Nonprofit Mergers

mergers.jpeg

Facing the severe impacts of the current public health and economic crises, many nonprofits are considering mergers and other forms of collaboration as a strategy for maintaining or strengthening their programmatic activities, their brand and clout, and, for some, their survival.

Motivations

Prior to entering into any negotiations around a collaboration, nonprofit leaders should identify and understand the motivations of each party to better assess the options, common goals, differing goals, and relative leverage in negotiations.

A nonprofit may consider a merger to:

Short-term Financial Benefits

  • address a current or imminent financial crisis that could otherwise cause the nonprofit to close down, terminate services and programs, or lay off employees;

  • improve and strengthen its cash flow position and available cash for investments (whether financial or programmatic), particularly during periods of critical need;

  • acquire new funding sources and leads;

  • access available space possessed by its contemplated merger partner at reduced cost;

  • eliminate competing with its contemplated merger partner for the same important funding sources, some of whom may be pushing for the organizations to merge;

Long-term Financial Benefits

  • create cost-efficiencies by consolidating overlapping administration, development, and programmatic human and other resources;

  • pursue a new opportunity requiring more resources than it has available;

  • utilize excess or under-used space;

  • eliminate competing with its contemplated merger partner for the same important funding sources, in bidding for the same contracts, and in establishing its brand and reputation with common stakeholders;

Programmatic Benefits

  • expand its programmatic reach to new communities;

  • increase its service provision with greater and more diversified resources;

  • develop innovative programs with additional expertise and resources;

  • consolidate programs for improved efficiency and effectiveness;

  • increase its public recognition as a leader in the space;

Advocacy Benefits

  • strengthen its influence as an advocate for critically important changes, possibly in response to a significant threat;

  • access additional networks that increase its ability to engage in lobbying and other advocacy efforts;

  • increase its lobbying expenditure cap without violating the prohibition against substantial lobbying;

  • build its knowledge, expertise, and public recognition as a powerful leader on key issues;

Leadership Benefits

  • address the departure of the executive or principal leader driving the organization;

  • address the decline of the board’s active participation and/or the reduction of board members to inadequate levels for proper governance and governing body leadership;

  • access valuable policies and practices developed and implemented by its contemplated merger partner;

  • consolidate and coordinate leaders from both organizations, possibly to help assure greater diversity, equity, and inclusion at multiple levels;

Marketing / Goodwill Benefits

  • strengthen its brand(s) and its recognition as a leader in its area;

  • develop or improve credibility in certain areas of importance and/or with certain stakeholders;

  • signal to its stakeholders its ability to adapt to changing circumstances in furtherance of its mission; and

  • appease funders and other stakeholders pushing a merger (often, not a good reason by itself).

Risks

Nonprofit leaders should also understand in contemplating a merger the risks associated with such transactions. The following are 10 common areas of risk associated with a merger between two charities:

Financial risks

  • acceptance of all of the debts, liabilities, and obligations of the other party, including any hidden or unripened liabilities (e.g., future lawsuit for a past act or omission resulting in harm);

  • costs associated with the merger, including for pre-merger due diligence and post-merger integration;

  • cash flow issues post-merger;

  • weak internal controls of the other party;

Culture risks

  • clash in values, including with respect to diversity, equity, and inclusion;

  • differing ideas on the sharing of power and leadership styles;

  • clash in workplace customs, preservation of the disappearing corporation’s legacy, communication styles, formality-informality in dress;

  • management of differences in how clients, beneficiaries, and others are treated;

Programmatic risks

  • changes to programs in the integration, including those related to the underlying beliefs that supported the past methodologies;

  • possible termination of certain programs of the disappearing corporation, including post-merger;

Leadership risks

  • removal or change in status of executive or other key managers inconsistent with their desires;

  • loss of board members of the disappearing corporation, some of whom may be extremely valuable and/or opposed to the merger;

Employee risks

  • disgruntled terminated employees or reassigned employees and the possibility of wrongful termination or other employment claims;

  • other known and unknown employee-related claims of the other party;

  • unhappy employees and the resulting reduction in productivity, job satisfaction, and recruitment and retention;

  • unionizing activities (which may result in better employee benefits but at a cost);

  • wrongful classification of employees as independent contractors by the other party;

Marketing / Goodwill risks

  • bad publicity originating from those who object to the merger or others who may be opposed to the works or advocacy of either corporation;

