Enterprise options
Stephen Lloyd and Simon Steeden explain the legal vehicles available to charities for social enterprise operations and outline the proposed social enterprise limited liability partnership
KEY POINTS
- Charities can also be social enterprises
- A community benefit society can be a charity, a cooperative can not
- Community interest companies (CICs) are a popular structure
- A bespoke model is needed
Many charities are looking to develop new revenue streams, particularly where they have previously been reliant on state funding. At the same time, the Big Society agenda has triggered interest in social enterprise as a mechanism for transferring responsibility for provision of public services out of the state, whilst ensuring that those services are provided for community benefit and not just private profit. But what social enterprise structures are currently available for charities seeking to trade? And what developments are there on the horizon?
Charities and primary purpose trading
It is often forgotten that charities themselves can be social enterprises. Charities are entitled to trade as a means of furthering their charitable purposes – referred to as ‘primary purpose trading’ (see Edward Finch’s article ‘Neither fish nor fowl’ on page 15 of this issue). The sale of tickets by a charitable theatre is an example. Another is trading activities carried on by a charity’s beneficiaries, such as a charity set up to relieve poverty by facilitating the sale of goods or services by people in poverty. In each case the charity could be seen as a business enterprise trading in the open market with a social purpose – in other words a ‘social enterprise’.
There are clear benefits for a charity in keeping any social enterprise activities ‘in house’. The costs of establishing and running a separate organisation can be avoided and the enterprise can benefit from the charity’s existing staff, branding and resources without worrying about cross-charging, brand licenses or VAT.
But this approach may not always be possible and desirable. If the proposed social enterprise activities fall outside of the charity’s objects they will constitute prohibited, non-primary purpose trading, unless they are not considered to constitute a ‘significant risk’ to the resources of the charity. Where the primary purpose activities are risky, the charity may also want to insulate itself from that risk by using a limited liability trading subsidiary. Some of the main legal forms for non-charitable social enterprise are outlined below.
Industrial and provident societies
Industrial and provident societies can take two forms:
- community benefit societies; and
- cooperatives.
Both are corporate bodies, with their own legal personality separate from its members and with liability of those members limited to the value of their shareholdings. But the societies are not companies and company law does not apply to them, with many of the rules relating to societies contained in the Cooperative and Community Benefits Societies and Credit Unions Act 1965 and other related legislation.
Like normal commercial companies, cooperatives are owned by, and exist principally to benefit, their members (though they might also pursue wider social benefits). Unlike commercial companies, these members tend to be customers, employees or members of the local community, rather than institutional shareholders and all members have an equal say in governance of the society.
Community benefit society
If a society is set up to benefit the broader community, rather than its members, it should instead be a community benefit society, or ‘BenCom’. A community benefit society must have some special reason for seeking registration as a society rather than as a company and must explain this in its registration application. In practice, this means including a standard constitutional provision requiring that benefits will not be returned to the society’s members, demonstrating that business will be conducted for the benefit of the community and, typically, including a one member, one vote principle, regardless of shareholding.
A community benefit society can be a charity, if its objects are charitable and it confers sufficient public benefit. A cooperative cannot, because it will generally be established for the private benefit of its members. Charitable community benefit societies historically have not had to register separately with the Charity Commission. However, their exempt status is set soon to end, with the Charity Commission planning to begin to register and actively regulate these previously exempt charities (as soon as reservations about the potential for private benefit to members have been overcome).
All societies must be registered with the Financial Services Authority (FSA), which currently acts as their principal regulator. A society’s constitution is contained in its ‘rules’, which must include the matters contained in schedule 1 of the 1965 Act. It is possible to register a bespoke set of rules with the FSA or to take the less expensive route of adopting model rules produced by a recognised sponsoring body.
