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University of California, Berkeley

Corporate Form and Social Entrepreneurship: A Status Report from California (and

Beyond)

Eric Talley (UC Berkeley)Berle V; Sydney AUS

May 2013

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Outline

The View from 20,000 Feet (6096 metres)– Current state of play in social ventures

Overview of new social ventures forms, and whether/why there is a perceived need for them

The California Experiment (one year in) Interpreting Results (so far)

– Investing Challenges– Assessing Fidelity to Public Purpose– Canaries, Caves and Legal Experimentation

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The View from 20,000 feetEnhanced Corporate Focus on Sustainability

For almost 2 decades, business entities of all sizes have become increasingly engaged with social and environmental issues.

Environmental Sustainability CSR (Corporate Social Responsibility) ESG (Environmental, Social, and Governance) metrics Double (or triple) bottom lines

Traditional corporations have been setting up non-profits (Google.org) and engaging in more robust and integrated CSR / ESG / sustainability programs.

Major consulting firms like McKinsie have joined boutique firms like BSR and Green Order in advising the Fortune 500 on how to become more environmentally sustainable.

Private equity firms like KKR and Carlyle are collaborating with the Environmental Defense Fund to review Environmental, Social, and Governance (ESG) factors to create value and unlock opportunities in their potential investments.

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Capital Market Trends – Investments in Sustainability Space

Increasing emphasis (particularly with impact investors) on measuring the social/environmental return on investment (SROI)– E.g, Sustainable and Responsible Investing (SRI) index, tabulates total

investment in social ESG-screened enterprise stocks and mutual funds

1995 1997 1999 2001 2003 2005 2007 2010$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

SRI Investments in US (1995-2010; $US bil)

Source: Social Inv. Forum Fnd’n (2011)

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Monthly Returns; ESG Equities (2005-pres)Consistent with small discount on comparably sized portfolio firms

Source: CRSP

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Public Company Governance Trends – Shareholder Resolutions

Shareholder resolutions (submitted under Rule 14a-8(i) of the Securities Exchange Act of 1934) on environmental concerns and sustainability reports remain the most common, and fastest growing, type of resolutions.

Social and environmental resolutions have increased 50% in the last 10 years, with more than 450 filed in both 2011 and 2012.

Climate change and fossil fuel production alone had a record breaking 109 shareholder resolutions filed with 81 U.S. and Canadian companies in 2011.

“Support for social and environmental resolutions has become increasingly mainstream.” – Michael Passoff, CEO of Proxy Impact

In 2011, there was 21.4% average approval for these proposals, the first time this support level had reached the 20% mark.

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Up next?Corporate Legal Reform

What, exactly, are these new forms as legal entities? FPC / Benefit Corps / L3Cs Why their emergence now?

How (if at all) is their legal structure distinct from conventional forms, as well as from one another? Statement of purpose in charter / bylaw provisions Fiduciary Duties (Care/Loyalty/Waste) and Business Judgment Rule Practical plasticity of shareholder primacy arguments Constituency statutes Other legal forms (Non-Profits; Hybrids)

Primary Answers Offered (jury still out, btw)– Cumbersome Corporate / Tax Statutes (E.g., California Corp. Code)– Signaling (to investors / customers / employees, etc)– Commitment; Short-Termism; FDs; and “Mission Creep”– M&A Context (Unocal / Revlon duties)– Pragmatic off-the-rack Middle Ground between For- and Non-Profit

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For those who fancy Technical Diagrams…

Mon

ey

Love

Traditional C Corps

Non-Profits

“New” Social Venture Forms

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Benefit Corporation (BC)

Arose from (but distinct from) B Lab’s “B Corporation” certification process. Companies can self-audit their socially responsible practices

under the B Lab standards and then pay a royalty to license the “B Corporation” mark for display.

B Lab co-drafted what became the Benefit Corporation legislation.

Various forms of this statute now exist in numerous states; California’s went effective on Jan. 1, 2012.

