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Building stronger together: M&A due diligence for NFPs

Collaborations to advance your NFP - A Baker Tilly series

This is the second article in our NFP collaboration series.
Not-for-profit (NFP) mergers and acquisitions (M&A), joint ventures and strategic alliances have become increasingly important as organizations face challenges such as funding constraints, competition, and changing regulations and marketplaces. M&A can help NFPs address these challenges and achieve their mission more effectively. A merger or acquisition can also help organizations expand their reach and improve their programs and services by combining resources and expertise.

M&A and other collaborative arrangements can provide several benefits to organizations, including:

  • Improved efficiency and effectiveness: M&A can help not-for-profits improve their efficiency and effectiveness by combining resources, reducing duplication, creating economies of scale, and sharing best practices.
  • Increased impact: M&A can help organizations increase their impact by expanding their reach, improving their programs and services, and addressing organizational challenges.
  • Financial stability: M&A can help NFPs achieve financial stability by combining resources and creating a more sustainable business model.

When an NFP organization considers a merger or acquisition to achieve its mission and goals, financial due diligence plays a critical role in the process. Financial due diligence helps organizations on both sides of the deal assess their own position as well as the financial health and performance of the potential partner organization and identify any financial or risk profile issues that may impact the transaction.

Let’s explore some of the financial due diligence considerations for not-for-profits.

1. Financial statements review

The financial statements of the potential partner organization should be reviewed carefully to assess the financial health and performance of the organization. This review should include an analysis of the target entity's financials at the trial balance account level, at which level most effectively allows for analysis of account level trends and anomalies. The review should also assess the quality of the financial statements, including the accuracy and completeness of the financial data.

2. Revenue and expense analysis

A detailed analysis of the revenue and expense of the potential partner organization is crucial in assessing the sustainability of the organization. This analysis should include a review of the sources of revenue, expense structure, and grant or donor funding history. The analysis should also look at the financial sustainability of the organization, in terms of free cash flows, and identify any potential risks that may impact the transaction, such as a reliance on a single source of funding or an unsustainable expense structure.

3. Donor or grant review

NFPs can rely heavily on donations and grants to operate. Therefore, a detailed review of the potential partner organization's donor and grant history is essential to assess its financial stability and sustainability. The review should include an analysis of the donor and grant relationships, their history, and any restrictions or conditions attached to them, especially restrictions that may become effective under a transfer of control.

4. Compliance and tax review

Not-for-profit organizations operate under strict compliance and tax regulations. Therefore, it is crucial to conduct a thorough review of the potential partner organization's compliance and tax status. This review should include an analysis of the organization's tax filings, compliance with state and federal regulations, and any outstanding tax liabilities. It should also assess the organization's ability to comply with future regulatory changes.

There are also special circumstances to consider when merging with a not-for-profit that has an embedded for-profit entity or when acquiring a for-profit entity. Generally, when contemplating a deal with both not-for-profit and for-profit elements, there are three basic paths forward: keep it, change it, or abandon it. You can keep the for-profit element and account for the tax requirements, you can change it into a not-for-profit, or you may determine that it is a deal breaker and abandon it all together. We have recently worked with a few NFPs who have looked to acquire for-profit entities into their NFPs. Two examples were in the healthcare space, looking to acquire mental health divisions into their organizations to expand capabilities to meet the current needs of their communities. Both acquisitions went forward after careful consultation on the tax implications. But we have also seen deals fall apart over tax considerations, which is why due diligence early in the transaction is so important.

5. Other financial considerations

Other financial considerations for not-for-profit M&A include the organization's debt and liquidity position, any contingent liabilities, and the potential impact of the transaction on the organization's financial position. The review should assess the organization's ability to service its debt and manage its liquidity. It should also identify any potential contingent liabilities, such as pending legal claims or unresolved disputes. One typically critical issue to understand also relates to potential pension plan obligations, that could have the risk of being underfunded. Finally, it should assess the potential impact of the transaction on the organization's financial position, including any costs associated with the transaction and the impact on donor or grant funding.

Just like in for-profit transactions, financial due diligence is a crucial part of not-for-profit M&A. A thorough review of the potential partner organization's financial health and performance can help NFPs make informed decisions and identify any potential financial risks that may impact the transaction. All of these financial elements factor into the valuation of the organization. If you are preparing for or contemplating selling or merging, look closely at these elements of your own organization as well. Remember, due diligence is often a two-way street. By conducting a comprehensive financial due diligence review, not-for-profit organizations can ensure that the M&A transaction is aligned with their mission and goals and contributes to their long-term sustainability.

Is your organization considering other options beyond a merger or sale?

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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Read our first article in the NFP collaboration series

How collaborations can support your mission and expand the impact in your communities

From mergers and joint ventures to cooperative activities, alliances and shared services, NFPs are finding creative ways to build and maintain their vital role in their communities.

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