New corporate forms to protect your investment in impact

R. Todd Johnson
Guest Author

R. Todd Johnson

Editor’s note: This post is part of ImpactAlpha’s series, “Frontiers in Social Innovation,”  the Center for Social Innovation at Stanford’s Graduate School of Business. The posts in the series are adapted from “Frontiers in Social Innovation,” edited by Neil Malhotra.

For more than 20 years, the emerging class of mission-driven entrepreneurs and impact investors have struggled with the false binary imposed by laws that force them into a “1” (a for-profit) or a “0” (a charitable organization). 

Driven primarily by the tax code and its legitimate policy goal of avoiding the use of tax subsidies to create private wealth, historic legal structures created obstacles for entrepreneurs and investors alike. Those obstacles are sometimes practical in nature, but frequently are in the thinking brought to bear in funding impact. 

The over-simplistic thinking has been: If you want to “do good,” then you should set up a charitable enterprise, take donations and pursue your mission. If your model can make money, then you should take investment and grow as quickly as possible, with the discipline and efficiency of private capital.

Unfortunately, this thinking often progresses to false negative implications, including that private capital is “bad” or even “evil,” and that philanthropy is inefficient or at least undisciplined. Neither is necessarily true.

Entrepreneurial and legal innovation have chipped away at this false binary, opening possibilities for entrepreneurs and impact investors to align business models with impact models. To assist entrepreneurs and impact investors, I partnered with Sarah Soule at Stanford’s Graduate School of Business and its Center for Social Innovation to pioneer online resources reviewing structural options, designed for use prior to consulting lawyers.  

Built around the entrepreneur’s and investor’s primary decision criteria – mission anchoring, revenue opportunities, incentive alignment, external funding, governance, scaling impact, and costs – this content suggests structures that entrepreneurs and investors might discuss with lawyers in an effort to better protect the impact of their investment.

Best of both worlds 

Increasingly, entrepreneurs attempt to attack the forced binary choice by doing both. With a so-called “tandem” approach, they establish a non-profit that owns a for-profit company, or establish two loosely affiliated entities – one a non-profit and one a for-profit – that align around mission and approach. 

Such structures offer obvious benefits, such as enabling the acceptance of philanthropic capital (particularly at the earliest stage) and providing tax deductions to donors, but also enabling investment capital (particularly after demonstration of a minimum viable product), permitting the opportunity for scale and value appreciation in the stock. 

These tandem structures were pioneered decades ago, primarily in the healthcare arena as non-profit hospitals entered other businesses. But they often carry real costs, given the compliance challenges of navigating IRS rules. As a result, tandem structures are not for the faint of heart and typically require the use of outside legal resources that are out-sized for most start-up ventures.

Corporate hybrids

Hybrid corporate forms now exist in most states and offer entrepreneurs the opportunity to capture their company’s multidimensional purpose in its founding documents, including in Delaware with its public benefit corporation or PBC. These hybrid forms have become more popular over the past decade, thanks to the work of B Lab, a certifying organization that uses the PBC as an anchoring requirement (among others) for its B Corporation certification. 

These hybrid forms create a new allowance for directors to consider the impact mission. In traditional corporations, directors owe fiduciary duties to apply their business judgment to do what is in the best interests of their stockholders and, in certain circumstances, to maximize stockholder value. By contrast, in a PBC, when a duty to maximize stockholder value accrues, directors needn’t give primacy to this consideration, but may balance their obligation to stockholders with other stakeholder interests and a public benefit set forth in their corporate charter. 

For example, this balancing allowance permitted directors to pursue their remarkable transaction last year that resulted in a donation by nearly 85% of investors’ stock to an affiliated charitable organization, and a subsequent merger of the company into a subsidiary of the charitable organization (disclosure: I served as a consultant to

The remaining stockholders (including employees holding stock options) received fair market value consideration for their stock, permitting the furtherance of the PBC’s mission through 100% ownership by a non-profit, rather than awaiting a later, potentially better offer some day in the future, by an independent, third-party purchaser, that may or may not have been mission aligned.

Incentives and alignment

Unfortunately, entrepreneurs and investors often fail to appreciate that organizing as a PBC, while necessary for mission considerations, remains insufficient for mission anchoring. 

Although conversion to a public benefit corporation requires directors to balance the mission against their other fiduciary duties owed to stockholders, it does not ensure that the mission will always remain anchored. What can be done with a majority vote (converting from a traditional Delaware company to a PBC), can be undone by a majority vote. 

