000 invesment from the Kay Family Foundation to support the development of their software.[15]

Other L3C entities that have been created throughout the years have been based around “alternative energy, food bank processing, a multitude of social services, social benefit consulting and media, arts funding, job creation programs, economic development, housing for low income and aging populations, medical facilities and practices in developing countries, environmental remediation, and medical research.”[16]

[1] http://www.nonprofitlawblog.com/l3c/

[2] Id.

[3] Id.

[4] https://www.forbes.com/sites/annefield/2012/05/04/irs-rules-could-help-the-fledgling-l3c/#3127621c2970

[5] http://www.triplepundit.com/2009/01/the-l3c-a-more-creative-capitalism/

[6] See https://www.forbes.com/sites/annefield/2012/05/04/irs-rules-could-help-the-fledgling-l3c/#3127621c2970

[7] See http://www.intersectorl3c.com/blog/104163/7726/.

[8] https://www.philanthropy.com/article/The-Gates-Foundation-Reveals/191365

[9] http://cullinanelaw.com/what-is-a-l3c/

[10] http://www.dmlp.org/legal-guide/should-you-form-l3c

[11] http://www.intersectorl3c.com/blog/104163/7726/

[12] https://nonprofitquarterly.org/2014/05/27/social-responsibility-or-marketing-ploy-the-branding-of-l3cs/

[13] Id.

[14] Id.

[15] Id.

[16] http://www.triplepundit.com/2009/01/the-l3c-a-more-creative-capitalism/

The Rise of the Public Benefit Corporation: Considerations for Start-ups

By Maria Stracqualursi

March 2017

What do Method Products, Kickstarter and Patagonia all have in common? They are all public benefit corporations (“PBCs”)! PBCs, also known as benefit corporations, are for-profit companies that balance maximizing value to shareholders with a legally binding commitment to a social or environmental mission. In contrast with other for-profit entities, which by law must focus exclusively on increasing investor returns, a PBC is required to consider other factors. A PBC’s charter identifies a public benefit, namely a positive effect or reduction of negative effects flowing to stakeholders, that is “artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific, or technological” in character. When making business decisions, in addition to considering the value to shareholders, PBCs also must consider other stakeholder interests, which may include employees, customers, certain communities, or the environment.

More than three thousand companies are now registered as public benefit corporations, comprising approximately .01% of American businesses. In 2010, Maryland became the first state to pass legislation creating public benefit corporations. Thirty states, including Delaware and Massachusetts, as well as the District of Columbia, now have laws allowing business to register as public benefit corporations, and seven more states have pending legislation. Public benefit corporations span the full range of industries and company sizes, from retail to education, and one-person businesses to multinational corporations.

Public benefit corporations are frequently confused with B-Corporations. Although the two are similar in name (the B also stands for benefit), they are very different in their legal significance. B-Corp status is a certification created and administered by B-Lab, a non-profit organization that assesses and verifies companies’ social and environmental performance and publishes a public B-Impact Report measuring the company’s social and environmental impact. There are currently over two thousand B-Corps. The cost of obtaining B-Lab certification can range from $500 to $50,000 depending on the company’s revenues, and recertification is required every two years. In contrast, it costs only $70 to $500 to register as a public benefit corporation. In order to qualify for B-Corp certification, a company must have a stated social or environmental mission with a legally binding fiduciary duty to consider the interests not only of shareholders but also of workers, the environment and the community. Whereas PBCs may elect to self-report on their performance, B-Corps are audited by B-Lab and need to earn a minimum score on the B-Impact Assessment to maintain certification. Furthermore, rather than establishing a legally binding responsibility to pursue a public benefit, B-Lab certification is simply a marketing tool that lends credibility to the advertising of the social focus of the company to its customers. According to B-Lab rules, businesses that are incorporated in states that have public benefit corporation laws are required, within four years from the date such legislation was passed or two years after B-Corp certification, to elect PBC status in their state of incorporation in order to retain B-Corp certification. Two American B-Corps, Etsy and Rally Software (which was later acquired) have gone public. Etsy, a Delaware corporation, must register as a public benefit corporation by August 2017 in order to keep its B-Corp certification.

So why should an entrepreneur consider registering their startup as a public benefit corporation? There are several benefits associated with registering as a PBC, especially for those companies whose social or environmental mission is essential to the way they operate their business. C-corporations and S-corporations are legally required to base their decisions solely on maximizing financial returns for shareholders. This can be constraining for companies who are driven by a social mission or who wish to be more environmentally conscious in their decision-making. By forming as a PBC, the company’s board of directors is actually obligated to go beyond their fiduciary duties and consider social and environmental factors when making business decisions. Directors and officers will be legally protected when they balance both financial and non-financial interests and pursue the company’s public benefit.

This protection creates added flexibility when directors are evaluating the sale of the company. C-corporations and S-corporations in Delaware must follow the Revlon standard, which establishes the duty of the board of directors to make business decisions based on increasing the short-term financial gains of the company. PBCs, on the other hand, can consider other factors besides whether the offered price and terms maximizes value for shareholders when making a determination of whether to sell the company and to whom, such as how the other company treats its employees or its environmental practices. This also means that there is less risk of a hostile takeover. Furthermore, companies can keep or terminate their status as a PBC either before or after a sale should the new owner wish to do so and can garner two-thirds of stockholder votes.

