Are there too many entities in our Not for Profit sector? At over 100,000 for a small country like New Zealand with a population of under 4.5m many people think so. Yet why is it so common that one hears the discussion about setting up another new legal entity?
It happened again today. A meeting with a NFP client, their organisation going well, funding efforts have been successful, to the extent that they are now building up a reasonable asset base. Then comes the conversation: “We are thinking about setting up a separate trust to transfer some of our assets into”. And as an advisor I silently groan inside…
Don’t get me wrong, new entities are not bad per se and there can be many good and valid reasons for establishing them. However I am not convinced that enough critical thought always goes into exploring the reasons and alternative options before making the decision to establish yet another entity. And while this may be considered heresy by many of my peers in the accounting profession and colleagues in the legal profession sadly I believe many accountants and lawyers are often to blame. Self-interest? Possibly. Or perhaps, if I am to be more charitable in my thinking, just not thinking deeply enough about the reasons and laterally enough about possible alternatives.
The Implications of a Separate Legal Entity
We are very lucky to live in a country like New Zealand where thanks to our good system of law it is relatively easy to establish a new legal entity, whether that be a trust, incorporated society or company. Subject to the nature of the entity it is also relatively easy for many NFPs to attain registered charitable status as well. Ironically perhaps it is this fortunate legal environment we live in that by default supports the on-going growth of NFP entities.
Some implications to consider:
Cost: The true cost is commonly underestimated. Often the basic initial set-up can be relatively inexpensive (although sadly this author has also seen some organisations charged extensive and occasionally what appear to be excessive professional fees for the privilege). However once established the on-going implications and effort should not be underestimated. This is both financially, i.e. the annual dollar cost to maintain the legal, accounting and other requirements, as well as the administrative effort that is required to maintain a separate legal entity as regards governance, management and operations.
Economies of Scale: Related to cost is the concept of economies of scale and how effective an entity can be. Every entity takes a certain amount of administration cost and effort to operate and consumes resources to do so. Hence for operating entities, at the smaller entity scale the relativity of the resources consumed compared to outcomes delivered is always poor compared to larger entities where the resources consumed percentage becomes much smaller.
Liability: This should be another concern. While many entities are set up because of their separate legal liability status, ultimately liability generally still tracks back to individuals. Even the limited liability company structure, by some considered the ultimate separate legal entity, still exposes its directors to legal liability issues and its shareholders to loss of their initial investment.
Brand: Yet another entity to confuse the market? There is an argument that the greater the number of entities, the greater the brand confusion, (think cancer charities) and the greater the splitting of available market resources. For example the more charitable entities there are the greater the splitting of the available philanthropic funds.
Bad (?) Reasons
There are some very valid reasons for establishing separate legal entities such as risk mitigation via separating what may be risky trading operations from more passive asset bases. However there are also what I would consider bad reasons.
A common reason provided for wishing to set up a separate legal entity relates to concerns about the perceived ability to attract funding. Take my scenario at the start of this article where the organisation is doing quite well. When pushed further for their main driver, it turns out that it is primarily the perception that if their operating entity looks too well resourced (“too rich” to use their terminology) then they will not be successful with funding applications to grant funding bodies. Hence their desire to “move” some of their assets into another entity and off their balance sheet so they look ‘more needy’.
In my opinion if this is the primary driver then this is not a valid reason due to the following:
- While an entity may be separate for legal purposes this does not automatically mean it will be separate for accounting purposes. Therefore many find out to their dismay after incurring the cost of set-up that they still are required to consolidate the legally separate entities by accounting standards. Hence they have not achieved what they wanted to.
- Many funders are increasingly concerned with the financial health and sustainability of the organisations they fund. This is born out of a concern that the funder wants some assurance that the organisations they fund have enough resources to stay in business and will be able to deliver whatever it is they are being funded for.
- The core issue that needs to be addressed in this circumstance is the better communication of the need for funding rather than trying to obscure the actual financial situation by splitting funds between entities.
Understand why a new entity is needed and ensure there are very valid reasons.
Ensure you have explored other avenues – eg is there already another entity(s) doing what you intend to do? Is the issue really one of better communications and relationships needed with funders?
Let’s ensure we have a strong and effective NFP sector and not just a crowded one with an ever increasing number of entities taking up sector oxygen.