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Debt is not a dirty word: Why your not-for-profit might want to borrow

August 15, 2012

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Debt is an integral part of many for-profit companies’ strategic plans, yet it has traditionally carried a stigma in the nonprofit world. That view is changing, as more organizations borrow money for major capital purchases, new program funding — even to manage current cash flow.

But if you’re hoping to borrow, know that not all not-for-profits qualify. And even if you’re able to find a lender, it takes prudent financial management and reliable donor support to pay back a loan.

Exhaust other options first

You may think your organization has a good rationale for borrowing, but that doesn’t mean lenders — or even your supporters — will agree. One of the primary criteria watchdog groups such as Charity Navigator and CharityWatch use to evaluate nonprofits is the percentage of available funds spent on programs. If a large portion of your budget is tied up in debt repayment, that’s likely to affect how the public, including prospective donors, perceives your organization.

What’s more, lender covenants may prevent you from borrowing for other purposes — and thus limit strategic flexibility — until your existing debt is paid off. And, as many nonprofits have learned in recent years, debt makes periods of economic uncertainty that much more challenging. So, in general, it’s best to exhaust other funding sources, such as public and private grants and major donations, before applying for a loan.

Are you prepared?

Even if you determine your nonprofit can handle the risks of borrowing, you likely won’t qualify for a loan unless you have all your ducks in a row. Before approaching a lender, make sure you have:

•    A realistic repayment plan that doesn’t strain your operating budget,
•    Current financial statements, recent tax returns and up-to-date cash-flow projections,
•    Collateral to secure the loan, such as your nonprofit’s accounts receivable or unencumbered real estate or equipment,
•    A proven history of prudent financial management, and
•    The support of your board of directors.

The odds of qualifying for a loan are better if you’ve already established relationships with lenders — preferably ones with experience lending to nonprofits. You may even want to establish a small line of credit with a local bank at a time you don’t actually need the money. That way, the bank will know you when you apply for a larger loan. And be sure to ask for assistance from board members who may work in banking or who can introduce you to lenders they know.

Justify your loan

Lenders want to know, in detail, why your nonprofit is seeking funds and what you hope to achieve with them.

One of the most common reasons nonprofits seek loans is to make a major purchase. For example, your private secondary school may want to replace its aging gym with a new athletic facility. Or your senior community center may need a specially equipped van to transport disabled clients. Generally, such purchases are partially funded by grants or donations — and evidence of such support is likely to help your application.

Many nonprofits borrow to stabilize cash flow — typically with a line of credit. You may, for example, need funds to bridge billing and collections gaps or to remain liquid while waiting for a major grant check to arrive. Such credit is usually acceptable so long as you don’t routinely borrow the maximum amount or continually operate your organization with a deficit.

It may be harder to justify a loan to fund new programs or initiatives — unless you can prove that they’re essential to your mission and that they’re likely to produce income down the line. And, while you may be able to borrow to address an emergency situation, don’t get into the habit of calling a loan officer every time the unexpected happens. That’s what emergency savings and contingency plans are for.

Reasonable certainty

As many consumers have learned the hard way, it’s easy to dig a hole for yourself with debt. But if you know with reasonable certainty how your organization will repay the loan and have determined with your board and financial advisors that the possible negative consequences of debt financing are remote, a loan may be right for you.

Where nonprofits go when they need a loan

When you hear the word “loan,” you probably think “bank.” While plenty of banks are willing to make term loans or lines of credit available to nonprofits, your organization may not want, or be able, to pay the interest rates attached to them. Fortunately, you have other options, including:

Community foundations. Short-term loans may be available from local nonprofit foundations or funds, such as the Fund for the City of New York or the Chicago Community Trust, or from national groups such as the Nonprofits Assistance Fund. Generally, these organizations charge low interest rates — and, in some cases, no interest at all.

Board members. Contrary to what you might have heard, there are no legal obstacles to borrowing from a board member. However, such loans merit caution. To avoid IRS scrutiny, the board member / lender must charge interest at or below market rate, the entire board (absent the lender) must vote to approve the loan, and you must report the loan on your Form 990. Finally, to protect all parties, you need to put the loan terms in writing.

Government bonds. Generally taken out to fund large capital investments related to real estate and facilities, a municipal or other government entity bond might be an option. Because these bonds’ income isn’t subject to federal income tax, your nonprofit can borrow at a lower-than-market interest rate. However, fees associated with structuring and issuing the bond could offset interest-rate advantages.

Mike Borowitz is a Shareholder with Clark Schaefer Hackett and can be reached at [email protected]

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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