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Florida B Corp: Social Entrepreneurs Probably Should Not Be Early Adopters

O7A9fAvYSXC7NTdz8gLQ_IMGP1039Social entrepreneurs looking to form or operate their business through a Florida business entity now have two dedicated types of for-profit corporations from which to choose: the social purpose corporation and the benefit corporation.  In this post, I will refer to both social purpose corporations and benefit corporations as “B Corps” because the differences between the two options are not material to the issues addressed.  As of July 1, Florida has officially joined the states who have created special laws to accommodate social enterprises.  However, this post will offer a few reasons why social entrepreneurs should think long and hard before they rush in to either of these new options.

First, let me make clear that we are strong proponents of both social enterprises, in general, as well as impact investment.  We have long seen these not as trends, but as permanent changes to the social contract through which for-profit entities will increasingly be judged by investors, employees and customers.  Those that know us are aware that we have not only acted as counsel to these companies—particularly through our longstanding emphasis on representing cleantech companies, we have also founded and operated several successful social enterprises ourselves over the last ten years.  To that point, it is important to know that social enterprises have existed long before the creation of various B Corp laws and are not dependent upon special laws such as the new Florida laws for their existence.  In fact, at least at this stage, forming your social enterprise as a B Corp is not a “no brainer” and caution is prudent. Always evaluate the pros and cons before selecting any form of entity for your business.  Your social enterprise is no different.

A Few Reasons to Hold off on B Corps

It is easy to find plenty of blog posts out there on what the new Florida B Corp laws allow and require.  These are mostly technical recitations of the statutes themselves.  We try to focus our posts on perspectives that address practical business issues for business owners beyond mere legal issues.  But given the amount of questions we have already received about the new Florida B Corp laws, we may do a white paper that goes into more detail.  For now, here are some reasons not to choose to form your new social enterprise as a B Corp or convert your existing social enterprise to a Florida B Corp:

  1.   Tax Classification.Keep in mind that B Corp status is not a tax classification and there is no current state or federal tax benefit to operating as a B Corp.  This is one of the regrettable consequences of the B Corp nickname itself as both “C Corp” and “S Corp” are mere tax classifications.  Do not consider the B Corp as an alternative to S corps or C corps.  Because both new B Corp entities are merely corporations under Florida state law, owners will still need to classify their B Corps as either C corporations or S corporations for tax purposes.  C corporations are inherently tax inefficient and S corporations are unnecessarily inflexible for most startups that seek any sophisticated capital.  If you want to maintain the most flexibility and tax efficiency for your social enterprise, the LLC, and not the B Corp, will likely continue to be your best option.
  2. Investor Uncertainty. In many cases, you will have selected a for-profit entity to form your social enterprise because you anticipate the potential need for investment capital–as opposed to donations received by non-profit entities.  “Investors” are indeed a broad category.  There is a very good chance that certain family offices and impact investors will embrace B Corps and welcome the associated legal protections and required transparency.  However, many institutional investors run from anything “new” like the plague.  Until issues like fiduciary obligations of B Corp directors, derivative lawsuit claims, enforceability of investor protections and a host of other issues are addressed by Florida courts through fact specific litigation, expect most institutional investors such as venture capital managers to be leery at best.  If you have decided that a for-profit entity is necessary because of the likely need for investment capital, don’t make an early decision that will likely eliminate a large category of potential investors before you even get started.
  3. Converting Later is Probably Easier.Flexibility is a powerful asset for startups.  We preach over and over that the successful path of mosts startups requires many pivots that are not predictable at the inception.  Maintain any option you have to stay flexible.  If you have investors that want your company to be governed by the B Corp provisions, you can always elect that status or convert your entity immediately prior to that investment.  All you need is the required vote. Undoing a B Corp status not only requires the minimum 2/3 vote of each class of stock, it also triggers appraisal rights under the relevant termination provisions for both social purpose corporations as well as benefit corporations.  Few things create more heartburn for founders than creating appraisal rights for dissenting shareholders.  Few things are less acceptable to venture capital investors than cashing out shareholders with their investment capital.  Don’t put yourself in this position.
  4. D&O Insurance Issues.Insurers typically do not like “new” either.  I am really not sure how directors and officers insurance underwriters will weigh the risks and exposure of insuring directors and officers of B Corps.  However, at a time when D&O insurance has gotten very expensive, I would not be excited about being the test cases.  It is true that one of the perceived benefits to social enterprises under the benefit corporation statutes is to make it clear that directors should not be liable to shareholders for pursuing agreed social benefits over mere profit maximization.  However, I’m not willing to make the assumption that insurers are going to treat the obligations of directors under these statutes more like directors of non-profits than their for-profit brethren. I would be interested to hear an insurance perspective on this.

