Nonprofits face pressure to merge or affiliate

“In business, you have to lead, follow or get out of the way.” — Lee Iacocca   

Gov. Cuomo has taken dead aim at the nonprofit sector in New York State, with particular emphasis on those agencies funded with state dollars. After issuing an executive order in January on CEO compensation and administrative cost caps for nonprofits, he released the proposed implementing regulations in May. Read them at http://www.governor.ny.gov/press/05162012State-Funded-Providers.

The message is clear. Gov. Cuomo and his administration are demanding more efficiency from New York nonprofits. While many have argued and debated the merits of his two edicts, I am reminded of the famous Iacocca quote above. 

Gov. Cuomo’s two executive orders essentially require the following from any New York State nonprofit that receives more than 30 percent of its revenue from the state:

1. CEO compensation is capped at an amount not to exceed $199,000 per year. In other words, no state funding source will reimburse a nonprofit for more than $199,000 of CEO compensation. In his executive order, Cuomo referenced his own salary at $179,000 per year.

2. Within two years, administrative costs for state-funded nonprofits will not exceed 15 percent of total costs. There is a phase-in period which allows for 25 percent in this fiscal year and 20 percent in fiscal year 2014, with 15 percent thereafter. Administrative costs are broadly defined in the proposed regulations and generally include more than just agency administrative costs. 

These two executive orders have and will continue to generate significant discussion in the board room, management meetings, and statewide provider associations. There are provisions which allow for waiver applications and exemptions to be granted. However, it is clear that every nonprofit organization must assess the effect of these regulations. 

The impact of these proposals extends far beyond the specifics of the regulations. If enacted, after expected legal challenges, these new requirements will continue to place significant pressure on many nonprofits to merge or affiliate with other organizations. This predicted result is what I have referred to as the “WalMarting” of the nonprofit sector. 

The following lists provide the primary external and internal factors which support my prediction of increased merger and affiliation activity. Therefore, maintaining autonomy may not be the best alternative strategy at this point. 

External factors include the following:

• “Bigger is better and more efficient” in the eyes of government

• Fewer providers = less cost

• Aggregation / transfer of financial risk = less state administrative cost

• Government views smaller providers as “higher risk”

• Networking and consortiums may create favorable contracting leverage 

Internal factors impacting agency strategy are as follows:

• Maintaining sophistication in information technology

• Affordability of electronic medical records and documentation

• Maintaining regulatory-compliance requirements

• ncreased regulatory-enforcement scrutiny and audits

• Pressure on administrative efficiency and cost

As you consider my strategic analysis of the nonprofit sector and the affiliation spectrum from autonomy to acquisition, please consider the following statistics:

• Fewer than 200,000 of the nation’s 1.4 million nonprofits reported expenses of more than $100,000 — less than 15 percent.

• Only 55,000 nonprofits reported expenses of more than $1 million — less than 5 percent.

There have been many local examples of success in tax-exempt service organizations collaborating to achieve an effective fulfillment of their collective mission. I believe that every nonprofit organization should have the strategic objective of continuing to assess the impact and outcomes of program services, while effectively managing the cost of service delivery.

In fact, every nonprofit should be able to candidly evaluate and answer the following two questions:

--What strategies can we implement that will make our organization more cost effective with improved-service outcomes? 

--What are the non-core competencies of our organization that could benefit from a strategic affiliation?

The external and internal factors described above necessitate action on the part of all tax-exempts to assess their strategic position in relation to the mission of the organization. The nonprofit board and management team must evaluate affiliations along a continuum of alternatives, from contractual relationships to structural affiliations.

The following 10-point continuum should be helpful to management and board members of nonprofits facing the challenges and opportunities presented by affiliation opportunities. The points in this continuum progress from autonomy to acquisition. In between these two ends of the affiliation spectrum, we have:

Co-optition. A true blend of cooperation and competition between service providers.

An example of co-optition is the willingness of multiple hospitals in urban areas to provide admitting privileges to the same
physician. The ability to cross competitive boundaries and accomplish benefits for both organizations is the key element of co-optition.

Collaboration. The spirit of collaboration covers a wide variety of relationships, typically supported by some form of letter agreement or memorandum of understanding. Collaborations between and among nonprofits occur every day in our community in multiple situations. 

A common example of collaboration is the fact that multiple nonprofit service providers apply for third-party funding from our local United Way or grant-making foundations. The local community foundation also supports a number of joint collaborative efforts in its grant-making activities. In the current environment, these community funders are intent on achieving maximum benefit and outcomes on a cost-effective basis from their financial support. 

Shared-service agreement. The first step in contractual affiliations, generally motivated by a desire to accomplish cost reduction through economies of scale and/or to enhance quality of services.

The focal point in this area is now on administrative and support functions, commonly referred to as non-core competencies. There is a general belief that sharing administrative services is the best and first step in establishing the solid relationships necessary for two or more organizations to move along the continuum.

Contractual affiliation. Commonly referred to as the “engagement” before “marriage” (or, in this case, merger). Typically, in this phase of the continuum, you will see shared decision-making, financial risk, and an interdependence of each organization that is party to the agreement.

A common example exists when administrative support, decision-making, and related services are provided to one organization by another. Another example is collaboration on the delivery of program services by multiple providers.

Network formation. Driven by a changing marketplace, most often under the umbrella of consolidated-funding sources, case-management initiatives and/or coordinated intake/service delivery.

The federal and state governments have sponsored a number of network initiatives for many years. The most visible example, depending upon where you live in the state, is the development and funding of rural-health-network initiatives.

Joint venture. Typically two or more organizations with separate governance and decision-making authority coming together to form an entity to address a particular service need.

A common objective in this model is cost efficiency and improved outcomes. There are many examples of joint ventures in providing services to the elderly and their caregivers, as well as addressing the educational needs of our youth. 

Partnership/corporation. A separate legal entity formed requiring capital contributions or dues and separate governance, and typically devoted to a common need for all partners. Risk and reward are shared among partners on terms specified in the partnership or shareholders’ agreement.

Most urban areas have developed a regional hospital association and health information organization. These are two examples of health-care service providers in partnership to address their joint group-purchasing needs, data-information sharing, and other matters of material interest.

Merger. When two become one. 

With thousands of nonprofit organizations in the primary urban areas of the state, the current environment would appear ripe for affiliation initiatives to produce both cost savings and improved outcomes.

Finally, at the other end of the spectrum is acquisition, generally a four-letter word in the continuum for the acquired party in the transaction.

Most often in the nonprofit sector, merger is the preferred terminology, regardless of the structure of the transaction. The desire of independent boards and management teams to “maintain their authority and decision-making control” can make an acquisition difficult to achieve, other than in situations of fiscal distress. 

Remember to keep your eyes focused on the mission of your organization. Do not allow the issues of who gets what job or who gets what number of votes to dictate your decision regarding any points along this continuum.                       

Gerald J. Archibald, CPA, is a partner in charge of the management advisory services at The Bonadio Group. He can be reached at (585) 381-1000, or via email at garchibald@bonadio.com