DETERMINING THE RIGHT LEGAL STRUCTURE FOR YOUR SOCIAL ENTERPRISE
This section of the tool kit explores the typical legal structures that are used in the social enterprise sector, the core advantages/ disadvantages of the respective structures and the key issues for consideration when deciding on the right legal structure for your organisation.
As there is no legal definition for what constitutes a social enterprise, there is considerable scope for choosing from a variety of different legal forms (although there are numerous viewpoints of what constitutes the ‘best’ social enterprise legal structure, often driven by vested interests). Before getting into the detail, it’s worth bearing in mind two fundamental principles:
- It is not the legal structure that makes an organisation a social enterprise – it is its activities.
- Your immediate and future funding and income generating opportunities will have a major impact on the structure you choose.
An individual operating a social enterprise without a legal structure is usually regarded as a sole trader or self employed. Organisations that are operating as a membership body without a legal structure are typically regarded as an unincorporated association (also known as voluntary association and community groups). There are a number of reasons why you might consider adopting a legal structure for you organisation:
- A requirement by stakeholders that you are planning to engage with
- A requirement based on the type of activities you plan to undertake
- To enhance your credibility with customers, funders, suppliers and employees
- To protect individuals involved from personal liability.
As a sole trader, self employed individual or unincorporated association (i.e. not recognised as a separate legal entity), the individual or management committee of the association is directly liable for any debts or legal actions affecting your organisation- a risky position. For example, if the organisation generates a financial deficit, it will be the responsibility of the individuals involved to find the money to pay any creditors. Adopting a formal legal structure can protect individuals (e.g. members/ trustees/ directors) from personal liability, therefore limiting this type of risk.
The variety and diversity of the possible legal structures for social enterprise complicates matters. However, there are a number of over-riding principles that should be considered; thinking through these should help you decide the best legal form to adopt for your project. After looking at the different possible legal structures, we’ll address some of these considerations.
Common legal structures
The most common legal structures used in the Social Enterprises sector are:
- Unincorporated Association (which may also be a Registered Charity)
- Company Limited by Guarantee (which may also be a Registered Charity)
- Company Limited by Shares
- Industrial & Provident Society
- Community interest company- CIC (Shares or Guarantee)
The following tables examine these legal structures in more detail, along with a summary of the key advantages and disadvantages associated with the respective structures:
Note: information source: UnLtd ‘Built to Last’ Toolkit
Considerations for choosing the appropriate legal structure
This guide gives you a general overview of some of the major considerations when choosing the legal structure for your social enterprise. It is not intended as any form of legal advice – this can only be given with reference to the facts relevant to you and your project. You should always seek professional advice, including legal advice, if you are not certain as to what legal structure is appropriate for you; this is important to get right from the beginning, since it can be both complex and expensive to change from some legal forms to another later on down the road.
The issues to consider when deciding on a legal structure for your social enterprise include:
- Personal liability
- Funding, both short and long term
- Profit distribution
1) Personal liability
Having a legal structure that separates the members / guarantors / owners from the enterprise will limit their personal liability if the enterprise suffers financial loss or if financial loss is caused by the enterprise. Please note that if the management and members / guarantors / owners have acted negligently or fraudulently they forfeit this protection.
Generally, most social enterprises that intend to operate long term will seek to use a legal structure that offers the owners / guarantors / members limited liability. This could be in the form of a limited liability company (including a CIC) or a co-operative structure such as an Industrial and Provident Society.
Charities can also have a limited liability structure. Some charities behave like social enterprises. However, because of legal restrictions on trading for companies with charitable status, this is not a popular choice for social enterprises. Charities seeking sustainable and diversified income tend to set up captive trading companies that operate as social enterprises. Most charities are registered with the Charity Commission but charities with a particularly low turnover, or some charities operating under the umbrella of a larger charitable organisation, may be exempt from the requirement for registration. Such organisations can apply directly to HMRC in order to receive the tax exemption and reliefs available to charities.
If the structure you choose is a company limited by shares then you have a shared or outright ownership of the company. The more shares you own, the more votes and influence you have over the strategy, management and operations of the enterprise (to the extent that these are not delegated to the directors). Normally, companies of this type will distribute profits to the owners by means of a dividend. The founders will usually be directors and are paid for their employment. The board may be enhanced through the appointment of non-executive directors.
A company limited by guarantee by definition does not have shares. The company has a number of guarantors. The liability of the guarantors is determined by the amount of guarantee they have committed to. There is no legal minimum or maximum guarantee amount. If each person guarantees the same amount, they will usually have one vote each. This gives a much flatter, equal voting structure. The majority of social enterprises in the UK choose this form of legal structure.
Companies limited by guarantee are free to distribute their profits to members in the form of dividends. Social enterprises with this structure may also embed within their constitution that profits will not be distributed but will be reinvested in the company, although some may choose to distribute profits to charities or to the community they serve. The constitution will also govern the distribution of any assets if the company closes down / is liquidated. Such assets may be distributed to other companies undertaking similar work, or to the guarantors. This protection is of particular appeal to grant making trusts and to public sector contractors.
In the co-operative model, i.e an industrial and provident society, ownership is shared with other members of the co-operative. In order to be considered as a co-operative, each member will usually have only one vote, however much they invest in the co-operative. The maximum investment by any one individual is restricted to £20,000.
