Social Firms and the CIC Consultation

Having recently drafted a response on behalf of Social Firms UK to the April consultation on amendments to the CIC Regulations, I'm now thinking about the June consultation on the dividend and interest caps.

While the credit crunch has certainly revealed a problem with tying the caps too closely to Base Rate, my main concern is that from the point of view of Social Firms this consultation in fact asks the wrong questions about the dividend and interest caps.

Social Firms create jobs for people with disabilities and other severe disadvantages in finding employment. In doing so they tackle some of the most intractable cases of social exclusion, for example of people with mental health problems or learning disabilities. Their workers often have high support needs, and for this reason Social Firms often need an element of grant funding, at least at start-up, while still aiming to fulfill their social inclusion mission by becoming financially sustainable from trading alone.

The CIC form was a godsend to Social Firms, precisely because it combines an asset lock – which reassures grant funders - with normal commercial operation. The weakness of the CIC form lies in it's treatment of stakeholders.

The limitation of the Share CIC form for Social Firms, in particular, is that it does not allow the reward of the 'sweat equity' of the founders or on-going workers in the way that an ordinary share company could. Thus while the limitation on dividends is essential for outside investors (to reassure grant funders and therefore maintain the fundamental strength of the CIC form), we do not feel this should apply to shares held by or on behalf of emloyees – many of whom already experience the most severe financial exclusion.

One solution might be to go back to the original CIC idea of divorcing financial participation from governance (allowing non-voting shares to receive uncapped dividends); however, I can see the practical difficulties with this approach. A better solution for Social Firms would be to allow the specification in the articles of an HMRC approved employee share trust (or a specifically defined all-employee benefit trust) as a qualifying asset locked body to which uncapped dividends could be paid. This would enable such a trust to purchase new shares in the Social Firm CIC on behalf of employees, and if indeed significant profits are made and therefore significant share values develop, to act as an internal market, purchasing shares when older staff leave and realising the real value of their 'sweat equity' – tax free if they have worked for the Social Firm 5 years or more. It would also, indirectly, enable the Social Firm to retain profits free of corporation tax.

If this were possible, it would be an easy matter to develop a model Social Firm Share CIC + Employee Trust model that would cost no more than a normal CIC design and registration – and the costs of administering the trust would be tax-deductable too.

While such a model might be a bit less attractive to some grant funders, the Guarantee CIC could be used if necessary in those cases. In fact, I believe this would be a small problem, because most likely funders see developing financial inclusion as indeed a key strength of Social Firms.

It might also be objected that non-disabled/disadvantaged CIC employees might benefit from such a provision. Indeed they might – but is this really a problem as long as the trust is indeed an ALL employee share scheme, not just an executive tax avoidance mechanism?

There is also an interesting governance advantage here: the CIC board would have their clear responsibility, regulated by the community interest test/reports, to act in the community interest, while the trustees as probably a major shareholder would have a clear responsibility to safeguard the interests of the staff. So we might begin to address the CIC stakeholder problem into the bargain...

is the CIC regulator trying to tell us something?

ordinarily I'd copy my latest thoughts from my blog here, but I'd kindly ask you to redirect your browsers to: http://thirdsectorexpert.blogspot.com/2009/07/is-cic-regulator-trying-to-tell-us.html, as my latest thinking includes photographs...

CIC | Asset Lock <AND> Dividend Caps Should be Modified

Geof,
I agree with most of your comments on the shares; excepting the comment about caps are ok for "big" investors.
I would add that the regulator has over egged the restrictions to play it safe, but has blocked money in the process. B/c the asset is locked, it is extremely difficult to find investors. Because the cap is not related to risk, it also makes it difficult to find a wide range of investors.

I would propose a simple solution: 49% cap on Asset Appreciation; 49% cap on any shareholder; introduction of sweat equity paid up shares.
This would do a number of things:
1. Investors would now be drawn by asset appreciation.
2. Investors could be partners, getting a large dividend for their shareholding (currently each shareholder is restricted to cap and totals to 35% for all shareholders as you know).
3. Funders would be able to move the asset lock up according to amount funded and purpose of asset.
4. Risk of the business would be matched more closely to investment return.

