In a new paper, we present a novel theory of “purposeful enterprise” to explain why nonprofit enterprises survive and thrive. We define nonprofit enterprises as nonprofits that generate revenue primarily through operations rather than donations.[1] Patagonia, Novo Nordisk, IKEA, Carlsberg, Anthropic, OpenAI (for now), and most hospitals and universities fall into this category.

Nonprofit OpenAI’s announcement this fall that it would transition to a for-profit structure surfaced important questions about the nonprofit form, including an existential one: Why do operating companies choose to incorporate as nonprofits? Why do nonprofit enterprises exist and thrive across many industries, despite the inefficiencies that come from a lack of shareholder control?[2]

For five decades, Henry Hansmann’s seminal paper on the nonprofit form answered this question. His “contract failure” theory posited that in certain industries, an information asymmetry exists between buyers and sellers. The nonprofit form provides assurance to consumers that the business won’t cut corners. For example, consumers might prefer nonprofit colleges because consumers believe that nonprofits are more likely to prioritize education rather than profits.

Hansmann’s theory is elegant and had significant explanatory power – but the world has changed, and information asymmetries in Hansmann’s paradigmatic examples have greatly decreased. University rankings, for example, offer consumers plenty of information about universities. Not only that, industries rife with information asymmetry, like dental practices, are mostly for-profit. Companies in industries with little information asymmetry, like Patagonia, are organized as nonprofits, too.

Our purposeful enterprise theory can explain the puzzling success of nonprofit enterprises. Drawing on insights from management science and behavioral economics, we propose that corporate purpose can play an important role in both the selection of the nonprofit form at the outset and the success of the nonprofit entity over time.

In the paper, we identify several specific ways that purposeful enterprise is important to the nonprofit form:

• Inversion of the profit/purpose relationship. In a typical for-profit company, management’s job is to maximize value for shareholders. This means that profit drives purpose. In a nonprofit, that relationship is reversed: Purpose drives profit. The purpose of the enterprise underpins everything that the organization does, allowing the organization to focus on its purpose, whether that is delivering higher education or inexpensive modular furniture.
• Purpose as motivation. Purposeful enterprise can motivate employees to work hard to advance the organization’s mission. This motivation can also substitute for stock-based compensation. Indeed, shareholder control and performance-based pay may undermine this positive incentive effect. This insight suggests that the nonprofit form may reduce managerial agency costs by elevating the entity’s purpose.
• Purpose as a substitute for shareholder monitoring and enforcement. Likewise, a well-defined, authentic, and specific purpose can substitute for shareholder monitoring. Stakeholders and employees, for example, can hold nonprofits to their purpose, as long as that purpose is sufficiently clear and specific.
• Insulation from outside influence. Nonprofits are also insulated from the market for corporate control because of their lack of shareholders.[3] This insulation is a double-edged sword because shareholder influence plays a major role in deterring managerial agency costs. On the one hand, insulation can lead to greater stability and managerial focus on purpose over time. On the other hand, the absence of shareholder influence can lead to inefficient operations, as decades of research in corporate governance cautions.

Nonprofit enterprise is not a perfect fit for all businesses. Indeed, our analysis is largely descriptive. Our theory seeks to explain why certain nonprofit enterprises may succeed over time and even outcompete for-profit competitors – it does not suggest that all companies should become nonprofits or use purpose as a substitute for shareholder control.

Our theory also sheds light on fundamental debates in corporate law and governance, including the debate over a corporation’s purpose in society. Conventional wisdom posits that corporations should be managed for the benefit of their shareholders, although advocates of alternative stakeholder governance theories have been gaining ground. Shareholder primacy proponents have greeted this interest in stakeholderism with dismay, arguing that directing management to pursue a purpose other than profit will undermine discipline and lead to runaway agency costs. Our analysis of nonprofit enterprise offers a different scenario – one of prolonged economic success rather than rampant organizational inefficiency. As such, our article provides an important counterweight to scholars that contend that accountability to shareholders is the only or best way to respond to agency costs and promote efficient business.

ENDNOTES

[1] We define the term broadly to include for-profit businesses that are owned and controlled non-profits, which are known as “enterprise foundations.”

[2] We largely sidestep tax laws that benefit nonprofits, as well as other regulations that inhibit nonprofit operations, to focus on the choice of organizational form. However, we note that tax does play an important role in giving nonprofits an incentive to elevate purpose and re-invest profits into the entity, therefore encouraging beneficial aspects of purposeful enterprise.

[3] The Hershey Company provides a current example of this phenomenon, as it was approached with an offer from Mondelez that the company did not like, and the nonprofit simply said no. See Hershey’s Main Owner Rejects Mondelez Offer as Too Low, Reuters, https://www.reuters.com/markets/deals/hersheys-main-owner-rejects-mondelezs-offer-too-low-bloomberg-news-reports-2024-12-11/ (Dec. 11, 2024).

This post comes to us from professors Cathy Hwang at the University of Virginia School of Law and Dorothy S. Lund at Columbia Law School. It is based on their recent article, “Purpose and Nonprofit Enterprise,” available here.