Therefore if control and ownership are important to you, a company with shares may be more appropriate for you than a non-profit company or a co-operative. However, this structure will most likely preclude you from receiving grants from grant-making trusts.
Most social entrepreneurs are happy with sharing decision-making control with other members on the board. This is discussed elsewhere in the toolkit.
Your legal structure will determine the types of funding that you are able to access.
Grant making trusts will only fund companies that do not distribute profits or their assets on dissolution. This precludes companies limited by shares and companies limited by guarantee which provide for assets to be distributed to members on winding up. On the other hand, a company limited by shares can sell shares and so receive investment. Companies limited by guarantee do not have shares to sell and so cannot attract equity investment.
Choosing a structure that allows you to receive grants in the short term may prevent you from accessing investment when you want to scale up your activities later on. Therefore, you should first establish what the most likely form of funding you will rely on in the long-run is and choose a legal structure that enables you to access it.
There are also a number of different types of co-operatives and most cannot access grant funding. There is a type of co-op however, which is charitable in nature, known as a co-op established for the Benefit of the Community, (this is a type of Industrial and Provident Society which is also an unregistered charity). Because of its charitable aims this type of co-op can access grants. However, as it is not in the nature of a co-operative to distribute dividends, it is unlikely to attract significant private investment.
All types of social enterprise can access loans; in the case of debt funding, the considerations of the lender will centre on the organisation’s ability to repay the loan (including interest), regardless of the legal form of the organisation. If the social enterprise does not have a legal identity separate from its members (for example in the case of an unincorporated association) the individual members may be liable to repay the amounts borrowed.
All organisations should have someone who sets the strategy, ensures that the strategy is delivered, makes sure that the organisation meets its legal obligations and operates within the law. This function is undertaken by a Board of Directors, Management Committee or Trustees depending upon the legal structure of the organisation. The people who constitute this group will be referred to in this section as Board Members. A co-operative can be run by all the members collectively or by a management committee provided that the managers are appointed by the members and can also be removed by them. This may depend largely on the number of members of the society (a co-operative registered as an industrial and provident society must have at least three members).
A shareholder or the guarantor of a limited liability company is known as a member of that organisation. It is common in start-ups for a member to also be a director of the company. However as a company grows directors may not necessarily be members as well. Members have the right to elect directors to manage the company on their behalf. The directors are accountable to the members for their performance. Members can change directors at annual general meetings, or at extraordinary general meetings, if they are dissatisfied with their performance.
Limited companies are only legally required to have one member and one director (who may be the same person). However, as most social enterprises claim to be operating for the good of stakeholders, the community or society, in general it is good practice to have at least three directors and five or more members. This demonstrates that there is a wider involvement by the community in your enterprise. This also allows the enterprise to have a wider set of complementary skills on the board as well as demonstrate wider stakeholder involvement and understand the needs of the community that the organisation aims to support.
Grant funders are also more likely to fund an organisation with wider membership. By and large, a greater number of board members improves the level of oversight held by the management, and ensures that there is transparency in what the enterprise is doing. Also, it ensures that the way grant money is being spent is overseen by more than one person. A setup where an individual founder does not have the sole power of decision-making may be more attractive to grant funders. However, you should bear in mind the practicalities; the more board members that you have the more difficult and time consuming your organisational decision-making will be. You need to strike the right balance in terms of enabling diversity of viewpoints and perspectives whilst maintaining a nimble and decisive business.
Governance is discussed in more detail in a separate theme of this toolkit.
5) Profit distribution
By definition social enterprises should be generating profits. How the profits are used is determined by the legal structure. If you have external investors they will expect some profit to be distributed to them – even if they have agreed to a restricted amount of profit distribution. Profit distribution will also happen in co- operatives.
Social enterprises that are constituted as a ‘company limited by guarantee’ will tend to reinvest the profits in the company rather than distribute it to the guarantors. The idea is that the company will use the profits to grow the enterprise and increase its social impact. Registered charities and to co-ops that are of charitable nature are not permitted to distribute profits to their members so they will usually also reinvest them in the business.
Social enterprises that are constituted as a ‘company limited by shares’ have the option to distribute profits to shareholders; these profit distributing structures can often provide an attractive proposition for private investors. However, profit distribution can often create conflict of financial interest between the individual social entrepreneur and broader shareholder constituency, and will rule out the opportunity of securing funding from grant makers.
One alternative legal structure that still allows profit distribution is the ‘CIC limited by share’ structure. A CIC limited by shares may pay a dividend, if agreed by a resolution of its members. Dividends payable to private shareholders (non-asset locked bodies) will be subject to a dividend cap. The cap is currently 20% of the paid up value of a share in the company and a maximum aggregated dividend of 35% of the distributable profits. Unused dividend capacity can be carried forward for 5 years. There is also a cap on performance-related interest of 10% of the average amount of debt or the sum outstanding under debentures issued by the company.
Key features of the typical legal structures
The table below provides a summary of the key legal structuring considerations discussed above:
The structure you decide should be determined as much by what it is you are hoping to achieve through your enterprise as the immediate funding requirement. Remember to think of the longer-term requirements and how these may be adversely affected by choosing a structure to meet short-term considerations.