The Role of Social Enterprise and Hybrid Organizations

The following post comes to us from Ofer Eldar of Yale Law School.

In my paper, The Role of Social Enterprise and Hybrid Organizations, which was recently made available on SSRN, I advance a theory of hybrid organizations that combine profit-seeking and social missions.

Recent years have brought remarkable growth in hybrid organizations, including firms that pursue corporate social responsibility (“CSR”) policies, socially responsible investment firms, and environmentally-friendly firms. In addition, much attention has focused on a broad but vaguely defined group of hybrid organizations which are commonly referred to as “social enterprises”; these include microfinance institutions, businesses that sell fair trade products, work integration firms, and companies that sell affordable products in developing countries (e.g., eyeglasses and bed-nets). Despite popular enthusiasm for hybrid organizations, legal reforms to facilitate their formation and growth—including, in particular, special enabling statutes for hybrid firms (e.g., the Low-Profit LLC and the Benefit Corporation)—have largely been ineffective. This failure stems in large part from the lack of a theory that identifies the structural and functional elements that make some types of hybrid organizations more effective than others. Rather, legal and economic scholars tend to treat different forms of hybrids, especially social enterprises and firms implementing CSR policies, as essentially the same form of enterprise, i.e., firms with a mixed profit and social mission.

However, defining hybrids by reference to their mission is problematic because verifying and measuring social missions is virtually impossible. Instead, I define hybrid organizations, including social enterprises, as commercial firms that channel subsidies to a class of beneficiaries. If there is no subsidy, the firm is simply a standard profit-maximizing firm. In this respect, I take a broad view of subsidies, to include not only government subsidies and donations, but also premium prices and subsidized investments at below-market rates. For example, a consumer may pay a premium for products if the firm has a strong CSR agenda, or if its products are sourced from fair trade producers. To evaluate hybrid organizations, we thus need to ask what forms of organization utilize subsidies more effectively than others.

The theory in the paper focuses on social enterprises, such as microfinance institutions and work-integration firms, and distinguishes them from all other forms of hybrid organization. Social enterprises have been relatively effective in addressing complex development problems, such as increasing access to capital, improving employment opportunities, and enhancing consumer welfare. The key common characteristic of social enterprises is that they transact with their beneficiaries as patrons, i.e., the beneficiaries are either purchasers of the firms’ goods or services, or suppliers of input (including labor) to the firm. For example, microfinance institutions make loans to low-income borrowers, and work integration firms employ disadvantaged workers. Transactions with the patron-beneficiaries are costly either because of information asymmetries with respect to the beneficiaries’ abilities, or because beneficiaries lack sufficient abilities to transact with commercial firms; hence, the need for a subsidy.

The essence of the theory is that social enterprises perform a measurement role. The financial viability of social enterprises depends in large part on the performance of their patron-beneficiaries. For example, microfinance institutions are financially dependent on the ability of their borrowers to repay their loans. Thus, social enterprises have incentives to measure or gather information on their patron-beneficiaries’ attributes (e.g., workers’ skills or borrowers’ creditworthiness) in order to ensure that they are capable of performing their duties and tasks under their transactional relationship with the social enterprise firm. This information enables social enterprises to allocate subsidies (e.g., a training subsidy) to their beneficiaries (e.g., disadvantaged workers) effectively. In particular, social enterprises have the ability and incentives to tailor the form and amount of subsidies to their beneficiaries’ abilities and preferences as well as the commercial needs of their business.

The measurement function makes social enterprises relatively efficient vehicles for allocating subsidies to promote development goals. For example, microfinance institutions have grown substantially in the last few decades and now provide financial services to millions of low-income customers in developing countries. The relative success of microfinance contrasts with the limited effectiveness of traditional donative organizations, including governments and aid agencies, in spurring development. This paper argues that a possible reason for this is that donative organizations transfer subsidies to external beneficiaries rather than transact with them as patrons. Thus, they have limited incentives and means to gather information on the effectiveness of the subsidies they allocate. Social enterprises should also be contrasted with other forms of hybrid organizations, especially firms that engage in CSR policies. Similar to donative organizations, CSR initiatives typically involve the allocation of subsidy to external beneficiaries. In fact, firms that engage in CSR not only have limited means and incentives to measure the social impact of their policies, but they also have incentives to exaggerate it to enhance their reputations.

The article also describes the various types of commitment devices that social enterprises adopt in order to commit to transacting with their beneficiaries. Social enterprises may form as both for-profits and nonprofits. When social enterprises form as for-profits, there is a risk that their owners will expropriate the subsidies they receive to address a development mission. Commitment devices generally involve a nonprofit or a government agency assuming responsibility for ensuring that the for-profit social enterprise transacts with a class of patron-beneficiaries, such as borrowers or workers. Commitment devices may take the form of certification by a nonprofit in accordance with certain standards (e.g., Fair Trade certification), a contract with a nonprofit, or control by a nonprofit through ownership or voting rights. These commitment devices seem to work well due to their simplicity. Whereas social rating mechanisms, such as the Global Reporting Initiative or B-Corp certification, attempt with questionable success to measure the overall social impact of corporations, these commitment devices verify structural elements (i.e., transactions with patron-beneficiaries) which can be observed at relatively low costs. The transactions with their beneficiaries ensure that social enterprises have incentives to utilize subsidies effectively.

Finally, the measurement function of social enterprises may serve the basis for designing a new social enterprise legal form and reforming corporate subsidy programs to promote development, including the Small Business Act and the Work Opportunity Tax Credit. In future work, I consider the policy implications in greater depth; this article focuses on laying out the structural and theoretical underpinnings of social enterprises and other hybrid organizations.

The full article is available for download here.

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One Comment

  1. Thomas R Carter
    Posted Tuesday, March 4, 2014 at 8:10 am | Permalink

    In addition to the types of hybrid enterprises that are described, there is the cooperative which is not a hybrid, but which is an enterprise that by its structure and governance benefits the user, not the investor. Sadly, many consider the cooperative as “old news”. Cooperatives are not a new and sexy idea like microenterprise, a form that generally falls far short of the type of economic impact its proponents claim.