I am going to urge the regulator to create simple restrictions to allow decent returns for social entrepreneurs and investors; all the while locking asset value (a meaningful majority portion) for communities.

I'm not sure about this

I'm not sure about this Todd.
The CIC Consultation on the Asset Lock & Dividend Caps is closed now; that doesn't of course mean that we should stop discussion of how to optimise the CIC form, and putting forward our views to the Regulator - but for me one of the things that has emerged most strongly from the discussion to date is the lack of consensus - even among some of the most expert people in social enterprise like Jim Brown, Philip Angier, Adrian Ashton and Dr Ridley-Duff, who have commented here before.
For me I suppose there is a glaring problem around how the CIC form sits with what has always been - and should be - a really central aspect of social enterprise: employee participation (including financial participation). This has a social justice implication highlighted by Social Firms - because a Share CIC form tweaked in the way I suggest could enable disadvantged people to participate in the way that wealthier people can in ordinary share companies.
This is a different (and I think more ethically-driven) argument from the points you raise around the ability of the Share CIC form to raise investment, although of course there is a 'justice' aspect to the risk-return equation.
As I have said - especially in the light of what happened to interest rates etc in the credit crunch - I would not be opposed myself to some loosening around Share CIC dividends and capital gains - but this does have to be approached very carefully because of the lack of consensus among social entrepreneurs themselves, and the possible impact on the Share CIC as a grant-raising vehicle - which for the vast majority is much more important than equity-raising.
One question I would want answering for example is whether raising large scale equity investment is a central problem - after all if you're going to meet the costs of that exercise can't you afford the relatively small additional cost of say a dual company structure - like for example the Centre for Alternative Technology - that combines ownership and investment vehicles without using the CIC form?
GEOF

CIC Review submission

We must be careful not to try to have our cake and eat it. The benefit of a CIC is that it offers a framework for philanthropic investment in an enterprise underpinned by an assest lock (So as against Co's limited by g'tee there is an easier mechanism to introduce patient equity)

If investors want a more commercial return - including founders - there is always scope to use the conventional vehicle of a company limited by shares. There are examples of social enterprises trading as sole traders or limited companies for precisely these reasons.

So I don't see a compelling argument to uncap dividends - if you choose the CIC route it is right to accept restrictions on investment return

Since posting this entry a

Since posting this entry a few people have e-mailed me directly for further explanation of the issue I'm trying to address.
The specific problem is that the CIC regulations limit dividends to a small percent of sums actually invested. This is fine for external capital or large investors - because a small percent of a large sum is still worthwhile - but poor employees investing mainly time and effort but only a little cash can't get a decent return - and their early effort building the business but not taking commensurate wages cannot really be rewarded - they're building a future value that is not available to them in cash yet. Educated/independent/well-off workers will just form an ordinary share company and get unrestricted returns for their time and effort, but because disabled/poor workers need a powerful grant-raising structure they don't have this option. In this sense, regulation 'in the community interest' actually works in favour of the rich and powerful and against the poor and excluded.
The core of the issue is stakeholder analysis - how to draw a distinction in the rights attached to shares between disadvantaged workers actually investing and risking a relatively huge amount of both time and money - and remote exploitative investors.

My thoughts

Goef, I would support the idea you have here. So far as I can remember from practice, there are legal problems with a company buying back shares from its own staff (i.e. it could be challenged in a court as illegal practice). Adrian's solution, while grounded in common practice in the charity section, still privileges the corporate entity over the individual and the issue here is the meaningful transfer of wealth throughout the community (not a vehicle for the great and good to monopolise both power and wealth). The solution you propose is not "too complicated" - it is the norm in employee buyouts, so far as I can tell, so the issue is whether the trust would itself be seen as in the community interest. There is a significant literature on this in the USA, and the EAO and Baxi Partnership advocate the model you propose, albeit investing in a non-CIC legal entity. It is in use in the social enterprise at Eaga, Sunderland Care Home Associates etc. so there is expertise throughout the sector on how to make it work. I don't agree entirely with Jim Brown's assessment that coops simply "top-up" basic wages through dividends, and use equity as an incentive scheme for financial prudence. The equity stake is an important expression of membership (more outside the UK, than inside - see Zvi Gabor's writings), granting voting and governance rights. Some theorist regard it as a mechanism to ensure that staff are not exploited by a ruling elite: it ensures that they receive the full value of their labour contribution and that any ruling elite has to seek their consent to reinvest their dividends (thereby ensuring broader consent for the retention of surpluses in the enterprise). Your proposal is similar to the original SHU submission on the CIC that argued for capital growth shares for beneficiaries identified in the Mem & Arts, and for employees through a community bank or trust. This is now in the public domain at: http://www.scribd.com/doc/13647544 (see page 16 for the ownership model) Good luck. Best wishes Rory

