UPDATE: Bill to be Signed Tomorrow, April 30th at the State House, 10:30am.
Hat tip to BP who started the conversation on Low-Income Limited Liability Companies in his diary, “In the Business Section.”
Once the governor signs the bill, Vermont will be the first state to allow this unique business entity, aptly referred to as “The For Profit With a Non-Profit Soul.” Frankly, I think this is a great opportunity for Vermont and reassures me that maybe we haven't lost our sense of national leadership on progressive issues. Vermont now has an expansive opportunity to lead the nation in the creation of L3Cs which can operate here or anywhere in the world.
There's a great PDF presentation on the subject, from which I draw some thoughts below the fold. Also, you can get information about the driving force behind L3Cs at www.americansforcommunitydevelopment.org
What is an L3C? Why is it useful? Answers and examples of a couple creative applications below the fold.
Business as usual just got a lot more interesting….
The L3C is legal solution that allows a philanthropic orgranization to invest, create, or purchase for-profit companies in an effort to fulfill its mission. Apparently, this is similar to the original purpose of the Program Related Investments (PRI). The reasons PRIs aren't commonly used are two-fold.
- First, non-profit leaders are cautious about tax law, and rightfully ask, “Would the proposed PRI concept fit the IRS definition?” That question, it turns out, requires an IRS Private Letter Ruling, a process that costs tens of thousands of dollars and about a year and a half processing time. So a PRI presents an immediate financial and bureacratic hurdle. This can make a PRI more bother than it might be worth, especially since the investment presents a risk unlike other prudent investments the non-profit might ordinarily make.
- Second, a PRI's primary objective is shareholder interest, otherwise known as Return On Investment. The bottom line is that the non-profit's mission is really nothing more than a nice marketing message, making a PRI more like a standard Socially Responsible for-profit company. Since the PRI is required to put shareholder interest ahead of the non-profit's mission, the investment can inadvertantly run counter to the foundation's mission and goals.
So why is an L3C important and how does it work?
It doesn't take an expert on non-profit organizations and private foundations to discover an entrerprenurial solution to a foundation's missions and goals. In fact, if foundations and non-profits begin to put for-profit entrepreneurs to work, they can expect to see some really creative solutions brought to the table. The timing for the birth of L3Cs is very intriguing, too. As we being to experience significant changes in our food, fuel, and consumer economy, L3Cs can offer the new , for-profit solutions without being tied to short-term, quarterly gains expectations. Also, as we begin to enter a recession, L3Cs can help sustain economic activity as it allows venture capital from a completely unlikely source: private foundations.
So what kind of business would a private foundation purchase, invest in, or form from the ground up? The answer would depend on the foundation's mission and goals. There are as many opportunities as there are private foundations and non-profit orgs.
Let's offer a hypothetical.
Farm Foundation, which has worked in the area of economic and policy issues affecting agriculture for 75 years, wants to fulfill one of their High Priority Topics, in the area of Environment and Natural Resources. At the root of this non-profit initiative is a clear desire to help reduce the environmental impact from farms. The traditional non-profit method is to facilitate the work already being done by others. But the root of the problem can also be approached with a for-profit business solution.
For example, dairy farms impact waterways with excess phosphorous runoff. It happens that there is a for-profit feed solution which reduces phosphorous, improves milk output, and improves the health of the farm's herd. But the average farmer won't see an immediate financial benefit significant enough to justify the investment. Farm Foundation might consider creating an L3C named Phosphorous Solutions to purchase the technology and get the product out to market on at a lower profit margin, making the product more accessible. At the same time Farm Foundation fulfills it's High Priority initiative via Phosphorous Solutions it generates revenue for continued reinvestment instead of just giving the money away. It also fills in an economic gap which would have been left void by virtue of market failure. Farmers wouldn't have bought the product because it was too expensive and the traditional for-profit couldn't offer an affordable discount because it would not make a reasonable profit for its shareholders.
The real opportunity for L3Cs is in these areas where there is an opportunity for gain that has not been captured for one reason or another. In that sense, maybe we can call the L3C the solution for market failure. Using the vehicle of the L3C, foundations can:
- Promote creative efforts to offset negative externalities in the marketplace, such as pollution. In that regard, L3Cs could become the primary tool in the environmental economy. L3Cs can also:
- Support positive externalities, such as health and wellness clinics. Imagine a low-income healthcare model supported with a captive insurance company. The combination of controlling health care costs on both the risk management side (the captive insurance company) as well as the provider side (low-income health care clinic) would be a truly American solution to the problem of health and wellness.
