Charter schools have become a robust – if somewhat controversial – mechanism for experimenting with new and promising approaches to K-12 education, strongly supported by the likes of Secretary of Education Arne Duncan.  As of the fall 2010, there were 5,268 charter schools in the U.S., serving 1.6 million children.  Despite rapid growth in numbers, charter school advocates say that their efforts are hampered by limitations in access to funding that traditional public schools don’t face.

Charter schools in Minnesota are structurally an interesting hybrid: They are nonprofit corporations that are also public school districts. Unlike some states that create charter schools within traditional school districts or local government agencies, Minnesota’s charter school law encourages independence and innovation by requiring stand-alone organizations with independent boards of directors, management, and financial structures.

The 149 charter schools currently operating in the state serve 38,000 students, about 5 percent of the state’s public school enrollment. In Minnesota, the primary source of funding for public education is aid paid directly from the state to schools based on student enrollment. In the current state budget environment, these independent nonprofits are struggling to absorb the financial hits and costs stemming from serious cash flow delays.

Making matters worse is a relatively new budget technique of deferring or holding back current school year education aid to future years.  Because state aid in Minnesota (and in most jurisdictions around the nation) is allocated on a per pupil basis, the strategy of waiting for a final, definitive count of pupils in schools allows states to defer payments until future years.  The motivation may be more about plugging state budget deficits than paying for financial education.  The lessons of Minnesota may prove to be important warning signs for public schools and especially charter schools around the nation.

State Shifts Payments to Schools

The state of Minnesota has been grappling with a growing budget deficit for several years. A deficit of $5 billion, or 13 percent of the general fund balance, is projected for the current budget cycle . With a statutory requirement mandating a “balanced” budget every year, the governor and legislators in Minnesota have relied on budget cuts and revenue sources to fill part of the gap. Like other states, Minnesota has also turned to a variety of accounting transfers and shifts to balance the revenue and expenses while kicking the can down the road.

Public education consumes 38 percent of the state’s budget and the largest single budget shift is a delay totaling $1.4 billion in state aid payments for K-12 education. State aid to public schools is paid based on the number of students.  The state’s payment schedule includes a final “holdback” paid in the following year to allow for final verification of enrollment.  In other words, the state would be able to delay payment for a year, ostensibly to verify the count of pupils, in effect pushing the $1.4 billion obligation off to a future year.  The end result is a budget balancing trick accomplished by putting off –or holding back – a third of the state’s education aid payments.

This recordkeeping holdback has become a regular budget shift, increasing twice in the last two years. For the current fiscal year the shift is 30 percent of state aid.  Because of the state’s continuing budget difficulties, the payment shift seems likely to stay in place for years to come. While all public school districts have been affected by the funding shifts, charter schools have borne a disproportionate financial burden due to a combination of legal structure, state restrictions, and financial scale.

Financing options for charter schools

Traditional public school districts have ready access to very low cost credit in the form of Aid Anticipation Certificates, a well-established tool for public agencies to finance the cash flow of expected payments from the state. Aid anticipation certificates are available to independent school districts because of their status as a public agency with taxing authority. The school districts borrow these funds as general obligations of the district with the ability, if needed, to levy additional property taxes to pay the debt.

As an additional protection, the state guarantees payment of the funds if the district defaults. Because these notes have little risk for investors, the interest rates are low, typically 1 percent or less.  While charter schools are recognized as public school districts, they do not have the taxing authority given to traditional independent school districts. Charter schools have no access to Aid Anticipation borrowing or equivalent low cost, accessible sources of cash flow financing. Instead, they have to use every tool available to them to manage their cash flow.

Survey of Charter Schools

In February 2011, Nonprofits Assistance Fund, Charter School Partners, and Minnesota Association of Charter Schools surveyed Minnesota’s 149 charter schools to learn more about how they were managing the funding shifts, the costs of financing, and impact on the schools. Over 100 surveys were completed, a 74 percent response rate. Of the 110 schools respondents, only 13 were able to cover the entire funding shift with internal budget reserves. The rest turned to outside sources for deferred payments, loans, and other financing. Most schools reported that they used more than one of these strategies.

Disparate Impact on Charter Schools

Even with planning and careful budgeting, many charter schools encountered more barriers and costs than they anticipated. The shifts in state payments have affected charter schools more seriously than other school districts for a variety of reasons.

