Premature Incorporation

Don't let it happen to you.


This article was originally published by Stanford Social Innovation Review on December 11th, 2012 with the headline: Premature Incorporation

I'm spending an inordinate amount of time these days talking social entrepreneurs out of launching for-profits. Many drank deeply of the impact-investing Kool-Aid, and came away believing that going for-profit is the only way to drive financial and operational discipline, that it will give them immediate access to much more capital, and that they will find the holy grail of sustainability while the deluded do-gooders who went nonprofit are still grubbing around in the bushes for donations.

It's mostly bullshit.

Instead, a typical scenario goes like this: Social entrepreneur has cool idea. Social entrepreneur launches for-profit venture with own/friends'/family's dough, maybe even gets a chunk or two of seed funding. Hard work ensues. Money runs out. Venture is nowhere near ready for real investment. Venture goes off a cliff.

Sure, there are exceptions. Sometimes those revenue projections turn out to be accurate. Sometimes the entrepreneur is ridiculously good at raising money. Sometimes they just get lucky. Mostly, though, it follows the script, and here's why: Social entrepreneurship is largely about overcoming market failure. That is a lengthy and expensive undertaking, and even if you manage to pull it off, the result is rarely lucrative -- and the more profound the social impact, the more expensive and less lucrative it's likely to be.

It's expensive because there is usually a ton of R&D to do before you emerge with a viable business model. It's one thing if you're just tweaking a proven microfinance model or adding a mobile platform -- wow! -- to something that already works. It's another thing entirely if you're tackling a big problem in a new way, in a place where markets don't work very well. You're going to need a lot of runway to go through all the iterative cycles it will take to end up with something that makes sense to people who expect to get their money back.

You need -- and ought to get -- free money to do it. Philanthropy, done well, is about making good things happen that wouldn't have happened otherwise. When you come up with a high-impact solution that can spark a new industry, that's a public good. I used to think that spending philanthropic money on something that someone else will someday make money from was somehow unethical. I was wrong. When you can make the case that it generates big social impact that wouldn't have happened otherwise, it's a home run for philanthropy and something that we ought to be searching for.

But if you launch right away as a for-profit, you'll likely end up an orphan: Philanthropists won't know what to do with you, and investors will rightly view your firm as a lousy place to put their money. You've made it hard for philanthropists to give you grants, and you offer investors an unlovely combination of high risk and low returns. In short, you're screwed.

Some point to hybrids as an answer. I don't like them. Trying to remember their convoluted structures is like waking from a dream -- after a few moments of clarity, the whole thing slips away. Worse, they too often succumb to the temptation to dump all the questionable parts of the business model into the nonprofit side. Aside from the inherent lameness of that, the result can be a sort of stealth-subsidized business model that will never scale. The other big problem with hybrids is that if one side of the arrangement bombs, it pulls down the other -- and in any case, the two sides rarely grow at the same pace. I've seen a few hybrids that work well -- typically with the nonprofit side focused on R&D to drive new impact -- but by and large, I think they're messy one-offs.

I'd like to see a sequential approach become the norm: If you have a potentially high-impact new idea, you start out as a subsidized nonprofit that is focused on developing a scalable business model worthy of real capital. If you manage to get there, the organization flips into a for-profit and raises money from investors. The emerging business must be structured to ensure that it stays on mission, but that can be managed. We haven't worked out all the kinks yet, but it's cleaner than the alternative and more likely to produce a business that really can scale via the market. All we need to make it work are philanthropists and investors who know their jobs and are willing to try something (kind of) new.

And if your impact is profound but your breakeven point stays over the horizon, you can simply remain a nonprofit. You can't sell equity, but you can get grants and cheap loans. Grants are free money, and zero-interest loans to nonprofits are not unheard of. Better a struggling nonprofit than a dead for-profit, and given the overall performance of social enterprise equity investments so far, would-be impact investors might want to save themselves a headache and just give you the money instead. They probably weren't going to see it again anyway.

As weird as it sounds, for your lovely idea to survive and get to scale, you may need to dodge the world of impact investing for a while. Remember all that patient capital that was supposed to show up for all you and your fellow social entrepreneurs? Most of it was so lacking in urgency that it never left home. It probably never will show up: It doesn't make philanthropists feel good, and it doesn't make investors feel smart. Given that, you might want to stay in a cozy nonprofit burrow until your business is strong enough to survive above ground. When -- and if -- you do poke your head out, keep in mind that the right financial structure is the one that provides the best path to the maximum social impact. Nothing else really matters.