Monday
November 7
2016

David B. Guenther

‘Doing Good By Doing Deals’: How Law Students Help Social Entrepreneurs Help Small Farmers

Most Africans earn a living based on agriculture. While many African economies have experienced remarkable growth in recent years, the benefits of that growth have not always reached the rural poor. Many social entrepreneurs are accordingly inventing new ways to strengthen agriculture in rural Africa.

At the International Transactions Clinic (ITC) at the University of Michigan Law School, many of our clients are now working in one form or another with small African farmers to improve agricultural inputs, develop sustainable farming practices, and build supply chains for the sale of crops. Some of these clients are nonprofits that want to use for-profit tools to be sustainable; others are for-profits with a nonprofit social and/or environmental mission. All of them are operating in a legal no-man’s land between existing nonprofit and for-profit regimes that raises novel issues for international social enterprise. Following is a summary of recent ITC experience with these legal and practical issues and how our clients have dealt with them.

 

Background on the ITC

The ITC is a full-year law school clinic where second- and third-year law students work on live international transactions for clients with a social or environmental mission. Students typically work in teams of two, under the supervision of an experienced international transactional lawyer and faculty member, with two or more client matters at a time. ITC students currently work with clients based in Kenya, Ethiopia, Senegal and South Africa on obtaining or providing grant, debt and equity financing, structuring social enterprises and hybrid company groups, developing microfranchise networks, transacting international sales of goods, implementing best corporate governance practices, and drafting required legal documents – all in coordination with other legal counsel. We aim to train lawyers who can dive into an international transactional or social impact practice as soon as they graduate. The ITC’s unofficial motto is “doing good by doing deals.”

Founded in 2008, the ITC was the first – and until 2015, the only – law school clinic in the United States to combine transactional work with an international focus. While transactional clinics at U-M Law and elsewhere do not necessarily require clients to have a social or environmental mission, the ITC has always focused on social enterprise as part of its pro bono mandate.

 

Background on ITC Clients

Some of our clients work directly with small farmers engaged in production of avocados, herbs, honey and other crops. Other clients have established or are working to establish agricultural dealer franchises with quality products, identifiable brands, shop design and packaging, and trained personnel to serve small rural farmers. More generally, these clients seek to:

  • improve the quality of agricultural inputs (seeds, seedling trees, fertilizers, tools and equipment) and provide them to farmers at lower cost by achieving economies of scale;
  • provide training to farmers on environmentally friendly, sustainable farming practices (demonstration plots, soil testing, technical training clinics, product presentations from suppliers, organic pesticides and organic certification);
  • enhance farmers’ access to finance by partnering with local microfinance institutions and farmer cooperatives; and
  • increase farmers’ access to markets by building and managing supply chains (through assistance with supplier management, harvest and crop collection, crop storage, packaging and marketing, negotiation of sales agreements, transport to customer markets, access to the internet and information technology).

The impacts these clients are looking for are primarily the production of more and better crops, strengthening the incomes of small rural farmers, and protecting and preserving the local environment. If small farmers make more money, the extra income may have important ancillary effects, such as better food security, increased ability to pay school fees and therefore better education of farmers’ children, and greater gender equity, particularly where small rural farmers are largely women.

 

Common Financing Model

Many of the ITC’s social enterprise clients working in African agriculture are pursuing a similar financing model as they grow. The first step in this model is to establish a nonprofit, either in the United States and/or an African jurisdiction, to seek grant funding. Grant funding is then used to implement and develop the company’s business model. When the business model has reached proof of concept on an operational level, the second step is often to organize a for-profit entity, typically in the African jurisdiction where the company operates. If the assets and operations (including cash, contracts, tangible assets and intellectual property (IP), and employees) are deemed commercial, the nonprofit may then shift such assets and operations to the for-profit. Nonprofit operations such as research and development, training and education, and consulting may remain at the nonprofit. The third step is typically to seek commercial equity funding, either directly in the African for-profit or in a controlling parent company organized in a tax- and investor-friendly jurisdiction such as Mauritius, to enable the for-profit to scale up. The scaled-up enterprise will then pursue its mission and hopefully achieve its desired social and environmental impact on a broader scale.

 

Legal and Practical Issues for Social Entrepreneurs in Africa

In pursuing this model, ITC clients have faced a number of challenges and pitfalls:

Organizational. Some African jurisdictions do not appear to have a viable form of nonprofit entity, or they may require government or ministry recognition on a case-by-case basis. In some cases, organizing an African nonprofit may take years and be subject to hold-up by corrupt bureaucrats.

African for-profit entities may pose other challenges. Organizing statutes may require that shareholders be citizens; that one or more company directors, the company secretary or the company auditor be citizens or residents of the jurisdiction; or that the company maintain a registered office in the jurisdiction. If shareholders are not citizens, for-profits may be subject to capitalization requirements that are hard for young companies to meet. The number of shareholders may be limited if the company is not listed on an exchange. There may also be restrictions on capital or currency export, which could make it difficult or impossible to raise commercial equity down the road.

