Legal Considerations for Nonprofit M&A
Increasingly, nonprofits are considering merging with, acquiring, or being acquired by other organizations. These types of transactions in which an organization acquires the equity or assets of another are generically referred to in this article as “M&A,” or when a nonprofit is involved, “nonprofit M&A.”
Nonprofit M&A can help nonprofits achieve their goals and solve many of the challenges that they face throughout their existence. There are, however, some distinct differences between nonprofit M&A and for-profit M&A that make it important for nonprofit leaders to understand the nuances of nonprofit M&A before engaging in such transactions. This “Legal Considerations for Nonprofit M&A” series will help staff, board members, financial institutions, professional advisors, and other key nonprofit players understand legal matters concerning this type of transaction.
Before reading the second part of this series, please refer to “Part One: Why Consider Nonprofit M&A?”
Part Two: Structuring the Nonprofit Acquisition
The acquisition or combination of nonprofit entities or “nonprofit M&A” can be effectuated in a variety of ways. Some acquisition structures that are common in for-profit acquisitions can also apply in the nonprofit context, such as the purchase of a nonprofit entity’s assets and the merger or combination of one or more nonprofit entities. However, the reasons for and consequences of such transactions may differ for nonprofits. In fact, deal dynamics may predicate that the transaction does not take the form of an acquisition at all, but rather the parties enter into a joint venture to achieve the transaction’s underlying purpose.
Ultimately, the unique characteristics of each transaction are relevant in determining which transaction strategy to use, including the underlying reasons for engaging in the transaction; the tax consequences of the transaction, such as preservation of Section 501(c) status; the post-acquisition governance structure; and the fit of each constituent entity’s respective mission. This article highlights some common merger and acquisition structures when one or more nonprofits are party to the transaction and the unique considerations that arise when effectuating such transactions.
In a statutory merger, two organizations combine with only one organization surviving the merger. State law governs the merger process, but generally speaking, the surviving organization automatically receives all of the assets and liabilities of the other organization by operation of law upon filing “Articles of Merger” with the applicable secretary of state.
The primary strength of the merger structure – and a commonly cited reason for consummating a merger – is that both constituent entities can achieve greater economies of scale that help further both missions by combining operations into one legal entity. In most mergers, the surviving entity eliminates redundant governance structures, overhead, and administrative resources. These cost efficiencies free up resources for other activities that align with the surviving entity’s combined mission.
With these economies of scale, even the “non-surviving” entity may find its ultimate mission better served due to the ability to use newly available resources to expand programmatic or geographic reach. In some instances, the merger option may be a lifeline to a financially distressed entity that would otherwise be unable to continue its mission without the fiscal stability of the “acquirer” organization. An additional strength is that because mergers are statutory, there is clear law to rely on in consummating the structure.
The primary weakness of the merger approach is that the “surviving organization” to the merger assumes all known and unknown liabilities of the “non-surviving” organization. Following the merger, creditors of the historic organization could seek reimbursement and damages from the assets of both the non-surviving organization and the surviving organization. Taxing and regulatory authorities, such as state attorney generals, may require additional reporting obligations with respect to the merger, including disclosure of significant dispositions of assets, transaction fees, information about the recipient of the assets, and information about how the officers, directors, and important employees will be treated in the surviving organization. Some states have also enacted filing and notice requirements related to mergers. These obligations will result in increased transaction costs at a minimum but could also trigger audits or other similar regulatory examinations.
Affiliations or Parent-Subsidiary Acquisitions
Another type of nonprofit M&A involves making one nonprofit the sole member of another or creating a new parent organization that is the sole member of both nonprofits. Nonprofits can be governed by members or by a board of directors. In affiliation transactions, the new sole member of one or both of the involved organizations has control over their officers and major decisions but both legal entities continue to exist as tax-exempt nonprofit limited liability companies, taxed through the parent.
Affiliation transactions may be beneficial in circumstances where the nonprofits want to retain limited liability as separate entities. Likewise, since neither organization dissolves under this structure, the brands of the organizations can remain the same and donors do not have to navigate any significant changes. This structure may also be of interest when a tax-exempt organization and taxable organization would like to explore “merging” but retain the favorable tax status afforded to the tax-exempt organization and its related activities.
Affiliation transactions, however, are less likely to achieve the economies of scale and reduction in overhead costs that mergers can provide because each organization must be organized and maintained separately, with its own board of directors and administrative services. That said, significant mission alignment may be achieved, while also increasing the scope of services offered by the new affiliated entities.
Asset sales involve the transfer of an organization’s assets, but not its liabilities, to another. An “acquiring” organization may wish to purchase substantially all or a specific subset of the assets of another. In contrast to mergers, asset sales are not effectuated automatically by the operation of law – rather, the parties negotiate what assets are transferred. Meanwhile, the “selling” organization may continue to exist or dissolve after the transaction is finalized.
This form of M&A may be useful for an organization that handles multiple programs, only some of which are financially viable, or when a program or service line makes less sense over time given an organization’s evolution. In these scenarios, the organization has the option to sell a subset of its programs and use the proceeds to focus on other programming or issues more in line with its mission. Asset sales can be a simpler process than mergers and affiliations because they do not require the organizations to negotiate combining boards of directors nor do new entities need to be formed. This is also an option for strategic growth by organizations that are looking to expand their services by “acquiring” a service line from another nonprofit looking to exit the same space and focus more specifically on other existing services provided by that entity.
Some disadvantages of asset sales, however, include that the organizations may still be required to make certain governmental filings and there may be other transaction costs such as obtaining consent to the transaction from important third parties. Furthermore, the buyer organization in an asset sale does not receive the benefits of the selling organization’s brand or donor base that it might otherwise garner in a merger or affiliation transaction.
Nonprofits may be able to attain some of the benefits of nonprofit M&A while remaining independent through joint ventures. Typically organizations enter into joint ventures in order to reach a shared goal or combine programming. Joint ventures may be created by forming a separate legal entity or by entering into a contract.
Management services organizations represent one form of joint venture in which multiple nonprofits create a legally distinct entity whose purpose is to provide administrative services. While organizations can also enter into intercompany service agreements in order to share administrative services, management services organizations provide another option for nonprofits seeking to share overhead costs while remaining distinct entities. Separately, nonprofits that wish to align with for-profit entities may choose to utilize a joint venture structure to memorialize the relationship. The IRS has examined joint ventures between nonprofits and for-profits and laid out legitimate reasons for such relationships and guidance on how nonprofits can avoid issues relating to their Section 501(c) status, focusing primarily on whether the joint venture furthers the charitable purposes of the nonprofit.
While joint ventures may not require the same amount of transaction expenses as mergers or asset sales, particularly when they are created through a contractual relationship, the organizations involved also may not receive the same level of benefits as in a merger or asset sale because they must maintain separate legal structures and joint ventures are more narrow in scope than mergers and asset sales typically are. Additionally, when nonprofits choose to align with for-profit organizations, they risk increased scrutiny from the IRS and must be careful not to overstep their boundaries such that they could lose their Section 501(c) status.
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The next installment of the Nonprofit M&A series will address practical considerations for nonprofits when considering these nonprofit M&A structures, including a discussion of non-legal reasons why an organization might explore them.