We believe it is important to first define the two terms:
- A merger is a statutory term that refers to when two organizations go forward as a single firm rather than remaining separately owned and operated.
- An acquisition describes a transaction where one organization purchases another and incorporates it into its operational structure.
For example, when a regional nonprofit hospital system decides to purchase a hospital in a new market to expand its geographic reach, that purchase is generally considered an acquisition. In contrast, if a chapter of a trade association in the southern part of a state decides to combine forces with a chapter in the northern part of that state to better serve the membership statewide, that action is generally considered a merger. The two examples are simplistic by nature and could in practice be accomplished in either case by a merger or a transaction, but we think they illustrate the difference in intended outcome.
Why is There an Uptick in Nonprofit Mergers and Acquisitions?
There are two distinct reasons why there is an uptick: strategic intention and failure avoidance. Starting with strategic intention, the reason behind this kind of activity is to drive organizational growth through increasing revenue sources, reducing overhead/expenses, or some combination of the two. As an example, we point to three geographically contiguous hospice providers—JourneyCare, Midwest, and Horizon—who completed a merger to “expand its collective customer impact and to gain a competitive advantage in an industry where for-profit providers had become significant players.” These organizations understood that, as standalone entities, they would struggle to muster the resources necessary to compete with some of the for-profit entities that were entering the industry. By combining resources into a single entity, however, they were able to remain competitive and work toward their strategic growth goals.
The second side, failure avoidance, is perhaps less glamorous but no less important. One does not have to look long or hard at the world today to understand that there are more needs, causes, and missions than there are nonprofit or even government dollars to support them. A recent example would be three geographic mergers of youth mentoring organizations across northern Illinois and Indiana, including the Big Brothers Big Sisters of Metro Chicago, which turned “a largely insolvent operation serving 100 or so at-risk children in 2005 into a $4 million sustainable enterprise promoting high quality services for 1,800 at-risk children in 2015.” On its own, the Big Brothers Big Sisters of Metro Chicago ran the risk of running out of funding for the worthy cause of helping at-risk kids in Chicago. Instead, the organization chose to combine its resources with other like-minded organizations and was able to continue supporting the mission for which it was formed. When resources are strained, donor support dries up, or other operational concerns cause financial hardship, mergers and/or being acquired can help see that the mission endures.
Key Considerations for a Merger or Acquisition
Due Diligence, Due Diligence, Due Diligence
In any consideration of a merger or acquisition, the overwhelming and overarching strategy should focus on due diligence. In our opinion, there are a few key questions that should be paramount in this process:
- Will a merger or acquisition, traditionally a scaling up of operations, help the organization to succeed in its mission?
- What types of organizations would create synergies with existing operations that would have the greatest impact on the target mission, demographic, or region for the organization?
- Does the organization have the requisite resources, experience, and capacity to engage in the highly complex process of a merger or acquisition?
- With regard to the target organization for a merger or acquisition, is there a cultural, mission, and operational fit that will engender success?
We have outlined four questions here, but there could easily be many more for any given merger or acquisition plan. We suggest engaging advisory firms and/or legal counsel with experience in these types of transactions to increase the likelihood of success in the endeavor.
Retirement Plan Health
Financial health, typically including both the balance sheet and income statement, is center in any merger or acquisition due diligence process. We advise paying extra attention to the retirement plan status of the target organization. For example, a religious-based health care system that looks healthy on the balance sheet and shows a steady operating surplus on the income statement could nevertheless have a severely underfunded church pension plan. If a nonprofit hospital system without a religious orientation were to acquire that religious-based health care system, the church pension plan could potentially lose its exemption under the Employee Retirement Income Security Act of 1974, as amended (ERISA), creating the need for funding status remediation. This remediation could have a significant impact on the acquiring organization’s financial status, cash on hand, and perhaps credit rating. Having a firm understanding of the health of the target organization’s retirement plan could help avoid some of the potential pitfalls, such as those described in the hypothetical transaction above. This understanding can come from asset-liability studies, actuarial reports, or other forms of risk analysis on the target entity as part of the due diligence process.