The gist is this: while additional options for social entrepreneurs are always good, the intention of this post is to evaluate whether the B Corp is actually a wise option for your social enterprise under these brand new laws.  In some case, it will be.  Before the Florida law became effective in July, we have advised companies that have formed new B Corps under Delaware law.  In some cases, the marketing benefit alone is probably worth the potential negative characteristics mentioned in this post.  However, most LLC statutes are predicated upon freedom of contract and it is possible to have governing documents that clearly provide for business purposes and actions that address social issues and in addition to profit goals.  In some respects, the B Corp laws are something of a solution in search of a problem.  Do not assume that you need these new entities to achieve your social goals.  The costs may greatly exceed the perceived benefits.

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LLCs Making an S Corp Election? . . . Usually, No.

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Continuing a series on choice of entity for startups, I’m going to address the issue of whether your entity should be a LLC that elects to be treated as an S corporation for tax purposes.  This is a two step process for federal tax requirements that can be achieved with the single action of timely filing an IRS Form 2553 election for the LLC. What is deemed to then happen is, firstly, the LLC is electing to be treated as a corporation (rather than a partnership for multi-member LLCs or a disregarded entity for single member LLCs). Secondly, the “corporation” for tax purposes is filing an election to be treated as an S corporation for federal tax purposes. Needless to say, your LLC needs to qualify under the many rules that govern qualification as an S corporation. These rules are beyond the scope of this post but a few are particularly relevant.

Is LLC Electing S Corp Status the “Best of all Worlds?”

In virtually every conversation I have on startups, someone asks if the LLC electing S corporation status is the “best of all worlds” form of entity. As with all posts on our blog, I’m going to get to the punchline rather than doing a treatise on all issues involved. In most cases, it is not and can have very disastrous consequences later. There are good reasons to use an S corporation for “simple” businesses that will likely never take on sophisticated outside capital. Most startups we see do not fall into this category. Most startups plan on taking on investment of some form from an outside investor other than pure friends and family (or they at least want to plan for the possibility). Almost all outside investors with any level of sophistication want rights and protections that would create a “second class of stock” for Subchapter S purposes and would disqualify the LLC as an S corporation. Liquidation preferences? Investor-only Dividends? Foreign Investors? Consider the S status blown. Even the casual angel investor is likely to want protections or rights that will disqualify the Subchapter S qualification. In order to maintain qualification as an “S corporation,” the LLC also cannot have institutional investors, such as other LLCs and venture capital funds, as owners. Again, for companies that may even possibly take on institutional investment at a later stage, the election can be a lurking tax problem.

The Tax Time Bomb–Phantom Income When You Least Need It

The reason the later termination can be a tax problem is because the termination results in a deemed sale of the company’s assets for federal tax purposes if the LLC elects the less restrictive partnership tax status (assuming its is eligible to do so at the time) or merges into another LLC in order to achieve this result. Without getting into the technical aspects, this often creates a recognized tax gain on assets that creates a present tax where no tax would have existed and where there is often no liquidity to distribute out the tax liability to the owners.  This would not be the case if the LLC had simply accepted its default status as a partnership (or disregarded entity for a single member LLC) rather than an S corporation.

In these circumstances, starting as an S corporation (whether in the traditional way or by electing this for your LLC) is shortsighted in my view. I’m really at a loss as to why so many advisers suggest it without qualification. My own experience is that the advice usually comes from accountants who are mostly focused on employment taxes to the exclusion of a broader business perspective. I also think there is a desire by advisers to say something they think clients have not heard before in order to be perceived as cutting edge and valuable. Without going in to charging orders (which are really relevant in a stunning minority of cases) and self-employment taxes (which can be significant but should not be the only factor), if you plan on raising money from an investor that has a clue, my suggestion is to keep your LLC as a partnership or disregarded entity for tax purposes and save the stamps on the S corporation elections.

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Transaction Advisors Need to be Aware of Aiding and Abetting Fiduciary Liability Exposure

Board directors are increasingly facing scrutiny and liability for failures to meet their fiduciary obligations to shareholders.  These duties include duties of care and duties of loyalty.  As directors and officers’ insurance policies become more expensive and provide more exclusions and less coverage, outside directors such as investor fund designees are facing a new reality of personal liability exposure.
We will have some future posts on this topic as it relates to fund board designees but a recent case in Delaware reminds us that advisors to the board can face liability for aiding and abetting breaches of fiduciary duty by the board of directors that they advise.  In the case of  In re Rural Metro Corp. Stockholders Lit. (Del. Ch. March 7, 2014), the Delaware chancery court focused on the M&A advisor’s conflicts of interest and its failures to disclose these conflicts to the board. The conflicts of interest related to the advisor’s efforts to participate in the financing of the sale of the company as well as the financing of the sale of a competitor company in a contemporaneous sale process.
Without getting too much into the specific facts of the case, when advisors have a vested interest in seeing a closing occur (as opposed to helping the company reach a wise resolution), they can cross a line where the advice they provide is incomplete–and even misleading.  In this case, the board seems to have relied on this advice but not taken reasonable care to evaluate the advice.
The advisors thereby aided and abetted the breach of fiduciary duties by the board. While a proper focus is now placed on director fiduciary liability, advisors are well advised to consider this exposure as it relates to their own services.

