Are social enterprises different?

Social enterprises: fundamentally different or just another shade of grey?

Jeff Skinner, Executive Director of the Institute of Innovation and Entrepreneurship tells us.

It seems to me…

In recent years I’ve noticed many more people talking about social enterprises, purpose-driven ventures and impact investment. Many more students use these labels for their new venture ideas and there are now accelerators and funds dedicated to the sector.

Such talk can be confusing to observers who struggle to understand the distinction. Social entrepreneurs (and their enterprises) must surely be fundamentally different from conventional, ‘for-profit’ ventures. Otherwise, why else all the fuss and spotlight on distinct sets of skills, stakeholders and sources of funds?

I have agonised over the differences and whether they are material, especially at a venture’s early stages. I‘ve seen dozens of social enterprises competing in London Business School (LBS) competitions – for example, the Global Social Venture Competition, MIINT, the CleanTechChallenge. I’ve studied many others – indirectly as supervisor of student consultancy projects, and directly as an advisor to student start-ups. In terms of the challenges these entrepreneurs face and the strategies they follow, I’d argue that social enterprises and unabashed for-profits have far more in common than you might think.

Enterprising students

It’s wonderful that so many students want to start their own businesses. While motivations may differ, very few seem extrinsically attracted by downstream riches. Most have identified a need (a ‘pain point’) and are determined to find a product or business model that will fix that pain and thereby do ‘good’. They want to improve lives, and their chosen vehicle to make that change happen is a freestanding venture.

By this measure, most enterprises are ‘social’. They may not be solving all the problems for those at the ‘bottom of the wealth pyramid’ or clearing up urgent environmental issues. However, their very existence depends on developing products that benefit others in the hope that someone will reward (i.e. pay) them for doing so. They also provide employment and pay taxes, which compounds the social benefit. As economics pioneer Adam Smith observed, public good often results from private interest.

In many ways, new ventures must be social. At the outset they exercise no power over anyone, and so other entities and individuals will only engage with them if they provide a fair return to everyone they do business with. It is only later, when those businesses have developed sources of ‘sustainable competitive advantage’ that they can exploit new-found power over their value chain and use ‘rent-seeking’ behaviour to start making supernormal profits.

When businesses accumulate power …

According to Harvard Business School professor Michael Porter, social enterprises “create economic value in a way that also creates value for society by addressing its needs and challenges”. The trouble with this definition for a new enterprise is that there is very little surplus ‘value’ to share. However, to ‘qualify’ as a social enterprise (and distinguish itself from its for-profit nemeses) founders feel that they must share value immediately. They often do this by under-pricing goods and services and by scrimping and saving on staff and infrastructure.

The irony is that this strategy starves the social enterprise of the very funds it needs to self-sustain and for profits to grow. On the other hand, a for-profit venture will charge what it can for its goods, and pay what it must for its resources. It still satisfies a need in the eyes of its customers (otherwise no one would do business with it) but it now has the resources it needs to thrive and deliver an impact.

Monopolies apart, the invisible hand of the market prevents for-profits from profiteering. I teach a lovely case study based on Azuri, a solar power company that operates in Kenya. Azuri developed a novel ‘pay as you go’ business model for solar electricity to off-grid homes. I tell my students that Azuri breaks even at a subscription of $3 per month. Then I ask: If households currently pay $10 a month in diesel, how much should Azuri charge? I ask one half of the class to advise Azuri as a social enterprise, the other half as a for-profit. What do you think happens?

Well, the for-profit contingent often argues a lower price than the social enterprise lot. They cite the need for building a trusted brand, maximising penetration, deterring competitors and avoiding accusations of profiteering. Meanwhile, the social entrepreneurs argue for higher prices on the basis that they need profits to scale the business and maximise its impact.

Perhaps the social entrepreneurs need lessons in building solid for-profits and vice versa!

… social enterprises succeed

Strategy is defined as “the sources of inter-organisational performance differential” – in other words, how firms develop strategies to outperform competitors. A firm builds sources of ‘sustainable competitive advantage’ – including ‘sticky’ customer relationships, brands, scale, know-how, data, intellectual property and other assets. This enables the company to charge more (or produce cheaper) than its competitors. It uses this ‘power’ to generate profits that exceed the ‘risk-adjusted rate of return’ for its industry.

