Defining social business

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This is an excerpt from our response to the European Commission public consultation on the working paper “The Social Business Initiative: Promoting Social Investment Funds“. The complete document is available on our slideshare profile  following this link.

We are fully committed to supporting the development of social businesses and in promoting a cultural change which puts capital and profit at the service of social good. Comments and suggestions about our reflections are more than welcome.

Defining social business

The broad common features of social businesses (otherwise sometimes referred to as ‘social ventures’ – here no distinction is implied) can be quickly sketched out . Initial discussions with stakeholders suggest that social businesses will typically:

  • focus as a primary corporate objective on the achievement of social, ethical or environmental outcomes;
  • reinvest profits so as to maximise their ability to deliver on their primary objective, and therefore have no or limited profit redistribution for investors or stakeholders – this can limit their ability to raise funds, attract investors, and therefore expand and grow; and
  • follow specific governance arrangements, e.g. addressing social goals in their internal organisation.

While the definition of social businesses needs to be further explored, this consultation offers a first opportunity for input from stakeholders, in particular with respect to developing a social investment fund framework that targets these businesses or ventures.
This consultation does not prejudge the Communication or any formal proposal by the Commission. The Commission services recognise the heterogeneity of social businesses across Europe. Developing a definition of social business for the purposes of this initiative on investment funds does not mean that there could not be other elements or features of social businesses which have to be taken into account for the purposes of other policy measures.

(European Commission, Staff working paper, The Social Business Initiative: Promoting Social Investment Funds)

Do you agree that the main features of social businesses are as outlined above?

We agree with the proposed definition, but we think that the prohibition to distribute profit can be a limit. As long as these entities are businesses, e.g. organisations that use capitals to produce products and services, they should play with the same fundamental rules that “traditional” companies are subject to. We believe that social business should grow into the market – not in a side playground. Therefore, risk capital should be rewarded. Otherwise, no investor will ever be willing to put its money into them. Social businesses typically don’t distribute dividends in the early stage of their development, in order to reinforce their assets by reinvesting the margins; but there is no reason why they should continue to do so over time, once that the financial stability is reached.

The Italian law-decree 155/2006 has created the “social enterprise”. It’s a new category that can be added to the typical legal structure of both non-profit and for-profit companies. Without going into the detail of this measure, it’s clear that its failure (few hundreds entities asked to be registered as social enterprises) it’s also due to the fact that the prohibition of dividends distribution has been perceived as a barrier by investors.

That’s the reason why we consider more appropriate a cap to ROI (return on investment) which includes dividends and capital gain limitation. This could prevent that assets accumulation due to profit limitations translates into a capital gain when stocks are sold to the market.

To what extent do you think this initiative should focus solely on those social businesses that do not distribute profits to their investors? Or shall it also focus on those which distribute profits to their investors (e.g. at least to a limited extent)? If so, how might social businesses be distinguished from other businesses?

We think that the rationale of pure non-profit organisations is different from social business. Social businesses are less likely to generate massive capital gains because the logic behind their model prevents them to do so. Social business is low profit by definition, since the process of value creation implies equal treatment of all stakeholders: if workforce and suppliers are managed fairly, clients pay an honest price, environment and communities are respected, one can hardly produce huge margins. Typically, high profits appear when there are strong economies of scale (which is seldom the case for social businesses) or one or more of the stakeholders are exploited.

But being low profitable does not necessarily mean that risk shouldn’t be rewarded. To a certain extent, dividend should be distributed. We are not, in principle, neither favourable nor contrary to a definite cap; we think that capping the distribution might be a good solution in some circumstances – but the decision should be left to the partners or the shareholders on a case by case approach.

We think that a social business should be distinguished form other business on the ground of its outputs. No doubt that it has to clearly state into the Statute that the mission of the organisation is the creation of social and environmental value – but this can be not enough. The extent to which this goal is achieved has to be measured and communicated. We think that accountability is key in this respect and we encourage the highest possible level of transparency. In other words, the “sociality” has to be promised and, more importantly, to be proven.

 

The funding challenge

What are the main difficulties social businesses face, in your experience, in getting access to finance?

Social businesses operate in a typical area of market failure: they are not enough profitable to attract venture capitalists and private equity investors – but they are not eligible for grants. Social business need a specific type of capital providers, e.g. responsible investors that are happy with a blended divided, made of a social as well as an economic return (the latter being inevitably lower than a “normal” one).

Traditional capital suppliers are not comfortable with most social business because (i) they operate in the area of innovation – and therefore are more risky by definition; (ii) they are more often too small to cover the cost of assessment and due diligence; (iii) their governance is often driven by values rather than economic interests.

To what extent do you think barriers to access to finance are limiting the growth of social businesses across the EU?

We feel that indeed finance is the most critical aspect for a social business.

Do you agree that there is a need to tackle any such barriers at the EU level?

Yes. In particular, we think that EU can intervene to regulate the fiscal system. The paradox that has to be handled is that social businesses are subject to the same tax regime of socially irresponsible industries. The taxation system is focused on the legal nature of a given entity rather than on its output. One can produce a huge amount of social benefit, but if it does so using a limited liability company as a vehicle, it pays as it were a tobacco maker.

Even more important to promote social investment funds could be a specific tax regime for investors and financial operators that support social ventures. If we accept the idea of tax exemption for grants, we can imagine different levels of exemption for investments to non-profit and social business.

 

The role of investment fund

How do you think funding through investment funds might effectively compliment other sources of funding, e.g. philanthropic funding? Are there any challenges here?

We think that investment funds can play an important role because they can minimise the information asymmetry. The problem of social businesses is that they don’t speak the same language of [traditional] investors; and these are not eager to invest time to know more and eventually understand a model that is miles away from their standard. The market would need specialised players, who know their counterparts, the context in which they operate, their logic and their approach. In order to became a specialist, one need to reach the critical mass that allows the investment needed for knowledge – which is in fact the case of a fund.

On the other hand, we think that funds shouldn’t be the only or preferred instrument to supply capital to social businesses. In fact, different instruments can solve specific financial needs along with the development stage of the company. The problem is therefore broader: a complete chain has to be designed and supported. In other words, the market needs a sort of “parallel” system, where specialised players do the same job of traditional investors, but with a specific sensitivity and knowledge of a different object.

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