Swimming Upstream: Why I’m an L3C Skeptic

Campbell’s Alphabet Soup Book

I’m swimming against a current of alphabet soup with this post, publicly expressing some skepticism about the hot topic of last week, the L3C, a forum about which was livestreamed on newplay.tv: L3C and the Arts: Understanding the Potential of Low Profit Limited Liability Companies. I remain skeptical of the L3C’s potential to impact the arts infrastructure in a net positive way.  If you have 3 ½ hours, I encourage you to watch the archive video of the forum. But if you don’t, here’s a brief primer on the L3C: The L3C is a special type of limited liability corporation (LLC) authorized by about a dozen states.  Like a regular LLC, an L3C is a for-profit corporation but one with a charitable/educational mission, leading to a legally acceptable “double bottom line” of profit AND mission.  Foundations can invest in an L3C via a loan or even capital investment (with no guaranteed return) if the L3C’s mission is in alignment with the foundation’s as a “program related investment” (PRI).  There has been a lot of excitement about the possibilities the L3C form opens for the arts and culture sector, some of that excitement coming from me at times.  The L3C seems at first blush to be a boon to entrepreneurs with a conscience, people who want to start profit-making enterprises that balance mission with profitability. And, it is that.

But who (or what) benefits from the L3C form?  The chief beneficieries appear to be nonprofit foundations and existing (larger) 501c3 nonprofits.  Foundations can “invest” rather than “give” and thereby get some financial return rather than none, as would be the case if giving to a 501c3 nonprofit corp, with less reporting burden than if they had invested in a regular LLC.  Thus the L3C is, according to attorney Marc Lane, “particularly attractive to impact investors.”   But the giving or PRI requirement for foundations remains at 5% so, in the zero sum game that is the bottom line of an annual budget, if the L3Cs gain through PRI, there are likely 501c3 organizations that are losing out on the granting side.

The other potential beneficiaries of the L3C form are 501c3 organizations (usually large) that form wholly or partially owned  subsidiary for-profit L3Cs.  Thus, the large 501c3 reaps a benefit.  The small start-up independent entrepreneurial artist does not necessarily benefit here.  The L3C as a subsidiary of a 501c3 is a concept that has excited the larger social entrepreneurship community because it enables nonprofit social service providers to undertake some profitable activities that support their core mission without being subject to unrelated business income tax (UBIT).  But, the L3C does not specifically benefit the arts and culture sector.

I agree with Fractured Atlas’s Adam Huttler, who says, “I think the enthusiasm and excitement about the idea is a little bit disproportionate to the actual value it provides, at least right now.” Yes, it’s a new corporate form; yes, it’s another tool in the entrepreneurial toolbox – and I generally favor more flexibility over less flexibility. But is the L3C the panacea that will pull the arts and culture sector up by its bootstraps? Not right now.  If the arts and culture sector advances because of the L3C form, it seems it would be as a byproduct of it, rather than a direct beneficiary.  Let’s watch for developments.

About lindaessig

Linda Essig is Dean of the College of Arts & Letters at Cal State LA and principal/owner of Creative Infrastructure LLC. The opinions expressed on creativeinfrastructure are her own and not those of Cal State LA. You can follow her on twitter @LindaInPhoenix.
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10 Responses to Swimming Upstream: Why I’m an L3C Skeptic

  1. Aaron: All great points that I would like to address. First, in order to have a successful organization, for profit or non-profit, you need a business model based on revenue in excess of expenses, whether that revenue is earned or contributed. No person or foundation is likely to donate or invest in any business with bad financials. Second, when discussing a for profit entity such as the L3C, unearned income cannot be viewed from a non-profit perspective. Third, as you mentioned, the motivation behind funders can, and will differ. With the L3C, they are making an investment in a for profit entity with the charitable mission embedded in the statutory framework of the corporation. This is distinctive for two reasons (i) it gives the corporate entity a brand that distinguishes it from other for-profit companies because the L3C must be organized first and foremost for a charitable purpose (required by L3C legislation), and (ii) the officers and managers of the L3C, by law, can be held accountable by the stakeholders to uphold both the charitable mission and fiduciary responsibilities of the organization. The stakeholders interests and motivations are different with an L3C than other for profits. With the L3C their first motivation is to make an investment in an organization who’s charitable mission they believe in, followed by the motivation of a “possible” return on investment. Earning a profit is its secondary purpose. Not the other way around. It takes a paradigm shift in thinking to see the difference. I would like to address one other point regarding profits not being reinvested into charitable activities. Further reading on this topic would be advised as provisions can be outlined in the L3C’s Articles of Incorporation and Offering Papers to ensure a % of the profits are reinvested into other charitable for profits and/or regretted to 501(c)3 nonprofits. You may also want to do further research on the types of PRIs, they do come in many forms other than investments, such as a loan or loan guarantee as you mentioned.

