Show me the juice! When life gives you lemons, make lemonade and the implications for entity structures.

In the evolving landscape of social entrepreneurship, the structure of a Social Enterprise (SE) is a key matter that should be appropriately determined at the outset - enabling the enterprise to thrive and effectively target the social or environmental challenges it aims to address. The choices made at the foundational stage of structuring a SE are paramount, and can have ongoing implications in terms of governance, funding sources and growth strategy as the enterprise scales.

This article addresses some of the critical considerations that should guide the structuring of a SE. From the legal frameworks and governance models to funding and revenue generation, we unpack the components to be considered to not only safeguard the purpose underpinning the enterprise but also equip the enterprise for sustainable growth and success.

What is a social enterprise?

SEs are purpose-driven businesses that are designed to address social, cultural, or environmental issues through trade. There is no legal definition of a SE in Australia, however it is generally accepted (including by the national certifying body, Social Traders) that SEs are businesses that:

1. have 'social primacy' in that they are led by a defined social, cultural or environmental purpose consistent with a public benefit;
2. derive a substantial portion of their income from trade; and
3. invest efforts and resources into their purpose such that public benefit outweighs private benefit (the 'reinvestment requirement').

To meet the reinvestment requirement, costs incurred in pursuing the public benefit purpose must outweigh any private benefits (including distribution of profits through dividends). These costs include any direct resources or other contributions made in pursuing the public benefit purpose, or activities run in furtherance of that purpose. Examples include donations to for-purpose organisations, wages to, and the cost or wrap-around support for, marginalised cohorts engaged as employees, undertaking advocacy activities and education and awareness campaigns on social or environmental issues.

SEs can be structured as FP or NFP entities, provided they meet the criteria above.

The key consideration for FP entities is whether they meet the purpose and reinvestment requirements, while the primary factor for NFP businesses is whether they adopt a market-based approach to creating impact, with the majority of income derived from trade. This is the key determinant for SEs structured as NFPs and highlights the criticality of a sustainable and scalable business model.

There are a number of different SE models including:

1. Donation – businesses that donate a percentage of profits to another organisation creating public benefit;
2. Direct Benefit – businesses that deliver services in response to needs in the community or embed direct impact in their business model (such as work integrated SEs, that create employment opportunities for vulnerable cohorts facing barriers to employment in the open labour market); and
3. Cross-Subsidy – businesses that use a portion of their profits to provide access or support to underserved populations that would otherwise be unable to acquire such goods or services.

In Australia, the SE sector is rapidly growing, with over 12,000 SEs now contributing more than $21.3 billion per year to the economy (over 1% of the GDP). See The Business for Good Report, commissioned by Social Enterprise Australia, for more statistics on the economic contribution of SEs in Australia.

SEs can seek either certification or verification, including to enhance credibility and trust and facilitate access to social procurement contracting opportunities. For more information on certification and verification requirements and the application process, see our article on SE and B Corp certification requirements.

"To be or not to be" for-profit or NFP – the threshold question

A key question when determining a SE structure is whether the SE will operate on a FP (or 'profit-for-purpose') or NFP basis.

There is a common misconception that, due to the trading model, a SE must be structured as a traditional FP company. However, most SEs in Australia are structured as NFPs.

The assumption that SEs need to be structured as FPs stems from a number of misconceptions around NFPs, some of which are considered below.

Myth: NFPs cannot make a profit

• Fact: NFPs, like any other kind of business, should be making a profit or surplus to operate sustainably and ultimately be able to deliver on the NFP's purpose. The key difference is that NFPs need to ensure that all profits are applied to their purpose, rather than distributed to members for private benefit. The term ‘not-for-profit’ can be misleading - it does not refer to the capacity to generate profits, but rather to the allocation of those profits.

Myth: NFPs cannot undertake commercial activities

• Fact: NFPs, just like any other kind of business, can undertake commercial activities such as selling goods or services. The key difference is that NFPs must apply all of the profits derived from the activities towards the purpose. NFPs that are seeking to operate as charities will also need to consider whether commercial activities are a means to advance the charitable purpose(s), and specific advice should be sought on this point.

Myth: NFPs cannot pay operational expenses

• Fact: NFPs, like other businesses, need to incur some level of operational and administrative costs to run a sustainable business. These costs may include the cost of leasing premises, engaging and paying staff, paying service providers such as accountants and paying insurance premiums. Some of these costs may enhance the effectiveness of the NFP, for example by investing in training for staff and volunteers or impact measurement – which will ultimately assist in ensuring the NFP is well-resourced and data-backed to scale and grow.

Myth: NFPS cannot pay directors

• Fact: NFPs are not prohibited from remunerating directors. However, any remuneration must be reasonable, permitted under the governing document, appropriately authorised and in furtherance of the purpose. Some NFPs have tax concessions which can support salary packaging.

Myth: A person cannot earn a wage from a NFP

• Fact: A person (for example the founder of a NFP) could be employed by the NFP and earn a wage as an employee, subject to the NFP having sufficient funds to employ the person. A person could also be engaged for work provided in other capacities, such as consulting services. Provided any wage or other fee paid in exchange for services is reasonable and ultimately in furtherance of the purpose, a person is not prohibited from earning a wage from a NFP.