Yes I remember at the time

Yes I remember at the time of the original CIC Consultaton there was a lot of common ground between your response and mine (also on behalf of Social Firms UK). I'm with you also on the 'too complicated' issue - while it's true that in large businesses an Employee Share Trust can have a governance role - acting in fact like the supervisory board that oversees the company board in the German 'Mitbestimmung' system (that some still believe was responsible for the astounding growth of the German economy in the decades after the war) - but in a small CIC the Share Trust would just be an administrative device, with substantially the same individuals as Trustees and CIC Directors, and of course and admin costs would be tax deductable.

another initial response

Geof - initially, thanks for creating this opportunity for us all to start to think more creatively around some of the concerns over CICs, specifically in relation Social Firms (although the points of your argument could largely apply to most other models of social enterprise)

so - in terms of what amounts to a proposed two-part structure for Social firms pursuing CIC status (share CIC with employee Trust) why not simply simplify the arrangement to the lowest demoninators? So there'd be (1) a share CIC with workers receiving sweat-equity returns through annual share allocations (and as the shares couldn't be traded for more than their face value, would mean that the enterprise remains financially prudent and relatively sound while also encouraging loyalty and reducing turnover as workers could only sell them back to the company when they leave but in the meantime benefit from a share of profits created), and alongside this (2) a stand alone charity that has an interest in the CIC through owning some of its shares and a strong overlap of social mission/objective, and that (amongst other things) seeks to raise funds to deliver the activities that the Social Firm may struggle to otherwise cover in terms of support (and through its shares in it would be able to more easily and flexibility support start up and later development costs?)

Such an arrangement might have a few advantages over a linked employee trust and re-jigged CIC:
a) less complex so easier for people to 'get' and therefore adopt and use
b) more clearly seperates the enterprise from the charitable in the Social Firms' governance and financing - a tension of social firms in the past has been between both how they manage funders' requirements against economic market forces, and how they limit the number of people they can support; this arrangement should help to resolve both? It would also enable the enterprise to more easily present an apprpriate 'face' to respective stakeholders
c) creates more 'space' for creativity at the interface between enterprise and social in so clearly deliniating the two

of course there are potential downsides to it too, but that's why I'm going to stop typing now and allow others to start to compare and contrast arrangements/models/relationships in the hope that they might be able to spot other opportunities in helping us agree a consensus on how the CIC form might be best used.

My initial reaction to your

My initial reaction to your comments is that maybe what you propose is a bit too complicated. I think the concept of "sweat equity" can cause some confusion here between the role of capital and labour. As you know, IPS co-operatives pay interest on capital and dividends on transactions. The purpose of dividends isn't really to share profits; rather it is a device to encourage financial prudency. So, in a workers co-operative, members might receive a basic rate of pay, and if the co-operative is profitable, then members get a top up. As an entirely separate matter, workers can invest in the co-op, which will receive interest (sufficient to attract the investment), which in turn can be re-invested.

In it's early years Social

In it's early years Social Firms UK heavily promoted the co-op option, and it is a very remarkable fact that despite this - and despite the example of very successful Co-op Social Firms like Daily Bread - almost no Social Firms in fact chose to be co-ops. The reasons for this are many (analysed in my research report here - http://www.lsbu.ac.uk/bcim/cgcm/conferences/serc/2006/papers.shtml) - but 2 key practical points are their relative weakness as grant-raising vehicles (which is related to the worker co-op's own obvious stakeholder problem) and of course lack of potential for tax-efficiency.