To profit, or not to profit?

Of the few people who ever form a corporation, even fewer spend much time contemplating whether they want it to make money or lose money.

What could be less relevant than a post about a few of the few?  It matters because almost everyone gets almost everything from companies, and every company is formed either to make money or to lose it. We’re all affected by the differences in the way they’re incorporated and the ways they behave. So it’s worth trying to understand why they are the way they are, and how we might prefer them to be.

Just to be clear, charitable organizations are meant to lose money, but to lose it wisely. By working to a good purpose, they “earn” funding to close the gap between expense and revenue. The right to avoid tax, issue tax receipts, and receive public money is given in part payment for doing what neither business nor government will do. They shouldn’t be thought of as failed businesses.

At the time of incorporation, it may appear that the choice between commercial and charitable status is made for them. Sometimes incorporation is a mere formality for a business that’s already in operation. In some cases, the nature of the enterprise appears to dictate which category it belongs in. Your dog walking service, for example, is clearly for people of means, and should pay for itself. Your dog rescue organization, in contrast, is clearly for mutts without money, and will need to subsidized somehow. What is there to think about?

These choices are long forgotten by the time an enterprise grows, matures, and becomes more complex. A non-profit organization may have enjoyed the benefits of avoiding tax, issuing tax receipts, and receiving subsidies. Likewise, a commercial enterprise may be glad to have avoided the encumbrances of volunteer boards and public accountability that their non-profit counterparts endure, despite the pressure of generating profits and paying tax. Yet, over the long life of either corporation, a moment may come when it would be advantageous to adopt some of the other’s characteristics and behaviors, and when this change of motive or conduct would be good for society.

This isn’t really so hard to imagine. It has become commonplace to lament the singlemindedness of businesses that subject the rest of us to risk and harm in the pursuit of greater profits. Likewise, there is a widespread suspicion that charitable organizations would need less subsidy if they were just a little more “businesslike.” We all sense the gap between what’s possible and what’s actually being delivered by the two kinds of corporations that serve us.

Yet, when they behave in a way we deem to be out of character, they draw suspicions about their motives and practices. Our expectations of them were set at the point of incorporation, at the moment they chose whether to make money or lose money, and they are bound to that purpose from that moment forward.

Perhaps I’m belabouring an obvious contradiction, but there’s no point in continuing without clarity on this point. In the process of incorporation, we demand that an enterprise choose to dedicate itself to either the good of society at large, or to the benefit of its owners or shareholders. Despite the fact that most people wish that these two kinds of corporations would act a little more like one another, they are systematically discouraged from doing so.

Of course businesses can give money to non-profit organizations to do spend in their name, and non-profit organizations can develop earned revenue streams that resemble profitable businesses. Yet to act against type in a direct way, from within the enterprise itself, becomes more perilous with success. Government and shareholders can punish a business that acts too altruistically, just as the government and philanthropists will punish a charity that acts too commercially. Although neither behavior is absolutely forbidden, the risks generally outweigh the rewards.

In the Wizard of Oz, the happy ending includes Tinman acquiring a heart and Scarecrow finding a brain. Imagine that the Tinman was a commercial business and the Scarecrow was a charitable organization. Now imagine that there were laws against such a change of character. Tinman wouldn’t be able to act kindly even if he had a good heart, and Scarecrow couldn’t act rationally even if he held a Mensa membership. These kinds of change and growth would be treated with suspicion, whether or not they were strategically advantageous to Tinman and Scarecrow, and beneficial to the majority of Munchkins.

What a dismal movie that would be. Eventually Tinman’s kind impulses would be stunted and Scarecrow’s capacity for thought would shrink. This unnatural outcome would appear to validate laws that compelled and enforced their deficiencies. Along the Yellow Brick Road and in the Emerald City, the team would be defeated by the challenges confronting them. The Wicked Witch and the flying monkeys would prevail. Dorothy would never get back to Kansas. What a nightmare!

Isn’t that what we do to corporations in real life?. We give them the rights of a person under law, but force them to choose between two incomplete, antisocial behaviors. One can pursue profit to the disregard of everything else, while the other is compelled to deliver a social good to the detriment of itself. Then we police them through tax law to keep them performing true to type.

To make things worse, one mode of behavior creates mistrust of the other. One patronizes the other for being too needy, while the other struggles in perpetual dependency.

