Sector-bender: more and more nonprofits have for-profit subsidiaries. Now one CFO wants to turn that model upside down

CFO: Magazine for Senior Financial Executives,  August, 2004  by Tim Reason

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IT'S A QUESTION MANY SUCCESSFUL PRIVATE COMPAnies face: how to finance the next stage of growth. Initial public offering? More private equity? John W. Gillespie, CFO of The Mentor Network, a residential-care provider, has another idea: find a large nonprofit foundation with a similar mission to buy the company.

The idea, he admits, is highly speculative. Outside of the hospital industry, it's rare for a for-profit company to peddle itself to nonprofits as an acquisition target. Even if it were common, few foundations are large enough to absorb a company the size of Boston-based The Mentor Network, which has grown to more than half a billion dollars in annual revenues.

And that's not to mention the regulator, and tax changes that might be necessary for a deal of such scale. "I'd put the chances of it happening in the low single digits," says Gillespie. "But it's worth exploring." For one thing, Gillespie, a former investment banker, is less than sanguine about the prospect of going public in the era of the Sarbanes-Oxley Act. And while he's pleased with his company's private-equity owner, Chicago-based Madison Dearborn Partners, he can envision a day when The Mentor Network will outgrow the private-equity market.

Indeed, he says, with government shifting more social services to nonprofits and to firms like his, "we have a responsibility to look at the best way to do it." For The Mentor Network, an infusion of equity capital from a single, like-minded owner would simplify the capital structure enormously. "We are already mostly owned by nonprofit institutions," explains Gillespie, referring to the dozens of college endowment and public pension investment funds that are invested in Madison Dearborn's private-equity fund. Instead of paying dividends to that hodgepodge of "quasi-parent" nonprofits, he says, why not find just one that shares The Mentor Network's mission?

SCALING UP

There is precedent for Gillespie's idea. From museum gift shops to Girl Scout cookies, many nonprofit organizations have profit-making ventures. Increasingly, those ventures are set up to not only generate revenue but also advance their parents' underlying social goals.

To date, The Mentor Network, which provides care and shelter to the developmentally disabled, brain-injured adults, and children at risk for neglect or abuse, has followed a different path. "Social entrepreneurship" is based on the idea that a humanitarian mission is achieved most efficiently if it is supported by scale and a profit motive. "Upstreaming" those profits to a single charitable foundation instead of investors, says Gillespie, would create a "hybrid model" that preserves the business drivers of his company while simultaneously supersizing a practice already common in the nonprofit world.

"We have a number of for-profit subsidiaries," says Frank Gatti, CFO of Educational Testing Services. Best known for offering such academic tests as the SAT, the Princeton, New Jersey-based nonprofit also provides professional licensing exams for architects, financial planners, and others. Those exams don't meet ETS's academic mission, as defined by the Internal Revenue Service, and thus are offered by for-profit subsidiaries.

For any nonprofit buyer of a for-profit enterprise, one key issue is preservation of the nonprofit's precious tax-exempt status. Nonprofits typically must pay unrelated business income (UBI) tax on revenues not directly related to their mission. For example, says Walter Flaherty, CFO of New England Aquarium in Boston, "If the gift shop sells a T-shirt that doesn't have the Aquarium's name on it or a pencil without our logo, we allocate the expenses and create a tax return."

A big question for nonprofits: at what point does such income begin to threaten tax-exempt status? Even for smaller nonprofits, IRS rules are vague. The rule of thumb is that once UBI reaches 15 percent of revenues, a nonprofit should consider setting up a for-profit subsidiary. "The IRS uses revenues as a metric, even if profit is negative or zero," says Gatti. "So the CFO's traditional intuition of materiality doesn't apply."

For Gillespie, of course, for-profit status is less a tax consideration than an essential part of The Mentor Network's business model. But given the size of his firm's revenues, it's not clear what the implications would be for a nonprofit parent. It's likely the parent would need to be massive by nonprofit standards, both to provide the level of investment Gillespie needs and to avoid raising red flags at the IRS.

IRS rules about keeping for-profit subsidiaries at arm's length also are strict, and likely to get stricter as Congress cracks down on abusive use of tax-exempt status. For example, even treasury functions that would be standard at a public company, such as sweeping cash from subsidiaries into a concentration account, are forbidden. "We have to set the whole system up in miniature [for the subsidiary]," says Gatti. Profits can be returned to ETS only in the form of regular dividends.