Raising equity capital
A distinct advantage of the industrial and provident society structure lies in its ability to raise equity capital, particularly by facilitating the community financing of social enterprise projects. Cooperatives can distribute a share of surplus profits to members in the form of dividends and all societies can pay interest on members’ share capital. Societies are also able to issue withdrawable share capital, which can be bought back (or redeemed) by the society in circumstances specified in the society’s rules. Arguably, because investors can get their money back and can earn interest on it, they are more likely to invest in society-run projects than make donations to charities. However, where withdrawable shares are purchased as an investment it is important to consider the circumstances in which those shares could be cancelled and the impact that this could have on their value.
Although community interest companies (CICs) and commercial companies limited by shares can issue redeemable shares, the difference is that with a company, shares must be redeemed out of distributable profits (and CICs are subject to further restrictions) whereas a society can pay the shareholder out of capital or profit. Withdrawable share capital is, therefore, unique to societies.
An additional benefit of withdrawable share capital is that it benefits from specific exemptions under financial promotions regulation, meaning that promotions leading up to an investment in a society need not be approved by an FSA-approved person (but will remain subject to the general law on misstatement and representation). A society can also issue transferrable shares, but these do not carry the same FSA exemption advantages as withdrawable share capital and there is no easy way of trading them, such as on a recognised UK stock exchange (although shares can be registered with a broker that will attempt to match private buyers and sellers).
Entrenching social purpose
Societies also provide the option of entrenching the social purposes of an enterprise in a way that is not possible with a standard commercial company. Most BenComs are able to include in their rules an unalterable asset lock ensuring that certain assets will always be applied for the benefit of the community and that assets can be transferred only for full value or to other asset-locked BenComs, charities or community interest companies. So, the asset-locked BenCom provides a credible option for a charity seeking to establish a trading subsidiary able to generate both financial returns to the charity and social returns to the wider community.
Community interest companies
The community interest company (CIC) was introduced as a new form of company in the Companies (Audit, Investigations and Community Enterprise) Act 2004.1 The CIC is an asset-locked company, specifically designed to deliver social enterprise. A CIC must be established for a specified community benefit purpose and its directors are duty bound to pursue this purpose over and above the maximisation of shareholder value. CICs must register with the CIC regulator and report annually to the regulator to demonstrate their continued pursuit of community interest.
As with other companies, a CIC is governed by its articles of association, which can be drafted individually or using model forms recognised by the CIC regulator. However, all articles must include certain standard provisions prescribed by the CIC regulator. These provisions include the statutory asset lock that ‘hardwires’ the pursuit of community benefit into the CIC structure, ensuring that its assets will primarily be used towards furthering its social purposes. The percentage of a CIC’s profits that can be paid out to shareholders as dividends are limited to 35 per cent of annual distributable profits in total and to 20 per cent of the nominal value of any share. Returns for ‘quasi-equity’ debt investment, where interest payable on a loan is linked to the CIC’s financial performance, is also restricted, with interest limited to no more than ten per cent of debt in any year.
The statutory dividend cap does not apply to transfers to another asset-locked body (although this is not the case with the performance related interest cap). So, CICs can be used as trading subsidiaries of charities without losing the ability to pay the subsidiary’s profits to the charity tax-efficiently by way of corporate gift aid. This means that CICs provide another effective vehicle for charities to ensure that their trading subsidiary will be used to promote beneficial social purposes at the same time as benefiting the charity financially from the subsidiary’s trading profits.
CICs can be established as companies limited either by shares or by guarantee. The advantage of the former is that equity investment potentially can be obtained from third party investors, provided those investors are willing to accept the asset lock. In practice, the majority of CICs are still established as companies limited by guarantee, partly due to the democratic ‘one member, one vote’ governance provisions typical of this format and a perception of more widespread recognition by grant funders.All CICs benefit from their grounding in company law, which is widely understood by professional advisers and subject to regular parliamentary review. They are also inexpensive to establish and maintain, with only a small fee payable to the CIC regulator for registration and no fees payable on filing changes to constitutional documents. These benefits have seen the structure boom since its establishment in 2004, with nearly 5,000 CICs now registered.
Commercial companies
In principle, there is nothing to prevent a charity or social entrepreneur from establishing a normal commercial company to pursue some form of social enterprise.2 Arguably, the trading subsidiaries of large charities such as Oxfam, which sell donated goods and use the proceeds to cover operating costs before donating surpluses to the charity, are social enterprises – they pursue a commercial enterprise for a social end.
