Investing in the Arts

During a recent conversation with the artistic director of a New York-based theatre company, he told me about his meeting with a major philanthropist. At one point it became apparent to my colleague that the donor was not going to provide funding. He asked the donor the reason why. “The work you produce is too commercial. It isn’t artistic enough,” said the man. To which my friend replied, “I have to do work that appeals to commercial interests because you won’t invest in my company!” I was struck by his choice of the word invest, the word that makes the arts community shudder. “Invest? Invest? We are nonprofits with charitable missions. People do not invest in the arts. They donate!”

I fully understand my colleague choosing commercial work; material he believes holds commercial potential, yet still has the priority of artistic integrity. Producing work of artistic value and quality is a given for all of us in the arts, so for a moment, let’s take noble art out of the equation and look at this solely from a business and financial angle. I hear the screams of discontent coming already. “Creating art is not just about money!” I agree, it is not just about money, but historically the arts have always been dependent on financial benefactors such as the church, nobility, a rich merchant class, and even the government, which one could argue was the church, nobility, and rich merchant class. As the industrial age in Great Britain ushered in the Calvinist notion of charity, concurrent with the rise of a European leisure class with disposable income to spend on entertainment, the seeds of the spirit of capitalism were planted. The munificence of the noblesse oblige set the stage for our present concepts of philanthropy in the arts, as well as education, health, and religion.

Currently, in the United States a philanthropist donates money to a nonprofit tax-exempt charitable organization and, in return, receives a qualified taxable deduction. Or, a foundation grants money to a nonprofit, tax-exempt charitable organization and, in return, satisfies the foundation’s IRS distribution requirement of paying out 5 percent of their assets annually, which they must do to maintain their charitable status. Both 501(c)(3) companies and private foundations follow statutes established by the IRS and, in both situations, the IRS dictates there can be no personal financial gain or return on the funder’s investment. Or should I say donation?

What if we looked at this financial support, as my colleague does, not as a donation but an investment? After all, doesn’t one donate to (invest in) an organization because they believe in an artist and the work he or she produces? Don’t foundations grant to (invest in) organizations because they believe in its artistic mission? Although there is no actual financial gain for either the philanthropist or foundation, they definitely invest their money. If we look at the words donation and investment interchangeably, they begin to function in a similar fashion, with the exception of one major factor. There is no possibility of return on investment (ROI) with a donation.

What if there was a legal and corporate structure that allowed funders to support the arts and make a return on their donation/investment? Imagine an investment opportunity in which the foundation or philanthropist could receive some, if not all of their capital back, with the added bonus of making a profit, which could then be utilized to fund other creative ventures, furthering their charitable missions. If such a corporate entity existed, what potential would it hold for the arts? Would my colleague’s donor be more willing to invest in his theatre company? If we want to develop and produce theatre that is challenging, innovative, and pioneering, we need new business models that are equally as challenging, innovative, and pioneering. I believe there is such an alternative business model that can be utilized to build cultural institutions, fund projects, and develop new theatrical properties. The low-profit limited liability company (L3C), or “for-profit with the nonprofit soul” as its creator Robert Lang refers to it. Since it was first legislated in 2008 by the state of Vermont, other states including Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, and Wyoming have all adopted L3C legislation, with more states considering it, including New York.

The L3C is best viewed as a for-profit corporation, and not a nonprofit that makes money. Organized to achieve charitable and socially beneficial results, the L3C operates in the space between a pure for-profit entity and nonprofit organization. It combines the financial advantages of the limited liability company (LLC) with the social advantages of a nonprofit. Enacted as an amendment to a state’s general LLC act, rather than as a separate act, the L3C keeps intact years of LLC legislation, making it easier to understand than a completely new corporate structure. Like a LLC, with regards to its legal and tax structure, the L3C has the liability protection of a corporation and flexibility of a partnership, allowing its members to have management responsibilities, hold voting rights, make investments, and receive investment income. Unlike a standard LLC though, since the L3C is specifically formed to further a charitable purpose, the social mission is embedded into it’s statutory framework, providing the owners and managers of the corporation with the ability to place achieving a charitable mission as the company’s primary purpose, without violating any fiduciary duties to the company’s investors. Simply stated, they can put mission before finances, and make creative/artistic choices over financial ones, producing a “double bottom line” approach to business with a “blended value.”