In a conventional for-profit business, those profits become ‘shareholder funds’. Directors have a duty to maximise shareholder funds, eventually distributing them to shareholders, usually by way of dividends.

A successful social enterprise also generates surpluses that it could channel to shareholders. However – and this is where it visibly differs from for-profits – it deliberately chooses to share its surplus with others in its value chain rather than use its new-found market power to accumulate wealth for its owners. How it chooses to share value is determined by the purpose of the social venture – how it wants to create impact. The difference isn’t necessarily the business strategy, it’s a choice over how distributable surpluses should be shared.

In the long term, a social enterprise dreams of sharing surpluses with deserving players in its value chain by selectively paying more than it needs to some deserving suppliers and charging less than it could (subsidising) customers who couldn’t otherwise afford the good. In this way, the social enterprise selectively optimises ‘impact’ rather than shareholder return.

But start-ups have few bases of power and they struggle to make any surplus at all – yet they must do so if they’re going to invest in their own growth (bootstrap) or attract investors who can help them scale. Sharing surplus with other stakeholders remains a dream for social enterprises in the same way that paying dividends does for for-profits.

It is only when a social enterprise becomes established (has power to exercise over its stakeholders) that its behaviour can differ from a for-profit. In the early days of both businesses, neither has much surplus to share, and so both seem to act in a similar way, despite their different goals.

As the deals are done …

Every enterprise has to start doing deals with third parties, unless it remains a vertically integrated bootstrap. It needs partners and it needs investors. Every deal is two-way – rarely do you get something for nothing. Social enterprises are no different.

The very fact that a social enterprise wants to share its surplus to create a certain type of community impact means that it should do different deals from day one. Maybe this is the point that differentiates social enterprises from for-profits.

The best deals are those done with organisations that share the same objectives – they want to achieve the same impact. Because such opportunities are rare, social enterprises often prefer to partner with like-minded businesses, non-governmental organisations, government bodies or even charities.

The problem here is that such contracts can be ‘money in, money out’, providing little surplus for growth. The tail can also ‘wag the dog’ in a number of ways – either by side-tracking the social enterprise or by succumbing to ‘management capture’ – where employees who delivered the first contract look for further, similar contracts, mainly to sustain their own employment.

Sometimes as part of deals, social enterprises will create advisory groups, or give away seats on their Board. They cede some influence to externals, who may well give their time, networks and credibility for nothing. In the short term, this is beneficial. However, in the longer term, it can create divisive governance problems.

The problem is that, whereas ‘profit’ is measured in a single currency, ‘impact’ comes in many mediums. Stakeholders, though united in their desire to create profits, may want it distributed in different ways. The ‘pathways to impact’ (which determine the projects the social enterprise invests in) are more ambiguous and endlessly debatable, than simpler Internal Rate of Return (IRR) choices.

All such complexities can be sidestepped by seeking independent capital from ‘impact investors’ – a relatively new class of investors who provide social enterprises with growth capital. All is well if impact investors will, when under pressure, really forego profits in order to share value with partners. However, most now seek impact without expecting to sacrifice financial return. There are structural ways to guard against all these issues: by choosing the right legal structure – such as a community interest company (CIC); using contracts to create a clear understanding and penalise opportunism; building clear and unchanging covenants into your social enterprise; defining ‘impact’; and determining how value will be shared, and how decisions will be taken. The bottom line is that a social enterprise cannot remain isolated: it must do deals with potential ‘devils’ – it just has to make sure they are clever deals that do not compromise the DNA (purpose) of their enterprise.

… are they different – or just shades of grey?

The distinction between social and for-profit enterprises could still be illusory. Almost all student-run for-profit enterprises also start out with a genuine desire to solve pain points and do good. They are led by individuals who want to maintain control over their new venture and keep the enterprise true to their original mission. They also have to do deals, seek investment, draw on favours with third parties – all of which can be diversions, leading to loss of control to entities with different motives.

As I set out to write this piece, I hoped to be able to argue clear differences between social and for-profit businesses. Instead I’ve convinced myself that – though their paths eventually (and sometimes unintentionally) bifurcate – there isn’t much of a difference early on. They are just different shades of grey.