Leverage Hybrid Legal Forms
Social enterprises are increasingly exploring the strategy of creating hybrid forms to expand impact and income. Hybrid models bind nonprofit and for-profit entities together through governance and/or contract mechanisms — for example, a for-profit company that creates a nonprofit foundation, or a nonprofit that launches a for-profit to pursue a different type of revenue-generating activity. These models are often structured as parent-subsidiary relationships or as contract hybrids wherein contracts align their objectives on a long-term basis.
Regardless of the form, hybrid models can expand impact, increase access to different capital sources or customers, and provide important risk mitigation. Alongside those benefits, hybrid forms incur costs as they require additional overhead to manage two (or more) entities as well as additional legal complexity to ensure adherence to charitable restrictions — so that potentially conflicting transactions occur at arms-length.
Lesson 1: Leverage hybrid forms to increase income and extend impact
WSUP on launching a for-profit subsidiary. WSUP was focused on doing work in six core countries but it was seeing opportunities in different geographic regions, with different types of funders. Seeing an opportunity to extend its impact by bringing its expertise to more communities, as well as an opportunity to earn additional income, WSUP launched an internal team to provide consulting services. After 12 months, WSUP shifted from an internal team to launch a for-profit subsidiary — WSUP Advisory — that is 100% owned by the parent nonprofit. This for-profit structure allows WSUP to access different funders and revenue streams, mitigate risks, and attract talent that might not otherwise come to the nonprofit sector.
WSUP Advisory made a profit in 2017, and is on track to do so again in 2018. WSUP Advisory currently accounts for approximately 20% of WSUP’s revenue and targets a profit margin of 6–7%. However, regardless of the amount of profit that is cycled back to the parent organization, the leadership team sees this profit as an important source of unrestricted revenue that funds innovation and, more importantly, extends impact.
Yaver Abidi, Managing Director of WSUP Advisory, provided some additional context and caution: “WSUP Advisory is doing some amazing projects, building upon the expertise of WSUP. If it works, it’s not just about revenue and profit, it’s about finding another way to achieve impact. Approach it in that order if you can It’s not a money-spinner. Don’t do it from desperation. WSUP approached this as if it didn’t just see dollar signs. People somehow think it’s easy to make a lot of money on the for-profit side, but it really isn’t. Don’t approach it as a gravy train, because you will certainly fail.” He went on to say that it was critical for WSUP Advisory to be launched out of WSUP, which was in good financial health, because it provided the stability and platform to grow. “Starting something like this,” he said, “will not save a struggling organization. Don’t strap an eagle to the back of a turkey in the hope that both will fly.”
(To learn more about WSUP’s approach to scaling, read their scaling snapshot.)
Lesson 2: Keep strategy and ownership aligned with mission
B Lab on creating a for-profit subsidiary to raise equity-like capital. In 2012, a financial institution was interested in providing a significant loan to B Lab, a nonprofit which earns about 60% of its operating costs through earned revenue. B Lab was excited about the potential capital for scaling, but was concerned about creating excessive leverage on its balance sheet. So instead of a loan, B Lab and the financial institution devised a novel hybrid legal structure, executed in 3 steps:
1. B Lab set up a new, fully owned for-profit subsidiary (“New LLC”), and transferred its intellectual property into that subsidiary;
2. B Lab created an operating agreement in which it licensed back from New LLC the intellectual property for a fee equal to a percentage of B Lab’s operating income, or a guaranteed minimum; and
3. B Lab sold 50% of the economic interest (where the only income stream is the operating income percentage fee) of New LLC to the financial institution, while still maintaining 100% operating control of New LLC.For the financial institution, this agreement functions like an equity position in New LLC, providing it with rights to future cash flow indefinitely. For B Lab, the new hybrid structure avoided excessive leverage on its balance sheet, while reducing repayment risk by tying payments to fluctuating operating income. B Lab also has refusal rights for the financial institution’s sale of its interest with New LLC if B Lab deems there could be a negative impact on its reputation. According to B Lab co-founder Bart Houlahan, “At the end of the day, the financial institution receives about 10% of our operating income. If others are considering this structure, the key factors are separating the economic interest of the LLC from the operating control to avoid losing any rights to your intellectual property, and making sure the new LLC is in service of your non-profit mission.”
Advice from the Field on Pursuing Hybrid Legal Forms
If you’re just getting started…
- Consider a hybrid from a position of financial health, not desperation!
- Align purpose by starting with mission first, and seeing whether a hybrid form helps to expand your impact — not just your bottom-line.
- Make realistic assumptions (and test them) before launching a subsidiary. Will it ever be possible to cover all operating costs and generate a profit for the target audience that you seek to serve? How long will it take you to get to profitability and how much will you need to invest to get there?
If you’re digging deeper…
- Ensure clarity of boundaries among the entities, clear governance and decision-making rights, and culture alignment.
- Nonprofits CAN access equity-like funding if they have valuable intellectual property and a strong revenue stream and are willing to create a legal hybrid form.
- Be careful to consider and mitigate all the risks (legal, reputational, financial) of a hybrid structure.
- Make sure to protect your intellectual property and other assets, while maintaining control and alignment with mission.
Read next: Scaling through Disruption: Money Matters, Data for Scale, or return to see all articles in Money Matters.
This article was written by Catherine Clark, Erin Worsham, Kimberly Langsam, and Ellen Martin and released in March 2018.