Companies can be established either as share companies, allowing for equity investment and the payment of dividends to shareholders, or as companies limited by guarantee, in which membership generally is not transferrable and does not confer any financial benefits.
Using a commercial company to pursue a social enterprise has some advantages. Share companies are not constrained in their ability to raise equity finance (other than under financial promotions regulation) and the company structure is sufficiently flexible to allow the organisation’s social mission to change over time with the needs of beneficiaries. However, this flexibility is also a key disadvantage of the company when used as a vehicle for social impact. The objects of a company can always be amended by its members, allowing for the privatisation of community benefit purposes. The lack of an entrenched asset lock also means that there is no way to ensure the ongoing primacy of the organisation’s social mission over the pursuit of private profit.
Limited liability partnerships
Limited liability partnerships (LLPs) are effectively corporate partnerships with limited liability status. LLPs retain the organisational flexibility of a traditional partnership, with a governing document agreed freely between its members. However, the LLP has a legal personality separate from its members, like a company or industrial and provident society, and its members benefit from limited liability for the organisation’s debts.
As the LLP essentially is governed by a contract between the members, it is possible to agree that the organisation’s social mission will have primacy over its pursuit of financial returns. However, as with a commercial company, it will always be possible for the members to agree to amend that social purpose.
This makes it difficult to ensure that this primacy will always be maintained.
Nonetheless, the LLP model can offer some significant advantages to a charity seeking to pursue social enterprise. It is possible to make the charity a ‘golden shareholder’ entitled to veto any amendment of the LLP’s social purposes, thereby creating a de facto asset lock.
The LLP also has significant tax advantages where a charity wishes to pursue a social enterprise together with non-charitable co-investors. As the LLP is tax transparent, returns on investment into the LLP can be paid separately to each member and treated differently in accordance with each investor’s tax status.
However, LLPs should not be entered into lightly – they can raise complex issues in relation to tax and financial regulation and are likely to be appropriate only in a minority of cases.
The social enterprise limited liability partnership?
One of the difficulties faced by charities seeking to invest in social enterprise is the disproportionate regulatory burden they face in cooperating with private investors to achieve mixed social and financial returns.
A new legal structure designed specifically to tackle this difficulty is now on the horizon – the social enterprise limited liability partnership (SELLP). This would be a simple, cheap LLP designed specifically to combine charitable, state and private funding to achieve social goals as well as paying financial returns in a tax-efficient structure.3
The SELLP would have to be established to pursue a charitable purpose and regulated by the CIC regulator to ensure it abides by its social enterprise obligations. A minimum level of charitable investment would be required and a charitable golden shareholder would prevent changes to the purposes of the SELLP or its partnership agreement without its consent.
In return, some of the complexities of the LLP format would be swept away – legislation would make clear that it is legitimate for a charity established under English law to invest in an SELLP both under charity and tax law and that an SELLP would not be seen as, nor need to be regulated as, a collective investment scheme.
Outlook for social funding regulation
New approaches like SELLP are needed to bring new funding into the sector and tackle the pressing social problems that we continue to face. In the meantime, existing structures provide a variety of options for charities to use social enterprise to bring in new revenues without compromising their social impact motivations.
1. See: www.charitiesdirect.com/caritas-magazine/profits-of-the-right-sort-623.html
2. See: www.charitiesdirect.com/caritas-magazine/open-for-business-933.html
3. See the news story on the Caritas website about the report on the regulatory framework for social investment which campaigns for this structure: Investing in Civil Society http://tinyurl.com/6yxthc8
Author: Stephen Lloyd
Stephen Lloyd is senior partner of Bates Wells & Braithwaite London LLP and in his spare time is chair of the Centre for Innovation in Voluntary Action; vice-chair of Global Cool Foundation and serves on three other charities.
Author: Simon Steeden
Simon Steeden is a solicitor for charities and social enterprise at Bates, Wells and Braithwaite London LLP.
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