While many question the ability of a corporation to “serve two masters,“ the L3C legal structure provides a template for a for-profit whose main purpose is to further a charitable purpose. Its sole purpose does not have to be furthering a charitable mission as in a nonprofit 501(c)(3); it just has to be its primary purpose. Profit making is secondary to the mission. However, revenue generation needed to support the mission is not restricted as the IRS recognizes that a profit, even a substantial profit, might result with the corporation, as long as profit generation is not the original purpose for which the L3C was established. This priority of purpose is built into the L3C’s statutes and legal structure and becomes the fundamental principal behind the key pin of the L3C—the program-related investment (PRI).

By state statute, L3Cs are designed to implement their primary purpose—to dovetail with IRS regulations under the US Code of Federal Regulations 26 C.F.R. § 53.4944-3 relevant to program-related investments by foundations. Under Section 170(c)(2)(D) of the IRS tax code, in order for private foundations to maintain their tax exempt status they must distribute approximately 5 percent of their assets annually. Traditionally, this is done through grants to 501(c)(3) nonprofits. Foundations can also meet the IRS 5 percent annual distribution requirement in several other ways, including making a PRI, which can come in many forms such as a loan, loan guarantee, equity purchase, or other investment, and be made to either a nonprofit or for-profit entity as long as the funds are used to further an acceptable charitable purpose. The L3C provides a platform that is PRI compliant, streamlining the qualifying process for PRIs from foundations by eliminating their need to acquire a private letter ruling from the IRS, typically a lengthy and expensive legal process.

With a L3C one instantly recognizes a brand that represents the unique symbol of a for-profit company organized to achieve charitable and socially beneficial results.

In addition to allowing foundations to bypass the IRS private letter ruling requirement, the L3C works as a recognizable brand. One of the major problems facing hybrid corporations is a lack of clear terminology. It is hard to skate the for-profit and nonprofit world without a clear picture of what one is doing. The L3C addresses this crucial issue of branding because its charitable purpose is built into its core values. Like any other corporate structure, whether a C or S corporation, partnership, LLC, or 501(c)(3), the name itself indicates the type of business and immediately identifies how the organization approaches doing business. With a L3C one instantly recognizes a brand that represents the unique symbol of a for-profit company organized to achieve charitable and socially beneficial results.

Another key feature of the L3C is its ability to facilitate “tranche investing.” Tranche investing refers to different classes of offerings for investors within the same investment opportunity, enabling the company to attract various forms of equity. The L3C’s legal and statutory arrangement facilitates its profit making abilities through these various tranches. In an L3C's offering papers, the proposed structure outlines the tranches, which can vary as to risk and return on investments. By law, foundations can only receive a low return on their PRI investment. Strategic to an L3C’s operation is its use of this low cost foundation capital in a high risk tranche. Under the L3C’s structure, foundations would normally be expected to be the first in and to assume the highest risk at very low return, creating a desirable climate to attract capital from private and corporate investors interested in the charitable purpose of the L3C, as well as possible market-rate investors. Unlike a straight nonprofit 501(c)(3), the L3C can tap into conventional capital investment markets and philanthropy. This is the key issue—tapping into the usual places a corporation does for capital and tapping into philanthropy. While the L3C will not eliminate or replace the 501(c)(3) nonprofit structure based on charitable donations, in the words of Elizabeth Carrott Minnigh who authored the original L3C legislation, “It is always good to have another trick in your bag of tricks.” It is not a question of either/or but, instead, both/and. It is a matter of exploring ways we can incorporate this new corporate entity and business model into the way we fund artistic endeavors and, in the process, view ourselves in the arts more as start-ups looking to attract venture capital. The L3C provides the arts with the unusual opportunity of appealing to four different types of investors—foundations, philanthropists, social investors, and market rate investors, all of whom currently fund the arts through charitable donations.

