Why social enterprises should be kept non-profit

I spent 10 years in the private equity world firmly believing that self-interest/ incentives drove people to perform – capital appreciation/ dividends for owners and higher remuneration for employees. Even when it came to the social sector – in order to be sustainable one had to build a for-profit model. But the past two years, where I have spent a lot of time in the social sector, have forced me to back track a bit on this.

A part of this change in attitude is based on experiences I have seen at some social enterprises and the SKS Microfinance example is not an exception. I have seen education and artisan-based manufacturing enterprises change their DNA when they started focusing on profits after raising private equity from external investors. Friends who worked at such companies complained about three things:

1. All shareholders stood to gain financially if valuations went up. So there was more focus by the senior management on profit growth and expansion. This severely impacted service delivery and team spirit across the organization.
2. Many employees had joined the organization driven by a mission of service. As the enterprise’s focus changed to profitability they realized that they didn’t fit in and some people left. The soul had gone out of the organisation and a new breed of corporate professionals stepped in.
3. Sometimes capital is raised at a step-up valuation and then the management finds it tough to meet those targets. This causes tension between the promoters and the new investors forcing the organization to focus on unsustainable growth and less on service delivery.

This caused me a lot of angst since it went against what I believed was needed for building sustainable organizations.  I don’t believe that making profit is bad, but when profits become the sole driver, social enterprises change sometimes into a different beast.  A clarification is needed here – there are two types of for-profit organizations. The first is the one that we are familiar with – the ones where investors hope to make money from dividends, capital appreciation or both. The second is like our Section 25 companies where profits are not distributed to investors but are instead re-invested or distributed to the poorer stakeholders. I find that the second category is more sustainable because incentives don’t get distorted across different stakeholders. Take for example the leading educational universities in the US – they are private, non-profits but run as serious businesses with budgets, performance targets and measurement. And have existed for over a hundred years in many cases.

I discussed this with Priya Naik, founder of Samhita Social Ventures. She raised an interesting point – when all stakeholders don’t share in the upside fairly, problems occur. For example, if the investors make out like bandits but the poor borrowers don’t share in the upside we see tension. Or where investors make huge profits but teachers and artisans are still paid as if they work in a non-profit we see tension.  Hence, it is important that incentives are fairly aligned across the organization. The argument given by investors is that only investors share in the down side when the market capitalization falls and therefore they should have a disproportionate share of the upside. But try selling that argument to politicians, social-workers, activists, teachers and artisans who are not financially savvy. It is not easy. It is therefore important that social enterprises raise capital from appropriate sources – they should look for patient capital which is also interested in creating social impact.  Building a traditional bricks and mortar education business takes a long time no matter how steep the promoter’s growth forecast graph is!

There is one more type of social enterprise – the NGO or traditional social sector organization, mainly set up as a trust in India. India abounds with them – 3 million NGOs is one estimate. That means one for every 400 Indians. An absurdly high number, which is why I don’t believe this number. Most of these NGOs will fail and as Priya also remarked, the cost of failure at a non-profit is higher because many disadvantaged or helpless people would have become dependent on them.  These NGOs need to merge (sorry bankers, there are no fees in these M&A deals!) and pool resources in order to survive and grow – easier said than done with many NGOs run by very passionate and sincere people who, unfortunately, believe that they are the only ones  with the right model. These NGOs need to adopt corporate practices like budgets, processes and regular reporting to be sustainable. But it needs a lot of training and effort to get people who are solely driven by passion and who are doing excellent work to look at becoming more ‘corporate’ in some aspects of their work. These social enterprises would see even more turmoil if they converted into for-profits.

I started a discussion recently with a Gandhi scholar, which is still unfinished, where my argument is that when wealth accumulation becomes an option, people change their behaviour and even ‘good’ people get corrupted. I learnt this when I read ‘Animal Farm’ as a kid. I am currently reading a book on post-colonial Africa, The State of Africa, where tyrants were overthrown sometimes by well-meaning people who adopted the same tyrannical behaviour a few years later, just as the pigs did in Animal Farm. A well known European DFI (developmental financial institution) recently tore apart its team when the management tried to convert the organization into a for-profit entity with shareholder wealth creation as the main driver.  Even in private equity firms, which have always been for-profit, I have seen team dynamics change when carry (profits from investments) starts getting distributed.

So I maintain that it is very difficult for social enterprises to remain ‘social’ enterprises if they become for-profit since it is very difficult for all stakeholders to believe that the wealth creation is being shared fairly. The success stories are the exception, not the rule.

About the columnist: Luis Miranda founded IDFC Private Equity in 2002 and retired in 2010 to focus on helping not-for profits and driving his kids and wife crazy. He has had more success with the second.