Note that the for-profit entity receiving the PRI does not itself have to intend to engage in a charitable activity; rather, its activity must further the charitable purpose of the foundation. Consider an example:

The foundation is dedicated to eradicating a rare disease. A large pharmaceutical company is close to developing a promising vaccine, but because there isn’t a sizable market for it, the vaccine will not be fully developed and submitted for the long and costly FDA approval process, and it will therefore never be made available. To induce the pharmaceutical company to develop the vaccine, the foundation purchases shares of the common stock of a subsidiary of the pharmaceutical company established explicitly for researching and developing the vaccine.

Because the foundation’s investment in this vaccine is directly aligned with its charitable purpose, which means the development of the vaccine would significantly further the foundation’s mission, and because the foundation is making the investment only because doing so could help it fulfill its mission, the investment would pass the primary exempt purpose test. However, if the foundation were to make an investment in the same subsidiary without the intent of advancing its mission, the investment would probably fail the test.

How does a foundation know if a PRI has no significant  purpose of generating income or promoting the appreciation of property?

As there can be a significant opportunity for generating a profit, a foundation needs to be careful when making a PRI equity investment. The single test here is whether no significant purpose of the investment is the production of income or the appreciation of property. As a practical implication, a PRI should be less attractive to traditional investors. The IRS will consider whether investors solely concerned with profit would be likely to make the investment on the same terms. However, the fact that an investment actually produces significant income or capital appreciation is not, in the absence of other factors, conclusive evidence that income or appreciation was a significant purpose of the investment, and therefore does not preclude the investment from being a valid PRI.

Consider the vaccine for the rare disease in the previous example. What if, during the FDA approval process, the pharmaceutical company discovered that the vaccine also happened to prevent the common cold? Now, instead of having an unprofitable vaccine on their hands, they’ve got a potential gold mine, and investors are taking notice. Although the foundation didn’t invest in the vaccine for a financial return, it now stands to reap a substantial return on its investment. The fact that this “bad investment for a good cause” ultimately proved to be an excellent investment does not render the PRI invalid.

A private foundation could make its motives manifestly clear by developing an exit strategy that would cash it out of its investment as soon as it appears to be profitable, removing itself from participation in any financial gain. However, the foundation should consider the private benefit that may be bestowed upon other investors if the foundation gives up its share. In addition, while investing without the potential for any financial gain may help demonstrate the lack of financial motive, a foundation should not rely exclusively on divestment to justify a PRI that is expected to generate a return for others; the foundation’s analysis of the investment should still support a conclusion that an investor would not make the same investment if the production of income or the appreciation of property was a significant purpose.Although the no significant investment purpose test is easily satisfied if a PRI is made in the form of a loan at below-market interest rates, when a foundation makes an equity PRI, it must consider, among other things:

• Whether there are already individual and corporate investors ready to invest or the likelihood that the company could find other investors.

• Whether the lack of liquidity or the high-risk nature of the investment would fail to meet the foundation’s investment policy criteria for its normal investment portfolio. (Remember, to qualify as a PRI, it needs to be unattractive as a financial investment.)

Must the PRI recipient  demonstrate that it is unable to secure financing from traditional sources before the foundation makes its investment?

A common pattern in PRI examples provided by the IRS is that funding would be unavailable if the foundation does not invest, because other investors are either unable or unwilling to participate. A lack of alternative funding can be a significant factor in demonstrating that other investors solely concerned with profit would not invest on the same terms as the foundation. However, the IRS does not require an investment to lack alternative funding to qualify as a PRI.
A foundation may wish to be an early investor, rather than the investor of last resort, in order to influence the way in which a business will develop or to provide credibility or expertise that will help attract other investors. The IRS has not provided examples that clearly support this pattern; however, many practitioners would not limit PRIs only to recipients that already have tried and failed to obtain funding from traditional sources.

Does a foundation need to be concerned  about whether  an equity PRI creates a private  benefit?

Wholly apart from the private foundation rules, general principles under Section 501(c)(3) prohibit charities and foundations from providing an undue private benefit to individuals or for-profit entities. The foundation needs to be cautious if it is being asked to invest on terms that are significantly less favorable than terms that are being offered to other investors. Are for-profit investors likely to do very well as a result of the foundation taking less favorable terms? Could the foundation’s charitable purpose in making the investment be accomplished without providing this benefit to private parties? In other words, is the private benefit to private parties avoidable?

Assume a start-up drug company that will develop and sell a vaccine to eradicate Ebola is offering two classes of stock: one for foundations and one for individual investors. The foundation should not accept a class of stock with less favorable terms just to satisfy the “no significant purpose” test or because the foundation is not interested in making a profit, but it may accept a less favorable class of stock if doing so is reasonably necessary in order to attract other investors to properly capitalize the company.