Lending to nonprofits

RMA Journal, The, March, 2005 by Donald P. Johnson

There are well over a million nonprofits in operation today, so chances are good that every financial institution has or will have a nonprofit borrower. Thorough assessment of the board and understanding of liquidity sources are part of the due diligence that will result in a healthy and lasting lending relationship.

Nonprofit organizations (NPOs) are tax-exempt institutions operating outside the normal professional or business venue. Operating under IRC Section 501(c)(3) of the Tax Code, NPOs serve broad public interests, including educational, religious, scientific, literary, as well as the relief of poverty and other activities that benefit the public. According to the National Center of Charitable Statistics and contrary to what some may believe, there is no legal distinction between the terms "nonprofit" and "not-for-profit." (1) The diversity and complexity of the nonprofit sector make it hard to provide a count, but there were approximately 1.4 million non-profits in the U.S. in 2003, 26% more than in 1996. (2)

Lending to NPOs provides unique challenges to banking institutions. Due diligence should begin with an analysis of the board and key executives, liquidity and fund-raising, and working capital.

Management

The board. The organization is stronger if board members include professionals and business people who can assist in decisions ranging from finance to real estate projects. The lender needs to assess the board's composition to ensure the presence of such people in addition to the "feel good" people who support the mission without probing into its financial success. This can be accomplished by attending a few board meetings and also meeting with members individually. An overall assessment must include member stability, such as length of service, background, and general trends of past board membership versus the current membership.

If there is a board development committee, the lender should have a clear understanding of the recruitment process, any current backlog of candidates in the pipeline, and how active the board is in scheduling interviews with strong community members.

Executives. It's essential to learn the backgrounds of key employees--those responsible for fund-raising, project management, and business execution. Executives with nonbusiness backgrounds may experience a major learning curve on the financial side of the operation. When a lending relationship is established at the beginning of this curve, more oversight is necessary.

A good analyst will spend time with the CEO (or executive director) to ascertain his or her depth of business acumen. An inexperienced CEO may give overly general profit numbers and time lines. The lender should also evaluate the CEO's relationship to the board: Is it synergistic or does it portend future conflicts? It should be apparent from a few meetings whether or not the CEO is a visionary--someone with purpose and discipline who makes things happen--or merely presides over a gathering of caring but uninvolved people.

If the business acumen of the CEO is weak, further examination of the controller's office and a review of the disciplines of the board members will reveal whether there is backup in the event of problems. It is imperative that the controller have a detailed understanding of the various funding sources--public and private--and the means to access them. For example, if government funds are available, the controller must know the regulatory ins and outs along with potential problems in receiving the funds on a timely basis.

In addition to the controller, the lender should talk with department heads to ensure a true picture of the NPO's financial health. An analyst must have continued discussions with the head of fund-raising to test the validity of the projected numbers and to uncover any systemic problems that may hamper the NPO's ability to generate revenue or to back up promises made to donors. Additionally, the lender needs to assess transitional issues resulting from the replacement of one or more key individuals (such as a popular pastor or rabbi, a dynamic board member, or a strong and committed key employee).

The analyst must bore into the workings of the NPO, giving specific attention to the overall decisions affecting each income stream. For example, in a discussion with a CEO of a juvenile housing facility, I asked about major increases in the AWOL list. These increases had a direct funding effect because the school receives money based on head count. In fact, the CEO had changed the policy--from "no return" if the young men ran away to "we will take you back"--to keep up the head count. Upon review with department heads, the new policy was blamed for nascent financial problems. Young men would return with no repercussions and then go AWOL permanently. The staff felt that they could not discipline the young men under this policy change, and the system was breaking down. The CEO reevaluated the change and returned to the original policy. Within a few months, the runaway problem corrected itself and the funding stream improved remarkably.