Many social entrepreneurs accordingly consider organizing a for-profit parent or holding company in a low-tax and investor-friendly jurisdiction such as Mauritius. The Mauritius parent may be the sole shareholder of the African for-profit and the issuer of equity securities to commercial investors. The Mauritius company may be organized largely free from taxes and capital or currency restrictions, thereby resolving any such issues associated with an African issuer. The Mauritius parent may also be the owner of any IP, which it can then license for use at the African subsidiary. However, some of the same considerations (e.g. residency requirements) may apply in Mauritius as in mainland Africa.

Social entrepreneurs need to be prepared in any event to engage local legal and tax counsel and local accountants in each jurisdiction where they organize an entity or operate.

Shifting assets to the for-profit. If the nonprofit has received grants, standard agreements from foundations or other nonprofits may prohibit use of the grant proceeds, or the work product resulting from the grant, for any commercial or for-profit purpose. Even in the absence of such language, some grantors may be uncomfortable seeing funds shifted from the nonprofit to a for-profit, particularly where control of the for-profit overlaps with the nonprofit (see below regarding conflicts of interest). Social entrepreneurs pursuing this financing model will therefore want to be clear from the start with their grantors, perhaps in writing, as to their for-profit intentions, and should be careful that their grant agreements, to the extent possible, do not include such restrictive language.

Shifting assets from the nonprofit to the for-profit may also be difficult under local law. While nonprofits in most African jurisdictions do not appear to be as restricted as a U.S. 501(c)(3), social entrepreneurs should consult with African lawyers to make sure the desired asset transfers are authorized and to ensure that such transfers are properly disclosed, approved and memorialized in the nonprofit’s board minutes. Companies may need to be creative when moving funds. Grants, for example, may be treated as taxable income. The for-profit may wish to consider selling stock to, or taking a loan from, the nonprofit. Sales of stock may put a valuation on the for-profit as a whole, however, and affect its ability to negotiate price with future equity investors. The for-profit’s use of loan proceeds, in turn, may need to be restricted to the nonprofit’s mission.

Ownership of marks, logos, know-how and other IP may not be clear or well-documented. If IP can be transferred from the nonprofit to the for-profit (or contributed by the nonprofit’s founders in exchange for their shares in the for-profit), and the nonprofit still needs to use such IP, the for-profit may be able to license such IP back to the nonprofit for a specified royalty.

IP valuations are often subjective and may be challenged by tax authorities, particularly if stamp duties or taxes are due on asset transfers and/or IP is determined to be owned by founders and contributed in exchange for for-profit equity. African jurisdictions may or may not have transfer pricing rules, but social entrepreneurs need to ensure that the prices paid for asset transfers or for other goods or services in agreements between any nonprofit and for-profit under common control can be defended as arm’s length and fair market value.

As noted above, the nonprofit may need to obtain consents in order to assign grant agreements, supplier contracts, franchise agreements, leases and other contracts to the for-profit. Employees and employee-related benefits, some of which may be mandated by statute, may also need to be transferred to the for-profit. Such transfers may trigger mandatory benefit payouts.

If the control persons – shareholders, members, directors, officers, trustees, etc. – of the nonprofit also control the for-profit, conflicts of interest may be a significant issue, particularly if those at the for-profit financially benefit from an asset transfer. They should consider adopting, at both the nonprofit and the for-profit in advance of any asset transfers, a written conflict of interest policy.

Seeking commercial equity. In shifting commercial assets from the nonprofit to the for-profit, social entrepreneurs should consider a governance review at the African for-profit or Mauritius parent company, as applicable, to make sure that the entity is ready for commercial investment. Informal governance by founders, without an effective board, may not be reassuring to commercial investors. The company’s constituent documents should reflect that it has an effective board of directors, including independent directors; that there is at least one board committee comprised solely of independent directors to act as an audit, compensation and/or nomination committee; that the board has adopted appropriate written policies such as a board charter or terms of reference, conflict of interest policy, code of ethics and conduct, whistleblower policy, and diversity policy; and that the for-profit’s corporate governance is subject to periodic company or outside audit. Social entrepreneurs should also consider embedding a clear statement of their social and/or environmental mission in the company’s constituent documents.

For these and many other reasons, social entrepreneurs working with small farmers in Africa and their legal counsel will need to be enterprising.

 

David Guenther is director of the International Transactions Clinic at the University of Michigan Law School.

Main photo, and homepage photo by Alan C via Flickr.

 


 

Categories
Agriculture, Entrepreneurship
Tags
agriculture, financial innovation, investors, rural development, smallholder farmers, social enterprise, social entrepreneur, supply chains