Academic

The non-profit business organization

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

Does anyone teach non-profits in their business organizations class? I haven?t yet, but am contemplating it. After all, non-profits comprise a significant part of the economy and they offer fruitful comparisons to traditional corporations, just as LLCs and partnerships do.

For example, Larry Ribstein?s recent Uncorporating the Large Firm talks about ?uncorporations? (a catch-all term encompassing partnership-type entities like private equity firms, publicly traded partnerships, REITs, and hedge funds) often having a distributional mandate to help reduce agency costs. You?re worried about managers using retained earnings for empire building, paying themselves too much, or taking fancy company jets? Make them distribute a certain amount of the profits, or put an end date on the investment.

Non-profits use the opposite technique to achieve a similar result of cabining managerial discretion over profits. Here the non-distributional constraint helps solve the agency problem that otherwise results when you contract with an intermediary to provide a benefit to someone, say feed the homeless in your city. You could hire a grocery store like Safeway to provide this benefit. But a for-profit has an incentive to skimp on the food provided and pocket the difference as profit. So to reassure donors you take away the possibility for profit by making the intermediary a non-profit, which cannot distribute profits to its owners. Or so says Henry Hansmann, and it makes sense.

Another point: I tell students that the shareholders are the residual claimant, and that?s why they are the group with the right to vote?they have the incentive to monitor and make sure the firm does well, because they?re last in line. Partners and members take this place in partnerships and LLCs. But there isn?t really a residual claimant in the non-profit, or at least, it?s who ever happens to be named in the charter, and he/she/it isn't guaranteed a vote. Who does vote? The members, if the charter says so, but they don?t necessarily?the board can be self-perpetuating.

If nothing else, non-profits offer another way to show students that the corporate set-up where shareholders vote (and sell and sue) and managers manage and boards monitor isn?t the only way to run the railroad. With the added bonus of reminding them that non-profits need transactional lawyers, too.

Full post as published by Conglomerate on July 09, 2008 (boomark / email).