When thinking about mergers and acquisitions (M&As), not-for-profit (NFP) entities may not be the first to come to mind. However, just as in the for-profit world, M&As can be a powerful strategy to capitalize on strengths, manage risks, and drive an NFP’s mission. Sometimes, it may even make sense for an NFP to engage with a for-profit entity in an M&A transaction.
M&As are a type of business combination but not the only type, so it is important to note the differences between types of business combinations. There are several key factors to consider before, during, and after an M&A, as well as the accounting treatments and tax considerations that will come into play.
Various Business Combinations
To begin, let’s look at a few types of business combinations at a high level. One type is a contractual relationship, also referred to as a joint venture. In these types of transactions, the organizations involved in the deal remain independent. Via a contract, the organizations work together toward some common goal.
This could include, among other things, obtaining joint funding, contracting for combined services, or carrying out a joint program. These types of combinations can be between two NFP organizations or between a NFP and a for-profit entity. Again, each organization remains independent, so they retain autonomy while finding efficiencies working together.
Another type of business combination is a strategic alliance. Similar to joint ventures, the organizations involved in a strategic alliance remain independent and work together through collaboration and sharing. Examples could include sharing board members, staff, or services.
M&As are another type of business combination organizations and companies can enter into. A merger is the legal absorption of one organization or company into another. One party becomes the surviving organization, and its legal name remains the same. Mergers usually result in significant downsizing of staff, which can be a challenge for organizations to overcome.
On the other hand, an acquisition is the legal combination of two organizations, resulting in a new legal name, a new board of directors – essentially, the two parties come together and become a completely new organization.
Business combinations, more specifically, M&As, can be between two NFPs or between an NFP and a for-profit entity. The differences between these two types of entities should be considered when thinking about potential M&A deals. While an NFP is typically more driven by its mission, a for-profit entity may have more of a profit motive.
The availability of financial and people resources is another factor. An NFP can raise funds in ways that differ from for-profit entities, making it an extremely important consideration. People are key when it comes to the success of both NFP and for-profit organizations; however, they may come with varying mindsets. Therefore, this is again another important factor when considering an M&A transaction between NFPs and for-profit companies.
Although there are many differences , there are also numerous similarities to factor in when making decisions, especially those surrounding M&A deals. Both NFPs and for-profit entities may have a similar strategy, culture, business or financial disciplines, and relationships with external stakeholders (funders, customers, bankers, investors, etc.). It is important to note that a NFPs tax status is exactly that – a tax status and not a business model. Sometimes it may be best for two NFPs to come together in an M&A, but NFP managers and executives should not dismiss the possibility of working with a for-profit entity when it makes sense.
Adherence to FASB
NFP organizations must follow the guidance in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 958, Topic 805 – Business Combinations. The FASB defines a merger as a business combination when one organization cedes control to a new NFP organization. An acquisition happens in a business combination transaction when one organization obtains control over the other. For a business combination to qualify as a merger in which a new NFP organization is created, the combined entity must have a newly formed governing body.
Although the creation of a new legal entity is not required as part of a merger under FASB ASC 958-805-55, the result is often a new legal entity. Typical characteristics of an acquisition include retaining significantly more of its key senior officers, retaining bylaws, operating policies and practices remain substantially unchanged. One must evaluate and consider all of the various characteristics between mergers and acquisitions to determine which type of business combination the transaction falls under. No one characteristic determines whether the transaction is a merger or acquisition.
Determination Between Merger or Acquisition
Making the determination between a merger or acquisition is crucial as this dictates the accounting treatment that must be followed under accounting principles generally accepted in the United States (U.S. GAAP). For a merger, the carryforward method is used. Under this method, the combining assets and liabilities are recognized in a separate set of financial statements as of the merger date and no additional assets are recognized. Furthermore, any classifications, designations, or restrictions are carried forward.
If a business combination is determined to be an acquisition, the acquisition method is used. This method can be very complex, which is why organizations should seek professional guidance when working through an acquisition transaction.
The method includes five steps:
Along with the accounting treatments that must be adhered to under U.S. GAAP, there are also many different tax implications and considerations to think about when considering an M&A deal. M&As are typically between two NFP entities; however, it sometimes makes sense for an NFP and a for-profit entity to come together through an M&A. When this happens, the surviving entity usually retains its tax status. If the surviving entity is tax-exempt, it retains its exempt status after an M&A, but it must ensure the merged for-profit activities are consistent with those for the exempt status in order to avoid unrelated business income tax (UBI).
If the surviving entity is the for-profit entity, the NFP loses its tax-exempt status and therefore loses its ability to accept charitable contributions. As part of an M&A deal involving NFPs, management must be careful to not let activities not related to its tax-exempt status take over.
The following are some examples of activities that could jeopardize a tax-exempt organization’s 501(c)(3) status:
Benefits of M&A Transactions
There are many reasons an M&A may be a smart business decision, both for NFPs and for-profit entities. It can be a stressful and challenging transaction to work through, but definitely worth the time and effort. For NFPs, an M&A deal can help it to expand geographically, grow its service offerings, enhance community and funder partnerships, and allow costs for administrative services to be shared. The benefits are similar for for-profit entities, M&As can increase shareholder wealth, expand its market share, obtain access to new customers or vendors, and manage competitive risk (eliminating a competitor, for example).
There are six key points to keep in mind when preparing for an M&A deal:
Due diligence is probably the most important item to consider when preparing for an M&A. Lawyers should be included during this process. They are likely to be the biggest expense, but are worth the investment. With their expertise, they can help assess and manage risk, identify legal structure and requirements, and aid in human resources and payroll compliance, among other things.
When it comes to people, keep in mind there will be both personal and personnel decisions that will need to be made, and they will not all be easy decisions. Culture is also an important step in the preparation process. Commonalities and differences between the parties involved in the deal should be assessed appropriately.
Resources are also key. An M&A will take both financial and people resources, cross-functionally, so it is important to consider the strain a deal may have on these resources and budget for them. The management of the deal is critical. An emotionally intelligent project manager should be involved throughout the process. However, management of both parties should be cautious about who is involved in the deal, especially in the beginning.
Finally, reach out to your CPAs. Similar to lawyers who should be involved in the due diligence process, CPAs should also be included. They are well-equipped professionals that can lead due diligence, discuss financial audit implications, or even provide full-on internal audit and planning exercises.
Plan for Success
M&As can be an exciting change for any organization. While they can provide great opportunities for growth and expansion, they require extensive planning, communication and critical thinking to be successful. When it comes to closing day, it is usually anticlimactic – the hard work was done beforehand with more work to be done after the deal is closed.
Be sure to bring in resources, especially attorneys and CPAs – they should be involved not only throughout the due diligence process, but as part of the closing process as well. Understanding the complexities, including the accounting and tax implications, and being thoughtful and intentional with decision making can go a long way towards a successful M&A deal.
Our team of experienced M&A advisors can help you prepare for a streamlined M&A transaction for your NFP entity.