For better or worse, the economy has caused an increase in the consolidation of tax exempt organizations as less robust organizations have sought refuge for their programs in larger, more recession-proof organizations and as organizations of similar size or financial status have joined together to weather the economic storm. Whatever the reason, tax exempt organizations are increasingly finding themselves in the relatively uncommon territory of mergers and acquisitions. While these types of transactions can be comfortable ground for many for-profit entities, many tax exempt organizations find the mergers and acquisitions process unfamiliar and daunting.
Some aspects of a potential merger or acquisition are the same for both for-profit and tax exempt organizations, while others are drastically different. The process for a potential merger or acquisition for both types of organizations is much the same: (1) preliminary talks where both parties feel each other out in terms of overall goals and facets of activities involved; (2) the parties enter into a non-disclosure/confidentiality agreement in which they agree not to disclose any confidential information obtained while evaluating the potential transaction; (3) the parties enter into a letter of intent where they set forth the basic terms of the proposed transaction that they intend to consummate, assuming the due diligence process does not uncover unexpected information (many potential transactions are abandoned before the letter of intent is entered into); (4) the parties exchange information regarding the respective organizations and conduct due diligence as to the other to ascertain exactly what each is getting in the transaction; (5) the parties negotiate and execute a definitive agreement that sets forth the terms of the transaction, including representations and warranties with respect to the assets of the acquired organization or the merging organizations; and (6) the transaction is consummated.
The major distinguishing factors of a merger or acquisition involving a tax exempt organization as the acquired entity are that (a) no owners receive any compensation for the acquisition and, as a consequence, (b) no individuals are willing to stand behind the representations and warranties made in the definitive agreement. In the acquisition of a for-profit organization, the individual or entity owner of the acquired company would be required to indemnify the acquiring organization in the event any of the representations and warranties relating to the assets of the acquired organization were inaccurate and the acquiring organization suffered damages as a result. The scope of the representations and warranties and indemnification provisions is generally a heavily negotiated aspect of for-profit acquisitions. However, since there are no "owners" of a nonprofit organization, there is generally no individual or entity willing to make such an indemnification to induce the acquiring company to acquire the tax exempt organization. This lack of direct financial interest is why most merger and acquisition transactions involving tax exempt organizations are largely based on necessity and/or trust — and are often a leap of faith.
Practical Tips
Determine what type of strategic option is best to combine the activities of the tax exempt organizations. There are a variety of legal structures that a tax exempt organization can employ to combine its activities with those of another tax exempt organization. The basic components of these strategic options and some of their relative pros and cons follow.
Affiliation Agreement – This informal structure is based on a contract between the two organizations, in which the parties agree to assign control of different aspects of their assets or programs to each other.
Pros: No need to move assets; No change in leadership for either tax exempt organization; Relatively easy to sever relationship; Could achieve certain cost reductions and other synergies through combination of administrative and other functions; Gives parties ways to work together and achieve cost-savings and other efficiencies and, if successful, to possibly move toward greater integration.
Cons: Relatively easy to sever relationship as it is purely contractual; Contracts must clearly articulate functions over which parties exercise separate control; Potential antitrust issues; Need to check contracts for any restrictions on such type of transaction.
Joint Operating Agreement – This is an informal structure based on contract between the two organizations, in which the parties agree to control all or certain assets jointly and make decisions together or combine certain discrete functions such as back office operations, purchasing, and certain administrative functions.
Pros: Essentially the same as the affiliation agreement except there are greater opportunities for joint management, which will help the parties determine if they desire greater integration if the joint operating agreement is successful.
Cons: Essentially the same as the affiliation agreement.
Joint Venture Agreement – This can be in the form of a simple state law general partnership or a more formalized entity, such as a limited liability company. This would generally involve a transfer of assets to the joint venture. The joint venture agreement would establish a governing board, which would manage the assets owned by the joint venture. Ownership of the joint venture does not need to be 50/50, but can be as otherwise agreed by the parties. (Although note the potential issues described in this article of a tax exempt organization's involvement with a joint venture. They can be useful, but should be structured so as to protect the tax exempt organization from state law liability and adverse federal income tax exemption issues.)
Pros: No change in leadership of either tax exempt organization; New board of directors for the joint venture would oversee the management of the joint venture assets; Can structure governance so that one party has control, subject to a veto right by the other party on major decisions; More advantageous than an affiliation agreement or joint operating agreement from an antitrust standpoint.
Cons: Need to identify and transfer assets into the joint venture; Potential issues regarding provider numbers and license transfer issues; Need to check contracts for any restrictions on such type of transaction; Depending on governance structure, one party could cede control to the other; Due diligence is critical as there is no likely party to stand behind representations and warranties; Possible Hart-Scott-Rodino antitrust filing depending on structure and assets transferred into joint venture.
Merger – One corporation (the acquired corporation) merges into the other (the surviving corporation). The acquired corporation would cease to exist. All assets and liabilities of the acquired corporation would become assets and liabilities of the surviving corporation by operation of law. A merger agreement would set forth how the surviving corporation's governing documents would be amended going forward.
