January 19, 2018
 
Mergers’ Hidden Savings (and Costs)

By Thomas A. McLaughlin

Thomas A. McLaughlin
With the growing acceptance of nonprofit mergers, it is worth exploring the hidden financial and administrative complexities that often are not anticipated by either party until deadlines draw near – and sometimes even later.

The irony is that when two (or more) organizations seriously consider a merger dialog it is usually a cause for celebration and the anticipation of a long term and mutually productive relationship.

A major problem is often hidden in plain sight. To be specific, the collaboration that initially seemed a natural and even an exciting fit may turn into a source of concern that can arise from many different factors. We’ll show how to avoid some of these difficulties below.

Fringe Benefits

As an illustration, consider the mechanics of fringe benefits. This area of spending can include a pension plan (if any), plus employee benefits. The laws and standards behind these common employment advantages are reasonably well known and understood by managers and others inside an organization because, well, someone has to be familiar with the administrative aspects.

The hidden problem is that those planning the merger aren’t usually ‘back-room people’ because the CEO and one or more high level managers need to take into consideration dilemmas that even a smooth collaboration can produce. As a result, there can be slip-ups.

The benefit here is that nonprofit public charities are required to complete a report known as the Form 990, which can be 40 pages long or longer depending on many aspects of the reporting nonprofit. To illustrate what can happen, consider the seemingly straightforward reporting on benefits found on page 10, line 9 titled ‘Other Employee Benefits’. When planning a combination of two or more corporate entities, the benefits expense line can be a disaster waiting to happen.

For example, if those designing the newly merged entity simply accept the dollars listed as having been spent for fringe benefits, problems can arise quickly. If two different companies are providing these benefits to the two organizations there may be completely different ways of doing so, including the overall costs. One may pay for full benefits to their qualified employees, while the other may require each employee to pay some small level for the benefit package. And we haven’t even taken into consideration how the same health care company serving two similar but different organizations will likely charge more for the nonprofit with higher claims (or a higher ‘risk profile’). Blending the two organizations into a single plan will almost certainly affect the organization with a lower average cost basis per enrollee.
Although not often used by smaller nonprofits, Line 8 which is officially named ‘pension plan accruals and contributions’ can be easily overlooked. A significant difference between one organization that makes pension plan deposits for employees and a potential merger partner that doesn’t might well cause some friction once employees’ communication lines open up. The line below reports ‘Other employee benefits’, which aptly describes its role. Depending on the size and sophistication of the administrative staff, a newly merged entity could prompt a disconnect between those with higher benefit plans and those with smaller plans. If it’s any consolation, the same kind of disconnect is likely to be found elsewhere in one or both of the entities. For example, the compensation structure in two different organizations with very different formulas, requirements, and pay levels are almost certain to have a major impact on the two entities, as well as the internal culture that each has developed over the years.

The federal government also does its part to squeeze employees and employers. The most subtle but effective approach is so deeply buried in payroll tax management that it is often overlooked. This payroll tax is technically known as the Federal Insurance Contributions (FICA). Its most noticeable device is almost literally buried in the rules and regulations. Employers must pay a flat percentage of 7.65% of the first $118,500 in compensation, which they then pass on to employees. Happily, the rate has remained unchanged in the last few years (note that the Great Recession of 2007/8 had a tax basis of $102,000).

Putting two or more entities into the same corporate structure can lead to sudden adjustments such as compensation scales. From the employer’s perspective, blending two entities would be desirable for many reasons, but in all likelihood one corporation’s benefits will be higher and/or better than the other which means a substantial increase in one of the pay scales for the blended entity. This is one of the major drivers behind the retention of existing corporate structures. It is why the choice is often to keep the corporate structures intact. What this leads to is a management company at the ‘top’.

The management company is usually an amalgam of the executives and the two ‘back rooms’. Yes, there would be only one CFO in the back room, a single head of the personnel function, etc. But the offset is that there is usually a fairly close relationship between the scope of work that needs to be done and the number of people from the two ‘back rooms’ that are available to do it. Administrative personnel who are performing adequately in their existing roles will almost always find a satisfying position in the newly enlarged back room. For what would likely be an extended period of time, these individuals would also almost surely find that the process of integrating these operations will take at least a year and perhaps longer to take advantage of the opportunity to integrate two qualified groups of workers.

Other Potential Areas for Change

One area that rarely gets attention, even from accountants and in-house employees, can function as a long-term evaluation of management’s choices in a way that no other part of the Form 990 can. The calculation is very simple. Find the term ‘accumulated depreciation’ in the 10b box on page 11 (not Column B) and enter that number into your calculator. Then turn back to Page 10, column A, line 22, and divide the number in your calculator by the number in line 22, column A. The result is a clever measurement of an organization’s tangible holdings such as buildings, computer systems, etc. . The measurement itself is defined as the ‘accounting age’ -- the ‘higher’ the result, the ‘older’ (and more tired) your equipment is.

The salary scale is another important and complicated indicator. Most small to medium-sized nonprofits can muster some level of consistency in determining compensation, but larger nonprofits generally must have a fairly sophisticated system for these purposes. Employee benefits are an even more complicated area. While numbers of years served is a useful tool for evaluation, the many levels of evaluation that can and should be carried out quickly become a burden for many nonprofits. The Value of the Management Corporation

Complexities like the ones described above—and many others—are at the base of why merging organizations often find it worthwhile to keep their existing program structures intact while blending their management staffs. From a pragmatic perspective, this can solve many problems. For instance, each entity will likely have a CFO. Assuming that all parties can agree on which of the two existing CFO’s should become the CFO for the blended organizations, retaining the other CFO should add appreciably to the financial management talent in the new entity. This may seem like a prescription for internal strife, but if the new management company can retain the other CFO, the effect usually adds significantly to the overall strength of the financial management system. Not exactly a twofer, but close.

Thomas A. McLaughlin is the founder of the consulting firm McLaughlin & Associates and the author of Streetsmart Financial Basics for Nonprofit Managers (4th edition), published by Wiley. Email him at tamclaughlin@comcast.net. An earlier version of this article was published in The NonProfit Times.

September 2017

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