This article was first published online on June 20, 2017.
Nonprofits typically pursue mergers and acquisitions to broaden the range or improve the quality of services. Some nonprofits pursue mergers and acquisitions to stave off financial duress or to benefit from the stronger operational controls of a larger acquiring nonprofit.
Hope Community, a nonprofit based in East Harlem focused on building, renovating, managing, and renting low-income housing, sought to provide its residential and commercial tenants with microloans and business training through a formal affiliation with Project Enterprise, a Community Development Financial Institution (CDFI) that had been offering microfinance and business training for over 15 years. In addition to expertise, Project Enterprise had a strong reputation in the communities that it served. Project Enterprise needed to merge with or be acquired by a larger organization to survive and was motivated by the combination of captive potential clients among Hope Community tenants and Hope Community’s operating discipline and oversight. Hope Community’s board was thorough in its due diligence and mulled over the pros and cons of the affiliation. Project Enterprise’s board and management team was enthusiastic and aligned behind the transaction.
The purpose of this article is to share structural details and lessons learned from this formal affiliation with management and boards of troubled nonprofits and of nonprofits considering acquiring troubled nonprofits. More specifically, reading this article would ideally help such nonprofits mitigate consulting fees and staff workload in the early stages of a potential M&A transaction.
Structural recommendation: Mitigate risk with affiliation as an interim step
While being acquired may be critical for a nonprofit’s survival, adding the interim step of a formal affiliation mitigates risk for both the target and acquirer nonprofits. In the example of Hope Community and Project Enterprise, Hope Community is financially sound, and Project Enterprise is over-indebted. Hope Community prudently capped its exposure to Project Enterprise’s liabilities by retaining separate legal entities until and unless Project Enterprise is able to extinguish its liabilities predating the formal affiliation.
A service agreement in tandem with a formal affiliation allows nonprofits to combine some segments of their operations while keeping each other’s liabilities at arms’ length. The service agreement should specify what the target and acquirer nonprofits will and will not do for each other, including the terms of shared services and expenses. For example, the service agreement with Project Enterprise included efficiency gains as a result of consolidating back offices services, space for its offices, and other economies in return for a fee.
The affiliation agreement should specify: (i) the milestones that each organization must meet to transition to a full merger or acquisition, (ii) the breaches that would lead to terminating the affiliation, and (iii) any cures for those breaches. The potential target nonprofit must set up processes and systems to monitor and ensure compliance with the terms of the affiliation agreement. A simple spreadsheet that lists reporting requirements and matters that require potential acquirer nonprofit consent can be an effective tool if the target nonprofit management’s team compares the spreadsheet to operating results regularly.
Signing the service and affiliation agreements in tandem is important. Both the potential target and the potential acquirer nonprofits would benefit from understanding the details on how to work together before formalizing the affiliation. As an example, if the support offered in the service agreement is too limited or the fees too high for the target nonprofit, the affiliation is unlikely to be successful.
Distinct legal entities isolate each of the affiliating nonprofits from each other’s liabilities. Regardless of due diligence, organizational combinations involve asymmetrical information. Each of the nonprofits may have known and unknown contingent liabilities. One or more of the nonprofits may be restructuring loans, settling a lawsuit, or renegotiating vendor payables. To increase the likelihood of a sustainable future of each of the target and acquirer nonprofits, each board of directors may wish to consider an affiliation and service agreement for the greater of one year or when certain milestones have been met, such as restructuring loans or reducing debt. This avoids tainting a financially solvent nonprofit from the liabilities of an insolvent nonprofit until the liabilities are at least quantified and ideally also mitigated.
Nonprofit affiliations can also move more quickly than nonprofit mergers or acquisitions, which require state attorney general approval. Since securing approval can take months, affiliations facilitate vital speed in time-sensitive situations. Boards of directors and development professionals are often hesitant to fundraise without clarity on organizational structure; an affiliation shortens the period where uncertainty limits fundraising.