These misconceptions, as well as the relative ease in setting up a FP entity, can lead to selecting a structure that is not fit for purpose for the enterprise (which may include setting up a FP entity due to the misconception that a NFP cannot be used to undertake commercial activities), and later seeking to establish a NFP - whether to access grants, philanthropic funding or for another reason. This may involve setting up a separate NFP or converting the FP to a NFP (which while possible, is relatively uncommon and can give rise to confusion).

The best approach is to set up the most appropriate structure from the outset, and SEs should seek advice to ensure they make a fully informed decision on the right structure for the business to equip the SE for success.

Social enterprise structuring options

Key factors to reflect on when structuring a SE include:

FP or NFP – Determining whether the SE will be structured as a FP or NFP, as this will impact the available structuring options. Key factors when determining this will include:

• Underlying business, industry and competitive landscape - At the end of the day, equity takes on risk and is looking for equity style returns, so what is the underlying business and how sustainable and scalable is it and how much profit or surplus will be available? Is it B2C, B2B or B2G or a mix and how diverse and robust are the cash flows to be generated? Will it generate enough "juice" to cover costs and support an equity return? What does the industry and competitive landscape look like? Is the business in a low capital, low barriers to entry, low margin sector? Is it a scalable proposition and what is the productivity / growth model – is it reliant on technology, platforms or dependent on labour? Is there a subsidy inherent in the model compared to competitors – eg for "impact costs" - where needing to provide wrap around services to support training and flexible employment options?
• Expected sources of funding - Including whether sufficient funding will come through fees from commercial activities, or if it is anticipated that trading revenue will be supplemented through grants or other philanthropic funding opportunities. In many cases, grants and donations are only accessible to NFPs and may be needed to meet operating shortfalls.
• Whether there are plans to raise equity capital – This may indicate a FP structure is required, though in a NFP structure it is possible to receive impact investment with equity-like characteristics, such as through debt financing. Joint ventures can also be undertaken by NFPs themselves or with FP entities – it may be that part of a group structure could have a NFP investing alongside a FP in a particular venture.
• Intended use of profits - NFPs are constitutionally prohibited from distributing profits to members while operating or on winding up (members can receive payment in limited circumstances, such as reimbursement of out-of-pocket expenses or reasonable payment for services). If the intention is to extract profits from the SE for private benefit to reward risk taking, a NFP structure will not be appropriate.

Governance design – The proposed governance design, including membership structure. The proposed number of members will impact appropriate structuring options, noting both FP and NFP companies under the Corporations Act only require a minimum of one member or shareholder, while some other structures (including incorporated associations, co-operatives and Aboriginal and Torres Strait Islander corporations) generally require at least five members.

Area of operation – Whether the business will only operate in a local area or throughout Australia and internationally. If the latter, certain state and territory based structures that are subject to area of operation limitations, including incorporated associations, will not be appropriate.

Size – Some structures, including incorporated associations, are subject to size limitations, and therefore not appropriate for enterprises that want the flexibility to scale and grow in the future.

Market certifications – Whether the enterprise intends to seek any particular public benefit market certifications such as SE certification from Social Traders, verification through the People and Planet First framework, certification by B Lab as a B Corp or Supply Nation certification as an Indigenous business. While SE certification and verification is available to enterprises using a range of structures (including both FP and NFP enterprises), some certifications (including B Corp certification and Supply Nation certification (as opposed to registration)) are only available to FP enterprises.

How MinterEllison can assist

The Social Impact Practice at MinterEllison has extensive experience in guiding SEs and other purpose-led businesses from inception to scaling up, providing tailored support for enterprises that exist at the intersection of profit and purpose. Our services include:

1. Strategy and structuring Advice: We provide strategic advice in relation to business models and advice on the most appropriate legal structure for various for-purpose enterprises, assisting an organisation to implement the right framework at the outset to scale, operate sustainably and achieve the desired impact.
2. Setting up SEs: Our team assists with the entire set-up process, navigating through the intricacies of legal and regulatory frameworks to establish enterprises on solid foundations. We help draft and review constitutions and other governing documents to ensure they reflect the environmental, social, and governance goals.
3. Restructuring and M&A: For established SEs considering restructuring, for example converting to a NFP to expand funding options, our team can assist with advice and support with the restructure process. We also work on M&A, strategic alliances, joint ventures and winding ups.
4. Governance and Compliance: Good governance is the backbone of a successful SE. We can assist with the development of robust governance frameworks that reflect the enterprise's values while ensuring compliance with regulatory obligations. From drafting constitutions to advising on Board responsibilities and ethical policies, good governance is essential to ensuring a SE can operate transparently and sustainably.
5. Ongoing Support and Advice: We have extensive experience in the NFP and social impact sector, assisting with the full spectrum of legal advice, from structuring advice, start-up entity formation and charity registration (where applicable), through to governance, compliance, financing, contracting, risk management and restructuring support.
6. Advice on engaging with SEs: We provide advice to government and corporates on engaging with SEs, including embedding SEs in supply chains to meet social procurement targets and collaborating with SEs to meet goals, including through outcomes based contracting.

Please reach out if you have any questions regarding SE structuring, governance or the legal needs of purpose-led businesses.