Pros: Can be a cashless transaction between two tax exempt organizations; Assets transfer to surviving company by operation of law
Cons: Surviving entity emerges with all of the assets and liabilities (known and unknown) of the acquired company; Acquired company loses control of its historical assets unless it gets equal representation on the board of surviving corporation; Potential issues regarding provider numbers and license transfer issues; Need to check contracts for any restrictions on such type of transaction; Due diligence is critical as there is likely no party to stand behind representations and warranties; Possible Hart-Scott-Rodino antitrust filing.
Asset Purchase – The assets of the acquired corporation are sold to the acquiring corporation for some amount of consideration. The asset purchase agreement would set forth terms of the acquisition and representations and warranties with respect to the assets. The acquired corporation would continue to exist (and, assuming the acquired corporation is a tax exempt organization any consideration paid for the assets could be distributed to another tax exempt organization in compliance with the acquired corporation's governing documents). The acquiring corporation would own the newly acquired assets.
Pros: Acquiring company is able to select only the assets it would like to purchase; Acquiring company is able to select only the liabilities (if any) it would like to assume subject to "successor liability" principles; Assets could be acquired in a separate corporation to segregate liabilities and limit exposure.
Cons: Need to identify and transfer assets into the acquiring corporation; Potentially a very complicated transaction to accomplish depending on the types and amounts of assets and contracts of the acquired company; Acquired company loses control of its historical assets unless it obtains equal representation on the board of the acquiring corporation; Could require actual capital outlay to purchase assets if transaction is not essentially a gift; Potential issues regarding provider numbers and license transfer issues; Need to check contracts for any restrictions on such type of transaction; Due diligence is critical as there is likely no party to stand behind representations and warranties; Possible Hart-Scott-Rodino antitrust filing.
Change in Membership to Parent/Subsidiary Structure – The governance documents of one corporation (the subsidiary) are modified to provide that the other corporation (the parent) is the sole member of the subsidiary. The parent would be given broad oversight power and authority with respect to decisions made by the board of directors of the subsidiary. The subsidiary would continue to exist with its existing board, although election and removal of the directors of the subsidiary would be at the parent's discretion.
Pros: The parent does not actually take on any assets or liabilities; The parent controls the assets indirectly as the sole member; The level of control and autonomy of the subsidiary's board can be negotiated; Probably the least complicated transaction of the various alternatives with the possible exception of the affiliation or joint operating agreement; Might permit future financing based on "obligated group;" If both organizations are in good financial condition, this could provide greater access to capital.
Cons: Subsidiary loses some and potentially all control, although it would still have day-to-day control; Potential issues regarding provider numbers and license transfer issues on "change of control;" Control of parent is indirect, through its vote as a member and ability to appoint board members; Need to check contracts for any restrictions on such type of transaction; Possible Hart-Scott-Rodino antitrust filing.
New Holding Company – A new 501(c)(3) corporation is formed to manage both organizations. The governance documents of both organizations (the subsidiaries) would be modified to provide that the new corporation (the parent) is the sole member of both subsidiaries. The parent would be given broad oversight power and authority with respect to decisions made by the boards of directors of both subsidiaries. The subsidiaries would continue to exist with their existing boards, although election and removal of the directors of the subsidiaries would be at the parent's discretion.
Pros: New holding company parent does not actually acquire any assets or liabilities (other than membership interests in the two subsidiaries); New holding company parent indirectly controls assets as the sole member; The level of control and autonomy of each subsidiary's board can be negotiated; One of the least complicated transactions of the various alternatives; Might permit future financing based on "obligated group;" If both organizations are in good financial condition, this could provide greater access to capital.
Cons: Need to acquire 501(c)(3) status for new holding company; Subsidiaries lose some and potentially all control, although each would still have day-to-day control; Potential issues regarding provider numbers and license transfer issues on "change of control;" Control of parent is indirect, through its vote as a member of both subsidiaries and ability to appoint board members; Need to check contracts for any restrictions on such type of transaction; Possible Hart-Scott-Rodino antitrust filing.
Address potential legal issues. As the pros and cons outlined above indicate, a variety of legal issues must be evaluated with each scenario, even after the "best" strategic option for the tax exempt organization has been identified. Perhaps the most daunting legal hurdle tax exempt organizations face is the requirement that the proposed transaction not violate any existing contract or obligation of either organization. This means every lease, grant agreement, bond document, loan agreement, or other contract must be reviewed carefully during the due diligence process to be sure the proposed transaction will not trigger a breach of an agreement or that consent to the transaction is obtained prior to the transaction, if at all possible.
Address control issues before the closing of the transaction. Since there are no owners of a tax exempt organization and no compensation to be paid out to shareholders, the issue of control of the surviving organization, in whatever form, becomes a significant part of the merger and acquisition negotiation process. The parties must obtain a level of comfort with how the surviving organization will be governed, who will appoint the directors, and any time periods that must be met before those rules can be modified. Those agreements must be put into writing as part of the transaction's definitive agreement.
Be wary of potential private inurement. The parties should take special care to ensure that no extra compensation or excess benefit is being provided to any of the individuals involved in the transaction that would implicate the prohibition on private inurement or the imposition of excise taxes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