I know my friends who are principals in development departments of leading cultural nonprofits will be uneasy about the thought of money typically granted as donations diverting to investments. They are accustomed to working with foundations, grantmakers who underwrite organizations, and projects, and not with people who underwrite deals for investment and return. Their concern actually presents the very issue of what I believe is one of the successful hallmarks of the L3C, and other hybrid corporations; their ability to return capital and profit to the investor. Instead of giving away money in the form of donations that a philanthropist will never see again (100 percent loss), the investor (corporate, foundation, or individual) invests money, benefiting from the possible financial returns on the investment (1 percent to 100 percent ROI, with potential profits), allowing them to donate and/or invest more money in the arts. The L3C opens up the possibility of doing good and furthering a charitable mission. By redeploying revenue streams, an even larger pool of money is made available for investing and donating, with the even greater potential of further regranting and reinvesting. Creating what John Tyler, a leading thought leader in American philanthropy, refers to as the “virtuous cycle.”

Perhaps if the philanthropist my colleague spoke with had known about the L3C he might have considered investing in his theatre company. The donor likely had the mindset of giving his money away rather than making a sound financial investment that, concurrently, created great theatre. He is likely unaware of the existence of an investment from which he has the potential of seeing a ROI and making his capital back, something a nonprofit organization would never be able to offer. And what if he lost the money on the investment? Wouldn’t he be in the same financial position as if he’d given it away as a donation to a 501(c)(3)? In both scenarios, he would be out the money. With the donation he would receive a charitable tax deduction, and with the investment a business loss he could then amortize over the next couple of years. For a donor/investor, what they decide to do with their money depends on (i) their personal wealth management needs at any given time, (ii) how those needs align with their charitable goals, and (iii) their desire and willingness to make investments with a social impact. All three govern how they donate/invest their money. Herein lies the second aspect of the L3C’s great potential in the arts. The relationships are already established with funders. All that is required is a shift in perspective of how we view donations and investments.

How does the L3C gain traction and become more embraced as a business model in the arts? Success and inculcations of the model will require the adoption of L3C statutes by more states and continued legislation on the federal level; the education of foundations, private investors, corporations, government, and entrepreneurs on how this new business entity and investment tool is structured and operates; a paradigm shift in the art’s view towards philanthropic funding to include social impact investing, tapping into the rising tide of social investors seeking investment opportunities; the creation of business models that are based on predictable revenue in excess of expenses with producers, arts managers and artists thinking more like social entrepreneurs looking to attract venture capital; our present nonprofit arts institutions beginning to utilize the L3C to fund specific projects and endeavors; and, an increasing number of cultural entrepreneurs who chose to incorporate their businesses as L3Cs.

I’m confident we have cultural entrepreneurs; but do we have those willing to embrace this new model and invest in them?

My favorite quote about the L3C and its potential use in the arts comes from Diane Ragsdale, arts consultant. “We perhaps need to test the viability of the L3C model in a variety of circumstances over the next several years to know whether it holds real promise for the cultural sector. But this much I know: in order for the L3C model to work there will need to be both cultural entrepreneurs and those (private and public funders) willing to put in the risk capital … I’m confident we have cultural entrepreneurs; but do we have those willing to embrace this new model and invest in them? I hope so; because it’s going to take two daring souls to do this dance.”

One of those cultural entrepreneurs Ms. Ragsdale speaks about is the artistic director I mentioned at the beginning of this article. He is eager to utilize an alternative business model like the L3C to produce the new plays he is interested in presenting. I myself am passionately optimistic in finding the foundations and socially motivated philanthropists out there willing to invest in the arts because it is only going to take one—that first successful L3C in the arts to lead the way, and everyone in the cultural sector will become enthusiastic to understand how they can do it too.

(Editor's Note: This Friday, November 16, Watch and participate in the L3C symposium livestreaming on #NEWPLAY TV from 11am PST - 3pm PST / 1pm CST - 5pm CST / 2pm EST - 6pm EST / 19:00 GMT - 23:00 GMT. Participate in the online forum led by Alli Houseworth by using hashtags #newplay, #arts, #L3C and by following @L3C_ARTS. Click here for more information.)