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Strategic recommendation: Build a network before you need it to find the right partner
Finding an organization with a similar mission facilitates nonprofit M&A. Nonprofit boards of directors have many analogous duties to those of for-profit boards of directors; these duties survive insolvency. Nevertheless, one duty unique to nonprofit directors is to the nonprofit’s mission, as described in its organizational documents. Prioritizing maximizing value over mission can expose directors to liability. In addition, general bankruptcy law prevents unpaid creditors from receiving payment from funds donated to nonprofits for a specific purpose, or restricted grants. Being acquired by or merging with a nonprofit with a similar mission, rather than selling assets to the highest bidder, obviates these and other potential legal issues.
Among organizations with similar missions, Project Enterprise had the most productive conversations with potential acquirers:
- that (a) offered similar services to higher income target beneficiaries or (b) offered complementary services to similar target beneficiaries,
- had financial resources to commit to make the affiliation a success, and
- knew Project Enterprise well enough to make due diligence cost-effective.
The affiliation was attractive to potential acquirers that were either looking to expand to serving poorer clients or that were looking to add lending capabilities to their service platforms. This dynamic illustrates the broader trend of nonprofits pursuing mergers and acquisitions to buy vs. build geographic footprint and capabilities. Just as with for-profit M&A, strategic fit is critical, and relationships are key. Hope Community and Project Enterprise had collaborated for years before contemplating a formal affiliation.
As federal budget cuts loom, it is vital for both nonprofits with missions earmarked for cuts and all smaller nonprofits to strengthen their relationships with their peers. Collaboration and knowledge exchange both build networks for nonprofits before they need them and can increase nonprofit organizational effectiveness.
Personnel recommendation: Secure the assistance of a consultant or an advisor
Executives at nonprofit potential and target acquirers may not have the time or the specialized skills to focus on an M&A transaction. Due diligence, negotiating affiliation agreements, and integration are all time-consuming activities that require specialized skills. Thankfully, there are nonprofit merger specialist consultants and advisors, such as the firm KrasnePlows, which advised on Project Enterprise’s multiple loan restructurings that were a prerequisite to the affiliation. Hiring a consultant or advisor can help to keep deal discussions on track.
For an organization under financial duress like Project Enterprise, fundraising while being acquired is challenging. The value proposition for unaffiliated donors (i.e., those who are not board members or volunteers) would be fundamentally different is the deal succeeded vs. failed. It is therefore prudent to keep unaffiliated donors informed of the deal and integration status without explicitly soliciting funds. Accordingly, keeping deal discussions on track is critical as the target nonprofit spends on program and is only partially replenished by affiliated fundraising.
To defray the cost of KrasnePlows, SeaChange Capital Partners, which manages two funds that support nonprofit mergers, acquisitions, joint ventures, and other long-term collaborations, provided Project Enterprise with a grant. Such grants alleviate the financial burden of an M&A transaction among at least one if not two already resource-constrained organizations.
Project Enterprise was also lucky to hire an Interim Executive Director with extensive mainstream and microfinance investment banking experience shortly after Project Enterprise signed a term sheet with Hope Community. Her rare combination of skills enabled her to both manage the organization and facilitate the transaction.
A supportive and engaged board is paramount to facilitate nonprofit collaborations. The generosity of Project Enterprise co-founder Debra Schatzki in particular was crucial for the formal affiliation, as was the significant heavy lifting of the board’s Executive Committee on facilitating Hope Community’s due diligence and financial projections. Having the right directors and officers liability insurance is essential to retaining directors in the face of significant strategic decisions. Project Enterprise Board Chair David Singer’s extensive legal experience was critical in negotiating Project Enterprise’s loan restructurings and its affiliation agreement with Hope Community.
The integration of two nonprofits, which begins after ink dries on the affiliation and service agreements, is another topic for another article. The Project Enterprise and Hope Community story is still being written, although enough time has passed to say that Hope Community has been a fantastic partner for Project Enterprise. I did pro bono work for Project Enterprise over a 15-year period, ending after assisting on the integration for a few months. Accordingly, the epilogue will be an article for another author. In the interim, I hope the details and lessons learned discussed in this article are helpful to the nonprofit community during these turbulent times.