When Should a Not-For-Profit Consider Borrowing?

Not-for-profit organizations rely on cash inflows from general contributions, annual campaigns, fund-raising events, capital campaigns, investment income and operating revenues to pay for normal operations, help maintain an adequate cash balance and enable them to expand and grow. The timing of these cash flows can be a vital factor to an organization’s success, but it does not have to be the deciding factor.

Because of the uncertainty of contributions and limited collateral, many commercial lenders are reluctant to provide loans to not-for-profit organizations. As a result, many not-for-profit organizations never consider borrowing as a part of their financial strategy. But there are many cases in which a not-for-profit would benefit greatly from borrowing. The following lists a few scenarios in which not-for-profits should consider borrowing:

  • To finance the purchase of equipment, especially if the new asset will help to generate future cash flow. Lending institutions can use the equipment as collateral, which will allow the not-for-profit organization to receive lower interest rates.
  • To finance the remodeling construction or purchase of a new building. Commercial banks will often make short-term loans to organizations to help finance such purchases during the construction phase or while waiting to collect on pledges made to a capital campaign. Banks normally require that long-term financing for the building be secured before they will make the loan. Not-for-profits also can obtain long-term financing through various non-bank sources, such as the Rural Economic and Community Development (RECD) program, the Department of Housing and Urban Development (HUD) and loans guaranteed by the Small Business Administration. In addition, many local banks have community lending programs that offer low interest rates or have other structured lending programs for not-for-profit organizations.
  • To cover operating costs during a brief gap while the organization is waiting to receive funding or during a “valley” in the cash flow projection for the year. Not-for-profits often use revolving lines of credit established at local banks for this kind of funding.

How do not-for-profits obtain loans?

Lending institutions have the same lending criteria for not-for-profit organizations as for any other commercial borrower. They require that repayment is assured through a reliable source of funding. Lending institutions often look for the following criteria when considering loan applications:

  • Track record of borrowing
  • Significant, predictable, recurring funding from federal, state or foundation grants
  • Predictable earned revenue stream
  • Major pledges from reputable donors
  • Board members who are willing to guarantee (co-sign) a loan
  • Consistent ability to meet accounts payable and payroll obligations on a timely basis
  • Professional management and record keeping, including reviewed or audited financial statements
  • Good cash flow model

Should you borrow from board members?

Borrowing from board members has its pros and cons. It is easy, often does not require collateral and may at times be forgiven later. However, board members who loan to the organization may feel they should have more “say” in decisions and other board members may subconsciously defer to their opinions. If repayment is not forthcoming, resentment and bad feelings are inevitable. In any case, when loans from board members are considered, proceed with caution and use proper business practices in documenting the agreement, voting on the decision and treating its payback with the same priority as commercial loans.

Should you borrow from internal funds?

Borrowing internally could mean borrowing from investment portfolios or endowments. If the funds are unrestricted, but set aside for board-designated purposes, financial stability or are just excess funds, this may be something to consider. But the decision should take into consideration why the money was set aside in the first place and if “borrowing” it is a wise decision. It is a good idea, regardless of other factors, to Borrowing internally could mean borrowing from investment portfolios or endowments. If the funds are unrestricted, but set aside for board-designated purposes, financial stability or are just excess funds, this may be something to consider. But the decision should take into consideration why the money was set aside in the first place and if “borrowing” it is a wise decision. It is a good idea, regardless of other factors, to treat it like a commercial loan with clear terms and timelines, interest charges at a market rate and plans of how payback will be funded. But the bottom line is whether the organization can afford to permanently redirect the money from the board-designated purpose or long-term reserves for use in current operations. If not, find other sources of funding.

If the funds are permanently restricted endowment funds, this is very risky indeed and not recommended. Many organizational by-laws forbid borrowing restricted funds, and many endowment policies also will not allow it. State law requires investments of an endowment to be “prudent,” so if an organization is thinking of “investing” in its own entity by making a loan from endowment to operations, the decision should be viewed in terms of what a prudent investor would do in like circumstances: knowing the risk involved, taking into consideration how much of the portfolio will be used in this way, what the return will be and how sure the payback will be. The organization should definitely consult with legal counsel. Permanently restricted endowment funds cannot be changed to unrestricted funds so if these funds are not repaid, the organization is legally in trouble. Thus, it may be a good idea for the board to consider putting a clause in its endowment policy that forbids borrowing against the endowment to lessen the temptation for future boards to consider this option.

When there is a legitimate need for it, the use of debt can allow not-for-profit organizations to function more smoothly and not be as reliant upon the timing of its cash flows.

Maxine G. Romano can be reached at Email or 215.441.4600.

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