Registering as a PBC can also help emerging companies attract and retain consumers and talented employees. A 2014 study conduct by Horizon Media’s Finger on the Pulse showed that 81% of millennials surveyed “expect companies to make a public commitment to good corporate citizenship.” Thus, today’s companies must seriously consider commitment to social or environmental missions. Companies that organize as a PBC can distinguish themselves from their competition and align their corporate values with those of their consumers. The greater corporate transparency required by PBCs may also draw consumers who want to confirm the company’s commitment to a mission. Such guarantees to engage in promoting social or environmental benefits also may help the company attract employees who want to work for socially mindful businesses and who may sacrifice compensation for a sense of purpose.

There are certainly concerns surrounding PBCs that may cause entrepreneurs pause. Public benefit corporations are subject to more onerous reporting requirements than other corporations. This ensures greater transparency and that efforts are being made by the company to pursue its named public benefit purpose. Most states require PBCs to file annual benefit reports, which must be available to the public on the company’s website, that asses the social and environmental performance of the business. If the company fails to show a commitment to working towards these public goals, it can lose its public benefit status. Furthermore, stockholders of PBCs have the right to bring a derivative action against the company to enforce the business’ stated public benefit purpose. Thus companies must be serious about committing to a mission before registering as a public benefit corporation. Notably, third parties that stand to materially benefit from the company’s mission do not having standing to sue the PBC, unless this right is granted by the company’s stockholders. For example, Plum Organics, a Delaware public benefit corporation, seeks to deliver “nutrient rich, organic food into the hands of little ones in need across America.” Should Plum Organics, however, decide that it wishes to expand its market to sell food targeted to the elderly, “little ones” and their kin would not have standing to file a derivative action.

Given that these corporate entities are fairly new, there is also not a substantial amount of case law clarifying how courts will interpret the requirement that PBCs balance profits with purpose. This uncertainty, as opposed to the significant amount of court opinions especially in Delaware, may be a detractor for investors who fear potential litigation that could not only cost the corporation a significant amount of money, but also hold up funding rounds or exits. That said, both for impact investors and stockholders for whom the mission of the company is very important, this increased transparency and ability to hold the company accountable may actually make the business more attractive. Venture capitalists may also be concerned with the lack of PBCs that have gone public. However, as Laureate Education’s recent IPO shows, it is possible for PBCs to attract major investors and have a successful IPO.

Laureate Education is not only the largest, for-profit higher education institution in the world, it is also the largest public benefit corporation, with over four billion dollars in revenue. Laureate is also a B-Corp and uses B-Lab as a third party standard against which to track its performance as a public benefit corporation. The company, which runs 88 campuses across 28 countries, was a publicly traded C-corporation from 1993 to 2007 when it became private. In October 2015, Laureate Education converted to a Delaware public benefit corporation and filed an S-1 with the SEC. Laureate’s prospectus explained that its public benefit is “to produce a positive effect for society and students by offering diverse education programs both online and at campuses around the globe.” The company aims to provide access to affordable and high quality education in emerging countries, and names its stakeholders as students, regulators, employers, local communities and stockholders. The prospectus also acknowledged that the company has a long-term vision, and that short-term decisions in pursuit of the public benefit may negatively impact the business’ financial performance.

Although the IPO was delayed due to unstable financial markets and regulatory flux, student lawsuits, and controversy following claims that the Laureate had paid $17 million to former president Bill Clinton to serve as honorary chancellor during Hillary Clinton’s stint as Secretary of State, the firm decided to move forward with the public offering after the post-election market swell. The company is backed by major investors including Henry Kravis and Steve Cohen. On February 1, the company began trading between $12.12 and $13.22, less than their offer price of $14. Analysts have pointed to Laureate’s $4.2 billion debt, low revenue and risky for-profit education business to explain the weak demand from investors. Despite these concerns, analysts are excited to see the first IPO of a public benefit corporation, which may lead the way for other companies that make social and environmental improvement a priority.

Where does this leave startup founders? While a public offering will take years of business building for most companies, it is certainly exciting to see a PBC going public. It adds validity to the entity, and hopefully will continue a trend of greater acceptance of mission-driven businesses. Public benefit corporations are certainly viable and smart options for start-ups that wish to distinguish themselves from their competitors and ensure a commitment to a social mission while operating as a for-profit business.

http://benefitcorp.net/faq

https://www.kickstarter.com/blog/kickstarter-is-now-a-benefit-corporation

http://methodhome.com/beyond-the-bottle/our-business/

http://www.patagonia.com/b-lab.html

https://www.bcorporation.net/become-a-b-corp/how-to-become-a-b-corp/multinationals-and-public-companies

http://benefitcorp.net/businesses/benefit-corporations-and-certified-b-corps

https://www.bcorporation.net/community/plum-organics

https://thepienews.com/news/laureate-education-ipo-to-raise-490m/

http://www.baltimoresun.com/business/bs-bz-laureate-ipo-20170201-story.html

http://www.newyorker.com/magazine/2014/08/04/companies-benefits

https://www.sec.gov/Archives/edgar/data/912766/000104746915007679/a2209311zs-1.htm

https://www.nytimes.com/2015/04/17/business/dealbook/etsy-ipo-tests-pledge-to-emphasize-social-mission-over-profit.html?_r=0

8 Del.C. § 362

https://www.bcorporation.net/what-are-b-corps/certified-b-corps-and-benefit-corporations

http://www.investopedia.com/terms/r/revlon_rule.asp

Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986)