A Framework For Deciding Whether to Form a Nonprofit or a For-Profit Business

In the early stages of developing a mission driven venture, it will be essential to address the question of whether your venture will be a nonprofit organization or a for-profit business.

The answer to this question will dictate the direction that your new venture goes.   

So, before you delve into the various types of legal structures available, it’s essential to ask yourself some broader questions to determine if your venture should be a nonprofit organization or a for-profit business.

Fortunately, Jim Fruchterman, in his 2011 article For Love or Lucre[1], developed a fantastic framework for how to think through these issues.

Fruchterman groups mission driven entrepreneurs into three groups:

First, there are those entrepreneurs whose primary motivation is personal wealth.  For them, changing the world for the better may be important, but not fundamental.  This type of entrepreneur should create for-profit business. 

The second group are the entrepreneurs whose primary motivation is to give away money, or provide services at below cost, and to feel good about it.  These entrepreneurs fit squarely into a 501c3 nonprofit structure.

The third group falls somewhere in between making lots of money and giving most of it away.  This third group should consider the following four questions:

What Is Your Motivation?

Let’s assume for this purpose that you’re driven, at least in part, by a social motivation.  From that assumption, ask yourself the following questions:

How fundamental is the social mission? Is it your primary goal? Would you pass up a lucrative financial opportunity that took you away from the social goal?

What are your personal financial objectives for the venture? How much do you intend to invest in it personally? What payoff are you looking for eventually?

Remember nonprofits must spend their money in pursuit of their mission. This can include reasonable compensation of the organization’s employees. But there are no profit distributions from a nonprofit.  Rather, profit is invested in programs to carry out the mission.

For-profit businesses on the other hand can make profit distributions. For example, a corporation may issue dividends to shareholders.  An LLC may make profit distributions to the LLC members.

How do you define success?  

Keep in mind that external factors can impact how you define success.  In a for-profit business, investors will expect a say.  In a nonprofit, foundations or other grantors will have a role in defining success.

What Market Are You Targeting?

Consider each social issue that your venture will address, and re-cast them into market questions.  For example:

Who are your customers?  What need will you fill? What community will you serve? 

Are the users of your service or product the same people who will pay for it? Hint: If the answer to this question is no, then a nonprofit organization may be most appropriate.

Who or what is the competition?  How might the competition become distribution channels for your new solution?

Keep in mind the optics at play here.  A for-profit competitor may be vulnerable to a new nonprofit offering similar services since the nonprofit may be given more of the benefit of the doubt. 

On the other hand, if the nonprofit sector is not being responsive to a community’s needs, then a for-profit business focused on customer service may have a leg up.  

What is your value proposition?   How will you differentiate your product or service from the competition?

An interesting example of a company with a unique value proposition is Toms Shoes.  Toms Shoes pioneered the one-for-one business model.  For each pair of shoes sold, the company gives one pair to kids in developing countries. Toms’ value proposition is to improve the lives of millions of people around the world while creating a sustainable for-profit business selling fashionable shoes to aware consumers.

An example of a nonprofit organization with a clear and unique value proposition is charity:water. Charity: water’s website succinctly states what makes them different from other nonprofits. They promise that 100% of a donor’s contributions go to helping people. They provewhere donations go with GPS tracking. And they work with local partners around the world to supply water. 

Note that if you start a nonprofit organization that provides products or services that are typically provided by for-profit businesses, you will need to justify to the IRS why your organization should be tax-exempt.  If that is the case, ask yourself:

Is providing goods or services at below cost in line with your business plan? 

Are you willing to fundraise to close the gap between revenues and costs?

If your answer to either of these two questions is no, then you’ll probably want to start a for-profit business.

What is the market sizeand how profitable could you be serving that market?  The larger the market, the easier it is to build a for-profit business.  

Also consider what type of profit margins you expect, and whether they’re sustainable for a for-profit business. If you expect to lose money, then clearly you should consider a nonprofit structure.

How Do You Plan To Raise Capital?

Capital requirements play a pivotal  role in whether to form a  for-profit business or nonprofit organization.  A for-profit business may raise money from private investors, and it will need to provide a financial return on that investment.  Nonprofits can seek funding from individuals, foundations and corporations, who will expect a social return.  

Consider these questions:

How much money do you need to get your venture launched?  What options are available for finding that capital? 

How much money will you need to keep the business growing?  Remember that initial funding requirements may only get you through the startup phase and additional funds may be necessary to achieve profitability or sustainability, and to expand or scale. 

Will you have assets you could borrow against?

Note that foundations sometimes make low interest loans to quality nonprofits that advance the foundation’s charitable mission.

Would tax-exempt status affect your business finances significantly?   501c3 nonprofit organizations are generally exempt from income and property taxes.

Is your main source of capital philanthropy or government funds? If yes, then a nonprofit organization may be necessary.

Keep in mind that some ventures may be started on a shoe-string or as a side venture with only the founder’s personal investment of time or money.   If this is the case, you should still ask yourself if outside funding would be desirable at some point, and if so what kind of outside funding?  

What Type of Control Do you Want Over the Venture?

For-profit businesses tend to be more flexible and give the founder more control.  Nonprofits, on the other hand, are bound by certain governance structures and under the control of a board of directors.

Ask yourself these questions:

How important is confidentiality and privacy to you and your new venture?  Privately held for-profit businesses can be very private about their business information.  Nonprofits are required to operate with much greater transparency.

Can you run and fund your venture yourself?  If so, you may want to start a for-profit business rather than a nonprofit.  If you can completely control the venture, you have more flexibility to run it the way you want.

Will you need to share control with investors?  Keep in mind that once you have a return-oriented investor, your flexibility is more limited.

Will you need or want to share control with the public interest?  If you set up a nonprofit, the organization’s mission comes first, and the founder’s fate is somewhat in the hands of others. The board of directors could even remove the founder.  

In any case, as a founder, you should be sure to choose partners, investors and board members who share your vision and who can be trusted with stewarding your venture. 

This framework of questions was designed by Fruchterman to help social entrepreneurs decide whether to start a nonprofit organization, a for profit organization or some combination of the two.  From there, it’s easier to decide on the specific legal structure 

Once you’ve worked through the framework, you’ll be in a much better position to work with your attorney/accountant to choose  your specific legal structure (501c3, LLC, S corp, etc.).

[1]Fruchterman, Jim.  For Love or Lucre. Stanford Social Innovation Review. Spring 2011.