  • weakened branding if the surviving corporation’s brand gets diluted covering continuing programs and activities of the disappearing corporation;

  • lost or diminished branding associated with the disappearing corporation’s brand;

Fundraising risks

  • loss of support from some donors or funders to the disappearing corporation;

  • loss of support from other donors opposed to the merger;

  • reduction in support from some donors or funders who used to support both organizations;

  • potential loss of bequests and other planned gifts intended for the disappearing corporation;

  • grant compliance issues of the other party;

Real estate risks

  • acceptance of liabilities and obligations of the other party relating to its real estate ownership and/or leases, including those resulting from environmental issues (e.g., hazardous waste) and safety issues;

  • local taxes (e.g., transfer taxes) that may apply when title of property moves from the disappearing corporation to the surviving corporation, even if both corporations were exempt from property taxes;

Contract and license risks

  • assumption of the contractual obligations of the other party and any liabilities that may arise from any past breaches;

  • breach of certain contracts if any notice provisions regarding a merger are not complied with;

  • termination of certain contracts that provide as a termination event an assignment or a change to the contracting party as a result of a merger;

  • termination of the disappearing corporation’s licenses, permits, certifications, and/or accreditations that may not be assumed by the surviving corporation;

  • any identified or unidentified partnership liability obligations of the other party;

Tax-exemption and public charity classification risks

  • acceptance of past compliance issues of the other party relating to tax-exemption and the consequences of its noncompliance;

  • change in the surviving corporation’s public support ratio or other public support factors, which may threaten to tip the charity into private foundation status;

Other risks

  • failure of the surviving (merged) corporation to be qualified and/or registered in states/jurisdictions in which the disappearing (merging) corporation operated and in which surviving corporation will newly operate;

  • insufficient insurance protection; and

  • inheritance of the other party’s problematic relationships with regulatory agencies or key political actors.

Some Initial Legal Considerations

Generally, in a simple 2-party merger between A (the surviving corporation) and B (the disappearing or merging corporation), A automatically assumes all of the assets and liabilities of B upon the merger by operation of law. Thus, the debts of B become the debts of A, and A is automatically substituted for B in any lawsuit or legal proceeding. This may be problematic if B’s liabilities cannot be identified or if B’s liabilities are greater than expected, particularly if they exceed the value of the assets A acquired in the merger.

If the parties agree to a merger, the parties must determine early on which will be the surviving corporation and which will be the merging corporation, which may not always be obvious. From a legal perspective, the parties might consider the history of each entity and its recognition of tax-exempt status (e.g., a church may not have an IRS determination letter), existing government licenses, contracts, or registrations, and each entities’ employees and their employment benefits. For example, a smaller, less established nonprofit might be the more suitable surviving corporation if it possesses a critical license that the larger, more established nonprofit values. In such case, the merging corporation’s board might take over the surviving corporation’s board and rename the surviving corporation with the merging corporation’s name. As a result, the public would likely believe the merging corporation was actually the surviving corporation.

Once it is determined which entity will be the surviving corporation, the surviving corporation must plan how it will absorb both the assets and liabilities of the merging organization and take over any transferable rights and obligations. Accordingly, proper due diligence is key. While there is no prescribed set of materials that should be considered by the board of each entity, the goal of due diligence for each entity is to assure that its board has engaged in sufficient inquiry and acquired enough information to make an informed decision that merging is in the best interest of the corporation and that the integration will ultimately be successful.

From a corporate governance perspective, if either corporation has a voting membership structure, consideration should be placed on obtaining membership approval for the merger and the possible barriers. The mechanics of a membership vote can be onerous and may require additional time to obtain such approval. If an entity cannot get obtain a quorum of the members necessary for a vote, or if a faction of members disagrees with the merger, this may add significant cost and delay.

If the merging corporation has real property, the surviving corporation should consider issues such as the cost and requirements of transferring ownership, whether the terms of any loans require bank consent, whether there are any liens on the property, whether the merger will trigger transfer tax liability, and whether an environmental review should be conducted. The surviving entity will also want to review whether the merging corporation is a party to actual, pending, or threatened litigation, settlement agreements or court orders, and whether the merging corporation has any nontransferable permits or licenses. Further, the surviving corporation should consider the potentially complex employment issues that may result, particularly if not all employees of the merging corporation will be employed by the surviving corporation, there are union or organizing activities involved, and/or compensation and benefit structures are markedly different and not easily harmonized.

