When nonprofit structure makes business sense

The rewards of seizing the right opportunity with a nonprofit can be substantial. On the other hand, choosing to use a nonprofit corporate form to attempt to accomplish purely private goals—even the noblest—can be disastrous.  It is important to understand the special character, operational requirements, and limitations placed on nonprofit organizations before embarking on a nonprofit journey, lest you drift from the destination pinpointed on your strategic map.

Imprecise term

The term “nonprofit” is often used imprecisely. Most people use it to designate an organization with two distinct characteristics—incorporation under a state’s statute for nonprofit corporations, and recognition from the IRS of tax-exempt status (most often as a charitable organization described in Section 501(c)(3) of the Internal Revenue Code).  A basic understanding of the effect of state and federal regulations that attend this dual status will greatly assist businesses in deciding whether a nonprofit might help further their goals.

Consider, as a case study, DeviceCo, a privately held business that manufactures pediatric medical braces used by orthopedic physicians in treating children with certain bone conditions. DeviceCo’s market research has led it to believe it could obtain a substantial edge over its competitors if its braces were lighter weight, and believes it could develop a new material that would be both strong and ultralight. DeviceCo, however, is short on research capital. To solve the problem, DeviceCo hits on the idea of forming a subsidiary, DeviceLabs, as a nonprofit corporation, to work on this research objective. 

The management team at DeviceCo figures DeviceLabs’ nonprofit status will allow it to attract grant money unavailable to DeviceCo (as a for-profit enterprise) and that DeviceCo’s control of its new nonprofit subsidiary will ensure that the results of the R&D are put to good use by DeviceCo. Ultimately, the team reasons, the purpose of DeviceLabs will be to better serve children in need —what could be more charitable than that? 

For several reasons, the proposed nonprofit subsidiary is not a good fit for the management team’s stated goals:

1. DeviceCo will not “own” the intellectual property necessary to gain the competitive edge it desires. By law, although DeviceCo might be the controlling member of DeviceLabs, neither it nor any of its owners can be a shareholder with an interest in DeviceLabs’ assets.Further, if DeviceLabs were to qualify as a Section 501(c)(3) organization dedicated to scientific research, it would be required to make the results of such research public, and prohibited from giving a substantial private benefit to DeviceCo (or anyone else).

2. Similarly, if the end game for the DeviceCo management team is, as with most growth businesses, an IPO or sale of the company, whatever intellectual property is developed by DeviceLabs cannot be part of that sale. There is no way for the DeviceCo shareholders to receive distributions or other return on their investment from the IP created by DeviceLabs—and no way to unring this bell.  Even if DeviceLabs were subsequently dissolved, all of its assets would be required to be distributed to another charity or to the state—a process overseen by the attorney general.

3. While it is possible that there would be some public research grant money available to support the development of new lightweight materials, the DeviceCo team should be cautious about making this assumption. The prospects for gifts from individuals for this purpose will be vanishingly small. Grants from large foundations usually demand huge sums of time and energy to pursue, with no guarantee that any funding will result from the effort. 

4. A clever entrepreneur may plan to use DeviceLabs merely to get charitable funding, which can then be paid to DeviceCo at attractive profit margins.  But legal requirements mandate that DeviceLabs, as a charity, pay no more than fair market value for services it receives. Special care is required by DeviceLabs in any transaction with insiders (which will likely include DeviceCo and its managers) to avoid excise taxes on “excess benefit transactions.” 

Finally, DeviceLabs will have public disclosure requirements (on its annual federal Form 990 Information Return) regarding, among other things, payments made to its executives and major contractors.

DeviceCo’s stated goals likely make this project a better candidate for private investment capital (and such investors will expect a return, which makes a nonprofit the wrong vehicle). 

On the other hand

Altering the facts of the case study, however, makes a dramatic difference. Imagine that instead of materials research, DeviceCo, still cash-strapped, wants to study the disease contributing most heavily to the need for its braces. The goal is twofold: to have (nonexclusive) access to the research in the design of its braces; and to provide a purely public benefit in attempting to find a cure.

Now forming a nonprofit subsidiary makes sense. DeviceCo does not need to own DeviceLabs’ intellectual property—its market position and terminal value is not dependent on the results of the research.

 Also, the truly charitable mission of seeking a cure for a disease is more likely to attract not only grant money but also gifts from individuals, increasing the likelihood that the management team’s goal of tapping new revenue streams will bear fruit. 

Finally, DeviceCo’s close association with the research and its publication is likely not only to raise public awareness of the problem, but also to position DeviceCo as a thought leader in addressing it, in the eyes of both the general public and the physicians likely to prescribe DeviceCo’s braces.

Similarly positioned companies (or, as in our example, the same company in different circumstances) may find working with a nonprofit organization either a bane or a benefit.  For business leaders with truly public purposes who do not need a return on an investment in the traditional sense, a nonprofit structure is an idea worth exploring.

Greg Larson (top) is an attorney with the Minneapolis-based law firm of Gray Plant Mooty, in the firm’s nonprofit and tax-exempt organizations group: 612.632.3276; greg.larson@gpmlaw.com. Dan Tenenbaum is co-chair of the entrepreneurial services group: 612.632.3050; dan.tenenbaum@gpmlaw.com; www.gpmlaw.com