Able to Take Equity Investments. For-profit companies have the flexibility to bring in investors ranging from friends and family to institutional investors seeking a piece of the pie. Equity investors can provide the necessary capital, expertise, and an expanded network to help scale the impact of your venture.
No Limits on Revenue Generation. Unlike a nonprofit, there is no limit on a for-profit company’s ability to generate revenue by providing goods and services.
Limited Ability to Receive Grants, and No Tax Deduction to Donors. One big drawback of for-profit companies is that they are not generally eligible to receive foundation and government grants (with some exceptions). This stems from the fact that for-profit companies cannot offer tax deductions to donors, whereas non-profits can.
Taxes. To state the most obvious disadvantage, for-profit companies must pay taxes.
There are various kinds of nonprofits, but the most common is a nonprofit that seeks tax-exempt status through Section 501(c)(3) of the Internal Revenue Code. This type of nonprofit is the focus here.
Able to Receive Grants and Offer Tax Deduction to Donors. Donations to 501(c)(3) organizations are tax-deductible. Thus, 501(c)(3) nonprofits are among the largest recipients of government and foundation grants as well as individual donations. The ability to attract this type of funding is an important factor for businesses operating in a field with significant opportunities for grants, such as education or healthcare.
Taxes. Nonprofit organizations can receive tax-exempt status, thereby eliminating the necessity of paying taxes.
Limit on Revenue Generation. To summarize a complex and often misunderstood topic, a nonprofit can in fact sell products or services. However, if those sales are unrelated to the purpose for which the nonprofit received tax exemption, those aspects of the organization’s activities will be subject to tax. If the unrelated revenue is too substantial, the nonprofit risks losing its tax-exempt status.
No Ability to Take Equity Investments. Because a nonprofit does not have “owners” in the same sense that for-profit companies do, there is no equity to dish out. This means you would not be able to bring on equity investors, which eliminates a significant source of funding.
HYBRID STRUCTURE: BOTH A FOR-PROFIT AND A NONPROFIT
As we have seen, there are obvious limitations, as well as opportunities, associated with forming as purely a for-profit or purely a nonprofit. Therefore, it may make sense for some social entrepreneurs to pursue a combination of the two by forming both a for-profit and a nonprofit to serve the holistic needs of the organization.
Flexible Funding. Creating a hybrid structure allows access to grants and donations, as well as the ability to take on equity investors.
No Limit on Revenue-Generating Activities. As long as revenue-generating activities are carried out under the for-profit umbrella, there is no limit on generating revenue through the sale of goods and services.
Complicated Structure and Legal Issues. The tricky thing about these hybrid structures is how they are structured (and it is imperative that they are structured properly). The biggest concern with operating a hybrid structure is that you absolutely cannot exploit your nonprofit’s tax-exempt status to provide an improper “private benefit” to the for-profit business. Additionally, when operating under a hybrid structure you have to run two distinct organizations, each of which must follow all formalities associated with running either type of entity.
HOW HYBRID STRUCTURES WORK:
When it comes to creating a hybrid structure for your venture, there are two options:
1 PARENT-SUBSIDIARY. The first hybrid structure option is to have the for-profit be a subsidiary owned (in whole or in part) by the nonprofit. To do this, the nonprofit has to qualify as a “public charity,” which means that it must get most of its funding from public sources in order to satisfy the public support requirement. Note that you cannot have a for-profit own a nonprofit because there is no private ownership in a nonprofit.
2 BROTHER-SISTER. You can also have the nonprofit and for-profit be entirely separate entities that work together.
Under either structure, as a general rule, money can flow from the for-profit to the nonprofit, but not from the nonprofit to the for-profit (except as specified below). The for-profit entity can donate money to the nonprofit (lowering its tax liability by up to 10 percent of its net income), but because all assets of a nonprofit must be permanently dedicated to charitable causes, a nonprofit cannot give away its funds to the for-profit.
However, the nonprofit can purchase goods and services from the for-profit at reasonable rates as long as the proper formalities are followed. For example, when a nonprofit purchases a for-profit’s services, the board of the nonprofit must be fully informed of the terms of the purchase (which must be at or below market rate), and none of the board members with an interest in the for-profit may participate in the board’s decision to approve the transaction. For this reason, the board of the nonprofit must not be identical to the group of decision-makers in the for-profit.
While the hybrid structure is sometimes tricky to navigate, it can offer social entrepreneurs the best of both worlds: the advantages of both nonprofit and for-profit organizations. No matter which structure you choose, it is important to understand the advantages and disadvantages of each option and make thoughtful decisions to set up your venture in a way that serves your unique goals.
Ryan Shaening Pokrasso is an attorney who founded Elevate Law & Strategy in the San Francisco Bay Area to assist entrepreneurs using business as a tool for social change and environmental stewardship. Ryan advises for-profit and nonprofit businesses as general counsel on matters ranging from entity formation and financing to intellectual property.