For the merging corporation, issues may arise if it has assets (e.g., restricted funds, endowment funds) that are bound by charitable trust to a purpose that does not completely line up with the surviving corporation’s mission. In such case, the surviving corporation may have to amend its governing documents to broaden its purposes in order to receive such assets (however, then it must be careful not to use any funds it previously raised under its more limited purpose for the new broader purpose) or the merging corporation may have to grant such fund out to another organization prior to the merger. Of course, the merging corporation must also consider the sustainability of the surviving corporation, which may involve careful review of the surviving corporation’s financial statements, information returns, compliance history, and other characteristics that would indicate the surviving corporation’s ability to integrate the operations and activities.

The merging corporation should also review its contracts and determine which may be freely assigned and which require consent from, or notice to, the other party to the contract. The board of the merging corporation should also think through the requests it will bring to the merger negotiations regarding its legacy, such as whether certain named programs will carry on, or ensuring that a specific geographical area continues to be served by the surviving corporation post-merger.

 Legal considerations of an asset transfer in lieu of a merger (dissolution and transfer)

In some cases, an organization may want to consider dissolving and transferring its assets to another entity. In this scenario, when B (the dissolving corporation) distributes its remaining assets to A (the recipient corporation) and then dissolves, A generally does not automatically assume B’s liabilities. A may be able to limit the risk it takes on when acquiring B’s assets, as, unlike a merger, B’s liabilities do not necessarily transfer to A by operation of law.

The terms of such a transaction are governed by an asset transfer agreement. The recipient corporation may be able to reduce its liability exposure though a contractual provision stating that it is assuming only certain explicitly identified assets and liabilities and structuring the transaction so it does not appear to be a merger either in substance or form. Special consideration should be given to whether indemnification provisions and representations and warranties will provide much protection, as the recipient corporation may be left without remedy if the dissolving corporation breaches the agreement and has dissolved.

If the recipient corporation has a complicated membership structure, and assuming the bylaws do not state otherwise, one advantage to a dissolution and transfer of assets is that the recipient corporation would not have to seek membership approval of this transaction. Typically, the due diligence necessary on the part of the board of the recipient corporation may be significantly less arduous if it is merely approving a receipt of assets.

For the board of the dissolving corporation, an asset transfer in lieu of a merger may be far less desirable if certain liabilities are carved out of the transaction, which could expose the individual board members of the dissolving corporation into litigation in the future. 

It is important to note that although the recipient corporation does not automatically assume the dissolving corporation’s liabilities, there is always some risk associated with a full transfer of assets that a court could conclude the transfer constituted a de facto merger. Accordingly, the recipient corporation would want to carefully review such risk. Factors that may contribute to the risk include whether the boards of the dissolving corporation and the recipient corporation (post-transfer) are substantially similar or integrated. It may difficult to argue that the recipient corporation is different than the dissolving corporation if it is now governed by the same people. Along the same lines, does the recipient corporation carry on all of the same programs as the dissolving corporation with the same employees and pursuant to the same names, policies, practices, and procedures?

Overall, if the transfer of assets and dissolution results in exactly what would occur in a merger, for example (1) assumption of certain obligations of the dissolving corporation that allow for the recipient corporation to continue operating the dissolving corporation’s programs/businesses and (2) continuity of the management, personnel, locations and operations of the dissolving corporation, a court could conclude that the corporate restructuring was in substance a merger and that the recipient corporation should be treated as a surviving corporation in a merger.

Due Diligence

Due diligence generally refers to the performance of an investigation of an organization prior to entering into an agreement with such organization. Below is a sample of common due diligence items.  