Mandatory general social purpose (at minimum); third party compliance report; special enforcement proceeding

There is significant variation in the Benefit Corporation legislation among the states; sometimes not integrated smoothly into preexisting corporate codes.

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An Early Adopter…As seen on morning run along Bathurst St., Sydney 6:53 AM, 14 May 2013

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Flexible Purpose Corporation (FPC)

Crafted by the Working Group on New Corporate Forms, a group of 10 corporate lawyers from big and small firms, academia, and members of the Corporations Committee of the State Bar.

Signed into law by California Governor Brown in October 2011 and effective January 1, 2012.

Creates a new “safe harbor” in addition to the business judgment rule and requires boards and management to consider tailored ESG social goals in addition to shareholder value in both the ordinary course of business and change of control situations.

Protects boards and management from shareholder liability in connection taking action in furtherance of articulated social/environmental goals.

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Aside 1: A Note on “Hybrids”

General term for when a non-profit sets up a for-profit subsidiary or vice-versa

Also can refer to a close contractual relationship between the entities For-profits set up foundations (problems with arcane IRS rules) Non-profits (public charities) set up a for-profit, either majority (over

50%) or minority (20% or less) held Can sometimes be difficult to establish and maintain from both a legal

and an operational perspective Contracts between the two entities – e.g., paying for services, use of

equipment, license of IP, income from rents and royalties, etc. Issues with employee placement and compensation, as well as board

overlap and oversight

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Aside 2: Low Profit Limited Liability Company (L3C)

Statutory variant of the LLC considered in a few dozen states, and currently adopted in 8 (not Inc. CA).

Principally designed to assist for-profit companies that have a primarily charitable purpose and hope to obtain program-related investments (PRIs) from foundations.

Billed as a simple answer to a complex problem, these entities still have all of the issues of the LLC from an investment perspective and (according to some practitioners) have not made PRI investments any easier.

Both the L3C and LLC have limited capital market acceptance.

NOT ADDRESSED IN THIS PAPER / PRESENTATION

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A Scorecard of Adopting States’ Statutes

Non-Shareholder Stakeholder Standing to

Enforce?

Dissenting Shareholder

Rights Protection?

Min. Status or 2/3 Vote (Default)

Requirement to Change Purpose?

Creates New Officer or Director

Oversight Position?

Third-Party Accountability Standards Required?

Enforcement Through Special

Actions or Proceedings?

General Social

Purpose Required?

Special Social Purpose

Required?

Stock Certificate Notification

Requirement?

California FPC No Yes Yes No No No No Yes Yes

California BC No Yes Yes No Yes Yes Yes No Yes

Hawaii BC Unclear No Yes Yes Yes No Yes No No

Illinois BC No No Yes Yes Yes Yes Yes No No

Louisiana BC No No Yes Yes Yes Yes Yes No Yes

Maryland BC No No No No Yes No Yes No Yes

New Jersey BC Unclear No Yes Yes Yes Yes Yes No No

New York BC No No Yes No Yes No Yes No Yes

South Carolina BC No Yes Yes Yes Yes Yes Yes No No

Vermont BC No No Yes Yes Yes Yes Yes No No

Virginia BC No No Yes No Yes Yes Yes No No

Washington FPC No Yes Yes No No No No Yes Yes

Recent Additions: Arizona (2014);Arkansas (2013); Massachusetts (2013); Pennsylvania (2013) (All Ben. Corp. Statutes); Pending in others (Del; NV)

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California: Unique among adopting states

Economic Significance CA Long Arm Statute (CA Corps

Code §2115) ensures many domestic incorporations

Unique Experiment (simultaneous FPC/Ben Corp enactments 2012)

Availability of Data from State of California Sec. of State’s Office

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What we thought we might see…Oklahoma, 1889

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What we actually gotCalifornia, 2012

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Aggregate Take-up in 2012(Total New Statutory Business Entities in 2012: > 60,000)