Again, imagine how things could be different. Here are a couple of hypothetical possibilities to illustrate:

A non-profit arts organization accelerates renewal of a desolate part of a city, driving up the property values for landlords, but ultimately pricing itself out of the neighbourhood as a result. To keep this pattern from repeating, the non-profit organization seeks to partner with landlords so that it receives a share of the appreciated property values it helps to create. But this clouds its non-profit status, brings scrutiny to its charitable works, and deters donors and funders. It might also expose the weakness of its unwieldy governance structure, which puts every business decision under the authority of an inexperienced, volunteer board. This creates conflict with its real estate partners.  It’s not impossible to succeed in some measure under these circumstances, but it’s fraught with risk and strife.

Flip the case around and imagine a health club chain that has underutilized facilities during daytime hours in a specific neighbourhood of the city. It discovers that a local dance school lacks training and physio equipment. The dance school cannot afford to buy memberships and is at the limit of its fundraising capacity. The health club doesn’t want to create the precedent of giving the memberships away, so it proposes to incorporate a non-profit organization in partnership with the dance school, so that philanthropic and sponsorship dollars can be raised for this specific purpose, agreeing to allocate a block of space and time in their facilities at a discount. But this new activity proves to be a costly distraction to the company, and financial support proves disappointing because prospective donors and sponsors are skeptical about the complicated nature of the relationship between the corporations. As the two organizations struggle to make this improvised structure work, the relationship deteriorates until all the effort and resources it demanded are at risk of being wasted.

Both of these scenarios, and others from NetGain’s actual client experience, arise from the hard distinction between commercial and non-profit corporations in law. It’s easy to understand why statutes evolved in this way. For the government to grant the right to escape taxation, or to reward philanthropists with tax relief, assurance is required that the organization is focused on the provision of community benefit. The frustration is that this right comes with a set of obligations and limitations that make it harder to govern and manage. A constraining dependency relationship takes hold between the government and the charitably incorporated non-profit organization.

“Charity” was first described in British law in 1601. The definition of a “charitable organization” by the House of Lords occurred 290 years later. The underlying assumptions of charitable law haven’t changed that much since. Unsurprisingly Canada's treatment of charitable organizations draws on this tradition, although our Income Tax Act doesn’t actually provide a legal definition. It nevertheless sounds every bit as antiquated and restrictive as its English antecedent. It still limits charitable activity to four general purposes: the relief of poverty, the advancement of education, the advancement of religion, "or other purposes that benefit the community in a way the courts have said are charitable….”

WTF? Or as the authors of these laws might have said, “Good Lord!” Of these four kinds of social good, the miscellaneous category captures the most new social needs of the past century. Although billions are raised annually for poverty, education, and religion, think of all the other areas in which charities fill the social void left by government and business. In fact, so much has changed since the law began recognizing charities as a distinct form of enterprise, it’s surprising that Parliament hasn’t tossed this body of law out and started over.

There are ways to work around the restrictions of motive and behavior set at the point of incorporation. Corporate foundations enable a commercial enterprise to optimize the way it pools and distributes its money without running afoul of the law. It's intended to be a free standing organization that acts independently of the parent corporation's business interests.  Another response is the “social enterprise,” which is an attempt to hybridize the commercial and the non-profit corporation in a way that pursues profit, but distributes it beyond the owners or shareholders of the corporation. Although both of these practices are susceptible to overstatement of their social value, if not to outright abuse, they are symptomatic of the advantage sometimes seen in the mixing of commercial and charitable motives and behaviors.

Another way to combine the best of both worlds is to bind special purpose charitable and commercial organizationstogether in long term service agreements. Nothing limits their freedom to choose who they buy their services from or who they serve, and if the corporations and agreements are designed well, these services can be largely reciprocal, reducing the net amount of money being exchanged. This permits each of them to do for the other what it does best, according to its commercial or corporate status, while assuring that the costs don't exceed what the charitable partner can afford.

Both can be made stronger by the long term stability of demand and support assured through a long term contract, and neither raises questions about the purity of their profit motive or their community service mandates. It’s not simple, but it can work if the two partner corporations are adapted and committed to this purpose. It’s certainly less risky than a charity trying to act like a business, or vice versa.

Lawyers and politicians can argue about how best to reform the pertinent statutes. My only suggestion is that the law pertain to a defined activity rather than the entirety of a corporation, and only for the duration of that activity rather than for the full length of the corporation's life. A corporation needs a mechanism by which it can segregate the revenues and expenses of its investment in a social benefit, regardless of its form of incorporation, and be treated fairly by government and private donors for its good works.

