The following comes to us from Brian Galle, an associate professor at Boston College Law School.

Social enterprise lawmaking is a growth industry.  Over the past four years, state statutes authorizing new forms of corporate entities have proliferated.  The new entities come in several flavors — low-profit limited liability companies, “benefit corporations,” and others — all with the common element that they purport to authorize the firm’s managers to mix profit with some other socially valuable function.

These developments are puzzling.  As I argue in a new essay, organizational theory suggests that when it comes to traditional forms of charity, these “hybrid” forms will typically underperform “pure” nonprofit or for-profit alternatives.  On the other hand, social enterprise is a plausible vehicle for firms that seek to combine profit with some simple, easily-measurable “good deeds,” such as labor- or environmentally-friendly production processes.  Existing social enterprise statutes do not accommodate that scenario, as argued nicely in a forthcoming article by Dana Brakman-Reiser and Steven Dean.   I suggest instead that the laws are motivated largely by tax planning.  But this is not to say that they could not be better adapted in the future; Brakman-Reiser and Dean suggest one promising avenue for improvement.

Let me take a step back.  Nonprofit corporations are typically the product of profound agency costs.  For one, it’s difficult to measure the quality of most traditional charitable outputs, such as artistic achievement, educational success, or social justice.  Potential supporters, knowing this, are reluctant to commit funds without some assurance that managers will use their money wisely, rather than for the manager’s own purposes.  Managers therefore choose the nonprofit form as a kind of costly signal of their commitment to the cause.

Social enterprise firms do little to reduce these agency costs, and if anything may tend to magnify them.  Hybrid firms assign managers two tasks, but since no one has yet invented incentive pay for producing social justice, only one of those jobs—earning profits—can be easily monitored and rewarded by investors.  A standard management-literature response to this dynamic is to split the firm in two, or to outsource the hard-to-monitor task.

Hybrids are costly on other dimensions, too.  They may muddle another of the entrepreneur’s costly signals: the signal that she is sacrificing compensation on behalf of a noble cause, earning her public regard and social status.  Managers who are expert in one task (say, running Google) may be uninterested or unskilled at the other (say, running Google.org, the largely defunct experiment in corporate philanthropy).  There may some instances in which the benefits of combining traditional complex charities with profit-seeking could outweigh these costs, but so far we’ve seen no obvious success stories.

The combined form might perform better if the costs of contracting for the “social good” were low.  Some public benefits, such as worker wages or carbon offsets, can be relatively easy to measure, especially with trustworthy outside auditors in place.  Existing Delaware law arguably raises some barriers to that corporate strategy, although at least when shareholders have a ready exit option it is hard to understand why courts are so resistant.

In any event, even if Delaware permitted managers to pursue something other than shareholder profit, social-good minded investors and managers would still face the danger of opportunistic profit-seeking by their counterparts.  Managers can take “sustainable investment” dollars and then manage for pure profit, and funders can sell to hedge funds who will slash wages to raise profits.  Brakman-Reiser and Dean explain that, while social enterprise statutes nominally prohibit these kinds of defections from the original deal, in practice the only obstacle is a fairly easy (and likely tax-free) conversion to a traditional corporate form.

What then, could explain the popularity of social enterprise statutes?  In brief, a state competition for federal dollars.  With IRS acquiescence, social enterprise organizations might become highly desirable investments for tax-exempt foundations.  That would lower the social enterprise’s cost of capital, by in effect making much of their payout to investors tax free.  Little of that tax subsidy would come out of the coffers of the state legislators who have been working to enact these statutes.  Like the LLC movement of the 1990s, social enterprise puts pressure on lagging states to open the door for favorable federal treatment for their local firms, or risk seeing those firms go elsewhere.

Maybe the next generation of social enterprise statutes will do better.  Society should certainly keep its eyes open for ways to help firms commit to socially beneficial tasks.  But for now, social enterprise in the U.S. looks more like a fiscal shell game than a real advance in corporate governance.

The full essay, which is forthcoming in the Boston College Law Review, is available here.