Benefit Cor-porations; 91

FPCs; 24

California FPC and Benefit Corps Formations: By TypeJanuary-December 2012

Source: California Corporations Commission

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Time Trends

Jan. Feb. Mar. Apr. May Jun. July Aug. Sept. Oct. Nov. Dec.0

2

4

6

8

10

12

14

16

18

2020

9

6

910

7

10

6

109

7

13

19

8

4

78

7

54

9

4

6

10

1 12 2 2

0

5

21

5

12

California FPC and Benefit Corps Formations: By Type and MonthJanuary-December 2012

Total Benefit Corp FPCSource: California Corporations Commission

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Health

Education

Youth

Poverty

Environment

Energy

Civil Rights / Liberties

Charity/Other

General Purpose Only

0 5 10 15 20 25 30 35 40 45

Articulated Social Purpose(Jan. – Aug. 2012)

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Geographic Characteristics

NoCal55%

SoCal37%

Out of State8%

California FPC and Benefit Corps Formations: By HQ LocationJanuary-December 2012

Source: California Corporations Commission

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Means of Formation

Conversions / Amendments

New Incorporations

0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00%

19.83%

80.17%

California FPC and Benefit Corps Formations: By Means of FormationJanuary-December 2012

Source: California Corporations Commission

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Firm Vintage

New Less than 1 year 1 - 5 Years 5 - 10 Years 10 - 20 Years More Than 20 Years0

10

20

30

40

50

60

70

80

90

10093

74 4 3 5

California FPC and Benefit Corps Formations: By AgeJanuary-December 2012

Age in Years

Freq

uenc

y

Source: California Corporations Commission

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Firm Vintage and Means of Formation

New Incorp

Conversions / Amendments

0

10

20

30

40

50

60

21

2

54

39

California FPC and Benefit Corps Formations: By Type and MeansJanuary-December 2012

FPCs Benefit Corps.Source: California Corporations Commission

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First Quarter, 2013

2013Q1: 11 BCs+FPCs

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Interpreting the ResultsWhy are Take-up Rates so Low?

Fundamental Lack of Demand– No “real” interest in SRI / ESG (Dubious)– Amenability of existing business forms

Lack of Track Record / Predictability– Judicial Precedent = Public Good; Canary in a Cave– Network Effects (Economic; Sociological; Political)– Exacerbated by inter-statute cannibalization

Lingering Capital Market Questions about Investing in Alternative Business Forms

Added uncertainties:– Returns structure legal Social Enterprises– Costs / Difficulties in monitoring technologies

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Investing in Benefit Corps / FPCs

Do institutional investors face idiosyncratic challenges in investing in FPCs/Benefit Corps? E.g., ERISA prudence and fiduciary constraints

Attractiveness relative to alternatives (e.g., plain-vanilla, ESG-screened C corps)? Evidence of other forms of profitability (e.g., greater

productivity / employee loyalty?) Evidence of any P/E discounts? Lower expected

returns (ROI; ROA; negative a)? Different forms of systemic risk (upside / downside b)?

Embedded Real Option to Convert (supermajority vote)

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Cash Flow Implications of Embedded Conversion Option

Equ

ity

Val

ue

Enterprise Going Concern Value

Convert

Insolvency

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Assessing Fidelity with Public Purpose

Most Benefit Corp. statutes require an annual, audited assessment of compliance with public purpose; but legislation gives little guidance on best practices for conducting such an analysis.

What templates / metrics are likely to emerge as best practices for such assessments?

How to deal with public purposes that seem too vague or abstract for measurement? (“Eliminate Evil-Doing”, or “Maximizing Excellence”)

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Fiduciary Duties & Acquisitions

How do board members / officers satisfy their fiduciary duties of care / loyalty? How to trade off profit against social goals? How best to become informed of consequences of decisions?

M&A, and bids for control Freedom to “stiff arm” extremely attractive monetary offers? What

constitutes preclusive or coercive tactics (a la Unocal / Unitrin)?

Assuming sale seems desirable, what do Revlon duties look like, & how does a board discharge them? One or two fairness opinions? If two, can the same outside advisor

produce both? How to treat conditional offers (target must convert to C-corp as

condition precedent to closing)? Seller-side post-closing indemnification provisions?