Governance

  • Articles/Certificate of Incorporation and all amendments

  • Bylaws and all amendments

  • Conflict of Interest Policy

  • Investment Policy

  • Whistleblower Policy

  • Document Retention/Destruction Policy

  • Form 990 Review Policy

  • Other governance-related policies and guidelines (e.g., code of ethics)

  • Minute book

  • Organizational chart

  • Membership roster (if voting membership organization)

  • Good standing certificate

  • Schedule of states where organization is doing business or raising funds, or owns property

  • Foreign qualifications

  • Charitable registrations

  • Annual reports

  • Culture issues

Tax

  • Forms 990, 990-T

  • State tax returns

  • Local tax returns

  • Employment tax filings

  • Communications with IRS, State tax authorities

  • Tax liens

Real Property

  • Schedule of all real property owned or leased

  • Title policies, deeds, mortgages, security agreements, guaranties

  • Leases

  • Surveys, zoning approvals, variances, use permits

  • Environmental reviews

  • Schedule of hazardous wastes used, disposal methods employed

  • Permits, licenses

  • Communications with EPA and other regulatory agencies

  • Schedules of related litigation, investigations

  • Schedule of contingent environmental liabilities

Physical Property

  • Schedule of fixed assets and locations

  • UCC filings

  • Equipment leases

Intellectual Property

  • Schedule of significant IP, including trade secrets (e.g., donor lists, fundraising plans)

  • Registrations and applications

  • “Work for hire” and consulting agreements, nondisclosure agreements

Financials

  • Financials, audited (if available) – 3 years

  • Budgets, projections, strategic plans

  • Analyses of debt and contingent liabilities

  • Analyses of A/R and A/P

  • Analyses of fixed and variable expenses

  • Depreciation/amortization methods

  • Internal controls

Contracts

  • Subsidiary, partnership, joint venture, affiliation agreements

  • Agreements with directors and officers

  • Loan agreements, lines of credit, promissory notes

  • Security agreements, mortgages, indentures, collateral pledges

  • Grant agreements, enforceable pledges

  • Restricted gift agreements

  • Sales and service agreements

  • Program-related agreements

  • Nondisclosure and noncompete agreements (applicable to the organization)

  • Letters of intent, memoranda of understanding

Human Resources

  • Employee information – position, titles, compensation, benefits, years of service, contracts, background checks

  • Nondisclosure and noncompete agreements (applicable to the employees, contractors)

  • Key employee information – resumes

  • Workers’ compensation, unemployment, and other HR-related claims

  • Employment policies and handbooks

  • Retirement plans (qualified and nonqualified)

  • Collective bargaining agreements (if applicable)

  • Description of significant employee problems, including alleged wrongful termination, harassment, discrimination

  • Insurance policies (H/R-related)

  • Employee-independent contractor categorization under applicable employment and tax laws

  • Culture issues

Risk Management

  • Litigation – actual, pending, threatened

  • Settlement agreements

  • Injunctions, court orders, consent decrees

  • Unsatisfied judgments

  • Insurance policies

  • Schedule of claims

  • Risk management policies, practices, known violations

Other

  • Licenses, permits, accreditations

  • Program-, service-, and product-related due diligence

  • Marketing-related information

  • Statements of core values (which may address key determinants of strategic direction – e.g., racial equity)

Step-by-Step - California

There are many ways in which two or more nonprofits can collaborate (see La Piana Consulting’s Collaborative Map), including (1) mergers and (2) dissolutions and asset transfers discussed in Part 1 of this series. This post specifically examines a merger between two California nonprofit corporations.

Prior to moving forward with a merger, the parties should each assess its own positions (financial, programmatic, public relations/marketing, leadership, governance, available resources); its existing relationship with the other party; the consistency of their missions and cultures; its motivations for the contemplated merger; and its knowledge and understanding of the other party and its positions. Assuming, after careful consideration of these factors, the parties are still interested in moving forward, the following steps offer a general framework for the merger process.

Due Diligence

The primary goal of due diligence is to help assure a merger is in the best interests of a corporation, considering its mission, values, and key stakeholders. Reasonable due diligence under the circumstances is also necessary to satisfy the directors’ fiduciary duties of care and loyalty. Each corporation has the responsibility of conducting a thorough investigation into the other corporation’s organization and operations, including its governance structure, tax history, financials, real property, employment matters/human resources, intellectual property, contracts, and risk management. While there is no fixed list of materials which must be reviewed in all cases, each board should be aware of the relative benefits, detriments, opportunities, and threats with the merger, including any liabilities the other party may bring to the transaction. See Nonprofit Mergers – Due Diligence Items.