The possibilities are endless. Why not create an alternative energy utility L3C? How about solving the problem of Internet and cell phone connections in rural areas? Transportation? Etc. Etc. At at time when rational people have reason to be concerned about our economy, national debt, global competition, climate change, fuel costs, food and hunger, the L3C model offers new hope in it's unique position in providing potential safety nets where ever there is market failure in alignment with non-profit missions and goals.
To understand a little more about where this proposal is coming from, here's an example from the PDF linked above.
Take a hypothetical foundation with a $100 million endowment. If it conducts business as usual,
it distributes $5 million per year in the form of grants. At the end of ten years, assuming the
foundation’s endowment does not grow, it will have spent $50 million on social causes in the form of
grants.Contrast that with a $100 million foundation that spends 100% of its grant money in the form of
PRIs. Let’s say it earns an annual return of as little as 2% on PRIs, which it substitutes for grants.
Again, for the sake of simplicity, assume that the endowment does not grow. In the first year, it
spends $5 million; the second year, $5,100,000—and so forth. At the end of ten years, that means the
foundation will have spent $54,748,605 on social causes—an increase of about 9.5 %. On top of that,
the money will still be there—ready to be spent on yet more social issues.But, when it comes to extending the impact of foundation dollars that is not the end. The final
key is a concept known as layering. In fact, various foundations in partnership with New York City
used such an approach to build 40,000 new affordable housing units. The foundations provided $14
million ($1 million to $5 million each) in PRIs, and the city appropriated $8 million. As a result, the
project includes $200 million in bank debt which otherwise would not have been available. That’s a
leverage ratio of 9:1.But that’s just the beginning. After all, is there any reason that such deals, properly structured,
can’t also include partners like pension funds and other fiduciaries? Or smaller foundations, for that
matter—especially if we institutionalize the more user-friendly L3C? If leverage of the foundation
dollar in terms of social impact is what we want, in fact, the ideal PRI or L3C could even be equity
rather than debt.Take our project in North Carolina, where 60,000 manufacturing jobs have been lost in the last
five years due to competition from China in the form of low labor costs, looser environmental and
labor laws, subsidized buildings and equipment etc. For many of these workers, these jobs are 3rd or
4th generation. It’s not just jobs that are disappearing, but an entire culture. And as this culture
disappears, entire communities are being destroyed.As a small foundation, we want to level the playing field so these manufacturers can survive.
After the North Carolina legislature adopts the L3C, our first order of business is to form an L3C with
which to buy a factory where we will house a furniture manufacturing plant and furnish it with the
greenest and most efficient cutting edge equipment possible. As a foundation making a “social
investment” in a “low profit” company that replaces a grant, our goal is not to maximize profit.
Therefore we can make long-term investments like green equipment.The cheapest way to own the building, of course, is to buy it outright. Without a mortgage to
pay, the L3C can charge a furniture manufacturing company lower rent and equipment lease rate.
This, in turn, reduces costs for the manufacturer, which puts it in a stronger position to compete
—and thrive. The social benefit is saving jobs and a culture and promoting community economic
development.We estimate that it will be possible to lease the building and its equipment to the manufacturer
at a low rate: about 2%, plus a 1% management fee. But there’s no reason the return from the lease
can’t be split among different tranches of investors: 1%, or less, say, for foundations who treat this
PRI in an L3C as a grant by putting up, say, 20% of the total $10 million cost. And 5% for fiduciaries
who must match market returns when making such investments. (The endowment side of a
particular foundation could co-invest as a fiduciary.)Is it really appropriate to use foundation dollars to make such high risk investments? The
answer is: Does it really matter if the foundation loses money on an L3C or PRI? Remember, these
investments are intended as substitutes for grants, which foundations are required by law to
distribute anyway. Think about it this way. When a foundation makes a grant, it loses the money
forever.
Now that I've done my homework on the subject, I'd like to thank Bob Lang and the Manweiller Foundation for this kind of creative thinking. The L3C is an ingenious idea that comes at an appropriate time.
Nate Freeman
Northfield
NateFreeman@gmail.com