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LLC or Corporation? LLC Offers Best Flexibility if You Need to Make a Call

We always address the issue of which form of entity is best for your startup.  This is never a “one size fits all” answer.  If you are advised that one form of entity is right for all new businesses, your advisor does not understand all of the relevant issues.  As an aside, there seems to be an abundance of advisors that are pushing the “LLC that elects to be treated as a corporation that then elects Subchapter S status” routine but that is an issue for another post.  Suffice it to say that the determination is based on the type of company you will operate, the place that you form and operate it, the anticipated path for invested capital and a host of other issues.

Not every startup can afford to have those issues evaluated up front. So, this post is to those who are not in a position to pay for advice–just form an LLC and do not go through the process of treating it as an S corporation.  Now, a limited liability company may not end up being the correct entity for your business, or your later investors, or for you, as the initial owner, but I suggest that you err on the side of using it for reasons that I will briefly outline.
Firstly, the LLC is tax efficient and, in most cases, offers similar liability protection to its owners as a corporation.  Secondly, it does not require the filing of an election, as in the case of the S corporation, in order to have this tax efficiency.  In the case of the LLC, it exists by default.
The LLC will offer incredible flexibility because you can add founders or investors without respect to who they are or where they are and you can create whatever classes of interest that the market requires without destroying the tax efficiency (which is not the case with an S corporation or an LLC that elects to be treated as an S corporation).  Multiple classes, different economic rights, dividends, liquidation preferences–no problem.
The final simple answer is that it is quite easy, in most cases, to change from an LLC to a corporation and, unlike in the case of changing from a corporation to an LLC, this generally does not create a tax liability associated with the switch.  Just in the last several months, we have converted LLCs into corporations for three separate entities that needed to convert in connection with a subsequent change in circumstances.  The state filing fees are minimal and the legal issues and time are not significant.
Therefore, the LLC gives the most flexibility, tax efficiency and the ability to easily change later if you find you made a mistake (or the circumstances change and dictate a different form of business).  Starting companies is often done under imperfect circumstances such as when there is not sufficient ability to get professional advice.  In these circumstances, there are judgement calls that need to be made.  I would form an LLC.  Depending on what state you use, there could be other issues to consider. However, in the states where I have had first hand experience, the answer is the same. Best of luck with your new startup.

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Why Your Lawyer Should be More Engineer than Accountant

I have been very fortunate to work with many engineers over the years in my legal practice.  I enjoy being around people who do things, make things and solve problems using a combination of smarts and creativity. To me, that really describes what good engineers really do. In most cases, you don’t want creativity out of your accountant—you need creativity from your engineers. However, with no offense to engineers, I do think the best lawyers are actually much more like engineers than accountants. If your lawyer acts like an accountant, you may want to move on.

Outside of patent and startup lawyers, not many lawyers spend time with engineers.  As an outside lawyer, your direct contacts are typically upper managers or C-suite types who are more likely to be an MBA than a Double E.  Of course, there are many C-Suite types with an engineering background and I’m making some generalizations here but startup lawyers often times work directly with engineers who are working as engineers. In many ways, it is a shame that more lawyers do not work with practicing engineers because engineers approach challenges from the perspective of solving problems and finding solutions while many business lawyers are taught (often by large law firms) that coming up with reasons that things cannot be done is much more favorable, from a liability standpoint, than determining how things can be done. If the lawyer advises against doing something and it goes badly, there is simply less liability for the law firm.

What many engineers do not know is that many times laws do not provide a definitive answer. There are more gray areas than black and white. There are many areas in the tech world where laws have not yet caught up with technology and no “rules” yet exist. I am certainly not suggesting that your lawyer should be aggressive to the point of being risky. I would, however, say that those that are unimaginative enough not to consider new or different structures where a client’s business goal can be prudently accomplished do their clients a great disservice. Unfortunately, many corporate and business lawyers start with “no” as the go to response.  Startup lawyers typically need be more adaptive, responsive and creative. In my view, all lawyers should act like engineers.

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