Nonprofit Mergers and Acquisitions: Pros and Cons for This Increasing Trend

July 16, 2024
Publications

By Meagan Truong and Martha “Frannie” Reilly

Merging business entities—whether by a traditional merger or when one entity purchases the stock or assets of the other—is always a complicated legal transaction, but when one or more nonprofits are involved, the process is even more difficult.

Nonprofits and charitable entities require greater oversight of their affairs due to their status, which is granted by government agencies. There is an important, growing trend among nonprofit organizations to merge in order to conserve resources such as board members, grant funding and donors. Conservation of these resources will help to sustain the programs and services provided by nonprofit organizations for future generations. Below are additional considerations when merging nonprofit organizations.

General Merger Steps

When merging entities or having one acquire the other, there are basic steps which always need to be taken. As a brief overview, these include: Conducting due diligence so each entity is aware of the status, condition and historical operations of the other entity prior to pursuing the transaction; Drafting a game plan for implementing the merger, including a plan of merger or a purchase agreement (which may be an asset purchase agreement, member substitution agreement, or a stock/interest purchase agreement, depending on the parties’ preferences); Having both parties approve the transaction (which may involve member approval, similar to shareholder approval, and/or board approval); Obtaining any necessary governmental or regulatory approvals to continue providing programs and services; Closing on the definitive agreement and all documents drafted ancillary thereto; and Determining any necessary post-closing work to merge the operations of the entities post-closing.

Complications for Nonprofit Entities

In order to be approved for 501(c)(3) status, a nonprofit entity must state in its articles of incorporation (or applicable formation documents if not a corporation) that its purposes are charitable; its earnings will not inure to the benefit of private individuals; and that upon its dissolution or liquidation, its assets will be distributed to other exempt organizations having a purpose closely related to the entity. Following such an entity’s formation, it must also apply for 501(c)(3) tax-exempt status by providing a significant amount of information to the IRS about its goals and programs and/or services to be provided. Approval of this tax-exempt status is pending the IRS’ assurance that the entity is conducting programs or services that will benefit a charitable class. A nonprofit 501(c)(3) entity must largely continue to abide by such statements in its operations. All of these requirements must be considered when merging or acquiring a nonprofit entity. Considerations such as whether these programs or services will continue to be served will need further evaluation in determining whether to move forward with a merger or an acquisition.

Grants

Nonprofits often seek and obtain grants to further their operations and charitable purposes. Some common questions on grant applications are how such funds will be used, what specific purposes the funds would be put toward, what geographical area the funds will be used in, and what demographic the funds will serve. Once an entity has received a grant, an agreement is typically put in place or terms are proffered by the granting entity noting specific requirements for the use of such funds. Oftentimes, those terms include a requirement that if, during the term of the grant use period, any circumstances change, or the entity’s operations vary such that the original answers to the grant application would be different, the entity must notify the granting entity or agency of such changes. Nonprofit entities must be mindful in conducting due diligence for a merger or acquisition transaction to ensure that any changes resulting from the transaction are considered, that all such notice requirements contained in grants are met, and that funds and contributions will continue to be used for their originally intended purposes. In addition, the merging entities will need to consider whether their combined efforts will enhance their ability to raise additional funds through grants.

Attorney General and Orphan’s Court Approval

State attorneys general also oversee the operations of charitable and nonprofit entities. In Pennsylvania, the attorney general’s office performs a mandatory review of all “fundamental change transactions” entered into by nonprofits. This can include mergers, member substitutions and asset and stock acquisitions. Once the definitive agreement for such a fundamental change transaction has been agreed upon by the parties, it must be submitted to the attorney general’s office for review and approval. This is another instance of oversight to ensure the integrity of entities to which individuals and companies are donating their money, and which the government has exempted from paying taxes.

On top of grant requirements, state law directs the use of funds or assets donated to charities. For example, Pennsylvania law states that property committed to charitable purposes shall not “be diverted from the object to which it was donated, granted or devised, unless and until the board of directors or other body obtains from the Court an order specifying the disposition of the property.” See 15 Pa. C.S.A. Section 5547(b). Accordingly, a merger or acquisition transaction may require Orphan’s Court approval before it can be consummated.

Donor Intent

In reviewing whether nonprofit organizations should merge, the nonprofit boards should consider whether funds that have been previously donated (and some which may continue to be donated such as through estate plans) will be used in fulfillment of the purposes in which these funds were donated. If so, the Attorney General’s office will want to know that the donor intent will continue to be fulfilled through the merger or acquisition. If not, the attorney general’s office will want an explanation as to why the donor intent cannot or will not be fulfilled.

Conclusion

In sum, while many of the steps in effecting a merger or similar transaction are the same for both for profit and nonprofit entities, nonprofit and charitable organizations must be aware of the additional steps and requirements imposed on them by both state and federal law, as well as granting agencies. In addition, nonprofit organizations should consider the sustainability goals of being able to continue providing programs and services as a stand-alone entity in comparison to merging with another organization. Nonprofits should always seek the assistance of an attorney with specialized knowledge of these areas to ensure their proper adherence to these requirements.

Meagan Truong is a business attorney at McNees Wallace & Nurick and serves clients from Pittsburgh. She advises clients of all sizes on a range of corporate and business law matters, including mergers and acquisitions and acquisition and disposition of assets, including real property. She can be reached at mtruong@mcneeslaw.com or 412-227-2508.

Martha “Frannie” Reilly is co-chair of the firm’s public finance and government services group and chair of the firm’s charitable & nonprofit and environmental, social and governance (ESG) groups. Serving clients from Devon, she advises charitable and nonprofit organizations on fiduciary duties, compliance, planning and other matters. She can be reached at freilly@mcneeslaw.com or 484-329-8036.