The most issue-laden areas tend to be real property, contracts, and employment. For example, transferring ownership of a property subject to a bank loan typically requires bank consent, which can be quite onerous. Similarly, government contracts generally cannot be transferred without obtaining the consent of the government agency and failure to get such consent could halt the merger altogether. Determining how to transition employees, specifically their compensation and benefits packages (which may not match between the two entities), HR databases, and software systems, and whether and who may be laid off, can be very costly and time consuming. Employment-related disputes are typically the number one reason why a nonprofit may find itself in court. Ascertaining whether the merging entity has any actual, pending, or threatened employment related matters is imperative. Additionally, post-merger, the surviving corporation must consider compliance with employment laws across the organization.

Plan of Merger/Merger Agreement Drafting Process

Th next step is for the two parties to begin laying out the plan of merger and document it in a merger agreement. Sometimes, any binding contracts are preceded by letters of intent or term sheets, which may identify common areas of agreement, as well as a confidentiality agreement.

In California, some nonprofits choose to execute two merger agreements: (1) a long form merger agreement which details all of the terms and conditions of the merger; and (2) a short form merger agreement containing only the required provisions under state law, to be filed with the Secretary of State. This two agreement strategy can help make the filing simpler and faster by not providing the secretary of state with a long agreement to vet and then publish on its website.

The short form merger agreement (see a sample from the Secretary of State here) may include just the following four summarizing provisions:

  • Merging Corporation shall be merged into Surviving Corporation.

  • Each membership of Merging Corporation shall be converted into one membership of Surviving Corporation.

  • Merging Corporation shall from time to time, as and when requested by Surviving Corporation, execute and deliver all such documents and instruments and take all such action necessary or desirable to evidence or carry out this merger.

  • The effect of the merger and the effective date of the merger are as prescribed by law.

The long form merger agreement contains key terms negotiated by the parties regarding pre-merger conditions, representations and warranties (in support of the due diligence), and post-merger organization and operations. This agreement includes the often more emotionally-charged aspects of the merger such as the name of the merged (surviving) corporation, leadership and board representation, continuation of any of the merging corporation’s named programs, and how the merging corporation’s legacy will carry on.

Once the merger agreement and plan of merger are finalized, each board must approve it and document such approval in minutes. Additionally, if either entity has a voting membership structure, the members must also vote to approve it.

20 day Notice to the California Attorney General

The California Attorney General must receive 20-days’ prior notice before a California nonprofit corporation consummates a merger with another corporation. However, practitioners recommend proving the Attorney General with longer notice, and waiting for the Attorney General to respond before proceeding, in case there are any issues.

The California Attorney General requires the following to be included in the notice:

  • A letter signed by an attorney or director for the corporation setting forth a description of the proposed action and the material facts concerning the proposed action;

  • Copies of both merger agreements (the short and long form agreements);

  • A copy of the resolution of the board of directors authorizing the proposed action, and board meeting minutes reflecting discussion of the proposed action;

  • A copy of the corporation’s current financial statement; and

  • Copies of the current version of the corporation’s articles of incorporation, and the articles of incorporation of any other corporation that is a party to the proposed action.

Typically, during this notice period, the corporations will begin providing notices that the merger will take place and begin obtaining the necessary consents or approvals for the transaction itself or to transfer an agreement at the closing of the merger. The officers will also sign the merger agreements.

Filing of the Merger Agreement and Officers’ Certificates with the Secretary of State

After the notice to the Attorney General has been satisfied and the parties are ready to move forward, the final step is to file the short form merger agreement and the officers’ certificate with the California Secretary of State. Due to the sensitive timing of merger transactions, practitioners recommend pre-filing these documents with the Secretary of State for a desired date of merger, in case such documents are initially rejected by the Secretary of State.

Integration and Final Filings of the Merging Corporation

Integration may be the most difficult part of the merger process and the subject for a separate post. Elements to be integrated include governance, fundraising, programs, systems (including finance, communications, and information technology), and staffing. Cultural integration is critical to the perceived success of a merger, yet it is often insufficiently analyzed during the due diligence phase.

The final filings of the merging corporation must not be forgotten. Even after the merger, information returns to the Internal Revenue Service (e.g., Form 990) and California Franchise Tax Board (e.g., Form 199) will be due for the final tax year of the merging corporation, ending on the effective date of the merger. The surviving corporation will want to have assurances in the merger agreement that the such requirements will be fulfilled post-merger, particularly if those in charge of the merging corporation’s financials and filings are not part of the surviving corporation moving forward.