Designation Status of a New Organization
The Internal Revenue Service (IRS) lists explicit rules for tax-exempt organizations that “end their operations, either through shutting down, transferring their assets, or merging with another tax-exempt organization.” The guidance requires that the IRS be informed of the action, typically in the filing a final form 990, 990-EZ, or 990-N (for organizations other than foundations). In addition, organizations should consider asking for a private letter ruling on the tax consequences of the merger to confirm that the tax-exempt status is not lost for the resulting entity.
As mentioned above, organizations also should carefully consider whether the resulting entity will retain religious affiliation, if applicable. This can have a significant impact on certain aspects of the operation, especially as it pertains to retirement plan status. Loss of this church plan status could cause the need for immediate and significant contributions to a retirement plan, as well as additional expenses related to ERISA compliance, causing the potential for significant hardship for the plan sponsor.
Synergy, Overhead Reduction, and Cultural Integration
The first two parts of this consideration are closely linked. Synergy refers to operational benefits that can accrue from a successful merger or acquisition. An example of this would be two soup kitchens serving the same geographic area. On its own, each kitchen would be required to spend money on supplies, have a location to cook the meals, and retain the human resources necessary to cook and serve the meals. However, if they were to combine forces, they could take advantage of economies of scale by purchasing supplies in bulk, and having a single location to cook the meals as well as potentially less human resources to cook and serve the combined number of meals. By reducing overhead cost and taking advantage of the synergy of combining operations, the combined entity would likely have more capacity to serve its mission of providing meals to those in need.
The third part of this consideration, cultural integration, is important to any merger or acquisition activity. Many organizations, especially those that have been around for a long time, have a set way of doing things and may be reluctant to change. Sometimes this can get in the way of a successful merger or acquisition and may prevent the resulting entity from capitalizing on the above synergy and overhead reduction considerations. It is inevitable that not every organization and its employees will work seamlessly with another organization and its employees: Determining in advance the cultural fit of the two organizations and having a plan in place to ease the transition can help increase the likelihood of success in realizing synergistic and overhead cost reduction goals.
Donor restrictions may prevent mergers and acquisitions from happening easily. A common example of this occurs in higher education, where legacy donor gifts often can prevent colleges and universities from easily acquiring, or being acquired by, other institutions. A recent case of this occurred with Newcomb College, where the will of a donor established the name of the college. Following Hurricane Katrina, the college found itself in financial straits. As a result, the board of directors voted to create a new co-educational entity, Newcomb-Tulane College, which the family of the original donor argued violated donor intent. The issue was eventually heard by the Louisiana Supreme Court, which sided with the university after a drawn-out legal battle. While the outcome was in the college’s favor, it nevertheless likely caused significant legal, reputational, and time costs. Before considering a merger or acquisition, it is important to assess what donor or other charter restrictions might prevent the execution of a possible merger or acquisition.
Donor restrictions can also come into play with regard to combining endowments and/or planned giving programs. For example, certain charitable-giving vehicles can create liabilities that might not legally translate or transfer well into a new entity without donor permission. Similarly, combining endowments can create charter, investment policy, and other conflicts with regard to amalgamation under the new structure. Careful consideration should be given to handling donor outreach, especially around proactively planning and communicating how this would be managed under the new structure. We recommend consulting counsel in advance regarding the impact of a merger or acquisition on the organization’s status as a beneficiary of an irrevocable trust. In certain cases, court action may be required to obtain a ruling whether the operations and mission of the resulting organization are consistent with the charitable purposes for which the trust was originally established.
We have found more and more nonprofit organizations are considering mergers and acquisitions to create strategic growth, to shore up their financial position, and to help increase impact and/or mission success. With this in mind, we have suggested five key considerations that can help the leadership and boards of directors determine if this activity is right for their organization. Finally, it is advisable for organizations to engage legal, accounting, and merger and acquisition services early and often in the process.
The Endowment & Foundation National Practice Group
The Endowment & Foundation National Practice Group builds on our long-standing commitment to philanthropy and is focused on endowments, private and public foundations, and nonprofit organizations. We seek to help these organizations address their distinct investment, distribution and capital preservation challenges.
For more information, contact Henri Cancio-Fitzgerald at firstname.lastname@example.org.