Limited reserves

School districts plan for occasional shortfalls and cash flow gaps by building reserve funds through their annual budget process. Over time, districts accumulate sufficient reserves to manage through economic downturns, including the current holdback. Charter schools are relatively young organizations. The oldest charter school in Minnesota opened in 1992 and many have been open less than 10 years. In that time, schools haven’t accumulated sufficient reserve funds to cover a 30 percent cash flow delay.

Access to Capital

The most serious problem faced by charter schools has been the difficulty of accessing credit to bridge the cash flow delay caused by the holdback.  Even experienced finance directors and professional advisors from audit firms were surprised by the barriers that schools met when they applied for loans. Charter schools do not own many assets that are attractive to lenders. Commercial banks have been very hesitant to lend to charter schools because of limitations on using state aid payments as collateral and concerns that the state budget situation could get worse. Even for those schools that have been able to obtain a line of credit, the amount of time and management attention required was extraordinary. One school director summed it up in one comment, “Finding a loan was much more difficult than financing the loan.” The difficulty in obtaining market rate bank loans led many schools to make major budget reductions or to resort to selling their state receivables to a financing company.

Cost of borrowing

The barriers to accessing credit are reflected in the costs of borrowing. Interest rates and related costs paid by schools, including fees and legal expenses, range from 6 percent for bank loans to as high as 23 percent for schools that sold receivables.  Financing costs are paid from the school’s operating budget and the increased financing costs required reductions elsewhere in schools’ budgets. Surveyed schools reported cuts in music, foreign language, and enrichment programs. One school director wrote that salaries and benefits were cut and the cost of financing was one of the factors.

The survey revealed that the direct cost of financing has been high for charter schools. For the 2009- 2010 school year, surveyed schools report total direct cost of financing of $962,575. This equates to an estimated average rate of 10 percent to borrow funds for cash flow. The costs include interest on loans from banks, fees paid for selling receivables, and costs for legal guidance and payments to landlords and vendors for deferred payments. In addition to these direct expenses, school directors, business managers, and board members had to divert many hours from focusing on students to contacting banks, negotiating with landlords, and chasing sources for short-term borrowing. Contrast these costs to the low rates available to public school districts through Aid Anticipation borrowing.

An Ongoing Problem

The state aid payment delay is in place for at least two years and is highly likely to continue into the future. Borrowing from a line of credit or selling receivables addressed the problem for last year but each school now must repay those loans and make new plans for this year’s cash flow. Surveyed schools reported that they would use a similar variety of reserves and financing tools this year. Since financing will be a regular practice for charter schools, schools now include financing costs in their budgets based on their actual costs last year. The 110 schools surveyed have budgeted $1.2 million this year for financing costs. This is more than actual costs last year because of the snowball effect of the holdback, especially on schools that are growing and serving more students.  Schools have made room in the budget for financing costs by reducing teachers, enrichment classes, technology, curriculum materials, and increasing class sizes.  One director also noted that the payment delay resulted in a Catch-22 of sorts for their school – the school had difficulty meeting the state statute that requires payment of all bills within 35 days of when they are due.

Recommendations to reduce the inequity

Effective charter schools are an important strategy for improving educational results for students. The burden on charter schools of managing the cash flow of state aid payments is disproportionate to the size and scale of these schools. Instead of building a financial obstacle course for charter schools, the sponsors of this study believe that the State of Minnesota needs to create ways to help charter school leaders so they can turn their attention and resources to educating kids.

There are several approaches that could be used to address the problem, either individually or in combination.

1)    Reduce the holdback for charter schools from 30 percent to 1 percent.

2)    Provide a state-backed, low-interest loan pool.

3)    Improve access to private capital (market rate loans) via a state-authorized “written assignment” to banks.

The shift in state education aid payments has had a detrimental effect on the stability and financial health of the state’s charter schools. This disparate level of impact on charter schools is a result of a handful of state policies and structural requirements that require charter schools to operate within the budget and payment constraints that apply to public schools while at the same time preventing them from accessing the types of low cost credit that is available to independent school districts.

As the State of Minnesota focuses on high quality education for all students, maintaining strong charter school options will be important. Until charter schools have access to appropriate, affordable capital to manage the cash flow burden caused by the holdback, their attention and resources will be divided between educating students and financing their budgets.

Kate Barr is the executive director of the Nonprofit Assistance Fund.