    • lindaessig says:

      Michael: I have not done as much research on this topic as you have, but caution you about assuming that investors’ “first motivation is to make an investment in an organization who’s charitable mission they believe in.” While legislation may allow for a charitable mission to be primary or concurrent with profitability, it does not require specific motivations on the part of investors. Foundations, especially, may be motivated by the possibility of return on a mandatory distribution of 5% of assets rather than the guaranteed return of zero from a grant. This is what may make the L3C form an important development for the arts, but we simply can’t assume investor motivation based on the legislation. BTW, you may be interested in looking at the B-corp form, which I believe is authorized now in six states.

    • Michael, I am a nonprofit finance exec. I think about and work on business models and revenue/expense balance all the time. Previously, I worked in accounting in the for-profit sector. I’m very keen on revenue exceeding expense.

      The basis for my statement that any profits from profitable activities will be reinvested into unprofitable activities, therefore eliminating profits, is based on my experience working in a mission-driven organization and working with others in a Board capacity. I don’t mean that the L3C will take its profits and “invest” them into another 501c3. I mean something much simpler. For example, an L3C bicycle rental shop (mission is to preserve the environment by making it easier for people to get around downtown without a car or public transit) will very likely take whatever profits it makes from bicycle rentals and will reinvest them in more advertising and public education than is economically efficient. Or they’ll build more bicycle depot locations than a profit-maximizing business would, because it furthers the mission.

      Managers who are mission-motivated will want to spend all the surplus (besides what is reserved for longer-term sustainability by people like me) on expansion of the mission, just like in a nonprofit. The result won’t be much different than a 501c3, in practice. A profit-maximizer would avoid reinvesting surpluses in very marginal expansion with limited profit potential. A mission-maximizer would do exactly that, if it supports the mission.

      In the long run, I think these L3C’s are likely to look a lot like 501c3’s, but with access to different kinds of donors–not investors looking for economic return.

      • lindaessig says:

        Aaron (and Michael) – I am a bit more skeptical when it comes to the reinvestment of profits. Once the L3C starts seeing a profit, there will be stakeholders in the organization who may (and again, I couch all of this behavioral speculation as possibilities, not actualities) want to see some of that profit as profit rather than mission expansion.

      • Linda, here’s why I kind of doubt that.

        The classic principal-agent problem will apply to L3C’s just like it applies to for-profit corporations, but with a twist. The owner is the principal, and wants to maximize profit, because it returns to him/her. The manager is an employee of the principal, and doesn’t share as much of the profit, generally, and so is motivated by his/her paycheck, or empire building, or a desire to hire extra staff so he/she can go home at a reasonable hour. But in the case of the L3C, I am presuming that the principal (owner) is the one who was mission-motivated to start the business in the first place, and so there will be less pressure on profit-maximization, and both the principal and the agent will act more like the agent.

        Again, I’m not saying this will always be the case. I imagine there will be some who try to abuse the L3C to get access to financing that doesn’t have to be paid back, and will give themselves huge salaries. We’ve seen these abuses of 501c3’s, too (e.g., credit counseling nonprofits in the late 90’s/early aughts).

        So again, I expect users of this legal designation will converge to nonprofit business practices, in general, no matter what the “donations” are legally called.

        • lindaessig says:

          But Aaron, what happens when the owner is the manager? I am not familiar enough with the L3C legislation, largely because AZ doesn’t have any (although it has gone before the state legislature twice), but the LLC form – at least in AZ — allows for an owner/manager. In fact, that is a common structure here, especially in some of the small LLCs in the arts.

      • An owner/manager will definitely be more motivated to make profit than just a manager. Then that person will negotiate the tension between profit and mission him or herself. And what they decide to do will probably impact the kind of investors that they can successfully get on board.

  2. I would agree with you, Linda, about the flexibility. It would be great if a nonprofit could tell a funder that our projections show we’ll be able to give your money back (like a loan), but that this repayment is understood to be at risk, so you might not get it all. That would open the door to funders with different motivations, I suppose

  3. I’m going to state the obvious and say that investors seeking an actual financial return are not going to find it in the L3C. Because they are explicitly not expected to be managed for a profit, they won’t be. Surpluses from any activity that could generate profit are going to be reinvested into other activities that cannot. Yes, there will be exceptions, but I feel extremely comfortable predicting that the expected financial return across all L3C’s will converge to zero. Therefore, the unearned revenue is going to come from people and grantmakers who would have just made a grant in the past. Anybody trying to reap an actual financial return would be foolish to look for it here. This feels basically like a different kind of nonprofit.

  4. Linda: Some wonderful points! Would love to discuss further with you sometime and directly address your concerns. Meanwhile, please give a read to this article I wrote for Center for The Theatre Commons in which the concepts of “regranting and reinvesting” profits are presented. I believe it provides a logcial opposing arguement to the issue of “501c3 organizations…losing out on the granting side.” http://www.howlround.com/investing-in-the-arts-the-l3c-low-profit-limited-liability-company-by-michael-difonzo/

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