Starting Up: Nonprofit vs. For-Profit Social Ventures

From smSmallBiz

WHEN STARTING UP any business, there are obviously countless things to consider: Do I need a business plan? Should I work from home or lease office space? How will I reach prospective customers? But when you're launching a social enterprise, one more quandary needs to be added to the list: Do I set up shop as a nonprofit or a for-profit?

For Ned Tozun and his business partner Sam Goldman, who last year launched D.light Design, a New Delhi-based social venture that sells inexpensive lighting and power technologies in developing countries, that decision was pretty clear. "We felt like the only way to create a sustainable and scalable solution to the problem we aim to solve was via a commercial model," Tozun says.

D.light Design founders Ned Tozun (pictured left) and Sam Goldman (pictured right) discuss the problems with using kerosene lamps. However, given D.light's mission — that is, eradicating the use of polluting kerosene lanterns often used by people who don't have regular access to electricity — most entrepreneurs would probably have chosen a different path.

After all, social enterprises traditionally lean toward the nonprofit model because of the perks they can receive from the business's perceived "aura of goodness," says William T. Hutton, a nonprofit attorney and longtime law professor in San Francisco. "Particularly in the educational sphere," says Hutton, there's "an innate suspicion that [nonprofits] are much more inclined to be selfless." This perception, as well as the generous tax breaks that nonprofits typically provide to donors, make it significantly easier for social enterprises to raise funds and land government grants.

Of course, it isn't just about the ability to reap charitable donations; there are plenty of other reasons to launch a nonprofit social enterprise. The confusing thing is there are just as many reasons — if not more — for social entrepreneurs to set up a for-profit business as well.

To help you figure out which model makes more sense, we weigh the pros and cons:

Profits

Whether you do business as a nonprofit or for-profit entity depends largely on your venture's long-range picture and what you hope to accomplish, says Jesse Margolin, a tax attorney in New York specializing in corporate and nonprofit organizational law. "Most social ventures do not make much money," he says, so entrepreneurs tend to be better off forming a nonprofit. By doing so, they'll be in a better position to receive donations and other charitable dollars.

Under this status, however, any profits the company receives get reinvested back into the enterprise, not paid out to its owners. "What you give up by adopting a nonprofit designation," says Hutton, the nonprofit attorney in San Francisco, "is a proprietor's interest in growing equity."

If, on the other hand, you think the business is a potentially money-making venture, then for-profit status is the best course. That way, says Hutton "the founders [and other owners] can realize gains from the success of the business." If the company is incorporated, he says, the stakeholders can possibly receive stock and dividend payouts.

Tax Deductions

Securing start-up capital from an assortment of donors, including wealthy individuals, corporations, community groups and the government is typically the terrain of nonprofits. For for-profit social ventures, raising such charitable dollars — while possible — is generally rare, says Charles A. Wry, Jr., a business attorney in Waltham, Mass., who regularly consults with start-ups. After all, donors typically want to deduct their donation from their income taxes. To offer this perk, nonprofits need to apply to the Internal Revenue Service to receive a special 501(c)(3) designation — that is, a provision in the tax code that grants nonprofits an exemption from paying federal income tax — they may also be able to offer exemptions from city and state sales taxes as well.

Raising Capital

While they can't offer tax breaks, for-profits offer investors one advantage that nonprofits can't: financial returns. For-profits can give investors ownership stakes, or equity, in the company in exchange for capital. Investors can also feel more connected to the company as their financial fates are, to some degree, bound. For more on funding a social venture, click here .

Sticking to a Mission

While offering stock to investors is a great perk for for-profit ventures, it can also prove to be a hindrance when it comes to maintaining the company's social mission. As a for-profit venture, "you are accountable to your investors," says Tina Sciabica, deputy director of the Social Venture Network, a nonprofit network of social and business leaders in San Francisco.

Nonprofits will have an easier time sticking to their goals. "Venture capitalists or private capital [investors] may be more or less tolerant of your social mission," she says.

Scalability

Since growth is often the goal of for-profit ventures (even those with social missions) such companies are typically better positioned to grow at a faster clip than nonprofits. From the time they draw up the business plan, for-profits have a good idea of what the financial picture will look like from the start-up to the growth phase. They set a target for funding and work until they meet their goal. "For-profits tend to raise targeted amounts of significant contributions from [angels and] venture capitalists at the start," says Wry. As a result, for-profits can put those funds toward the purchase of facilities, research and development or hiring employees right away rather than adding operations or services little by little, as nonprofits tend to do, says Wry.

Even though for-profits operate at the mercy of market forces (i.e., the cost of materials), once a venture gains momentum it can generally afford to ramp up operations in order to meet demand. Tozun from D.light says, "we are completely scalable; if we want to grow, we can just produce more." He adds that "if we were a nonprofit we'd be limited by how much money we raised."

Hiring Employees

With more funds to work with, for-profits often have an edge over nonprofits when it comes to attracting and retaining highly-valued talent. Nonprofits tend to operate with more modest resources, and usually can't offer similarly high salaries and bonuses.

Additionally, says Wry, "nonprofits can't provide [employees] an equity stake." Many for-profit start-ups will offer new employees ownership stakes in order to offset a low salary. As the for-profit makes money, they won't have to depend on this strategy. But at least it gets talent through the door. Without stock options to dangle as carrots, nonprofits have a much harder time attracting desirable employees.

Focusing on Customers

Nonprofits can, of course, raise huge amounts of donor funds, but the process of grant writing and finding donor funds is tedious and practically never-ending. For Tozun and Goldman, this aspect of running a nonprofit was the most unappealing. Having employees focus on raising funds, as they often must at nonprofits, rather than catering to customers seemed at odds with common business sense, he says. So rather than marketing to donors, Tozun adds that "we're marketing to our customers."

("Starting Up," a weekly column written by Diana Ransom for smSmallBiz.com, follows entrepreneurs through the early stages of launching a business. Write to her at dransom@smartmoney.com .)

Other recent Starting Up columns:

• Starting Up: Funding Your Social Venture

• Starting Up: Becoming a Social Entrepreneur