I know this will sound crazy to sensible people, but why not let the subsidy, whether private philanthropy or public funding, go wherever it does the most good?  It's wrong to assume that non-profits are always best at what they do or that commercial businesses are always the best at what they do.  There may be times when one can do the traditional work of the other, to the benefit of their communities.  Wherever and whenever these opportunities arise, it makes no sense to allow corporate status to inhibit a company's best impulse.

Is it inconceivable, for example, that a grocery chain could devise a better way to distribute food than non-profit food banks across a region?  They have the expertise, the supply relationships, the truck fleets, the storage, locations, and inventory management and logistics systems required to get more food to more people.  If one of them had a genuine interest in providing this service more cost effectively than charitable food banks, it shouldn't be impossible for them to accept and recognize contributions from others to help defray their costs.  Of course they could do this now, but would be prevented from competing fairly for charitable dollars because they couldn't issue tax receipts, despite delivering the same or better service to society.

In the same way, should it be possible for a subsidized social enterprise, like a church based seniors home care charity, to get into the business of online purchase and home delivery of medical supplies?  This group has trust relationships with the customer, has access to their homes, and can ensure that the products are being used correctly.  The surplus generated by this activity could enable the organization to extend its services to more housebound seniors, and this should be good news to donors and funders.  However, if it's too successful, and the amount of money flowing through this profit making business appears out of proportion with their traditional money losing business, questions will be asked by the tax collector, donors, funders, and possibly rival charities and commercial businesses.

The attribution of charitable status to programs and events, rather than to corporations, would obviously necessitate an overhaul of relevant accounting principles, but that’s overdue anyway. Although it would add complexity to the financial statements and tax returns of every mixed company, at least they'd all be operating under the same set of rules.

In the end, most corporations would claim that they are serving a social need, even gun makers and tobacco producers. It should be possible for any corporation to perform a virtuous act, judged by the government to be charitable, without expectation or retention of profit.  Commercial businesses shouldn't be limited to employment and donations as their primary forms of community engagement.  Nor should charitable organizations be discouraged from earning a greater proportion of their revenues from commercial activity, if that makes them stronger and serves their mission.  In theory, both are capable of delivering social benefit, and either can generate a profit.

This crazy talk, taken to its logical extreme, would dissolve the hard distinction between commercial and charitable corporations.  There would simply be corporations, distinguished by their specific actions, not their general intentions at the point of incorporation.  Either they would be primarily commercial or primarily charitable in the conduct of their businesses, but as with most corporations now, not purely one or the other.

Even if charitable organizations would cease to exist as a category, they'd would continue to exist as corporations that act charitably.  Where their mandates are deemed worthy and underserved by government and business, they would attract public and private sector subsidy, as they do now.  If they deliver on their promises more efficiently and effectively than others, they can expect a greater share of the available support, which is also true now.

But, they wouldn't be discouraged from acting entrepreneurially, generating profits where possible, recruiting and rewarding better managerial talent, and retaining surpluses for strategic purposes as they are now.  While each would still pursue its unique corporate objectives, which might be very much like charitable mandates and missions are today, they would enjoy far greater strategic latitude than is permitted them now.

In this imaginary world, corporations at the commercial end of the spectrum would be induced to use their talents and resources, not just their cash, in innovative and socially beneficial ways.  They could stop thinking about philanthropy as a cost of doing business, and allocate more resources to strategic initiatives that align with their corporate values.

Of course the fear is that all the money goes to self-serving corporate purposes, thinly disguised as social responsibility, while those charities that serve the unsexy needs of the community become depleted.  But that is a rather naïve denial of the extent to which that is already true, and a dire condemnation of human nature.  My experience with leaders in both sectors leads me to believe that there is an impulse to expand and improve the non-commercial benefits they deliver in the communities they serve.  By liberating that impulse, it's possible for corporations to break with the habits of Tinman and Scarecrow, and become more complete citizens.

Admittedly that sounds wildly utopian, even to me.  It's difficult to conceive of a world in which people don't behave in the way we've scripted for them.  We're so inured to the way things are, that we mistake the rule-formed habits of corporate life for human nature, when in fact we've encouraged the crude motives and behaviors we now bemoan.

For those who hold no hope for the prospect of change, I suggest that they click the heels of their ruby slippers three times, grab firm hold of the nearest lapdog, close their eyes, and make a wish.  For more optimistic people, a constructive start might be a rethink of the effects our charitable tax laws have had on the way corporations behave, and how a softening of the distinctions between commercial and charitable corporations might encourage greater creativity and generosity across the board.

 

 

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