One need only look to the fate of Etsy. The online crafts marketplace qualified under a grandfather provision as a B Corp, but never became a public benefit corporation before it went public, and now won’t, having dropped their certification to avoid the transition requirement.

Danone, a public company whose North American operations became a B Corporation, has since faced stockholder pressure to abandon its social mission that resulted in the ouster of its CEO.

For this reason, start-up entrepreneurs and impact investors often consider legal design options for structuring traditional companies that desire to remain mission driven regardless of the corporate form selected. This often results in unbundling the rights typically represented by common stock, and creating separate classes of stock that can better allocate attributes such as appreciation value, income streams, and governance rights to align with the long-term mission of the enterprise. For example, more entrepreneurs are using Founders’ Preferred stock (or so-called FF Stock) to anchor the mission.

I would note that entrepreneurs often ask about super-voting stock, made popular among technology companies by the founders of Google and Facebook. Typically, this is not an option for most entrepreneurs, unless they are building the next Google or Facebook, given the allergic reaction of investment capital to such affirmative control residing exclusively in the hands of founders, and for good reason. 

Creation of a super-voting class of stock might solve issues around mission anchoring, but investors view it as an over-broad solution, putting investment capital at the risk of a “bad actor” entrepreneur. Those who doubt the concern need only look at the case of WeWork. The traditional design of FF Stock allows founders to take a little money off the table during subsequent financing rounds, rather than awaiting a terminal event (i.e., a merger, sale, or public offering). 

But more and more often, founders are also using the Founders’ Preferred vehicle to borrow the negative control features of venture preferred stock, but built solely around issues that may negatively affect the mission (such as switching from a PBC to a typical Delaware corporation). Simply put, the negative covenants attached to Founders’ Preferred stock permit the founder to vote this special class of stock to veto certain specified actions that might subvert the mission. 

Network for Good used Founders’ Preferred Stock when it spun its software platform out from a non-profit to a PBC. In that case, the negative control features included a sale of the company that negatively affected the mission (disclosure: I was counsel to N4G for this original structuring). The non-profit used its FF Stock as leverage to avoid a transaction pushed by investors where the sale was not well mission-aligned. Instead, the company recently sold in a transaction that both aligned with the mission and produced a better return for stockholders.

Impact performance bonuses

Impact investors have begun working with entrepreneurs to consider alternatives to stock options as mechanisms for incentive alignment. Traditionally, employee stock options served as the primary mechanism for long-term incentive compensation, aligning employees with investors around the fundamental goal of venture investing – appreciation value. 

But just as traditional venture investing carries built-in impatience driven by the metric of success – the internal rate of return – stock options carry a similar type of impatience and, therefore, expectation, for a liquidation event (i.e., a sale, merger, or public offering).  And in the case of investing for impact, impatience is not always a mission’s friend. As a side note, if a social enterprise or its impact investors have no real intention of entertaining an exit, then the dictates of fairness recommend that a company avoid creating false expectations among employees with stock options.

In most ways, the traditional stock option creates almost no incentives that are aligned with the long-term mission of a mission-driven enterprise. As a result, some ventures have begun employing performance metrics aligned with mission goals as a vehicle for measuring employee bonuses. This periodic monetary incentive, built upon individual contributions towards the outputs and outcomes measured to evaluate the success of the social enterprise’s impact, are often used in addition to stock options, rather than in lieu of stock options. 

Of course, in order to implement such a bonus program, an enterprise must have a robust impact measurement and management, or IMM, process. IMM represents an emerging and growing discipline where new tools and insights are developing quickly, sometimes monthly. As more and more data becomes available for tailoring compensation to impact performance at the individual, as well as the enterprise level, so do possibilities of further evolution in the legal structures and vehicles used for aligning incentives. 

As both entrepreneurs and impact investors focus on innovative ways to protect their investment of time, talent, and capital in the impact they are creating, they are moving beyond the traditional models that protected only capital investment and incentivized only around growth and value appreciation. 

Their innovation is pushing innovation as well in the legal profession, with its stodgy, status-quo reputation, forcing considerations beyond the traditional false binary set of choices.

R. Todd Johnson is a consultant, advisor and director for mission-driven enterprises. He was a co-founder and CEO of iPAR and a partner at the global law firm, Jones Day, where he co-led the energy practice and founded and led the renewable energy and sustainability practice and the Silicon Valley office. 

Disclosure: Johnson is a member of ImpactAlpha’s board of directors.