Key Legal Considerations in Nonprofit Spinout Transactions

I. What is a Nonprofit “Spinout”?

A nonprofit “spinout” refers to a transaction where a nonprofit organization sells all or a substantial portion of its assets to a for-profit organization. These transactions typically involve a nonprofit forming a for-profit subsidiary, contributing assets to such subsidiary, and then selling all or a majority stake in the subsidiary.[1]

This article focuses on key legal issues and considerations for transactions where a tax-exempt organization under Section 501(c)(3) of the Internal Revenue Code (the “IRC”) sells a material portion of its assets.

II. Increase in Spinouts.

There are a variety of reasons why a nonprofit may seek to do a spinout:

• The business needs a significant capital infusion that cannot be provided by concessionary capital markets.
• A line of business has become disconnected from the primary charitable purpose of the nonprofit or has become extremely profitable, generating concerns about unrelated business taxable income (“UBTI”) which can jeopardize a nonprofit’s tax exemption.
• The nonprofit operates in an industry and labor market where its inability to offer equity compensation to employees places it at a competitive disadvantage as compared to its for-profit competitors.
• The nonprofit’s leadership wishes to move the nonprofit in a new strategic direction, and needs to raise capital in order to do so.

For these reasons, at Morrison & Foerster we have seen increasing interest in non-profit spinout transactions, including the following transactions where we’ve advised foundations, charities and investors:

• The sale by ACT, Inc., to a new public benefit corporation majority owned by Nexus Capital with ACT, Inc. (now known as IntermediaryEd) holding a minority interest. Intermediary will continue to own a minority interest in the newly formed Delaware public benefit corporation and will use the proceeds from the transaction to continue to support its charitable mission.
• The sale by First Street Foundation of a majority stake in First Street Technology, a climate risk analytics firm, in a transaction valued at $21 million.
• The Ibis Group’s sale of a minority stake in Great Minds, PBC, a leading developer of K-12 curricula to A-Street, in a $150 million transaction.

III. Key Issues and Considerations.

Because of the rules and regulations governing nonprofits, spinouts come with a host of complications that can make structuring and consummating the transaction more complex than a typical M&A deal. Nonprofits enjoy favorable state and federal tax treatment, in exchange for the promotion of a public or charitable purpose. Accordingly, state attorneys general, which are the guardians of charitable assets in their states, have oversight of material transactions that could result in the misuse of charitable assets (for example, the sale of a nonprofit’s assets at below fair market value to an insider of the nonprofit). Additionally, the Internal Revenue Code (the “IRC”), and the implementing regulations that the IRS has promulgated, includes restrictions on the use of charitable assets as well as prohibitions on improper private benefits and self-dealing, in order to ensure that the exemption from federal income tax that nonprofits enjoy is only deployed in service of charitable ends. Flowing from these policies are considerations and risks that must be dealt with in structuring a spinout transaction:

1. Fair value. The nonprofit must receive at least fair market value for all assets and services that are sold to the for-profit, in order to avoid private inurement and private benefit issues. A formal, independent, third-party valuation must be obtained that analyzes the value of the assets that the nonprofit is selling. This enables the nonprofit’s decision makers to confirm the valuation.
2. Form of Consideration. Separately, the nonprofit must  assess what form of consideration it is willing to accept in the transaction (e.g., cash, rollover equity, a note, a license-back, revenue-sharing, or combination thereof, etc.) to make sure that the value of such consideration equals or exceeds the third-party valuation, and meets the needs of the charity after the transaction.
3. Disinterested Decision Makers. The nonprofit should form a special committee of disinterested directors to oversee the conversion with the assistance and input of disinterested executives.  Interested directors and executives should recuse themselves from negotiations on behalf of the nonprofit, and from the board deliberations and voting. Interested directors and executives can still be consulted for their views regarding the transaction but should still recuse themselves in the instances noted above.[2]
4. Attorney General Approval. Advance notice to and approval of the attorneys general in the states where (i) the nonprofit is formed in and (ii) has a significant portion of its operations may be required for any transaction pursuant to which a substantial portion of the assets of the nonprofit are transferred to a for-profit.   Best practices suggest approaching the attorney general early in the transaction (i.e., at the term sheet stage) to confirm acceptability of terms and timing.  Transactions involving health care businesses often have special review requirements.
5. Form of For-Profit.  If the nonprofit will not hold equity in the for-profit following the spinout, the for-profit can be a corporation or LLC. If the nonprofit will hold equity in the for-profit, the for-profit should be structured as a corporation, since an LLC creates several issues for the nonprofit, including UBTI and risk to exemption. Additionally, in such scenario, consider establishing the corporation as a public benefit corporation (a “PBC”) with a stated public benefit substantially aligned with the charitable purpose of the nonprofit prior to the transaction.  In instances where the conversion to a for-profit structure may have potential negative reactions publicly, establishing the for-profit as a PBC will help mitigate against such reactions.
6. Compensation of Disqualified Persons. If “disqualified persons”[3] are being transferred with the assets to the for-profit, the nonprofit must be careful that stock, compensation, and other benefits transferred to “disqualified persons” of the nonprofit do not run afoul of private benefit/private inurement/excess benefit rules.  Disqualified persons are subject to IRS compensation rules for 5 years after he or she has left the nonprofit. If the nonprofit controls the for-profit, then compensation decisions made at the for-profit may be subject to IRS rules and oversight by the nonprofit board for a lookback period of 5 years after the individuals have departed the position at the nonprofit. If the nonprofit holds less than 50% of the equity in the for-profit, there are no restrictions on compensation to members of management at the for-profit, even if they were a disqualified person.
7. Compensation for Management at Closing. The proceeds paid by a buyer or investor is the consideration for the business, which presumably reflects fair market value for what the nonprofit is transferring (i.e., assets, employees, etc.). For disqualified persons to receive part of the consideration is private inurement, which is prohibited by statute. Thus the buyer will be fairly limited in the sale proceeds that can be used to compensate disqualified individuals. However, the nonprofit may pay bonuses to its employees for services to the nonprofit; the nonprofit board would need to define the requirements for a bonus in advance (in terms of benefit to the nonprofit) and then determine whether the bonus is warranted – i.e., these could not be transaction-specific bonuses in the traditional sense, but would need to be tied to total services provided to the nonprofit in the scope of employment, including services provided with respect to the sale.  The bonus cannot be a percentage of the nonprofit’s consideration in the sale, but could be measured in part on the success of the sale, and must be capped to ensure that it is not excessive compensation under the excess benefit rules.
8. Go-forward Role for Nonprofit. After the spinout, the nonprofit can continue to operate as a public charity or transfer sale proceeds to another charity if its operations are to cease. Management of the nonprofit should consider whether the go-forward charity can have activities that support the public charity designation to hold the rollover equity. Alternatively, the charity can contribute sale proceeds to another charity and dissolve. Dissolution may require notice to or consent of an attorney general or a state agency. It is important that management of the nonprofit begin thinking about the future of the nonprofit at an early stage of the proposed transaction, as it will affect the terms of the transaction (e.g., it will impact the assets and personnel that the nonprofit will need to retain or have access to post-spinout).
9. Intercompany Agreements. In connection with the spinout, the nonprofit and for-profit may need to enter into a transition services agreement and other arrangements (e.g., license agreement) to share personnel, intellectual property and other resources in the immediate period post-closing.
10. Negotiations. The nonprofit may consider hiring a temporary consultant to assist with commercial negotiations if the disinterested management team is otherwise not familiar with similar transactions. Conversely, the nonprofit can instead designate a disinterested and knowledgeable board member to lead such negotiations, if they are available to do so.
11. Managing Public Perception. Depending on the stature of the nonprofit and nature of the business being transferred, there may be considerable media and public attention to the transaction. The attorneys general often consider to the impact on public services, benefits, jobs, or consumers in their state, and may be sensitive to anticipated political or public response. Written communications with the attorney general typically are open to the public under state public records laws. The nonprofit should be prepared to address the timing and scope of public disclosure and have a public relations plan ready.