Flexible Low Yield Paper for Financing Social Enterprises

This review is drawn from a 2013 article entitled “Hunting Stag with FLY Paper: A Hybrid Financial Instrument for Social Enterprise” by Professors Dana Brakman Reiser and Steven A. Dean of Brooklyn Law School, published in the Boston College Law Review volume 54 issue 4, pages 1495-1544.

When a socially-minded entrepreneur has traditionally raised capital they are faced with two concerns. First and foremost, there is the concern of legitimizing the venture. If the entrepreneur forms as a charitable organization, they are ensuring the social goal of the venture as a legacy but will not attract profit-minded investors. Conversely, if the entrepreneur organizes as a for-profit entity, they run into the second concern: investors may not share their same passion for the social cause that is the heart of the venture. The for-profit status may ultimately frustrate the venture’s ability to “do good”; as majority shareholders, the investors can jettison the social cause in favor of a more robust bottom line. For-profit formation could ruin the entrepreneur’s hopes for the venture’s socially conscious legacy. Further, the case law is replete with reminders that the purpose of for-profit entities is to promote their value for the benefit of the shareholders.

There have recently been several attempts to bridge the gap between a for-profit organizational structure and the benefits of a non-profit’s social mission protection. The Low-profit Limited Liability Company (L3C) came out of Vermont’s legislature in 2008. The L3C is essentially an LLC with the contractual framework tweaked to allow for a social mission in addition to member profits. As long as the for-profit business has a social mission, it will remain an L3C. The instant the statutory requirements are no longer met, the L3C automatically converts back to an LLC, affording minimal protection to the underlying social mission. In 2010, Maryland adopted legislation allowing for the formation of benefit corporations. The benefit corporation is based on the traditional framework but is required to define the corporation’s public benefit and is held accountable to third party standards. While the monitoring is aimed at ensuring the social mission of the benefit corporation is met, there is no guidance explicitly announced regarding the third party’s standards. Further, the benefit corporation is allowed to select its third party standards, making the monitoring an entirely self-serving process. While L3Cs have no protection to ensure a social mission, benefit corporations need a proposal from the board and a supermajority vote by shareholders. Lastly, there is the flexible purpose corporation (FPC). FPCs arose under 2012 California legislation that, like benefit corporations, relies on a standard corporation framework. Unlike benefit corporations, FPCs have no third party monitoring of their adherence to their stated social mission; the social mission is selected from a statutorily defined list and incorporated into the FPC’s charter. To revoke an FPC’s social mission, a two-thirds vote of the shareholders must be obtained. 

The recent attempts at protecting a social entrepreneur’s legacy, the L3C, benefit corporation, and FPC, all focus on the organization’s form. Further, none of the for-profit options can guarantee the legacy of the social mission. Brakman Reiser and Dean propose shielding the financial instrument creating the relationship between the investor and entrepreneur rather than protecting the organizational form itself. Instead of relying on legislation for the solution, Flexible Low Yield (FLY) paper gives investors debt with specific terms attached to it rather than equity through the form of a hybrid financial instrument. Similar hybrid financial instruments, such as convertible bonds, have previously been used for funding efforts tailored to meet the needs of both investors and entrepreneurs/issuers. Social entrepreneurs can use FLY paper tailored to serve their specific goal of preserving their social enterprise’s legacy. In so doing, it ties the investors to the ultimate success or failure of the underlying social cause. In turn, investor protection is afforded through giving them the power to convert their debt into equity on favorable terms should the entrepreneur attempt to cash out their own shares. If the entrepreneur sold their shares, the investor would have an equity stake in the venture and could focus solely on maximizing return. This allays an investor’s concerns that the entrepreneur is going to take the investor’s money and run; the investors would be able to cash out as well. As an added protection, the investor would hold a note senior to common stock but junior to traditional debt. With the investors acting essentially as lenders committed to the goal of the company, the entrepreneurs are free to pursue the goals of the social enterprise. As such, FLY paper guarantees protection of the social mission- so long as the entrepreneur holds his stock they have full control of their venture. 

Another advantage of FLY paper is that it can be issued by any organizational form that can borrow money; it is not nearly as restrictive as the legislative solutions that offer protection through choice of entity. The certainty of repayment that comes with FLY paper would likely mean treatment as debt for tax purposes. As such, the enterprise could count the future interest as a deduction before it is paid. The benefit to the investor is that due to its low yield, FLY paper would incur relatively low taxes, or none at all if the investor had tax exempt status. The tax drawback is that if the venture is too early stage, the note exchange would not likely count as a loan but would more likely be seen as a purely equity investment. 

A final benefit of FLY paper over alternatives is the low return rate and fixed terms buffer the potential risk associated with investing in an early stage social enterprise. The investor is afforded a modest return in addition to repayment of the initial investment. With both sides showing a strong commitment to the social mission, it is easier to focus on maximizing shareholder wealth, a secondary consideration which is still important for both the entrepreneur and investor. If both parties remain steadfast in their obligation to both the social mission of the venture and realizing profit, both can advance their financial and social missions without much sacrifice. 

The entire article is available here.